Zymogenetics (ZGEN) 10-Q 2010 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 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 JUNE 30, 2010

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: 0-33489

ZYMOGENETICS, INC.

(exact name of registrant as specified in its charter)

Washington	91-1144498
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
1201 Eastlake Avenue East, Seattle, Washington 98102
(Address of principal executive offices) (Zip Code)

(206) 442-6600

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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

Large accelerated filer	¨	Accelerated filer	x
Non-accelerated filer	¨  (Do not check if a smaller reporting company)	Smaller reporting company	¨

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common stock outstanding at July 29, 2010: 85,904,484 shares.

ZYMOGENETICS, INC.

Quarterly Report on Form 10-Q

For the quarterly period ended June 30, 2010

TABLE OF CONTENTS

		Page No.
PART I	FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements (unaudited)
a)	Balance Sheets	3
b)	Statements of Operations	4
c)	Statements of Cash Flows	5
d)	Notes to Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24
Item 4.	Controls and Procedures	24
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	25
Item 1A.	Risk Factors	25
Item 6.	Exhibits	45
SIGNATURE		46

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PART I FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

ZYMOGENETICS, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

	June 30, 2010			December 31, 2009
Assets
Current assets:
Cash and cash equivalents	$	24,007		$	141,634
Short-term investments		181,465			32,496
Receivables		10,394			7,672
Inventory		63,125			63,024
Prepaid expenses		3,644			5,043
Total current assets		282,635			249,869
Property and equipment, net		55,380			58,565
Deferred financing costs		4,597			5,172
Long-term investment		977			2,002
Other assets		2,945			3,688
Total assets	$	346,534		$	319,296
Liabilities and Shareholders’ Equity (Deficit)
Current liabilities:
Accounts payable	$	9,297		$	14,000
Accrued liabilities		17,824			24,299
Lease obligations		1,131			928
Deferred revenue		43,329			40,484
Collaboration obligation		53,840			60,105
Total current liabilities		125,421			139,816
Lease obligations		66,926			67,563
Debt obligation		25,000			25,000
Deferred revenue		32,058			63,899
Collaboration obligation		—			15,854
Other long-term liabilities		9,995			11,122
Commitments and contingencies
Shareholders’ equity (deficit):
Preferred stock, no par value, 30,000 shares authorized, no shares issued and outstanding		—			—
Common stock, no par value, 150,000 shares authorized, 85,884 and 69,353 issued and outstanding at June 30, 2010 and December 31, 2009, respectively		897,952			801,318
Non-voting common stock, no par value, 30,000 shares authorized, no shares issued and outstanding		—			—
Accumulated deficit		(811,374	)		(805,184	)
Accumulated other comprehensive income (loss)		556			(92	)
Total shareholders’ equity (deficit)		87,134			(3,958	)
Total liabilities and shareholders’ equity (deficit)	$	346,534		$	319,296

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

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ZYMOGENETICS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2010			2009			2010			2009
Revenues
Product sales, net	$	11,887		$	6,002		$	20,893		$	10,507
Royalties		183			294			527			615
Collaborations and licenses		25,641			16,276			51,806			36,295
Total revenues		37,711			22,572			73,226			47,417
Costs and expenses
Costs of product sales		2,618			1,363			4,498			2,379
Research and development		23,696			29,137			43,422			53,874
Selling, general and administrative		12,629			16,738			26,620			31,740
Total costs and expenses		38,943			47,238			74,540			87,993
Loss from operations		(1,232	)		(24,666	)		(1,314	)		(40,576	)
Other income (expense)
Investment income		165			384			373			890
Interest expense and other, net		(2,685	)		(2,695	)		(5,249	)		(5,420	)
Total other income (expense)		(2,520	)		(2,311	)		(4,876	)		(4,530	)
Net loss	$	(3,752	)	$	(26,977	)	$	(6,190	)	$	(45,106	)
Basic and diluted net loss per share	$	(0.04	)	$	(0.39	)	$	(0.07	)	$	(0.65	)
Weighted-average number of shares used in computing net loss per share		85,774			69,036			84,682			68,953

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

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ZYMOGENETICS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Six Months Ended June 30,
	2010			2009
Operating activities
Net loss	$	(6,190	)	$	(45,106	)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities
Depreciation and amortization		3,081			3,631
Amortization of debt issuance costs		575			805
Net gain on disposition of property and equipment		(134	)		(23	)
Net realized gain on sale of long-term investments		(608	)		—
Stock-based compensation		4,739			7,532
Net realized loss on sale of short-term investments		583			—
Impairment loss on short-term investments		258			—
Net amortization of premium on short-term investments		638			13
Changes in operating assets and liabilities
Receivables		(2,722	)		(19,076	)
Inventory		(101	)		(15,441	)
Prepaid expenses		1,399			(2,754	)
Other assets		743			1,052
Accounts payable		(4,703	)		(2,717	)
Accrued liabilities		(6,475	)		4,437
Lease obligations		(1,447	)		(178	)
Deferred revenue		(28,996	)		6,899
Collaboration obligation		(22,119	)		90,806
Other long-term liabilities		(114	)		(429	)
Net cash (used in) provided by operating activities		(61,593	)		29,451
Investing activities
Purchases of property and equipment		(196	)		(955	)
Purchases of short-term investments		(195,839	)		—
Proceeds from sale of property and equipment		134			5
Proceeds from sale and maturity of short-term investments		46,587			14,104
Proceeds from sale of long-term investment		1,085			—
Other investing activities		300			—
Net cash (used in) provided by investing activities		(147,929	)		13,154
Financing activities
Net proceeds from equity financing		90,757			—
Proceeds from exercise of stock options		1,138			424
Net cash provided by financing activities		91,895			424
Net (decrease) increase in cash and cash equivalents		(117,626	)		43,029
Cash and cash equivalents at beginning of period		141,634			50,088
Cash and cash equivalents at end of period	$	24,007		$	93,117
Supplemental disclosures
Cash paid for interest	$	3,948		$	3,875

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

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ZYMOGENETICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Basis of presentation

The accompanying unaudited consolidated financial statements of ZymoGenetics, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. In the opinion of management, the financial statements reflect all normal recurring adjustments necessary to present fairly the Company’s financial position and results of operations as of and for the periods indicated. Operating results for such periods are not necessarily indicative of the results that may be expected for the full year or for any future period.

These unaudited interim financial statements should be read in conjunction with the audited financial statements and related footnotes included in the Company’s Annual Report filed on Form 10-K for the year ended December 31, 2009. The Company issued its financial statements by filing with the Securities and Exchange Commission and has evaluated subsequent events up to the time of filing.

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

2. Loss per share

Basic and diluted net loss per share have been computed based on net loss and the weighted-average number of common shares outstanding during the applicable period. The Company has excluded certain options to purchase common stock, restricted stock units and warrants to purchase common stock, as such potential shares are antidilutive. The following table presents the securities not included in the net loss per share calculations for the three and six-month periods ended June 30 (in thousands):

	2010	2009
Options to purchase common stock	12,590	15,421
Restricted stock units	104	373
Warrants to purchase common stock	1,500	1,500

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ZYMOGENETICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

3. Available-for-sale securities

Short-term investments

Short-term investments consisted of the following (in thousands):

	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Estimated Fair Value
June 30, 2010
Type of security:
Corporate debt securities	$	162,666		234		(105	)	$	162,795
Asset-backed securities		4,657		5		(35	)		4,627
U.S. government sponsored enterprises		14,039		7		(3	)		14,043
	$	181,362	$	246	$	(143	)	$	181,465
Contractual maturity date:
Less than one year	$	114,081						$	114,081
Due in 1-5 years		63,468							63,605
Due in 5-10 years		—							—
Due in 10 years or more		3,813							3,779
	$	181,362						$	181,465
December 31, 2009
Type of security:
Commercial paper and money market	$	11,870	$	8	$	(1	)	$	11,877
Corporate debt securities		13,198		—		(73	)		13,125
Asset-backed securities		8,522		20		(1,048	)		7,494
	$	33,590	$	28	$	(1,122	)	$	32,496
Contractual maturity date:
Less than one year	$	11,870						$	11,877
Due in 1-5 years		14,433							14,379
Due in 5-10 years		—							—
Due in 10 years or more		7,287							6,240
	$	33,590						$	32,496

In assessing potential impairment of its debt securities, the Company determines if it intends to sell the security, if it is more likely than not that it will be required to sell the security before recovering its amortized cost basis, or if it expects to recover the security’s entire amortized cost basis. In addition, if the Company determines that a credit loss exists with respect to an individual debt security, it records an other-than-temporary impairment if it concludes that it would not be able to recover the entire amortized cost of the security, even if there was no intent to sell the security. The differentiating factors for equity securities, between temporary and other-than-temporary impairments, are primarily the length of the time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer and the intent and ability to retain an investment in the issuer for a period of time sufficient to allow for an anticipated recovery in fair value.

The Company concluded that an additional credit loss of $257,000 existed within its debt securities portfolio and recorded this loss as an other-than-temporary impairment in the three and six-month period ended June 30, 2010.

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ZYMOGENETICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

At June 30, 2010, the aggregate estimated fair value of the investments with unrealized losses was as follows (in thousands):

	Fair Value		Unrealized Loss
Corporate debt securities	$	42,598	$	(105	)
Asset-backed securities		1,013		(35	)
U.S. government sponsored enterprises		4,005		(3	)
	$	47,616	$	(143	)

The contractual maturities on unrealized loss positions for which other-than-temporary impairments have not been recognized at June 30, 2010, are summarized as follows (in thousands):

	Fair Value		Unrealized Loss
Less than one year	$	32,625	$	(45	)
Greater than one year		14,991		(98	)
	$	47,616	$	(143	)

Long-term investment

Long-term investment consists of common shares of BioMimetic Therapeutics, Inc. (BMTI), a company that licensed certain technologies from the Company and made certain payments in shares of common stock. These shares are publicly traded and are adjusted to fair value, with the unrealized gain reported as Accumulated Other Comprehensive Income (Loss) in shareholders’ equity (deficit). During April 2010, the Company sold 80,000 shares at prices ranging from $13.50 to $13.65 per share for a total of $1.1 million and realized a gain from the sale of $608,000. As of June 30, 2010, the unrealized gain on the remaining investment was $453,000.

Fair value measurements

The Company records its short-term and long-term investments at fair value. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price) and establishes a fair value hierarchy based on the inputs used to measure fair value. The three levels of the fair value hierarchy are as follows:

• Level 1 – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities (for example exchange quoted prices);

• Level 2 – Observable inputs, other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not sufficiently active to qualify as Level 1, other observable inputs, or inputs that can be corroborated by observable market data for substantially the full term of the assets or liabilities; and

• Level 3 – Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).

Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. The Company’s assets and liabilities accounted for at fair value are summarized below (in thousands):

	Level 1		Level 2		Level 3		Total
June 30, 2010
Cash equivalents:
Money market funds	$	6,710	$	—	$	—	$	6,710
Corporate debt securities		—		10,795		—		10,795
	$	6,710	$	10,795	$	—	$	17,505
Short-term investments:
Corporate debt securities	$	—	$	162,795	$	—	$	162,795
Asset-backed securities		—		4,627		—		4,627
U.S. government sponsored enterprises		—		14,043		—		14,043
	$	—	$	181,465	$	—	$	181,465
Long-term investment:
BMTI common stock	$	977	$	—	$	—	$	977

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	Level 1		Level 2		Level 3		Total
December 31, 2009
Cash equivalents:
Money market funds	$	117,980	$	—	$	—	$	117,980
Short-term investments:
Commercial paper and money market	$	11,877	$	—	$	—	$	11,877
Corporate debt securities		—		13,125		—		13,125
Asset-backed securities		—		7,494		—		7,494
	$	11,877	$	20,619	$	—	$	32,496
Long-term investment:
BMTI common stock	$	2,002	$	—	$	—	$	2,002

Cash Equivalents — The Company’s cash equivalents consist of corporate commercial paper and money market funds with original maturities of less than ninety days. The valuation is based on observable market transactions for the exact instrument, quoted prices for similar assets in active markets or models where all significant inputs are observable or can be derived from or corroborated by observable market data. The Company conducts reviews at the end of each quarter to assess liquidity and fair value.

Short-term investments — The Company’s short-term investments consist of various fixed income securities with maturities of greater than ninety days and include securities issued by U.S. government sponsored enterprises, corporate debt securities and asset-backed securities. This portfolio of investments is valued utilizing observable market transactions for the exact instrument; quoted prices for similar assets in active markets; or models whereby all significant inputs are observable or can be derived from or corroborated by observable market data. The Company utilizes a pricing service to obtain fair value for its investment portfolio. Fair value for certain securities is based on proprietary models, and inputs are documented in accordance with the fair value hierarchy. The Company conducts reviews at quarter end to assess liquidity and to determine fair value pricing. The Company did not hold any securities categorized as Level 3 as of June 30, 2010, or December 31, 2009.

4. Inventory

Inventory is stated at the lower of cost or market. Cost includes amounts related to materials, labor and overhead, and is determined on a specific identification basis in a manner which approximates the first-in, first-out (FIFO) method. Inventory balances reflect the cost of post-approval manufacturing activities for RECOTHROM. The manufacturing of RECOTHROM requires multiple steps which are performed by a series of primarily single-source third-party contractors based upon the Company’s specifications. As protection against product shortages, the Company maintains safety stocks of inventory at each stage in the manufacturing process and has entered into manufacturing contracts, some of which contain annual minimum purchase commitments. The Company reduces

9

inventory to its estimated net realizable value by reserving for excess and obsolete inventories based on forecasted demand. Inventory consisted of the following (in thousands):

	June 30, 2010		December 31, 2009
Raw materials	$	2,677	$	2,256
Work in process		59,170		58,327
Finished goods		1,278		2,441
Total	$	63,125	$	63,024

5. Debt financing

In June 2008, the Company entered into a financing arrangement with Deerfield Management (Deerfield). In November 2008, the Company borrowed $25.0 million under the Deerfield financing arrangement and issued 1.5 million warrants to Deerfield with a conversion price of $10.35 per share. No subsequent borrowings were made under the arrangement before the February 10, 2010 borrowing deadline.

