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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q
 
(Mark one)
x
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
  
 
SECURITIES EXCHANGE ACT OF 1934.
 
For the quarterly period ended September 30, 2002.
 
     OR
 
¨
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
  
 
SECURITIES EXCHANGE ACT OF 1934.
 
  
 
For the transition period from                        to                       .
 
Commission File Number: 000-31633
 
 
KOSAN BIOSCIENCES INCORPORATED
(Exact name of registrant as specified in its charter)
 
Delaware
  
94-3217016
(State or other jurisdiction of
incorporation or organization)
  
(I.R.S. Employer
Identification No.)
 
3832 Bay Center Place, Hayward, California 94545
(address of principal executive offices)
 
(510) 732-8400
(Registrant’s telephone number, including area code)
 
 
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days. Yes  x     No  ¨
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. Common Stock, $.001 par values; 25,377,310 shares outstanding at October 31, 2002.
 

Table of Contents
KOSAN BIOSCIENCES INCORPORATED
 
Form 10-Q
 
Quarter Ended September 30, 2002
 
INDEX
 
         
Page
PART I
   
FINANCIAL INFORMATION
     
           
Item 1:
   
Condensed Financial Statements and Notes (unaudited):
     
           
       
3
           
       
4
           
       
5
           
       
6
           
Item 2:
      
11
           
Item 3:
      
24
           
Item 4:
      
24
           
PART II
   
OTHER INFORMATION
     
           
Item 1:
      
25
           
Item 2:
      
25
           
Item 3:
      
25
           
Item 4:
      
25
           
Item 5:
      
25
           
Item 6:
      
25
           
  
27
           
 

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Table of Contents
 
PART I. FINANCIAL INFORMATION
 
Item 1: Condensed Financial Statements and Notes
 
KOSAN BIOSCIENCES INCORPORATED
 
CONDENSED BALANCE SHEETS
(in thousands)
 
    
September 30,
2002
     
December 31,
2001
  
    
(unaudited)
     
(1)
  
Assets
                  
Current assets:
                  
Cash and cash equivalents
   
$
23,371
 
   
$
18,561
 
Short-term investments
   
 
39,801
 
   
 
58,880
 
Prepaid expenses and other current assets
   
 
973
 
   
 
617
 
    
  
Total current assets
   
 
64,145
 
   
 
78,058
 
Property and equipment, net
   
 
4,864
 
   
 
3,567
 
Long-term investments
   
 
12,090
 
   
 
12,902
 
Notes receivable from related parties
   
 
549
 
   
 
1,041
 
Other assets
   
 
272
 
   
 
244
 
    
  
Total assets
   
$
81,920
 
   
$
95,812
 
    
  
 
Liabilities and Stockholders’ Equity
                  
Current liabilities:
                  
Accounts payable
   
$
1,692
 
   
$
1,439
 
Accrued liabilities
   
 
3,475
 
   
 
1,828
 
Deferred revenue
   
 
—  
 
   
 
999
 
Current portion of capital lease obligation and equipment loans
   
 
1,814
 
   
 
1,387
 
    
  
Total current liabilities
   
 
6,981
 
   
 
5,653
 
Equipment loans, less current portion
   
 
1,914
 
   
 
1,568
 
Stockholders’ equity:
                  
Common stock
   
 
25
 
   
 
25
 
Additional paid-in capital
   
 
142,314
 
   
 
141,863
 
Notes receivable from stockholders
   
 
(1,463
)
   
 
(1,541
)
Deferred stock-based compensation
   
 
(1,692
)
   
 
(4,430
)
Accumulated other comprehensive gain
   
 
74
 
   
 
1,216
 
Accumulated deficit
   
 
(66,233
)
   
 
(48,542
)
    
  
Total stockholders’ equity
   
 
73,025
 
   
 
88,591
 
    
  
Total liabilities and stockholders’ equity
   
$
81,920
 
   
$
95,812
 
    
  
 
(1)
 
The balance sheet data at December 31, 2001 has been derived from the audited financial statements at that date.
 
See accompanying notes.

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KOSAN BIOSCIENCES INCORPORATED
 
CONDENSED STATEMENTS OF OPERATIONS
(unaudited)
(in thousands, except per share data)
 
    
Three Months Ended
September 30,
     
Nine Months Ended
September 30,
  
    
2002
     
2001
     
2002
     
2001
  
Revenues:
                                    
Contract revenue
   
$
563
 
   
$
717
 
   
$
2,413
 
   
$
2,443
 
Grant revenue
   
 
320
 
   
 
783
 
   
 
1,647
 
   
 
1,264
 
    
  
  
  
Total revenues
   
 
883
 
   
 
1,500
 
   
 
4,060
 
   
 
3,707
 
Operating expenses:
                                    
Research and development (including charges for stock—based compensation of $605 and $1,279 in the three months ended September 30, 2002 and 2001, respectively, and $2,239 and $4,110 in the nine months ended September 30, 2002 and 2001, respectively)
   
 
7,320
 
   
 
6,478
 
   
 
20,426
 
   
 
18,784
 
General and administrative (including charges for stock—based compensation of $168 and $316 in the three months ended September 30, 2002 and 2001, respectively, and $495 and $967 in the nine months ended September 30, 2002 and 2001, respectively)
   
 
1,308
 
   
 
1,286
 
   
 
3,810
 
   
 
3,848
 
    
  
  
  
Total operating expenses
   
 
8,628
 
   
 
7,764
 
   
 
24,236
 
   
 
22,632
 
    
  
  
  
Loss from operations
   
 
(7,745
)
   
 
(6,264
)
   
 
(20,176
)
   
 
(18,925
)
Other income, net
   
 
379
 
   
 
1,118
 
   
 
2,486
 
   
 
2,861
 
    
  
  
  
Net loss
   
$
(7,366
)
   
$
(5,146
)
   
$
(17,690
)
   
$
(16,064
)
    
  
  
  
Basic and diluted net loss per common share
   
$
(0.29
)
   
$
(0.21
)
   
$
(0.71
)
   
$
(0.67
)
    
  
  
  
Shares used in computing basic and diluted net loss per common share
   
 
24,998
 
   
 
24,243
 
   
 
24,827
 
   
 
24,051
 
 
See accompanying notes.
 

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KOSAN BIOSCIENCES INCORPORATED
 
CONDENSED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
 
    
Nine Months Ended
September 30,
  
    
2002
     
2001
  
Operating activities
                  
Net loss
   
$
(17,690
)
   
$
(16,064
)
Adjustment to reconcile net loss to net cash used in operating activities:
                  
Depreciation and amortization
   
 
1,257
 
   
 
912
 
Amortization of investment premiums and discounts, net
   
 
335
 
   
 
(867
)
Amortization of stock-based compensation
   
 
1,610
 
   
 
4,642
 
Other stock-based compensation
   
 
1,124
 
   
 
435
 
Realized (gain)/ loss on investment
   
 
(990
)
   
 
990
 
Changes in assets and liabilities:
                  
Prepaid expenses and other current assets
   
 
(356
)
   
 
(590
)
Other assets and notes receivable from related parties
   
 
464
 
   
 
(149
)
Accounts payable and accrued liabilities
   
 
1,900
 
   
 
367
 
Deferred revenue
   
 
(999
)
   
 
98
 
    
  
Net cash used in operating activities
   
 
(13,345
)
   
 
(10,226
)
    
  
Investing activities
                  
Acquisition of property and equipment
   
 
(2,554
)
   
 
(1,372
)
Purchase of investments
   
 
(46,943
)
   
 
(77,525
)
Proceeds from maturity of investments
   
 
66,347
 
   
 
75,203
 
    
  
Net cash provided by (used in) investing activities
   
 
16,850
 
   
 
(3,694
)
    
  
Financing activities
                  
Proceeds from issuance of common stock, net of repurchases
   
 
519
 
   
 
404
 
Proceeds from the repayment of notes receivable from stockholders
   
 
13
 
   
 
336
 
Proceeds from equipment loans
   
 
1,947
 
   
 
1,092
 
Principal payments under capital lease obligation and equipment loans
   
 
(1,174
)
   
 
(833
)
    
  
Net cash provided by financing activities
   
 
1,305
 
   
 
999
 
    
  
Net increase (decrease) in cash and cash equivalents
   
 
4,810
 
   
 
(12,921
)
Cash and cash equivalents at beginning of period
   
 
18,561
 
   
 
36,425
 
    
  
Cash and cash equivalents at end of period
   
$
23,371
 
   
$
23,504
 
    
  
 
See accompanying notes.

