Verenium 10-Q 2006 Q1 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 March 31, 2006.

OR

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

For the transition period from                    to                    

Commission file number 000-29173

DIVERSA CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	22-3297375
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
4955 Directors Place, San Diego, California	92121
(Address of principal executive offices)	(Zip Code)

(Registrant’s telephone number, including area code (858) 526-5000)

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.x Yes  ¨ No

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.

Large accelerated filer  ¨ Accelerated filer  x Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of Act). Yes ¨   No x

The number of shares of the registrant’s Common Stock outstanding as of April 28, 2006 was 47,283,000.

DIVERSA CORPORATION

INDEX

		Page No.
PART I - FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements
	Condensed Consolidated Balance Sheets as of March 31, 2006 (unaudited) and December 31, 2005	3
	Condensed Consolidated Statements of Operations for the three months ended March 31, 2006 and 2005 (unaudited)	4
	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and 2005 (unaudited)	5
	Notes to Condensed Consolidated Financial Statements (unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	25
Item 4.	Controls and Procedures	26
PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	26
Item 1A.	Risk Factors	27
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	36
Item 3.	Defaults Upon Senior Securities	36
Item 4.	Submission of Matters to a Vote of Security Holders	36
Item 5.	Other Information	36
Item 6.	Exhibits	36
SIGNATURES		38

2

DIVERSA CORPORATION

PART I - FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.

DIVERSA CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value)

	MARCH 31, 2006			DECEMBER 31, 2005
	(Unaudited)			(Note)
ASSETS
Current assets:
Cash and cash equivalents	$	34,225		$	43,859
Short-term investments		25,351			21,569
Accounts receivable (including $1,528 and $1,657 from a related party at March 31, 2006 and December 31, 2005)		7,186			9,012
Other current assets		5,673			4,996
Total current assets		72,435			79,436
Property and equipment, net		16,245			18,245
Other assets		309			388
Total assets	$	88,989		$	98,069
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	4,424		$	4,968
Accrued liabilities		5,834			6,156
Current portion of restructuring liabilities		1,986			—
Deferred revenue (including $6,827 and $5,931 from a related party at March 31, 2006 and December 31, 2005)		9,185			7,535
Current portion of debt obligations		6,890			7,024
Total current liabilities		28,319			25,683
Notes payable, less current portion		5,510			6,332
Deferred revenue, less current portion		1,125			1,250
Restructuring liabilities, less current portion		6,331			—
Commitments and contingencies
Stockholders’ equity:
Preferred stock - $0.001 par value; 5,000 shares authorized, no shares issued and outstanding at March 31, 2006 and December 31, 2005		—			—
Common stock - $0.001 par value; 90,000 shares authorized, 47,039 and 45,048 shares issued and outstanding at March 31, 2006 and December 31, 2005		47			45
Additional paid-in capital		359,433			358,307
Deferred compensation		—			(3,130	)
Accumulated deficit		(311,616	)		(290,215	)
Accumulated other comprehensive loss		(160	)		(203	)
Total stockholders’ equity		47,704			64,804
Total liabilities and stockholders’ equity	$	88,989		$	98,069

Note: The balance sheet data at December 31, 2005 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.

See accompanying notes to condensed consolidated financial statements.

3

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

	THREE MONTHS ENDED MARCH 31,
	2006			2005
Revenues (including related party revenues of $4,439 and $6,659 for the three months ended March 31, 2006 and 2005):
Collaborative	$	6,324		$	9,253
Grant		651			2,023
Product-related		2,535			1,553
Total revenue		9,510			12,829
Operating expenses:
Cost of product-related revenue		2,182			1,692
Research and development		14,061			19,550
Selling, general and administrative		3,871			3,063
Amortization of acquired intangible assets		—			650
Restructuring charges		11,023			—
Total operating expenses		31,137			24,955
Loss from operations		(21,627	)		(12,126	)
Interest and other income, net		226			140
Net loss	$	(21,401	)	$	(11,986	)
Net loss per share, basic and diluted	$	(0.47	)	$	(0.27	)
Weighted average shares used in calculating basic and diluted net loss per share		45,368			43,838

See accompanying notes to condensed consolidated financial statements.

4

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	THREE MONTHS ENDED MARCH 31,
	2006			2005
Operating activities:
Net loss	$	(21,401	)	$	(11,986	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		2,668			4,489
Non-cash share-based compensation charges		1,301			134
Non-cash restructuring charges		226			—
Changes in operating assets and liabilities:
Accounts receivable		1,826			(1,708	)
Other assets		(598	)		(695	)
Accounts payable and accrued expenses		(246	)		(2,748	)
Restructuring liabilities		8,317			—
Deferred revenue		1,525			696
Net cash used in operating activities		(6,382	)		(11,818	)
Investing activities:
Purchases of short-term investments		(42,131	)		(77,276	)
Sales and maturities of short-term investments		38,392			86,894
Purchases of property and equipment		(668	)		(2,265	)
Net cash (used in ) provided by investing activities		(4,407	)		7,353
Financing activities:
Net proceeds from sale of common stock		2,111			1,425
Principal payments on debt obligations		(1,784	)		(2,849	)
Advances under notes payable		828			1,865
Net cash provided by financing activities		1,155			441
Net decrease in cash and cash equivalents		(9,634	)		(4,024	)
Cash and cash equivalents at beginning of period		43,859			33,796
Cash and cash equivalents at end of period	$	34,225		$	29,772
Supplemental disclosure of non-cash operating and financing activities:
Common stock issued to settle employee bonus liabilities	$	620		$	—

See accompanying notes to condensed consolidated financial statements.

5

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Organization and Business

The Company

Diversa Corporation (the “Company) was incorporated in December 1992 and began operations in May 1994. The Company is a leader in applying proprietary genomic technologies for the rapid discovery and optimization of novel protein-based products, including (a) enzymes, which are catalytic proteins, and (b) antibodies, which are binding proteins. The Company is directing its integrated portfolio of technologies to the discovery, evolution, and production of commercially valuable molecules with agricultural, industrial, and chemical applications, such as enzymes, as well as optimized antibodies with pharmaceutical applications. While the Company’s technologies have the potential to serve many large markets, the key areas of focus for internal product development are alternative fuels, specialty industrial processes, and health and nutrition.

As more fully described in the accompanying footnotes and prior filings with the Securities and Exchange Commission, on January 5, 2006 the Company announced a strategic reorganization, pursuant to which the Company plans to focus its resources on advancing its most promising product candidates and programs that have the greatest near-term opportunities. As part of this reorganization, the Company eliminated and/or significantly scaled back its investments in certain programs and lines of business, which were not consistent with the current strategic focus. As a result, the Company reduced its workforce by 83 employees and consolidated its facilities. In connection with the reorganization, during the fourth quarter of 2005, the Company recorded a non-cash impairment charge of $45.7 million to write off long-lived tangible and intangible assets that are no longer essential to the Company’s focus and determined to be impaired under current accounting rules. During the quarter ended March 31, 2006, the Company also recorded restructuring charges of $11.0 million related to employee separation and facilities consolidation costs (See Note 8—Restructuring Charges).

2. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with U.S. generally accepted accounting principles for interim financial information. Accordingly, they do not include all the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, which are necessary for a fair presentation of the results of the interim periods presented, have been included. The results of operations for the interim periods are not necessarily indicative of results to be expected for any other interim period or for the year as a whole. These unaudited condensed consolidated financial statements and footnotes thereto should be read in conjunction with the audited financial statements and footnotes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in the condensed consolidated financial statements and related footnotes. Changes in the estimates may affect amounts reported in future periods.

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

3. Revenue Recognition

The Company recognizes revenue when all of its contractual obligations are satisfied and collection of the underlying receivable is reasonably assured, in accordance with Securities and Exchange Commission Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition.” Billings to customers or payments received from customers are included in deferred revenue on the balance sheet until all revenue recognition criteria are met.

Collaborative Revenue

Revenue from research funding under the Company’s collaboration agreements is earned and recognized on a percentage-of-completion basis as research hours are incurred in accordance with the provisions of each agreement. Fees received to initiate research projects are deferred and recognized over the life of the project. Fees received for exclusivity in a field are deferred and recognized over the period of exclusivity. Milestone payments are recognized when earned, as evidenced by written acknowledgement from the collaborator, provided that (i) the milestone event is substantive and its achievement was not reasonably assured at the inception of the agreement, and (ii) the Company’s performance obligations after the milestone achievement will continue to be funded by the collaborator at a level comparable to the level before the milestone achievement.

6

Grant Revenue

Revenue from grants is recognized as related costs are incurred, as long as such costs are within the funding limits specified by the underlying grant agreements.

Product-Related Revenue

Product-related revenues are recognized at the time of shipment to the customer provided all other revenue recognition criteria have been met. The Company recognizes revenue on product sales through third-party distribution agreements, if the distributor has a right of return, in accordance with the provisions set forth in Financial Accounting Standards Board Statement (“FASB”) No. 48,“Revenue Recognition When Right of Return Exists.” Under FASB No. 48, the Company recognizes product revenues upon shipment to distributors, provided that (a) the price is substantially fixed and determinable at the time of sale; (b) the distributor’s obligation to pay the Company is not contingent upon resale of the products; (c) title and risk of loss passes to the distributor at time of shipment; (d) the distributor has economic substance apart from that provided by the Company; (e) the Company has no significant obligation to the distributor to bring about resale of the products; and (f) future returns can be reasonably estimated. For any sales that do not meet all of the above criteria, revenue is deferred until all such criteria have been met.

The Company recognizes profit-sharing revenue during the quarter in which such revenue is earned, based on estimates provided by the Company’s profit-sharing partner. These estimates are adjusted for actual results in the subsequent quarter. Profit-sharing revenue is included in product-related revenue in the statement of operations.

Revenue Arrangements with Multiple Deliverables

The Company sometimes enters into revenue arrangements that contain multiple deliverables. The Company recognizes revenue from such arrangements entered into subsequent to June 30, 2003 in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” This issue addresses the timing and method of revenue recognition for revenue arrangements that include the delivery of more than one product or service. In these cases, the Company recognizes revenue from each element of the arrangement as long as separate value for each element can be determined, the Company has completed its obligation to deliver or perform on that element, and collection of the resulting receivable is reasonably assured.

As of March 31, 2006, the Company had $10.3 million in deferred revenue, of which $0.9 million was related to product sales, and $9.4 million was related to funding from collaborative partners.

4. Share-based Compensation

Equity Incentive Plans

2005 Non-Employee Directors’ Equity Incentive Plan

In March 2005, the Board of Directors of the Company (“Board”) adopted the Company’s 2005 Non-Employee Directors’ Equity Incentive Plan (“Directors’ Plan”), and reserved a total of 636,000 shares for issuance thereunder. As of March 31, 2006, there were approximately 481,000 shares outstanding under the Directors’ Plan.

1999 Employee Stock Purchase Plan

In December 1999, the Board of Directors adopted the 1999 Employee Stock Purchase Plan (the “ESPP”). As of March 31, 2006, a total of 1,437,000 shares of the Company’s common stock have been reserved for issuance under ESPP. The ESPP permits eligible employees to purchase common stock at a discount, but only through payroll deductions, during defined offering periods. The price at which stock is purchased under the ESPP is equal to 85% of the fair market value of the common stock on the first or last day of the offering period, whichever is lower. The ESPP provides for annual increases of shares available for issuance under the ESPP. As of March 31, 2006, there were approximately 47,000 shares available for future issuance under the ESPP.

7

1997 Equity Incentive Plan

In August 1997, the Company adopted the 1997 Equity Incentive Plan (the “1997 Plan”), which provides for the granting of incentive or non-statutory stock options, stock bonuses, and rights to purchase restricted stock to employees, directors, and consultants as administered by the Board. Unless terminated sooner by the Board, the 1997 Plan will terminate in August 2007. The incentive and non-statutory stock options are granted with an exercise price of not less than 100% and 85%, respectively, of the estimated fair value of the underlying common stock as determined by the Board. The 1997 Plan allows the purchase of restricted stock at a price that is not less than 85% of the estimated fair value of the Company’s common stock as determined by the Board of Directors. Options granted under the 1997 Plan vest over periods up to four years and are exercisable over periods not exceeding ten years. As of March 31, 2006, the aggregate number of shares which may be awarded under the 1997 Plan is 12,983,000, with approximately 3,282,000 available for grant.