Interest accrues on the outstanding balance at a rate of 4.9% per annum, compounded quarterly, and will be due, along with outstanding principal, in June 2014. Accrued interest was $2.1 million as of June 30, 2010 and $1.5 million as of December 31, 2009 and is included in other long-term liabilities. Deerfield is entitled to a royalty equal to 2% of RECOTHROM net sales in the U.S. up to a maximum of $18.8 million over the term of the loan. For the three and six-month periods ended June 30, 2010, royalty expense which is included in interest expense was approximately $238,000 and $412,000, respectively. Royalty expense for the three and six-month periods ended June 30, 2009 was approximately $111,000 and $208,000, respectively. Royalties are payable quarterly. The Company can repay borrowed amounts in whole or in part at any time, without penalty, and all associated interest and royalty obligations cease.

Deferred financing costs totaling $7.4 million, which include the value of the warrants issued in 2008, are being amortized to interest expense through June 2014. For the three and six-month periods ended June 30, 2010 approximately $287,000 and $575,000 respectively, of amortization is included in interest expense. Deferred financing costs amortized to interest expense for the three and six-month periods ended June 30, 2009 was approximately $369,000 and $805,000, respectively.

6. Stock Offering

On January 12, 2010, The Company sold 16.1 million shares of common stock in an underwritten public offering at $6.00 per share. Net proceeds from the sale, after deducting underwriter discounts and other issuance costs, were $90.8 million.

7. Bristol-Myers Squibb collaboration and license agreement

In January 2009, the Company entered into a co-development/co-promotion and license agreement with Bristol-Myers Squibb Company (BMS) for the type III interferon family, of which PEG-IFN-lambda is the designated development candidate. The Company is required to fund the first $100.0 million of joint development costs (the Collaboration Obligation) and additional development costs will be funded 80.0% by BMS and 20.0% by the Company. The Company’s substantive obligations under this agreement are expected to be satisfied through 2012.

For the three and six-month periods ended June 30, 2010, the Company recorded collaboration and license revenue of $15.7 million and $29.0 million, respectively, and for the comparable periods in 2009 recorded collaboration and license revenue of $7.6 million and $16.5 million, respectively. As of June 30, 2010, the remaining balance of the Collaboration Obligation was $53.9 million and deferred revenue was $75.4 million.

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8. Stock compensation

The following table summarizes stock-based compensation expense by expense classification and type of award for the periods presented (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2010		2009		2010		2009
Research and development expense
Stock options	$	976	$	1,896	$	2,000	$	4,036
Restricted stock units		166		238		329		543
		1,142		2,134		2,329		4,579
Selling, general and administrative expense
Stock options		1,174		1,295		2,248		2,795
Restricted stock units		75		75		162		158
		1,249		1,370		2,410		2,953
Total	$	2,391	$	3,504	$	4,739	$	7,532

No income tax benefit has been recorded for stock option exercises as the Company has a full valuation allowance and management has concluded it is more likely than not that the net deferred tax asset will not be realized.

9. Restructuring

In April and December 2009, the Company restructured its operations and reduced its workforce by a total of 206 employees. Restructuring charges totaling $13.1 million were recorded in 2009. In addition to employee severance, benefits and related costs, the Company ceased using certain rental space as a result of these restructurings. The Company recorded a liability of $1.0 million in 2009 based on the remaining rental costs for which no economic benefit is derived, reduced by the estimated sublease rentals that could reasonably be obtained. The amount was discounted using a credit-adjusted risk-free rate.

The changes in liabilities related to these restructuring plans for the periods presented are as follows: (in thousands)

	Severance			Lease			Total
Balance, January 1, 2010	$	5,331		$	1,000		$	6,331
Severance payments		(3,171	)		—			(3,171	)
Lease payment		—			(54	)		(54	)
Balance, June 30, 2010	$	2,160		$	946		$	3,106

10. Comprehensive loss

For the three and six months ended June 30, 2010, total comprehensive loss was $3.6 million and $5.6 million, respectively. For the three and six months ended June 30, 2009, total comprehensive loss was $26.4 million and $45.7 million, respectively. Comprehensive loss is composed of net loss and unrealized gains and losses on short-term and long-term investments. The net change in accumulated other comprehensive gain for the six months ended June 30, 2010 was an increase of $105,000, reflecting a $858,000 decrease in net unrealized losses on short-term investments and a decrease of $753,000 in unrealized gain on long-term investments.

11

ZYMOGENETICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

11. Related party transactions

Novo Nordisk A/S (Novo Nordisk) owned approximately 27% and 30% of the Company’s outstanding common stock at June 30, 2010 and 2009, respectively. The following table summarizes collaboration and license revenues earned from Novo Nordisk for the periods presented (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2010		2009		2010		2009
Option and license agreement
IL-20	$	4	$	4	$	8	$	3,508
IL-21		9,789		4		22,540		8
Total	$	9,793	$	8	$	22,548	$	3,516

Option and license agreement

In 2000, Novo Nordisk entered into an option and license agreement with the Company which expired in November 2006. Under the terms of the agreement, Novo Nordisk entered into individual license agreements for various proteins. Novo Nordisk is responsible for all development activities for the licensed proteins and is obligated to make payments upon the achievement of predefined development milestones and to pay royalties on sales of any resulting products.

IL-20

Pursuant to the IL-20 license agreement, the Company earned and recognized as revenue a milestone payment of $3.5 million for the three-month period ended March 31, 2009.

IL-21

In December 2009, the agreement relating to embodiments of IL-21 other than the IL-21 protein was amended to provide worldwide development and commercialization rights to Novo Nordisk. Under the terms of the revised agreement, Novo Nordisk paid an initial milestone payment of $24.0 million. In addition, the Company was obligated to perform certain transition activities. Because of the substantive transition activities for which the Company was responsible, the Company recognized the initial $24.0 million milestone payment over the estimated performance period on a proportional performance basis through June 2010. The Company recorded collaboration and license revenue of $8.0 million and $20.0 million for the three and six-month periods ended June 30, 2010, respectively. In addition, the Company earned $285,000 and $1.0 million for transition activities performed during the three and six-month periods ended June 30, 2010, respectively, which are included in collaboration and license revenue. As of June 30, 2010, the Company has no remaining material performance obligations under the agreement.

In June 2010, Novo Nordisk submitted a clinical trial application for IL-21 mAb in Europe that entitles the Company to receive a milestone payment of $1.5 million. The Company recorded the milestone as revenue in June 2010 since there are no continuing performance obligations associated with the milestone.

12. Recent accounting pronouncements

In October 2009, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new

12

ZYMOGENETICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. This guidance is effective for the Company on January 1, 2011. The Company believes the adoption of this new guidance will not have a material impact on its results of operations, cash flows or financial condition.

In January 2010, the FASB issued authoritative guidance to amend the disclosure requirements related to recurring and nonrecurring fair value measurements. The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in active market for identical assets or liabilities) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. Additionally, the guidance requires a roll forward of activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). The guidance became effective for the Company on January 1, 2010, except for the disclosure on the roll forward activities for Level 3 fair value measurements, which will become effective for the Company on January 1, 2011. The Company has adopted the guidance as required by January 1, 2010 and will adopt the additional disclosure as required on January 1, 2011.

In March 2010, the FASB issued guidance related to the Milestone Method of Revenue Recognition, which recognizes the milestone method as an acceptable revenue recognition method for substantive milestones in a research or development transaction. The guidance is effective for the Company on January 1, 2011, with early adoption permitted. The Company is currently assessing the potential impact, if any, this guidance may have on its results of operations, cash flows or financial condition.

13. Commitments and Contingencies

In November 2009, King Pharmaceuticals, Inc. and affiliated entities filed suit against the Company in the United States District Court for the Eastern District of Tennessee. King alleges that the Company has engaged in unfair competition, false advertising, trademark infringement, and related claims under federal law and Tennessee state law. King seeks various forms of relief, including damages and injunctive relief precluding the Company from making certain representations regarding King’s products and the Company’s RECOTHROM product. King also filed motions with the District Court seeking temporary restraining orders and preliminary injunctive relief. In December 2009, the judge denied King’s motions for preliminary injunction, but the lawsuit continues and is not likely to be resolved for some time. The Company disputes the allegations of wrongdoing in King’s complaint and will vigorously defend itself in this matter. Trial in the case is currently projected to take place in the fourth quarter of 2011. The Company has not recorded a liability related to this suit.

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

Forward-Looking Statements

The following discussion and analysis should be read in conjunction with the financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and our consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2009. This Quarterly Report on Form 10-Q contains, in addition to historical information, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. This Act provides a “safe harbor” for forward-looking statements. All statements other than statements of historical fact made in this Quarterly Report on Form 10-Q are forward looking. When used in this Quarterly Report on Form 10-Q, the words “may,” “will,” “should,” “could,” “would,” “estimates,” “projects,” “believes,” “expects,” “anticipates,” “intends,” “plans” and similar expressions, are intended to identify certain of these forward-looking statements. However, these words are not the exclusive means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Examples of these statements include, but are not limited to, statements regarding: industry prospects and future results of operations or financial position, sales of and commercialization efforts related to RECOTHROM, achievement of milestones and payments under collaboration agreements, the progress of our research programs including clinical testing, our anticipated timing for initiation or completion of our clinical trials for any of our product candidates, our ability to identify new product candidates, the potential of such product candidates to lead to the development of commercial products, our future operating expenses, our future losses, our future expenditures for research and development, pending or threatened litigation and the sufficiency of our cash resources. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in Part II, Item 1A of this Quarterly Report on Form 10-Q and our other filings with the Securities and Exchange Commission. The cautionary statements made in this Quarterly Report on Form 10-Q should be read as being applicable to all related forward-looking statements wherever they appear in this Quarterly Report on Form 10-Q. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to revise any forward-looking statements whether as a result of new information, future events, or otherwise. Readers are urged to carefully review and consider the various disclosures made in this Quarterly Report on Form 10-Q and in our other reports filed with the Securities and Exchange Commission that attempt to advise interested parties of the risks and other factors that may affect our business, prospects, results of operations and financial condition.

Business Overview

We are a biopharmaceutical company focused on developing and commercializing therapeutic protein-based products for the treatment of human diseases. The process for taking one of our discoveries to the marketplace is long, complex and very costly. It is difficult to predict the time it will take to reach the market with any given product candidate, but it would not be unusual to span ten years or more and cost hundreds of millions of dollars. It is also a business of attrition; it is expected that, for the industry as a whole, less than 20% of the drug candidates entering human clinical trials will actually make it to the marketplace. For the products that do make it, particularly for those that address previously unmet medical needs, the markets can be significant, with a number of successful products selling in excess of $1.0 billion per year.

In late 2006, we began preparations for the commercial launch of our first product, RECOTHROM^®, which was approved by the Food and Drug Administration in January 2008. In 2007, we hired approximately 60 field personnel and additional headquarters-based personnel to support the commercial operations for selling RECOTHROM. We are incurring substantial marketing costs to penetrate the market and to support our selling efforts. We have also built significant levels of inventory in anticipation of expected demand for the product and to minimize the risk of product shortages. We recorded net sales revenue of $29.6 million in 2009 and we anticipate continued increases in RECOTHROM sales over time; however, we cannot be certain of the future rate of market penetration. These commercialization activities have utilized substantial cash resources and will continue to do so until such time as RECOTHROM sales reach a level, if ever, that will cover our related costs.

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An important element of our business strategy is that we intend to maintain a significant share of the commercial value for our product candidates under development. As a result, we will be required to pay for a portion of the development and commercialization costs for our partnered product candidates, such as PEG-IFN-lambda, and all of the development and commercialization costs for our internal product candidates, such as IL-21 and IL-31 mAb. In some cases, we may out-license our product candidates, as we have done with atacicept, Factor XIII and IL-21 mAb, for example.

Generating the operating capital necessary to fund our business can be challenging. There are a number of potential sources of revenues and cash that we pursue in order to address our funding needs, including the following:

• product sales of RECOTHROM, net of all related discounts and allowances;

• research, development and commercialization collaborations, such as the one we have entered into with Bristol-Myers Squibb for PEG-IFN-lambda, which provide revenues while also enabling us to reduce our ongoing research and development expenses;

• licensing of technologies or product candidates, such as atacicept, Factor XIII and most recently IL-21 mAb, to other companies, which typically provide license fees and potential milestone payments and royalties on sales;

• issuance of equity or equity-based securities, such as the offering of common stock we completed in January 2010;

• debt financing, such as the financing arrangement we entered into with Deerfield Management in June 2008; and

• investment income on our cash, cash equivalents and short-term investments.

We expect that it will be at least several years before we can generate enough product-related revenues for our company to reach net income or cash flow breakeven, and we expect to continue to invest significant amounts of cash in developing our business. In the future, we may pursue additional collaborations or license transactions related to IL-21 and IL-31 mAb in order to realize the full potential of the product candidate, which would likely generate additional cash and reduce our ongoing related expenses. In addition, we are committed to diligently monitoring our operating cost structure and making changes when necessary, as we did in 2009 through corporate restructurings.

It is possible that we will look for opportunities to raise capital by issuing equity or equity-related securities to help fund our company over the next several years. These opportunities may arise at any time, depending on factors such as overall market conditions; dynamics in the biotechnology sector of the market; investor appetite for certain types of companies; and fundamental characteristics of our business. At times, it may be difficult to raise capital on terms favorable to our company, if at all. Accordingly, we would expect to raise capital when it is available, as we did in January 2010, not waiting until there is an immediate need. We believe this strategy is important to minimize the financial risks to our company.

