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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

For the quarterly period ended September 30, 2004.

or

For the transition period from              to             .

Commission File Number:

000-31633

Kosan Biosciences Incorporated

(Exact name of registrant as specified in its charter)

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 by check mark whether the registrant is an accelerated filer (as defined in Rules 12b-2 of the Exchange Act).     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 value; 29,008,354 shares outstanding at October 31, 2004.

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KOSAN BIOSCIENCES INCORPORATED

Form 10-Q

Quarter Ended September 30, 2004

INDEX

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PART I. FINANCIAL INFORMATION

Item 1: Condensed Financial Statements and Notes

KOSAN BIOSCIENCES INCORPORATED

CONDENSED BALANCE SHEETS

(in thousands)

See accompanying notes.

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KOSAN BIOSCIENCES INCORPORATED

CONDENSED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per share data)

See accompanying notes.

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KOSAN BIOSCIENCES INCORPORATED

CONDENSED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

See accompanying notes.

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KOSAN BIOSCIENCES INCORPORATED

NOTES TO CONDENSED FINANCIAL STATEMENTS

(unaudited)

1. Organization and Summary of Significant Accounting Policies

Overview

Kosan Biosciences Incorporated (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. The Company has proprietary technologies for the manipulation of polyketides, a rich source of pharmaceutical products. The Company uses its platform technologies to develop product candidates that target large pharmaceutical markets. In collaboration with Hoffmann-La Roche Inc. and F. Hoffmann-La Roche Ltd., collectively Roche, the Company is testing KOS-862 (Epothilone D), a potential anticancer agent, in Phase Ib and Phase II clinical trials. The three Phase Ib trials are traditional dose-escalating trials in combination with other chemotherapeutic agents. The two current Phase II studies are Simon two-stage design trials that have an interim review and decision point following the completion of stage one before advancing to stage two. The Phase II clinical trial in breast cancer is currently in stage one, with a review and decision point expected in the first half of 2005. The Phase II clinical trial in non-small cell lung cancer is expected to reach a stage one review and decision point in the fourth quarter of 2004. Recent enrollment rates in this trial have surpassed the number of patients expected to be required for evaluation at stage one, and new patient screening for admission to the trial has been temporarily suspended pending review of results from stage one when it is completed. The Company expects to initiate a third KOS-862 Phase II clinical trial of the same Simon two-stage design for the treatment of prostate cancer in the fourth quarter of 2004. An evaluation and decision point for stage one of this trial will likely occur in late 2005.

The Company is also developing geldanamycin analogs as anticancer agents and are collaborating with the National Cancer Institute, or NCI, to test two of them, 17-AAG, which is in Phase II, Phase I and Phase Ib clinical trials, and DMAG, which is in Phase I. 17-AAG is in Phase II clinical trials as monotherapy in several cancers and in several Phase Ib combination trials. In collaboration with the NCI, the Company expects to announce interim results for several of these trials over the course of 2005. The Company is also developing its own proprietary formulation of 17-AAG, which it refers to as KOS-953. KOS-953 is in Phase I clinical trials as monotherapy in multiple myeloma and the Company expects to announce interim results in mid-2005. In combination Phase Ib trials, KOS-953 is being used with Velcade and Gleevec; the Company expects to announce interim results from one or more of these trials in the second half of 2005. The Company also has additional product candidates in the areas of infectious disease and gastrointestinal motility that are undergoing preclinical evaluation and several early stage product and research technology development programs.

The Company has funded its operations primarily through sales of convertible preferred stock and common stock, contract payments under its collaboration agreements, government grant awards, interest income and equipment financing arrangements. 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, 2004, and for the three and nine months ended September 30, 2004 and 2003, 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 unaudited 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, 2003.

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.

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KOSAN BIOSCIENCES INCORPORATED

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)

(unaudited)

1. Organization and Summary of Significant Accounting Policies (continued)

Cash Equivalents and Investments (continued)

The Company holds a restricted investment consisting of a certificate of deposit of approximately $949,000 at September 30, 2004 and $903,000 at December 31, 2003. This investment is carried at fair value and is restricted as to withdrawal under a letter of credit agreement related to a facility lease. This investment is held in the Company’s name and is included in long-term investments on the Company’s financial statements.

Revenue Recognition

The Company recognizes license and other up-front and initial fees pursuant to research and development collaboration agreements over the estimated research and development term of the respective agreement. These estimated terms are reviewed on a periodic basis and updated if the underlying assumptions are modified. 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 as the related services are performed or delivered in accordance with contract terms. Such payments generally are made based on the number of full-time equivalent researchers assigned to the collaboration project and the related research and development expenses incurred or as other deliverables under the contract are fulfilled. Revenues related to government grants are recognized at the time a grant is awarded and as 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, including associated stock-based compensation, facility-related expenses, licensing-related expenses, depreciation of facilities and equipment, lab consumables, clinical trial-related services performed by clinical research organizations and research institutions and other outside service providers.

As the Company’s epothilone and geldanamycin programs advance into and through clinical trials, the related costs will have a significant effect on the Company’s research and development expenses. Expenses related to clinical trials generally are accrued based on the level of patient enrollment and activity according to the protocol. The Company monitors patient enrollment levels and related activity and adjusts estimates accordingly.

Research and development expenses under government grant awards and collaborative agreements approximated the revenue recognized, excluding milestone payments, up-front and initial fees 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 anti-dilutive.

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KOSAN BIOSCIENCES INCORPORATED

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)

(unaudited)

1. Organization and Summary of Significant Accounting Policies (continued)

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

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.

