Oruka Therapeutics 10Q 2002 Q2 Quarterly report

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

FORM 10-Q

(Mark One)


[X]		QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002


[ ]		TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		FOR THE TRANSITION PERIOD FROM __________ TO __________

Commission File Number 000-22873

HYSEQ, INC.
(Exact Name of Registrant as Specified in Its Charter)


NEVADA (State or Other Jurisdiction of Incorporation or Organization)		36-3855489 (I.R.S. Employer Identification Number)

670 ALMANOR AVENUE, SUNNYVALE, CA 94085
(Address of Principal Executive Offices, including Zip Code)

408-524-8100
(Registrant’s Telephone Number, including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Sections 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 [ ]

COMMON STOCK OUTSTANDING ON AUGUST 7, 2002: 22,994,366

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TABLE OF CONTENTS


	ITEM 1. FINANCIAL STATEMENTS
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
PART II. OTHER INFORMATION
	ITEM 1. LEGAL PROCEEDINGS
	ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
	ITEM 3. DEFAULTS UPON SENIOR SECURITIES
	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
	ITEM 5. OTHER INFORMATION
	ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURE

HYSEQ PHARMACEUTICALS, INC.

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2002

TABLE OF CONTENTS


		PAGE

Part I	Financial Information
	Item 1. Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets as of June 30, 2002 and December 31, 2001	3
	Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2002 and 2001	4
	Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2002 and 2001	5
	Notes to Condensed Consolidated Financial Statements	6
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	8
	Item 3. Quantitative and Qualitative Disclosures about Market Risk	29
Part II	Other Information
	Item 1. Legal Proceedings	29
	Item 2. Change in Securities and Use of Proceeds	29
	Item 3. Defaults Upon Senior Securities	30
	Item 4. Submission of Matters to a Vote of Security Holders	30
	Item 5. Other Information	30
	Item 6. Exhibits and Reports on Form 8-K	30
Signature		31

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ITEM 1. FINANCIAL STATEMENTS

HYSEQ PHARMACEUTICALS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)


			JUNE 30,			DECEMBER 31,
			2002			2001

ASSETS
Current Assets:
Cash			$	11,834		$	12,329
Accounts receivable				363			53
Other current assets				2,694			3,919

	Total Current Assets			14,891			16,301
Cash on deposit				1,606			1,606
Equipment, leasehold improvements and capitalized software, net				17,572			18,988
Patents, licenses and other assets, net				2,781			3,009

		Total Assets	$	36,850		$	39,904

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable			$	2,694		$	3,210
Accrued professional fees				795			928
Line of credit				4,000			—
Other current liabilities				6,607			7,672
Deferred revenue				2,115			3,702
Current portion of capital lease and loan obligations				1,861			2,506

	Total Current Liabilities			18,072			18,018
Noncurrent portion of capital lease and loan obligations				1,594			2,228
Other noncurrent liabilities				125			125
Note payable				4,000			4,000

		Total Liabilities		23,791			24,371

Commitments and contingencies
Minority interest				—			112
Stockholders’ Equity:
Preferred stock, par value $0.001; 8,000,000 shares authorized; none issued and outstanding as of June 30, 2002 and December 31, 2001				—			—
Common stock, par value $0.001; 100,000,000 shares authorized; 22,994,366 and 19,307,735 shares issued and outstanding as of June 30, 2002 and December 31, 2001, respectively				23			19
Additional paid-in capital				148,454			123,849
Deferred stock compensation				—			(53	)
Accumulated deficit				(135,418	)		(108,394	)

	Total stockholders’ equity			13,059			15,421

		Total liabilities and stockholders’ equity	$	36,850		$	39,904

See accompanying notes to condensed consolidated financial statements.

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HYSEQ PHARMACEUTICALS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)


				THREE MONTHS ENDED						SIX MONTHS ENDED
				JUNE 30						JUNE 30,

				2002			2001			2002			2001

Contract revenues				$	6,661		$	5,981		$	11,893		$	11,649

Operating expenses:
	Research and development				10,740			11,130			31,754			20,182
	General and administrative				3,165			3,200			6,223			6,202
	Restructuring				610			—			610			—

		Total operating expenses			14,515			14,330			38,587			26,384

		Loss from operations			(7,854	)		(8,349	)		(26,694	)		(14,735	)

Interest income					40			116			70			179
Interest expense					(254	)		(194	)		(512	)		(550	)

		Net loss before minority interest			(8,068	)		(8,427	)		(27,136	)		(15,106	)

Loss attributable to minority interest					—			—			112			—

			Net loss	$	(8,068	)	$	(8,427	)	$	(27,024	)	$	(15,106	)

Basic and diluted net loss per share				$	(0.37	)	$	(0.55	)	$	(1.32	)	$	(1.04	)

Shares used in computing basic and diluted net loss per share					22,055			15,369			20,399			14,558

See accompanying notes to condensed consolidated financial statements.

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HYSEQ PHARMACEUTICALS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)


			SIX MONTHS ENDED
			JUNE 30,

			2002			2001

		NET CASH USED IN OPERATING ACTIVITIES		(16,277	)		(11,256	)

Cash flows from investing activities:
	Purchases of property and equipment			(1,630	)		(4,417	)
	Proceeds from sale of fixed assets			38			—

		NET CASH USED IN INVESTING ACTIVITIES		(1,592	)		(4,417	)

Cash flows from financing activities:
	Payment on capital lease and loan obligations			(1,279	)		(1,161	)
	Proceeds from drawdown on line of credit			4,000			20,000
	Proceeds from issuance of common stock, net of issuance costs			14,266			—
	Proceeds from issuance of common stock upon exercise of options/ESPP			387			476

		NET CASH PROVIDED BY FINANCING ACTIVITIES		17,374			19,315

Net increase (decrease) in cash				(495	)		3,642
Cash at beginning of period				12,329			2,699

Cash at end of period			$	11,834		$	6,341

See accompanying notes to condensed consolidated financial statements.

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HYSEQ PHARMACEUTICALS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2002
(Unaudited)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by Hyseq, Inc. d/b/a Hyseq Pharmaceuticals, Inc. (“Hyseq,” the “Company,” “we,” “us,” or “our”) in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The accompanying financial information is unaudited, but includes all adjustments (consisting of normal recurring adjustments) which the Company considers necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented. The condensed consolidated balance sheet as of December 31, 2001 is derived from the Company’s audited financial statements. The condensed consolidated financial statements include the accounts of the Company’s majority-owned subsidiary Callida Genomics, Inc. The results of operations for the interim period shown herein are not necessarily indicative of operating results expected for the entire year.

2. Per share data

The per share data for the three and six months ended June 30, 2002 excludes 614,298 shares of common stock issued to our Chairman and senior management as part of a private placement in the third quarter of 2001. The Company’s stockholders were asked to ratify these additional shares at the Company’s 2002 annual meeting of stockholders on August 6, 2002. These shares are excluded from weighted-average shares outstanding in the earning per share calculation.

3. Segment Information

In October 2001, the Company created majority-owned subsidiary Callida Genomics, Inc. to develop and commercialize the Company’s sequencing-by-hybridization (SBH) technology, including a high-speed DNA sequencing chip developed in collaboration with Affymetrix, Inc. Management has chosen to organize Callida as a separate entity to provide DNA analysis solutions useful to businesses engaged in the genomic sciences. This stands in contrast to the business goal of Hyseq Pharmaceuticals, which is to develop and market therapeutic drugs for the treatment of human diseases. The Company anticipates that in the future the two segments will grow in different business directions, requiring different skills of their key employees, different business practices, and exist within different regulatory environments.

In the first quarter of 2002, the Company began reporting Callida as a separate segment for internal management reporting purposes. Total assets for Callida as of June 30, 2002 were $11.0 million, compared with $14.1 million as of December 31, 2001. There is no comparative data for the quarter ended June 30, 2001.

During the second quarter, Callida received a $0.5 million upfront non-refundable license fee as part of a non-exclusive licensing arrangement with Agilent Technologies, Inc. The license gives Agilent access to Callida’s early microarray patent portfolio for commercial use in the field of non-universal DNA microarrays and provides Callida with potential running royalties from Agilent’s sales of such microarrays. During the second quarter Callida also received a second $0.15 million milestone payment from Intel Corporation as part of the cumulative $0.75 million in funding that Intel has agreed to provide as part of the collaboration with Callida to explore certain new technologies for biomolecule detection and identification.

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RECONCILIATION OF REPORTABLE SEGMENTS’ FINANCIAL INFORMATION


	(in thousands)

	THREE MONTHS ENDED									SIX MONTHS ENDED
	JUNE 30, 2002									JUNE 30, 2002

	Hyseq			Callida			Total			Hyseq			Callida			Total

Contract revenues	$	6,161		$	500		$	6,661		$	11,378		$	515		$	11,893

Loss from operations		(6,733	)		(1,121	)		(7,854	)		(24,001	)		(2,693	)		(26,694	)

Net loss	$	(6,947	)	$	(1,121	)	$	(8,068	)	$	(24,331	)	$	(2,693	)	$	(27,024	)

4. Restructuring Charge

During the quarter ended June 30, 2002, the Company recorded a restructuring charge of $0.6 million for personnel and severance costs due to our strategic restructuring concurrent with the agreement in May 2002 with BASF Plant Science to accelerate completion of our agricultural gene discovery collaboration with BASF. The strategic restructuring plan includes a total reduction of approximately 76 employees from research, operations and administration.

5. Private Placement

On April 5, 2002, the Company completed a private placement with gross proceeds of approximately $15.0 million ($14.3 million, net of offering expenses). Under the terms of the financing, the Company sold 3,575,691 shares of newly issued common stock at $4.20 per share to accredited investors. The Company also issued warrants to the investors to purchase approximately 893,927 shares of common stock at $5.67 per share, a 35% premium to the per unit purchase price. The warrants are exercisable at any time through and including April 5, 2007. The securities were sold to accredited investors in a private placement pursuant to Section 4(2) under the Securities Act of 1933, as amended.

