Diadexus 10Q 2007 Q3 Quarterly report

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

FORM 10-Q

(Mark One)


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

	For the Quarterly Period Ended September 30, 2007

	OR

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

	Commission File Number 0-26483

	VaxGen, Inc. (Exact name of Registrant as Specified in its Charter)


Delaware		94-3236309
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)

349 Oyster Point Boulevard
South San Francisco, California		94080
(Address of Principal Executive Offices)		(Zip Code)

(650) 624-1000 (Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yesx Noo

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

Large accelerated filero Accelerated filerx Non-accelerated filero

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

Yeso Nox

The issuer has one class of common stock with 33,106,523 shares outstanding as of October 31, 2007.

VaxGen, Inc.

Form 10-Q

For the Quarter Ended September 30, 2007

Table of Contents


		Page

Part I	Financial Information
Item 1	Financial Statements (unaudited):
	Condensed Consolidated Balance Sheets	3
	Condensed Consolidated Statements of Operations	4
	Condensed Consolidated Statements of Cash Flows	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Overview	13
	Critical Accounting Policies and Estimates	15
	Results of Operations	15
	Liquidity and Capital Resources	18
Item 3	Quantitative and Qualitative Disclosures About Market Risk	20
Item 4	Controls and Procedures	21

Part II	Other Information
Item 1	Legal Proceedings	26
Item 1A	Risk Factors	26
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	35
Item 3	Defaults Upon Senior Securities	35
Item 4	Submission of Matters to a Vote of Security Holders	35
Item 5	Other Information	35
Item 6	Exhibits	35

	Signatures	35

	Certifications

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

VaxGen, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(in thousands)


	September 30, 2007			December 31, 2006

ASSETS
Current assets:
Cash and cash equivalents:
Cash and commercial paper	$	56,610		$	18,697
Reverse repurchase agreements		—			54,378

Total cash and cash equivalents		56,610			73,075
Investment securities		20,710			24,668
Accounts receivable		—			516
Unbilled accounts receivable		—			7,164
Prepaid expenses and other current assets		2,078			2,828

Total current assets		79,398			108,251
Property and equipment		23,678			28,417
Restricted cash		3,030			2,895
Other assets		1,717			2,497

Total assets	$	107,823		$	142,060

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,363		$	4,660
Accrued and other current liabilities		2,604			5,610
Derivative liability		4,377			8,220

Total current liabilities		9,344			18,490
Convertible senior subordinated notes		30,589			30,321
Deferred rent and other liabilities		4,656			4,188

Total liabilities		44,589			52,999

Contingencies (Note 12)

Stockholders’ equity:
Common stock		331			331
Additional paid-in capital		301,111			299,226
Accumulated deficit		(238,212	)		(210,498	)
Accumulated other comprehensive income		4			2

Total stockholders’ equity		63,234			89,061

Total liabilities and stockholders’ equity	$	107,823		$	142,060

See accompanying notes to condensed consolidated financial statements.

VaxGen, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share data)


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

	2007				2006			2007			2006


Revenues		$	416		$	2,356		$	4,798		$	13,269

Operating expenses:
Research and development			4,125			11,158			16,050			39,128
General and administrative			5,403			6,496			16,778			20,882
Restructuring			1,092			—			5,374			—

Total operating expenses			10,620			17,654			38,202			60,010

Loss from operations			(10,204	)		(15,298	)		(33,404	)		(46,741	)

Other income (expense):
Interest expense			(612	)		(613	)		(1,835	)		(1,857	)
Interest income and other			1,163			981			3,682			1,432
Valuation adjustments			(201	)		(195	)		3,843			(1,658	)
Equity in loss of affiliate			—			—			—			(5,290	)
Gain on foreign currency transactions			—			—			—			4,678
Gain on sale of investment in affiliate			—			—			—			61,198

Total other income, net			350			173			5,690			58,503

Net income (loss)		$	(9,854	)	$	(15,125	)	$	(27,714	)	$	11,762

Basic net income (loss) per share		$	(0.30	)	$	(0.46	)	$	(0.84	)	$	0.36

Diluted net income (loss) per share		$	(0.30	)	$	(0.46	)	$	(0.84	)	$	0.36

Weighted average shares used in computing basic net income (loss) per share			33,107			33,107			33,107			32,594

Shares used in computing diluted net income (loss) per share			33,107			33,107			33,107			32,761

See accompanying notes to condensed consolidated financial statements.

VaxGen, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)


	Nine Months Ended September 30,

	2007			2006

Cash flows from operating activities:
Net income (loss)	$	(27,714	)	$	11,762
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Gain on sale of investment in affiliate		—			(61,198	)
Gain on foreign currency transactions		—			(4,678	)
Equity in loss of affiliate		—			5,290
Valuation adjustments		(3,843	)		1,658
Depreciation and amortization		4,606			4,665
Stock-based compensation		1,885			2,434
Amortization of premiums and discounts on investment securities		(988	)		(27	)
Non-cash interest expense		535			532
Changes in assets and liabilities:
Receivables		7,907			(5,502	)
Prepaid expenses and other current assets		891			(1,295	)
Accounts payable		(2,297	)		(5,796	)
Accrued and other current liabilities		(508	)		(7,029	)
Other		620			1,612

Net cash used in operating activities		(18,906	)		(57,572	)

Cash flows from investing activities:
Purchase of property and equipment		(19	)		(2,316	)
Proceeds (fees) from sale of investment in affiliate, net		(2,441	)		76,472
Proceeds from sale and maturities of investment securities		51,074			12,532
Purchases of investment securities		(46,126	)		(11,237	)
Other		(47	)		654

Net cash provided by (used in) investing activities		2,441			76,105

Cash flows from financing activities:
Proceeds from private placements, net		—			25,226
Other		—			(177	)

Net cash provided by financing activities		—			25,049

(Decrease) increase in cash and cash equivalents		(16,465	)		43,582
Cash and cash equivalents at beginning of period		73,075			4,560

Cash and cash equivalents at end of period	$	56,610		$	48,142

See accompanying notes to condensed consolidated financial statements.

VaxGen, Inc.
Notes to Condensed Consolidated Financial Statements


1.	Organization

Nature of Business Activities

VaxGen, Inc., or VaxGen, is a biopharmaceutical company focused on the development, manufacture and commercialization of biologic products for the prevention and treatment of human infectious disease.

VaxGen was incorporated on November 27, 1995. During 2002 through 2006, VaxGen developed vaccines against inhalation anthrax and smallpox for the purpose of biodefense. In December 2006, the Department of Health and Human Services, or HHS, terminated its contract with VaxGen related to the development and delivery of a next-generation anthrax vaccine. Following the HHS decision, VaxGen ceased actively developing its anthrax vaccine, scaled back its biodefense activities and began pursuing strategic and other alternatives.

Through March 31, 2007, VaxGen’s principal source of revenue has been the U.S. government, principally the National Institutes of Health, or NIH, and related entities. Since April 1, 2007, VaxGen’s principal source of revenue has been Celltrion, Inc., or Celltrion, a company developing and operating a mammalian cell culture biomanufacturing facility in the Republic of Korea.

VaxGen’s activities involve inherent risks. These risks include, but are not limited to, the possibility that internal controls are not or will not be adequate to ensure timely and reliable financial information, the risk that VaxGen may not be able to raise additional capital, the risk that VaxGen may fail to identify a strategic option that is attractive and the risk that VaxGen may be unable to commercialize any product candidates it may identify.

Delisting from the Nasdaq National Market

As a result of VaxGen’s inability to timely file financial statements with the Securities and Exchange Commission, or SEC, it was delisted effective August 9, 2004 from the Nasdaq National Market, now the Nasdaq Global Market, or Nasdaq. Since that time, VaxGen’s common stock has traded over the counter, or OTC, and has been quoted on the Pink Sheets LLC under the symbol, VXGN.PK. VaxGen became current in its filing of reports with the SEC on October 4, 2007.

Basis of Presentation

The unaudited condensed consolidated financial statements of VaxGen and its subsidiaries, collectively referred to as the Company, included herein have been prepared pursuant to the rules and regulations of the SEC. All intercompany accounts and transactions have been eliminated in consolidation.

Certain information or footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States of America, or GAAP, have been condensed or omitted pursuant to such rules and regulations. In the opinion of the Company’s management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair statement of the unaudited condensed consolidated financial information included herein. While VaxGen believes that the disclosures are adequate to make the information not misleading, these unaudited condensed consolidated financial statements should be read in conjunction with VaxGen’s audited financial statements contained in its Annual Report on Form 10-K for the year ended December 31, 2006.

The results of operations for the nine month period ended September 30, 2007 are not necessarily indicative of the operating results for the full year. The preparation of financial statements in conformity with GAAP requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. While management believes its estimates, judgments and assumptions are reasonable, the inherent nature of estimates is that actual results will likely be different from the estimates made.

For the six months ended June 30, 2006, VaxGen’s investment in Celltrion was accounted for under the equity method. During 2006, VaxGen sold substantially all of its Celltrion common stock. Accordingly, VaxGen no longer had the ability to exercise significant influence over operating and financial policies of Celltrion, and as of July 1, 2006, VaxGen accounted for its investment in Celltrion under the cost method. At September 30, 2006, VaxGen’s ownership interest in Celltrion was 8%. At December 31, 2006 and September 30, 2007, VaxGen held a nominal ownership interest in Celltrion.


2.	Summary of Significant Accounting Policies

The Company’s significant accounting policies are disclosed in the Company’s annual report of Form 10-K for the year ended December 31, 2006 and have not changed significantly as of September 30, 2007, with the exception of the following:

Accounting Principles Recently Adopted

In July 2006, the Financial Accounting Standards Board, or FASB, issued FIN 48,Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, or FIN 48, which clarifies the accounting for uncertainty in tax positions. FIN 48 requires that the Company recognize in its financial statements the impact of a tax position if that position is more likely than not of being sustained upon audit, based on the technical merits of the position. FIN 48 is effective for fiscal years beginning after December 15, 2006 which is the beginning of the Company’s fiscal 2007. The Company’s unaudited consolidated financial statements have not been materially impacted by the adoption of FIN 48 as of January 1, 2007. In May 2007, the FASB issued FSP No. FIN 48-1, Definition of ‘Settlement’ in FASB Interpretation No. 48,or FIN 48-1. FIN 48-1 provides guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. The adoption of FIN 48-1 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows. See Note 9, Income Taxes, for further details of the impact of adoption.

In December 2006, the FASB issued FASB Staff Position EITF 00-19-2,Accounting for Registration Payment Arrangements, or FSP 00-19-2, which provides guidance on accounting for registration payment arrangements. FSP 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB Statement No. 5,Accounting for Contingencies. FSP 00-19-2 is required to be applied to reporting periods beginning after December 15, 2006. The Company adopted the disclosure requirements of FSP 00-19-2 as of January 1, 2007. The Company’s previous accounting for registration payment arrangements in connection with its 5 1/2% Convertible Senior Subordinated Notes, due April 1, 2010, or Notes, as well as shares issued or issuable in private placements of its common stock, or collectively Issuable Shares, was already in compliance with FSP 00-19-2.

Accounting Principles Not Yet Adopted

In September 2006, the FASB issued FAS No. 157,Fair Value Measurement,or FAS 157. FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company is evaluating the impact of adopting FAS 157 on the Company’s consolidated financial position, results of operations and cash flows.

In February 2007, the FASB issued FAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115, or FAS 159, which permits all entities to choose to measure eligible items, including many financial instruments, at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. Most of the provisions in FAS 159 are elective; however, the amendment to FAS No. 115,Accounting for Certain Investments in Debt and Equity Securities,applies to all entities with available-for-sale and trading securities. FAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is evaluating the impact of adopting FAS 159 on its consolidated financial position, results of operations and cash flows.

In June 2007, the Emerging Issues Task Force, or EITF, published Issue No. 07-3,Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities, or EITF 07-3. The EITF reached a consensus that these payments made by an entity to third parties should be deferred and capitalized. Such amounts should be recognized as an expense as the related goods are delivered or the related services are performed. Entities should report the effects of applying this Issue as a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. EITF 07-3 is effective beginning on January 1, 2008. Earlier application is not permitted. The Company does not expect that adoption of EITF 07-3 will have a material effect on its financial position or results of operations.


3.	Net Income (Loss) per Share

Basic net income (loss) per share is calculated based on net income (loss) and the weighted-average number of shares of common stock outstanding during the reported period. Diluted net income (loss) per share is calculated by increasing the weighted-average number of common shares outstanding during the period- if not anti-dilutive- by the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of potential common stock (including outstanding stock options, common stock warrants and convertible senior subordinated debt) is reflected in diluted net income per share by application of the treasury stock method, which includes consideration of share-based compensation as required by FAS 123R in the three and nine months ended September 30, 2007.