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Table of Contents
 
KOSAN BIOSCIENCES INCORPORATED
 
NOTES TO CONDENSED FINANCIAL STATEMENTS
(unaudited)
 
1. Organization and Summary of Significant Accounting Policies
 
Overview
 
Kosan Biosciences Incorporated (“Kosan” or the “Company”) was incorporated under the laws of the State of California on January 6, 1995 and commenced operations in 1996. In July 2000, the Company was reincorporated under the laws of the state of Delaware. Kosan has proprietary gene-engineering technologies for the manipulation and production of polyketides, a rich source of pharmaceutical products.
 
The Company has funded its operations primarily through sales of common stock, convertible preferred stock, contract payments under its collaboration agreements, equipment financing arrangements and government grant awards. Prior to achieving profitable operations, the Company intends to fund operations through the additional sale of equity securities, strategic collaborations, government grant awards and debt financing.
 
Basis of Presentation
 
The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. The information as of September 30, 2002, and for the three and nine months ended September 30, 2002 and 2001, reflects all adjustments (including normal recurring adjustments) that the management of the Company believes are necessary for a fair presentation of the results for the periods presented. Results for any interim period are not necessarily indicative of results for any future interim period or for the entire year. The accompanying condensed financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.
 
Use of Estimates
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates.
 
Cash Equivalents and Investments
 
The Company considers all highly liquid investments with a maturity from date of purchase of three months or less to be cash equivalents. The Company limits its concentration of risk by diversifying its investments among a variety of issuers. All investment securities are classified as available-for-sale and are recorded at fair value based on quoted market prices, with unrealized gains and losses excluded from earnings and reported in other comprehensive income/(loss). Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Realized gains and losses and declines in the fair value that are deemed to be other than temporary are reflected in earnings. The cost of securities sold is based on the specific identification method.
 
The Company holds restricted investments consisting of a certificate of deposit. This investment is carried at fair value and is restricted as to withdrawal under a letter of credit agreement related to a facility lease (see Note 7). These investments are held in the Company’s name and are included in long-term investments on the Company’s financial statements.

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Table of Contents
 
KOSAN BIOSCIENCES INCORPORATED
 
NOTES TO CONDENSED FINANCIAL STATEMENTS
(unaudited)
 
1. Organization and Summary of Significant Accounting Policies (Continued)
 
Revenue Recognition
 
The Company recognizes license and other up-front fees pursuant to research and development collaboration agreements over the estimated research and development term of the respective agreement. Payments related to substantive performance milestones that are at risk at the initiation of an agreement are recognized upon successful completion of a performance milestone event. Contract revenues related to collaborative research and development efforts are recognized as revenue on a ratable basis as the related services are performed. Such payments generally are made based on the number of full-time equivalent researchers assigned to the collaboration project. Revenues related to government grant awards are recognized at the time a grant is awarded and the related research expenses are incurred. Any amounts received in advance of performance are recorded as deferred revenue until earned.
 
Research and Development
 
Research and development expenses consist of costs incurred for Company-sponsored and collaborative research and development activities. These costs consist primarily of salaries and other personnel-related expenses, stock-based compensation, facility-related expenses, depreciation of facilities and equipment, lab consumables and fees paid to outside service providers that conduct certain research activities on behalf of the Company. Research and development expenses under government grant awards and collaborative agreements approximated the revenue recognized, excluding milestone payments received under such arrangements.
 
Net Loss per Share
 
Basic and diluted net loss per common share has been computed using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase. Diluted net loss is not presented separately as the Company is in a net loss position and including potentially dilutive securities in the loss per share computation would be antidilutive.
 
The following table presents the calculation of basic, diluted and pro forma basic and diluted net loss per share (in thousands, except per share data):
 
    
Three Months Ended
September 30,
     
Nine Months Ended
September 30,
  
    
2002
     
2001
     
2002
     
2001
  
Net loss
   
$
(7,366
)
   
$
(5,146
)
   
$
(17,690
)
   
$
(16,064
)
    
  
  
  
Weighted-average shares of common stock outstanding
   
 
25,319
 
   
 
25,192
 
   
 
25,285
 
   
 
25,180
 
Less: weighted-average shares subject to repurchase
   
 
(321
)
   
 
(949
)
   
 
(458
)
   
 
(1,129
)
    
  
  
  
Weighted-average shares used in computing basic and diluted net loss per common share
   
 
24,998
 
   
 
24,243
 
   
 
24,827
 
   
 
24,051
 
    
  
  
  
Basic and diluted net loss per common share
   
$
(0.29
)
   
$
(0.21
)
   
$
(0.71
)
   
$
(0.67
)
    
  
  
  
 

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Table of Contents
KOSAN BIOSCIENCES INCORPORATED
 
NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
(unaudited)
 
1.    Organization and Summary of Significant Accounting Policies (Continued)
 
Stock-Based Compensation
 
The Company accounts for common stock options granted to employees using the intrinsic value method and, thus, recognizes compensation expense for options granted with exercise prices less than the fair value of the Company’s common stock on the date of the grant. Deferred stock compensation calculated for options granted with exercise prices less than the deemed fair value of the common stock is amortized over the vesting period of the individual options, generally four years, using the graded vesting method.
 
Stock-based compensation expense for options granted to non-employees has been determined in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” and Emerging Issues Task Force (“EITF”) Consensus No. 96-18 as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. The measurement of stock-based compensation to non-employees is subject to periodic adjustment as the underlying securities vest. As such, changes to these measurements could be substantial should the Company experience significant changes in its stock price.
 
Reclassification
 
Certain reclassifications of the prior year’s balances have been made to conform to the current year presentation. These reclassifications had no effect on the prior year’s net loss or stockholders’ equity.
 
2.    Collaborative Research and Development and License Agreements
 
Johnson & Johnson Pharmaceutical Research and Development, LLC
 
In September 1998, the Company signed a collaborative agreement with The R.W. Johnson Pharmaceutical Research Institute, LLC and Ortho-McNeil Pharmaceutical, Inc., both Johnson & Johnson companies. In September 2001, the collaborative agreement was amended to provide that the research program and funding will be extended until at least December 28, 2002. Effective January 2002, the rights and obligations under the agreement were assigned to Johnson & Johnson Pharmaceutical Research and Development, LLC, a subsidiary of Ortho-McNeil Pharmaceutical, Inc. In February 2001, the Company received, and recognized in full, a $250,000 milestone in connection with this agreement.
 
License Agreements
 
The Company has collaborative and license agreements with several academic and medical institutions. For the nine months ended September 30, 2002 and 2001, the Company made payments under these agreements of approximately $533,000 and $371,000, respectively.
 