6. Collaboration with Amgen, Inc.

The Company is currently focusing on the development of alfimeprase, an early stage clinical product candidate that it began developing in collaboration with Amgen, Inc. in January 2002. Alfimeprase is a thrombolytic agent that dissolves blood clots. It was originally identified through Amgen’s research program and is a novel recombinant derivative of fibrolase, a naturally occurring enzyme. Unlike other thrombolytic plasminogen activators, alfimeprase can directly and rapidly degrade the network of fibrin protein that captures red blood cells to form blood clots. The first target medical indication is Peripheral Arterial Occlusion (or PAO). In PAO, a clot blocks blood flow to a distant body part, usually in the leg. It is estimated that more than 100,000 cases of PAO are reported in the United States per year. Pre-clinical studies indicate that alfimeprase is a promising agent for dissolving clots (clot lysis), and may be particularly well suited for the PAO indication. An IND has been filed in the PAO indication and we initiated Phase I human studies for this indication in the second quarter of 2002. The Phase I trial is a multi-center, open-label, dose-escalation study to evaluate alfimeprase’s safety and pharmacokinetics that will be conducted in twenty patients across six centers in the United States. If the early safety profile of alfimeprase is acceptable after the phase I study, alfimeprase will proceed to phase II human studies in 2003 to gather additional safety data and to evaluate preliminary efficacy and dosages, to be followed by phase III studies to provide the statistical proof of efficacy and safety required by regulatory agencies.

Under the terms of the collaboration agreement with Amgen, the Company will lead development and be responsible for all clinical development activities, while Amgen will be responsible for manufacturing activities. Amgen will have the option to lead commercialization efforts in which both companies may participate. The Company will fund all development costs up to an agreed amount, after which costs as well as eventual profits will be shared equally. The Company can terminate the agreement at any time with notice. For a limited time period, Amgen may opt out of the collaboration by converting it to an exclusive licensing arrangement. Amgen also has the right to terminate the agreement if we do not begin human clinical trials within a certain time period upon our uncured material breach or material default, or upon a materially adverse clinical development, or upon our bankruptcy. In January of 2002, the Company recorded a $10.0 million non-cash charge as research and development expense for the fair value of warrants granted to Amgen under the terms of the collaboration. No cash has changed hands to date under the agreement.

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Research and development expenses for the second quarter of 2002 for the Alfimeprase project were $0.7 million, and research and development expenses for the six months ended June 30, 2002 were $1.0 million.

The Company expects research and development costs for our Alfimeprase clinical studies to be approximately $3.0 million in 2002. We expect our research and development expenses to increase substantially in 2003 and beyond if the Company proceeds beyond Phase I clinical trials with Alfimeprase. It is not unusual for the clinical development of these types of products to take in excess of 5 years and to cost well in excess of $100 million. The time and cost of completing the clinical development of any product candidate will depend on a number of factors, including the disease or medical condition to be treated, clinical trial design and endpoints, availability of patients to participate in trials and the relative efficacy of the product versus treatments already approved. Due to these uncertainties, we are unable to estimate the length of time or the costs that will be required to complete the development of this product candidate.

7. Recent Accounting Pronouncements

In July 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 requires recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability is incurred. Adoption of this statement is required for exit or disposal activities initiated after December 31, 2002. We do not expect the adoption of SFAS 146 to have a material impact on our financial position or results of operations.

8. Subsequent Events

The Company held its Annual Meeting of Stockholders on August 6, 2002. A quorum was present at that meeting and all six proposals in our 2002 proxy were approved or ratified by a majority of the shares that were represented at the meeting and entitled to vote: (1) each nominee for Director, Dr. George B. Rathmann and Mr. Thomas N. McCarter, III, was elected; (2) the 2002 Equity Incentive Plan was adopted; (3) the sale and issuance of 644,298 shares of our common stock, and warrants to purchase 322,149 shares of our common stock, including issuance of our common stock upon exercise of the warrants, to some of our officers and directors as part of the private placement in August 2001 was ratified; (4) the option grant of 1,000,000 shares to Dr. Rathmann as our Chairman in August 2001 was ratified; (5) the issuance of securities to Dr. Rathmann in repayment of amounts owing, from time to time, under his $20.0 million line of credit to the Company, was approved; and (6) the selection of KPMG LLP as our independent auditors for the fiscal year 2002 was ratified.

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by words including “anticipate,” “believe,” “intends,” “estimates,” “expect,” “should,” “may,” “potential” and similar expressions. Such statements are based on our management’s current expectations and involve risks and uncertainties. Actual results and performance could differ materially from those projected in the forward-looking statements as a result of many factors discussed herein and elsewhere including, in particular, those factors described under “Risk Factors” set forth below, and in our other periodic reports filed from time to time with the Securities and Exchange Commission, or “SEC.” Actual results and performance could also differ materially from time to time from those projected in our filings with the SEC.

Company Overview

We were incorporated in Illinois in August 1992 and reincorporated as a Nevada corporation on November 12, 1993. We have being doing business as Hyseq Pharmaceuticals, Inc. since October 2001.

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We are engaged in research and development of novel biopharmaceutical protein-based products for the treatment of human disease from our collection of proprietary genes discovered using our high-throughput signature-by-hybridization platform. We are researching several product candidates to treat a variety of serious diseases and medical conditions. We intend to develop and commercialize these types of product candidates on our own or in collaboration with other biotechnology or pharmaceutical companies.

We believe our signature-by-hybridization platform, which is related to our proprietary sequencing-by-hybridization (or SBH) technology, gives us a significant advantage in discovering novel, rarely-expressed genes. We believe we possess one of the most important proprietary databases of full-length human gene sequences and have the potential to develop a significant pipeline of product candidates for research and development. Previously, our activities have focused primarily on full-length gene sequencing, patenting, bioinformatics, cloning, and early stage research activities to prioritize potential therapeutic protein candidates. As of August 7, 2002, we had filed patent applications on approximately 10,000 full-length human gene sequences. We are accelerating our research activities to elucidate the role of novel genes in our proprietary database, their encoded proteins and corresponding antibodies. Our database includes chemokines, growth factors, stem cell factors, interferons, integrins, proteases, hormones, receptors and other potential protein therapeutics or drug targets. Our focused bioinformatics and screening capabilities have significantly enhanced our understanding of the biological activity of these genes and their corresponding proteins, enabling us to file strategic patent applications that encompass both composition of matter and method of use claims.

We are primarily focused on discovering and developing therapeutic protein-based products, as we believe that naturally occurring therapeutic proteins have several commercial advantages over small molecule drugs.

In the near term, we are balancing the risks in developing therapeutics from our full-length gene database by also focusing on an early stage clinical product candidate acquired through collaboration with Amgen, Inc. We entered into this collaboration in January 2002, with the goal of developing and commercializing alfimeprase, a thrombolytic enzyme, for the treatment of peripheral arterial occlusion (or PAO) and other cardiovascular indications. Pre-clinical studies suggest that alfimeprase is a promising agent for dissolving blood clots (clot lysis) and may be well suited for the PAO indication. In June of 2002 we initiated Phase I clinical trials in a multi-center, open-label, dose-escalation study to evaluate alfimeprase’s safety and pharmacokinetics, to be conducted in 20 patients across six centers in the United States.

RESULTS OF OPERATIONS

Contract Revenues

Comparison of the Three and Six Months Ended June 30, 2002 and 2001. Revenues were $6.7 million and $11.9 million for the three and six months ended June 30, 2002, respectively, compared to $6.0 million and $11.6 million for the same periods in 2001. BASF contract revenues were $5.5 million and $9.7 million for the three and six months ended June 30, 2002, respectively, compared to $5.6 million and $10.9 million during the three and six months ended June 30, 2001, reflecting the fact that we processed clones slightly above contractual levels in 2001. In May 2002, Hyseq and BASF announced an agreement to accelerate completion of our agricultural gene discovery collaboration, which will advance our final BASF revenue recognition to approximately January 31, 2003.

Revenues earned during the three and six months ended June 30, 2002 also included $0.5 million and $1.2 million amortization of a $4.0 million license payment received from Affymetrix in October 2001 at the time of settlement of our outstanding litigation and the creation of our majority-owned subsidiary Callida Genomics (“Callida”). Affymetrix’s payment was made in return for a non-exclusive license, without the right to grant sublicenses, under 11 U.S. patents and 30 U.S. patent applications and counterpart foreign patents and applications to make, use, sell, and import products in the non-universal gene array field. This license payment will continue to be amortized as revenue as Callida utilizes its cash in conducting research & development efforts. As of June 30, 2002, $2.0 million of this license payment remains as deferred revenue.

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Revenues earned during the three months ended June 30, 2002 also included a one-time upfront non-refundable license payment of $0.5 million that Callida received as part of a non-exclusive license agreement with Agilent technologies.

Our revenues typically vary from quarter to quarter and may result in significant fluctuations in our operating results from year to year. In the future, we may not be able to maintain existing collaborations, obtain additional collaboration partners or obtain revenue from other sources. The failure to maintain existing collaborations or the inability to enter into additional collaborative arrangements or obtain revenues from other sources could have a material adverse effect on our revenues and operating results. We expect revenues for 2003 to be reduced substantially as a result of the accelerated completion of our collaboration with BASF Plant Science.

Operating Expenses

Comparison of the Three and Six Months Ended June 30, 2002 and 2001.Our total operating expenses, consisting of research and development expenses and general and administrative expenses, were $14.5 million and $38.6 million for the three and six months ended June 30, 2002, respectively, compared to $14.3 million and $26.4 million for the same periods in 2001.