A reconciliation of weighted-average basic shares outstanding to weighted-average diluted shares outstanding follows (in thousands):


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

	2007		2006		2007		2006


Weighted-average number of common shares outstanding used in computing basic net income (loss) per share		33,107		33,107		33,107		32,594
Dilutive potential common shares used in computing diluted net income (loss) per share		—		—		—		167

Total weighted-average number of shares used in computing diluted net income (loss) per share		33,107		33,107		33,107		32,761

Basic net loss per share is computed as net income (loss) divided by the weighted average number of common shares outstanding for the period. For all periods presented, the following potential common shares were excluded from the computation of diluted net income (loss) per share, as their effect was antidilutive (in thousands):


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

	2007		2006		2007		2006


Options to purchase common stock		5,552		4,399		5,552		3,604
Warrants to purchase common stock		2,320		2,009		2,320		2,009
Convertible senior subordinated notes		2,134		2,134		2,134		2,134

Total		10,006		8,542		10,006		7,747


4.	Comprehensive Income (Loss)

Comprehensive income (loss) combines net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) represents certain amounts that are reported as components of stockholders’ equity in the consolidated balance sheet, including foreign currency translation adjustments and unrealized gains or losses on investment securities. The Company’s comprehensive income (loss) consists of the following (in thousands):


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

	2007				2006				2007			2006


Net income (loss)	$	(9,854		)	$	(15,125		)	$	(27,714	)	$	11,762
Foreign currency translation adjustments			—				—			—			(3,326	)
Unrealized gains on investment securities			1				(6	)		2			67

Comprehensive income (loss)	$		(9,853	)	$		(15,131	)	$	(27,712	)	$	8,503


5.	Accrued and Other Current Liabilities

The Company’s accrued and other current liabilities consist of the following (in thousands):


	September 30, 2007			December 31, 2006

Employment benefits		$	620	$	2,049
Restructuring			952		—
Income taxes			60		1,210
Clinical trial expenses			—		931
Interest			866		433
Other			106		987

		$	2,604	$	5,610


6.	Contract Changes and Restructuring

Anthrax Contract

In September 2002, the Company was awarded a $20.9 million cost-plus contract, or 2002 Anthrax Contract, from the National Institute of Allergy and Infectious Diseases, or NIAID, to develop a new anthrax vaccine candidate and to create a feasibility plan for how the Company would manufacture an emergency stockpile of 25 million doses of the vaccine. On September 30, 2003, NIAID awarded the Company a second cost-plus contract valued at $80.3 million for the advanced development of the Company’s anthrax vaccine candidate.

In November 2004, the Company was awarded a contract for $877.5 million to provide 75 million doses of its recombinant anthrax vaccine, or rPA102, to the U.S. government Strategic National Stockpile, or SNS, for civilian defense, or SNS Contract. In November 2006, VaxGen received a clinical hold notification from the Food and Drug Administration that postponed the initiation of the second Phase 2 trial for rPA102. On December 19, 2006, HHS terminated for default the SNS Contract. HHS based the decision on its determination that VaxGen “failed to successfully cure the condition endangering performance and failed to” meet a milestone imposed by HHS that required VaxGen to initiate the Phase 2 trial of the vaccine candidate by December 18, 2006.

On April 3, 2007, the Company entered into a settlement agreement with HHS. In accordance with the agreement, the parties terminated the remaining cost-plus contract related to the development of a next-generation anthrax vaccine through a separate contract modification. As part of the settlement agreement, NIAID paid the Company $11.0 million. The settlement agreement also released both parties of all liabilities associated with the Company’s three government anthrax contracts: the 2002 Anthrax Contract, the 2003 Anthrax Contract and the SNS Contract. As part of the settlement agreement, the parties converted the termination of the SNS Contract, which HHS terminated for default on December 19, 2006, to a termination for convenience and also terminated the 2003 Anthrax Contract under a bilateral contract modification for the convenience of the government on a no-cost basis. During the nine months ended September 30, 2007, the Company recorded the $11.0 million settlement as a collection of $7.1 million of 2006 receivables and $3.9 million of 2007 receivables. The $3.9 million was recorded as revenue during the three months ended March 31, 2007 primarily for the reimbursement of restructuring costs incurred as a result of the termination of the contracts.

Smallpox

In June 2007, the Company and the Chemo-Sero-Therapeutic Research Institute of Japan, or Kaketsuken, terminated by mutual consent their agreement to co-develop a next-generation, attenuated smallpox vaccine, LC16m8, for use in the United States and elsewhere. Under the terms of the termination agreement, VaxGen will transfer to Kaketsuken or its designee all reports, data and materials and all intellectual property rights that relate to conducting non-clinical and clinical development of LC16m8 in the U.S. In return, Kaketsuken has released VaxGen from all ongoing obligations.

Restructurings

In January 2007, the Company restructured operations to significantly reduce operating costs and announced it was actively pursuing avenues to enhance stockholder value through a strategic transaction. The Company incurred restructuring costs associated with this plan of $2.6 million for employee termination benefits, $0.1 million related to the acceleration of stock options and $1.0 million of costs associated with the consolidation of its facilities in California. The majority of these costs were recovered from the U.S. government as part of the April 2007 settlement agreement. In May and September 2007, the Company further reduced its workforce to decrease operating costs. Restructuring costs relating to the May and September 2007 workforce reductions included employee termination and benefit costs.

All restructuring costs are expected to be paid by December 31, 2008. At September 30, 2007, $1.0 million of these costs were unpaid, included in accrued and other current liabilities and include the following:


	Balance as of December 31, 2006		Costs Incurred		Amounts Paid			Balance as of March 31, 2007

Workforce reduction	$	—	$	2,642	$	(2,070	)	$	572
Consolidation of excess facilities and other		—		1,006		(746	)		260

Total	$	—	$	3,648	$	(2,816	)	$	832


	Balance as of March 31, 2007		Costs Incurred		Amounts Paid			Balance as of June 30, 2007

Workforce reduction	$	572	$	566	$	(695	)	$	443
Consolidation of excess facilities and other		260		—		(260	)		—

Total	$	832	$	566	$	(955	)	$	443


	Balance as of June 30, 2007		Costs Incurred		Amounts Paid			Balance as of Sep. 30, 2007

Workforce reduction	$	443	$	1,092	$	(583	)	$	952


7.	Private Placement Warrants

In February 2006, VaxGen raised net proceeds of $25.2 million through a private placement to a group of accredited institutional investors. In connection with this financing, VaxGen issued to the investors five-year warrants initially exercisable to purchase 699,996 shares of common stock at an exercise price of $9.24 per share. Because VaxGen did not file all of its delinquent periodic reports with the SEC by September 30, 2006, the warrants became exercisable for an additional 349,994 shares of common stock, at a price of $9.24 per share. Because VaxGen again did not file all of its delinquent periodic reports with the SEC by January 31, 2007, the warrants became exercisable for an additional 349,994 shares of common stock, at a price of $9.24 per share.


8.	Executive Officer Compensation

In February 2007, the Board of Directors granted to executive officers options for 1,590,000 shares and implemented an option exchange program allowing executive officers to exchange old options for 714,700 shares for new options for 178,675 shares. All of the options were granted effective February 12, 2007 with an exercise price of $2.23 per share, the closing market price of one share of the Company’s common stock on that date. Each option will vest monthly on a pro-rata basis over one to four years. The Board also approved two potential retention bonus payments. During the three months ended September 30, 2007, the aggregate first retention bonus payment of $0.3 million was made to the executives who remained regular full-time employees in good standing through June 30, 2007. Additionally, a second cash bonus payment of the same amount will be made, conditioned upon certain terms, including that the executive remain a regular full-time employee in good standing through the completion of a strategic transaction.


9.	Income Taxes

The Company accounts for income taxes using an asset and liability approach, which requires the recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. Deferred income tax assets and liabilities are determined based upon the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates. A valuation allowance is provided on deferred tax assets if it is determined that it is more likely than not that the asset will not be realized.

The Company adopted FIN 48 on January 1, 2007 and in so doing, has analyzed filing positions in all of the federal and state jurisdictions where it is required to file income tax returns, as well as all open tax years in these jurisdictions. The implementation of FIN 48 did not have a material impact on the condensed consolidated financial statements and did not require an adjustment to accumulated deficit. The Company has an unrecognized tax benefit of approximately $1.2 million, which did not change significantly during the three or nine months ended September 30, 2007. If recognized, there would be no impact to the 2007 effective income tax rate due to the existence of the valuation allowance. In addition, future changes to the unrecognized tax benefits will have no impact on the effective tax rate to the extent that a valuation allowance exists.

Under special IRS rules, or Section 382 Limitation, cumulative stock purchases by material shareholders exceeding 50% during a 3-year period can potentially limit a company’s future use of net operating losses, or NOL’s. Under current tax rules, any Section 382 Limitation is not expected to significantly impact the recorded value or timing of utilization of the Company’s NOL’s.

The Company’s policy is to classify and accrue interest expense and penalties on income tax underpayments (overpayments) as other expense in its condensed consolidated statement of operations. The amount of unrecognized tax related interest expense and penalties at January 1, 2007 was zero. The Company did not incur any income tax related interest income, interest expense or penalties for the three or nine months ended September 30, 2007.

As a result of significant changes to its financial statements, the Company has amended its U.S. federal and state returns for the tax years ended December 31, 2002 through 2005. These amendments will have no impact on the effective tax rate due to the existence of the valuation allowance. The Company’s U.S. tax returns for 2002 and subsequent years remain subject to examination by tax authorities. The Company is also subject to examination in various state jurisdictions for 2002 and subsequent years.


10.	Stock-Based Compensation

The impact on consolidated results of operations of recording stock-based compensation for the three and nine months ended September 30, 2007 and 2006 was as follows (in thousands):


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

	2007		2006		2007		2006

Research and development	$	162	$	407	$	883	$	1,627
General and administrative		187		261		1,002		807

Total stock-based compensation	$	349	$	668	$	1,885	$	2,434


11.	Celltrion

VaxGen provides services to assist Celltrion with its operations under a Technical Support and Services Sub-Agreement. VaxGen is paid for out-of-pocket expenses and services rendered. VaxGen recognized $0.2 million and $0.3 million of revenue from Celltrion during the three months ended September 30, 2007 and 2006, respectively; and $0.7 million and $1.3 million of revenue from Celltrion during the nine months ended September 30, 2007 and 2006, respectively.

In February 2006, Celltrion and VaxGen entered into an agreement, or Agreement to Provide U.S. GAAP Financial Information, whereby Celltrion agreed to use its best efforts to timely prepare annual and quarterly financial statements in accordance with U.S. GAAP. Under the agreement, VaxGen agreed to reimburse Celltrion for all invoiced costs of its independent accountants relating to the preparation of U.S. GAAP financial statements as well as all invoiced costs of audits and reviews performed by another independent registered public accounting firm. In addition, VaxGen agreed to compensate Celltrion for the cost of internal resources utilized in support of these activities at a rate of 190% of the employee’s hourly wage; such costs shall not exceed the U.S. dollar equivalent of 300 million Korean Won (equivalent to $0.3 million at the exchange rate on September 30, 2007) per year and shall be subject to VaxGen’s approval. In March 2007, Celltrion and VaxGen amended the Technical Support and Services Sub-Agreement as well as the Agreement to Provide U.S. GAAP Financial Information to reflect a reduction in overhead rate on services performed from 90% to 40%. During the three and nine months ended September 30, 2007, the Company incurred zero and $1.2 million of expenses under these agreements, respectively. During the three and nine months ended September 30, 2006, the Company incurred $0.5 million and $1.9 million of expenses under these agreements, respectively.

VaxGen provided mammalian cell culture technology and biologics production expertise as its 2002 investment in Celltrion. VaxGen’s proportionate share of the investee’s undistributed losses was recorded as equity in loss of affiliate through July 1, 2006. Summarized selected financial information for the six months ended June 30, 2006, while the Company’s investment in Celltrion was accounted for under the equity method, was as follows (in thousands):


Operating expenses	$	22,953

Loss from operations		(22,953	)
Other expense		(2,825	)

Net loss	$	(25,778	)

In 2007, the Company paid the final $2.4 million in fees due from the 2006 sale of substantially all of its remaining Celltrion common stock.


12.	Contingencies

If an executive officer’s employment with VaxGen is terminated without cause, or the executive resigns due to good reasons, as defined in their employment agreements, the executive would be entitled to receive as severance 12 months of their base salary and all of their outstanding unvested stock options would be accelerated and become immediately exercisable. If this occurs within 13 months of a change of control, as defined in their agreements, the executive will also be eligible to receive a bonus payment equal to up to 30 percent of his salary on a prorated basis. As of September 30, 2007, the aggregate salary and bonus obligations under these circumstances would be $1.5 million.