Outstanding awards that were previously granted under predecessor plans also remain in effect in accordance with their terms.

Accounting for Share-Based Compensation

In January 2006 the Company adopted FASB No. 123(R), “Share-Based Payment,” which is a revision of FASB No. 123, “Accounting for Share-based Compensation.” FASB No. 123(R) supersedes APB No. 25 and amends FASB No. 95, “Statement of Cash Flows.” Generally, the approach in FASB No. 123(R) is similar to the approach described in FASB No. 123. However, FASB No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure, which has previously been used by the Company, is no longer an alternative.

The Company adopted the fair value recognition provisions of FASB No. 123(R), using the modified prospective transition method. Under this transition method, compensation expense includes options vesting for (1) share-based payments granted prior to, but not vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of FASB No. 123; (2) share-based payments granted after December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of FASB No. 123(R); and (3) shares issued under the ESPP after December 31, 2005, based on calculations of fair value which are similar to how stock option valuations are made. Because this transition method was selected, results of prior periods have not been restated.

Prior to January 1, 2006, the Company accounted for share-based employee compensation plans using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and its related interpretations. Under the provisions of APB 25, no compensation expense was recognized with respect to purchases of the Company’s common stock under the ESPP or when stock options were granted with exercise prices equal to or greater than market value on the date of grant.

All of the Company’s equity incentive plans are considered to be compensatory plans under FASB No. 123(R).

The Company recognized $1.3 million ($0.03 per share) and $0.1 million ($0.00 per share) in share-based compensation expense for its share-based awards during the three-month periods ended March 31, 2006 and 2005. These charges had no impact on the Company’s reported cash flows. Share-based compensation expense was allocated among the following expense categories:

	THREE MONTHS ENDED MARCH 31,
	2006		2005
Research and development	$	872	$	75
Selling, general and administrative		429		59
	$	1,301	$	134

Under the modified prospective method of transition under FASB No. 123(R), the Company is not required to restate its prior period financial statements to reflect expensing of share-based compensation under the new standard. Therefore, the results for the three months ended March 31, 2006 are not comparable to the same periods in the prior year.

8

4. Share-based Compensation

Equity Incentive Plans

2005 Non-Employee Directors’ Equity Incentive Plan

In March 2005, the Board of Directors of the Company (“Board”) adopted the Company’s 2005 Non-Employee Directors’ Equity Incentive Plan (“Directors’ Plan”), and reserved a total of 636,000 shares for issuance thereunder. As of March 31, 2006, there were approximately 481,000 shares outstanding under the Directors’ Plan.

1999 Employee Stock Purchase Plan

In December 1999, the Board of Directors adopted the 1999 Employee Stock Purchase Plan (the “ESPP”). As of March 31, 2006, a total of 1,437,000 shares of the Company’s common stock have been reserved for issuance under ESPP. The ESPP permits eligible employees to purchase common stock at a discount, but only through payroll deductions, during defined offering periods. The price at which stock is purchased under the ESPP is equal to 85% of the fair market value of the common stock on the first or last day of the offering period, whichever is lower. The ESPP provides for annual increases of shares available for issuance under the ESPP. As of March 31, 2006, there were approximately 47,000 shares available for future issuance under the ESPP.

1997 Equity Incentive Plan

In August 1997, the Company adopted the 1997 Equity Incentive Plan (the “1997 Plan”), which provides for the granting of incentive or non-statutory stock options, stock bonuses, and rights to purchase restricted stock to employees, directors, and consultants as administered by the Board. Unless terminated sooner by the Board, the 1997 Plan will terminate in August 2007. The incentive and non-statutory stock options are granted with an exercise price of not less than 100% and 85%, respectively, of the estimated fair value of the underlying common stock as determined by the Board. The 1997 Plan allows the purchase of restricted stock at a price that is not less than 85% of the estimated fair value of the Company’s common stock as determined by the Board of Directors. Options granted under the 1997 Plan vest over periods up to four years and are exercisable over periods not exceeding ten years. As of March 31, 2006, the aggregate number of shares which may be awarded under the 1997 Plan is 12,983,000, with approximately 3,282,000 available for grant.

Outstanding awards that were previously granted under predecessor plans also remain in effect in accordance with their terms.

Accounting for Share-Based Compensation

In January 2006 the Company adopted FASB No. 123(R), “Share-Based Payment,” which is a revision of FASB No. 123, “Accounting for Share-based Compensation.” FASB No. 123(R) supersedes APB No. 25 and amends FASB No. 95, “Statement of Cash Flows.” Generally, the approach in FASB No. 123(R) is similar to the approach described in FASB No. 123. However, FASB No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure, which has previously been used by the Company, is no longer an alternative.

The Company adopted the fair value recognition provisions of FASB No. 123(R), using the modified prospective transition method. Under this transition method, compensation expense includes options vesting for 1) share-based payments granted prior to, but not vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of FASB No. 123; 2) share-based payments granted after December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of FASB No. 123(R); and 3) shares issued under the ESPP after December 31, 2005, based on calculations of fair value which are similar to how stock option valuations are made. Because this transition method was selected, results of prior periods have not been restated.

9

Prior to January 1, 2006, the Company accounted for share-based employee compensation plans using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and its related interpretations. Under the provisions of APB 25, no compensation expense was recognized with respect to purchases of the Company’s common stock under the ESPP or when stock options were granted with exercise prices equal to or greater than market value on the date of grant.

All of the Company’s equity incentive plans are considered to be compensatory plans under FASB No. 123(R).

The Company recognized $1.3 million ($0.03 per share) and $0.1 million ($0.00 per share) in share-based compensation expense for its share-based awards during the three-month periods ended March 31, 2006 and 2005. These charges had no impact on the Company’s reported cash flows. Share-based compensation expense was allocated among the following expense categories:

	THREE MONTHS ENDED MARCH 31,
	2006		2005
Research and development	$	872	$	75
Selling, general and administrative		429		59
	$	1,301	$	134

Under the modified prospective method of transition under FASB No. 123(R), the Company is not required to restate its prior period financial statements to reflect expensing of share-based compensation under the new standard. Therefore, the results for the three months ended March 31, 2006 are not comparable to the same periods in the prior year.

10

The Company has determined its share-based compensation expense under FASB No. 123(R) for the three months ended March 31, 2006 as follows:

Valuation of Stock Options

Share-based compensation related to stock options includes both the amortization of the fair value of options granted prior to January 1, 2006, determined using the multiple option approach under the Black-Scholes Merton (“BSM”) valuation model, as well as the amortization of the fair value of options granted after December 31, 2005, determined using the single option approach under the BSM valuation model. The fair value of options determined under FASB No. 123(R) is amortized to expense over the vesting periods of the underlying options, generally four years.

The fair value of stock option awards for the three months ended March 31, 2006 was estimated on the date of grant using the assumptions in the following table. The expected volatility in this model is based on the historical volatility of the Company’s stock. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time awards are granted, based on maturities which approximate the expected life of the options. The expected life of the options granted is estimated using the historical exercise behavior of employees. The expected dividend rate takes into account the absence of any historical payments and management’s intention to retain all earnings for future operations and expansion.

Average Risk-Free Interest Rate	Dividend Yield	Average Volatility Factor	Average Option Life
4.5%	0%	0.61	Five Years

Valuation of ESPP Awards

Share-based compensation related to awards issued under the ESPP after December 31, 2005 are based on calculations of fair value under the BSM valuation model which are similar to how stock option valuations are made. The fair value of ESPP awards determined under FASB No. 123(R) is amortized to expense over the vesting periods of the underlying awards, ranging from six months to two years. For the three months ended March 31, 2006, the fair value was based on the following assumptions.

Average Risk-Free Interest Rate	Dividend Yield	Average Volatility Factor	Average Option Life
3.7%	0%	0.53	Six months to two years

Valuation of Non-Restricted and Restricted Stock Awards

The fair value of non-restricted and restricted stock awards is equal to the closing market price of the Company’s common stock at the date of grant. The fair value of non-restricted awards is charged to share-based compensation upon grant. The fair value of restricted awards is amortized to share-based compensation expense over the vesting period of the underlying awards, ranging from two years to four years.

The Company is required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods on a cumulative basis in the period the estimated forfeiture rate changes for all share-based awards. The Company considered its historical experience of pre-vesting option forfeitures as the basis to arrive at its estimated pre-vesting option forfeiture rate of 5% per year for the three months ended March 31, 2006 for all share-based awards.

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Equity Incentive Awards Activity

Information with respect to all of the Company’s stock option plans is as follows (in thousands, except per share data):

	Shares		Weighted Average Exercise Price Per Share		Aggregate Intrinsic Value
Outstanding at December 31, 2005	7,539		$	10.34
Granted	1		$	6.89
Exercised	(941	)	$	1.89
Cancelled	(1,323	)	$	13.22
Outstanding at March 31, 2006	5,276		$	11.12	$	4,905
Exercisable at March 31, 2006	4,608		$	11.68	$	3,685

The grant date fair value of options granted during the three months ended March 31, 2006 was $4.16 per share. The total intrinsic value of options exercised during the three months ended March 31, 2006 was $3.8 million, or $4.01 per share.

A further detail of the options outstanding as of March 31, 2006 is set forth as follows (in thousands, except per share data):

Range of Exercise Prices	Options Outstanding	Weighted- Average Remaining Life in Years	Weighted- Average Exercise Price Per Share		Options Exercisable	Weighted- Average Exercise Price Per Share
$  0.42 – $  7.36	1,358	6.6	$	5.88	964	$	5.74
$  7.37 – $10.05	2,395	7.6	$	9.44	2,121	$	9.52
$10.06 – $27.00	1,425	5.4	$	17.11	1,425	$	17.11
$29.00 – $88.63	98	4.1	$	37.95	98	$	37.95
$  0.42 – $88.63	5,276	6.7	$	11.12	4,608	$	11.68

Non-Restricted and Restricted Share Awards

Information with respect to all of the Company’s non-restricted and restricted share awards is as follows (in thousands, except per share data):

	Shares		Weighted Average Fair Value
Nonvested awards outstanding at December 31, 2005	560		$	6.47
Granted	1,029		$	6.41
Vested	(219	)	$	7.17
Forfeited and cancelled	(75	)	$	7.02
Nonvested awards outstanding at March 31, 2006	1,295		$	6.27

12

Unrecognized Share-Based Compensation Expense

As of March 31, 2006, there was $9.4 million of total unrecognized compensation expense related to nonvested share-based compensation arrangements granted under the equity incentive plans. This expense is expected to be recognized over a weighted-average period of 1.6 years as follows:

	(in thousands)
Fiscal Year 2006 (April 1, 2006 to December 31, 2006)	$	4,104
Fiscal Year 2007		3,346
Fiscal Year 2008		1,583
Fiscal Year 2009		355
Fiscal Year 2010		10
	$	9,398

During the fourth quarter of fiscal 2005, the Company accelerated the vesting of unvested stock options awarded to all employees and officers under its stock option plans that had exercise prices greater than $10.00. The unvested options to purchase approximately 710,000 shares became fully vested as of December 8, 2005 as a result of the acceleration. These stock options would have all become fully vested before or during 2008. The Company accelerated these options because the options had exercise prices significantly in excess of the then current market value ($5.25 at December 8, 2005), and thus were not fully achieving their original objectives of incentive compensation and employee retention. The Company expects the acceleration to have a positive effect on employee morale, retention, and perception of value. The acceleration also eliminated future compensation expense that would have been recognized in the statements of operations with respect to these options with the implementation of FASB No. 123 (R). The future expense eliminated as a result of the acceleration of the vesting of these options was approximately $1.1 million.

Prior Year Proforma Disclosure of Share-Based Compensation Expense

The following table sets forth the pro forma disclosure of the Company’s net loss and net loss per share for the prior year period assuming the estimated fair value of the options granted prior to January 1, 2006 were calculated pursuant to FASB No. 123 , and amortized to expense over the option-vesting period (in thousands, except per share data):

	THREE MONTHS ENDED MARCH 31, 2005
(In thousands, except per share data)
Net loss, as reported	$	(11,986	)
Add: Share-based employee compensation expense included in reported net loss		134
Deduct: Total share-based employee compensation expense determined under fair value based method for all awards		(2,020	)
Pro forma net loss	$	(13,872	)
Basic and diluted net loss per share, as reported	$	(0.27	)
Pro forma basic and diluted net loss per share	$	(0.32	)

Pro forma information regarding net loss and net loss per share was been determined as if the Company had accounted for its employee stock options and stock purchase plan under the fair value method of FASB No. 123. For the three months ended March 31, 2005, the fair value of these options was estimated using the Black-Scholes model with the following assumptions: risk-free interest rates ranging from 3.58% to 4.18%, dividend yield of 0%; volatility factor of 0.56 and a weighted-average expected life of the options of three years.