Our research and development expenses increased to $10.7 million and $31.8 million during the three and six months ended June 30, 2002, respectively, from $11.1 million and $20.2 million during the same periods in 2001. Our increased research and development expenses were due mainly to a $10.0 million non-cash charge for the fair value of warrants granted to Amgen, Inc. in the first quarter as we began our collaboration to develop and commercialize alfimeprase, a novel acting thrombolytic, for the treatment of peripheral arterial occlusion (PAO) and other indications. Due to the addition of laboratory and office space leased in April 2001, rent expense increased to $2.7 million and $5.4 million during the three and six months ended June 30, 2002, respectively, compared to $1.8 million and $2.7 million during the same period last year. Offsetting these increases were lower supply expenses resulting from the early completion of our collaboration with BASF Plant Science according to an agreement signed in May 2002, as well as lower personnel costs from the associated reduction in force. In addition, we recorded cost recoveries from Kirin Brewery, Ltd and Intel Corporation in connection with our research collaborations, and lower payments to our collaboration partners University of California, San Francisco and Aurora Biosciences Corporation.

Our general and administrative expenses were the same at $3.2 million and $6.2 million during the three and six months ended June 30, 2002, respectively, compared with $3.2 million and $6.2 million during the same periods in 2001. Lower outside Legal expenses resulting from the settlement of all outstanding litigation with Affymetrix late in 2001 were offset by higher cost of internal patent attorney and patent writer headcount.

During the quarter ended June 30, 2002, we recorded a restructuring charge of $0.6 million for personnel severance costs due to strategic restructuring concurrent with an agreement with BASF Plant Science to accelerate completion of our agricultural gene discovery collaboration. The strategic restructuring plan includes a total reduction of approximately 76 employees in research, operations and administration. We expect savings in operating expenses attributable to this restructuring to be approximately $7.3 million on an annualized basis.

We expect operating expenses during the remainder of 2002 to decrease as a result of our agreement with BASF Plant Science to accelerate completion of our collaboration, and our other cost control efforts including a partial hiring freeze, a freeze on capital expenditures, delay of our facilities expansion plans, and deferral of as many of our contractual financial commitments as possible. These savings will be partially offset by higher costs of outside clinical research services for Phase I clinical trials for alfimeprase in the third quarter.

Interest Income and Expense

Comparison of the Three and Six Months Ended June 30, 2002 and 2001.Our net interest expense was $0.2 million and $0.4 million during the three and six months ended June 30, 2002, respectively, compared with $0.1 million and $0.4 million during the same periods in 2001. The change in net interest expense was due to interest on our $4.0 million loan from Affymetrix.

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Net Loss

Comparison of the Three and Six Months Ended June 30, 2002 and 2001.Since our inception, we have incurred operating losses, and as of June 30, 2002 we had an accumulated deficit of $135.4 million. The Company incurred a net loss for the three and six months ended June 30, 2002 of $8.1 million and $27.0 million, respectively, compared to a net loss of $8.4 million and $15.1 million in the same periods of 2001. This change in net loss resulted primarily from our continued research and development of our biopharmaceutical product candidates, and from the $10.0 million non-cash charge for the fair value of warrants granted to Amgen Inc. in the first quarter of 2002, as part of our collaboration to develop and commercialize alfimeprase. We expect to continue to incur significant operating losses, which may increase substantially as we further expand research and development of our potential biopharmaceutical product candidates and other operations, and as we prosecute and enforce our intellectual property rights.

LIQUIDITY AND CAPITAL RESOURCES

Cash and Cash on Deposit

As of June 30, 2002, we had $11.8 million in cash. This amount reflects a net decrease of $0.5 million from the $12.3 million in cash we had as of December 31, 2001.

In addition, we have $1.6 million in restricted cash on deposit as security for a $2.0 million letter of credit in conjunction with a facility lease. Provided that our landlord agrees, the letter of credit and the cash collateralizing it may be reduced by $0.5 million per year in July 2002, July 2003, and July 2004. The cash on deposit at any time in conjunction with this letter of credit is restricted and cannot be withdrawn. We control the investment of the cash and receive the interest earned thereon.

Our primary source of liquidity is cash from financing activities and cash received from collaborations. We generated cash of $17.4 million and $19.3 million from financing activities, and cash of $11.6 million and $11.3 million from collaborations in the first six months of 2002 and 2001, respectively. On April 5, 2002, we completed a private placement with gross proceeds of approximately $15.0 million ($14.3 million, net of offering expenses). Cash inflows from the accelerated completion schedule agreed to by Hyseq and BASF Plant Science in May 2002 will be $5.3 million on September 30, 2002, $5.3 million on December 31, 2002, and $2.0 million on January 31, 2003, provided Hyseq continues to meet its deliverables under the terms of the revised collaboration agreement. Other than net cash inflows in connection with our BASF collaboration, we do not anticipate receiving significant net cash inflows from any projects during the foreseeable future.

Our primary use of cash has been to fund operating activities and to acquire capital equipment and make leasehold improvements. We used cash of $16.3 million and $11.3 million for operating activities, and cash of $1.6 million and $4.4 million to acquire capital equipment and make leasehold improvements in the first six months of 2002 and 2001, respectively. The decrease for capital equipment and leasehold improvements is due to deferral of our facilities expansion plans. We expect operating expenses during the remainder of 2002 to decrease moderately, and we will need additional funding in 2003 in order to continue our biopharmaceutical research efforts and execution of clinical trials for alfimeprase. If we do not obtain adequate financing or collaboration receipts in a timely manner, this could significantly harm our business, financial condition, and results of operations, and may require us to delay and scale back one or more of our research or development programs, or relinquish greater rights to products at an earlier stage of development or on less favorable terms than we would otherwise seek to obtain, which could materially adversely affect our business, financial condition, and operating results.

Our future capital requirements and the adequacy of available funds will depend on many factors, including those set forth under “Risk Factors — We Must Be Able to Continue to Secure Additional Financing” below. We may not be able to secure additional financing to meet our funding requirements on acceptable terms, if at all. If we raise additional funds by issuing equity securities, substantial dilution to our existing stockholders may result. If we are unable to obtain additional funds we may have to significantly curtail the scope of our operations. We have implemented a plan to delay, scale back or eliminate some of our operating expenditures, including facilities expansion plans, until we obtain additional funding. This plan includes a partial hiring freeze, a reduction in capital

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expenditures and a deferral of as many of our contractual financial commitments as possible. If we are unable to obtain third party financing, we may need to look to our Chairman to provide additional financing, which he has agreed to do.

Cash Used in Operating Activities

Comparison of the Three and Six Months Ended June 30, 2002 and 2001.The amount of net cash used in operating activities was $16.3 million during the six months ended June 30, 2002, increasing from $11.3 million used during the same period of 2001. The increase in cash used by operating activities was due primarily to higher research and development costs resulting from our biopharmaceutical development efforts and Phase I clinical trials for alfimeprase, partially offset by lower supplies expense resulting from our early completion of our collaboration with BASF Plant Science according to an agreement signed in May 2002, as well as lower personnel costs from the associated reduction in force. Hyseq also received cash of $0.3 million, $0.5 million, and $0.5 million from Kirin Brewery, Ltd., Intel Corporation, and Agilent Technologies, respectively, in connection with our research collaborations, and made lower payments to our collaboration partner University of California, San Francisco.

Cash Provided by (Used in) Investing Activities

Our investing activities consisted primarily of capital expenditures.

Comparison of the Three and Six Months Ended June 30, 2002 and 2001.Net cash used in investing activities was $1.6 million during the six months ended June 30, 2002, compared to $4.4 million during the same period of 2001. The decrease was primarily due to a freeze on new capital equipment and leasehold improvement expenditures during 2002. We expect net cash used in investing activities to stay at low levels for the foreseeable future.

Cash Provided by Financing Activities

Comparison of the Three and Six Months Ended June 30, 2002 and 2001.Net cash provided by financing activities for the first six months of 2002 was $17.4 million compared to $19.3 million for the same period of 2001.

On April 5, 2002, we completed a private placement with gross proceeds of approximately $15.0 million ($14.3 million, net of offering expenses).

In August 2001, we received a commitment from Dr. Rathmann to provide a second line of credit of up to $20.0 million in aggregate principal amount, available for draw down through August 5, 2003. Amounts outstanding under the line of credit bear interest at prime plus 1% and are payable in 48 equal monthly installments beginning upon the expiration date of August 5, 2003. The promissory note issued pursuant to the line of credit is convertible by mutual agreement by us and Dr. Rathmann into either (a) that number of shares of our common stock as shall equal the quotient obtained by dividing the aggregate principal and interest then outstanding under the note (i) by the average closing price of our common stock on the Nasdaq National Market as reported in The Wall Street Journal for the twenty trading days ending on the second trading day immediately prior to the day of such conversion or, (ii) in connection with an offering of our equity securities, by the per share price of the common stock at which such equity securities shall be offered for sale by us or (b) if within one month of the closing of any equity financing by us for aggregate gross proceeds in excess of $10,000,000, the same equity securities issued by us in the financing, at the same purchase price, with the same exercise price, if any, at the same discount, if any, and otherwise on substantially the same terms and conditions. In February 2002, we drew down $4.0 million under the line of credit. The balance available for drawdown by us under this second line of credit as of June 30, 2002 was $16.0 million.