On October 5, 2007, or Filing Date, the Company filed with the SEC a registration statement, or Registration Statement, under the Securities Exchange Act of 1933, as amended, or Securities Act, with respect to the Issuable Shares. The Company has agreed to use its best efforts to cause the Registration Statement to become effective on or before the date that is the earlier of (1) in the event of no review by the SEC no later than 90 days after the Filing Date, (2) in the event of a review by the SEC, no later than 120 days after the Filing Date, the earlier of (1) and (2) is referred to as the Required Effective Date.

In the event of a default, the Company is required to pay as liquidated damages, for each 30-day period of a default, an amount in cash equal to 1% of the principal amount of the purchase price of the 2006 private placement until the applicable failure has been cured. The Company considers the likelihood of becoming obligated for such liquidated damages to be remote and accordingly no provision for their payment has been recorded. Should the Company become obligated to make payment of these liquidated damages, it could have a material adverse effect on its financial position and results of operations, particularly if the Company becomes obligated to make a payment in full for all liquidated damages potentially due and payable under these agreements.

The Company’s obligation to maintain the effectiveness of the Registration Statement ends upon the earlier to occur of (i) two years from the date of effectiveness of the Registration Statement, (ii) the date when all holders of Issuable Shares are eligible to sell such securities under Rule 144(k) promulgated under the Securities Act, (iii) the date when all securities registered under the Registration Statement have been sold and (iv) the date when all securities registered under the Registration Statement cease to be outstanding. The Company estimates that the maximum monthly amount of consideration that the Company could be required to pay as liquidated damages under these registration payment obligations is $0.3 million.


13.	Segment Information

Since July 1, 2005, the Company has operated in one business segment, the development of vaccines that immunize against infectious disease. All of VaxGen’s operating assets are located in the United States of America. Substantially all of VaxGen’s revenue has been derived from federal government contracts and grants, primarily from HHS, NIH and related entities.


14.	Subsequent Event

On October 11, 2007, the Company amended its lease agreement, dated October 26, 1998, or Lease Amendment. The Lease Amendment calls for the Company to relinquish occupancy of one of its two buildings subject to the lease, effective March 1, 2008. The Lease Amendment will reduce the Company’s lease obligations by $12 million over the remaining lease term, which runs through December 31, 2016. The Company paid a surrender fee to the landlord of $0.1 million. Under the Lease Amendment, the amount of the $2.35 million letter of credit delivered by the Company in favor of the landlord will be reduced by $0.95 million, with further reductions over the remaining term of the lease upon the achievement of financial benchmarks by the Company.

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

SpecialNoteRegardingForward-LookingStatements

This discussion and analysis should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2006, and our unaudited condensed consolidated financial statements and related notes thereto appearing in Item 1 of this Quarterly Report on Form 10-Q. In addition to the other information contained or incorporated by reference in this Quarterly Report on Form 10-Q, you should carefully consider the risk factors described in Part II – Item 1A herein when evaluating an investment in our common stock. This Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, or Securities Act, and Section 21E of the Securities Exchange Act of 1934, or Exchange Act. All statements other than statements of historical fact are “forward-looking statements” for purposes of these provisions, including any statements of the plans and objectives of management for future operations, any statements regarding future operations, any statements concerning proposed new products or services, any statements regarding pending or future mergers or acquisitions, any statements regarding future economic conditions or performance, and any statement of assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expects,” “plans,” “anticipates,” “estimates,” “potential” or “continue” or the negative thereof or other comparable terminology.

There can be no assurance that such expectations or any of the forward-looking statements will prove to be correct, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our forward-looking statements are subject to inherent risks and uncertainties including, but not limited to, the risk factors set forth in this Quarterly Report. Factors that could cause or contribute to such differences include, but are not limited to, our limited cash resources, our ability to finance our research, our significant corporate and Securities and Exchange Commission, or SEC, related expenses and limited revenue to offset these expenses, availability of appropriate prospective acquisitions or investment opportunities, litigation and the risks discussed in our other SEC filings. All forward-looking statements and reasons why results may differ included in this Quarterly Report are made as of the date hereof, and we assume no obligation to update any such forward-looking statement or reason why actual results might differ. When used in the report, unless otherwise indicated, “we,” “our” and “us” refers to VaxGen.

OVERVIEW

We are a biopharmaceutical company focused on the development, manufacture and commercialization of biologic products for the prevention and treatment of human infectious disease. We were incorporated in 1995 and formed to complete the development of an investigational recombinant protein vaccine intended to prevent infection by human immunodeficiency virus. In 2002, we broadened our product development portfolio to also include biodefense vaccines.

On August 6, 2004, we announced that we had received notification from Nasdaq that our stock would discontinue trading on Nasdaq effective August 9, 2004. This action followed our appeal to Nasdaq for a listing extension after not meeting the stated time requirements to file Quarterly Reports on Form 10-Q for the quarters ended March 31 and June 30, 2004, respectively. We became current again in our filing of reports with the SEC on October 4, 2007. Our common stock is currently quoted on the OTC Pink Sheets under the symbol VXGN.PK.

In September 2002, we were awarded a $20.9 million cost-plus contract, or 2002 Anthrax Contract, from the National Institute of Allergy and Infectious Diseases, or NIAID, to develop a new anthrax vaccine candidate and to create a feasibility plan for how we would manufacture an emergency stockpile of 25 million doses of the vaccine. On September 30, 2003, NIAID awarded us a second cost-plus contract, or 2003 Anthrax Contract, valued at $80.3 million for the advanced development of our anthrax vaccine candidate, collectively referred to as Anthrax Contracts.

In November 2004, we were awarded a contract for $877.5 million to provide 75 million doses of our recombinant anthrax vaccine, or rPA102, to the U.S. government Strategic National Stockpile, or SNS, for civilian defense, or SNS Contract. In November 2006, we received a clinical hold notification from the Food and Drug Administration, or FDA, that postponed the initiation of the second Phase 2 trial for rPA102. On December 19, 2006, the U.S. Department of Health and Human Services, or HHS, terminated for default the SNS Contract. HHS based the decision on its determination that we “failed to successfully cure the condition endangering performance and failed to” meet a milestone imposed by HHS that required us to initiate a clinical trial of the vaccine candidate by December 18, 2006. Following the HHS decision, we ceased actively developing rPA102, scaled back our biodefense activities and are actively pursuing strategic and other alternatives.

In December 2006, we announced the termination of the SNS Contract by HHS. As a result, we implemented a reduction in force, or RIF, in January 2007. The cash outflow of the January RIF was $2.8 million and $0.5 million during the three months ended March 31, 2007 and June 30, 2007, respectively, and $0.3 million thereafter. Beginning in April 2007, wage savings per month were $0.7 million and $0.2 million, respectively, for Research and Development, or R&D, and General and Administrative, or G&A. In addition, we did not renew an office space lease that expired at the end of May 2007. This lease, coupled with utilities and maintenance, reduced future expenses by $0.2 million per month.

In May 2007, we further reduced our workforce to decrease operating costs. The cash outflow of this RIF was $0.4 million during the three months ended June 30, 2007 and $0.2 million thereafter. This RIF mostly impacted R&D. Beginning in July 2007, additional wage savings were $0.1 million per month. The RIFs in January 2007 and May 2007 have reduced our cash disbursements by approximately $1.2 million to $1.4 million per month since June 30, 2007. We do not expect these savings to be materially offset by any anticipated increases in other expenses.

In June 2007, we terminated by mutual consent our agreement with the Chemo-Sero-Therapeutic Research Institute of Japan, or Kaketsuken, to co-develop a next-generation, attenuated smallpox vaccine, LC16m8, for use in the United States and elsewhere. Under the terms of the termination agreement, we transferred to Kaketsuken or its designee all reports, data and materials and all intellectual property rights that relate to conducting non-clinical and clinical development of LC16m8 in the U.S. In return, Kaketsuken has released us from all ongoing obligations.

In September 2007, we further reduced our workforce to decrease operating costs. Restructuring costs included employee termination and benefit costs. Estimated costs of the restructuring are $1.1 million. The cash outflow of this RIF was $0.3 million during the three months ended September 30, 2007 and is expected to be $0.6 million and $0.2 million during the three months ended December 31, 2007 and thereafter, respectively. Beginning in October 2007, additional expected wage savings are $0.3 million per month. We do not expect these savings to be materially offset by any anticipated increases in other expenses.

On October 11, 2007, we amended our lease agreement, dated October 26, 1998, or Lease Amendment. The Lease Amendment calls for us to relinquish occupancy of one of our two buildings subject to the lease, effective March 1, 2008. The Lease Amendment will reduce our lease obligations by $12 million over the remaining lease term, which runs through December 31, 2016. We paid a surrender fee to the landlord of $0.1 million. Under the Lease Amendment, the amount of the $2.35 million letter of credit we delivered in favor of the landlord will be reduced by $0.95 million, with further reductions over the remaining term of the lease upon our achievement of financial benchmarks.

Celltrion

For the six months ended June 30, 2006, our investment in Celltrion, Inc., or Celltrion, a company developing and operating a mammalian cell culture biomanufacturing facility in the Republic of Korea, was accounted for under the equity method. At June 30, 2006, our ownership interest in Celltrion was 8%. During June and December 2006, we received gross proceeds of $130.3 million from the sale of substantially all of our Celltrion common stock. At December 31, 2006 and September 30, 2007, we held a nominal ownership interest in Celltrion.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Reference should be made to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, filed with the SEC in August 2007, for a description of our critical accounting policies. There have been no significant changes to our policies since we filed that report other than our adoption of FIN 48,Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, or FIN 48 and FSP No. FIN 48-1, Definition of ‘Settlement’ in FASB Interpretation No. 48,or FIN 48-1.

Effective January 1, 2007, we adopted FIN 48 and FIN 48-1; see Note 9. We have filed tax returns with positions that may be challenged by the tax authorities. These positions relate to, among others, deductibility of certain expenses, expenses included in our research and development tax credit computations, as well as other matters. Although the outcome of tax audits is uncertain, in management’s opinion, adequate provisions for income taxes have been made for potential liabilities resulting from such matters. We regularly assess the tax positions for such matters and include reserves for those differences in position. The reserves are utilized or reversed once the statute of limitations has expired and/or at the conclusion of the tax examination. We believe that the ultimate outcome of these matters will not have a material impact on our financial position, financial operations or liquidity.

In December 2006, the FASB issued FASB Staff Position EITF 00-19-2,Accounting for Registration Payment Arrangements, or FSP 00-19-2, which provides guidance on accounting for registration payment arrangements. FSP 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB Statement No. 5,Accounting for Contingencies. FSP 00-19-2 is required to be applied to reporting periods beginning after December 15, 2006. We adopted FSP 00-19-2 as of January 1, 2007. Our previous accounting for registration payment arrangements in connection with our 5 1/2% Convertible Senior Subordinated Notes, due April 1, 2010, or Notes, as well as shares issued or issuable in private placements of our common stock, or collectively Issuable Shares, was already in compliance with FSP 00-19-2.

RESULTS OF OPERATIONS

Comparison of Fiscal Quarters and Nine Months Ended September 30, 2007 and 2006

Revenues


	Three Months Ended September 30,				Percent change 2007/2006	Nine Months Ended September 30,				Percent change 2007/2006

	2007		2006			2007		2006

	(in thousands)					(in thousands)
Revenues	$	416	$	2,356	(82)%	$	4,798	$	13,269	(64)%

Revenues prior to March 31, 2007 were primarily from our Anthrax Contracts principally reflecting work performed for NIAID and the reimbursement of restructuring costs incurred as a result of the termination of the Anthrax Contracts in December 2006. In 2007, NIAID-related activities decreased from the comparable period in the prior year as our work on the Anthrax contract ended in December 2006 and revenue for the three months ended March 31, 2007 was primarily related to the government’s reimbursement of our January 2007 restructuring costs incurred as a result of the termination of the contracts. Services revenues were also earned as part of a consulting services agreement with Celltrion to provide technical assistance related to the design, engineering and construction of Celltrion’s manufacturing facility. VaxGen recognized $0.2 million and $0.3 million of revenue from Celltrion during the three months ended September 30, 2007 and 2006, respectively; and $0.7 million and $1.3 million of revenue from Celltrion during the nine months ended September 30, 2007 and 2006, respectively. The amounts earned vary with the level of services required. VaxGen also recognized $0.2 million of revenue from the sale of miscellaneous manufacturing by-products during the three months ended September 30, 2007.

Revenues earned in one period are not indicative of revenues to be earned in future periods. Following the HHS decision, we ceased actively developing our anthrax vaccine, scaled back our biodefense activities and are actively pursuing strategic and other alternatives; therefore, we expect revenues for the three months ended December 31, 2007 to primarily include revenues from Celltrion, which are not expected to be significant.