Results of Operations

Revenues

Product sales.Sales of RECOTHROM are recognized as revenue when the product is shipped and title and risk of loss have passed. Product sales are recorded net of provisions for estimated discounts, rebates, chargebacks and returns. We recognized net product sales revenue of $11.9 million and $20.9 million for the three and six-month periods ended June 30, 2010 as compared to $6.0 million and $10.5 million for the corresponding periods in 2009. The increase is due to additional hospitals converting usage from bovine thrombin to RECOTHROM and existing customers increasing their purchase of RECOTHROM, resulting in overall market share increases. In May 2010, we amended an agreement with one of the large Group Purchasing Organizations (GPOs) which provides us greater

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access to member hospitals and support in converting those hospitals to RECOTHROM. In conjunction with the amendment, we offered a temporary incentive program whereby the member hospitals could purchase a limited quantity of short-dated RECOTHROM at an additional discount with no right of return. A similar offer was extended to other hospitals purchasing RECOTHROM for the first time. In June 2010, we recorded $0.7 million in net sales associated with this incentive program.

Collaborations and licenses. We enter into various collaborative agreements that may generate license, option or other upfront fees with subsequent milestone payments earned upon completion of development milestones. Where we have no continuing performance obligations under an arrangement, we recognize such payments as revenue when contractually due and payment is reasonably assured, as these payments represent the culmination of a separate earnings process. Where we have continuing performance obligations under an arrangement, revenue is recognized using one of two methods. Where we are able to estimate the total amount of services under the arrangement, revenue is recognized using a proportional performance model. Costs incurred to date compared to total expected costs are used to determine proportional performance, as this is considered to be representative of the delivery of outputs under the arrangement. Revenue recognized at any point in time is limited to cash received and amounts contractually due. Changes in estimates of total expected costs are accounted for prospectively as a change in estimate. Where we cannot estimate the total amount of service that must be provided, a time-based method is used to recognize revenue. Under the time-based method, revenue is recognized over the arrangement’s estimated performance period, starting with the contract’s commencement, but not before the removal of any contingencies for each milestone. From period to period, license fees and milestone payments can fluctuate substantially based on the completion of new licensing or collaborative agreements and the achievement of development-related milestones.

Bristol-Myers Squibb

In January 2009, we entered into a co-development/co-promotion and license agreement with Bristol-Myers Squibb for the type-3 interferon family, with PEG-Interferon lambda being the lead product candidate. We received a total of $200.0 million under the agreement in 2009, consisting of $105.0 million in license fees and two milestone payments related to the initiation of Phase 2 clinical trials. We granted a license to related technology and are obligated to fund the first $100.0 million of costs for development in the U.S. and Europe, after which we will be responsible for 20% of such costs. We are recognizing revenue using a proportional performance model. We are recording revenue related to the license fees and near-term milestone payments over approximately 42 months, which corresponds to the period over which we anticipate satisfying our performance obligations under the agreement.

Novo Nordisk

In December 2009, we amended our license agreement with Novo Nordisk related to IL-21antagonists, whereby we added certain intellectual property, expanded their commercial rights to include North America and provided exclusive rights to our IL-21 mAb product candidate. In exchange, Novo Nordisk paid us a $24.0 million upfront payment in December 2009 and will pay future milestone payments and royalties. We are obligated to perform certain transition activities, which were substantively completed as of June 30, 2010, and Novo Nordisk will reimburse us for our costs of completing these activities. We recognized the $24.0 million milestone payment as revenue over the estimated performance period on a proportional performance basis.

In June 2010, Novo Nordisk submitted a clinical trial application for IL-21 mAb in Europe which entitles us to receive a milestone payment of $1.5 million. We recorded the milestone as revenue in June 2010 since there are no continuing performance obligations associated with the milestone.

Bayer

In June 2007, we entered into a license and collaboration agreement with Bayer Schering Pharma AG and a U.S. co-promotion agreement with Bayer HealthCare, LLC. (collectively, Bayer). The agreements provided Bayer with an exclusive license to develop and sell rThrombin outside the United States and to co-promote rThrombin in the United States for up to four years. In December 2009, we substantially amended the license and collaboration agreement and the U.S. co-promotion agreement. Under the amended agreements, Bayer returned all licensed

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territories to us except Canada; exited the U.S. co-promotion effective December 31, 2009; and forgave the $20.0 million in guaranteed U.S. sales bonuses which the Company had previously recorded as a liability. As part of the amendments, the Company agreed to pay Bayer a commission on U.S. net sales for the two-year period ending on December 31, 2011 up to a maximum of $12.0 million; to provide finished U.S. approved drug product for Canada at cost plus a fixed profit margin; and to forgive the $3.5 million milestone associated with Canadian approval of rThrombin. As of December 31, 2009, we recognized all previously deferred license and milestone revenue and recorded a $12.0 million liability to Bayer associated with U.S. commissions, for which Bayer has no further performance obligations.

Collaboration and license revenues totaled $25.6 million and $51.8 million for the three and six-month periods ended June 30, 2010, reflecting increases of $9.4 million and $15.5 million as compared to the corresponding periods in 2009. The increases resulted primarily from the following two factors.

• We recognized incremental collaboration and license revenue of $8.2 million and $12.5 million for the three and six-month periods ended June 30, 2010, respectively, related to the Bristol-Myers Squibb agreement for PEG-Interferon lambda.

• We recognized revenue of $9.8 million and $22.5 million for the three and six-month periods ended June 30, 2010, respectively, related to the Novo Nordisk IL-21 agreement signed in December 2009.

These increases were partially offset by the following decreases.

• Recognition of deferred license and milestone revenues related to our Merck Serono agreements decreased by $5.0 million and $9.9 million for the three and six-month periods ended June 30, 2010, respectively because all deferred revenues were fully amortized upon termination of the strategic alliance agreement in October 2009.

• Milestone revenue of $3.5 million related to the Novo Nordisk license agreement for IL-20 was earned in the three-month period ended March 31, 2009, but no corresponding amounts were earned in 2010.

• Bayer license revenue decreased by $3.7 million and $6.3 million for the three and six-month periods ended June 30, 2010, respectively because the related deferred revenues were fully amortized as of December 31, 2009 upon amendment of the agreements as described above.

Changes in deferred collaboration and license revenue were as follows:

	Three Months Ended June 30, 2010			Six Months Ended June 30, 2010
Beginning balance	$	87,393		$	104,383
Cash received or receivable		—			—
Revenue recognized		(12,006	)		(28,996	)
Ending balance	$	75,387		$	75,387

As of June 30, 2010, the deferred revenue balance consisted of $75.4 million related to the Bristol-Myers Squibb agreement. As of June 30, 2010, the remaining collaboration obligation related to funding the first $100.0 million of development costs under the Bristol-Myers Squibb collaboration was $53.8 million.

Costs and expenses

Costs of product sales. Costs of product sales include the inventory and distribution costs associated with RECOTHROM product revenue. Prior to FDA approval of RECOTHROM in January 2008, all third-party manufacturing costs and an allocation of our labor and overhead associated with the manufacturing of RECOTHROM for commercial sale were expensed as research and development costs as incurred. Subsequent to approval, these costs are recorded as inventory. Accordingly, we expect that costs of product sales will be lower as a percentage of product sales revenue during the time we are selling product manufactured prior to approval.

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Cost of product sales as a percentage of net product sales were 22.0% and 22.7% for the three months ended June 30, 2010 and 2009, respectively, and 21.5% and 22.6% for the six months ended June 30, 2010 and 2009, respectively.

Research and development. Research and development expense consists primarily of salaries and benefit expenses, costs of consumables, facility costs, contracted services and stock-based compensation. These amounts have, in the past, been offset by certain cost reimbursements from collaborators. We evaluate cost reimbursements received under our collaboration arrangements based on the underlying nature of the collaboration. Where the collaboration embodies the principles of cost sharing and revenue sharing, cost reimbursements are recorded as reductions to research and development expenses. A breakdown of research and development expenses is shown in the following table (in thousands):

	Three Months Ended June 30,					Six Months Ended June 30,
	2010		2009			2010		2009
Salaries and benefits	$	7,018	$	17,537		$	15,185	$	30,679
Consumables		961		1,514			1,964		3,783
Facility costs		1,614		2,003			3,388		4,129
Contracted services		11,836		5,378			18,460		10,032
Depreciation and amortization		1,125		1,192			2,096		2,432
Stock-based compensation		1,142		2,134			2,329		4,579
Subtotal		23,696		29,758			43,422		55,634
Cost reimbursement from collaborators		—		(621	)		—		(1,760	)
Net research and development expense	$	23,696	$	29,137		$	43,422	$	53,874

Salaries and benefits, stock-based compensation and consumables generally track with changes in our employee base from year to year. In April and December 2009, we reduced our research and development headcount by a total of 172 employees. These staff reductions resulted in our headcount-related costs being reduced by a total of $10.5 million and $15.5 million for the three and six-month periods ended June 30, 2010, respectively as compared to the corresponding periods in 2009. Salaries and benefits for both the three and six-month periods ended June 30, 2009 included approximately $7.0 million in severance related costs.

Contracted services include the cost of items such as contract research, development related contract manufacturing, clinical trials, non-clinical studies and payments to collaborators. These costs primarily relate to clinical development programs and can fluctuate substantially from period-to-period depending on the stage of our various programs. Generally, these external costs increase as a program advances toward commercialization, but there can be periods between major clinical trials or manufacturing campaigns during which costs decline. Our contracted services costs increased by $6.5 million and $8.4 million for the three and six-month periods ended June 30, 2010, respectively as compared to the corresponding periods in 2009 primarily due to the increased costs related to our PEG-Interferon lambda collaboration with Bristol-Myers Squibb. We expect to see continuing increasing trend in these development costs over the remainder of 2010 as we continue to incur substantial Phase 2b clinical trial costs.

Cost reimbursements from collaborators for the three and six-months ended June 30, 2009 included reimbursements from Bayer and Merck Serono. The license and collaboration agreement with Bayer was terminated effective December 2009 and our activities under the collaboration with Merck Serono ended in June 2009.

To date, our business needs have not required us to fully allocate all research and development costs among our various programs. However, we track direct labor, contracted services and certain consumable costs by program, which we monitor to assist us in appropriately utilizing our company resources. We also incur indirect costs that are not allocated to specific programs. These costs include indirect labor, certain consumable costs, facility costs, and depreciation and amortization, all of which benefit all of our research and development programs. The following table presents our research and development costs allocated to clinical development, pre-development and discovery

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research programs, together with the unallocated costs that benefit all programs for the periods presented (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2010		2009		2010		2009
Clinical development programs:
Autoimmunity and oncology	$	710	$	906	$	1,244	$	2,761
Antiviral		11,401		4,073		18,767		7,772
Preclinical and research programs		4,040		3,457		6,351		9,463
RECOTHROM		3,096		3,275		6,051		6,389
Unallocated indirect costs		4,449		17,426		11,009		27,489
Total	$	23,696	$	29,137	$	43,422	$	53,874

The major trends in research and development program costs for the periods presented in the table were as follows:

• Autoimmunity and oncology clinical development program (atacicept and IL-21) costs decreased for the six-month period ended June 30, 2010 as compared to the corresponding period in 2009 primarily due to the transition between Phase 2a and Phase 2b trials for IL-21.

• Antiviral clinical development program costs increased for both the three and six-month periods ended June 30, 2010 as compared to the corresponding period in 2009, primarily due to an increase in both internal and external costs related to PEG-Interferon lambda Phase 2a and Phase 2b clinical trials.

• Preclinical and research program costs decreased for the six-month period ended June 30, 2010, as compared to the corresponding period in 2009, primarily due to the discontinuation of certain preclinical and research programs following our corporate restructurings in April and December 2009. For the three-month period ended June 30, 2010, the decreasing trend was offset by a milestone payment on underlying licensed technology related to Novo Nordisk’s clinical trial application for IL-21 mAb in Europe.

• Unallocated indirect costs decreased for both the three and six-month periods ended June 30, 2010, as compared to the corresponding period in 2009, primarily reflecting the 2009 corporate restructuring.

Selling, general and administrative. Selling, general and administrative expense, which consists primarily of salaries and benefit expenses, professional fees and other corporate costs, decreased 24.6% and 16.1% for the three and six-month periods ended June 30, 2010 as compared to the corresponding periods in 2009. The decrease was primarily due to the reduction in administrative headcount of approximately 30 employees in April 2009, discontinuation of Bayer commission expense, which is now being charged against a liability established in December 2009, and decreases in professional fees. Salaries and benefits for both the three and six-month periods ended June 30, 2009 included approximately $1.0 million in severance related costs.

Stock-based compensation.Stock-based compensation expense decreased by $1.1 million and $2.8 million for the three and six-month periods ended June 30, 2010 as compared to the corresponding periods in 2009. The decreases were primarily due to a lower underlying share price for stock options granted in 2009 and 2010, and the forfeiture of stock options related to the termination of employees in 2009. The following table shows stock-based compensation by expense classification and type of award for the periods presented (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2010		2009		2010		2009
Research and development expense
Stock options	$	976	$	1,896	$	2,000	$	4,036
Restricted stock units		166		238		329		543
		1,142		2,134		2,329		4,579
Selling, general and administrative expense
Stock options		1,174		1,295		2,248		2,795
Restricted stock units		75		75		162		158
		1,249		1,370		2,410		2,953
Total	$	2,391	$	3,504	$	4,739	$	7,532

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Other income (expense)

Investment income. Investment income is generated primarily from our investment in fixed-income securities. The primary factors affecting the amount of investment income that we report are: the amount of cash, cash equivalents and short-term investments (cash reserves) invested, the effective interest rate, the amount of realized gains or losses on investments sold during the period and the amount of other-than-temporary impairment recorded in the period. The following table shows how each of these factors affected investment income for the periods presented (in thousands, except percentages):

	Three Months Ended June 30,						Six Months Ended June 30,
	2010			2009			2010			2009
Weighted average amount of cash reserves	$	215,116		$	131,766		$	227,645		$	114,719
Effective interest rate		0.19	%		0.29	%		0.27	%		0.78	%
Investment income before gains and losses		400			384			605			890
Net gain on sales of investments		23			—			26			—
Other-than-temporary impairment loss		(258	)		—			(258	)		—
Investment income, as reported	$	165		$	384		$	373		$	890

We sold two asset-backed securities during the quarter ended June 30, 2010 for a total of $2.0 million and recognized an incremental loss of $493,000, over the amount of other-than-temporary impairment losses previously recognized. In addition, we sold a portion of our investment in BioMimetic Therapeutics, Inc. for $1.1 million and recognized a gain of $608,000.