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5. Computation of Net Loss per Share

Basic and diluted net loss per share has been computed using the weighted-average number of shares of common stock outstanding during the period. As of March 31, 2006, there were approximately 1,295,000 outstanding nonvested restricted shares. For purposes of the computation of net loss per share, these nonvested shares are considered contingently returnable shares under FASB No. 128,“Earnings Per Share,” and are not considered outstanding common shares for purposes of computing net loss per share until all necessary conditions are met that no longer cause the shares to be contingently returnable. The impact of these nonvested shares on weighted average shares outstanding has been excluded for purposes of computing net loss per share.

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):

	Quarter Ended March 31
	2006			2005
Weighted average shares outstanding during the period		46,298			43,838
Less: Weighted average nonvested restricted shares outstanding		(930	)		—
Weighted average shares used in computing basic and diluted net loss per share		45,368			43,838
Net loss	$	(21,401	)	$	(11,986	)
Net loss per share, basic and diluted	$	(0.47	)	$	(0.27	)

The Company has excluded all outstanding stock options and warrants from the calculation of diluted net loss per share because all such securities are anti-dilutive for all applicable periods presented.

6. Comprehensive Loss

Comprehensive loss is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources, including unrealized gains and losses on marketable securities. The Company presents comprehensive loss in its statements of stockholders’ equity.

The comprehensive loss consisted of the following (in thousands):

	THREE MONTHS ENDED MARCH 31,
(In thousands)	2006			2005
Net loss	$	(21,401	)	$	(11,986	)
Other comprehensive gain (loss):
Unrealized gain (loss) on investments		43			(84	)
Comprehensive loss	$	(21,358	)	$	(12,070	)

7. Contingencies

In June 2004, the Company executed a formal settlement agreement with the plaintiffs in a class action lawsuit filed in December 2002 in a U.S. federal district court (the “Court”). This lawsuit is part of a series of related lawsuits in which similar complaints were filed by plaintiffs against hundreds of other public companies that conducted IPOs of their common stock in 2000 and the late 1990’s. On February 15, 2005, the Court issued a decision certifying a class action for settlement purposes and granting preliminary approval of the settlement subject to modification of certain orders contemplated by the settlement. On August 31, 2005, the Court reaffirmed class certification and preliminary approval of the modified settlement

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in a comprehensive order, and directed that notice of the settlement be published and mailed to class members beginning November 15, 2005. On February 24, 2006, the Court dismissed litigation filed against certain underwriters in connection with the claims to be assigned to the plaintiffs under the settlement. On April 24, 2006, the Court held a final fairness hearing to determine whether to grant final approval of the settlement. A decision is expected this summer. The Company is covered by a claims-made liability insurance policy which it believes will satisfy any potential liability of the Company under this settlement.

8. Restructuring Charges

In connection with the January 2006 decision to reorganize and refocus the Company’s resources, management commenced several cost containment measures, including a reduction in workforce of 83 employees and the consolidation of its facilities. Pursuant to FASB No. 146,“Accounting for Costs Associated with Exit or Disposal Activities,”the Company recorded charges of $11.0 million in the first quarter of 2006 related to these activities. The following table sets forth the activity in the restructuring reserves during the three months ended March 31, 2006 (in thousands):

	Facility Consolidation Costs			Employee Separation Costs			Other Costs			Total
Balance at December 31, 2005	$	—		$	—		$	—		$	—
Accrued and expensed		8,356			2,607			60			11,023
Charged against accrual		(39	)		(2,607	)		(60	)		(2,706	)
Balance at March 31, 2006	$	8,317		$	—		$	—		$	8,317

During the first quarter of 2006, the Company completed the employee termination activities under this restructuring and no further payments or expenses related to employee separation are anticipated under this program. The facility consolidation costs are based on estimates, representing the discounted cash flow of lease payments (net of anticipated sublease income) on the vacated space through its contractual lease term in 2016. Pursuant to FASB No. 146 the Company is required to re-assess these estimates on a periodic basis. Accordingly, the Company may revise these estimates in future periods, which could give rise to additional charges or adjustments.

9. Related Party Transactions

Syngenta AG

On February 20, 2003, the Company entered into a research collaboration with Syngenta, a greater-than 10% owner of the Company’s outstanding common stock. Under the collaboration, which was amended in May 2004, the Company is entitled to receive a minimum of $118.0 million in research and development funding over the initial seven-year term of the related research collaboration agreement and is eligible to receive certain milestone payments and royalties upon product development and commercialization.

The Company recognized revenue from Syngenta and its affiliates of $4.4 million and $6.7 million for the three months ended March 31, 2006, and 2005. Accounts receivable due from Syngenta were $1.5 million and $1.7 million, and deferred revenue associated with Syngenta was $6.8 million and $5.9 million, at March 31, 2006 and December 31, 2005.

In connection with the research collaboration with Syngenta, the Company received $94,500 and $147,000 in rental cost reimbursements from Syngenta during the three months ended March 31, 2006 and 2005, which was recorded as a reduction in rent expense.

Notes Receivable from Officers

In February 2000, the Company initiated a loan program for certain key employees and executive officers to pay personal tax liabilities resulting from the failure to file Form 83(b) elections with the Internal Revenue Service related to those employees’ exercise of incentive and non-qualified stock options during 1999, pursuant to which the Company agreed to loan the employees up to $1.6 million in full recourse promissory notes. As of March 31, 2006 and December 31, 2005, the Company had a remaining loan balance from three individuals aggregating $0.6 million, which amounts are included in

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other current assets on the accompanying balance sheet. The notes bore interest at 4.94%, and were repaid in full as they came due in April 2006.

10. Concentration of Business Risk

During the three months ended March 31, 2006 and 2005, the Company had collaborative research agreements that accounted for 67% and 72% of total revenue. Additionally, during the three months ended March 31, 2006 and 2005, one collaborator accounted for 47% and 52% of total revenue.

A relatively small number of customers and collaboration partners historically have accounted for a significant percentage of the Company’s revenue. Revenue from significant customers and / or collaboration partners as a percentage of total revenue was as follows:

	THREE MONTHS ENDED MARCH 31,
	2006		2005
Customer A	47	%	52	%
Customer B	14	%	11	%

Accounts receivable from three significant customers comprised approximately 21%, 21%, and 18% of accounts receivable at March 31, 2006. Accounts receivable from four significant customers comprised approximately 21%, 18%, 15%, and 12% of accounts receivable at December 31, 2005. Accounts receivable derived directly or indirectly from agencies of the U.S. Government comprised 19% and 13% of total accounts receivable at March 31, 2006 and December 31, 2005.

Revenue by geographic area was as follows (in thousands):

	THREE MONTHS ENDED MARCH 31,
	2006		2005
North America	$	3,092	$	4,007
South America		465		—
Europe		5,953		8,596
Asia		—		226
	$	9,510	$	12,829

11. Impact of Recently Issued Accounting Standards

As discussed inNote 4, “Share-Based Compensation,” the Company adopted FASB No. 123(R) effective January 1, 2006 under the “modified prospective” method. The Company recorded $1.3 million in stock –based compensation during the first quarter of 2006, and estimates that, based on current share-based awards granted to date, share-based compensation expense for fiscal 2006 will be approximately $5.5 million.

On January 1, 2006, the Company adopted FASB No. 154, “Accounting Changes and Error Corrections,” a replacement of APB Opinion No. 20, “Accounting Changes” and FASB No. 3, “Reporting Accounting Changes in Interim Financial Statements.” FASB No. 154 changes the requirements for the accounting for and reporting of changes in accounting principles. Previously, most voluntary changes in accounting principles required recognition via a cumulative effect adjustment within net income in the period of the change. FASB No. 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. FASB No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the statement does not change the transition provisions of any existing accounting pronouncements. The adoption of FASB No. 154 did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

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On January 1, 2006, the Company adopted FASB No. 153, “Exchanges of Nonmonetary Assets.” FASB No. 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. FASB No. 153 is effective for fiscal periods beginning after June 15, 2005. The adoption of FASB No. 153 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

On January 1, 2006, the Company adopted FASB No. 151, “Inventory Costs,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. The adoption of FASB No. 151 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

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

The following discussion of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and the notes to those statements included elsewhere in this report.

Except for the historical information contained herein, the following discussion contains forward-looking statements that involve risks and uncertainties. These statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement. Forward-looking statements include statements related to investments in our core technologies, investments in our internal product candidates, our future revenues, including our expectations for future collaborative, grant, and product revenues, our future net losses, our estimates of our facilities consolidation costs, our expectations for the percentage of total revenue that our product revenue will constitute in the future, our expected gross margins on our product-related revenue, our expectations for our future research and development and sales and marketing costs, our expectations for the sufficiency of our cash and cash equivalents, and our future capital requirements, all of which are prospective. Such statements are only predictions, and the actual events or results may differ materially from those projected in the forward-looking statements. Factors that could cause or contribute to differences include, but are not limited to, risks involved with our new and uncertain technologies, risks associated with our dependence on patents and proprietary rights, risks associated with our protection and enforcement of our patents and proprietary rights, our dependence on existing collaborations, our ability to enter into and/or maintain collaboration and joint venture agreements, our ability to commercialize products directly and through our collaborators, the timing of anticipated regulatory approvals and product launches, and the development or availability of competitive products or technologies, as well as other risks and uncertainties set forth below and in the section of this report entitled “Risk Factors.”

Overview

We were incorporated in December 1992 and began operations in May 1994. We are a leader in applying proprietary genomic technologies for the rapid discovery and optimization of novel protein-based products, including (a) enzymes, which are catalytic proteins, and (b) antibodies, which are binding proteins. We are directing our integrated portfolio of technologies to the discovery, evolution, and production of commercially valuable molecules with agricultural, industrial, and chemical applications, such as enzymes, as well as optimized antibodies with pharmaceutical applications. While our technologies have the potential to serve many large markets, our key areas of focus for internal product development are alternative fuels, specialty industrial processes, and health and nutrition. In addition to our internal product development efforts, we have formed alliances with market leaders, such as BASF, Cargill Health and Food Technologies, DuPont Bio-Based Materials, Medarex, Merck, and Xoma. We have also formed a broad strategic relationship with Syngenta AG, a world-leading agribusiness company. We have two inactive subsidiaries, Innovase LLC and TNEWCO Inc.

In January 2006, following a comprehensive review of our operations, we announced a strategic reorganization designed to focus our resources on advancing our most promising products and product candidates in three key areas: alternative fuels; specialty industrial processes; and health and nutrition. As a result of this decision, we discontinued development of a number of less promising products and programs and reduced our workforce by 83 employees. In the fourth quarter of 2005, we recorded a non-cash impairment charge of $45.7 million. During the first quarter of 2006 we recorded restructuring charges of $11.0 million related to employee separation and facilities consolidation costs. During the first quarter of 2006, we completed the employee termination activities under this restructuring, and incurred related costs of $2.6 million. We do not anticipate further payments or expenses related to employee separation under this program. The facility consolidation costs, which total $8.4 million, are based on estimates that represent the discounted cash flow of lease payments (net of anticipated sublease income) on the vacated space through its contractual lease term in 2016. Pursuant to current accounting rules, we are required to re-assess these estimates on a periodic basis. Accordingly, we may revise these estimates in future periods, which could give rise to additional charges or adjustments.

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We have dedicated substantial resources to the development of our proprietary technologies, which include capabilities for sample collection from the world’s microbial populations, generation of environmental libraries, screening of these libraries using ultra high-throughput methods capable of analyzing more than one billion genes per day, and optimization based on our gene evolution technologies.