Research and development expenses


	Three Months Ended September 30,				Percent change 2007/2006	Nine Months Ended September 30,				Percent change 2007/2006

	2007		2006			2007		2006

	(in thousands)					(in thousands)
Research and development expenses	$	4,125	$	11,158	(63)%	$	16,050	$	39,128	(59)%

Research expenses, which are currently general facility maintenance in nature, include the costs of internal personnel, outside contractors, allocated overhead and laboratory supplies. The decrease in research and development expenses in the three months ended September 30, 2007 over the comparable period in 2006 was primarily due to:


	•	Facilities and other overhead costs, including allocations from general and administrative expense, which decreased by $4.6 million due to changes in the relative headcounts by department and reduced spending;

	•	Outside consultant expenses, which decreased by $1.4 million primarily due to reduced activities related to our Anthrax Contracts; and

	•	Labor and benefits, which decreased by $1.0 million primarily associated with the reductions in force in January and May 2007 as a result of overall reductions in activities related to our Anthrax Contracts.

The decrease in research and development expenses in the nine months ended September 30, 2007 over the comparable period in 2006 was primarily due to:


	•	Labor and benefits, which decreased by $8.6 million primarily associated with the reductions in force in January and May 2007 as a result of overall reductions in activities related to our Anthrax Contracts;

	•	Facilities and other overhead costs, including allocations from general and administrative expense, which decreased by $8.4 million due to changes in the relative headcounts by department and reduced spending; and

	•	Outside consultant expenses, which decreased by $6.1 million primarily due to reduced activities related to our Anthrax Contracts.

The process of conducting preclinical studies and clinical trials necessary to obtain FDA approval is costly and time consuming. The probability of success for each product candidate and clinical trial may be affected by a variety of factors, including, among others, the quality of product candidate early clinical data, investment in the program, competition, manufacturing capabilities and commercial viability. Development timelines, probability of success and development costs vary widely. While we are currently not actively developing any product candidates, we anticipate that we will make determinations as to which new programs to pursue and how much funding to direct to each program on an ongoing basis in response to the scientific and clinical success of future product candidates.

We expect quarterly research and development expenses to decrease during the three months ended December 31, 2007 because following the HHS decision we ceased actively developing our anthrax vaccine, scaled back our biodefense activities and are actively pursuing strategic and other alternatives.

General and administrative expenses


	Three Months Ended September 30,				Percent change 2007/2006	Nine Months Ended September 30,				Percent change 2007/2006

	2007		2006			2007		2006

	(in thousands)					(in thousands)
General and administrative expenses	$	5,403	$	6,496	(17)%	$	16,778	$	20,882	(20)%

General and administrative expenses consist primarily of compensation costs, occupancy costs including depreciation expense, fees for accounting, legal and other professional services and other general corporate expenses.

The decrease in general and administrative expenses in the three months ended September 30, 2007 over the comparable period of 2006 was primarily due to:


	•	Labor and benefits, which decreased by $1.3 million primarily associated with the reductions in force in January and May 2007;

	•	Professional fees, which increased by $0.6 million due to audit and legal fees and expenses associated with our efforts to comply with various reporting and regulatory requirements including the Sarbanes-Oxley Act of 2002; and

	•	Outside consultant expenses, which decreased by $0.6 million primarily due to reduced activities associated with the reaudit of our prior year financial statements.

The decrease in general and administrative expenses in the nine months ended September 30, 2007 over the comparable period of 2006 was primarily due to:


	•	Labor and benefits, which decreased by $4.0 million primarily associated with the reductions in force in January and May 2007;


	•	Outside consultant expenses, which decreased by $1.8 million primarily due to reduced activities associated with the reaudit of our prior year financial statements;

	•	Professional fees, which increased by $0.9 million due to audit and legal fees and expenses associated with our efforts to comply with various reporting and regulatory requirements including the Sarbanes-Oxley Act of 2002; and

	•	Facilities and other overhead costs, net of allocations to research and development expense, which increased by $0.8 million due to changes in the relative headcounts by department.

We expect quarterly general and administrative expenses to decrease during the three months ended December 31, 2007 because following the HHS decision we scaled back activities and are actively pursuing strategic and other alternatives.

Restructuring expenses


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

	2007		2006		2007		2006

	(in thousands)				(in thousands)
Restructuring	$	1,092	$	—	$	5,374	$	—

During January, May and September 2007, we reduced our workforce to reduce operating costs. Restructuring costs include $4.4 million for employee termination benefits and $1.0 million for costs associated with consolidation of our facilities in California.

Other income (expense)


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

	2007			2006			2007			2006

	(in thousands)						(in thousands)
Interest expense	$	(612	)	$	(613	)	$	(1,835	)	$	(1,857	)
Interest income and other		1,163			981			3,682			1,432
Valuation adjustments		(201	)		(195	)		3,843			(1,658	)
Equity in loss of affiliate		—			—			—			(5,290	)
Gain on foreign currency transactions		—			—			—			4,678
Gain on sale of investment in affiliate		—			—			—			61,198

Other income, net	$	350		$	173		$	5,690		$	58,503

The decrease in other income for the three and nine months ended September 30, 2007 from the comparable period in 2006 was primarily due to:


	•	Interest income and other increased due to greater overall cash, cash equivalent and investment balances primarily due to the sale of substantially all of our Celltrion common stock in June 2006 and December 2006, partially offset by our operating losses;

	•	Expenses for mark-to-market adjustments related to the valuation of our outstanding derivatives on our 5 1/2% Convertible Senior Subordinated Notes, due April 1, 2010, or Notes, changed primarily due to changes in the likelihood of a change in control potentially triggering the redemption option related to the Notes;

	•	For the three and six months ended June 30, 2006, we recognized our share of Celltrion’s losses under the equity method. We sold substantially all of our ownership interest in Celltrion during 2006 and accordingly, effective July 1, 2006, no longer account for it under the equity method;

	•	Realized foreign currency gains in 2006 were primarily due to the collection of the June 2006 proceeds from the sale of Celltrion common stock; and

	•	Gain on sale of investment in affiliate resulting from our June 2006 sale of 3.6 million of our Celltrion common stock for gross proceeds of $79.0 million, net of $11.8 million in basis, $4.9 million in expenses and the deferral of $1.1 million related to an option sold along with the shares.

We anticipate future investment income will fluctuate and will be primarily driven by our future cash, cash equivalent and investment balances. Valuation adjustments will continue to be impacted by changes in our common stock price, our volatility and our expectations relative to a change in control. No changes in our debt levels are anticipated and therefore quarterly interest expense is expected to remain at the three months ended September 30, 2007 level throughout 2007.

As noted in Note 13, Segment Information, included in the notes to the unaudited condensed consolidated financial statements in Part I – Item 1 of this report, we have only one segment.

LIQUIDITY AND CAPITAL RESOURCES


	2007			2006

	(in thousands)
As of September 30:
Cash, cash equivalents and investment securities	$	77,320		$	59,403
Working capital		70,054			57,625

Nine Months ended September 30:
Cash provided by (used in):
Operating activities	$	(18,906	)	$	(57,572	)
Investing activities		2,441			76,105
Financing activities		—			25,049

Our primary financing requirements as of September 30, 2007 are the funding of our reduced levels of facility maintenance and general administration because following the HHS decision we ceased actively developing rPA102, scaled back our biodefense activities and are actively pursuing strategic and other alternatives. Through December 31, 2006, we financed our operations primarily through sales of our common stock, the issuance of Series A Preferred Stock, the issuance of the Notes, sales of our Celltrion common stock as well as through revenues from research contracts and grants.

In April 2005, we raised aggregate net proceeds of $29.7 million through a private placement of $31.5 million of Notes due April 1, 2010. The Notes require us to make semi-annual payments of interest in cash at a rate of 5 1/2%, due April 1 and October 1. If a change in control occurs, as defined in the indenture, on or prior to the stated maturity of the Notes, the holders of the Notes may require under certain circumstances us to repurchase the Notes and pay a make-whole premium to the holders of the Notes. If the stock price on the effective date of redemption is less than $12.30 per share, no make-whole premium will be paid. If the holders request such a repurchase, we or our successor entity, may choose to pay in cash, common stock or a combination of cash and common stock.

During the year ended December 31, 2006, we received gross proceeds of $130.3 million from the sale of substantially all of our Celltrion common stock. The Company’s basis in the shares sold in 2006 was $19.0 million. The Company incurred $7.3 million in fees and related expenses associated with the sale of this stock, resulting in a gain of $104.0 million. At December 31, 2006 and September 30, 2007, we held a nominal ownership interest in Celltrion.

As a result of the termination of our SNS Contract, we implemented a RIF in January 2007. The cash outflow of the January RIF was $2.8 million and $0.5 million during the three months ended March 31, 2007 and June 30, 2007, respectively, and $0.3 million thereafter. Beginning in April 2007, wage savings per month were $0.7 million and $0.2 million, respectively, for R&D and G&A. In addition, we did not renew an office space lease that expired at the end of May 2007. This lease, coupled with utilities and maintenance, reduced future expenses by $0.2 million per month.

In May 2007, we reduced our workforce to further lower operating costs. The cash outflow of this RIF was $0.4 million during the three months ended June 30, 2007 and $0.2 million thereafter. This RIF mostly impacted R&D. Beginning in July 2007, additional wage savings were $0.1 million per month. The RIFs in January 2007 and May 2007 have reduced our cash disbursements by approximately $1.2 million to $1.4 million per month since June 30, 2007. We do not expect these savings to be materially offset by any anticipated increases in other expenses.

Net cash used in operating activities of $18.9 million and $57.6 million for the nine months ended September 30, 2007 and 2006, respectively, was primarily attributable to our operating losses although the effect of non-cash items upon operating activities was significant in both periods and included:


	•	During the nine months ended September 30, 2006, we recognized our share of Celltrion’s losses under the equity method. We sold substantially all of our ownership interest in Celltrion during 2006 and accordingly effective July 1, 2006 no longer account for it under the equity method;

	•	Stock-based compensation expense of $1.9 million in 2007 and $2.4 million in 2006. Both periods primarily reflect charges from the fair value of stock options; and

	•	Valuation gain of $3.9 million in 2007 and valuation loss of $1.7 million in 2006, respectively, reflecting changes in the fair value of outstanding derivatives from the Notes.

The $61.2 million gain on the 2006 sale of 3.6 million shares of our investment in Celltrion was removed from operating activities and the net proceeds received are reflected in investing activities.

Cash used in operating activities was also affected by the following:


	•	Prepaid expenses and other current assets, which decreased by $0.9 million in 2007 and increased by $1.3 million in 2006 primarily due to the timing of payments and the reduced level of operating activities;

	•	Accounts payable, which decreased by $2.3 million in 2007 and by $5.8 million in 2006 primarily due to the timing of payments and the reduced level of operating activities;

	•	Accrued and other current liabilities, which decreased by $0.5 million in 2007 and by $7.0 million in 2006 primarily due to the timing of payments and the reduced level of operating activities; and

	•	Receivables, which decreased by $7.9 million in 2007 and increased by $5.5 million in 2006 primarily due to reduced revenues earned from the U.S. government and the timing of payments received.

Net cash provided by investing activities during the nine months ended September 30, 2006 consisted primarily of the $76.5 million in net proceeds from the 2006 sale of our Celltrion common stock net of activities relating to the purchase and sale of investment securities as well as capital expenditures. Capital expenditures in the nine months ended September 30, 2007 were minimal. During 2006, capital expenditures of $0.8 million were made in connection with the expansion of the research and development laboratories and leasehold improvements associated with the California manufacturing facility and office facilities. In addition, during the nine months ended September 30, 2006 we purchased $1.5 million of software related to the implementation of a new enterprise resource planning system. We expect minimal capital expenditures during the remainder of 2007 because the California manufacturing facilities are now substantially complete. Net cash provided by investing activities also includes net purchases and sales of securities. During the nine months ended September 30, 2007, we paid the final $2.4 million in fees due from the 2006 sale of substantially all of our remaining Celltrion common stock.

Net cash provided by our financing activities in the nine months ended September 30, 2006 was from our collection of net proceeds of $25.2 million through a private placement of 3.5 million shares of our common stock at $7.70 per share at a discount to the $9.20 per share closing price together with warrants to purchase up to 1.4 million shares of common stock at a price of $9.24 per share.

At September 30, 2007, $77.3 million, or 72%, of our assets consisted of cash, cash equivalents and investment securities. We had working capital of $70.1 million at September 30, 2007, compared to $57.6 million at September 30, 2006. This increase in working capital is primarily due to the net proceeds from the 2006 sale of our Celltrion common stock and the following:


	•	Receivables, which decreased by $8.8 million primarily due to reduced revenues earned from the U.S. government and the collection of amounts due from them;

	•	Accounts payable, which decreased by $1.9 million primarily as a result of reduced operations; and

	•	Accrued and other current liabilities, which decreased by $2.6 million primarily due to the timing of payments and as a result of reduced operations.