3.    Realized Gain on Investment
 
At June 30, 2001, the Company determined that an other-than-temporary decline in fair value of its investment in short-term commercial paper of Southern California Edison, or SoCalEd, a utility company, had occurred. At the time of purchase, the security was a high investment-grade security, but was subsequently downgraded due to the financial uncertainty that resulted from the California energy crisis.

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Table of Contents
KOSAN BIOSCIENCES INCORPORATED
 
NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
(unaudited)
 
3.    Realized Gain on Investment (Continued)
 
The security matured on April 18, 2001, and SoCalEd defaulted on payment. The amortized cost of the security was $3.0 million, and the security was valued at approximately 67% of cost at June 30, 2001. Accordingly, the Company recorded a $990,000 loss on the related write-down in the carrying value of the investment. In March 2002, the security was fully repaid. Thus, the Company recorded a realized gain on the investment of $990,000 in the quarter ended March 31, 2002.
 
4.    Comprehensive Loss
 
For the three and nine months ended September 30, 2002 and 2001, comprehensive loss was as follows (in thousands):
 
    
Three Months Ended
September 30,
     
Nine Months Ended
September 30,
  
    
2002
     
2001
     
2002
     
2001
  
Net loss
   
$
(7,366
)
   
$
(5,146
)
   
$
(17,690
)
   
$
(16,064
)
Unrealized gain/(loss) on
                                    
    available-for-sale securities
   
 
(83
)
   
 
671
 
   
 
(152
)
   
 
449
 
Reclassification of realized (gain)/loss
                                    
    on available-for-sale securities
   
 
—  
 
   
 
—  
 
   
 
(990
)
   
 
990
 
    
  
  
  
Comprehensive loss
   
$
(7,449
)
   
$
(4,475
)
   
$
(18,832
)
   
$
(14,625
)
    
  
  
  
 
5.    Equipment Financing
 
The Company finances certain equipment and facility improvements under debt obligations. In April 2002, the Company entered into a $3.0 million equipment line of credit agreement. As of September 30, 2002, the Company had utilized approximately $1.9 million of the line of credit.
 
The terms of the loan obligations range from 42 to 49 months. Some of the loans have a balloon payment at the end of the term. The interest rates of each of the loans are fixed at the time of the draw down, with the interest rates ranging from 7.19% to 13.86%. Obligations under the loans are secured by the assets financed under the loans.
 
6.    Accrued Liabilities
 
Accrued liabilities consisted of the following (in thousands):
 
      
September 30, 2002
   
December 31, 2001
Facilities-related
     
$
447
   
$
349
Compensation-related
     
 
993
   
 
827
Professional services
     
 
765
   
 
289
Research & development-related
     
 
837
   
 
60
Other
     
 
433
   
 
303
      
  
      
$
3,475
   
$
1,828
      
  
 

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KOSAN BIOSCIENCES INCORPORATED
 
NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
(unaudited)
 
7.    Facility Leases
 
In June 2002, the Company expanded its facilities by entering into an assignment of a non-cancelable operating lease, which commenced in June 2002 and expires in March 2008, with an option to renew. The Company also extended the terms of its existing facility lease to August 2013, with an option to renew. Minimum annual rental commitments at September 30, 2002 were as follows (in thousands):
 
        
Year ended December 31,
       
2002
   
$
449
2003
   
 
1,708
2004
   
 
1,588
2005
   
 
1,609
2006
   
 
1,624
Thereafter
   
 
7,635
    
Total minimum payments
   
$
14,613
    
 
In June 2002, the Company obtained a stand-by letter of credit for approximately $903,000 from a commercial bank as security for the Company’s obligation under one of its facility leases. The letter of credit is secured by a certificate of deposit in the amount of $904,000 held in an investment account that the Company must maintain for the term of the lease. The investment account is classified within long-term investments on the balance sheet.
 
8.    Subsequent Event
 
In October 2002, the Company closed its research and development collaboration agreement with Hoffman-La Roche, Inc. and F. Hoffman-La Roche Ltd., collectively Roche. Under the terms of the agreement, Roche will have the worldwide exclusive rights to market and sell KOS-862 (Epo D) and the Company will co-develop and have the right to co-promote the product in the United States. The Company may receive payments for the reimbursement of research and development expenditures, funding of a back-up program, achievement of clinical, regulatory and commercial milestones, development activities, and royalties on sales, subject to potential offsets and credits. Subsequent to September 30, 2002, the Company received payments of $12.5 million related to the agreement.

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Item 2:    Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Forward-Looking Statements
 
The following discussion of our financial condition and results of operations contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as may, will, should, expect, plan, anticipate, believe, estimate, predict, potential or continue, the negative of terms like these or other comparable terminology. Actual events or results may differ materially from those anticipated in these forward-looking statements. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. In evaluating these statements, you should specifically consider various factors, including the risks outlined under the caption “Factors That May Affect Results of Operations and Financial Condition” set forth at the end of this Item 2, the Risk Factors set forth in our Annual Report on Form 10-K filed with the SEC and those contained from time to time in our other filings with the SEC. We caution investors that our business and financial performance are subject to substantial risks and uncertainties.
 
Overview
 
We have proprietary gene-engineering technologies for the manipulation and production of polyketides, a rich source of pharmaceutical products. We use our platform technologies to develop product candidates that target large pharmaceutical markets. In collaboration with Hoffman-La Roche, Inc. and F. Hoffman-La Roche Ltd., we are testing KOS-862 (Epothilone D), a potential anti-cancer agent, in Phase I human clinical trials. In infectious disease, we have a collaboration with Johnson & Johnson Pharmaceutical Research and Development, LLC, focusing on the development of a next generation antibiotic. We have additional product development and research programs.
 
We have incurred significant losses since our inception. As of September 30, 2002, our accumulated deficit was approximately $66.2 million. We expect to incur additional operating losses over the next several years as we continue to develop our technologies and fund internal product research and development.
 
Critical Accounting Policies
 
Revenue Recognition
 
We recognize license and other up-front fees pursuant to research and development collaboration agreements over the estimated research term of each respective agreement. If an agreement does not have a specified term, we must apply judgment in determining the appropriate timing of revenue recognition. Milestone payments are recognized upon successful completion of a performance milestone event. We apply judgment as to the timing of recognizing milestone payments and whether such payments represent the culmination of a separate earnings process. Contract revenues related to collaborative research and development agreements are recognized on a ratable basis as services are performed. Revenues related to government grant awards are recognized after a grant is awarded as the related research expenses are incurred. Any amounts received in advance of performance are recorded as deferred revenue until earned.
 
Stock-Based Compensation
 
We account for common stock options granted to employees using the intrinsic value method and, thus, recognize compensation expense for options granted with exercise prices less than the fair value of our common stock on the date of the grant. We recorded total deferred stock-based compensation of approximately $15.6 million in 2000 and $2.9 million in 1999, which amounts are being amortized to expense using the graded vesting method over the vesting periods of the underlying options, generally four years. We recognized stock-based compensation related to employees of approximately $1.6 million and

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$4.6 million for the nine months ended September 30, 2002 and 2001, respectively. Based on deferred stock-based compensation recorded as of September 30, 2002, we expect to record amortization of deferred stock-based compensation approximately as follows: $513,000 in the remaining three months of 2002, $973,000 in 2003 and $206,000 in 2004.
 
Stock-based compensation expense for options granted to non-employees has been determined as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. We recognized other stock-based compensation for non-employees of approximately $1.1 million and $435,000 in the nine months ended September 30, 2002 and 2001, respectively. In addition, assuming no changes, we expect to recognize other stock-based compensation in connection with stock options granted to non-employees of approximately $382,000 in the remaining three months of 2002, $526,000 in 2003, $388,000 in 2004 and $240,000 in 2005. The measurement of stock-based compensation to non-employees is subject to periodic adjustment as the underlying securities vest. As such, changes to these measurements could be substantial should we experience significant changes in our stock price. See Note 1 of our financial statements.
 