Interest expense. We have accounted for a sale-leaseback transaction completed in October 2002 as a financing transaction. Under this method of accounting, an amount equal to the net proceeds of the sale is considered a long-term interest-bearing liability. Rent payments under the leases are considered to be payments toward the liability and are allocated to principal and interest. We recorded related interest expense of $1.9 million and $3.8 million for the three and six-month periods ended June 30, respectively in both 2010 and 2009. In addition, we recorded interest expense of $852,000 and $795,000 for the three months ended June 30, 2010 and 2009, respectively, and $1.6 million for both the six-month periods ended June 30, 2010 and 2009, related to the Deerfield financing arrangement, which represents amortization of the deferred financing costs, including the assumed fair value of the warrants issued; 4.9% interest on the $25.0 million drawn in November 2008; and additional interest expense equal to the 2% royalty payable on RECOTHROM net sales. In January 2010, the term of the outstanding loan was extended by one year to June 2014, and the amortization period for the remaining balance of deferred financing costs was similarly extended.

Liquidity and Capital Resources

As of June 30, 2010, we had cash, cash equivalents and short-term investments of $205.5 million, an increase of $31.3 million from December 31, 2009. The increase is attributable to the receipt of net proceeds from our January 2010 stock offering totaling $90.8 million partially offset by cash used to fund our operations, including substantial funding obligations under our type-3 interferon collaboration with Bristol-Myers Squibb. We intend to use these assets to fund our operations and capital expenditures. Our cash reserves have been held in a variety of fixed-income securities, including money market funds, corporate bonds, U.S. government sponsored enterprises and asset-backed securities that were investment grade at the time of purchase. Subsequent to our purchase, some asset-backed securities have been downgraded by the major bond rating agencies. Together with the discretionary investment manager responsible for investing our portfolio, we monitor our investments closely taking into account market conditions and our expected working capital requirements.

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We expect to fund our future operations using our existing cash; revenues from RECOTHROM sales; cash generated from existing and newly established collaborations and licenses; and public or private financings, including debt or equity financings. We believe that our existing cash resources will be sufficient to fund our operations at least through 2011 and potentially longer, depending on certain future events, including the sales performance of RECOTHROM, progress in the development activities for PEG-IFN-lambda and development plans for our other product candidates.

Cash flows from operating activities

The amount of cash used to fund our operating activities differs from our reported net losses due to the following items:

• non-cash items, such as depreciation and amortization of fixed assets, amortization of deferred debt issue costs, gain or loss on sale or disposal of assets, other-than-temporary impairment losses on investments and stock-based compensation, which do not result in uses or sources of cash;

• net realized gains and losses and accretion and amortization of discounts and premiums on short-term investments, which are reflected as sources of cash from investing activities upon maturity or sale of the respective investments;

• changes in receivables, which generally represent temporary timing differences between the recognition of certain revenues and the subsequent receipt of cash payments;

• additions to RECOTHROM inventory subsequent to the January 17, 2008 approval date, which reflect the use of cash but will not be expensed until the related product is sold;

• changes in deferred revenue, which reflect the difference in timing between the receipt of cash from option fees, license fees, other upfront payments and milestone payments, and the subsequent recognition of these amounts as revenue over the period we are contractually required to provide other rights or services that represent continuing obligations;

• the collaboration obligation under the Bristol-Myers Squibb agreement to fund the first $100.0 million of certain development costs, which is anticipated to be paid through early 2011; and

• changes in other assets and liabilities, which generally represent temporary timing differences between the recognition of certain expenses and their payment.

Most of these items do not cause material fluctuations in the relationship between our net loss and the amount of net cash used in operating activities. Exceptions are non-cash items, changes in deferred revenue and collaboration obligations and RECOTHROM inventory changes. Substantial license or upfront fees may be received when we enter into new licensing or collaborative agreements and be recorded as deferred revenue, which is then recognized as revenue over a future period. For example, we received $200.0 million in upfront and milestone payments from Bristol-Myers Squibb in 2009, of which $100.0 million was recorded as a collaboration obligation reflecting our responsibility to fund the first $100.0 million of research and development costs incurred for the collaboration. The remaining $100.0 million was recorded as deferred revenue. As of June 30, 2010, the remaining collaboration obligation was $53.8 million, which is expected to be paid through early 2011. The deferred revenue is currently expected to be recognized as revenue through mid-2012. The timing of additional collaboration transactions is expected to be irregular and, accordingly, has the potential to create additional future fluctuations in the relationship between our net loss and the amount of cash used in operating activities.

The supply chain for RECOTHROM involves single source suppliers in various countries. These suppliers often require annual minimum production levels, significant lead times and firm purchase commitments to ensure

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that manufacturing capacity is available. We have established safety stocks of inventory at each stage in the RECOTHROM manufacturing supply chain in an effort to ensure that sufficient product is available to meet anticipated demand. The purchase of inventory under these arrangements has resulted in a significant use of cash. Our current levels of inventory are higher than necessary to support our current volume of sales; however, work in process and finished goods inventories have shelf lives of five and three years, respectively. We perform periodic reviews of inventory levels, including reviews of the product expiration dates and forecasted sales, and write-down the value of inventory to reflect any anticipated obsolescence. Such write-downs are reflected as a component of cost of product sales. For example, we recorded an obsolete inventory charge of $4.2 million in the fourth quarter of 2008 and $500,000 in the quarter ended June 30, 2010.

Cash flows from investing activities

Our most significant cash flows in investing activities are for the purchase of short-term investments and receipts from the sale and maturity of short-term investments. These amounts primarily relate to shifts between cash and cash equivalents and short-term investments. Because we manage our cash usage with respect to our total cash, cash equivalents and short-term investments, we generally do not consider these cash flows to be important to an understanding of our liquidity and capital resources. The Company sold two asset-backed securities during the quarter ended June 30, 2010 for a total of $2.0 million and recognized an incremental loss of $493,000. In addition, we sold a portion of our investment in BioMimetic Therapeutics, Inc. for $1.1 million and recognized a gain of $608,000. Purchases of property and equipment were minimal for the six-month periods ended June 30, 2010 and 2009.

Cash flows from financing activities

In January 2010, we sold 16.1 million shares of our common stock in an underwritten public offering and received $90.8 million in net proceeds. We also received $1.1 million and $400,000 of proceeds from the exercise of stock options for the six-month periods ended June 30, 2010 and 2009, respectively. The amounts we receive from stock option exercises are dependent upon various factors that include our stock price, employee turnover and the expiration dates of stock option grants.

We expect to incur substantial additional losses in the coming years as we continue to build the market for RECOTHROM and advance our pipeline candidates, such as PEG-IFN-lambda. It might be some time, if ever, before our RECOTHROM revenues enable us to achieve positive operating cash flow. If at any time our prospects for funding our various initiatives decline, we may decide to look for ways to reduce our ongoing investment. For instance, we might consider discontinuing our funding under existing co-development arrangements, as we did with our atacicept collaboration with Merck Serono in August 2008. Further, we may establish new co-development arrangements for other product candidates to provide additional funding sources, as we did in early 2009 with our PEG-IFN-lambda collaboration with Bristol-Myers Squibb. Also, we may out-license products, product candidates or certain rights related to products or product candidates that we might otherwise choose to develop and commercialize internally, as we did in late 2009 with our IL-21 mAb license agreement with Novo Nordisk. Additionally, we could consider delaying or discontinuing development of product candidates to reduce the level of our related expenditures.

We believe our existing cash and cash equivalents and short-term investments provide us with sufficient resources to fund our operations at least through 2011 and potentially longer, depending on certain future events, including the sales performance of RECOTHROM, progress in the development activities for PEG-IFN-lambda and development plans for our other product candidates. We may seek additional funding through new license and/or collaboration transactions or public or private financings, including debt or equity financings. If we are unable to raise additional funds when we need them, we could be required to delay, scale back or eliminate expenditures for some of our development programs, or grant rights to third parties to develop and market product candidates that we would prefer to develop and market internally, with license terms that are not favorable to us.

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Contractual Obligations

At June 30, 2010, we were contractually obligated to make payments as follows (in thousands):

	Payments Due by Period
	Total		Less than 1 Year		1-3 Years		3-5 Years		More than 5 Years
Building lease obligations	$	87,908	$	8,584	$	18,079	$	19,367	$	41,878
Operating leases		27,358		2,679		5,655		6,076		12,948
Collaboration obligation		53,840		53,840		—		—		—
RECOTHROM manufacturing contracts		54,674		8,105		17,169		9,800		19,600
Total	$	223,780	$	73,208	$	40,903	$	35,243	$	74,426

The building lease obligations resulted from our 2002 sale-leaseback financing transaction and run until May 2019. The operating leases relate to office space near our corporate headquarters buildings which expire in April 2019. We have certain renewal provisions at our option, which are not reflected in the above table, for the building leases and the operating leases. The collaboration obligation relates to the collaboration and license agreement we entered into with Bristol-Myers Squibb, which obligates us to fund the first $100.0 million of costs for development in the U.S. and Europe, after which we will be responsible for 20% of such costs unless we elect to convert to a royalty arrangement. RECOTHROM manufacturing contracts include the manufacture of rThrombin bulk drug and RECOTHROM finished product for commercial sale.

Off-Balance Sheet Arrangements

As of June 30, 2010, we did not have any material off-balance sheet arrangements (as defined by Item 303(a)(4)(ii) of Regulation S-K).

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

Generally, our exposure to market risk has been primarily limited to interest income sensitivity, which is affected by changes in the general level of United States interest rates, particularly because the majority of our investments are in short-term debt securities. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive without significantly increasing risk. To minimize risk, we maintain our portfolio of cash, cash equivalents and short-term investments in a variety of interest-bearing instruments, which have included United States government and agency securities, high-grade United States corporate bonds, asset-backed securities, corporate commercial paper and money market funds.

We have estimated the effect on our investment portfolio of a hypothetical increase in interest rates by one percent to be a reduction of $200,000 in the fair value of our investments as of June 30, 2010.

In 2008, 2009 and continuing into 2010, due to deteriorating conditions in the debt markets, our exposure to market risk increased and impacted our investment portfolio. Overall liquidity for many debt issues declined substantially, meaning that we may realize losses if we are required to liquidate securities upon short notice. Additionally, with respect to asset backed securities, overall economic conditions have generated concerns about the value of underlying assets held as collateral and highlighted risks associated with insurance policies used to enhance the credit of the related debt issues. In 2009, we revised our investment guidelines to exclude future purchases of asset-backed securities. To date, we have not experienced material defaults on any of our asset backed securities, but we have seen the time for expected repayment increase significantly. Since 2008, we have recorded other-than-temporary impairment losses totaling $2.3 million with respect to asset-backed securities. In June 2010, we sold two asset-backed securities for a total of $2.0 million and recognized an incremental loss of $493,000. As of June 30, 2010, we hold three asset-backed securities with a market value of $4.7 million. We continue to monitor our asset-backed securities closely.

We have no material foreign currency exposure, nor do we hold derivative financial instruments.

Item 4. Controls and Procedures

Our principal executive officer and principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, or Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q, have concluded that as of such date our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. No change in our internal control over financial reporting occurred during the quarter ended June 30, 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II OTHER INFORMATION

Item 1. Legal Proceedings

In November 2009, King Pharmaceuticals, Inc. and affiliated entities filed suit against us in the United States District Court for the Eastern District of Tennessee. King alleges that we have engaged in unfair competition, false advertising, trademark infringement, and related claims under federal law and Tennessee state law. King seeks various forms of relief, including damages and injunctive relief precluding us from making certain representations regarding King’s products and our RECOTHROM product. King also filed motions with the District Court seeking temporary restraining orders and preliminary injunctive relief. In December 2009, the judge denied King’s motions for preliminary injunction, but the lawsuit continues and is not likely to be resolved for some time. We dispute the allegations of wrongdoing in King’s complaint and will vigorously defend ourselves in this matter. Trial in the case is currently projected to take place in the fourth quarter of 2011.

Item 1A. Risk Factors

You should carefully consider the risks described below together with the other information set forth in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2009 and subsequent Quarterly Reports, which could materially affect our business, financial condition or future results. The risks described below are not the only risks facing our company. Risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

Risks Related to Our Business

If we fail to increase sales of RECOTHROM^® recombinant human thrombin or to successfully develop and commercialize product candidates in our pipeline, we will not meet our financial goals.

Our near-term financial success is highly dependent on our ability to increase revenue from the commercialization of RECOTHROM. The successful commercialization of RECOTHROM will depend on many factors, including the following:

• the effectiveness of our product differentiation, marketing, promotion, distribution, sales and pricing strategies and programs, and those of our competitors;

• our ability to maintain effective promotional materials that are acceptable to regulatory officials;

• product demand within the medical community;

• our ability to penetrate the existing thrombin market and develop complementary products;

• the introduction of new alternative topical hemostats that may compete with RECOTHROM and offer desirable features or benefits;

• new data or adverse event information relating to RECOTHROM or any similar products and any resulting regulatory action;

• clinical practice or other guidelines regarding topical hemostats published by professional organizations or specialty groups;

• successfully maintaining a product supply chain to meet demand;

• successfully maintaining a commercial infrastructure, including a sales force; and

• the ability to gain formulary acceptance and favorable formulary positioning in a timely fashion or at all.