In February 2003, we completed a series of transactions with Syngenta. Under the transactions, we formed an extensive research collaboration whereby we are entitled to receive a minimum of $118.0 million in research and development funding over the initial seven-year term of the agreement and will be eligible to receive certain milestone payments and royalties upon product development and commercialization. Additionally, we acquired certain intellectual property rights licenses used in activities that primarily involve tools, technologies and methods relating to proteomics, metabolomics, RNA dynamics, and bioinformatics and methods to analyze and link these components of genomics or that primarily relate to their fungal program, for use outside of Syngenta’s exclusive field as defined in the research collaboration agreement. We also purchased certain property and equipment. As of December 31, 2005, in connection with our strategic reorganization, we assessed the carrying values of these assets and technologies on our balance sheet and determined that such assets and technologies were impaired. As a result, we have written off the carrying value of these assets and technologies on our balance sheet as of December 31, 2005.

In May 2004, we entered into an agreement with Syngenta to continue our research and product development alliance, including the development and commercialization of novel animal feed enzymes beyond the five-year initial term of our 1999 Zymetrics joint venture agreement, which ended in 2004. Under the agreement, Syngenta agreed to continue its collaboration with us in the area of animal feed enzymes on an exclusive basis, paid us an exclusivity fee, and agreed to continued research and development funding. As of March 31, 2006, Syngenta is committed to pay us more than $45 million in additional minimum research funding (exclusive of milestones and royalties) under our current collaboration.

For the quarter ended March 31, 2006, total revenues decreased 26% compared to the quarter ended March 31, 2005, while product-related revenue increased 63% over the same period. We expect that product-related revenue will represent a larger percentage of our total revenues in the future. For 2006, we expect to de-emphasize grant revenue and certain collaborations that are not strategic to our current market focus; however, certain of our partners and funding sources have ongoing obligations to fund our programs, and we have ongoing obligations to provide research and development services under our current agreements. As of March 31, 2006, our strategic partners have provided us with approximately $250 million in funding since inception and are committed to additional minimum funding of more than $50 million through 2010, subject to our performance under existing agreements, excluding milestone payments, license and commercialization fees, and royalties or profit sharing. Our strategic partners often pay us before we recognize the revenue, and these payments are deferred until earned. As of March 31, 2006, we had $10.3 million in deferred revenue, of which $0.9 million was related to product sales, and $9.4 million was related to funding from our collaborative partners, primarily Syngenta.

We have incurred net losses since our inception. As of March 31, 2006, our accumulated deficit, including $45.7 million in non-cash asset impairment charges in 2005 and $11.0 million in restructuring-related charges in the first quarter of 2006, was $311.6 million. Our results of operations have fluctuated from period to period and likely will continue to fluctuate substantially in the future. We expect to incur losses for the next two fiscal years as we continue to develop independent products and as a result of our continued investment in sales and marketing infrastructure intended to strengthen our customer contact and focus, our continued investment in manufacturing facilities necessary to meet increased demand for our products, as well continued research and development expenses for our internal product candidates. Results of operations for any period may be unrelated to results of operations for any other period. In addition, we believe that our historical results are not a good indicator of our future operating results.

Results of Operations

Three Months Ended March 31, 2006 and 2005

Revenues

Revenues decreased 26%, or $3.3 million, to $9.5 million for the quarter ended March 31, 2006 from $12.8 million for the quarter ended March 31, 2005. This decrease was attributed primarily to a decrease in collaborative revenue, offset in part by an increase in product-related revenues.

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Collaborative revenue decreased 32%, or $3.0 million, to $6.3 million from $9.3 million and accounted for 67% and 72% of total revenue for the quarter ended March 31, 2006 and 2005. This decrease is primarily a result of the lower utilization of research and development resources under our collaboration with Syngenta, as certain projects within the collaboration concluded in advance of new projects commencing. Our recent strategic reorganization was designed to focus our resources on advancing our most promising products and product candidates, and as a result, we have discontinued a number of less promising programs. As a result, we expect to de-emphasize certain collaborative programs that are not strategic to our market focus, and anticipate that collaborative revenue will decrease in 2006 as compared to 2005.

Product-related revenue for the quarter ended March 31, 2006 increased $0.9 million, or 63%, to $2.5 million from $1.6 million for the quarter ended March 31, 2005. This increase was attributable primarily to increased revenue and profit sharing associated with Phyzyme^™ XP phytase sold through our collaboration with Danisco Animal Nutrition, or Danisco. During the first quarter of 2006, we sold approximately $0.9 million of our Valley Ultra-Thin™ enzyme, or Ultra-Thin, to our distributor, Valley Research, or Valley. Ultra-Thin is a new product designed to make ethanol production more efficient. We received final U.S. regulatory approval for Ultra-Thin at the end of February 2006, and Valley is currently testing it in a number of ethanol plant trials. Due to our limited commercial experience with this product and the distributor, we have deferred revenue recognition during the first quarter on sales of this product made to Valley. We expect to continue to defer revenue on sales of Ultra-Thin to Valley until we are reasonably assured that payment of the underlying receivable is not contingent upon sell-through to the end-user. At March 31, 2006, we also had an additional $1.2 million in outstanding purchase orders from Valley.

Grant revenue decreased 68%, or $1.3 million, to $0.7 million for the quarter ended March 31, 2006 as compared to $2.0 million for the year ended March 31, 2005. As a result of our recent strategic organization , we expect to de-emphasize grants and contracts that are not strategic to our market focus, and anticipate that grant revenue will decrease in 2006 as compared to 2005.

As of March 31, 2006, we had $10.3 million in deferred revenue, of which $0.9 million was related to product sales, and $9.4 million was related to funding from our collaborative partners, primarily Syngenta.

Our revenues have historically fluctuated from period to period and likely will continue to fluctuate in the future based upon the timing and composition of funding under existing and future collaboration agreements and grants` regulatory approval timelines for new products, as well as adoption rates of our new and existing commercial products. We anticipate that our revenue mix will continue to shift toward a higher percentage of product-related revenue.

Cost of Product-Related Revenue

Cost of product-related revenue includes both fixed and variable costs, including materials and supplies, labor, facilities and other overhead costs, associated with our product-related revenues. Excluded from cost of product-related revenue are costs associated with the scale-up of manufacturing processes for new products which have not reached commercial-scale production volumes, which we include in our research and development expenses. For the quarter ended March 31, 2006, cost of product-related revenue increased $0.5 million to $2.2 million compared to $1.7 million for the quarter ended March 31, 2005. This increase resulted primarily from an increase in fixed costs related to expanded manufacturing capacity to support anticipated growth in product-related revenues and an increase in product-related revenues. Cost of product-related revenue was 86% of product-related revenues for the quarter ended March 31, 2006 compared to 109% of product-related revenues for the quarter ended March 31, 2005. Despite an increase in fixed costs over the prior year, during the first quarter of 2006, we generated a positive gross margin of approximately 14%. We expect that the cost of product-related revenue will decrease as a percentage of product-related revenue once we have completed our manufacturing ramp-up and have achieved a scalable volume of product sales. However, our gross margins are dependent upon the mix of product-related sales as the cost of product-related revenue varies from product to product. We expect our gross margins in 2006 to be positively impact by continued growth in sales of Ultra-Thin through our distributor agreement with Valley, and growth in sales of Phyzyme XP through our relationship with Danisco, as well as cost efficiencies we expect to achieve as we scale up production and improve our manufacturing yields. Under our manufacturing agreement, we supply Danisco commercial quantities of Phyzyme XP at our cost. We are paid a royalty on related product sales made by Danisco equal to 50% of the cumulative profits generated by Danisco on such sales. We only began receiving profit share revenue during mid-2005, but we expect a full year of profit share revenue during 2006. During the quarter ending June 30, 2006, we expect to expand our manufacturing capabilities by approximately 50%, which will increase our fixed manufacturing costs by $0.5 million per quarter.

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Research and Development

Research and development expenses consist primarily of costs associated with internal development of our technologies and our product candidates, manufacturing scale-up and bioprocess development for our current products, and costs associated with research activities performed on behalf of our collaborators. We track our researchers’ time by type of project. However, we do not track other research and development costs by project; rather, we track such costs by the type of cost incurred.

For the three month periods ended March 31, 2006 and 2005, we estimate that approximately 61% of our research and development personnel costs, based upon hours incurred, were spent on research activities funded by our collaborators and grants, and that approximately 39% were spent on internal product and technology development. Our research and development expenses decreased $5.5 million to $14.1 million (including share-based compensation of $0.9 million) for the quarter ended March 31, 2006 from $19.5 million (including share-based compensation of $75,000) for the quarter ended March 31, 2005. This decrease was attributed in large part to a $2.3 million decrease in personnel costs for direct research and development, resulting from our strategic reorganization announced in January of 2006. As a result of this decision, we discontinued development of a number of less promising products and programs and reduced our workforce by 83 employees. Our direct research and development staff decreased to 136 full time employees at March 31, 2006 from 269 at March 31, 2005. In addition our outside services costs decreased due primarily to our discontinuation of internally-funded projects for our pharmaceutical programs, as well as a decrease in third-party costs incurred under our collaborations and grants. This decrease was partially offset by $0.5 million in costs related to manufacturing scale-up and bioprocess development costs for new products, primarily our Ultra-Thin enzyme product.

Research and development direct costs and unallocated costs incurred by type of project during the quarters ended March 31, 2006 and 2005 were as follows (in thousands):

	THREE MONTHS ENDED MARCH 31,
	2006		2005
Collaborations:
Syngenta	$	1,113	$	1,525
Other		1,515		1,521
Total collaborations		2,628		3,046
Grants		290		1,131
Internal development		1,668		2,696
Unallocated		9,475		12,677
	$	14,061	$	19,550

Research and development costs based upon type of cost incurred for the quarters ended March 31, 2006 and 2005 were as follows (in thousands):

	THREE MONTHS ENDED MARCH 31,
	2006		2005
Personnel related	$	4,586	$	6,873
Share-based compensation		872	$	75
Laboratory and supplies		1,542		1,897
Outside services		1,474		3,556
Equipment and depreciation		1,923		2,322
Manufacturing scale-up		481		—
Facilities, overhead and other		3,183		4,827
	$	14,061	$	19,550

We have only recently launched our first products. Additionally, we have several product candidates in various stages of development related to collaborations and grants as well as internally developed products. It can take many years from the initial decision to perform research through development until products, if any, are ultimately marketed. The outcome of research is unknown until each stage of testing is completed, up through and including product trials and regulatory

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approvals, if needed. Accordingly, we are unable to predict which potential product candidates we may proceed with, the time and costs to complete development, and ultimately whether we will have any products approved by the appropriate regulatory bodies. The various risks associated with our research and development activities are discussed more fully in this report under “Risk Factors.” While we anticipate that we will continue to dedicate significant resources to development of future products, we expect that our total research and development costs will decrease in future periods as we position our Company to focus on near-term commercialization, sales and marketing of products, and reducing our loss and cash usage.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 26%, or $0.8 million, to $3.9 million (including share-based compensation of $0.4 million) for the quarter ended March 31, 2006 from $3.1 million (including share-based compensation of $59,000) for the quarter ended March 31, 2005. This increase was primarily related to personnel costs to support sales and marketing for our products. We expect our sales and marketing expenses to remain at comparable levels, or increase, in future periods as we introduce new products and invest in the necessary infrastructure to support our anticipated increase in product revenue.

Amortization of Acquired Intangible Assets

We recorded amortization of acquired intangible assets of zero and approximately $0.7 million for quarters ended March 31, 2006 and 2005. The amortization recorded for the quarter ended March 31, 2005 was primarily associated with the February 2003 acquisition of intellectual property rights licenses from Syngenta, which we were previously amortizing over 7 to 15 years. During the fourth quarter of 2005, we determined that these intellectual property assets were impaired and wrote off the value of these assets.

Non-Cash, Share-Based Compensation Charges

In January 2006 we adopted Financial Accounting Standards Board Statement, or FASB, No. 123(R), “Share-Based Payment,” which requires all share-based payments to employees and non-employee directors, including stock option grants, to be recognized in the income statement based on their fair values. Pro forma disclosure, which we previously used, is no longer an alternative

Prior to January 1, 2006, we accounted for share-based employee compensation plans using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion, or APB, No. 25,Accounting for Stock Issued to Employees, and its related interpretations. Under the provisions of APB No. 25, no compensation expense was recognized with respect to purchases of the our common stock under the ESPP or when stock options were granted with exercise prices equal to or greater than market value on the date of grant.