Investments
 
We invest in debt and equity securities. The price of these securities is subject to significant volatility. We record an impairment charge when we believe that an investment has experienced a decline in value that is other than temporary. Generally, we review an investment for impairment if its market value has been below its carrying value for each trading day in a six-month period. Changes in the market price of these securities may impact our profitability.
 
Results of Operations
 
Revenues
 
Our revenues were approximately $883,000 and $4.1 million for the three and nine months ended September 30, 2002, respectively, compared to approximately $1.5 million and $3.7 million, respectively, for the same periods in 2001. Grant revenue was approximately $1.6 million for the nine months ended September 30, 2002, compared to approximately $1.3 million for the same period last year. Total contract revenues under our collaboration with Johnson & Johnson Pharmaceutical Research and Development, LLC, or J&J, were approximately $1.5 million for the nine months ended September 30, 2002, compared to approximately $1.7 million for the same period in 2001. Included in 2001 contract revenue was a non-recurring $250,000 milestone payment received in connection with this collaboration. The initial term of the collaboration with J&J has been extended to December 28, 2002. If we do not maintain or further extend this agreement, our revenues will significantly decrease thereafter, unless we enter into additional collaborations. In September 2002, we entered into a collaboration agreement with Hoffman-La Roche, Inc. and F. Hoffman-La Roche Ltd., collectively Roche, in connection with the development and commercialization of our anti-cancer agent, KOS-862. Under the terms of the agreement, we will receive over $30 million in initial committed payments. For the quarter ended September 30, 2002, no revenue was recognized in connection with this collaboration. Under this collaboration agreement, revenue was recognized upon closing in October 2002.
 
Research and Development Expenses
 
Our research and development expenses consist primarily of salaries and other personnel-related expenses, fees paid to outside service providers, stock-based compensation, facility-related expenses, depreciation of facilities and equipment, and lab consumables. Research and development expenses increased to approximately $7.3 million and $20.4 million for the three and nine months ended September 30, 2002, respectively, from approximately $6.5 million and $18.8 million, respectively, for the same periods in 2001. The increase in the 2002 periods was primarily attributable to our expanded research and development efforts, including three Phase I studies of KOS-862 and continued investment in our

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internally funded programs and technologies. Additionally, the increase was partially offset by the decrease in stock-based compensation expense for the three and nine months ended September 30, 2002, compared to the same periods in 2001. We expect our research and development expenses will increase substantially to advance KOS-862 through clinical development, advance other in-house research programs into later stages of development, fund the expansion of our technology platform, support our collaborative research programs and fund the expansion and improvement of our facilities as we continue to expand our laboratory capabilities.
 
General and Administrative Expenses
 
General and administrative expenses were approximately $1.3 million and $3.8 million, respectively, for the three and nine months ended September 30, 2002, respectively, as well as for the three and nine months ended September 30, 2001, respectively. General and administrative expenses remained unchanged primarily due to lower stock-based compensation offset by higher employee-related costs to support our expanding research and development activities. We expect our general and administrative expenses will increase in the future to support the continued growth of our research and development efforts and expansion and improvement of our facilities.
 
Interest Income
 
Interest income decreased to approximately $473,000 and $1.7 million for the three and nine months ended September 30, 2002, respectively, from approximately $1.2 million and $3.1 million, respectively, for the same periods in 2001. These decreases were attributable to lower average investment balances and lower investment yields associated with declining interest rates.
 
Interest Expense
 
Interest expense increased to approximately $94,000 and $267,000 for the three and nine months ended September 2002, respectively, from approximately $88,000 and $262,000 respectively, for the same periods in 2001. These increases resulted from additional debt financing during 2002.
 
Realized Gain on Investment
 
At June 30, 2001, we determined that an other-than-temporary decline in the fair value of our investment in short-term commercial paper of Southern California Edison, or SoCalEd, a utility company, had occurred. At the time of purchase, the security was a high investment-grade security, but was subsequently downgraded due to the financial uncertainty that resulted from the California energy crisis. The security matured on April 18, 2001, and SoCalEd defaulted on payment. The amortized cost of the security was $3.0 million, and the security was valued at approximately 67% of cost at June 30, 2001. Accordingly, for the quarter ended June 30, 2001, we recorded a write-down on the carrying value of the investment of $990,000. In March 2002, the security was fully repaid. Thus, we recorded a realized gain on the investment of $990,000 in the three months ended March 31, 2002.
 
Liquidity and Capital Resources
 
We have financed our operations from inception primarily through sales of convertible preferred stock and common stock, totaling approximately $120.4 million in net proceeds, contract payments under our collaboration agreements, equipment financing arrangements and government grants. As of September 30, 2002, we had approximately $75.3 million in cash, cash equivalents and investments, compared to approximately $90.3 million as of December 31, 2001. Our funds are currently invested in U.S. Treasury and government agency obligations and corporate obligations.
 
Our operating activities used cash of approximately $13.3 million for the nine months ended September 30, 2002, compared to approximately $10.2 million for the same period in 2001. Our net loss of approximately $17.7 million for the nine months ended September 30, 2002 included a $990,000 non-cash realized gain on a previously written-down investment, and was partially offset by non-cash expenses of $4.3 million related to stock-based compensation, depreciation and amortization of investment

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premiums and discounts. Cash used for the same period in 2001 was used primarily to fund our net operating loss of approximately $16.1 million, which included a $990,000 non-cash write-down of an investment, partially offset by non-cash expenses of approximately $5.1 million related to stock-based compensation, depreciation and amortization of investment premiums and discounts.
 
Our investing activities, excluding changes in our investments, for the nine months ended September 30, 2002 used cash of approximately $2.6 million, compared to approximately $1.4 million for the same period in 2001, reflecting capital expenditures related to the expansion and improvement of our facilities as we continued to expand our laboratory capabilities.
 
Cash provided by financing activities was approximately $1.3 million for the nine months ended September 30, 2002, compared to cash provided by financing activities of approximately $999,000 for the same period in 2001. Financing activities for 2002 included approximately $1.9 million in proceeds from equipment loans, partially offset by normal payments on existing debt.
 
In April 2002, we entered into a $3.0 million equipment line of credit agreement for facility improvements and capital purchases. As of September 30, 2002, we had utilized approximately $1.9 million of the line of credit. See Note 5 to our financial statements.
 
We believe our existing cash and investments and anticipated cash flow from existing collaborations will be sufficient to support our current operating plan through at least 2004. Our future capital uses and requirements depend on numerous forward-looking factors. These factors include, but are not limited to, the following:
 
 
•
 
our ability to establish, and the scope of revenues received under, any new collaborations;
 
 
•
 
the progress and number of research programs carried out by us;
 
 
•
 
the progress and success of preclinical testing and clinical trials of our drug candidates;
 
 
•
 
our ability to maintain or extend our existing collaborations with Johnson & Johnson Pharmaceutical Research and Development, LLC, and Hoffman-La Roche, Inc. and F. Hoffman-La Roche Ltd.;
 
 
•
 
the costs and timing of obtaining, enforcing and defending our patent and intellectual rights;
 
 
•
 
the costs and timing of our facilities expansion;
 
 
•
 
the costs and timing of regulatory approvals; and
 
 
•
 
expenses associated with unforeseen litigation.
 
In addition, we review from time to time potential opportunities to expand our technologies or add to our portfolio of drug candidates. In the future, we may need further capital in order to acquire or invest in technologies, products or businesses.
 