We believe that our existing cash, cash equivalents and investment securities will be sufficient to cover our working capital needs, capital expenditures, debt obligations and commitments through at least December 31, 2008. Our future capital requirements will depend upon our ability to identify and exploit business development opportunities including actively pursuing avenues to enhance stockholder value through a strategic transaction.

Off-Balance Sheet Arrangements

As of September 30, 2007, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board, or FASB, issued FAS No. 157, Fair Value Measurement, or FAS 157. FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are evaluating the impact of adopting FAS 157 on our consolidated financial position, results of operations and cash flows.

In February 2007, the FASB issued FAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115, or FAS 159, which permits all entities to choose to measure eligible items, including many financial instruments, at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. Most of the provisions in FAS 159 are elective; however, the amendment to FAS No. 115,Accounting for Certain Investments in Debt and Equity Securities,applies to all entities with available-for-sale and trading securities. FAS 159 is effective for fiscal years beginning after November 15, 2007. We are evaluating the impact of adopting FAS 159 on our consolidated financial position, results of operations and cash flows.

In June 2007, the Emerging Issues Task Force, or EITF, published Issue No. 07-3,Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities, or EITF 07-3. The EITF reached a consensus that these payments made by an entity to third parties should be deferred and capitalized. Such amounts should be recognized as an expense as the related goods are delivered or the related services are performed. Entities should report the effects of applying this Issue as a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. EITF 07-3 is effective beginning on January 1, 2008. Earlier application is not permitted. We do not expect that adoption of this new Standard will have a material effect on our financial position or results of operations.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

We are exposed to market rate changes by debt securities included in our investment portfolio. By policy, we invest in debt instruments of the U.S. government, federal agencies and high-quality corporate issuers, limit the amount of credit exposure to any one issuer, and limit duration by restricting the term. Investments in both fixed rate and floating rate instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may decrease due to changes in interest rates or due to losses we may suffer when securities decline in market value. At September 30, 2007, we held available-for-sale securities in the principal amount of $20.7 million. If market interest rates were to increase immediately and uniformly by 10% from levels at September 30, 2007, the fair value of our portfolio would decline by an immaterial amount, and would not have a significant effect on our operations or cash flows. Our exposure to losses as a result of interest rate changes is managed through investing in a portfolio of securities with a weighted-average maturity of one year or less.

Indebtedness

At September 30, 2007, our outstanding non-current liabilities include $31.5 million of our Notes due April 1, 2010 which we sold in a private placement in April 2005. As the Notes bear interest at a fixed rate, our interest expense under the Notes would not be affected by interest rate changes. As of September 30, 2007, we did not invest in derivative financial instruments, interest rate swaps or other investments that alter interest rate exposure.

Derivative Valuation Risk

The terms of our Notes include put features not under our control. These features are considered to be an embedded derivative liability and we determined the fair value of this derivative to be $1.8 million on the date of issuance. Due to the quarterly revaluation of the embedded derivative liability, we recorded in our statements of operations other expense of $0.2 million and income of $3.8 million for the three and nine months ended September 30, 2007, respectively. At September 30, 2007, the embedded derivative liability was valued at $4.4 million. We determine the fair value of the derivative liabilities using the Monte Carlo Simulation methodology. This methodology allows flexibility in incorporating various assumptions such as probabilities of certain triggering events. The valuations are based on the information available as of the various valuation dates. Factors affecting the amount of these liabilities include expectations regarding triggering events, the market value of our common stock, the estimated volatility of our common stock, our market capitalization, the risk free interest rate and other assumptions. A change in probability of a triggering event and or a change in the market value of our common stock could have a significant impact on the results of our operations; however, there would not be any impact on our cash flows.

ITEM 4. CONTROLS AND PROCEDURES

Background

As described in Item 9A of our Annual Report on Form 10-K for the year ended December 31, 2006, which we refer to as our 2006 10-K, we identified material weaknesses which are listed below under the heading “Material Weaknesses Reported in 2006.”A material weakness is a control deficiency in our internal control over financial reporting, or ICFR, or a combination of control deficiencies in ICFR, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. We have implemented, and will continue to implement and evaluate remediation measures and improvements to the overall design of our control environment, as described below, to address the material weaknesses in our ICFR. We believe the remediation measures described below have strengthened our ICFR. As we are able to evaluate the effectiveness of these remedial measures over a sufficient period of time, we would expect that the remaining material weaknesses identified in section IV below would be remediated.

This report is presented in the following sections:


	I.	Management’s Conclusion

	II.	Materials Weaknesses Reported in 2006

	III.	Remediation of Material Weaknesses Reported in 2006

	IV.	Ongoing Remediation Initiatives

	V.	Other Information

I. Management’s Conclusion

As required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended, or Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Disclosure controls and procedures are designed to ensure that the information required to be disclosed in our reports which we file or submit under the Exchange Act is (i) accumulated and communicated to our management (including the Chief Executive Officer and Chief Financial Officer) as appropriate to allow timely decisions regarding required disclosures, and (ii) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission, or SEC, rules and forms. Based upon the material weaknesses in our ICFR as described below, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective as of the end of the period covered by this report. The certifications of our principal executive officer and principal financial officer required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, or SOX, are attached as exhibits to this Quarterly Report on Form 10-Q. The disclosures set forth in this Item 4 contain information concerning the evaluation of our disclosure controls and procedures and changes in ICFR, referred to in the certifications. Those certifications should be read in conjunction with this Item 4 for a complete understanding of the matters covered by the certifications.

II. Material Weaknesses Reported in 2006

As described in Item 9A of our 2006 10-K, we previously identified the following material weaknesses:


1)	We did not maintain an effective control environment, specifically, the following material weaknesses were identified within the control environment:

	a)	We did not maintain an effective control environment based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Specifically, the financial reporting organization structure was not adequate to support the size, complexity or activities of the Company. In addition, certain finance positions were staffed with individuals who did not possess the level of accounting knowledge, experience and training in the application of generally accepted accounting principles in the United States of America, or GAAP, commensurate with our financial reporting requirements.

	b)	We did not maintain effective financial reporting processes, including sufficient formalized and consistent finance and accounting polices and procedures; nor did we prevent or detect instances of non-compliance with existing policies and procedures that do exist. Specifically, we lacked formalized reporting policies and procedures.

	c)	We did not maintain effective monitoring controls and related segregation of duties over automated and manual transactions processes. Specifically, we failed to implement processes to ensure periodic monitoring of our existing internal control activities over financial reporting to identify and assess significant risk that may impact financial statements and related disclosures. Additionally, inadequate segregation of duties led to untimely identification and resolution of accounting and disclosure matters and failure to perform timely and effective supervision and reviews.


The above control deficiencies resulted in audit adjustments to our 2006 interim and annual consolidated financial statements. These control deficiencies affect substantially all financial statement accounts, which could result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected.

2)	The material weaknesses in our control environment contributed to the existence of the following control deficiencies, each of which was considered to be a material weakness:

	a)	We did not maintain effective controls over our process to ensure the complete, accurate and timely preparation and review of our consolidated financial statements in accordance with GAAP. Specifically, we did not have effective controls over the process for identifying, accumulating and reviewing all required supporting information to ensure the completeness, accuracy and timely preparation and review of our consolidated financial statements and disclosures. This control deficiency resulted in audit adjustments to our 2006 interim and annual consolidated financial statements. Additionally, this control deficiency could result in a misstatement of substantially all financial statement accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected.

	b)	We did not maintain effective controls to ensure that journal entries, both recurring and non-recurring, were consistently reviewed and approved in a timely manner to ensure the validity, completeness and accuracy of recorded entries. This control deficiency resulted in audit adjustments to our 2006 interim and annual consolidated financial statements. Additionally, this control deficiency could result in a misstatement of substantially all financial statement accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected.

	c)	We did not maintain effective controls over the procurement process. Specifically, effective controls were not in place over the approval of new vendors, authorization of purchase orders, including categorization of appropriate expense line items, the receipt of goods and the approval and authorization of vendor payments. This control deficiency could result in a misstatement of current liabilities and operating expenses that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected.

	d)	We did not maintain effective controls over the completeness and accuracy of certain revenue and expense accruals. Specifically, we failed to identify, analyze and review certain accruals at period end relating to certain accounts receivable, accounts payable, accrued liabilities, revenue and other direct expenses to ensure that they were accurately, completely and properly recorded. This control deficiency resulted in audit adjustments to our 2006 interim and consolidated financial statements. Additionally, this control deficiency could result in a misstatement of the aforementioned accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected.

	e)	We did not maintain effective controls over the existence, completeness and valuation of fixed assets and related depreciation expense. Specifically, effective controls were not designed and in place to ensure that fixed asset additions and disposals were recorded, as well as, the periodic physical verification of fixed assets. This control deficiency resulted in audit adjustments to our 2006 interim and annual consolidated financial statements. Additionally, this control deficiency could result in a misstatement of fixed assets and depreciation expense that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected.

	f)	We did not maintain effective controls over spreadsheets. Specifically, we did not maintain effective controls over the completeness, accuracy and validity of spreadsheets used in our financial reporting process to maintain effective version control and ensure that access was restricted to appropriate personnel, and that unauthorized modification of the data or formulas within spreadsheets was prevented. This control deficiency resulted in audit adjustments to our 2006 interim and annual consolidated financial statements. Additionally, this control deficiency could result in a misstatement of substantially all financial statement accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected.

	g)	We did not design and maintain effective controls over the completeness, accuracy and valuation of our payroll and payroll expense. Specifically, we did not design and maintain effective controls over the administration of employee data or controls to provide reasonable assurance regarding the proper authorization of non-recurring payroll changes. This control deficiency could result in a misstatement of the aforementioned accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected.

We have made certain changes and are in the process of making additional changes and improvements to the overall design of our control environment to address the material weaknesses in ICFR described above. The Audit Committee has reviewed and approved management’s remediation plans for establishing and maintaining adequate ICFR. Management reports on its progress on implementing improvements to the Audit Committee at least quarterly.

During 2007, we have implemented remediation measures as described below under section III “Remediation of Material Weaknesses Reported in 2006” and have implemented and plan to continue to implement, the specific initiatives described below under section IV “Ongoing Remediation Initiatives.” In addition, management and financial consultants undertook and completed reconciliations, analyses and detailed reviews of the financial statements and supporting documentation in addition to those historically completed to confirm that this Quarterly Report fairly presents in all material aspects our financial position, results of operations and cash flows as of, and for the periods presented in accordance with GAAP.

III. Remediation of Material Weaknesses Reported in 2006

As of September 30, 2007, we believe we have effectively remediated the following material weaknesses in ICFR that were included in “Management’s Report on Internal Control over Financial Reporting” in Item 9A of our 2006 10-K (the numerical and alphabetical references correspond to section II above):


a)	We did not maintain an effective control environment based on criteria established in Internal Control-Integrated Framework issued by COSO –We implemented control processes to address and remediate the material weakness reported in 2006 related to our organizational structure. The Chief Financial Officer, with assistance from his senior financial staff and outside consultants, has reviewed and will continue to review and adapt the overall design of our financial reporting organizational structure, including the roles and responsibilities of each functional group within the Company, to ensure that we have a sufficient compliment of personnel with knowledge, experience and training in the application of GAAP commensurate with our financial reporting requirements. Our activities to address and remediate the material weakness in this area included:

	i)	Retaining the services of outside consultants with relevant accounting experience, skills and knowledge in the application of GAAP, working under the supervision and direction of our management, to supplement our existing finance personnel. In addition, we retained well-qualified consultants to fill open senior financial compliance and internal audit positions. We plan to continue to supplement our staff with accounting, compliance and internal audit personnel, with relevant accounting experience, skills and knowledge in the application of GAAP and SOX, as required.

	ii)	Hiring an experienced Vice President of Finance in December 2006 who was subsequently replaced by an experienced consultant in September 2007, whose responsibilities include overseeing the corporate accounting and SEC external financial reporting functions.

	iii)	Sending accounting staff for relevant financial and accounting training as deemed necessary and continuing to evaluate and execute on any needs for continuing education.

	iv)	Completing job performance evaluations and determining areas for ongoing performance improvement and staff training needs.

c)	We did not maintain effective controls over the procurement process.

	i)	Senior level managers verify that invoices are properly coded and supported, and that services or goods are received prior to payment.

	ii)	An approved vendor change request form is utilized to initiate any new vendors or update existing vendor information. In conjunction with remedial efforts under 1c above, system privileges were analyzed and modified to ensure proper segregation exists relating to vendor creation or modification. In conjunction with the monthly open purchase order review (2d above), vendors without an open purchase order are automatically closed in the financial system.

	iii)	We utilize the accounting system’s purchase order routing feature to ensure all purchases are properly authorized. Additionally, the accounting system requires goods or services to be flagged as received and three or two-way matched prior to releasing an invoice for payment.

	iv)	A review of all purchase orders without an approved purchase requisition is performed monthly to ensure proper approval.

	v)	All checks over a specified dollar limit are signed by two members of management and all check registers are properly approved.

	vi)	All wire transfers are approved on our online banking system by executive management.

	vii)	Check signing and wire transfer authorization privileges are properly segregated.

e)	We did not maintain effective controls over the existence, completeness and valuation of fixed assets and related depreciation expense.

	i.	All journal entries associated with fixed asset additions, disposals or related depreciation are properly completed, supported and approved by senior management.


	ii.	A quarterly roll-forward of fixed asset additions, disposals and related depreciation expenses is prepared and reconciled to the general ledger fixed asset accounts to ensure completeness and accuracy of the recorded fixed assets. The fixed asset reconciliations are reviewed and approved by senior management.

	iii.	Fixed assets are physically verified on an annual basis, such that all assets greater than a specified dollar limit are physically counted every two years. The last physical count of all assets with a net book value greater than a specified dollar limit was performed in September 2007. The physical count procedures and results are reviewed and approved by senior financial management and the Chief Financial Officer.

g)	We did not design and maintain effective controls over the completeness, accuracy and valuation of our payroll and payroll expense.

	i.	All employee changes are documented in an approved personnel action request form.

	ii.	Changes in salary and bonus payouts are approved by the Chief Executive Officer and the Chief Financial Officer.

	iii.	All employee data and salary changes are reconciled quarterly to data in the employee master file within our accounting system as well as our payroll database to ensure accuracy and validity.

	iv.	A monthly and quarterly reconciliation of the payroll per the service provider is reconciled to the general ledger payroll accounts to ensure completeness and accuracy of processing. These reconciliations are reviewed and approved by senior management.