The comparable period in 2001 included a $20.0 million drawdown of the first of two lines of credit extended to us by Dr. Rathmann, which was subsequently converted to shares of our common stock. In November 2000, we received a commitment from our Chairman to provide a first line of credit of up to $20.0 million in aggregate principal amount, secured by a promissory note and available for draw down through November 29, 2002. Amounts outstanding under the line of credit were to bear interest at prime plus 1% and would be payable in 48 equal monthly installments beginning upon the expiration date of November 30, 2002. The promissory

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note issued pursuant to such line of credit was convertible, only at our option, into shares of our common stock at fair market value on the day we elected such conversion. In March 2001, we completed the draw down of the balance of the $20.0 million available under the line of credit and paid off the outstanding principal balance in shares of our common stock as provided in the agreement. As a consequence, we issued 2,237,637 shares of common stock to our Chairman in satisfaction of $20.0 million in outstanding principal under the line of credit.

In the first six months of 2002, principal payments of capital leases and loan obligations were $1.3 million compared to the same period last year at $1.2 million. Proceeds from the issuance of common stock upon the exercise of stock options and the Employee Stock Purchase Plan were $0.4 million, compared to $0.5 million during the first six months of 2001.

Risk Factors

We Must Be Able to Continue to Secure Additional Financing

Our business does not currently generate the cash needed to finance our operations. We will require substantial additional financial resources to conduct the time-consuming and costly research, preclinical development, clinical trials and regulatory approval and marketing activities necessary to commercialize our potential biopharmaceutical products. Also, in pursuing our goal of building a fully integrated biopharmaceutical company, we will need to expand our facilities and hire and train significant numbers of employees to staff these facilities, which will require substantial additional funds. We will need to secure additional financing in order to conduct our research and expand our facilities. However, unanticipated expenses, or unanticipated opportunities that require financial commitments, could give rise to requirements for additional financing sooner than we expect. Financing may be unavailable when we need it or may not be available on acceptable terms. The unavailability of financing may require us to delay, scale back, or eliminate expenditures for our research and development program or our facilities expansion plans. We may also be required to grant rights to third parties to develop and market product candidates that we would prefer to develop and market ourselves. If we were required to grant such rights, the ultimate value of these product candidates to us would be reduced.

We intend to seek additional funding through collaborations or other strategic transactions and public or private equity or debt financings. We have financed our operations since inception primarily through the sale of equity securities, and revenue from corporate collaborations. We have not generated royalty revenues from product sales, and do not expect to receive significant revenues from royalties in the foreseeable future, if ever.

To execute an operating plan that includes facilities expansion and additional staffing, we will need to secure additional financing. Additional financing, however, may not be available on acceptable terms, if at all. Given the current state of the markets for public and private offerings of securities, we may have difficulty raising the amount of funds, on reasonable terms, necessary to finance our current operating plan. We have implemented a plan to delay, and scale back some of our operating expenditures, including facilities expansion plans, until we obtain additional funding. This plan includes a hiring freeze, a freeze on capital expenditures and a deferral of as many of our contractual financial commitments as possible. If we are unable to obtain additional financing, we may need to look to our Chairman to provide financing, which he has agreed to do. The planned reduction in operating expenditures may have a negative effect on our business. In addition, the perception in the capital markets that we may not be able to raise the amount of financing we desire, or on terms favorable to us, may have a negative effect on the trading price of our stock. Additional equity financings could result in significant dilution of current stockholders’ equity interests. If sufficient capital is not available, we will delay, reduce the scope of, eliminate or divest one or more of our subsidiaries, discovery, research or development programs or our facilities expansion. Any such action could significantly harm our business, financial condition and results of operations.

Our future capital requirements and the adequacy of our currently available funds will depend on many factors, including, among others, the following:

•

continued scientific progress in our research and development programs, including progress in our research and preclinical studies on our potential therapeutic protein candidates;

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	•		the cost involved in our facilities expansion to support research and development of our potential therapeutic protein candidates;

	•		our ability and the ability of our subsidiary Callida to attract additional financing on favorable terms;

	•		the magnitude and scope of our research and development programs, including development of potential therapeutic protein candidates and Callida technology and applications;

	•		our ability to maintain, and the financial commitments involved in, our existing collaborative and licensing arrangements;

	•		our ability to establish new corporate relationships with other biotechnology and pharmaceutical companies to share costs and expertise of identifying and developing product candidates;

	•		the cost of prosecuting and enforcing our intellectual property rights;

	•		the cost of manufacturing material for preclinical, clinical and commercial purposes;

	•		progress in our clinical studies of alfimeprase;

	•		the time and cost involved in obtaining regulatory approvals;

	•		our need to develop, acquire or license new technologies or products;

	•		competing technological and market developments;

	•		future funding commitments to our subsidiary Callida, and our ability to borrow funds from Affymetrix to fund our commitment, under the terms of the Affymetrix settlement;

	•		Affymetrix’ ability to declare all outstanding principal and interest under our $4.0 million promissory note held by it immediately due and payable in the event that our market capitalization falls below $50 million and Affymetrix reasonably determines that the loan evidenced by the note is impaired, and our obligation to prepay amounts owing under the note to the extent that the amounts outstanding exceed 10% of our market capitalization;

	•		our ability to use our common stock to repay our outstanding note to Affymetrix (including upon any acceleration of amounts owing) and our line of credit with our Chairman;

	•		legal and Nasdaq restrictions that impede our ability to raise funds from private placements of our common stock;

	•		future funding commitments to our collaborators;

	•		general conditions in the financial markets and in the biotech sector;

	•		the uncertain condition of the capital markets; and

	•		other factors not within our control.

Development of Our Products Will Take Years; Our Products Will Require Approval Before They Can Be Sold

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effective or that we will obtain regulatory approvals. In addition, any products that we develop may not be economical to manufacture on a commercial scale. Even if we develop a product that becomes available for commercial sale, we cannot be certain that consumers will accept the product. We cannot predict whether we will be able to develop and commercialize any of our protein candidates successfully. If we are unable to do so, our business, results of operations and financial condition will be materially adversely affected.

We do not yet have products in the commercial markets. We cannot apply for regulatory approval of our potential products until we have performed additional research and development and testing. We cannot be certain that we, or our strategic partners, will be permitted to undertake clinical testing of our potential products and, if we are successful in initiating clinical trials, we may experience delays in conducting them. Our clinical trials may not demonstrate the safety and efficacy of our potential products, and we may encounter unacceptable side effects or other problems in the clinical trials. Should this occur, we may have to delay or discontinue development of the potential product that causes the problem. After a successful clinical trial, we cannot market products in the United States until we receive regulatory approval. Even if we are able to gain regulatory approval of our products after successful clinical trials and then commercialize and sell those products, we may be unable to manufacture enough products to maintain our business, which could have a negative impact on our financial condition.

The Success of Our Potential Products in Preclinical Studies Does Not Guarantee that these Results Will Be Replicated in Humans

Even though some of our therapeutic protein candidates have shown results in preclinical studies, these results may not be replicated in our clinical trials with humans. Human clinical results could be different from our expectations following our preclinical studies. Consequently, there is no assurance that the results in our preclinical studies are predictive of the results that we will see in our clinical trials with humans. Also, while we have demonstrated some evidence that our therapeutic protein candidates have utility in preclinical studies, these results do not mean that the resulting products will be safe and effective in humans. Our therapeutic protein candidates may have undesirable and unintended side effects or other characteristics that may prevent or limit their use.

Our Ability To Commercialize Gene-Based Products is Unproven

We have not developed any therapeutic or diagnostic products using proteins produced by the genes we have discovered. Before we make any products available to the public, we or our collaboration partners will need to conduct further research and development and complete laboratory testing and animal and human studies. Moreover, with respect to biopharmaceutical products, we or our collaboration partners will need to obtain regulatory approval before releasing any such products. With respect to agricultural products, our collaboration partner may need to obtain regulatory approval before releasing any such products. We have spent, and expect to continue to spend, significant amounts of time and money in determining the function of genes and the proteins they produce, using our own capabilities and those of our collaboration partners. Such determination process constitutes the first step in developing commercial products. We also have spent and will continue to spend significant amounts of time and money in developing processes for manufacturing of our recombinant proteins under pre-clinical development, yet we may not be able to produce sufficient protein for preclinical studies. A commercially viable product may never be developed from our gene discoveries.

Our development of gene-based products is subject to several risks, including but not limited to:

	•		the possibility that a product is toxic, ineffective or unreliable;

	•		failure to obtain regulatory approval for the product;

	•		the product may be difficult to manufacture on a large scale, or may not be economically feasible to market;

	•		competitors may develop a superior product; or

	•		other persons’ or companies’ patents may preclude our marketing of a product.

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Our biopharmaceutical development programs are currently in the research stage or in preclinical development. None of our potential therapeutic protein candidates from our own portfolio have advanced to Phase I clinical trials. Our programs may not move beyond their current stages of development. Even if our research does advance, we will need to engage in certain additional preclinical development efforts to determine whether a product is sufficiently safe and efficacious to enter clinical trials. We have little experience with these activities and may not be successful in developing or commercializing products.

Under our collaboration arrangement with Chiron in the solid tumor cancer field, Chiron maintains responsibility for the development of a product. Under our collaboration arrangement with Kirin Brewery Company, Ltd., Kirin has primary responsibility for clinical development in its territory and we have primary responsibility in our territory. Under our collaboration arrangement with Deltagen, we share responsibility for development of a product. With respect to these arrangements, we run the risk that Chiron or Kirin may not pursue clinical development in a timely or effective manner, if at all, and that Deltagen may not cooperate with us in pursuing clinical development in a timely or effective manner.

If a product receives approval from the FDA to enter clinical trials, Phases I, II, and III of those trials include multi-phase, multi-center clinical studies to determine the product’s safety and efficacy prior to marketing. We cannot predict the number or extent of clinical trials that will be required or the length of the period of mandatory patient follow-up that will be imposed. Assuming clinical trials of any product are successful and other data appear satisfactory to us, we or our applicable collaboration partner will submit an application to the FDA and appropriate regulatory bodies in other countries to seek permission to market the product. Typically, the review process at the FDA is not predictable and can take up to several years. Upon completion of such review, the FDA may not approve our or our collaboration partner’s application or may require us to conduct additional clinical trials or provide other data prior to approval. Furthermore, even if our products or our collaboration partner’s products receive regulatory approval, delays in the approval process could significantly harm our business, financial condition and results of operations.