We expect that additional financing will be required in the future to fund operations. We expect to finance future cash needs through the sale of equity securities, strategic collaborations, government grant awards and debt financing. We cannot assure you that additional financing or collaboration and licensing arrangements will be available when needed or that, if available, will be on terms favorable to us or our stockholders. Insufficient funds may require us to delay, scale back or eliminate some or all of our research or development programs, to lose rights under existing licenses or to relinquish greater or all rights to product candidates at an earlier stage of development or on less favorable terms than we would otherwise choose or may adversely affect our ability to operate as a going concern. If additional funds are obtained by issuing equity securities, substantial dilution to existing stockholders may result. In addition, see “Factors That May Affect Results of Operations and Financial Condition”.

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Factors That May Affect Results of Operations and Financial Condition
 
You should carefully consider the risks described below, together with all of the other information included in this report, in considering our business and prospects. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. The occurrence of any of the following risks could harm our business, financial condition or results of operations.
 
We have a history of net losses and may never become profitable.
 
We commenced operations in 1996 and are still in an early stage of development. We have not commercialized any products, and we have incurred significant losses to date. As of September 30, 2002, we had an accumulated deficit of approximately $66.2 million. To date, our revenues have been solely from collaborations and government grants. Our expenses have consisted principally of costs incurred in research and development and from general and administrative costs associated with our operations. We have incurred net losses since our inception, including a net loss of approximately $17.7 million for the nine months ended September 30, 2002. We expect our expenses to increase and to continue to incur operating losses for at least the next several years as we continue our research and development efforts for our drug candidates. The amount of time necessary to commercialize any of our drug candidates successfully is long and uncertain, and successful commercialization may not occur at all. As a result, we may never become profitable.
 
If our current corporate collaborations or license agreements are unsuccessful or if conflicts develop with these relationships, our research and development efforts could be delayed.
 
Our collaboration with Johnson & Johnson Pharmaceutical Research and Development, LLC, is scheduled to expire on December 28, 2002. Effective September 2002, we entered into a collaboration with Hoffman-La Roche, Inc. and F. Hoffman-La Roche Ltd., collectively, Roche, that was closed October 2002. We may not be able to maintain or extend these collaborations on acceptable terms, if at all. If we do not maintain or extend these collaborations, our research and development efforts could be delayed.
 
We do not control the amount and timing of resources that our corporate collaborators devote to our programs or potential products. As a result, we do not know if our corporate collaborators will dedicate sufficient resources or if the development or commercialization efforts by our corporate collaborators will be successful. We also do not know whether our current collaborative partners or future collaborative partners, if any, might pursue alternative technologies or develop alternative products either on their own or in collaboration with others, including our competitors, as a means for developing treatments for the diseases targeted by collaborative arrangements with us. In addition, if business combinations involving our existing corporate collaborators were to occur, the effect could diminish, terminate or cause delays in our corporate collaborations. Should our collaborative partners fail to develop or commercialize compounds or products for which they have rights from us, we may not receive any future milestone payments and will not receive any royalties associated with such compounds or products. Conflicts might also arise with collaborative partners or licensors concerning proprietary rights to particular compounds. If our corporate collaborators were to breach or terminate their agreements with us or otherwise fail to conduct the collaborative activities successfully and in a timely manner, the preclinical or clinical development or commercialization of the affected product candidates or research program could be delayed or terminated.
 
We are also a party to various license agreements that give us rights to use specified technologies in our research and development processes or to product candidates. The agreements, pursuant to which we

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have in-licensed technology, permit our licensors to terminate the agreement under certain circumstances. If we are not able to continue to license these future technologies on commercially reasonable terms, our product development and research may be delayed.
 
If we fail to enter into new collaborative agreements in the future, our business and operations would be negatively impacted.
 
Our strategy depends upon the formation and sustainability of multiple collaborative arrangements and license agreements with third parties in the future. We expect to rely on these arrangements for not only financial resources, but also for expertise that we expect to need in the future relating to clinical trials, manufacturing, sales and marketing, and for license and technology rights. Although we have established collaborative arrangements and various license agreements, we do not know if we will be able to establish additional arrangements on favorable terms, or whether current or any future collaborative arrangements will ultimately be successful. There have been, and may continue to be, a significant number of recent business combinations among large pharmaceutical companies that have resulted, and may continue to result, in a reduced number of potential future corporate collaborators, which may limit our ability to find partners who will work with us in developing and commercializing our drug candidates. If we do not enter into new collaborative agreements, then our revenues will be reduced, and our drug candidates may not be developed, manufactured or marketed.
 
Our potential products are in an early stage of development, and substantial additional effort will be necessary for development.
 
Our technologies are new, and our drug candidates are in early stages of research and development. We may not develop products that prove to be safe and effective, meet applicable regulatory standards, are capable of being manufactured at reasonable costs or can be marketed successfully. All of the potential products that we are currently developing will require significant development and investment, including extensive preclinical and clinical testing, before we can submit any application for regulatory approval.
 
Our products must satisfy rigorous standards of safety and efficacy before they can be approved by the U.S. Food and Drug Administration and international regulatory authorities for commercial use. We will need to conduct significant additional research, preclinical testing and clinical trials, before we can file applications with the FDA for product approval. Clinical trials are expensive and have a high risk of failure. In addition, to compete effectively, our products must be easy to use, cost-effective and economical to manufacture on a commercial scale. We may not achieve any of these objectives. Any of our products may not attain market acceptance. Typically, there is a high rate of attrition for products in preclinical testing and clinical trials. Also, third parties may develop superior products or have proprietary rights that preclude us from marketing our products. If research and testing is not successful or we fail to obtain regulatory approval, we will be unable to market and sell our future product candidates.
 
The progress and results of our animal and human testing are uncertain.
 
We must provide the FDA and foreign regulatory authorities with clinical data that demonstrates the safety and efficacy of our products before they can be approved for commercial sale. As a result, commercialization of our product candidates depends upon successful completion of clinical trials. Preclinical testing and clinical development are long, expensive and uncertain processes. It may take us several years to complete our testing, and failure can occur at any stage of testing. Success in preclinical testing and early clinical trials does not ensure that later clinical trials will be successful, and interim results of trials do not necessarily predict final results. A number of companies in the pharmaceutical industry, including biotechnology companies, have suffered significant setbacks in advanced clinical trials, even after promising results in earlier trials. None of the product candidates that we have internally

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developed or licensed have advanced beyond the stage of human testing designed to determine safety, known as Phase I clinical trials.
 
We do not know whether planned clinical trials will begin on time or whether any of our clinical trials will be completed on schedule, or at all. Negative or inconclusive results or adverse medical events during a clinical trial could cause a clinical trial to be repeated or a program to be terminated. In October 2001, we initiated clinical trials of KOS-862, which is directed to the treatment of cancer. Anti-cancer drugs generally have a narrow therapeutic window between efficacy and toxicity. If unacceptable toxicity is observed in clinical trials, the trials may be terminated at an early stage. Drug-related deaths may occur in clinical trials with anti-cancer drugs, because drugs for the treatment of cancer are typically dangerous and many cancer patients are critically ill.
 