IV. Ongoing Remediation Initiatives

To remediate the material weaknesses related to the control environment and certain process controls, we have begun implementing new and enhanced internal controls in a number of areas designed to remediate the material weaknesses identified and to strengthen our ICFR. To the extent that these measures have been implemented, they have yet to operate for a sufficient period of time. These measures include the following (the numerical and alphabetical references correspond to section II above):


1b)	We did not maintain effective financial reporting processes, including sufficient formalized and consistent finance and accounting polices and procedures; nor did we prevent or detect instances of non-compliance with certain such policies and procedures that do exist.

	i.	A training program was developed and implemented in August 2007 to ensure employees understand the importance of ICFR.

	ii.	Our financial policies and procedures were reviewed for completeness, accuracy and adequacy and updated as necessary. Financial personnel were provided with the policies and procedures and instructed to comply with the updated policies and procedures in the performance of their duties.

	iii.	A quarterly communication and certification plan was implemented to ensure internal controls over financial reporting are updated, as appropriate.

	iv.	A quarterly certification program was implemented to monitor employee’s compliance with financial policies and procedures.

	v.	The Chief Financial Officer and Board of Directors reviews monthly and quarterly cash projections and actual results, prepared by senior finance management, to monitor the cash resources and expenditures of the Company.

1c)	We did not maintain effective monitoring controls and related segregation of duties over automated and manual transaction processes.

	i.	All system access privileges were analyzed and changes made as appropriate to ensure proper segregation exists within the accounting system.

	ii.	All required system changes were documented and properly approved by the most senior person in the affected department as well as by Information Technology staff.

	iii.	An analysis of manual procedures was performed in September 2007 and continues to be monitored. Appropriate changes were made to duties and responsibilities to strengthen the effectiveness of our segregation of duties within the accounting and finance department. Training was provided to finance team members on their new duties to ensure proper understanding and application.


2a)	We did not maintain effective controls over our process to ensure the complete, accurate and timely preparation and review of our consolidated financial statements in accordance with GAAP.

	i.	We have retained and intend to continue to retain the services of outside consultants with relevant accounting experience, skills and knowledge in the application of GAAP, working under the supervision and direction of our management, to supplement our existing corporate accounting and financial reporting personnel.

	ii.	Management and financial consultants review support for financial results and financial statement disclosures.

	iii.	Checklists are completed to ensure preparation and review procedures related to our external SEC financial reporting processes are properly completed and documented.

2b)	We did not maintain effective controls to ensure that journal entries, both recurring and non-recurring, were consistently reviewed and approved in a timely manner to ensure the validity, completeness and accuracy of recorded entries.

	i.	Journal entries are reviewed for proper coding and supporting documentation and approved by appropriate levels of management in a timely manner.

	ii.	Approved journal entries are reconciled against posted journal entries to ensure completeness and accuracy.

2d)	We did not maintain effective controls over the completeness and accuracy of certain revenue and expense accruals.

	i.	Appropriate finance staff review and approve the monthly accrual listings to ensure completeness and accuracy.

	ii.	The monthly accrued paid time off reconciliation is reviewed and approved by senior management.

	iii.	Vendor invoices are reviewed and approved to ensure they are recorded or accrued in the proper period.

2f)	We did not maintain effective controls over spreadsheets.

	i.	During August 2007, a checklist of all spreadsheets was prepared and the spreadsheets were reviewed and analyzed to determine the level of controls necessary based upon the spreadsheet’s use and complexity.

	ii.	Access controls and back-up procedures have been implemented over all high and moderate risk spreadsheets.

	iii.	The formulas within high and moderate risk spreadsheets are checked annually to ensure the accuracy of the information generated by the spreadsheets. This check was last performed during August 2007.

V. Other Information

Changes in Internal Control over Financial Reporting

The discussion above under section III, “Remediation of Material Weaknesses Reported in 2006,”and under section IV, “Ongoing Remediation Initiatives,” includes a description of the material changes to our ICFR during 2007 that materially affected, or are reasonably likely to materially affect, our ICFR.

Inherent Limitations on Effectiveness of Controls

Our management, including the Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our ICFR will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.

PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None.

ITEM 1A. RISK FACTORS

You should carefully consider the following risk factors as well as other information in our filings under the Exchange Act before making any investment decisions regarding our common stock. The risks and uncertainties described herein are not the only ones we face. Additional risks and uncertainties that we do not know or that we currently deem immaterial may also impair our business, financial condition, operating results and prospects. If events corresponding to any of these risks actually occur, they could materially adversely affect our business, financial condition, operating results or prospects. In that case, the trading price of our common stock could decline. When used in this report, unless otherwise indicated, “we,” “our” and “us” refers to VaxGen. Risk factors which have materially changed since our 2006 10-K are marked with an “*”.

We are not currently listed on a national exchange and cannot assure you we will ever be listed.

As a result of our failure to make timely filings of financial statements, we were delisted from Nasdaq, and our common stock is not currently listed on another national stock exchange. We have completed all necessary filings with the SEC pursuant to Sections 13 and 15(d) of the Exchange Act; we have not yet applied for our common stock to be listed on a national exchange. We do not know when, if ever, this will be completed, and thus, whether our common stock will ever be listed. In addition, we cannot be certain that Nasdaq will approve our stock for relisting or that any other exchange will approve our stock for listing. In order to be eligible for relisting or listing, we must meet Nasdaq’s or another exchange’s initial listing criteria, and we believe we will need to be in compliance with Sections 13 and 15(d) of the Exchange Act. Our common stock is currently quoted on the Pink Sheets, LLC.

Our business to date has been largely dependent on the success of rPA102, which was the subject the SNS Contract that was terminated in December 2006. Although we ceased active development of rPA102 and have reduced our workforce, we may be unable to successfully manage our remaining resources, including available cash, while we seek to identify and complete a strategic transaction.

We discontinued clinical development of rPA102 after HHS terminated our SNS Contract. In addition, in June 2007 we terminated our contract with Kaketsuken to develop a smallpox vaccine. We had previously devoted substantially all of our research, development and clinical efforts and financial resources toward the development of rPA, and we have no product candidates in clinical or preclinical development. In connection with the termination of our clinical development of rPA102, we announced restructuring activities, including significant workforce reductions. During the three quarter periods ended September 30, 2007, we incurred charges associated with our restructuring activities of approximately $5.4 million, which includes employee severance costs of $4.4 million and facilities-related and other expenses of $1.0 million. As a result of the termination of our SNS Contract, we are evaluating strategic alternatives and have retained Lazard Ltd. to act as our advisor in this process. We cannot predict whether we be able to identify an appropriate strategic alternative which will either provide us with a pipeline or return value to our shareholders on a timely basis or at all. We also cannot predict whether any such transaction would be consummated on favorable terms, and anticipate that such transaction may require us to incur significant additional costs.

If we fail to manage successfully any company or product acquisitions, joint ventures or in-licensed product candidates, we may be limited in our ability to develop our product candidates and to rebuild our product candidate pipeline.

Our prior product development programs were initiated through in-licensing or collaborative arrangements. These collaborations include licensing proprietary technology from, and other relationships with, biotechnology companies and government research institutes and organizations. As part of our business strategy, we intend to continue to expand our product pipeline and capabilities through company or product acquisitions, merging or in-licensing.

Any such activities will be accompanied by certain risks including:


	•	exposure to unknown liabilities of acquired companies;

	•	higher than anticipated acquisition costs and expenses;

	•	the difficulty and expense of integrating operations and personnel of acquired companies;

	•	disruption of our ongoing business;

	•	diversion of management’s time and attention; and

	•	possible dilution to stockholders.

If our competitors successfully enter into partnering or license agreements or we are unable to reach agreement on license or partnering agreements on terms acceptable to us, we may then be precluded from pursuing those specific opportunities. Since each of these opportunities is unique, we may not be able to find a substitute. In addition, if we are unable to manage successfully any acquisitions, joint ventures and other collaboration opportunities, we may be limited in our ability to develop new products and therefore to continue to expand our product pipeline.

If we fail to cause our registration statement to be declared effective in accordance with agreements we have made in connection with the 2006 private placement of our common stock, or to remain effective, we may be subject to liquidated damages or liability for breach of contract. *

In February 2006, we raised gross proceeds of $26.95 million through a private placement of our common stock and warrants exercisable for common stock. We agreed to register under the Securities Act the shares of our common stock sold in this transaction, and the shares of common stock issuable upon exercise of the warrants. On October 5, 2007, we filed a registration statement for these shares. We agreed to use our best efforts to cause the registration statement to become effective in no event later than 120 days after the filing of such registration statement. We have also made other customary agreements regarding such registrations, including matters relating to indemnification, maintenance of the registration statement, payment of expenses and compliance with state “blue sky” laws. We may be liable for liquidated damages to each holder of shares sold in the private placement if the registration statement is not declared effective by the SEC on or prior to 120 days from filing; or if the registration statement (after being declared effective) ceases to be effective in a manner that violates such agreements. In this case, we may be required to pay liquidated damages. Should we become obligated to make payment of these liquidated damages, it could have a material adverse effect on our financial position and our results of operations, particularly if we become obligated to make a payment in full for all liquidated damages potentially due and payable under these agreements.

Our internal controls may be insufficient to ensure timely and reliable financial information.

We believe we need to correct deficiencies in our internal controls and procedures for financial reporting. Because of the material weaknesses described in Item 9A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 and Item 4 of this Quarterly Report, management has concluded that we did not maintain effective internal control over financial reporting as of December 31, 2006, March 31, 2007, June 30, 2007 or September 30, 2007, based on theInternal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.

Failure to address the identified deficiencies in a timely manner might increase the risk of future financial reporting misstatements and may prevent us from being able to meet our filing deadlines with the SEC. Under the supervision of our Audit Committee, we are continuing the process of identifying and implementing corrective actions where required to improve the design and effectiveness of our internal control over financial reporting, including the enhancement of systems and procedures. Significant additional resources will be required to establish and maintain appropriate controls and procedures and to prepare the required financial and other information during this process.

Even after corrective actions are implemented, the effectiveness of our controls and procedures may be limited by a variety of risks including:


	•	faulty human judgment and simple errors, omissions or mistakes;

	•	collusion of two or more people;

	•	inappropriate management override of procedures; and

	•	the risk that enhanced controls and procedures may still not be adequate to assure timely and reliable financial information.

If we fail to have effective internal controls and procedures for financial reporting in place, we could be unable to provide timely and reliable financial information. Additionally, if we fail to have effective internal controls and procedures for financial reporting in place, it could adversely affect our ability to comply with financial reporting requirements under future government contracts.

We may need to raise additional capital to support our operations and in order to continue as a going concern if we successfully complete a strategic transaction. *

Absent a strategic transaction, we believe that our existing cash, cash equivalents and securities available-for-sale as of September 30, 2007 will be sufficient to meet our projected operating requirements through at least December 31, 2008. In addition to our workforce reductions and the termination of our rPA102 and smallpox development activities, we have announced that we are exploring strategic alternatives. We may not successfully identify or implement any of these alternatives, and even if we determine to pursue one or more of these alternatives, we may be unable to do so on acceptable financial terms. Our restructuring measures implemented to date and any proposed strategic alternatives may disappoint investors and further depress the price of our common stock and the value of an investment in our common stock thereby limiting our ability to raise additional funds.