In addition, we may not be able to produce any products in commercial quantities at a reasonable cost or may not be able to market successfully such products. If we do not develop a commercially viable product, then we would suffer significant harm to our business, financial condition and operating results.

The Success of Our Business Depends on Patents and Other Proprietary Information

We currently have patents that cover some of our technological discoveries and patent applications that we expect to cover some of our gene, protein and technological discoveries. We have twelve issued patents relating to our gene and protein discoveries. We will continue to apply for patents for our discoveries. We cannot assure you that any of our currently pending or future applications will issue as patents, or that any patent issued to us will not be challenged, invalidated, circumvented or held unenforceable by way of an interference proceeding or litigation. The patent positions of biotechnology companies involve complex legal and factual questions. Even though we own patents, we cannot be certain that:

	•		our patents will not be challenged;

	•		protection against competitors will be provided by such patents; or

	•		competitors will not independently develop similar products or design around our patents.

We seek patents on:

	•		full-length gene sequences;

	•		partial gene sequences;

	•		proteins produced by those genes;

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	•		antibodies to those proteins;

	•		diagnostic and therapeutic methods involving such genes, proteins or antibodies; and

	•		processes, devices and other technology that enhance our ability to develop and/or manufacture gene-based products.

To obtain a patent, we must identify a utility for the gene or the protein we seek to patent. Identifying a utility may require significant research and development with respect to which we may incur a substantial expense and invest a significant amount of time.

Patent applications we may apply for with respect to human therapeutics could require us to generate data, which may involve substantial costs. Finally, we cannot predict the timing of the grant of a patent.

We also rely on trade secret protection for our confidential and proprietary information. Although our policy is to enforce security measures to protect our assets, trade secrets are difficult to protect. We require all employees to enter into confidentiality agreements with us. However:

	•		competitors may independently develop substantially equivalent proprietary information and techniques;

	•		competitors may otherwise gain access to our trade secrets;

	•		persons with whom we have confidentiality agreements may disclose our trade secrets; or

	•		we may be unable to protect our trade secrets meaningfully.

Certain of the patent applications protecting our subsidiary Callida’s SBH technology are filed only in the United States. Therefore, Callida currently is not able to prevent others from practicing SBH technology outside of the United States. Furthermore, although we believe Callida intends to defend its patents, it may not prevail in a court case against others who use similar technology.

Certain of the patent applications protecting our gene-related information are filed only in the United States. Even where we have filed our patents applications internationally, we may choose not to maintain foreign patent protection through failure to enter national phase or failure to pay maintenance annuities.

We may be required to obtain licenses to patents or other proprietary rights of others. These required licenses may not, however, be made available on terms acceptable to us, or at all. If we do not obtain these licenses, we may not be able to develop, manufacture or sell products, or encounter delays in product market introductions, or incur substantial costs while we attempt to design around existing patents. Any of these obstacles could significantly harm our business, financial condition and operating results.

Our Business is Difficult to Evaluate Because We Have Been Focused on Our Current Business Strategy for Only Approximately Four Years

We commenced operations in the fourth quarter of 1994. Our initial business focused on gene discovery using our signature by hybridization platform, and applications of our SBH technology including the HyChip system. Not only is our operating history relatively short, but we began to transition our business strategy from gene discovery to research and development of potential therapeutic protein candidates in 1998. Accordingly, we have a limited operating history from which you can evaluate our present business and future prospects. As a relatively new entrant to the business of biopharmaceutical research and development, we face risks and uncertainties relating to our ability to implement our business plan successfully. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in their early state of development, particularly companies in new and rapidly evolving markets such as research and development of gene-based products. If we are unsuccessful in addressing

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these risks and uncertainties, our business, results of operations, financial condition and prospects will be materially adversely affected.

We Lack Manufacturing Experience and We Intend to Rely Initially on Contract Manufacturers

We do not currently have significant manufacturing facilities. We are dependent on contract research and manufacturing organizations, and will be subject to the risks of finalizing contractual arrangements, transferring technology and maintaining relationships with such organizations in order to file an IND with the FDA and proceed with clinical trials for any of our potential therapeutic protein candidates. We are dependent on third-party contract research organizations to conduct certain research, including good laboratory practices toxicology studies in order to gather the data necessary to file an IND with the FDA for any of our potential therapeutic protein candidates. Our potential therapeutic protein candidates have never been manufactured on a commercial scale. Third-party manufacturers may not be able to manufacture such proteins at a cost or in quantities necessary to make them commercially viable. In addition, if any of our potential therapeutic protein candidates enter the clinical trial phase, initially we will be dependent on third-party contract manufacturers to produce the volume of current good manufacturing practices materials needed to complete such trials. We will need to enter into contractual relationships with these or other organizations in order to (i) complete the GLP toxicology and other studies necessary to file an IND with the FDA, and (ii) produce a sufficient volume of cGMP material in order to conduct clinical trials of our potential therapeutic protein candidates. We cannot be certain that we will be able to do so on a timely basis or that we will be able to obtain sufficient quantities of material on commercially reasonable terms. In addition, the failure of any of these relationships with third-party contract organizations may result in a delay of our filing for an IND, or our progress through the clinical trial phase. Any significant delay or interruption would have a material adverse effect on our ability to file an IND with the FDA and/or proceed with the clinical trial phase for any of our potential therapeutic protein candidates.

Moreover, contract manufacturers that we may use must continually adhere to current cGMP regulations enforced by the FDA through a facilities inspection program. If the facilities of such manufacturers cannot pass a pre-approval plant inspection, the FDA premarket approval of our products will not be granted.

We Are Dependent Upon Collaborative Arrangements

As we have transitioned our business from gene discovery to research and development of biopharmaceutical candidates, we have shifted our focus for new collaborative arrangements. We are now focusing on new collaborative arrangements where we would share costs of identifying, developing and marketing product candidates. There can be no assurance that we will be able to negotiate new collaboration arrangements of this type on acceptable terms, or at all.

Our subsidiary Callida, engaged in the development of SBH technology, is also dependent on the cooperation of its partners in collaborative arrangements and may also need to negotiate new collaborative arrangements in the future.

The success of our business is dependent, in significant part, upon our ability to enter into multiple collaboration arrangements and to manage effectively the numerous issues that arise from such collaborations. Management of our relationships with our collaboration partners will require:

	•		our management team to devote a significant amount of time and effort to the management of these relationships;

	•		effective allocation of our resources to multiple projects; and

	•		an ability to obtain and retain management, scientific and other personnel.

Our need, including the need of our direct and indirect subsidiaries, to manage simultaneously a number of collaboration arrangements may not be successful, and the failure to manage effectively such collaborations would significantly harm our business, financial condition and results of operations.

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The research we perform in our gene discovery collaborative arrangements is at an early stage of product development. The successful development of products under these collaborations is highly dependent on the performance of our collaboration partners. Under our gene discovery collaborative arrangements, our collaboration partners are generally required to (i) undertake and fund certain research and development activities with us, (ii) make payments to us upon achievement of certain scientific milestones and (iii) pay royalties to us when and if they commercially market a product developed from the collaborative arrangement. We do not directly control the amount or timing of resources devoted to development activities by our collaboration partners. We, therefore, face a risk that our collaboration partners may not commit sufficient resources to our research and development programs or the commercialization of our products or may not perform their obligations as expected. If any collaboration partner fails to conduct its activities to be performed under our collaboration arrangement in a timely manner, or at all, our expectations of royalties and milestone payments related to such collaboration arrangement could be delayed or eliminated. Also, our current or future collaboration partners, if any, may independently pursue existing or other development-stage products or alternative technologies in preference to those they are developing in collaboration with us. Further, disputes may arise with respect to ownership of products developed under any such collaboration arrangement. Finally, any of our current collaboration arrangements may be terminated or not renewed by our collaboration partners, and we may not be able to negotiate additional collaboration arrangements in the future on acceptable terms, or at all.

We Are Dependent on Key Personnel

The success of our business is highly dependent on the principal members of our scientific and management staff and including our chairman and senior management team. The loss of the services of any such individual might significantly delay or prevent us from achieving our scientific or business objectives. Competition among biotechnology and biopharmaceutical companies for qualified employees is intense. The ability to retain and attract qualified individuals is critical to our success. We may not be able to attract and retain qualified employees currently or in the future on acceptable terms, or at all. The failure to do so would significantly harm our business, financial condition and results of operations.

Management of Growth

We expect to increase significantly the number of our employees and the scope of our operations. Such growth may place a significant strain on our management and operations. In order to execute our strategy to build a fully integrated biopharmaceutical company, develop therapeutic or diagnostic products, and obtain regulatory approvals, we will need to:

	•		attract and train skilled employees;

	•		attract and retain employees with expertise to ensure that we meet FDA and foreign regulatory requirements for conducting clinical trials;

	•		expand our facilities for additional research and development laboratories and offices and acquire additional equipment and supplies;

	•		expand our protein production capacity;

	•		enter into and manage contractual relationships with contract research and manufacturing organizations; and

	•		get additional funding.

Our ability to manage such growth effectively will depend upon our ability to broaden our management team and to attract, hire and retain skilled employees. Our success also will depend on the ability of our officers and key employees to continue to implement and improve our operational, management information and financial control systems and to expand, train and manage our employee base.