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Part of our business strategy involves developing and commercializing new products, such as PEG-IFN-lambda, IL-21 and IL-31 monoclonal antibody (IL-31 mAb), at times through entry into strategic alliances and collaborations. This part of our strategy requires us or our collaborators to conduct clinical trials to support approval of these new products. The success of this component of our strategy will depend on the outcome of these clinical trials, the success of our collaborators, the content and timing of our submissions to regulatory authorities and whether and when those authorities determine to grant approvals. The other element of our business strategy is maximizing the commercial opportunity for RECOTHROM. Our commercial organization was formed only within the past few years, and we are still developing capabilities in some key areas. If we fail to significantly increase sales of RECOTHROM, our ability to successfully complete development and commercialization activities for our other product candidates, and our ability to become profitable in the future, will be adversely affected.

We anticipate incurring additional losses and may not achieve profitability.

As of June 30, 2010, we had an accumulated deficit of $811.4 million. We expect to continue to incur significant losses over the next several years, and we may never become profitable. Although we began generating RECOTHROM sales revenue in 2008, it will be a number of years before we generate revenues from sales of other product candidates, if ever. Our revenues from the sales of RECOTHROM and existing collaborative and licensing arrangements are currently insufficient to fund our operating expenses, and we may never generate revenues sufficient to fund these expenses. In addition, we will continue to incur substantial expenses relating to our product development and commercialization efforts. The development and commercialization of our product candidates will require significant further research, development, testing, regulatory approvals and sales and marketing activities. We will continue to incur substantial operating losses for at least the near term as we continue to support the commercialization of RECOTHROM and as a result of our development activities for the product candidates in our development pipeline. These losses have had and will have an adverse effect on our shareholders’ equity (deficit) and working capital. Even if we become profitable in the future, we may not remain profitable.

If we fail to obtain or generate the capital we need to fund our operations, we will be unable to continue operations.

Our revenues from sales, collaborations and licensing agreements do not currently generate the cash needed to finance our operations, and we do not expect them to do so in the foreseeable future. We anticipate that we will continue to expend substantial funds on the development of our product candidates, and the amount of these expenditures may increase in the future. We expect to seek additional funding through public or private financings, including equity financings, credit facilities, or through other arrangements, including collaborative and licensing arrangements. Poor financial results, including sales of RECOTHROM being less than expected, unanticipated expenses or unanticipated opportunities that require financial commitments could give rise to additional financing requirements or require us to obtain additional financing sooner than we expect. However, financing may be unavailable when we need it or may be unavailable on acceptable terms. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our existing shareholders will be diluted, and these securities may have rights superior to those of our common stock. If we are unable to raise additional funds when we need them, we may be required to delay, scale back or eliminate expenditures for some of our development or commercial programs. We may also be required to grant rights to third parties to develop and commercialize products and product candidates that we would prefer to develop and commercialize ourselves, and such rights may be granted on terms that are not favorable to us. If we were required to grant such rights, the ultimate value of these products or product candidates to us would be reduced. In addition, if our cash and cash equivalents drop below specified levels it may result in the loss of co-promotion rights and U.S. patent rights under our agreement with Bristol-Myers Squibb relating to PEG-IFN-lambda and constitute an event of default under our June 28, 2008 Facility Agreement with Deerfield Private Design Fund, L.P., Deerfield Private Design International, L.P. and Deerfield ZG Corporation, which would result in the principal and accrued and unpaid interest on the loans made under the agreement to become immediately due and payable.

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Additionally, a substantial portion of our operating expenses are funded through our collaborative agreements with third parties. For example, as part of the co-development/co-promotion and license agreement with Bristol-Myers Squibb for PEG-IFN-lambda, we received $200.0 million in 2009. To the extent that we lose collaborative partners for a program or a portion of a program that we do not fund internally, or to the extent that we do not receive the funding that we expect from our collaborative agreements, unless we are able to obtain alternative sources of funding, we would be delayed in or unable to continue developing product candidates under the affected program. In addition, to the extent that funding is provided by a collaborator for non-program-specific uses, the loss of significant amounts of collaborative funding could result in the delay, reduction or termination of additional research and development programs, a reduction in capital expenditures or business development and other operating activities, or any combination of these measures, which would harm our business. Subject to the terms of the relevant agreement, each collaborator has the right to terminate its obligation to provide research funding.

We are focused on a limited number of product candidates, and adverse developments with respect to one or more of those candidates could harm our business.

Our business is focused on a limited number of product candidates. We have discontinued discovery research activities in oncology and immunology and have retained only those research capabilities necessary to support the continued development of PEG-IFN-lambda, IL-21 and IL-31 mAb. Our focus on a limited number of internal product candidates means that adverse developments with respect to one or more of these candidates could have a more significant adverse impact on our business than if we maintained a broader portfolio of product candidates.

We are subject to extensive and rigorous governmental regulation including the requirement of approval before our products may be lawfully marketed.

Both before and after the approval of our product and product candidates, we, our product, our product candidates, our operations, our facilities, our suppliers, and our contract manufacturers, contract research organizations, and contract testing laboratories are subject to extensive regulation by governmental authorities in the United States and other countries, with regulations differing from country to country. In the United States, the FDA regulates, among other things, the pre-clinical testing, clinical trials, manufacturing, safety, efficacy, potency, labeling, storage, record keeping, quality systems, advertising, promotion, sale and distribution of therapeutic products. Failure to comply with applicable requirements could result in, among other things, one or more of the following actions: notices of violation, untitled letters, warning letters, fines and other monetary penalties, unanticipated expenditures, delays in approval or refusal to approve a product candidate; product recall or seizure; interruption of manufacturing or clinical trials; operating restrictions; injunctions; and criminal prosecution. We or the FDA, or an institutional review board, may suspend or terminate human clinical trials at any time on various grounds, including a finding that the subjects are being exposed to an unacceptable health risk. Except for RECOTHROM, none of our product candidates has been approved for sale in the United States. Our product candidates, PEG-IFN-lambda, IL-21, IL-31 mAb, or any subsequent product candidates cannot be lawfully marketed in the United States without FDA approval. Any failure to receive the marketing approvals necessary to commercialize our product candidates could harm our business.

The regulatory review and approval process of governmental authorities, which includes the need to conduct nonclinical studies and clinical trials of each product candidate, is lengthy, expensive and uncertain, and regulatory standards may change during the development of a particular product candidate. We are not permitted to market our product candidates in the United States or other countries until we have received requisite regulatory approvals. For example, securing FDA approval requires the submission of a new drug approval (NDA) or biologics license approval (BLA) application to the FDA. The approval application must include extensive nonclinical and clinical data and supporting information to establish the product candidate’s safety and effectiveness for each indication. The approval application must also include significant

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information regarding the chemistry, manufacturing and controls for the product. The FDA review process typically takes many years to complete and approval is never guaranteed. If a product is approved, FDA may limit the indications for which the product may be marketed, require extensive warnings on the product labeling, impose restricted distribution programs, require expedited reporting of certain adverse events, or require costly ongoing requirements for post-marketing clinical studies and surveillance or other risk management measures to monitor the safety or efficacy of the product candidate. Markets outside of the United States also have requirements for approval of drug candidates with which we must comply prior to marketing. Obtaining regulatory approval for marketing of a product candidate in one country does not ensure we will be able to obtain regulatory approval in other countries but a failure or delay in obtaining regulatory approval in one country may have a negative effect on the regulatory process in other countries. Also, any regulatory approval of any of our products or product candidates, once obtained, may be withdrawn.

The FDA may grant orphan drug designation to a drug intended to treat a “rare disease or condition,” which generally is a disease or condition that affects fewer than 200,000 persons in the United States. Orphan drug designation must be requested before submitting an application for marketing authorization. Orphan drug designation does not convey any advantage in, or shorten the duration of, the regulatory review and approval process. If a product which has an orphan drug designation subsequently receives the first FDA approval for the indication for which it has such designation, the product is entitled to orphan exclusivity, which means the FDA may not approve any other application to market the same drug for the same indication for a period of seven years, except in limited circumstances, such as the showing of clinical superiority to the product with orphan exclusivity. Also, competitors may receive approval of other different drugs or biologics for the indications for which the orphan product has exclusivity.

FDA has increased its attention to product safety concerns in light of recent high profile safety issues with certain drug products in the United States. Moreover, heightened scrutiny by the U.S. Congress on the adequacy of the FDA’s drug approval process and the agency’s efforts to assure the safety of marketed drugs has resulted in proposed agency initiatives and new legislation addressing drug safety issues. If adopted, any new legislation or agency initiatives could result in delays or increased costs during the period of product development, clinical trials and regulatory review and approval, as well as increased costs to conduct studies and assure compliance with any new post-approval regulatory requirements.

In addition, we, our suppliers, our operations, our facilities, our contract manufacturers, our contract research organizations, and our contract testing laboratories are required to comply with extensive FDA requirements both before and after approval of our products. For example, we are required to report certain adverse reactions and production problems, if any, to FDA, and to comply with certain requirements concerning advertising and promotion for our products. Also, quality control and manufacturing procedures must continue to conform to current Good Manufacturing Practices (cGMP) regulations after approval, and the FDA periodically inspects manufacturing facilities to assess compliance with cGMP. Accordingly, we and others with whom we work must continue to expend time, money, and effort in all areas of regulatory compliance, including manufacturing, production, and quality control. In addition, discovery of safety issues may result in changes in labeling or restrictions on a product manufacturer or BLA holder, including removal of the product from the market.

Our ability to differentiate RECOTHROM in the marketplace may be limited if FDA challenges our promotional and marketing materials.

FDA has authority to regulate advertising and promotional labeling for RECOTHROM under the Federal Food, Drug, and Cosmetic Act and implementing regulations. In general, that authority requires advertising and promotional labeling to be truthful and not misleading, and requires that products be marketed only for the approved indications. FDA routinely provides its interpretations of that authority in informal communications and also in more formal communications such as untitled letters or warning letters, and although such communications are not final agency decisions, companies may decide not to contest the agency’s interpretations so as to avoid disputes with FDA, even if they believe the claims to be truthful, not misleading and otherwise lawful. FDA has generally given close scrutiny to claims making a comparison of the attributes of one product to another. We have made such claims for RECOTHROM as a means of

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differentiating RECOTHROM from competitive products containing bovine thrombin, and are aware that King Pharmaceuticals, Inc. has repeatedly complained to FDA about those claims. In April 2008, we received an untitled letter from FDA identifying concerns with certain comparative statements contained in a press release relating to antibody formation for RECOTHROM and bovine thrombin. We provided our response to the FDA and received a letter from the FDA confirming that the matter was closed in May 2008. Subsequently, in its response filed in October 2009 to a Citizen Petition we filed with FDA in August 2009 requesting that FDA remove King’s bovine thrombin product from the market in the interest of patient safety, King identified comparative claims from our promotional materials that it believes are false and misleading. We believe our claims, including those challenged by King, are truthful, not misleading, and otherwise lawful, but it is possible that FDA or other regulatory authorities may disagree with our conclusion. If FDA or other regulatory authorities were to challenge our promotional materials or activities, and if we were to elect not to contest such a challenge or were unable to resolve it in a satisfactory manner, our ability to differentiate RECOTHROM in the marketplace could be adversely affected.

Our success with RECOTHROM will depend on our ability to effectively compete with large and well established competitors who have greater resources and broader product lines than we do.

The biotechnology and pharmaceutical field is extremely competitive, and RECOTHROM faces substantial competition from alternative topical hemostats. In the United States, stand-alone plasma-derived thrombin products on the market include Thrombin-JMI, a bovine plasma-derived thrombin sold by King, and Evithrom, a pooled human plasma-derived thrombin sold by Ethicon, Inc., a division of Johnson & Johnson. In addition, Baxter International, Inc. markets the GELFOAM Plus Hemostasis Kit, which is Pfizer Inc.’s GELFOAM sterile sponge co-packaged with human plasma-derived thrombin. Further, a number of companies, including Johnson & Johnson and Baxter International, Inc., currently market other hemostatic agents that may compete with RECOTHROM, including passive agents such as gelatin and collagen pads and flowable hemostats, as well as fibrin sealants and tissue glues. Many of these alternative hemostatic agents are relatively inexpensive and have been widely used for many years. Consequently, physicians and hospital formulary decision-makers may be hesitant to adopt RECOTHROM.

Several companies, some of which have substantial experience and resources, have products or are developing product candidates in the areas we have targeted for our product candidates.

For our product candidates in development, we face competition from other entities involved in the research and development of therapeutic proteins, antibody products and pharmaceuticals, including Human Genome Sciences, Inc., Biolex Therapeutics, Inc., Bristol-Myers Squibb Company, Plexxikon Inc., and Genentech, Inc., among others. A number of our largest competitors are pursuing the development or marketing of pharmaceuticals that address the same diseases that we are pursuing, and it is possible that the number of companies seeking to develop products and therapies for these diseases will increase. We also face competition from entities developing other types of products related to particular diseases or medical conditions, including other biotechnology and pharmaceutical companies, universities, public and private research institutions, government entities and other organizations.

Furthermore, our potential products, if approved and commercialized, may compete against well-established therapeutic protein-based products or well-established antibody products, many of which may be currently reimbursed by government health administration authorities, private health insurers and health maintenance organizations.

Many of our existing and potential competitors have substantially greater research, product development and commercial capabilities and financial, scientific, marketing and human resources than we do. As a result, these competitors may:

• succeed in developing therapeutic protein-based products or alternative therapies, earlier than we do;

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• obtain approvals for products from the FDA or other regulatory agencies more rapidly than we do;

• obtain patents that block or otherwise inhibit our ability to develop and commercialize our product candidates;

• develop treatments or cures that are safer, more effective, convenient or economical than those we propose to develop;

• devote greater resources to marketing or selling their products;

• introduce products that make the continued development of our potential products uneconomical;

• withstand price competition more successfully than we can;

• negotiate more favorable terms with third-party collaborators, licensees, group purchasing organizations and other large customers; and

• take advantage of acquisitions or other opportunities more readily than we can.

Because of these and other potential disadvantages, we may be unable to compete effectively with these competitors. All of our product candidates face competition and we expect that competition in our industry will continue to be intense.