We recognized $1.3 million, or $0.03 per share, and $0.1 million, or $0.00 per share, in share-based compensation expense for our share-based awards during the three-month periods ended March 31, 2006 and 2005. These charges had no impact on the our reported cash flows. Share-based compensation expense was allocated among the following expense categories:

	THREE MONTHS ENDED MARCH 31,
	2006		2005
Research and development	$	872	$	75
Selling, general and administrative		429		59
	$	1,301	$	134

Under the modified prospective method of transition under FASB No. 123(R), we are not required to restate our prior period financial statements to reflect expensing of share-based compensation under the new standard. Therefore, the results for the three months ended March 31, 2006 are not comparable to the same periods in the prior year.

During the fourth quarter of fiscal 2005, we accelerated the vesting of unvested stock options awarded to all employees and officers under our stock option plan that had exercise prices greater than $10.00. The unvested options to purchase approximately 710,000 shares became fully vested as of December 8, 2005 as a result of this acceleration. These stock options would have all become fully vested before or during 2008. We accelerated these options because the options had exercise prices significantly in excess of then current market value ($5.25 at December 8, 2005), and thus were not fully achieving their original objectives of incentive compensation and employee retention. We expect the acceleration to have a positive effect on employee morale, retention, and perception of value. The acceleration also eliminated future compensation expense we would otherwise have been required to recognize in our statements of operations with respect to these options with the implementation of FASB No. 123R, The future expense eliminated as a result of the acceleration of the vesting of these options was approximately $1.1 million.

Effective in 2006, we have also shifted a significant amount of our share-based awards from stock options to restricted shares.

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Restructuring Charges

In connection with the decision to reorganize and refocus our resources, in January 2006 we commenced several cost containment measures, including a reduction in workforce of 83 employees and the consolidation of our facilities. We recorded charges of $11.0 million in the first quarter of 2006 related to these activities. A summary of these charges is set forth below (in thousands):

	Three Months Ended March 31, 2006
Facilities consolidation costs	$	8,356
Employee separation costs		2,607
Other costs		60
Total	$	11,023

During the first quarter of 2006, we completed the employee termination activities under this restructuring and do not anticipate further payments or expenses related to employee separation under this program. The facility consolidation costs are based on estimates that represent the discounted cash flow of lease payments (net of anticipated sublease income) on the vacated space through its contractual lease term in 2016. Pursuant to current accounting rules, we are required to re-assess these estimates on a periodic basis. Accordingly, we may revise these estimates in future periods, which could give rise to additional charges or adjustments.

Interest Income, net

Interest income on cash and short-term investments was $0.2 million for the quarter ended March 31, 2006 compared to $0.1 million for the quarter ended March 31, 2005. The increase was primarily due to higher average rates of return on our investments, consistent with the increase in short-term interest rates from 2005 to 2006. This increase was partially offset by a decrease in cash and investment balances during 2005.

Liquidity and Capital Resources

Since inception, we have financed our business primarily through the sale of common and preferred stock and funding from strategic partners and government grants. Our strategic partners and funding from grants have provided us with approximately $250 million in funding from our inception through March 31, 2006, and they are also committed to fund at least an additional $50 million through 2010. Future committed funding is subject to our performance under existing agreements, and excludes milestone payments, license and commercialization fees, and royalties or profit sharing. Our future committed funding is concentrated within a limited number of collaborators. Our failure to successfully maintain our relationship with these collaborators could have a material adverse impact on our operating results and financial condition.

As of March 31, 2006, we had cash, cash equivalents, and short-term investments of approximately $59.6 million. Our short-term investments as of such date consisted of U.S. Treasury and government agency obligations and investment-grade corporate obligations. Historically, we have funded our capital equipment purchases through available cash, capital leases and equipment financing line of credit agreements.

During 2002, we entered into a manufacturing agreement with Fermic to provide us with the capacity to produce commercial quantities of certain enzyme products. Based on actual and projected increased product requirements, the agreement was amended in 2004 to provide for additional capacity to be installed over the succeeding four year period. Under the terms of the agreement, we can cancel the committed purchases with thirty months’ notice provided that the term of the agreement, including the termination notice period, aggregates four years. Pursuant to our agreement with Fermic, we are also obligated to reimburse monthly costs related to manufacturing activities. These costs scale up as our projected manufacturing volume increases. As of March 31, 2006, under this agreement we have made minimum commitments to Fermic of approximately $14.4 million, over the next two years. During the quarter ending June 30, 2006, we expect to expand our manufacturing capabilities by approximately 50%, which will increase our fixed manufacturing costs by $0.5 million per quarter. In addition, under the terms of the agreement, we are required to purchase certain equipment required for fermentation and downstream processing of the products. Through March 31, 2006, we had incurred costs of approximately $11.2 million for equipment related to this agreement.

We purchased capital equipment totaling $0.7 million during the quarter ended March 31, 2006, and financed approximately $0.8 million of these and prior period purchases through our existing financing arrangements. We anticipate the cost of capital equipment required to support the ongoing needs of our existing research will be approximately $7.2

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million for the remainder of 2006. We anticipate funding our capital requirements for the remainder of 2006 with new financing arrangements, if available on satisfactory terms, and with available cash.

Our operating activities used cash of $6.4 million for the three months ended March 31, 2006. Our cash used by operating activities consisted primarily of cash used to fund our net loss of $21.4 million, an increase in other current assets of $0.6 million, and payments against liabilities of $0.2 million, partially offset by an increase in our liabilities of $8.3 million for restructuring charges, depreciation of $2.7 million, and collections on accounts receivable of $1.8 million.

Our investing activities used cash of $4.4 million for the three months ended March 31, 2006. Our investing activities consisted primarily of a net increase in short-term investments of $3.7 million to fund operations, and purchases of property and equipment of $0.7 million.

Our financing activities provided cash of $1.2 million for the three months ended March 31, 2006. Our financing activities consisted primarily of borrowings under notes payable of $0.8 million and proceeds from the sale of common stock under our Employee Stock Purchase Plan and from the exercise of stock options of $2.1 million, partially offset by payments on notes payable and capital leases of $1.8 million.

The following table summarizes our contractual obligations at March 31, 2006 (in thousands):

	Total		Less Than 1 Year		1-3 Years		3-5 Years		After 5 Years
Contractual Obligations
Long-term debt	$	13,568	$	7,664	$	5,638	$	266	$	—
Operating leases		56,029		4,708		9,851		10,540		30,930
Fermic-related obligations		14,400		6,480		7,920		—		—
License and research agreements		1,499		388		486		250		375
Total Contractual Obligations	$	85,496	$	19,240	$	23,895	$	11,056	$	31,305

As of March 31, 2006, we had $9.4 million of total unrecognized compensation expense related to nonvested share-based compensation arrangements granted under our equity incentive plans, which we expect to be recognized over a weighted-average period of 1.6 years. This will have no impact on our future cash flows.

We expect that our current cash and cash equivalents, short-term investments, and funding from existing collaborations and grants will be sufficient to fund our working and other capital requirements through at least 2007, including amounts required to fund internal research and development and enhancements of our core technologies, as well as the potential costs of acquiring businesses, technologies, or products that we believe are a strategic fit with our business. This estimate is a forward-looking statement that involves risks and uncertainties. Our future capital requirements and the adequacy of our available funds will depend on many factors, including scientific progress in our research and development programs, the magnitude of those programs, our ability to maintain our collaborations and achieve milestones under them and our ability to establish new collaborative relationships, our ability, alone or with our collaborative partners, to commercialize products successfully, and competing technological and market developments. Therefore, it is possible that we may seek additional financing in the future, whether through private or public equity offerings, debt financings, or collaborations, which may not be available on terms favorable to us, if at all. In addition, if we enter into financing arrangements in the future, such arrangements could dilute our stockholders’ ownership interests and adversely affect their rights.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures. On an ongoing basis, we evaluate these estimates, including those related to revenue recognition, long-lived assets, accrued liabilities, and income taxes. These estimates are based on historical experience, information received from third parties, and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

Revenue Recognition

We follow the provisions as set forth by current accounting rules, which primarily include the Securities and Exchange Commission’s Staff Accounting Bulletin, or SAB, No. 104, “Revenue Recognition.”

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We generally recognize revenue when we have satisfied all contractual obligations and we are reasonably assured of collecting the resulting receivable. We are often entitled to bill our customers and receive payment from our customers in advance of recognizing the revenue under current accounting rules. In those instances where we have billed our customers or received payment from our customers in advance of recognizing revenue, we include the amounts in deferred revenue on the balance sheet.

We generate revenue from research collaborations generally through funded research, up-front fees to initiate research projects, fees for exclusivity in a field, and milestones. We recognize revenue from research funding on a percentage-of-completion basis, as research hours are incurred under each agreement. We recognize fees to initiate research over the life of the project. We recognize revenue from exclusivity fees over the period of exclusivity. Our collaborations often include contractual milestones. When we achieve these milestones, we are entitled to payment, as defined by the underlying agreements. We recognize revenue for milestone payments when earned, as evidenced by written acknowledgement from the collaborator, provided that (i) the milestone event is substantive and its achievement was not reasonably assured at the inception of the agreement, and (ii) our performance obligations after the milestone achievement will continue to be funded by the collaborator at a level comparable to the level before the milestone achievement.

We recognize revenue from grants as related costs are incurred, as long as such costs are within the funding limits specified by the underlying grant agreements.

We recognize revenue related to the sale of our inventory as we ship or deliver products, provided all other revenue recognition criteria have been met. We recognize revenue from products sold through distributors or other third-party arrangements upon shipment of the products, if the distributor has a right of return, provided that (a) the price is substantially fixed and determinable at the time of sale; (b) the distributor’s obligation to pay us is not contingent upon resale of the products; (c) title and risk of loss passes to the distributor at time of shipment; (d) the distributor has economic substance apart from that provided by us; (e) we have no significant obligation to the distributor to bring about resale of the products; and (f) future returns can be reasonably estimated. For any sales that do not meet all of the above criteria, revenue is deferred until all such criteria have been met. We include our profit-sharing revenues in product-related revenues on the statement of operations. We recognize profit-sharing revenues during the quarter in which such profit sharing revenues are earned, based on estimates provided by our profit-sharing partner. We adjust these estimates for actual results in the subsequent quarter. To date, we have generated a substantial portion of our product-related revenues, including profit-sharing revenues, through our agreements with Danisco.

We sometimes enter into revenue arrangements that include the delivery of more than one product or service. In these cases, we recognize revenue from each element of the arrangement as long as we are able to determine a separate value for each element, we have completed our obligation to deliver or perform on that element and we are reasonably assured of collecting the resulting receivable.

Share-based Compensation

Effective January 1, 2006, we calculate the fair value of all share-based payments to employees and non-employee directors, including grants of stock options, non-restricted and restricted shares, and awards issued under the employee stock purchase plan, and amortize these fair values to share-based compensation in the income statement over the respective vesting periods of the underlying awards.

Share-based compensation related to stock options includes both the amortization of the fair value of options at the date of grant determined using Black-Scholes Merton (“BSM”) valuation model. We amortize the fair value of options to expense over the vesting periods of the underlying options.

Share-based compensation related to awards issued under the employee stock purchase plan (“ESPP”) after December 31, 2005 are based on calculations of fair value under the BSM valuation model which are similar to how stock option valuations are made. We amortize the fair value of ESPP awards to expense over the vesting periods of the underlying awards.

We estimate the fair value of stock option awards and awards under the ESPP on the date of grant using assumptions about volatility, expected life of the awards, risk-free interest rate, and dividend yield rate. The expected volatility in this model is based on the historical volatility of our common stock. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time awards are granted, based on maturities which approximate the expected life of the options. The

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expected life of the options granted is estimated using the historical exercise behavior of employees. The expected dividend rate takes into account the absence of any historical payments and management’s intention to retain all earnings for future operations and expansion.

We estimate the fair value of non-restricted and restricted stock awards based upon the closing market price of our common stock at the date of grant. We charge the fair value of non-restricted awards to share-based compensation upon grant. We amortize the fair value of restricted awards to share-based compensation expense over the vesting period of the underlying awards.

Long-Lived Assets

We review long-lived assets, including leasehold improvements, property and equipment, and acquired intangible assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. This requires us to estimate future cash flows related to these assets. Actual results could differ from those estimates, which may affect the carrying amount of assets and the related amortization expense.

Income Taxes

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amounts, an adjustment to the deferred tax assets would increase our income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. As of December 31, 2005, we had $116.9 million in gross deferred tax assets, which were fully offset by a valuation allowance.