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We may also seek to grow through acquisitions. The integration of companies that have previously operated separately involves a number of risks, including:

	•		demands on management related to the increase in our size after an acquisition;

	•		the diversion of our management’s attention from the management of daily operations to the integration of operations;

	•		difficulties in the assimilation and retention of employees;

	•		potential adverse effects on operating results; and

	•		potential adverse impact on funding requirements.

If we do not successfully integrate acquisitions, we may not realize anticipated operating advantages, cost savings and other benefits. Our inability to manage growth effectively,including through successful integration of acquisitions, could significantly harm our business, financial condition and operating results.

We Must Attract and Retain Qualified Employees and Consultants

Our success will depend on our ability to retain our key executive officers and scientific staff to develop our potential products and formulate our research and development strategy. We have programs in place to retain personnel, including programs to create a positive work environment and competitive compensation packages. Because competition for employees in our field is intense, however, we may be unable to retain our existing personnel or attract additional qualified employees. Our success also depends on the continued availability of outside scientific collaborators to perform research and develop processes to advance and augment our internal research efforts. Competition for collaborators is intense. If we do not attract and retain qualified personnel and scientific collaborators, and if we experience significant turnover or difficulties recruiting new employees, our research and development programs could be delayed and we could experience difficulties in generating sufficient revenue to maintain our business.

Future Sales of Our Common Stock May Depress Our Stock Price

Sales in the public market of substantial amounts of our common stock could depress prevailing market prices of our common stock. As of August 7, 2002, we had 22,994,366 shares of our common stock outstanding. All of these shares are freely transferable without restriction or further registration under the Securities Act of 1933, as amended, except for shares held by our affiliates and unregistered shares held by non-affiliates. As of August 7, 2002, our affiliates held 4,384,988 shares of our common stock and non- affiliates held 543,027 unregistered shares of our common stock, which are transferable pursuant to Rule 144 as promulgated under the Securities Act of 1933, subject to the volume limitations of Rule 144. Although we do not believe that our affiliates have any present intentions to dispose of any shares of common stock owned by them, there can be no assurance that such intentions will not change in the future. An additional 708,480 shares owned by a Yugoslav entity have been held in a blocked account pursuant to restrictions imposed by the U.S. Department of Treasury arising from the political situation in former Yugoslavia and therefore have not been able to be voted or transferred. We believe that some of these restrictions may have been removed and the remaining restrictions may be removed in the future. There can be no assurance as to how long any such restrictions will remain in effect.

As of August 7, 2002, warrants to purchase 3,905,840 shares of our common stock were outstanding. In addition, under registration statements on Form S-8 under the Securities Act of 1933, we have registered approximately 5,605,572 shares of our common stock for sale upon the exercise of outstanding options under our 1995 Stock Option Plan, Non-Employee Director Stock Option Plan, Scientific Advisory Board/ Consultants Stock Option Plan, and stock option agreements entered into outside of any of our stock option plans and under our Employee Stock Purchase Plan and our Non-Qualified Employee Stock Purchase Plan. Shares of our common stock acquired pursuant to these plans and agreements are available for sale in the open market. In addition, we have reserved approximately 1,443,160 shares of our common stock for issuance upon the exercise of outstanding options under stock option agreements entered into outside of any of our stock option plans. As of August 7, 2002, 429,540 of the 1,443,160 shares of

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these options were exercisable. Although these shares have not been registered under the Securities Act of 1933, and therefore are restricted securities within the meaning of Rule 144 under the Securities Act of 1933, we intend to register these shares on a registration statement on Form S-8 under the Securities Act of 1933. Certain options or warrants may have exercise prices that are substantially below the prevailing market price of our common stock. The exercise of those options or warrants, and the prompt resale of shares of our common stock received, may result in downward pressure on the price of our common stock. The existence of the currently outstanding warrants and options to purchase our common stock may negatively affect our ability to complete future equity financings at acceptable prices and on acceptable terms.

As of August 7, 2002, 2,339,983 shares of our common stock were issuable upon repayment of our note held by Affymetrix. Affymetrix has the ability to declare all outstanding principal and interest under the note immediately due and payable in the event that our market capitalization falls below $50 million and Affymetrix reasonably determines that the loan evidenced by the note is impaired. Moreover, we have registered the resale of these shares on a registration statement that has been declared effective by the SEC. If we decide to repay this note with our common stock, whether pursuant to acceleration of the note or otherwise, the prompt resale of shares of our common stock received by Affymetrix may also result in significant downward pressure on the price of our common stock and the possibility of this occurrence may also affect our ability to complete future equity financings at acceptable prices and on acceptable terms.

Our Subsidiary Callida Genomics, Inc. May Not Be Able to Raise Third Party Financing

In October 2001, we formed Callida Genomics, Inc. to develop and commercialize our SBH technology. We recognize 90% of Callida’s operating losses in our consolidated results of operations up to the point where Affymetrix’s initial majority interest investment is depleted. Beyond that point, the Company will absorb 100% of the net losses until Callida generates net income. There is no guarantee, however, that Callida will meet its technical milestone and other requirements to obtain additional funding through Affymetrix and Hyseq. There is also no assurance that Callida will be able to obtain any third party financing or that any such financing that Callida obtains will be on favorable terms or that the funding from outside sources will be sufficient to fund Callida’s operations. We cannot assure the success of Callida, and if Callida is unable to obtain sufficient funding from outside sources, we may abandon their projects or bear the costs of financing Callida ourselves, which will divert our resources from other biopharmaceutical projects.

We Have a History of Operating Losses and May Never Be Profitable

For the years ended December 31, 2001, 2000 and 1999, we had net losses of $36.5 million, $22.3 million and $18.5 million, respectively. As of June 30, 2002, we had an accumulated deficit of $135.4 million. The process of developing our therapeutic protein candidates will require significant additional research and development, preclinical testing, clinical trials and regulatory approvals. These activities, together with general administrative expenses, are expected to result in operating losses for the foreseeable future. We may never generate profits, and if we do become profitable, we may be unable to sustain or increase profitability on a quarterly or annual basis. As a result, the trading price of our stock could decline.

We May Face Fluctuations in Operating Results

Our operating results may rise or fall significantly as a result of many factors, including:

	•		the amount of research and development we engage in;

	•		the progress we make with research and preclinical studies on our therapeutic protein candidates, and the number of candidates in research and preclinical studies;

	•		our ability to expand our facilities to support our operations;

	•		our ability to enter into new strategic relationships;

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	•		the nature, effectiveness, size, timing or termination of our collaborative arrangements;

	•		the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims;

	•		the possibility that others may have or obtain patent rights that are superior to ours;

	•		changes in government regulation; and

	•		competitors’ release of successful products into the market.

Because substantially all of our potential products currently are in research or preclinical development, revenues from sales of any products will not occur for at least the next several years, if at all. We also have a high percentage of fixed costs such as lease obligations. As a result, we may experience fluctuations in our operating results from quarter to quarter and continue to generate losses. Quarterly comparisons of our financial results may not necessarily be meaningful and investors should not rely upon such results as an indication of our future performance.

We Face Potential Volatility of Our Stock Price

Our common stock has been traded on the Nasdaq National Market since August 1997. The market price of our common stock may fluctuate substantially because of a variety of factors, including:

	•		volatility and uncertainty in the capital markets in general;

	•		fluctuations in our results of operations;

	•		sales of our common stock by existing holders;

	•		loss of key personnel;

	•		economic and other external factors;

	•		announcements by governmental agencies that may have, or may be perceived to have, an impact on our potential products;

	•		changes in our earnings estimates;

	•		changes in accounting principles;

	•		lack of trading volume in our stock;

	•		fluctuations within the biotechnology sector;

	•		announcements by competitors; and

	•		other factors not within our control.

In addition, the stock market in general, and the market for biotechnology and other life science stocks in particular, has historically been subject to extreme price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to the operating performance of these companies. In the past, following periods of volatility in the market price of a company’s securities, class action securities litigation has often been instituted against

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such a company. Any such litigation instigated against us could result in substantial costs and a diversion of management’s attention and resources, which could significantly harm our business, financial condition and operating results.

FDA Regulatory Approval of Our Products is Uncertain; We Face Heavy Government Regulation

Products such as those proposed to be developed by us or our collaboration partners, typically will be subject to an extensive regulatory process by federal, state and local governmental authorities, including the FDA, and comparable agencies in other countries before we may market and sell such products. In order to obtain regulatory approval of a drug product, we or our collaboration partners must demonstrate to the satisfaction of the applicable regulatory agency, among other things, that such product is safe and effective for its intended uses. In addition, we must show that the manufacturing facilities used to produce the products are in compliance with cGMP requirements. In the event we or our collaboration partners, develop products classified as drugs, we and our collaboration partners will be required to obtain appropriate approvals as well.

If our subsidiary Callida sells applications of our SBH technology for clinical diagnostics, it will need to comply with appropriate cGMP regulations pertaining to devices. The new Quality System Regulation imposes design controls and makes other significant changes in the requirements applicable to manufacturers. Callida must also demonstrate that a Biologic License Application or New Drug Application for any biological products would be approved by the applicable government agency. In addition, if Callida markets applications of our SBH technology as diagnostic products, they may be considered to be medical devices and Callida or its collaboration partners will be required to show that the diagnostic product is substantially equivalent to a legally marketed product not requiring FDA approval. In addition, Callida must demonstrate that it is capable of manufacturing the product in accordance with the relevant standards. To obtain FDA approval for such products, Callida must submit extensive data to the FDA, including pre-clinical and clinical trial data to prove the safety and efficacy of the device. Clinical trials are normally conducted over a two- to five-year period, but may take longer to complete as a result of many factors, including:

	•		slower than anticipated patient enrollment;

	•		difficulty in finding a sufficient number of patients fitting the appropriate inclusion criteria;

	•		difficulty in acquiring a sufficient supply of clinical trial materials; or

	•		adverse events occurring during the trials.