Clinical trials may fail to demonstrate the safety and effectiveness of our product candidates, which could delay, limit or prevent their regulatory approval.

Clinical trials involving PEG-IFN-lambda, IL-21, IL-31 mAb or any subsequent product candidates may reveal that those candidates are ineffective, are insufficiently effective given their safety profile, have unacceptable toxicity or safety profiles or have other unacceptable side effects. In addition, data obtained from tests and trials are susceptible to varying interpretations and FDA or other regulatory authorities may interpret the results of our preclinical studies or clinical trials less favorably than we do, which may delay, limit or prevent regulatory approval. Likewise, the results of preliminary studies do not predict clinical success, and larger and later-stage clinical trials may not produce the same results as earlier-stage trials. Frequently, product candidates that have shown promising results in early clinical trials have subsequently suffered significant setbacks in later clinical trials. Similarly, clinical trial results may vary between different arms of a clinical trial for reasons that we cannot adequately explain. In addition, the design of a clinical trial can determine whether its results will support approval of a product and flaws in the design of a clinical trial may not become apparent until the clinical trial is well advanced. We have limited experience in designing clinical trials that have supported the approval of a product and may be unable to do so successfully. Further, clinical trials of potential products often reveal that it is not practical or feasible to continue development efforts. The failure to provide clinical and preclinical data that are adequate to demonstrate to the satisfaction of the regulatory authorities that our product candidates are safe and effective for their proposed use will delay, limit or prevent approval and will prevent us from marketing those products.

If we or others identify previously unknown side effects or safety concerns for RECOTHROM our business could be harmed.

If we or others identify previously unknown side effects, safety concerns, for RECOTHROM or any products perceived to be similar to RECOTHROM, then in any of these circumstances:

• sales of RECOTHROM may decrease significantly;

• regulatory approvals for RECOTHROM may be restricted or withdrawn;

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• we may decide to, or be required to, initiate a recall or send product warning letters to physicians, pharmacists and hospitals;

• reformulation of the product, additional preclinical or clinical studies, changes in labeling or changes to or re-approvals of manufacturing facilities may be required;

• our reputation in the marketplace may suffer; and

• government investigations and lawsuits, and private party lawsuits, including class action suits, may be brought against us.

Any of the above occurrences could harm or prevent sales of RECOTHROM, increase our expenses and impair our ability to successfully commercialize RECOTHROM.

Furthermore, now that RECOTHROM is approved in the United States, it is being used in a wider population and in a less rigorously controlled fashion than in clinical studies. It is expected that some patients exposed to RECOTHROM will become sick or die suddenly, that in some or even many of these cases there will not be sufficient information available to rule out RECOTHROM as a contributing factor or cause of sickness or mortality, and that safety reporting from physicians or from us to regulatory authorities may link RECOTHROM to death or other serious adverse effects. As a result, regulatory authorities, healthcare practitioners, third-party payers or patients may perceive or conclude that the use of RECOTHROM is associated with death or other serious adverse effects, any of which could mean that our ability to commercialize RECOTHROM could be adversely affected and our business could be impaired.

We may be required to defend lawsuits and pay damages in connection with alleged or actual harm caused by our products and product candidates.

The design, testing, manufacture and sale of therapeutic products involve an inherent risk of product liability claims and associated adverse publicity, even if the claims arise from use of the product in a manner inconsistent with label or other instructions. In addition, RECOTHROM is and will be used on patients undergoing surgery, where there are significant risks to patients, and adverse outcomes in patients exposed to RECOTHROM could result in lawsuits.

If any of these potential lawsuits against us were to be successful, we may incur significant costs and could be required to make significant modifications to our business. Even if such lawsuits are without merit or otherwise unsuccessful, they could cause adverse publicity, divert management attention and be costly to respond to, and, therefore, could have an adverse effect on our business. Although we maintain product liability and general insurance, our coverage may not be adequate to cover product liability or other claims. We do not know if we will be able to maintain existing or obtain additional product liability insurance on acceptable terms or with adequate coverage against potential liabilities. This type of insurance is expensive and may in the future be unavailable on acceptable terms, if at all. Any product liability claims, whether or not ultimately successful, could have a negative effect on our reputation, stock price, ability to penetrate the market and sell our products and our financial condition and results.

Guidelines, recommendations, codes and other literature published by various organizations, including competitors, may affect our ability to effectively promote and sell RECOTHROM.

Various professional societies, industry trade associations, practice management groups, private health/science foundations, and organizations periodically publish guidelines, codes, recommendations and other literature to the healthcare and patient communities. These organizations have in the past made recommendations about RECOTHROM or products that compete with RECOTHROM, such as the treatment guidelines of the Society of Thoracic Surgeons. Competitors may also conduct and publish the results of clinical trials or support the conduct and publishing of other reviews or analyses aimed at diminishing concerns about their own products or indicating advantages over RECOTHROM. We have no control over

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the content of many of these publications, even those for which we may provide some form of financial support. For example, from time to time, we make medical education grants to organizations that in some cases result in a publication. The content of these publications or independent medical education programs may not be favorable to RECOTHROM and may negatively impact our ability to penetrate the market.

Pending litigation by our primary competitor for RECOTHROM could have an adverse impact on our business.

We are involved in litigation with King Pharmaceuticals, Inc., our primary competitor in the stand-alone thrombin market, and they have been aggressive in defending their leading position in that market. In November 2009, King and affiliated entities filed a lawsuit against us in federal district court in Tennessee, seeking to prevent us from making certain claims relating to Thrombin-JMI and RECOTHROM and from making certain comparative claims regarding King’s products and our RECOTHROM product. King alleges that we have engaged in unfair competition, false advertising, trademark infringement, and related claims under federal law and Tennessee state law. On December 10, 2009, the judge denied King’s motions for a preliminary injunction. However, the lawsuit continues and will likely not be resolved for some time. King is seeking a permanent injunction, as well as monetary damages, and if they ultimately prevail in the litigation our business could be harmed. Further, King’s litigation efforts, even if they are not successful, will require significant management time and attention, potentially diverting focus from direct efforts to secure additional customers for RECOTHROM.

Our patents and patent applications may not result in meaningful protection against competitors, or provide us with any competitive advantage.

We own or control exclusive rights to many issued U.S. and foreign patents and pending patent applications related to the development and commercialization of RECOTHROM and our product candidates. These patents and patent applications cover our protein and antibody compositions, therapeutic uses, methods of making, and other inventions related to our products and product candidates. Our success will depend in part on our ability to obtain and maintain patent protection for our products and product candidates in the United States and other countries.

Although we diligently seek to identify and protect our important discoveries and inventions, we cannot guarantee that any patents, including those covering our products and product candidates, will be sought or will issue from any pending or future patent applications that we own or control. Moreover, our issued patents may not be valid or enforceable. Our rights under any patents may not provide us with adequate protection against competitive products or otherwise cover commercially valuable products, uses or processes. Our patents may not provide us with any competitive advantage. Although we have a number of issued patents, the products or product candidates covered by these patents may not have any value. These issued patents may not provide commercially meaningful protection against competitors, nor may they provide all rights necessary to commercialize our products or product candidates. Patent holders, courts or other governmental or legal entities may conclude that our products, processes or actions in developing, manufacturing or selling RECOTHROM require licenses from third party patent holders. If any licenses are required, we may be unable to obtain any such licenses and we might be prevented from making or selling RECOTHROM. Our failure to obtain a license to any technology that we may require may harm our business. In addition, we may be unable to obtain patent term extensions on patents or data exclusivity covering our products in a manner that would provide commercially meaningful protection against competitors.

Because our patents may not fully protect our product candidates and products, our competitors may be able to commercialize products similar to ours around or hinder commercialization of our products.

Other parties may be able to design around our issued patents or independently develop products having attributes or uses similar or identical to our patented product candidates. Our patents may not provide meaningful protection against such activities and competition. Our patents to compositions and manufacture of RECOTHROM may be unable to prevent other parties from manufacturing or selling recombinant

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thrombin. Other parties may discover other methods of manufacture or uses for our proteins or antibodies that are different from those described in our patents, and these other methods and uses may be separately patentable. If another party holds a patent on the use of a protein or antibody, then even if we hold the patent covering the composition of matter of the protein or antibody itself, that party might prevent us from promoting and selling any product directed to such use.

Our patents may be unenforceable against infringers.

Although our patents may be infringed, it may be difficult or impossible for us to police third party activities and detect or act on such infringement, or we may be challenged by a third party in court in an action to declare our patents invalid or otherwise unenforceable. Patent litigation is very expensive and time-consuming and is a distraction to management and personnel who are needed to supply evidence and support to litigation efforts. Enforcing our patents against third parties may require significant expenditures regardless of outcome. We may incur substantial expenditures in such patent litigation and the outcome of any lawsuit is uncertain.

Additionally, the outcome of such litigation proceedings may conclude that our patents have not been infringed or that they are invalid, unenforceable or otherwise subject to limitations, which would impair our business. For example, competitors and licensees, may be able to commercialize our products and product candidates without paying licensing fees or royalties to us, which would diminish the value of our intellectual property and impair our business.

Moreover, our patents may be subject to administrative proceedings in patent office’s including re-examination proceedings or interference proceedings in the U.S. Patent and Trademark Office, or opposition proceedings in patent authorities outside of the United States. The outcome of any such proceeding is uncertain and may determine that our patents are invalid, limited in scope, not infringed, or unenforceable, which would impair our business. Participating in such proceedings requires significant expenditures and would divert the attention of our management and key personnel from other business concerns, which may also impair our business.

Protecting the intellectual property covering our products and product candidates is difficult and costly, and the law surrounding protection of our products and product candidates is in flux.

Patent protection for protein-based therapeutic products is highly uncertain and involves complex legal and factual questions. Thus we cannot predict with certainty the scope or strength of claims that will be allowed in our patents, or whether our patents will be enforceable if challenged in court. In recent years, significant changes in patent law have impacted the scope and enforceability of protein and biotechnology patents. Court decisions have made it more difficult to obtain patents, by making it more difficult to satisfy the requirements of patentability, and have decreased the ability of a patent owner to enjoin infringers, and have increased the likelihood of an infringer to challenge the validity of a patent. Taken together, these decisions make it more difficult and costly for us to obtain, license and enforce our patents.

There also have been, and continue to be, legislative policy discussions concerning the scope of patent protection awarded to biotechnology inventions which may lead to changes in laws resulting in narrower patent protection, or narrower claim interpretation, or additional ways to challenge patents covering our proteins, antibodies, therapeutic uses, methods of making, and other inventions related to our products and product candidates. Patent protection relating to biotechnology products is also subject to a great deal of uncertainty outside the United States, and patent laws are evolving and undergoing revision in many countries. Changes in, or different interpretations of, patent laws worldwide may result in our inability to obtain or enforce patents, and may allow others to use our discoveries to develop and commercialize competitive products, which would impair our business.

We may be subject to patent infringement claims, which would result in substantial costs and liability and prevent us from commercializing our products and product candidates.

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We may be subject to lawsuits in the future by third parties patent holders who claim that our products or product candidates, therapeutic uses, methods of making or processes related thereto infringe their patents. Furthermore, we may not be aware of any or all U.S. and foreign patents that pose a risk of infringement by our products or product candidates.

Any patent infringement or other legal claims that might be brought against us may cause us to incur significant expenses, divert the attention of our management and key personnel from other business concerns and, if successfully asserted against us, require us to pay substantial monetary damages to a patent holder. In addition, as a result of a patent infringement suit, we may be forced to stop or delay developing, manufacturing, using or selling products or product candidates unless that patent holder grants us rights to use its intellectual property. We may be unable to obtain these rights on acceptable business terms, if at all. Even if we are able to obtain rights to such intellectual property, these rights may be non-exclusive, which would allow our competitors to obtain access to the same intellectual property. Ultimately, we may be unable to commercialize our potential products or may have to cease some of our business operations, which would harm our business.

We may be unable to protect our trade secrets, which would enable others to compete more effectively with us.

We may not be able to meaningfully protect our trade secrets. We rely on trade secrets and confidentiality agreements to protect our proprietary technology and confidential information. We have not sought patent protection for such technology and information. Other parties may independently develop equivalent technologies or information. While we have entered confidentiality agreements and material transfer agreements with our corporate partners, consultants and employees, we may not be able to prevent their disclosure of our proprietary technology or information, and legal recourse may not be enough to protect against the damaging effects of such disclosure to our business.

We rely to a significant extent, and expect to continue to rely, on obtaining and maintaining third-party relationships to assist us in developing and commercializing our product candidates.

We have historically entered into collaboration arrangements with partners to co-develop and co-commercialize products and expect to continue to pursue similar opportunities. To be successful, we must identify and attract partners whose competencies and priorities complement ours. We must enter into collaboration agreements on terms beneficial to us and integrate and coordinate their processes, resources and capabilities with our own on a continuing basis. We may be unsuccessful in entering into collaboration agreements with acceptable partners or negotiating favorable terms in these agreements or maintaining such relationships so as to benefit from them over time. Also, we may be unsuccessful in integrating the resources, processes, capabilities or priorities of these collaborators on a continuing basis. In addition, our collaborators may prove difficult to work with or less skilled than we expected. If we are unsuccessful in our collaborative efforts, our ability to develop and market our product candidates could be limited.

Collaboration arrangements require close and frequent communications between several different teams within the respective companies, technology transfer, and in general a collaborative sharing of responsibilities for clinical studies and all other development activities. Difficulties in collaboration arrangements could result in lower than expected revenue, delays in development, loss of market opportunities, and significant deterioration in the value of the related product candidate and our company.

We rely on contract suppliers to manufacture commercial supplies of RECOTHROM and clinical material for our product candidates and, therefore, we may be unable to effectively control production or obtain adequate supplies, particularly in situations where we rely on a sole source of supply, which could cause delays in product manufacturing, subject us to product shortages or reduce product sales.