Inventories

We value inventory at the lower of cost (first in, first out) or market value and, if necessary, reduce the value by an estimated allowance for excess and obsolete inventories. The determination of the need for an allowance is based on our review of inventories on hand compared to estimated future usage and sales, as well as, judgments, quality control testing data, and assumptions about the likelihood of obsolescence.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Our exposure to market risk is limited to interest rate risk and, to a lesser extent, foreign currency risk. Our exposure to changes in interest rates relates primarily to the increase or decrease in the amount of interest income we can earn on our investment portfolio and on the increase or decrease in the amount of interest expense we must pay with respect to our various outstanding debt instruments. Our risk associated with fluctuating interest expense is limited to our future financings, including any future equipment financing line of credit agreements, the interest rates under which are expected to be closely tied to market rates. Our risk associated with fluctuating interest income is limited to our investments in interest rate sensitive financial instruments. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure the safety and preservation of our invested principal funds by limiting default risk, market risk, and reinvestment risk. We mitigate default risk by investing in short-term investment grade securities and limiting the amount invested in any single security. We mitigate market risk by maintaining an average maturity of less than one year for our investments. We mitigate reinvestment risk by investing in securities with varying maturity dates. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would have decreased the fair value of our interest sensitive financial instruments at March 31, 2006 and December 31, 2005 by $0.1 million and $0.2 million. Declines in interest rates over time will reduce our interest income, while increases in interest rates over time will increase our interest expense. In connection with one of our research collaborations, we engage third parties to provide various services. Certain of these services result in obligations that are denominated in other than U.S. dollars. Foreign currency risk is minimized because the amount of such obligations is not material. Additionally, the collaboration under which such services are performed provides for reimbursement of such costs in U.S. dollars.

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ITEM 4. CONTROLS AND PROCEDURES.

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”), who is our principal executive officer, and Chief Financial Officer (“CFO”), who is our principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (“the Exchange Act”), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q.

There are inherent limitations in the effectiveness of any internal control, including the possibility of human error and the circumventions or overriding of controls. Consequently, even effective internal controls can only provide reasonable assurances with respect to any disclosure controls and procedures and internal control over financial statement preparation and presentation.

Changes in Internal Control over Financial Reporting

Our CEO and CFO also evaluated whether a change had occurred in our internal controls over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Based on such evaluation, such officers have concluded that there was no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

In December 2002, we and certain of our officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, now captioned In re Diversa Corp. Initial Public Offering Sec. Litig., Case No. 02-CV-9699. In the amended complaint, the plaintiffs allege that we and certain of our officers and directors, and the underwriters (the “Underwriters”) of our initial public offering, or IPO, violated Sections 11 and 15 of the Securities Act of 1933, as amended, based on allegations that our registration statement and prospectus prepared in connection with our IPO failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the Underwriters. The complaint also contains claims for violation of Sections 10(b) and 20 of the Securities Exchange Act of 1934, as amended, based on allegations that this omission constituted a deceit on investors. The plaintiffs seek unspecified monetary damages and other relief. This action is related to In re Initial Public Offering Sec. Litig., Case No. 21 MC 92, in which similar complaints were filed by plaintiffs (the “Plaintiffs”) against hundreds of other public companies (collectively, the “Issuers”) that conducted IPOs of their common stock in the late 1990s and 2000 (collectively, the “IPO Cases”). On January 7, 2003, the IPO Case against us was assigned to United States Judge Shira Scheindlin of the Southern District of New York, before whom the IPO Cases have been consolidated for pretrial purposes.

In February 2003, the Court issued a decision denying the motion to dismiss the Sections 11 and 15 claims against us and our officers and directors, and granting the motion to dismiss the Section 10(b) claim against us without leave to amend. The Court similarly dismissed the Sections 10(b) and 20 claims against two of our officers and directors without leave to amend, but denied the motion to dismiss these claims against one officer/director.

In June 2003, Issuers and Plaintiffs reached a tentative settlement agreement and entered into a memorandum of understanding providing for, among other things, a dismissal with prejudice and full release of the Issuers and their officers and directors from all further liability resulting from Plaintiffs’ claims, and the assignment to Plaintiffs of certain potential claims that the Issuers may have against the Underwriters. The tentative settlement also provides that, in the event that Plaintiffs ultimately recover less than a guaranteed sum of $1 billion from the Underwriters in the IPO Cases and related litigation, Plaintiffs would be entitled to payment by each participating Issuer’s insurer of a pro rata share of any shortfall in the Plaintiffs’ guaranteed recovery. In the event, for example, the Plaintiffs recover nothing in judgment against the Underwriter defendants in the IPO Cases and the Issuers’ insurers therefore become liable to the Plaintiffs for an aggregate of $1 billion pursuant to the settlement proposal, the pro rata liability of our insurers, with respect to us, would be $5 million,

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assuming that 200 Issuers which approved the settlement proposal, and their insurers, were operating and financially viable as of the settlement date. We are covered by a claims-made liability insurance policy that would satisfy our insurers’ pro rata liability described in this hypothetical example.

In June 2004, we executed a settlement agreement with the Plaintiffs pursuant to the terms of the memorandum of understanding. On February 15, 2005, the Court issued a decision certifying a class action for settlement purposes and granting preliminary approval of the settlement subject to modification of certain bar orders contemplated by the settlement.

On August 31, 2005, the Court reaffirmed class certification and preliminary approval of the modified settlement in a comprehensive order, and directed that notice of the settlement be published and mailed to class members beginning November 15, 2005. On February 24, 2006, the Court dismissed litigation filed against certain underwriters in connection with the claims to be assigned to the plaintiffs under the settlement. On April 24, 2006, the Court held a final fairness hearing to determine whether to grant final approval of the settlement. A decision is expected this summer. We are covered by a claims-made liability insurance policy which we believe will satisfy any potential liability of ours under this settlement.

We are also, from time to time, subject to legal proceedings and claims which arise in the normal course of business. In our opinion, the amount of ultimate liability with respect to these actions will not have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

ITEM 1A.     RISK FACTORS.

Except for the historical information contained herein, this quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those discussed here. Factors that could cause or contribute to differences in our actual results include those discussed in the following section, as well as those discussed in Part I, Item 2 entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere throughout this quarterly report. You should consider carefully the following risk factors, together with all of the other information included in this quarterly report on Form 10-Q. Each of these risk factors could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our common stock.

We have marked with an asterisk those risk factors that reflect substantive changes from the risk factors previously disclosed in our Form 10-K for the year ended December 31, 2005.

* We have a history of net losses, we expect to continue to incur net losses, and we may not achieve or maintain profitability.

We have incurred net losses since our inception, including a net loss of approximately $21.4 million for the quarter ended March 31, 2006. As of March 31, 2006, we had an accumulated deficit of approximately $311.6 million. We expect to incur additional losses in 2006 and 2007 as we continue to develop independent products and as a result of our continued investment in our sales and marketing infrastructure to support anticipated growth in product sales. The extent of our future losses will depend, in part, on the rate of growth, if any, in our contract revenue, future product sales at profitable margins, and on the level of our expenses. To date, most of our revenue has been derived from collaborations and grants, and we expect that a significant portion of our revenue for 2006 will result from the same sources.

Future revenue from collaborations is uncertain because our ability to generate revenue will depend upon our ability to maintain our current collaborations, enter into new collaborations and to meet research, development, and commercialization objectives under new and existing agreements. We anticipate that our sales and marketing expenses will remain at comparable levels, or increase, in future periods as we introduce new products and invest in the necessary infrastructure to support an anticipated increased level of product revenues. We will need to generate significant additional revenue to achieve profitability. In order for us to generate revenue, we must not only retain our existing collaborations and/or attract new ones and achieve milestones under them, but we must also develop products or technologies that we or our partners choose to commercialize and that are commercially successful and from which we can derive revenue through sales or royalties. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis.

Because we are an early stage company developing and deploying new technologies, we may not be able to commercialize our technologies or products, which could cause us to be unprofitable or cease operations.

You must evaluate our business in light of the uncertainties and complexities affecting an early stage biotechnology company. Our existing proprietary technologies are new and in the early stage of development. We may not be successful in the commercial development of these or any further technologies or products. Successful products require significant development and investment, including testing, to demonstrate their cost- effectiveness prior to regulatory approval and commercialization. To date, we have commercialized only eight of our own products, Valley “Ultra-Thin”^™ enzyme,

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Pyrolase^™ 160 enzyme, Pyrolase^™ 200 enzyme, Cottonase^™ enzyme, Luminase^™ PB-100 enzyme, Bayovac^® SRS, and blue and green fluorescent proteins. In addition, four of our collaborative partners, Invitrogen Corporation, Danisco Animal Nutrition, Givaudan Flavors Corporation, and Syngenta Animal Nutrition (formerly known as Zymetrics, Inc.), have incorporated our technologies or inventions into their own commercial products from which we have generated and/or can generate royalties. Our products and technologies have generated only modest revenues to date. Because of these uncertainties, our discovery process may not result in the identification of product candidates that we or our collaborative partners will successfully commercialize. If we are not able to use our technologies to discover new materials or products with significant commercial potential, we will not be able to achieve our objectives or build a sustainable or profitable business.

* We are dependent on our collaborative partners, and our failure to successfully manage our existing and future collaboration relationships could prevent us from developing and commercializing many of our products and achieving or sustaining profitability.

We currently have license agreements, strategic alliance agreements, collaboration agreements, supply agreements, and/or distribution agreements with BASF, Bayer Animal Health, Cargill Health and Food Technologies, DSM Pharma Chemicals, DuPont Bio-Based Materials, Givaudan Flavors Corporation, Medarex, Merck, Valley Research, inc., and Xoma. We have also formed a broad strategic relationship with Syngenta AG, a world-leading agribusiness company. For the quarter ended March 31, 2006, approximately 47% of our revenue was from affiliates of Syngenta AG, and a major portion of our future committed funding is also to be received from affiliates of Syngenta AG. We expect that a significant portion of any future revenue will be derived from our collaboration agreements. Since we do not currently possess the resources necessary to independently develop and commercialize all of the potential products that may result from our technologies, we expect to continue to enter into, and in the near-term derive additional revenue from, strategic alliance and collaboration agreements to develop and commercialize products. We will have limited or no control over the resources that any strategic partner or collaborator may devote to our partnered products. Any of our present or future strategic partners or collaborators may fail to perform their obligations as expected. These strategic partners or collaborators may breach or terminate their agreements with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. Further, our strategic partners or collaborators may not develop products arising out of our collaborative arrangements or devote sufficient resources to the development, manufacture, marketing, or sale of these products. If any of these events occur, or we fail to enter into or maintain strategic alliance or collaboration agreements, we may not be able to commercialize our products, grow our business, or generate sufficient revenue to support our operations. Our present or future strategic alliance and collaboration opportunities could be harmed if:

• We do not achieve our research and development objectives under our strategic alliance and collaboration agreements;

• We develop products and processes or enter into additional strategic alliances or collaborations that conflict with the business objectives of our strategic partners or collaborators;

• We disagree with our strategic partners or collaborators as to rights to intellectual property we develop, or their research programs or commercialization activities;

• We are unable to manage multiple simultaneous strategic alliances or collaborations;

• Our strategic partners or collaborators become competitors of ours or enter into agreements with our competitors;

• Our strategic partners or collaborators become less willing to expend their resources on research and development due to general market conditions or other circumstances beyond our control;

• Consolidation in our target markets limits the number of potential strategic partners or collaborators; or

• We are unable to negotiate additional agreements having terms satisfactory to us.

* We may not be able to realize any future benefits from the products and programs that we are discontinuing and/or de-emphasizing in connection with the strategic reorganization that we announced in January 2006.

In January 2006, we announced a strategic reorganization designed to focus our resources on programs and products that have the greatest opportunity for success. Accordingly, we elected to discontinue or to exit certain products and programs, many of which we have spent significant amounts of research funds on to date. We will attempt to sell and/or out-

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license to third parties some of these products and programs, including, but not limited to, our sordarins anti-fungal program, our recombinant natural products program, and our animal health programs. It is possible that we could be unsuccessful in our attempts to sell or out-license these products and/or programs. In the event that we are successful in selling or out-licensing any of these products and/or programs, the structure of such transactions may provide for only future compensation in the event that the third party is ultimately successful in development of the products and/or programs. Accordingly, it is possible that we may not receive any financial benefit from any sale or out license of these products and/or programs.