Furthermore, data obtained from preclinical and clinical activities are susceptible to varying interpretations, which could delay, limit or prevent regulatory approval or clearance for a product.

The process of obtaining FDA and other required regulatory approvals and clearances is lengthy and will require us to expend substantial capital and resources. We may not ultimately be able to obtain the necessary approvals and clearances. Moreover, if and when our products do obtain such approval or clearances, the marketing, distribution and manufacture of such products would remain subject to extensive ongoing regulatory requirements. Failure to comply with applicable regulatory requirements can result in:

	•		warning letters;

	•		fines;

	•		injunctions;

	•		civil penalties;

	•		recall or seizure of products;

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	•		total or partial suspension of production;

	•		refusal of the government to grant approvals, premarket clearance or premarket approval; or

	•		withdrawal of approvals and criminal prosecution.

We also are subject to numerous federal, state and local laws, regulations and recommendations relating to safe working conditions, laboratory and manufacturing practices, the experimental use of animals, the environment and the use and disposal of hazardous substances used in connection with our discovery, research and development work, including radioactive compounds and infectious disease agents. In addition, we cannot predict the extent of government regulations or the impact of new governmental regulations that might significantly harm the discovery, development, production and marketing of our products. We may be required to incur significant costs to comply with current or future laws or regulations and we may be adversely affected by the cost of such compliance.

If we market therapeutic and diagnostic products outside the United States, such products will be subject to foreign regulatory requirements governing the conduct of clinical trials, product licensing, pricing and reimbursement. Such requirements vary from country to country and are becoming more restrictive throughout the European Community. The process of obtaining foreign regulatory approvals can be lengthy and require the expenditure of substantial capital and resources. We or our collaboration partners may not be successful in obtaining the necessary approvals.

Any delay or failure by us or our collaboration partners to obtain regulatory approvals for our products:

	•		would adversely affect our ability to generate product and royalty revenues;

	•		could impose significant additional costs on us or our collaboration partners;

	•		could diminish competitive advantages that we may attain; and

	•		would adversely affect the marketing of our products.

We Face Intense Competition

The genomics and biopharmaceutical industries are intensely competitive. Our strategy as a biopharmaceutical company is to find the genes of the human genome that are most likely to be involved in a disease condition and to focus on identifying product candidates from the proteins produced by genes. There are a finite number of genes in the human genome, virtually all of which have been or will soon be identified. Our competitors include major pharmaceutical and biotechnology firms, not-for-profit entities and United States and foreign government-financed programs, many of which have substantially greater research and product development capabilities and financial, scientific, marketing and human resources than we do. As a result, they may succeed in identifying genes and determining their functions or developing products earlier than we or our current or future collaboration partners do. They also may obtain patents and regulatory approvals for such products more rapidly than we or our current or future collaboration partners, or develop products that are more effective than those proposed to be developed by us or our collaboration partners. Further, any potential products based on genes we identify ultimately will face competition from other companies developing gene-based products as well as from companies developing other forms of treatment for diseases which may be caused by, or related to, the genes we identify.

Many of the companies developing competing products have significantly greater financial resources than we have. Many such companies also have greater expertise than we or our collaboration partners have in discovery, research and development, manufacturing, preclinical and clinical testing, obtaining regulatory approvals and marketing. Other smaller companies may also prove to be significant competitors, particularly through collaborative arrangements with large and established companies. Academic institutions, government agencies and other public and private research organizations may also conduct research, seek patent

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protection and establish collaborative arrangements for discovery, research, clinical development and marketing of products similar to our products. These companies and institutions compete with us in recruiting and retaining qualified scientific and management personnel as well as in acquiring technologies complementary to our programs. We will face competition with respect to:

	•		product efficacy and safety;

	•		the timing and scope of regulatory approvals;

	•		availability of resources;

	•		reimbursement coverage; and

	•		price and patent position, including potentially dominant patent positions of others.

There can be no assurance that research and development by others will not render the products that we may develop obsolete or uneconomical, or result in treatments, cures or diagnostics superior to any therapy or diagnostic developed by us or that any therapy we develop will be preferred to any existing or newly developed technologies. While we believe that our technology provides a significant competitive advantage, any one of our competitors may discover and establish a patent position in one or more genes which we designate as a product candidate, before we do. Competition in this field is expected to intensify. Certain of our collaboration partners may now be, or could become, competitors.

Competition in the area of DNA analysis tools is intense and expected to increase. Technologies in this area are new and rapidly evolving. Other companies also are developing or have developed DNA analysis tools that may compete with applications of Callida’s SBH technology. Many of these companies have significantly greater research and development, marketing and financial resources than we do, and therefore represent significant competition.

We Lack Marketing Experience for Biopharmaceuticals

We currently have no sales, marketing or distribution capability. For the foreseeable future, we intend to rely primarily on our current and future collaboration partners or licensors, if any, to market our products. Such collaboration partners, however, may not have effective sales forces and distribution systems. If we are unable to maintain or establish such relationships and are required to market any of our products directly, we will have to develop our own marketing and sales force with the appropriate technical expertise and with supporting distribution capabilities. We may not be able to maintain or establish such relationships with third parties or develop in-house sales and distribution capabilities. To the extent that we depend on our collaboration partners or third parties for marketing and distribution, any revenues we receive will depend upon the efforts of such collaboration partners or third parties. Such efforts may not be successful.

Our Products May Not Be Accepted in the Marketplace

Even if they are approved for marketing, products we develop may never achieve market acceptance. Our products, if successfully developed, will compete with a number of traditional drugs and therapies manufactured and marketed by major pharmaceutical and other biotechnology companies. Our products will also compete with new products currently under development by such companies and others. The degree of market acceptance of any products developed by us, alone, or in conjunction with our collaboration partners, will depend on a number of factors, including:

	•		the establishment and demonstration of the clinical efficacy and safety of the products;

	•		our products’ potential advantage over alternative treatment methods; and

	•		reimbursement policies of government and third-party payors.

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Physicians, patients or the medical community in general may not accept and utilize any of the products that we alone, or in conjunction with our collaboration partners, develop. The lack of such market acceptance would significantly harm our business, financial condition and results of operations.

We may develop diagnostic testing products in the future. Our success in diagnostics will depend in large part upon our ability to obtain customers and upon the ability of these customers to market genetic tests performed with our technology properly. Genetic tests, including any performed using applications of Callida’s SBH technology, may be difficult to interpret and may lead to misinformation or misdiagnosis. Even when a genetic test identifies the existence of a mutation in a person, the test cannot determine with absolute certainty whether the tested individual will develop the disease or condition for which the test is performed. The prospect of broadly available genetic predisposition testing has raised societal and governmental concerns regarding the appropriate use and the confidentiality of information provided by such testing. Government authorities could limit the use of genetic testing or prohibit testing for genetic predisposition to certain conditions. Ethical concerns about genetic testing may adversely affect market acceptance of our technology for diagnostic applications. Impaired market acceptance of our technology could significantly harm our business, financial condition and operating results.

We Face Uncertainties Related to SBH Technology Applications

We have developed applications of our SBH technology, currently in our subsidiary, Callida, including the chip component to be used with the HyChip system. As Callida continues development of SBH technology applications, it may discover problems in the functioning of these applications, including the HyChip system. Callida may be unable to improve applications of our SBH technology enough to be able to market them successfully. Further, SBH technology applications compete against other DNA analysis tools and well-established technologies. We cannot predict the outcome of these uncertainties.

We Face Uncertainty With Respect to Pricing, Third-Party Reimbursement and Health Care Reform

Our ability to collect significant royalties from our products may depend on our ability, and the ability of our collaboration partners or customers, to obtain adequate levels of reimbursement from third-party payors such as:

	•		government health administration authorities;

	•		private health insurers;

	•		health maintenance organizations;

	•		pharmacy benefit management companies; and

	•		other health care related organizations.

Currently, third-party payors are increasingly challenging the prices charged for medical products and services, and the overall availability of third-party reimbursement is limited and uncertain for genetic predisposition tests. Third-party payors may deny their insured reimbursement if they determine that a prescribed device or diagnostic test (i) has not received appropriate clearances from the FDA or other government regulators, (ii) is not used in accordance with cost-effective treatment methods as determined by the third-party payor, or (iii) is experimental, unnecessary or inappropriate. If third-party payors routinely deny reimbursement, we may not be able to market our products effectively. We also face the risk that we will have to offer our diagnostic products at low prices as a result of the current trend in the United States towards managed health care through health maintenance organizations. Prices could be driven down by health maintenance organizations which control or significantly influence purchases of health care services and products. Legislative proposals to reform health care or reduce government insurance programs could also adversely affect prices of our products. The cost containment measures that health care providers are instituting and the results of potential health care reforms

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may prevent us from maintaining prices for our products that are sufficient for us to realize profits and may otherwise significantly harm our business, financial condition and operating results.

We Face Product Liability Exposure and Potential Unavailability of Insurance

We risk financial exposure to product liability claims in the event that the use of products developed by us or our collaboration partners, if any, result in personal injury. We may experience losses due to product liability claims in the future. We have obtained limited product liability insurance coverage. Such coverage, however, may not be adequate or may not continue to be available to us in sufficient amounts or at an acceptable cost, or at all. We may not be able to obtain commercially reasonable product liability insurance for any product approved for marketing. A product liability claim or other claim, product recalls, as well as any claims for uninsured liabilities or in excess of insured liabilities, may significantly harm our business, financial condition and results of operations.