We rely and expect to continue to rely on contract manufacturers and suppliers over whom we exercise little control and who may not always be motivated to do what is in our best interests. The manufacture and delivery of sufficient quantities of pharmaceutical products is a time-consuming and complex process. In

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order to successfully commercialize our products, including RECOTHROM, and continue to develop our product candidates, including PEG-IFN-lambda, we need to contract or otherwise arrange for the necessary manufacturing. For example, we have entered into an agreement with Abbott Laboratories for commercial-scale production of RECOTHROM bulk drug substance and an agreement with Patheon Italia S.p.A., Inc. for fill and finish of the dosage form of RECOTHROM. We have also entered into agreements with several suppliers of critical raw materials, manufacturing aids, and components for RECOTHROM, some of which are located outside the United States. For our PEG-IFN-lambda product candidate, we will rely on our collaborative partner Bristol-Myers Squibb to manufacture supplies for late-stage clinical trials and, if approved, commercial sales.

Reliance on contract manufacturers, other vendors and collaborators limits our control regarding many aspects of the manufacturing and delivery processes and therefore exposes us to a variety of significant risks relating to the following, particularly in situations where we rely on a sole-source manufacturer, vendor or other collaborator as with RECOTHROM:

• our ability to schedule production with contract suppliers when needed to supply market demand or clinical trials;

• reliance on contract suppliers for legal and regulatory compliance and quality assurance;

• contract suppliers’ insistence on exclusivity, minimum and/or maximum levels of supply and related restrictions on our ability to increase or decrease supply, including provisions whereby we pay a penalty if we fail to order a minimum amount;

• breach of agreements by contract suppliers; and

• termination, price increases, or non-renewal of agreements by contract suppliers, based on other business priorities, at times that are costly or inconvenient for us.

Moreover, these contract manufacturers must comply with FDA’s cGMP requirements. These requirements include quality control, quality assurance, and the maintenance of records and documentation. One or more of these suppliers may be unable to comply with these cGMP requirements and with other FDA, state, or foreign regulatory requirements. A failure to comply with these requirements may result in, among other things, notices of violation, untitled letters, warning letters, fines and other monetary penalties, unanticipated expenditures, delays in approval or refusal to approve a product, suspension of production, product seizure or recall, interruption of manufacturing or clinical trials, operating restrictions, withdrawal of product approval injunctions, and criminal prosecution. If the safety of any quantities supplied of RECOTHROM or any other product we commercialize that is manufactured by a contract party is compromised due to that party’s failure to adhere to applicable laws or for other reasons, we may be unable to obtain regulatory approval for or successfully commercialize our products, which would harm our business.

If any of the circumstances described in these risks occur, our product supply could be interrupted resulting in lost or delayed revenues, delayed clinical trials, and significant increase in production costs and cost of goods. While we seek to negotiate effective remedies in our agreements, we may not have an adequate remedy for all performance-related issues. In particular, terminating a manufacturing arrangement entails significant risks associated with identifying an alternative manufacturer, the length of time it takes for an alternative manufacturer to meet the regulatory requirements and the possibility of litigation arising from any alleged breach.

We and the manufacturers of our products rely on suppliers of raw materials used in the production of our products. Some of these materials are available from only one source and others may become available from only one source. In addition, if, for any reason, we are required to engage an additional, second-source or replacement manufacturer or other vendor, the investment of funds and management time could be significant. There are a limited number of manufacturers and other vendors that operate under the FDA’s

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cGMP regulations capable of manufacturing for us, and we have not established backup manufacturers and suppliers for RECOTHROM or any of our product candidates. Accordingly, if we are unable to maintain third-party manufacturing on commercially reasonable terms, or if we lose a significant supplier used for RECOTHROM or for our other product candidates, we may be unable to market our products, meet certain contractual supply obligations or complete development of our product candidates on a timely basis, if at all.

We cannot predict whether any of the manufacturers and vendors that we may use will continue to meet our requirements for quality, quantity or timeliness for the manufacture of RECOTHROM, its intermediates or components or for our other product candidates.

We may be unable to generate any revenue from product candidates developed by collaborators or licensees.

We may be unable to derive any value from product candidates developed by or with collaborators or licensees, including Novo Nordisk, Merck Serono and Bristol-Myers Squibb. Our ability to generate revenues from existing or future collaborations and license arrangements is subject to numerous risks, including:

• the possibility that our collaborators or licensees lack sufficient financial, technical or other capabilities to develop these product candidates;

• the possibility that our collaborators or licensees choose to scale back or discontinue their development activities due to changes in their strategies, restructuring, mergers or acquisitions or because their view of the commercial market or regulatory landscape in their licensed territory has changed;

• the length of time that it takes for our collaborators or licensees to solve technical problems or achieve various clinical development and regulatory approval milestones;

• differences in opinion about development, clinical and regulatory strategies and timeframes;

• the inability of collaborators or licensees to successfully address any regulatory or technical challenges they may encounter; and

• the possibility that these product candidates may not be effective or may prove to have undesirable side effects, unacceptable toxicities or other characteristics that preclude regulatory approval or prevent or limit commercial use.

RECOTHROM has not been approved for sale outside of the United States and Canada and, although we intend to seek new licensing arrangements with one or more third parties for such territories, our ability to do so on a timely basis on favorable terms is uncertain, and we would be dependent on any such licensee to seek approval for and market and promote RECOTHROM outside the United States and Canada.

In the United States, RECOTHROM was approved for marketing on the basis of clinical studies showing non-inferiority to bovine plasma-derived thrombin. The only other country where RECOTHROM has been approved is Canada. In December 2009, our then licensee outside the United States, Bayer Schering Pharma, withdrew the Marketing Authorization Application for RECOTHROM in Europe, due to concerns raised by European regulatory authorities regarding the extent to which the application met the standards described in their guidance applicable to approval of fibrin sealant products. The European Medicines Agency will require at least one additional clinical trial using a comparator other than bovine thrombin in order to support the approval of RECOTHROM, because bovine plasma-derived thrombin is not currently on the market in Europe. In addition, other foreign regulatory authorities may not be satisfied with the safety and efficacy data submitted in support of the foreign applications, which could result in either non-approval or a requirement of additional clinical trials or further analysis of existing data. Furthermore, as an element of the foreign approval process, the applicable regulatory authority must be satisfied with the processes and facilities

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for all stages of the manufacture, packaging and distribution of RECOTHROM, which may include physical inspections of many or all relevant facilities. Any conclusion that there are shortcomings in the processes, facilities, quality control or oversight of contract manufacturers, or other quality assurance procedures related to manufacture, packaging and distribution of the drug could result in a significant delay in or failure to receive foreign approval.

Effective January 1, 2010, our License and Collaboration Agreement with Bayer Schering Pharma was amended to return to ZymoGenetics all rights to develop and commercialize RECOTHROM in territories other than Canada, where Bayer Schering Pharma will commercialize RECOTHROM and pay royalties to ZymoGenetics. No form of thrombin is currently sold in Canada and, therefore, Bayer Schering Pharma will have to create a new market for RECOTHROM, an endeavor in which it may not be successful.

We will seek to establish licensing arrangements with one or more third parties to pursue development and approval of RECOTHROM outside the United States and Canada, but our ability to do so on a timely basis on favorable terms is uncertain, if at all. Even if we are able to identify interested third parties and enter into one or more license arrangements, the ability of any licensee to obtain approval for RECOTHROM in these territories and to successfully commercialize the product, as well as the timing for these activities, is uncertain.

Failure to effectively manage the RECOTHROM supply chain could result in inventory shortages, supply interruptions or inventory obsolescence.

Our supply chain for RECOTHROM, its intermediates and components is particularly complex and involves a number of third parties on several continents. In addition to coordinating the efforts of these third-party contractors, we must navigate the laws and regulations of multiple jurisdictions, and our failure to do so effectively may negatively impact our business. Failure to adequately manage our supply chain could result in inventory shortages or other supply interruptions that could negatively impact RECOTHROM sales and, consequently, negatively impact product revenue.

We have limited expiration dating for RECOTHROM. Consequently, if we are unable to sell at forecasted levels we may have excess RECOTHROM inventory, resulting in inventory obsolescence, increased costs of product sales and ineffective use of our financial resources.

Because we will depend on third parties to conduct certain laboratory tests, clinical trials and other critical services, we have limited control and may encounter delays in our efforts to develop product candidates.

We commonly rely on third parties to conduct laboratory tests, clinical trials and other critical services for us, especially to the extent clinical trials include sites outside the United States. For example, we rely on a contract research organization to manage all sites outside the United States participating in our current Phase 2 clinical trial of PEG-IFN-lambda and will rely on the National Cancer Institute of Canada to conduct a proposed Phase 2b clinical trial of IL-21. If we are unable to obtain these services in the future on acceptable terms, we may be unable to complete our product development efforts in a timely manner. Also, to the extent we will rely on third parties for laboratory tests and clinical trials, we will have limited control over these activities or may be unable to manage them appropriately, or may become too dependent on these parties. These third parties may not complete the tests or trials on our schedule, may not comply with applicable laws or could otherwise fail in their performance. We may experience unexpected cost increases that are beyond our control. Problems with the timeliness or quality of the work of a contract research organization may lead us to seek to terminate the relationship and use an alternative service provider. However, making this change may be costly and may delay our trials, and contractual restrictions may make such a change difficult. Additionally, it may be difficult to find a replacement organization that can conduct our trials in an acceptable manner and at an acceptable cost.

We may expand our business through the acquisition of companies or businesses or in-licensing products or product candidates that could disrupt our business and harm our financial condition.

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We may in the future seek to expand our products and capabilities by acquiring one or more companies or businesses or in-licensing one or more product candidates. Acquisitions and in-licenses involve numerous risks, which may include:

• substantial cash expenditures;

• dilutive issuances of equity securities;

• incurrence of debt and contingent liabilities, some of which may be difficult or impossible to identify at the time of acquisition;

• difficulties in assimilating the operations of the acquired companies;

• diverting our management’s attention away from other business concerns;

• entering markets in which we have limited or no direct experience; and

• potential loss of our key employees or key employees of the acquired companies or businesses.

Historically, we have not expanded our business through acquisition or in-licensing and, therefore, our experience in making acquisitions and in-licensing is limited. Any acquisition or in-license may not result in short-term or long-term benefits to us. We may incorrectly judge the value or worth of an acquired company or business or in-licensed product candidate. In addition, our future success could depend in part on our ability to manage the rapid growth associated with some of these acquisitions and in-licenses. We may be unable to make the combination of our business with that of acquired businesses or companies or in-licensed product candidates work or be successful. Furthermore, the development or expansion of our business or any acquired business or company or in-licensed product candidate may require a substantial capital investment by us. We may not have the necessary funds or they may be unavailable to us on acceptable terms, if at all. We may also seek to raise funds by selling shares of our stock, which could dilute our current shareholders’ ownership interest, or securities convertible into our stock, which could dilute current shareholders’ ownership interest upon conversion.

The failure to attract or retain key management or other personnel could decrease our ability to discover, develop and commercialize potential products.

We depend on our senior executive officers as well as key scientific, management and other personnel. Only a small number of our key personnel are bound by employment agreements, and those with employment agreements are bound only for a limited period of time. Competition for qualified employees is intense among pharmaceutical and biotechnology companies. The loss of qualified employees, or an inability to attract, retain and motivate the highly skilled employees required for our activities, could hinder our ability to develop and commercialize our product candidates.

Our restructuring activities in 2009 may place a strain on certain of our remaining personnel, and may have unanticipated effects.

Our restructuring in April 2009 resulted in a workforce reduction of approximately 160 employees, and a further restructuring in December 2009 resulted in an additional workforce reduction of approximately 50 employees. Following these workforce reductions, we had approximately 250 employees at our facility in Seattle, Washington. Our restructuring may yield unanticipated consequences such as attrition beyond our planned reduction in workforce. These workforce reductions may place a significant strain on certain of our remaining personnel. As a result, our ability to respond to unexpected challenges may be impaired and we may be unable to take advantage of new opportunities. In addition, certain of the terminated employees possess specific knowledge or expertise, and that knowledge or expertise may prove to have been important to our operations. In that case, their absence may create significant difficulties.

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Environmental and health and safety laws may result in liabilities, expenses and restrictions on our operations.

State and federal laws and regulations and those of foreign jurisdictions regarding environmental protection, hazardous substances and human health and safety may adversely affect our business. The use of hazardous substances in our operations exposes us to the risk of accidental releases. If our operations, including those of our third-party service providers and collaborators, result in contamination of the environment or expose individuals to hazardous substances, we could be liable for damages and fines. Future changes to environmental and health and safety laws could cause us to incur additional expenses or restrict our operations. In addition, the site where our principal headquarters and facilities are located has been listed as a contaminated property by the state of Washington due to its previous use by the city of Seattle as an electricity-generating plant. The city of Seattle has agreed to defend us against and indemnify us for any claims that arise from this pre-existing contamination, except to the extent that we caused the claim through our negligence or intentional fault, or to the extent that we contributed to the contamination that is the subject of the claim, caused an increase in the clean-up costs or failed to comply with our obligations under our agreement with the city of Seattle. This indemnity may be insufficient and we may be subject to environmental liabilities or be prohibited from using or occupying some or all of the property as a result of environmental claims.

If we use biological and hazardous materials in a manner that causes contamination or injury or violates laws, we may be liable for damages.

Our research and development activities and clinical trials involve the use of potentially harmful biological materials, as well as hazardous materials, chemicals, and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury from the distribution, use, storage, handling, or disposal of these materials. In the event of contamination or injury, we could be held liable for damages that result, and any liability could exceed our available financial resources. We do not maintain liability insurance coverage for our handling of biological or hazardous materials. We, our collaborative partners, the third parties that conduct clinical trials on our behalf, and our third-party manufacturers are subject to federal, state, local or foreign laws and regulations governing the use, storage, handling, and disposal of these materials and waste products. The cost of compliance with these laws and regulations could be significant. The failure to comply with any of these laws and regulations could result in significant fines and work stoppages and may harm our business.

We are exposed to financial risks related to foreign currency exchange rates.