We will require substantial funds to conduct development activities if we acquire additional products or companies or consummate certain strategic transactions. Our ability to conduct the required development activities related to any new product candidates will be

significantly limited if we are unable to obtain the necessary capital. We may seek to raise additional funds through the sale of equity or debt to meet our working capital and capital expenditure needs. We do not know, however, whether additional financing will be available when needed, or whether it will be available on favorable terms or at all. Failure to obtain adequate financing also may adversely affect our ability to operate as a going concern.

As a result of the reductions in our workforce that we announced in January, May and September 2007, we may not be successful in retaining key employees and in attracting qualified new employees as required in the future. If we are unable to retain our management, scientific staff and scientific advisors or to attract additional qualified personnel, our ability to rebuild our business will be seriously jeopardized. *

In January 2007, we implemented a restructuring resulting in the reduction of our workforce by approximately 51%. In May 2007, we announced the discontinuation of any further development activities with respect to rPA102 and a corporate restructuring plan that included a reduction in our workforce to fewer than 70 employees. In September 2007, we further reduced our workforce to fewer than 30 employees. Competition among biotechnology companies for qualified employees is intense, and the ability to retain and attract qualified individuals is critical to our success. We may experience further reductions in force due to voluntary employee resignations and a diminished ability to recruit new employees. We may be unable to attract or retain key personnel on acceptable terms, if at all.

If we fail to meet our obligations under the 5 1/2% Convertible Senior Subordinated Notes due 2010, or Notes, our payment obligations may be accelerated.

The Notes have the following features:


	•	require semi-annual payment of interest in cash at a rate of 5 1/2%;

	•	convert, at the option of the holder, into shares of our common stock at an initial conversion price of approximately $14.76 per share, subject to adjustment;

	•	will be provisionally redeemable at our option in cash upon the occurrence of certain circumstances, including among others, that the closing price of VaxGen common stock exceeds $22.14 per share, subject to adjustment, for at least 20 trading days within a period of 30 consecutive trading days;

	•	if a change in control, as defined in the indenture, occurs on or prior to the stated maturity of the Notes, the holders of the Notes may require us to repurchase the Notes and pay a make-whole premium to the holders of the Notes. If the holders request such a repurchase, we or the successor entity may choose to pay in cash, common stock or a combination of cash and common stock; and

	•	constitute senior subordinated obligations.

Under the terms of the Notes, if certain events occur, including, without limitation, our failure to pay any installment of principal or interest due under the Notes, then the holders may, among other things, elect to accelerate our obligations under the Notes and declare the outstanding principal balance of the Notes and accrued but unpaid interest thereon immediately due and payable. In the event that the holders declare the Notes immediately due and payable or seek to foreclose on any of our assets, it would have a material adverse effect on our financial position and we may not have sufficient cash to satisfy our obligations.

Our indebtedness could adversely affect our financial health, limit our cash flow available to invest in the ongoing requirements of our business and adversely affect the price of our common stock.

Our existing indebtedness consists of $31.5 million in Notes. This indebtedness, and any future indebtedness we may incur, could have important consequences, including:


	•	making it more difficult for us to satisfy our financial and payment obligations, or to refinance maturing indebtedness;

	•	making us more vulnerable to a downturn in the economy or our business;

	•	limiting our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions and other general corporate purposes;

	•	requiring application of a significant portion of our cash flow from operations to the payment of debt service costs, which would reduce the funds available to us for our operations;

	•	limiting our flexibility in planning for, or reacting to, changes in our industry, business and markets; and

	•	placing us at a competitive disadvantage to the extent we are more highly leveraged than some of our competitors.

We may incur significant additional indebtedness in the future to fund our continued operations or future acquisitions. To the extent new debt is added to our current debt levels, the substantial leverage risks described above would increase. We may be required to repurchase the Notes if certain change-in-control events occur.

We have only a limited operating history and we expect to continue to generate operating losses. *

To date, we have engaged primarily in research, development and clinical testing. Since our inception in 1995, our operations have not been profitable, and we cannot be certain that we will ever achieve or sustain operating profitability. At September 30, 2007, we had an accumulated deficit of $238 million. Developing any future product candidates will require significant additional research and development, including non-clinical testing and clinical trials, as well as regulatory approval. We expect these activities, together with our general and administrative expenses, to result in operating losses for the foreseeable future.

Biopharmaceutical product development is a long, expensive and uncertain process and the approval requirements for many products, including vaccines used to fight bioterrorism, are still evolving. If we are unable to successfully develop and test product candidates in accordance with such requirements, our business will suffer.

We are subject to rigorous and extensive regulation by the FDA and comparable foreign regulatory authorities for any product candidates we may develop. In the United States, our potential product candidates would likely be regulated by the FDA as biological drug products, known as Biologics. In order to obtain approval from the FDA to market our product candidates, we will be required to submit to the FDA a Biologics License Application, or BLA, which must include both preclinical and clinical trial data as prescribed by the FDA’s current regulatory criteria, as well as extensive data regarding the manufacturing procedures and processes for the product candidates. Ordinarily, the FDA requires a sponsor to support a BLA application with substantial evidence of the product’s safety and effectiveness in treating the targeted indication based on data derived from adequate and well-controlled clinical trials, including Phase 3 efficacy trials conducted in patients with the disease or condition being targeted.

We cannot predict whether we will obtain regulatory approval for any product candidates pursuant to these provisions. We may fail to obtain approval from the FDA or foreign regulatory authorities, or experience delays in obtaining such approvals, due to varying interpretations of data or failure to satisfy current safety, efficacy and quality control requirements. Further, our business is subject to substantial risk because the FDA’s current policies may change suddenly and unpredictably and in ways that could impair our ability to obtain regulatory approval of product candidates. We cannot guarantee that the FDA will approve product candidates on a timely basis or at all.

Delays in successfully completing any clinical trials we may conduct could jeopardize our ability to obtain regulatory approval or market our potential product candidates on a timely basis.

If we resume development of any potential product candidates, our business prospects may depend on our ability to complete patient enrollment in clinical trials, to obtain satisfactory results, to obtain required regulatory approvals and to successfully commercialize our product candidates. Product development to show adequate evidence of effectiveness in animal models and safety and immune response in humans is a long, expensive and uncertain process, and delay or failure can occur at any stage of our non-clinical studies or clinical trials. Any delay or significant adverse clinical events arising during any of our clinical trials could force us to abandon a product candidate altogether or to conduct additional clinical trials in order to obtain approval from the FDA or other regulatory body. These development efforts and clinical trials are lengthy and expensive, and the outcome is uncertain. Completion of any clinical trials we may commence, announcement of results of the trials and our ability to obtain regulatory approvals could be delayed for a variety of reasons, including:


	•	slower-than-anticipated enrollment of volunteers in the trials;

	•	lower-than-anticipated recruitment or retention rate of volunteers in the trials;

	•	serious adverse events related to the product candidates;

	•	unsatisfactory results of any clinical trial;

	•	the failure of our principal third-party investigators to perform our clinical trials on our anticipated schedules; or

	•	different interpretations of our preclinical and clinical data, which could initially lead to inconclusive results.

Our development costs will increase if we have material delays in any clinical trial or if we need to perform more or larger clinical trials than planned. If the delays are significant, or if any of our product candidates do not prove to be safe or effective or do not receive required regulatory approvals, our financial results and the commercial prospects for our product candidates will be harmed. Furthermore, our inability to complete our clinical trials in a timely manner could jeopardize our ability to obtain regulatory approval.

If we fail to comply with extensive regulations enforced by domestic and foreign regulatory authorities both before and after we obtain approval of our future product candidates, the commercialization of our future product candidates could be prevented, delayed or suspended.

Product candidates are subject to extensive government regulations related to development, testing, manufacturing and commercialization in the United States and other countries. Our potential product candidates have not received required regulatory approval from the FDA to be commercially marketed and sold in the United States. Our future product candidates have not received required regulatory approval from foreign regulatory agencies to be commercially marketed and sold. The process of obtaining and complying with FDA, other governmental and foreign regulatory approvals and regulations is costly, time consuming, uncertain and subject to unanticipated delays. Despite the time and expense exerted, regulatory approval is never guaranteed.

We also are subject to the following regulatory risks and obligations, among others;


	•	the FDA or foreign regulators may refuse to approve an application if they believe that applicable regulatory criteria are not satisfied;

	•	the FDA or foreign regulators may require additional testing for safety and effectiveness;

	•	the FDA or foreign regulators may interpret data from non-clinical testing and clinical trials in different ways than we interpret them;

	•	if regulatory approval of a product is granted, the approval may be limited to specific indications or limited with respect to its distribution. In addition, many foreign countries control pricing and coverage under their respective national social security systems;

	•	the FDA or foreign regulators may not approve our manufacturing processes or manufacturing facilities;

	•	the FDA or foreign regulators may change their approval policies or adopt new regulations;

	•	even if regulatory approval for any product is obtained, the marketing license will be subject to continual review, and newly discovered or developed safety or effectiveness data may result in suspension or revocation of the marketing license;

	•	if regulatory approval of the vaccine candidate is granted, the marketing of that vaccine would be subject to adverse event reporting requirements and a general prohibition against promoting products for unapproved or “off-label” uses; and

	•	in some foreign countries, we may be subject to official release requirements that require each batch of the vaccine we produce to be officially released by regulatory authorities prior to its distribution by us.

Failure to comply with the regulatory requirements of the FDA and other applicable foreign regulatory bodies may subject us to administrative or judicially imposed sanctions, including:


	•	warning letters;

	•	civil penalties;

	•	criminal penalties;

	•	injunctions;

	•	product seizure or detention, including any products that we manufacture;

	•	product recalls;

	•	total or partial suspension of production; and

	•	suspension or revocation of the marketing license.

We may be subject to ongoing regulatory review and periodic inspection and approval of manufacturing procedures and operations, including compliance with cGMP regulations.

The manufacturing methods, equipment and processes used by us and any future subcontractors must comply with the FDA’s current Good Manufacturing Practices, or cGMP, regulations. The cGMP requirements govern, among other things, recordkeeping, production processes and controls, personnel and quality control. The FDA must approve the facilities used to manufacture our products before they can be used to commercially manufacture our vaccine products and these facilities are subject to ongoing and periodic inspections. If we or our subcontractors fail to comply with cGMP requirements, or fail to pass a pre-approval inspection of our manufacturing facility, we may not receive regulatory approval for any future product candidates. In addition, preparing a manufacturing facility for commercial manufacturing may involve unanticipated delays and the costs of complying with the cGMP regulations may be significant. Any material changes we make to our manufacturing processes after we obtain approval of a product may require approval by the FDA, state or foreign regulatory authorities.

Our future product development efforts may not yield marketable products due to results of studies or trials, failure to achieve regulatory approvals or market acceptance, proprietary rights of others or manufacturing issues.

Our success depends on our ability to successfully acquire, develop and obtain regulatory approval to market new biopharmaceutical products. Development of a product requires substantial technical, financial and human resources. Our potential products may appear to be promising at various stages of development yet fail to reach the market for a number of reasons, including:


	•	the lack of adequate quality or sufficient prevention benefit, or unacceptable safety during preclinical studies or clinical trials;

	•	their failure to receive necessary regulatory approvals;

	•	the existence of proprietary rights of third parties; or

	•	the inability to develop manufacturing methods that are efficient, cost-effective and capable of meeting stringent regulatory standards.

We may fail to protect our intellectual property or may infringe on the intellectual property rights of others, either of which could harm our business.

If we are unable to protect our intellectual property, we may be unable to prevent other companies from using our technology in competitive products. If we infringe on the intellectual property rights of others, we may be prevented from developing or marketing our product candidates. We rely on patent and other intellectual property protection to prevent our competitors from manufacturing and marketing our product candidates. Given the rights retained and licenses granted to the U.S. government with regard to our anthrax vaccine candidate, to the extent that the U.S. government or foreign governments or organizations procuring vaccines through treaties or agreements with the U.S. government constitute the primary market for any of our products, the licenses granted by the U.S. government may not provide us with a competitive advantage.

In addition, under our U.S. government contracts, we have a duty to disclose each invention that we conceive or reduce to practice in performing the agreement, and if we wish to retain title to such invention, we must affirmatively elect to do so. If we fail to strictly follow these disclosure requirements, the U.S. government could take title to such inventions and preclude us from using them. For each invention to which we retain title, the U.S. government has both a worldwide, irrevocable, royalty-free license to practice or have practiced such invention on behalf of the U.S. government, and certain “march-in” rights pursuant to which the U.S. government could require us to license the invention that we own to third parties, including our competitors.