Completion of clinical trials may take several years or more. The length of time generally varies substantially according to the type, complexity, novelty and intended use of the drug candidate. Our clinical trials may be suspended at any time if we or the FDA believe the patients participating in our studies are exposed to unacceptable health risks. Our commencement and rate of completion of clinical trials may be delayed by many factors, including:
 
 
•
 
ineffectiveness or toxicity of the study compound, or perceptions by physicians that the compound is not safe or effective for a particular indication;
 
•
 
inability to manufacture sufficient quantities of compound for use in clinical trials;
 
•
 
failure of the FDA to approve our clinical trial protocols;
 
•
 
slower than expected rate of patient recruitment;
 
•
 
the death of patients during a clinical trial;
 
•
 
inconclusive or negative results experienced during the clinical trial;
 
•
 
third-party clinical investigators may not perform our clinical trials on our anticipated schedule or consistent with a clinical trial protocol, and other third-party organizations may not perform data collection and analysis in a timely or accurate manner; and
 
•
 
government or regulatory delays.
 
Any clinical trial may fail to produce results satisfactory to the FDA. Preclinical and clinical data can be interpreted in different ways, which could delay, limit or prevent regulatory approval.
 
Our product development costs will increase if we have delays in testing or approvals or if we need to perform more or larger clinical trials than planned. If the delays are significant, our financial results and the commercial prospects for our products will be harmed, and our ability to become profitable will be delayed.
 
We do not know whether our existing or any future clinical trials will demonstrate safety and efficacy sufficient to obtain the requisite regulatory approvals or will result in marketable products. Our failure to adequately demonstrate the safety and efficacy of our products under development will prevent receipt of FDA approval and, ultimately, commercialization of our products. If any current or future clinical trials are not successful, our business, financial condition and results of operations will be harmed.
 
Any inability to protect our proprietary technologies adequately could harm our ability to successfully commercialize product candidates.
 
Our commercial success will depend in part on our ability to obtain patents and maintain adequate protection of other intellectual property for our technologies and products in the United States and other countries. If we do not adequately protect our intellectual property, competitors may be able to use our

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technologies and erode or negate any competitive advantage we may have. The laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States, and we may encounter significant problems in protecting our proprietary rights in these countries.
 
The patent positions of biotechnology companies, including our patent position, involve complex legal and factual questions, and, therefore, validity and enforceability cannot be predicted with certainty. Patents may be challenged, deemed unenforceable, invalidated or circumvented. We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary technologies are covered by valid and enforceable patents or are effectively maintained as trade secrets.
 
The degree of future protection for our proprietary rights is uncertain, and we cannot ensure that:
 
 
•
 
we were the first to make the inventions covered by each of our pending patent applications;
 
•
 
we were the first to file patent applications for these inventions;
 
•
 
others will not independently develop similar or alternative technologies or duplicate any of our technologies;
 
•
 
any of our pending patent applications will result in issued patents;
 
•
 
any patents issued to us or our licensors will provide a basis for commercially viable products or will provide us with any competitive advantages or will not be challenged by third parties;
 
•
 
we will develop additional proprietary technologies that are patentable; or
 
•
 
the patents of others will not have an adverse effect on our business.
 
We apply for patents covering both our technologies and drug candidates as we deem appropriate. However, we may fail to apply for patents on important technologies or products in a timely fashion or at all. Our existing patents and any future patents we obtain may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products. In addition, we generally do not control the patent prosecution of technology that we license from others. Accordingly, we are unable to exercise the same degree of control over this intellectual property as we would over our own.
 
We rely upon trade secret protection for our confidential information. We have taken measures to protect our confidential information. However, these measures may not provide adequate protection for our trade secrets. We seek to protect our confidential information by entering into confidentiality agreements with employees, collaborators and consultants. Nevertheless, we may not be able to protect adequately our trade secrets.
 
Litigation or other proceedings or third-party claims of intellectual property infringement would require us to spend time and money and could prevent us from developing or commercializing products.
 
Our commercial success depends in part on not infringing the patents and proprietary rights of other parties and not breaching any licenses that we have entered into with regard to our technologies and products. Others have filed patent applications and issued patents, and in the future are likely to continue to file patent applications and issue patents, claiming drug candidates that we are developing and genes, gene fragments, compounds and technologies we use or may wish to use. If we wish to use the claimed technology in issued and unexpired patents owned by others, we may need to obtain a license from another party, enter into litigation or incur the risk of litigation.
 
The biotechnology industry is characterized by extensive litigation regarding patents and other intellectual property rights. We are aware of patents and published patent applications that, if valid, and if we are unsuccessful in circumventing or acquiring the rights to these patents, may block our ability to

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commercialize products based on the drug candidates that we are developing. We cannot be sure that other parties have not filed for or been issued relevant patents that could affect our ability to obtain patents or to operate as we would like. Others may sue us in the future to challenge our patent rights or claim infringement of their patents. An adverse determination in litigation or in an administrative proceeding to which we may become a party could subject us to significant liabilities to others, require us to license disputed rights from others or require us to cease using the disputed technology.
 
We are aware of a significant number of patents and patent applications relating to aspects of our technologies and compounds filed by, and issued to, other parties. Others have filed patent applications or have been granted patents claiming inventions also claimed by us, and we may have to participate in an interference proceeding declared by the relevant patent agency or court to determine priority of invention and, thus, the right to a patent for these inventions in the United States. For example, we believe one or more interferences may be declared between patents and applications we own or have exclusively licensed and patents and applications owned by Novartis relating to epothilone biosynthetic genes and Epothilone D, one or more patent applications owned by Gesellschaft für Biotechnologische Forschung mbH relating to Epothilone D and patents and applications owned by Abbott Laboratories and Biotica Ltd. relating to erythromycin polyketide synthase genes, methods for altering polyketide synthase genes and erythromycin analogs and derivatives. Such a proceeding, or a lawsuit in which we are alleged to have infringed an issued patent, could result in substantial cost to us even if the outcome is favorable, and if the outcome is unfavorable, we could be required to license the other party’s rights, at terms that may be unfavorable to us, or cease using the technology. Even if successful on priority grounds, an interference may result in loss of claims based on patentability grounds raised in the interference. Although patent and intellectual property disputes in the biotechnology area are often settled through licensing or similar arrangements, costs associated with these arrangements may be substantial and could include ongoing royalties. Furthermore, we cannot be certain that a license would be available to us on satisfactory terms, if at all.
 
Other parties may obtain patents in the future and claim that the use of our technologies infringes these patents or that we are employing their proprietary technology without authorization. We could incur substantial costs and diversion of management and technical personnel in defending ourselves against any of these claims or enforcing our patents against others. Furthermore, parties making claims against us may be able to obtain injunctive or other equitable relief that could effectively block our ability to develop, commercialize and sell products, and could result in the award of substantial damages against us. In the event of a successful claim of infringement against us, we may be required to:
 
 
·
 
pay substantial damages;
 
·
 
stop using certain products and methods;
 
·
 
develop non-infringing products and methods; and
 
·
 
obtain one or more licenses from other parties.
 
We may not be able to obtain licenses from other parties at a reasonable cost, if at all. In that event, we could encounter substantial delays in product introductions while we attempt to develop alternative methods and products, which we may not be able to accomplish.
 
Litigation or failure to obtain licenses could prevent us from commercializing available products.
 
We rely on third parties to conduct our clinical trials, and those third parties may not perform satisfactorily.
 
If third parties do not successfully carry out their contractual duties or meet expected deadlines, we will not be able to obtain regulatory approvals for our product candidates and will not be able to

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successfully commercialize our product candidates for targeted diseases. We do not have the ability to independently conduct clinical trials for our product candidates, and we rely on third parties such as contract research organizations, medical institutions and clinical investigators to perform this function. If these third parties do not perform satisfactorily, our clinical trials may be extended or delayed. We may not be able to locate any necessary acceptable replacements or enter into favorable agreements with them, if at all.
 
If we are unable to manage our growth effectively through recruiting and retaining skilled employees and expand our management and facilities and improve our controls and systems, we may not be able to manage our day-to-day operations.
 