We do not own equipment with the capacity to manufacture products on a commercial scale. If we are unable to access the capacity to manufacture products in sufficient quantity, we may not be able to commercialize our products or generate significant sales.

We have only limited experience in enzyme manufacturing, and we do not have our own capacity to manufacture products on a commercial scale. We expect to be dependent to a significant extent on third parties for commercial scale manufacturing of our products. We have arrangements with third parties that have the required manufacturing equipment and available capacity to manufacture Valley “Ultra-Thin”^™ enzyme, Phyzyme^™ XP, Bayovac^® SRS, Quantum^™phytase, Luminase^™ PB-100 enzyme, Pyrolase 160 enzyme, Pyrolase 200 enzyme, and Cottonase^™ enzyme. While we have our own pilot development facility, we continue to depend on third parties for large-scale commercial manufacturing. Additionally, our third party manufacturers are located in foreign countries. Any difficulties or interruptions of service with our third party manufacturers or our own pilot manufacturing facility could disrupt our research and development efforts, delay our commercialization of products, and harm our relationships with our strategic partners, collaborators, or customers.

We have only limited experience in independently developing, manufacturing, marketing, selling, and distributing commercial products.

We intend to pursue some product opportunities independently. We currently have only limited resources and capability to develop, manufacture, market, sell, or distribute products on a commercial scale. We will determine which products to pursue independently based on various criteria, including: investment required, estimated time to market, regulatory hurdles, infrastructure requirements, and industry-specific expertise necessary for successful commercialization. At any time, we may modify our strategy and pursue collaborations for the development and commercialization of some products that we had intended to pursue independently. We may pursue products that ultimately require more resources than we anticipate or which may be technically unsuccessful. In order for us to commercialize more products directly, we would need to establish or obtain through outsourcing arrangements additional capability to develop, manufacture, market, sell, and distribute products. If we are unable to successfully commercialize products resulting from our internal product development efforts, we will continue to incur losses. Even if we successfully develop a commercial product, we may not generate significant sales and achieve profitability.

Ethical, legal, and social concerns about genetically engineered products could limit or prevent the use of our products and technologies and limit our revenue.

Some of our anticipated products are genetically engineered. If we and/or our collaborators are not able to overcome the ethical, legal, and social concerns relating to genetic engineering, our products may not be accepted. Any of the risks discussed below could result in expenses, delays, or other impediments to our programs or the public acceptance and commercialization of products dependent on our technologies or inventions. Our ability to develop and commercialize one or more of our technologies and products could be limited by the following factors:

• Public attitudes about the safety and environmental hazards of, and ethical concerns over, genetic research and genetically engineered products, which could influence public acceptance of our technologies and products;

• Public attitudes regarding, and potential changes to laws governing, ownership of genetic material which could harm our intellectual property rights with respect to our genetic material and discourage collaborative partners from supporting, developing, or commercializing our products and technologies; and;

• Governmental reaction to negative publicity concerning genetically modified organisms, which could result in greater government regulation of genetic research and derivative products, including labeling requirements.

The subject of genetically modified organisms has received negative publicity, which has aroused public debate. The adverse publicity could lead to greater regulation and trade restrictions on imports of genetically altered products.

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If we are unable to continue to collect genetic material from diverse natural environments, our research and development efforts and our product development programs could be harmed.

We collect genetic material from organisms found in diverse environments. We collect material from government-owned land in foreign countries and in areas of the United States under formal resource access agreements and from private lands under individual agreements with private landowners. If our access to materials under biodiversity access agreements or other arrangements is reduced or terminates, it could harm our internal and our collaborative research and development efforts. We also collect samples from other environments where agreements are currently not required, such as the deep sea. All of our agreements with foreign countries expire in 2008 or earlier, are renewable, and are all subject to earlier termination. We have voluntarily ceased collections of further samples in Yellowstone National Park pending the park’s resolution of collection guidelines.

Our ability to compete may decline if we do not adequately protect our proprietary technologies or if we lose some of our intellectual property rights due to becoming involved in expensive lawsuits or administrative proceedings.

Our success depends in part on our ability to obtain patents and maintain adequate protection of our other intellectual property for our technologies and products in the United States and other countries. The laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and many companies have encountered significant problems in protecting their proprietary rights in these foreign countries. These problems can be caused by, for example, a lack of rules and methods for defending intellectual property rights.

Our commercial success depends in part on not infringing patents and proprietary rights of third parties, and not breaching any licenses or other agreements that we have entered into with regard to our technologies, products, and business. The patent positions of biotechnology companies, including our patent position, involve complex legal and factual questions and, therefore, enforceability cannot be predicted with certainty. We will apply for patents covering both our technologies and products as we deem appropriate. Patents, if issued, may be challenged, invalidated, or circumvented. We cannot be sure that relevant patents have not been issued that could block our ability to obtain patents or to operate as we would like. Others may develop similar technologies or duplicate technologies developed by us. There may be patents in some countries that, if valid, may block our ability to commercialize products in these countries if we are unsuccessful in circumventing or acquiring the rights to these patents. There also may be claims in published patent applications in some countries that, if granted and valid, may also block our ability to commercialize products in these countries if we are unable to circumvent or license them.

In 2003, an interference proceeding was declared in the U.S. Patent and Trademark Office in 2004 between a U.S. patent assigned to us and a pending U.S. patent owned by another company with allowable claims directed to optimization of immunomodulatory genetic vaccines. Other than this interference proceeding, we are not currently a party to any litigation with regard to our patent position. However, the biotechnology industry is characterized by extensive litigation regarding patents and other intellectual property rights. Many biotechnology companies have employed intellectual property litigation as a way to gain a competitive advantage. If we became involved in litigation or interference proceedings declared by the United States Patent and Trademark Office, or oppositions or other intellectual property proceedings outside of the United States, to defend our intellectual property rights or as a result of alleged infringement of the rights of others, we might have to spend significant amounts of money. We are aware of a significant number of patents and patent applications relating to aspects of our technologies filed by, and issued to, third parties. Should any of our competitors have filed patent applications or obtained patents that claim inventions also claimed by us, we may have to participate in an interference proceeding declared by the relevant patent regulatory agency to determine priority of invention and, thus, the right to a patent for these inventions in the United States. Such a proceeding, like the one described above, could result in substantial cost to us even if the outcome is favorable. Even if successful on priority grounds, an interference may result in loss of claims based on patentability grounds raised in the interference. The litigation or proceedings could divert our management’s time and efforts. Even unsuccessful claims could result in significant legal fees and other expenses, diversion of management time, and disruption in our business. Uncertainties resulting from initiation and continuation of any patent or related litigation could harm our ability to compete.

An adverse ruling arising out of any intellectual property dispute, including an adverse decision as to the priority of our inventions, would undercut or invalidate our intellectual property position. An adverse ruling could also subject us to significant liability for damages, prevent us from using processes or products, or require us to negotiate licenses to disputed rights from third parties. Although patent and intellectual property disputes in the biotechnology area are often settled through licensing or similar arrangements, costs associated with these arrangements may be substantial and could include ongoing royalties. Furthermore, necessary licenses may not be available to us on satisfactory terms, if at all.

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We may encounter difficulties managing our growth, which could adversely affect our results of operations.

Our strategy includes entering into and working on simultaneous projects across multiple industries. While we do not expect to significantly increase our headcount in the near future, if we add more projects, it may place increased demands on our limited human resources. Our ability to effectively manage our operations, growth, and various projects requires us to continue to improve our operational, financial and management controls, reporting systems and procedures and to attract and retain sufficient numbers of talented employees. We may not be able to successfully implement improvements to our management information and control systems in an efficient or timely manner. In addition, we may discover deficiencies in existing systems and controls.

Confidentiality agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.

In order to protect our proprietary technology and processes, we also rely in part on trade secret protection for our confidential and proprietary information. We have taken security measures to protect our trade secrets and proprietary information. These measures may not provide adequate protection for our trade secrets or other proprietary information. Our policy is to execute confidentiality agreements with our employees and consultants upon the commencement of an employment or consulting arrangement with us. These agreements generally require that all confidential information developed by the individual or made known to the individual by us during the course of the individual’s relationship with us be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us shall be our exclusive property. There can be no assurance that proprietary information will not be disclosed, that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets, or that we can meaningfully protect our trade secrets. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.

Many potential competitors who have greater resources and experience than we do may develop products and technologies that make ours obsolete.

The biotechnology industry is characterized by rapid technological change, and the area of biomolecule discovery and optimization from biodiversity is a rapidly evolving field. Our future success will depend on our ability to maintain a competitive position with respect to technological advances. Rapid technological development by others may result in our products and technologies becoming obsolete.

We face, and will continue to face, intense competition. We are not aware of another company that has the scope and integration of technologies and processes that we have. There are, however, a number of companies who compete with us in various steps throughout our technology process. For example, Codexis, Maxygen, Inc., Evotec, and Xencor have alternative evolution technologies. Integrated Genomics Inc., Myriad Genetics, Inc., and ArQule, Inc. perform screening, sequencing, and/or bioinformatics services. Novozymes A/S and Genencor International Inc. are involved in development, overexpression, fermentation, and purification of enzymes. Abgenix, Inc., Cambridge Antibody Technology, Medarex, Inc., and Morphosys AG are involved in the development of human monoclonal antibodies. There are also a number of academic institutions involved in various phases of our technology process. Many of these competitors have significantly greater financial and human resources than we do. These organizations may develop technologies that are superior alternatives to our technologies. Further, our competitors may be more effective at implementing their technologies for modifying DNA to develop commercial products.

Any products that we develop through our technologies will compete in multiple, highly competitive markets. Many of our potential competitors in these markets have substantially greater financial, technical, and marketing resources than we do and may succeed in developing products that would render our products or those of our collaborators obsolete or noncompetitive. In addition, many of these competitors have significantly greater experience than we do in their respective fields. Our ability to compete successfully will depend on our ability to develop proprietary products that reach the market in a timely manner and are technologically superior to and/or are less expensive than other products on the market. Current competitors or other companies may develop technologies and products that are more effective than ours. Our technologies and products may be rendered obsolete or uneconomical by technological advances or entirely different approaches developed by one or more of our competitors. The existing approaches of our competitors or new approaches or technology developed by our competitors may be more effective than those developed by us.

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Stringent laws and required government approvals could delay our introduction of products.

All phases, especially the field testing, production, and marketing, of our potential products are subject to significant federal, state, local, and/or foreign governmental regulation. Regulatory agencies may not allow us to produce and/or market our products in a timely manner or under technically or commercially feasible conditions, or at all, which could harm our business.

In the United States, products for our target markets are regulated based on their application, by either the Food and Drug Administration, or FDA, the Environmental Protection Agency, or EPA, or, in the case of plants and animals, the United States Department of Agriculture, or USDA. The FDA regulates drugs, food, and feed, as well as food additives, feed additives, and substances generally recognized as safe that are used in the processing of food or feed. While substantially all of our projects to date have focused on non-human applications of our technologies and products outside of the FDA’s review, in the future we may pursue collaborations for further research and development of drug products for humans that would require FDA approval before they could be marketed in the United States. In addition, any drug product candidates must also be approved by the regulatory agencies of foreign governments before any product can be sold in those countries. Under current FDA policy, our products, or products of our collaborative partners incorporating our technologies or inventions, to the extent that they come within the FDA’s jurisdiction, may be subject to lengthy FDA reviews and unfavorable FDA determinations if they raise safety questions which cannot be satisfactorily answered, if results from pre-clinical or clinical trials do not meet regulatory requirements or if they are deemed to be food additives whose safety cannot be demonstrated. An unfavorable FDA ruling could be difficult to resolve and could prevent a product from being commercialized. Even after investing significant time and expenditures, our collaborators may not obtain regulatory approval for any drug products that incorporate our technologies or inventions. Our collaborators have not submitted an investigational new drug application for any product candidate that incorporates our technologies or inventions, and no drug product candidate developed with our technologies has been approved for commercialization in the United States or elsewhere. The EPA regulates biologically derived chemical substances not within the FDA’s jurisdiction. An unfavorable EPA ruling could delay commercialization or require modification of the production process resulting in higher manufacturing costs, thereby making the product uneconomical. In addition, the USDA may prohibit genetically engineered plants from being grown and transported except under an exemption, or under controls so burdensome that commercialization becomes impracticable. Our future products may not be exempted by the USDA.