We Use Hazardous Materials

Our research and development activities involve the controlled use of hazardous materials. Although we believe that our safety procedures for handling and disposing of these materials comply with applicable laws and regulations, we cannot eliminate the risk of accidental contamination or injury from hazardous materials. If a hazardous material accident occurred, we would be liable for any resulting damages. This liability could exceed our financial resources. Additionally, hazardous materials are subject to regulatory oversight. If our access to hazardous materials necessary for our operations is limited by federal, state or local regulatory agencies, we could experience delays in our research and development programs. Paying damages or experiencing delays caused by restricted access to necessary materials could reduce our ability to generate revenues and make it more difficult to fund our operations.

Many corporate actions will be controlled by our officers and directors regardless of the opposition of other stockholders or the desire of other stockholders to pursue an alternative course of action.

Our executive officers and directors, including Dr. Rathmann, beneficially own, in the aggregate, approximately 27.2% of our common stock outstanding as of August 7, 2002, and Dr. Rathmann beneficially owns approximately 24.0% of our common stock outstanding as of August 7, 2002. For purposes of this paragraph, beneficial ownership is determined in accordance with Rule 13d-3 under the Exchange Act. If they act together, these stockholders will be able to exercise substantial influence and control over all matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying or preventing a change in our control.

We Have Implemented Anti-Takeover Provisions that May Reduce the Market Price of Our Common Stock

Our Amended and Restated By-Laws provide that members of our board of directors serve staggered three-year terms. Our Amended and Restated Articles of Incorporation provide that all stockholder action must be effected at a duly called meeting and not by a consent in writing. The Amended and Restated By- Laws provide, however, that our stockholders may call a special meeting of stockholders only upon a request of stockholders owning at least 50% of our capital stock. These provisions of our Amended and Restated Articles of Incorporation and our Amended and Restated By-Laws could discourage potential acquisition proposals and could delay or prevent a change in control. These provisions are intended to enhance the likelihood of continuity and stability in the composition of our board of directors and in the policies formulated by our board of directors. We also intended these provisions to discourage certain types of transactions that may involve an actual or threatened change of control. We designed these provisions to reduce our vulnerability to unsolicited acquisition proposals and to discourage certain tactics that may be used in proxy fights. These provisions, however, could also have the effect of discouraging others from making tender offers for our shares. As a consequence, they also may inhibit fluctuations in the market price of our shares that could result from actual or rumored takeover attempts. Such provisions also may have the effect of preventing changes in our management.

We are permitted to issue shares of our preferred stock without stockholder approval upon such terms as our board of directors determines. Therefore, the rights of the holders of our common stock are subject to, and may be adversely affected by, the rights of the

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holders of our preferred stock that may be issued in the future. In addition, the issuance of preferred stock could have a dilutive effect on the holdings of our current stockholders.

On June 5, 1998, our board of directors adopted a rights plan and declared a dividend with respect to each share of our common stock then outstanding. This dividend took the form of a right, which entitles the holders to purchase one-one thousandth of a share of our Series B junior participating preferred stock at a purchase price of $175, subject to adjustment from time to time. These rights have also been issued in connection with each share of our common stock issued after June 15, 1998. The rights are exercisable only if a person or entity or affiliated group of persons or entities acquires, or has announced its intention to acquire, 15% (27.5% in the case of certain approved stockholders) or more of our outstanding common stock. The adoption of the rights plan makes it more difficult for a third party to acquire control of us without the approval of our board of directors.

Nevada Revised Statutes Sections 78.411 through 78.444 prohibit an “interested stockholder,” under certain circumstances, from entering into specified combination transactions with a Nevada corporation, unless certain conditions are met. Under the statute, an “interested stockholder” is a person who beneficially owns, directly or indirectly, 10% or more of a corporation’s voting stock or an affiliate or associate of a corporation who at any time within the prior three years beneficially owned, directly or indirectly, 10% or more of a corporation’s voting stock. According to the statute, we may not engage in a combination within three years after an interested stockholder acquires our shares, unless (i) our board of directors approves the combination prior to the interested stockholder becoming an interested stockholder or (ii) holders of a majority of voting power not beneficially owned by the interested stockholder approve the combination at a meeting called no earlier than three years after the date the interested stockholder became an interested stockholder.

Nevada Revised Statutes Sections 78.378 through 78.3793 further prohibit an acquirer, under certain circumstances, from voting shares of a target corporation’s stock after crossing certain threshold ownership percentages, unless the acquirer obtains the approval of the target corporation’s stockholders. This statute only applies to Nevada corporations that do business directly or indirectly in Nevada. We do not intend to do business in Nevada within the meaning of the statute. Therefore, it is unlikely that the statute will apply to us.

The provisions of our governing documents, our existing agreements and current Nevada law may, collectively:

	•		lengthen the time required for a person or entity to acquire control of us through a proxy contest for the election of a majority of our board of directors;

	•		discourage bids for our common stock at a premium over market price; and

	•		generally deter efforts to obtain control of us.

Risk of Natural Disasters and Power Blackouts

Our facilities are located in Sunnyvale, California. In the event that a fire or other natural disaster (such as an earthquake) prevents us from operating our production line, our business, financial condition and operating results would be materially, adversely affected. Some of our landlords maintain earthquake coverage for our facilities. Although we maintain personal property and business interruption coverage, we do not maintain earthquake coverage for personal property or resulting business interruption.

The State of California has experienced natural gas and electricity problems, which have resulted in rolling power blackouts, some of which have affected our facilities. In addition, we, like others, have experienced large fluctuation in our natural gas rates and may experience steep fluctuations in our electric rates. Although we have an auxiliary generator, it is intended for emergency backup in the event of a power outage and is not capable of powering our entire operations. Future power blackouts and/or large increases in our utility costs could harm our business, financial condition and results of operations.

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We are at risk of having our stock delisted from the Nasdaq National Market, which could have a material adverse impact on our stock price, the market for our stock and our ability to raise capital

Our common stock is listed on the Nasdaq National Market, which has minimum quantitative listing criteria that are required to be maintained. Two of these criteria are a minimum stock price of one dollar per share and, beginning in November 2002, minimum stockholders’ equity of $10 million. For the period commencing on January 1, 2002 through July 31, 2002, the high and low closing sales price of our common stock as reported by the Nasdaq National Market was $8.65 and $1.75, respectively. If our stock price were to decline to below one dollar per share, The Nasdaq Stock Market may take action to have our common stock delisted from the Nasdaq National Market. In addition, as of June 30, 2002, we had shareholders’ equity of $13.1 million. If we do not continue to satisfy the $10.0 million shareholders’ equity requirement and the other applicable continued listing requirements, our common stock may be delisted from the Nasdaq National Market. If this were to happen, it would be more difficult to purchase or sell our common stock or obtain accurate quotations as to the price of the securities, and the price of our common stock could suffer a material decline. In addition, any such delisting could have a materially adverse affect our access to the capital markets, and the limited liquidity of our common stock could materially adversely affect our ability to raise capital through alternative financing sources on terms acceptable to us or at all.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We have exposure to changes in interest rates in our cash, which are held primarily in money market accounts which earn interest at variable rates. We do not use derivative financial instruments in our investment portfolio. We place our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer. We are averse to principal loss and ensure the safety and preservation of our invested funds by limiting default, market and reinvestment risk.

We also have exposure to changes in interest rates in our line of credit with our Chairman, which bears interest at the prime rate plus one percent. See Note 2 of Notes to Condensed Consolidated Financial Statements. Our interest rate exposure is mitigated by our ability to repay amounts outstanding under the line of credit with our common stock.

Changes in interest rates do not affect interest income on our restricted cash as it is maintained in commercial paper with fixed rates and maturities of less than 90 days. Changes in interest rates do not affect interest expense on our lease obligations as they bear fixed rates of interest. Changes in interest rates do not affect our note payable as it bears fixed rate of interest.

There were no significant changes in our market risk exposures through the second quarter 2002.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Not applicable.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

On April 5, 2002, we completed a private placement of common stock and warrants for aggregate gross proceeds of approximately $15.0 million ($14.3 million, net of offering expenses). Under the terms of the financing, we sold 3,575,691 shares of newly issued common stock at $4.20 per share to accredited investors. We also issued warrants to the investors to purchase approximately 893,927 million shares of common stock at $5.67 per share, a 35% premium to the per unit purchase price. The warrants are exercisable at any time from October 5, 2002 through and including April 5, 2007. The exercise price of the warrants is subject to adjustment in the event of stock dividends, stock splits and other pro rata issuances, and price-based anti-dilution adjustment on a weighted average basis, subject to exceptions set forth in the warrants. The securities were sold to accredited investors in a private placement pursuant to Section 4(2) under the Securities Act of 1933, as amended.

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ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

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

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits —


Exhibit Number		Description

4.1		Form of Warrant, dated as of April 5, 2002.*

10.1		Securities Purchase Agreement, dated as of April 5, 2002, by and among Hyseq, Inc. and the investors party thereto.*

10.2		Registration Rights Agreement, dated as of April 5, 2002, by and among Hyseq, Inc. and the investors party thereto.*

Incorporated by reference to our Registration Statement filed on Form S-3, File No. 333-90458, filed on June 14, 2002.

Reports on Form 8-K


DATE OF FILING		SUBJECT

April 9, 2002		Form 8-K, Item 5, Hyseq announces completion of a private placement from which the company received gross proceeds of approximately $15.0 million.

May 16, 2002		Form 8-K, Item 5, Hyseq and BASF Plant Science announce agreement to accelerate the completion of their collaboration to discover and develop agriculturally based genes, and Hyseq announces an internal restructuring in order to align its workforce with the company’s focus on developing pharmaceuticals.

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SIGNATURE

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

Hyseq, Inc. (Registrant)
d/b/a Hyseq Pharmaceuticals, Inc.


	By:	/s/ Peter S. Garcia

		Peter S. Garcia Senior Vice President and Chief Financial Officer

Date: August 14, 2002

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Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	8th grade Good

Oruka Therapeutics (ORKA) 10-Q2002 Q2 Quarterly report

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