We have experienced a period of rapid and substantial growth that has placed, and if this growth continues will further place, a strain on our human and capital resources. If we are unable to manage this growth effectively, then our losses could increase. The number of our employees increased from 94 on September 30, 2001 to 109 on September 30, 2002. Retaining our current employees and recruiting qualified scientific personnel to perform future research and development work will be critical to our success. Competition is intense for experienced scientists, and we may not be able to retain or recruit sufficient skilled personnel to allow us to pursue collaborations and develop our products and core technologies to the extent otherwise possible. Additionally, we are highly dependent on the principal members of our management and scientific staff, such as our two co-founders, the loss of whose services would adversely impact the achievement of our objectives. Although we maintain and are the beneficiary of $1.0 million key-man life insurance policies for the lives of each of our two co-founders, Dr. Daniel Santi, our chief executive officer, and Dr. Chaitan Khosla, a director and consultant, we do not believe the proceeds would be adequate to compensate us for their loss.
 
Our facilities consist of approximately 118,000 square feet of research and office space located in Hayward, California, of which approximately 44,000, 69,000 and 5,000 square feet are leased to us until 2013, 2008 and 2005, respectively. We have an option to renew our lease on the 44,000 square foot facility for one additional period of five years and an option to renew our lease on the 69,000 square foot facility for two additional periods of five years.
 
Our ability to manage our operations and growth effectively requires us to continue to expend funds to expand our management and improve our controls and systems. If we are unable to implement successfully these expansions and improvements, then we may not be able to effectively manage our day-to-day operations.
 
We face intense competition from large pharmaceutical companies, biotechnology companies and academic groups.
 
We face, and will continue to face, intense competition from organizations such as large biotechnology and pharmaceutical companies, as well as academic and research institutions and government agencies, that are pursuing competing technologies and products. These organizations may develop technologies or products that are superior alternatives to ours. Further, our competitors in the polyketide gene engineering field may be more effective at implementing their technologies to develop commercial products. Some of these competitors have entered into collaborations with leading companies within our target markets to produce polyketides for commercial purposes.
 
Any products that we develop through our technologies will compete in multiple, highly competitive markets. Development of pharmaceutical products requires significant investment and resources. Many of the organizations competing with us in the markets for such products have greater capital resources, research and development and marketing staffs, facilities and capabilities, and greater experience in

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modifying DNA, obtaining regulatory approvals and product manufacturing and marketing. Accordingly, our competitors may be able to develop technologies and products more easily, which would render our technologies and products and those of our collaborators obsolete and noncompetitive.
 
If we face liability claims in clinical trials of a drug candidate, these claims will divert our management’s time and we will incur litigation costs.
 
We face an inherent business risk of clinical trial liability claims in the event that the use or misuse of our potential products results in personal injury or death. We may experience clinical trial liability claims if our drug candidates are misused or cause harm before regulatory authorities approve them for marketing. Even though we have obtained clinical trial liability insurance, it may not be sufficient to cover claims that may be made against us. Clinical trial liability insurance is expensive, difficult to obtain and may not be available in the future on acceptable terms, if at all. Any claims against us, regardless of their merit, could materially and adversely affect our financial condition, because litigation related to these claims would strain our financial resources in addition to consuming the time and attention of our management. If we are sued for any injuries caused by our products, our liability could exceed our total assets.
 
We use hazardous chemicals and radioactive and biological materials in our business. Any claims relating to improper handling, storage or disposal of these materials could be time consuming and costly.
 
Our research and development processes involve the controlled use of hazardous materials, including hazardous chemicals and radioactive and biological materials. Some of these materials may be novel, including bacteria with novel properties and bacteria that produce biologically active compounds. Our operations also produce hazardous waste products. We cannot eliminate the risk of accidental contamination or discharge and any resultant injury from these materials. Federal, state and local laws and regulations govern the use, manufacture, storage, handling and disposal of these materials. We believe that our current operations comply in all material respects with these laws and regulations. We could be subject to civil damages in the event of an improper or unauthorized release of, or exposure of individuals to, hazardous materials. In addition, we could be sued for injury or contamination that results from our use or the use by third parties or our collaborators of these materials, and our liability may exceed our total assets. Compliance with environmental laws and regulations may be expensive, and current or future environmental regulations may impair our research, development or commercialization efforts.
 
We have a stockholders rights plan and anti-takeover provisions in our corporate charter documents that may result in outcomes with which you do not agree.
 
Our board of directors has the authority to issue up to 10,000,000 shares of preferred stock and to determine the rights, preferences, privileges and restrictions of those shares without further vote or action by our stockholders. The rights of the holders of any preferred stock that may be issued in the future may adversely affect the rights of the holders of common stock. The issuance of preferred stock could make it more difficult for third parties to acquire a majority of our outstanding voting stock.
 
Our certificate of incorporation provides for staggered terms for the members of the board of directors and prevents our stockholders from acting by written consent. These provisions and other provisions of our bylaws and of Delaware law applicable to us could delay or make more difficult a merger, tender offer or proxy contest involving us. This could reduce the price that investors might be willing to pay for shares of our common stock and result in the market price being lower than it would be without these provisions.

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We have adopted a rights agreement under which stockholders have the right to purchase shares of a new series of preferred stock at an exercise price of $70.00 per one one-hundredth of a share, if a person acquires more than 20% of our common stock. The rights plan could make it more difficult for a person to acquire a majority of our outstanding voting stock. The rights plan could also reduce the price that investors might be willing to pay for shares of our common stock and result in the market price being lower than it would be without the rights plan.
 
Some of our existing stockholders can exert control over us and may not make decisions that are in the best interest of all stockholders.
 
Our officers, directors and affiliates together control approximately 38% of our outstanding common stock. As a result, these stockholders, if they act together, are able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may delay or prevent a change in control of us and might affect the market price of our common stock, even when a change may be in the best interests of all stockholders. In addition, the interests of this concentration of ownership may not always coincide with our interests or the interests of other stockholders and accordingly, they could cause us to enter into transactions or agreements which we would not otherwise consider.
 
Our stock price has been, and may continue to be, extremely volatile.
 
The trading price of our common stock has been, and is likely to continue to be, highly volatile and could be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including:
 
 
·
 
announcements of technological developments in research by us or our competitors;
 
·
 
delay or failure in initiating, conducting, completing or analyzing clinical trials or unsatisfactory design or results of these trials by us or our competitors;
 
·
 
achievement of regulatory approvals;
 
·
 
new products or services introduced or announced by us or our competitors;
 
·
 
changes in financial estimates by securities analysts;
 
·
 
announcements of departures or departures of key personnel;
 
·
 
announcements of litigation or an unfavorable outcome in litigation; and
 
·
 
sales of our common stock.
 
In addition, the stock market in general, and the Nasdaq National Market and the market for biotechnology companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class-action litigation has often been instituted against that company. If this type of litigation were instituted against us, we would be faced with substantial costs and management’s attention and resources would be diverted, which could in turn seriously harm our business, financial condition and results of operations.
 
We expect that our quarterly results of operations will fluctuate, and this fluctuation could cause our stock price to decline, creating investor losses.

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Our quarterly operating results have fluctuated in the past and are likely to do so in the future. These fluctuations could cause our stock price to fluctuate significantly or decline. Some of the factors that could cause our operating results to fluctuate include:
 
 
·
 
expiration or termination of research contracts with collaborators or government research grants, which may not be renewed or replaced;
 
·
 
the success rate of our discovery efforts leading to milestones and royalties;
 
·
 
the timing and willingness of collaborators to commercialize our products; and
 
·
 
general and industry specific economic conditions, which may affect our collaborators’ research and development expenditures.
 