The European regulatory process for these classes of biologically derived products has been in a state of flux in the recent past, as the EU attempts to replace country by country regulatory procedures with a consistent EU regulatory standard in each case. Some country-by-country regulatory oversight remains. Other than Japan, most other regions of the world generally find adequate either a United States or a European clearance together with associated data and information for a new biologically derived product.

* If we require additional capital to fund our operations, we may need to enter into financing arrangements with unfavorable terms or which could adversely affect the ownership interest and rights of our common stockholders as compared to our other stockholders. If such financing is not available, we may need to cease operations.

We currently anticipate that our available cash resources, short-term investments, receivables, and committed funding from collaborative partners and government grants will be sufficient to meet our capital requirements for the near-term. However, market acceptance of our products could be slower than anticipated, or we may use a significant amount of our cash to successfully develop and market our products.

Our capital requirements depend on several factors, including:

• The level of research and development investment required to maintain our technology leadership position;

• Our ability to enter into new agreements with collaborative partners or to extend the terms of our existing collaborative agreements, and the terms of any agreement of this type;

• The success rate of our discovery efforts associated with milestones and royalties;

• Our ability to successfully commercialize products developed independently and the demand for such products;

• The timing and willingness of strategic partners and collaborators to commercialize our products that would result in royalties, and the success of their commercialization efforts;

• Costs of recruiting and retaining qualified personnel; and

• Our need to acquire or license complementary technologies or acquire complementary businesses.

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If additional capital is required to operate our business, we cannot assure you that additional financing will be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, our ability to fund our operations, take advantage of opportunities, develop products or technologies, or otherwise respond to competitive pressures could be significantly limited. In addition, if financing is not available, we may need to cease operations.

If we raise additional funds through the issuance of equity securities, the percentage ownership of our stockholders will be reduced, stockholders may experience additional dilution or such equity securities may provide for rights, preferences or privileges senior to those of the holders of our common stock. If we raise additional funds through the issuance of debt securities, such debt securities would have rights, preferences and privileges senior to holders of common stock and the terms of such debt could impose restrictions on our operations.

We expect that our quarterly results of operations will fluctuate, and this fluctuation could cause our stock price to decline, causing investor losses.

Our quarterly operating results have fluctuated in the past and are likely to do so in the future. These fluctuations could cause our stock price to fluctuate significantly or decline. Revenue in future periods may be greater or less than revenue in the immediately preceding period or in the comparable period of the prior year. Some of the factors that could cause our operating results to fluctuate include:

• Termination of strategic alliances and collaborations;

• The success rate of our discovery efforts associated with milestones and royalties;

• The ability and willingness of strategic partners and collaborators to commercialize, market, and sell royalty-bearing products on expected timelines;

• Our ability to enter into new agreements with strategic partners and collaborators or to extend the terms of our existing strategic alliance agreements and collaborations, and the terms of any agreement of this type;

• Our ability to successfully satisfy all pertinent regulatory requirements;

• Our ability to successfully commercialize products developed independently and the demand for such products; and

• General and industry specific economic conditions, which may affect our collaborative partners’ research and development expenditures.

If revenue declines or does not grow as anticipated due to the expiration of strategic alliance or collaboration agreements, failure to obtain new agreements or grants, lower than expected royalty payments, slow market acceptance of our products, or other factors, we may not be able to correspondingly reduce our operating expenses. A large portion of our expenses, including expenses for facilities, equipment and personnel, are relatively fixed. Failure to achieve anticipated levels of revenue could therefore significantly harm our operating results for a particular fiscal period.

Due to the possibility of fluctuations in our revenue and expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. Our operating results in some quarters may not meet the expectations of stock market analysts and investors. In that case, our stock price would probably decline.

If we lose our key personnel or are unable to attract and retain qualified personnel as necessary, it could delay our product development programs and harm our research and development efforts.

Our success depends to a significant degree upon the continued contributions of our executive officers, management, and scientific staff. If we lose the services of one or more of these people, we may be unable to achieve our business objectives or our stock price could decline. We may not be able to attract or retain qualified employees in the future due to the intense competition for qualified personnel among biotechnology and other technology-based businesses, particularly in the San Diego area. If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that will adversely affect our ability to meet the demands of our collaborative partners in a timely fashion or to support our internal research and development programs. In particular, our product development programs

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depend on our ability to attract and retain highly skilled scientists, including molecular biologists, biochemists, and engineers. Although we believe we will be successful in attracting and retaining qualified personnel, competition for experienced scientists and other technical personnel from numerous companies and academic and other research institutions may limit our ability to do so on acceptable terms. All of our employees are at-will employees, which means that either the employee or we may terminate their employment at any time.

Our planned activities will require additional expertise in specific industries and areas applicable to the products developed through our technologies. These activities will require the addition of new personnel, including management, and the development of additional expertise by existing management personnel. The inability to acquire these services or to develop this expertise could impair the growth, if any, of our business.

If we engage in any acquisitions, we will incur a variety of costs and may potentially face numerous other risks that could adversely affect our business operations.

If appropriate opportunities become available, we may consider acquiring businesses, assets, technologies, or products that we believe are a strategic fit with our business. We currently have no commitments or agreements with respect to any material acquisitions. If we do pursue such a strategy, we could

• Issue equity securities which would dilute current stockholders’ percentage ownership;

• Incur substantial debt; or

• Assume liabilities.

We may not be able to successfully integrate any businesses, assets, products, technologies, or personnel that we might acquire in the future without a significant expenditure of operating, financial, and management resources, if at all. In addition, future acquisitions might negatively impact our business relations with our collaborative partners. Further, recent accounting changes could result in a negative impact on our results of operations as well as the resulting cost of the acquisition. Any of these adverse consequences could harm our business.

We may be sued for product liability.

We may be held liable if any product we develop, or any product which is made with the use of any of our technologies, causes injury or is found otherwise unsuitable during product testing, manufacturing, marketing, or sale. We currently have limited product liability insurance that may not fully cover our potential liabilities. In addition, if we attempt to obtain additional product liability insurance coverage, this additional insurance may be prohibitively expensive, or may not fully cover our potential liabilities. Inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could prevent or inhibit the commercialization of products developed by us or our collaborative partners. If we are sued for any injury caused by our products, our liability could exceed our total assets.

We are subject to anti-takeover provisions in our certificate of incorporation, bylaws, and Delaware law and have adopted a shareholder rights plan that could delay or prevent an acquisition of our company, even if the acquisition would be beneficial to our stockholders.

Provisions of our certificate of incorporation, our bylaws 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. In addition, we adopted a share purchase rights plan that has anti-takeover effects. The rights under the plan will cause substantial dilution to a person or group that attempts to acquire us on terms not approved by our board of directors. The rights should not interfere with any merger or other business combination approved by our board, since the rights may be amended to permit such an acquisition or may be redeemed by us. These provisions in our charter documents, under Delaware law, and in our rights plan could discourage potential takeover attempts and could adversely affect the market price of our common stock. Because of these provisions, our common stockholders might not be able to receive a premium on their investment.

* Our stock price has been and may continue to be particularly volatile because of the industry we are in.

The stock market, from time to time, has experienced significant price and volume fluctuations that are unrelated to the operating performance of companies. The market prices of technology companies, particularly life science companies, have been highly volatile. Our stock has been and may continue to be affected by this type of market volatility, as well as by our

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own performance. The following factors, among other risk factors, may have a significant effect on the market price of our common stock:

• Developments in our relationships with current or future strategic partners and collaborators;

• Announcements of technological innovations or new products by us or our competitors;

• Developments in patent or other proprietary rights;

• Our ability to access genetic material from diverse ecological environments and practice our technologies;

• Future royalties from product sales, if any, by our collaborative partners;

• Future product sales by us;

• Fluctuations in our operating results;

• Litigation;

• Developments in domestic and international governmental policy or regulation; and

• Economic and other external factors or other disaster or crisis.

* Concentration of ownership among our existing officers, directors and principal stockholders may prevent other stockholders from influencing significant corporate decisions and depress our stock price.

Our officers, directors, and stockholders with at least 5% of our stock together controlled approximately 70.3% of our outstanding common stock as of April 28, 2006. If these officers, directors, and principal stockholders act together, they will be able to exert a significant degree of influence over our management and affairs and control matters requiring stockholder approval, including the election of directors and approval of mergers or other business combination transactions. In addition, as of April 28, 2006, Syngenta and its affiliates controlled approximately 17% of our outstanding common stock, and by themselves will be able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval. The interests of this concentration of ownership may not always coincide with our interests or the interests of other stockholders. For instance, officers, directors, and principal stockholders, acting together, could cause us to enter into transactions or agreements that we would not otherwise consider. Similarly, this concentration of ownership may have the effect of delaying or preventing a change in control of our company otherwise favored by our other stockholders. This concentration of ownership could depress our stock price.

Future sales of our stock by large stockholders could cause the price of our stock to decline.

A number of our stockholders hold significant amounts of our stock. For example, as of April 28, 2006, Syngenta, our largest stockholder, owned 7,963,593 shares of our common stock, or approximately 17% of our outstanding shares. All of our shares owned by Syngenta are eligible for sale in the public market subject to compliance with the applicable securities laws. We have agreed that, upon Syngenta’s request, we will file one or more registration statements under the Securities Act in order to permit Syngenta to offer and sell shares of our common stock. Sales of a substantial number of shares of our stock by our large stockholders, including Syngenta, in the public market could adversely affect the market price of our stock.

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We use hazardous materials in our business. Any claims relating to improper handling, storage, or disposal of these materials could be time consuming and costly.

Our research and development processes involve the controlled use of hazardous materials, including chemical, radioactive, and biological materials. Our operations also produce hazardous waste products. We cannot eliminate entirely the risk of accidental contamination or discharge and any resultant injury from these materials. Federal, state, and local laws and regulations govern the use, manufacture, storage, handling, and disposal of these materials. We may be sued for any injury or contamination that results from our use or the use by third parties of these materials, and our liability may exceed our total assets. In addition, compliance with applicable environmental laws and regulations may be expensive, and current or future environmental regulations may impair our research, development, or production efforts.

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

Our Registration Statements on Form S-1 (File Nos. 333-92853 and 333-30290) relating to the initial IPO were declared effective by the Securities and Exchange Commission on February 11 and February 14, 2000, respectively. Upon completion of our initial public offering, we received net proceeds of $184.5 million after underwriting discounts and expenses. Through March 31, 2006, approximately $16 million of the net proceeds had been used to purchase property and equipment and approximately $109 million had been used for general corporate purposes. The balance is invested in cash equivalents and short-term investments.

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)

Exhibit Number	Description of Exhibit
3.1	Amended and Restated Certificate of Incorporation.(1)
3.2	Amended and Restated Bylaws.(1)
4.1	Form of Common Stock Certificate of the Company.(2)
4.2	Rights Agreement by and between the Company and American Stock Transfer and Trust Company, as Rights Agent, dated as of December 13, 2000 (including the Form of Certificate of Designation of Series A Junior Participating Preferred Stock attached thereto as Exhibit A, the Form of Right Certificate attached thereto as Exhibit B, and the Summary of Rights to Purchase Preferred Shares attached thereto as Exhibit C).(3)
4.3	First Amendment to Rights Agreement by and between the Company and American Stock Transfer and Trust Company, as Rights Agent, dated as of December 2, 2002.(4)
4.4	The Company’s Certificate of Designation of Series A Junior Participating Preferred Stock.(3)
31.1	Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities and Exchange Act of 1934, as amended.
31.2	Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities and Exchange Act of 1934, as amended.
32	Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1) Filed as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2000, filed with the Securities and Exchange Commission on May 12, 2000, and incorporated herein by reference.

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(2) Filed as an exhibit to the Company’s Registration Statement on Form S-1 (File No. 333-92853) originally filed with the Securities and Exchange Commission on December 21, 1999, as amended, and incorporated herein by reference.

(3) Filed as an exhibit to the Company’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 15, 2000, and incorporated herein by reference.

(4) Filed as an exhibit to the Company’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 4, 2002, and incorporated herein by reference

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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.

	DIVERSA CORPORATION
Date: May 8, 2006	/s/ Anthony E. Altig
	Anthony E. Altig Senior Vice President, Finance and Chief Financial Officer (Principal Financial Officer)

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