Some of our costs and expenses are denominated in foreign currencies and, even if they are not as a matter of contract, vendors may seek concessions in the event that their anticipated economic return is impaired by exchange rate fluctuations. Most of our existing foreign expenses are associated with the manufacture of RECOTHROM and global clinical studies. We are primarily exposed to changes in exchange rates with the Euro. When the U.S. dollar weakens against other currencies, the dollar value of the foreign-currency denominated expense increases, and when the dollar strengthens against other currencies, the dollar value of the foreign-currency denominated expense decreases. Consequently, changes in exchange rates, and in particular a weakening of the U.S. dollar, may adversely affect our operating results. We currently do not hedge against our foreign currency exposure.

Our liquidity, capital resources and results of operations may be adversely affected by declines in the value of our investments in marketable securities.

As of June 30, 2010, we had $205.5 million in cash and cash equivalents, and investments in marketable securities. Until required for use in our business, we invest our excess cash in bank deposits, money market

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funds, high-grade corporate notes, asset-backed securities and U.S. government instruments. As of June 30, 2010, we held asset-backed securities with an estimated fair value of $4.7 million, which had an original cost of $6.0 million.

We do not intend to purchase any additional asset-backed securities, but our liquidity, capital resources and results of operations may be adversely affected by further declines in the value of our existing investments in asset-backed securities. These investments may be adversely affected by rating downgrades, deterioration in the underlying collateral or bankruptcies affecting the issuers of such securities, whether caused by instability in the global financial markets, lack of liquidity in the credit and capital markets, or other factors.

Natural or man-made disasters may impair our ability to conduct our business.

While our headquarters and principal research and development operations are in Seattle, Washington, we also have partners, manufacturers, suppliers and distributors in various parts of the United States, Europe and Australia. Our facilities and those of our partners, manufacturers, suppliers or distributors may be subject to natural or man-made disasters. A natural or man-made disaster could cause damage to our facility, personnel or equipment, which in turn, could cause us to cease or curtail operations. Our business and financial position may also be affected by disasters affecting the operations of one of our partners, manufacturers, suppliers or distributors. Disasters may include, but are not limited to earthquakes, volcanic eruptions, tsunamis, fires, floods, power loss, communication failures and other similar events, including the effects of war or acts of terrorism. If any disaster were to occur, our ability to operate our business could be seriously or completely impaired. Although we maintain insurance coverage for many of these types of risks, it may not be adequate to cover our losses resulting from disasters or other business interruptions.

Risks Related to Our Industry

Changes in the third-party coverage and reimbursement environment may affect our product sales, results of operations and financial condition.

The market for RECOTHROM and our other product candidates that are subsequently approved for marketing could be adversely affected by changes in reimbursement for the products and/or the procedures in which they are used. Third-party payers and governmental health programs increasingly attempt to limit and/or regulate the reimbursement of medical products and services, including branded prescription drugs. The long-term consequences of the healthcare reforms recently enacted in the United States on pricing, coverage and reimbursement are uncertain, and, despite such reforms, the pricing, coverage and reimbursement environment for RECOTHROM, our product candidates, and medical procedures may change further in the future and become more challenging. Any decrease in third-party coverage or reimbursement for procedures in which RECOTHROM is used or for our other product candidates that are subsequently approved for marketing could impact our ability to successfully market and sell our such products and may have a material adverse effect on our product sales, royalties based on sales by our licensees, results of operations and financial condition.

Negative public opinion and increased regulatory scrutiny of genetic and clinical research may limit our ability to conduct our business.

Ethical, social and legal concerns about genetic and clinical research could result in additional regulations restricting or prohibiting some of our activities or the activities of our suppliers and collaborators. In recent years, federal and state agencies, congressional committees and foreign governments have expressed interest in further regulating the biotechnology industry. More restrictive regulations could delay or complicate nonclinical studies or clinical trials, or prevent us from obtaining regulatory approvals or commercializing any products. In addition, animal rights activists may protest our use of animals in research and development and may attempt to disrupt our operations, which could cause us to incur significant expenses and distract management attention from other business concerns.

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The marketing and sale of pharmaceutical products and biologics is subject to extensive regulation and aggressive government enforcement, and our corporate compliance program cannot guarantee that we are in compliance with all relevant laws and regulations.

Our activities relating to the sale and marketing of RECOTHROM and any other products we commercialize will be subject to extensive regulation under the U.S. Federal Food, Drug and Cosmetic Act and other federal statutes and associated regulations. These laws and regulations limit the types of marketing claims and other communications we can make regarding marketed products. We are also subject to various U.S. federal and state laws pertaining to healthcare “fraud and abuse,” including anti-kickback and false claims laws. Anti-kickback laws prohibit payments of any kind intended to induce physicians or others either to purchase or arrange for or recommend the purchase of healthcare products or services, including the selection of a particular prescription drug. These laws make certain business practices that are relatively common in other industries illegal in our industry. False claims laws prohibit anyone from knowingly and willingly presenting, or causing to be presented for payment to third-party payors, including Medicare and Medicaid, claims for reimbursed drugs or services that are false or fraudulent. The government has asserted very broad interpretations of these laws against pharmaceutical manufacturers, even though these manufacturers did not directly submit claims for reimbursement to government payors. In addition, regulation is not static and regulatory authorities, including the FDA, evolve in their staff, interpretations and practices and may impose more stringent requirements than currently in effect, which may adversely affect our sales and marketing efforts. In addition, it is possible that action by federal or state regulatory authorities, such as the FDA, or private legal actions related to our sales and marketing efforts could result in additional investigations or legal actions by state attorneys general. Violations of the above laws may be punishable by criminal and/or civil sanctions, including fines and civil monetary penalties, as well as the possibility of exclusion from federal healthcare programs, including Medicare and Medicaid. Many pharmaceutical and biotechnology companies have in recent years been the target of lawsuits and investigations, by both federal and state governmental authorities, alleging violations of government regulation, including claims asserting violations of the federal False Claims Act, the federal anti-kickback statute, state consumer protection statutes and other violations in connection with off-label promotion of products, pricing, and government price reporting. While we will strive to comply with these complex requirements, the interpretation of these laws as applied to particular sales and marketing practices continues to evolve, and it is possible that our sales and marketing practices might be challenged. Further, although we have taken measures to prevent potential challenges, including through our corporate compliance program, we cannot guarantee that such measures will protect us from future challenges, lawsuits or investigations. Even if such challenges are without merit, they could cause adverse publicity, divert management attention and be costly to respond to, and thus could have a material adverse effect on our business, including impact on our stock price. In addition, our strategic partners and licensees are required to comply with comparably complex requirements in jurisdictions outside the United States.

In order to sell RECOTHROM to federal institutions, such as military hospitals and the Veterans Administration, we must satisfy the requirements of listing on the Federal Supply Schedule and we are required to periodically report product pricing-related information. The calculations used to generate the pricing-related information are complex. If we fail to accurately and timely report product pricing-related information or to comply with any of these or any other laws or regulations, various negative consequences could result, including criminal and/or civil prosecution, substantial criminal and/or civil penalties, exclusion of the approved product from coverage under governmental healthcare programs (including Medicare and Medicaid), costly litigation and restatement of our financial statements. In addition, our efforts to comply with this wide range of laws and regulations are, and will continue to be, time-consuming and expensive.

Risks Related to Ownership of Our Stock

We may issue additional equity securities in the future, which may result in dilution to existing investors.

We believe that our existing cash, cash equivalents and short-term investments will be sufficient to meet our projected operating requirements at least through 2011 and potentially longer, depending on certain future events. However, we may need to raise additional capital in the future. Any additional financing we

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undertake could impose covenants upon us that restrict our operating flexibility and, to the extent such capital is raised through our issuance of additional equity securities, our then existing shareholders may experience dilution or the new securities may have rights senior to those of our common stock. In addition, to the extent outstanding stock options are exercised, there will be further dilution to investors.

Our operating results are subject to fluctuations that may cause our stock price to decline.

Our operating results have fluctuated in the past and are likely to continue to do so in the future. Our revenues have been unpredictable and could fluctuate due to slow or erratic uptake of RECOTHROM sales or the timing of licensing fees or the achievement of milestones under new or existing licensing and collaborative arrangements. In addition, our expenses may fluctuate from quarter to quarter due to the timing of expenses, particularly with respect to contract manufacturing and clinical and nonclinical testing.

Accordingly, we believe that period-to-period comparisons of our past operating results are not good indicators of our future performance and should not be relied on to predict our future operating results. It is possible that in the future our operating results in a particular quarter or quarters will not meet the expectations of securities analysts or investors, causing the market price of our common stock to decline, perhaps substantially.

Our stock price is volatile and subject to many factors beyond our control.

The market price of our common stock may fluctuate significantly in response to many factors beyond our control, including:

• changes in the recommendations of securities analysts or changes in their financial estimates of our operating results;

• recommendations or opinions of journalists, media personalities or market commentators;

• failures in meeting performance expectations of securities analysts or investors;

• acts or omissions of our licensees, collaborators and suppliers;

• changes in the political climate and changes in or uncertainties about federal and state legislation, policies, and programs affecting healthcare and pharmaceuticals;

• fluctuations in the valuations of companies perceived by securities analysts or investors to be comparable to us; and

• share price and volume fluctuations attributable to inconsistent trading volume levels of our shares.

Furthermore, the stock markets often experience significant price and volume fluctuations that affect the market prices of equity securities of many companies. In particular, there have been high levels of volatility in the market prices of securities of biotechnology companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. These market and industry fluctuations, as well as general economic, political and market conditions such as recessions, interest rate changes or international currency fluctuations, may negatively impact the market price of our common stock.

Certain of our shareholders have significant control of our management and affairs, which they could exercise against other shareholders’ best interests.

Novo Nordisk, together with Warburg Pincus Equity Partners, L.P., beneficially owned an aggregate of approximately 37.7% of our outstanding common stock as of June 30, 2010, with Novo Nordisk beneficially

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owning approximately 26.8% and Warburg beneficially owning approximately 10.9%. Four of the ten current members of our board of directors are representatives or designees of these shareholders pursuant to a shareholders’ agreement. Novo Nordisk, acting independently or together with Warburg, has the ability to significantly influence our management and affairs and matters requiring shareholder approval, including the election of directors and approval of corporate strategy and significant corporate transactions, such as mergers, consolidations or the sale of substantially all of our assets. Consequently, Novo Nordisk, acting independently or together with Warburg, may be able to cause a change in control, as well as delay or prevent a change in control. They may also discourage a potential acquirer from making a tender offer or otherwise attempting to effect a change in control, even if such a change in control would benefit our other shareholders.

Sales of shares of common stock by our significant shareholders could cause the price of our common stock to decline.

Collectively, Novo Nordisk and Warburg Pincus Equity Partners, L.P. beneficially owned 37.7% of our outstanding common stock, as of June 30, 2010, and we have previously filed a registration statement covering the resale of the majority of the shares they own. The sale by either shareholder of a substantial number of shares of our common stock or the perception among investors that these sales may occur, could result in the decline of the market price of our common stock.

Provisions in Washington law, our charter documents and executive employment agreements we have entered into may prevent, discourage or delay a change in control.

We are subject to the Washington laws regulating corporate takeovers, which, with limited exceptions, prohibit a “target corporation” from engaging in certain “significant business transactions” for a period of five years after the share acquisition by an acquiring person, unless (i) the prohibited transaction or the acquiring person’s purchase of shares was approved by a majority of the members of the target corporation’s board of directors prior to the acquiring person’s share acquisition or (ii) the prohibited transaction was both approved by the majority of the members of the target corporation’s board and authorized at a shareholder meeting by at least two-thirds of the outstanding voting shares (excluding the acquiring person’s shares) at or subsequent to the acquiring person’s share acquisition. An “acquiring person” is defined as a person or group of persons that beneficially owns 10% or more of the voting securities of the target corporation. Such prohibited transactions include, among other things:

• certain mergers or consolidations with, dispositions of assets to, or issuances of stock to or redemptions of stock from, the acquiring person;

• termination of 5% or more of the employees of the target corporation as a result of the acquiring person’s acquisition of 10% or more of the shares;

• allowing the acquiring person to receive any disproportionate benefit as a shareholder; and

• liquidating or dissolving the target corporation.

After the five-year period, certain “significant business transactions” are permitted, as long as they comply with certain “fair price” provisions of the Washington statute or are approved by a majority of the outstanding shares other than those of which the acquiring person has beneficial ownership. A corporation may not “opt out” of this statute.

As such, these laws could prohibit or delay mergers or a change in control and may discourage attempts by other companies to acquire us.

In addition, our articles of incorporation and bylaws contain provisions, such as undesignated preferred stock and prohibitions on cumulative voting in the election of directors that could make it more difficult for a

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third party to acquire us without the consent of our board of directors. Also, our articles of incorporation provide for a staggered board, removal of directors generally only for cause and certain requirements for calling special shareholder meetings. Further, our bylaws require advance notice of shareholder proposals and nominations and impose restrictions on the persons who may call special shareholder meetings. These provisions may have the effect of preventing or hindering any attempts by our shareholders to replace our current board of directors or management.

We may become involved in securities class action litigation that could divert management’s attention and harm our business.

The stock markets have from time to time experienced significant price and volume fluctuations that have affected the market prices for the common stock of biopharmaceutical companies. These broad market fluctuations may cause the market price of our common stock to decline. In the past, securities class action litigation has often been brought against a company following a decline in the market price of its securities. This risk is especially relevant for us because biotechnology and biopharmaceutical companies have experienced significant stock price volatility in recent years. We may become involved in this type of litigation in the future. Litigation often is expensive and diverts management’s attention and resources, which could adversely affect our business.

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Item 6. Exhibits

Exhibit Number
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURE

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

	ZYMOGENETICS, INC.
Date: August 3, 2010	By:	/S/    JAMES A. JOHNSON
		James A. Johnson
		Executive Vice President and Chief Financial Officer
		(Principal Financial Officer and Authorized Officer)

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