A large portion of our expenses is relatively fixed, including expenses for facilities, equipment and personnel. Accordingly, if revenues decline or do not grow due to expiration or termination of research contracts or government research grants, failure to obtain new contracts or other factors, we may not be able to reduce our operating expenses correspondingly. In addition, we expect operating expenses to continue to increase. Failure to achieve anticipated levels of revenues could therefore significantly harm our operating results for a particular fiscal period.
 
Due to the possibility of fluctuations in our revenues and expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. Our operating results in some quarters may not meet the expectations of stock market analysts and investors. In that case, our stock price would probably decline.
 
If we fail to obtain the capital necessary to fund our operations, we will be unable to successfully develop products.
 
We expect that additional financing will be required in the future to fund operations. We do not know whether additional financing will be available when needed, or that, if available, we will obtain financing on terms favorable to our stockholders or us. Insufficient funds may require us to delay, scale back or eliminate some or all of our research or development programs, to lose rights under existing licenses or to relinquish greater or all rights to product candidates at an earlier stage of development or on less favorable terms than we would otherwise choose or may adversely affect our ability to operate as a going concern. We have consumed substantial amounts of cash to date and expect capital outlays and operating expenditures to increase over the next several years as we expand our infrastructure and research and development activities.
 
We believe that existing cash and investment securities and anticipated cash flow from existing collaborations will be sufficient to support our current operating plan through at least 2004. We have based this estimate on assumptions that may prove to be wrong. Our future capital requirements depend on many factors that affect our research, development, collaboration and sales and marketing activities. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
 
We may raise additional financing through public or private equity offerings, debt financings or additional corporate collaboration and licensing arrangements. To the extent we raise additional capital by issuing equity securities, our stockholders may experience dilution. To the extent that we raise additional funds through collaboration and licensing arrangements, it may be necessary to relinquish some rights to our technologies or product candidates, or grant licenses on terms that are not favorable to us. If adequate funds are not available, we will not be able to continue developing our products.

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Item 3: Quantitative and Qualitative Disclosures About Market Risk
 
Interest Rate Risk
 
The primary objective of our investment activities is to preserve principal while at the same time maximize the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment balance to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and investment-grade corporate obligations.
 
The following table represents the fair value balance of our cash, cash equivalents and short-term and long-term investments that are subject to interest rate risk by year of expected maturity and average interest rates as of September 30, 2002 (dollars in thousands):
 
    
2002
     
2003
     
2004
  
Cash & cash equivalents
   
$
23,371
 
   
 
—  
 
   
 
—  
 
Average interest rates
   
 
1.73
%
                  
Short-term investments
   
$
9,389
 
   
$
30,412
 
   
 
—  
 
Average interest rates
   
 
2.41
%
   
 
2.77
%
         
Long-term investments
   
 
—  
 
   
 
—  
 
   
$
12,090
 
Average interest rates
                     
 
2.50
%
 
We did not hold derivative instruments as of September 30, 2002, and we have never held such instruments in the past. In addition, we had outstanding debt, consisting of borrowings under equipment financings, of $3.7 million as of September 30, 2002, with a range of interest rates from 7.19% to 13.86%.
 
Item 4: Controls and Procedures
 
Kosan’s management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
 

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Table of Contents
PART II. OTHER INFORMATION
 
Item 1.    Legal Proceedings
 
Not applicable.
 
Item 2.    Changes in Securities and Use of Proceeds
 
d)  Use of Proceeds
 
Our initial public offering of common stock was effected in October 2000, in which we sold 5,750,000 shares of our common stock.
 
The net proceeds of the 5,750,000 shares registered and sold were approximately $73.4 million. We paid a total of approximately $5.6 million in underwriting discounts and commissions and approximately $1.5 million in other costs and expenses in connection with the offering. None of the expenses were paid, directly or indirectly, to directors, officers or persons owning ten percent or more of our common stock.
 
Of the net offering proceeds, through September 30, 2002, approximately $1.6 million had been used to purchase property and equipment and approximately $6.4 million had been used for general corporate purposes. We intend to use the remaining net proceeds for advancing our drug candidates through preclinical and later stage development, discovering or acquiring new drug candidates, expanding our technology platform, capital expenditures, working capital, general corporate purposes and possible future acquisitions. Pending such uses, the balance has been invested in U.S. Treasury and government agency obligations, investment-grade asset-backed securities and corporate obligations.
 
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
No.
     
3.1
   
Amended and Restated Certificate of Incorporation (1)
      
3.2
   
Bylaws of Registrant (2)
      
4.1
   
Form of Specimen Common Stock Certificate (2)
      
  10.43†
   
Collaborative Research, Development and Commercialization Agreement, dated as of September 19, 2002, by and between Registrant and Hoffman-La Roche, Inc.
      
  10.44†
   
Consent to the License Agreement, effective as of September 16, 2002, by and between Registrant and Stanford University
      
  10.45†
   
Consent to the License Agreement, effective as of September 16, 2002, by and between Registrant and The Sloan-Kettering Institute for Cancer Research
      
99.1  
   
99.2 Certification, dated as of November 13, 2002, by Chief Executive Officer and President, Chief Operating Officer (3)

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Table of Contents
(b) Reports on Form 8-K
On September 23, 2002, we filed a Current Report on Form 8-K, in connection with the announcement of our Collaborative Research, Development and Commercialization Agreement with Hoffman-La Roche, Inc.
(1)
 
Filed with Kosan’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001 and incorporated herein by reference.
(2)
 
Filed with Kosan’s Registration Statement on Form S-1, as amended (No. 333-33732), and incorporated herein by reference.
(3)
 
The certification accompanies this Quarterly Report on Form 10-Q pursuant to §906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by Kosan for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.
†
 
Confidential treatment has been requested with respect to certain portions of this exhibit. Omitted portions have been separately filed with the Securities and Exchange Commission.
 

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Table of Contents
 
SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
       
Kosan Biosciences Incorporated
   
November 13, 2002
      
By:
  
/s/      Daniel V. Santi, M.D., Ph.D.    
               
Daniel V. Santi, M.D., Ph.D.
               
Chairman and Chief Executive Officer
 
 
 
         
   
November 13, 2002
      
By:
  
/s/      Michael S. Ostrach
               
Michael S. Ostrach
               
President, Chief Operating Officer and Acting
Principal Financial and Accounting Officer
 

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Table of Contents
 
EXHIBIT INDEX
 
Exhibit No.
     
3.1 
   
Amended and Restated Certificate of Incorporation (1)
3.2 
   
Bylaws of Registrant (2)
4.1 
   
Form of Specimen Common Stock Certificate (2)
10.43†
   
Collaborative Research, Development and Commercialization Agreement, dated as of September 19, 2002, by and between Registrant and Hoffman-La Roche, Inc.
10.44†
   
Consent to the License Agreement, effective as of September 16, 2002, by and between Registrant and Stanford University
10.45†
   
Consent to the License Agreement, effective as of September 16, 2002, by and between Registrant and The Sloan-Kettering Institute for Cancer Research
99.1  
   
Certification, dated as of November 13, 2002, by Chief Executive Officer and President, Chief Operating Officer (3)
      
(1)
 
Filed with Kosan’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001 and incorporated herein by reference.
(2)
 
Filed with Kosan’s Registration Statement on Form S-1, as amended (No. 333-33732), and incorporated herein by reference.
(3)
 
The certification accompanies this Quarterly Report on Form 10-Q pursuant to §906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by Kosan for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.
†
 
Confidential treatment has been requested with respect to certain portions of this exhibit. Omitted portions have been separately filed with the Securities and Exchange Commission.

28