Technology that we may acquire or license in the future, if any, will be protected from unauthorized use by others only to the extent that it is covered by valid and enforceable patents, or effectively maintained as trade secrets and exclusively licensed to us. The patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal and factual questions. Accordingly, we cannot predict the scope and breadth of patent claims that may be afforded to other companies’ patents. In addition, we could incur substantial costs in litigation if we are required to defend against patent suits brought by third parties, or if we initiate these suits, even in such instances in which the outcome is favorable to us.

The degree of future protection for our proprietary rights is uncertain, and we cannot ensure that:


	•	others will not independently develop similar or alternative technologies or duplicate any of our technologies;

	•	any patents issued to us or licensed from the U.S. Army Medical Research Institute of Infectious Diseases, or USAMRIID, or other parties, or that we may license in the future, if any, will provide a basis for commercially viable products or will provide us with any competitive advantages or will not be challenged by third parties;

	•	we or any of our current or future licensors will adequately protect trade secrets; or

	•	we will develop additional proprietary technologies that are patentable; or the patents of others will not have a material adverse effect on our business.

We cannot be certain that patents issued to us in the future, if any, or that we may license in the future, if any, will be enforceable and afford protection against competitors. In this regard, the U.S. government has the right to use, for or on behalf of the U.S. government, any technologies developed by us under our U.S. government contracts and we cannot prohibit third parties, including our competitors, from using those technologies in providing products and services to the U.S. government. Accordingly, under our license agreement with USAMRIID granting us an exclusive license to commercialize the anthrax vaccine, the U.S. government retains a license for any federal government agency to practice USAMRIID’s anthrax-related inventions, by or on behalf of the government, thereby allowing the use of the inventions in support of government contracts with other parties, including our competitors.

Moreover, we could lose the USAMRIID license if the U.S. government terminates the license if we or any of our sublicensees:


	•	fail to diligently develop a vaccine product in accordance with the development plan described in the agreement;

	•	materially breach the agreement;

	•	make a materially false statement (or fail to provide required information) in a plan or report required under the agreement;

	•	fail to make payments required under the agreement; or

	•	file for bankruptcy.

In addition, we cannot assure you that our operations or technology will not infringe intellectual property rights of others. The United States Patent and Trademark Office keeps United States patent applications confidential while the applications are pending. As a result, we cannot determine which inventions third parties claim in pending patent applications that they have filed. We may need to engage in litigation to defend or enforce our patent and license rights or to determine the scope and validity of the proprietary rights of others. If we infringe the intellectual property of others, there can be no assurance that we would be able to obtain licenses to use the technology on commercially reasonable terms or at all. Failure to obtain licenses could force us to cease development or sale of a product candidate.

We face competition from several companies with greater financial, personnel and research and development resources than ours.

Our competitors are developing product candidates which could compete with those we may develop in the future. Our commercial opportunities will be reduced or eliminated if our competitors develop and market products for any of the diseases that we target that:


	•	are more effective;

	•	have fewer or less severe adverse side effects;

	•	are more adaptable to various modes of dosing;

	•	are easier to store or transport;

	•	are easier to administer; or

	•	are less expensive than the product candidates we develop.

Even if we are successful in developing effective products and obtain FDA and other regulatory approvals necessary for commercializing them, our products may not compete effectively with other successful products. Researchers are continually learning more about diseases, which may lead to new technologies for treatment. Our competitors may succeed in developing and marketing products either that are more effective than those that we may develop, alone or with our collaborators, making our products obsolete, or that are marketed before any products we develop are marketed.

Our competitors include fully integrated pharmaceutical companies and biotechnology companies that currently have drug and target discovery efforts, as well as universities and public and private research institutions. Many of the organizations competing with us may have substantially greater capital resources, larger research and development staffs and facilities, greater experience in drug development and in obtaining regulatory approvals, and greater marketing capabilities than we do.

Natural disasters, including earthquakes, may damage our facilities.

Our corporate and manufacturing facilities are primarily located in California. Our facilities in California are in close proximity to known earthquake fault zones. As a result, our corporate, research and manufacturing facilities are susceptible to damage from earthquakes and other natural disasters, such as fires, floods and similar events. Although we maintain general business insurance against fires and some general business interruptions, there can be no assurance that the scope or amount of coverage will be adequate in any particular case.

Our use of hazardous materials and chemicals require us to comply with regulatory requirements and exposes us to potential liabilities.

Our research and development may involve the controlled use of hazardous materials and chemicals. We are subject to federal, state, local and foreign laws governing the use, manufacture, storage, handling and disposal of such materials. We cannot eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for significant damages or fines. These damages could exceed our resources and any applicable insurance coverage. In addition, we may be required to incur significant costs to comply with regulatory requirements in the future.

We may become subject to product liability claims, which could result in damages that exceed our insurance coverage.

We face an inherent risk of exposure to product liability suits in connection with product candidates tested in human clinical trials or sold commercially. We may become subject to a product liability suit if any product candidate we develop causes injury, or if individuals subsequently become infected or otherwise suffer adverse effects from our product candidates. If a product liability claim is brought against us, the cost of defending the claim could be significant and any adverse determination could result in liabilities in excess of our insurance coverage. We maintained product liability insurance, including clinical trial liability, in the amount of $10.0 million for our programs up until March 2007, when the programs were suspended. We have an extended reporting period for claims that may arise under this coverage. We cannot be certain that additional insurance coverage, if required, could be obtained on acceptable terms, if at all.

We may be subject to claims that our employees or we have wrongfully used or disclosed alleged trade secrets of their former employers.

As is commonplace in the biotechnology industry, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies, including our competitors or potential competitors. Although no claims against us are currently pending, we may be subject to claims that these employees, or we, have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management.

We are not compliant with Section 404 under the Sarbanes-Oxley Act of 2002.

Section 404 under the Sarbanes-Oxley Act of 2002 requires that we perform an assessment of our internal control over financial reporting, and engage our independent registered public accounting firm to perform an audit of our internal control over financial reporting. We were required to complete the assessment as to the adequacy of our internal control reporting as of December 31, 2006, 2005 and 2004.

Although we completed our assessments in 2006 and 2005, given our focus on completing and filing our financial statements for those years, we did not have sufficient time nor did we provide sufficient time to our independent registered public accounting firm to complete our and their 2004 respective responsibilities before December 31, 2004. Our independent registered public accounting firm concluded that we failed to complete the required 2004 assessment as to the effectiveness of our internal control over financial reporting, and they were unable to complete their required audit of internal control over financial reporting. Accordingly, they disclaimed an opinion as to the effectiveness of our internal control over financial reporting for 2004.

We do not believe that the SEC has provided guidance as to the effect of such a disclaimer. Having received such a disclaimer, our Annual Report on Form 10-K for the year ended December 31, 2004, may be deemed to be deficient by the SEC. If our 2004 10-K were deemed to be deficient, the SEC may conclude that we are in violation of Sections 13 and 15(d) of the Exchange Act.

Our operating results may be adversely impacted by recently adopted changes in accounting for stock options.

The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123(R),Share-Based Payment, or FAS 123R, in December 2004. FAS123R, which we implemented effective January 1, 2006, requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. The future impact of FAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. We use the Black-Scholes option pricing model as allowed under FAS 123R to determine the fair value.

Risks Related to our Common Stock

Our stockholders could experience substantial dilution as a result of the issuance of additional shares of common or preferred stock.

Our Board of Directors has the authority to establish the designation of almost 20,000,000 shares of preferred stock that are convertible into common stock without any action by our stockholders, and to fix the rights, preferences, privileges and restrictions, including voting rights, of such shares. In February 2006, we raised net proceeds of $25.2 million through a private placement of 3.5 million shares of common stock at $7.70 per share to a group of accredited institutional investors. We also issued to the investors five-year warrants initially exercisable to purchase 699,996 shares of common stock at an exercise price of $9.24 per share. Because we did not file all of our delinquent periodic reports with the SEC by January 31, 2007, the warrants became exercisable for an additional 699,988 shares of common stock, at a price of $9.24 per share. We may raise additional funds through public or private offerings of our preferred stock or our common stock, or through issuance of debt securities that are convertible into shares of our common stock. The issuance of additional shares of our common stock, or conversion of preferred stock or debt securities into shares of common stock, would further dilute the percentage ownership of our stockholders.

Shares of our common stock eligible for future sale may adversely affect the market for our common stock.

Shares of our common stock issued in a private placement February 2006 are being registered for resale under a registration statement filed with the SEC. In addition, pursuant to Rule 144, generally, a stockholder (or stockholders whose shares are aggregated) who has satisfied a one year holding period may, under certain circumstances, sell within any three month period a number of securities which does not exceed the greater of 1% of the then outstanding shares of common stock or the average weekly trading volume of the class during the four calendar weeks prior to such sale. Rule 144 also permits, under certain circumstances, the sale of securities, without any limitation, by our stockholders that are non-affiliates that have satisfied a two year holding period, such as certain of those stockholders who purchased shares of our common stock in our November 2004 private placement or Notes convertible into shares of our common stock in our 2005 private placement of the Notes. Any substantial sale of our common stock under effective resale registration statements or pursuant to Rule 144 or pursuant to any resale prospectus may have a material adverse effect on the market price of our securities.

Our stock price is likely to be volatile. *

Currently, our common stock is traded OTC and is quoted on the OTC Pink Sheets LLC. Stocks traded OTC typically are subject to greater volatility than stocks traded on stock exchanges, such as the Nasdaq Global Market or the Nasdaq Capital Market, due to the fact that OTC trading volumes are generally significantly less than on stock exchanges. This lower volume may allow a relatively few number of stock trades to greatly affect the stock price. The trading price of our common stock has been and is likely to continue to be extremely volatile. For example, between August 9, 2004 and September 30, 2007, the closing price of our common stock, as quoted on the Pink Sheets, has ranged from a high of $18.55 per share to a low of $1.24 per share.

Our stock price could continue to be subject to wide fluctuations in response to a variety of factors, including:


	•	timing and consistency of filing financial statements;

	•	announcements or speculation about any strategic transactions we may enter into;

	•	failure to win future government contracts and government activities relating to prior contracts;

	•	adverse results or delays in clinical trials;

	•	delays in our product development efforts;

	•	real or perceived safety issues with any of our product candidates;

	•	failure to obtain or maintain required regulatory approvals;

	•	changes in financial estimates by securities analysts and our failure to meet or exceed such estimates;

	•	rumors about our business prospects, product development efforts or the progress, timing and completion of our clinical trials;

	•	new products or services offered by us or our competitors or announcements relating to product developments by our competitors;

	•	issuances of debt or equity securities;

	•	issuances of securities or the expectation of the issuance of securities as part of a merger or other strategic transaction;

	•	actual or expected sales by our stockholders of substantial amounts of our common stock, including shares issued upon exercise of outstanding options and warrants; and

	•	other events or factors, many of which are beyond our control.

In addition, the stock market in general and biotechnology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of these companies. Broad market and industry factors may negatively affect the market price of our common stock, regardless of actual operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against companies. If we face securities litigation in the future, even if it is without merit or unsuccessful, it would result in substantial costs and a diversion of management attention and resources, which could have a material adverse effect on our business.

We have no history of paying dividends on our common stock.

We have never paid cash dividends on our common stock and do not anticipate paying any cash dividends on our common stock in the foreseeable future. We plan to retain any future earnings to finance our growth. If we decide to pay dividends to the holders of our common stock, such dividends may not be paid on a timely basis.

Our charter documents and Delaware law may discourage an acquisition of VaxGen.

Provisions of our certificate of incorporation, by-laws, and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. We may issue shares of preferred stock in the future without stockholder approval and upon such terms as our board of directors may determine. Our issuance of this preferred stock could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from acquiring, a majority of our outstanding stock. Our charter and by-laws also provide that special stockholders meetings may be called only by our Chairman of the board of directors, by our Secretary at the written request of the chairman or by our board of directors, with the result that any third-party takeover not supported by the board of directors could be subject to significant delays and difficulties.


ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

�� (a) Exhibits required by Item 601 of Regulation S-K:

The following exhibits are filed as part of this report:

Incorporated by Reference

Exhibit
No.

Exhibit

Form

File No.

Filing Date

Exhibit
No.

Filed
Herewith

10.1

VaxGen, Inc. Severance Benefit Plan, dated August 1, 2007

8-K

0-26483

August 7, 2007

10.1

31.1

Certification of Chief Executive Officer

10-Q

31.2

Certification of Principal Financial Officer

10-Q

32.1

Section 1350 Certification

10-Q

Signatures

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


	VaxGen, Inc.

Dated:November 8, 2007	By: /s/ James P. Panek

	James P. Panek
	*Chief Executive Officer*
	*(Principal Executive Officer)*

Dated:November 8, 2007	By: /s/ Matthew J. Pfeffer

	Matthew J. Pfeffer
	*Chief Financial Officer*
	*(Principal Financial Officer)*

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. freshman Avg

Diadexus (VXGN) Inactive 10-Q2007 Q3 Quarterly report

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