Pro forma net loss and net loss per share information is required by SFAS 123 and has been determined as if the Company had accounted for its employee stock options under the fair value method of that statement. The effects of applying the intrinsic value method for either recognizing compensation expense or providing pro forma disclosures are not likely to be representative of the effects on net income for future years.

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KOSAN BIOSCIENCES INCORPORATED

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)

(unaudited)

The Company’s pro forma information follows (in thousands, except per share data):

New Accounting Pronouncement

On March 31, 2004, the FASB issued an Exposure Draft (ED), “Share-Based Payment—An Amendment of FASB Statements No. 123 and 95.” The proposed statement addresses the accounting for transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB 25, and generally would require instead that such transactions be accounted for using a fair-value based method. As proposed, companies would be required to recognize an expense for compensation cost related to share-based payment arrangements including stock options and employee stock purchase plans. As proposed, the new rules would be applied on a modified prospective basis as defined in the ED, and would be effective for the Company beginning July 1, 2005. The FASB expects to issue a final standard by December 31, 2004. The Company is currently evaluating option valuation methodologies and assumptions in light of the proposed standards related to employee stock options. Current estimates of option values using the Black-Scholes method may not be indicative of results from valuation methodologies ultimately adopted in the final rules.

2. Research and Development Agreements

Roche

Effective September 2002, the Company entered into a research and development collaboration agreement (the “Agreement”) with Hoffmann-La Roche, Inc. and F. Hoffmann-La Roche Ltd. (collectively “Roche”). Under the terms of the Agreement, Roche has worldwide exclusive rights to market and sell KOS-862 (Epothilone D) and other epothilones (including KOS-1584) in the field of oncology, and the Company will co-develop and has the right to co-promote the product in the United States. The Agreement provides for the Company to 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

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KOSAN BIOSCIENCES INCORPORATED

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)

(unaudited)

2. Research and Development Agreements (continued)

royalties on sales of collaboration products. Effective July 1, 2004, the Company entered into an amendment to the Agreement that provided for the reimbursement of costs that exceeded the previously stipulated amounts set forth in the Agreement. In addition, the Company has the opportunity to increase its royalties through a buy-in at a later stage of clinical development and by co-promotion of products resulting from the collaboration. For the three and nine months ended September 30, 2004, the Company recognized revenue related to this agreement of approximately $5.8 million and $17.1 million, respectively. For the three and nine months ended September 30, 2003, the Company recognized revenue related to this agreement of approximately $5.5 million and $17.3 million, respectively, of which $2.0 million was related to a non-recurring milestone payment in the second quarter of 2003.

Johnson & Johnson Pharmaceutical Research and Development, LLC

Effective 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. Effective December 28, 2003, the agreement expired and rights to compounds and technologies developed in the collaboration have reverted to the Company. For the nine months ended September 30, 2003, the Company recognized revenue in connection with this agreement of approximately $993,000, of which $250,000 was related to a non-recurring milestone payment in the first quarter of 2003.

License Agreements

The Company has collaborative and license agreements with several academic, government and medical institutions. Included in research and development expenses were total payments made under these agreements of approximately $675,000 and $775,000 for the three months ended September 30, 2004 and 2003, respectively, and $769,000 and $1.5 million for the nine months ended September 30, 2004 and 2003, respectively.

3. Comprehensive Loss

For the three and nine months ended September 30, 2004 and 2003, comprehensive loss was as follows (in thousands):

4. Equipment Financing

The Company finances certain equipment and facility improvements under debt obligations. The terms of the loan obligations range from 42 to 48 months. The interest rates of each of the loans are fixed at the time of the draw down, with the interest rates ranging from 6.31% to 9.40%. Obligations under the loans are secured by the assets financed under the loans.

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KOSAN BIOSCIENCES INCORPORATED

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)

(unaudited)

4. Equipment Financing (continued)

In May 2003, the Company entered into a $3.5 million equipment line of credit agreement. As of September 30, 2004, the Company had utilized approximately $3.3 million of the line of credit, and the remaining amount was allowed to expire. In April 2004, the Company entered into a new $3.5 million equipment line of credit agreement, of which $359,000 had been utilized as of September 30, 2004.

5. Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

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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 “Risk Factors That May Affect Results of Operations and Financial Condition” set forth at the end of this Item 2 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 technologies for the manipulation 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 Hoffmann-La Roche Inc. and F. Hoffmann-La Roche Ltd., collectively Roche, we are testing KOS-862 (Epothilone D), a potential anticancer agent, in Phase Ib and Phase II clinical trials. The three Phase Ib trials are traditional dose-escalating trials in combination with other chemotherapeutic agents. The two current Phase II studies are Simon two-stage design trials that have an interim review and decision point following the completion of stage one before advancing to stage two. The Phase II clinical trial in breast cancer is currently in stage one, with a review and decision point expected in the first half of 2005. The Phase II clinical trial in non-small cell lung cancer is expected to reach a stage one review and decision point in the fourth quarter of 2004. Recent enrollment rates in this trial have surpassed the number of patients expected to be required for evaluation at stage one, and new patient screening for admission to the trial has been temporarily suspended pending review of results from stage one when it is completed. We expect to initiate a third KOS-862 Phase II clinical trial of the same Simon two-stage design for the treatment of prostate cancer in the fourth quarter of 2004. An evaluation and decision point for stage one of this trial will likely occur in late 2005.

We are also developing geldanamycin analogs as anticancer agents and are collaborating with the National Cancer Institute, or NCI, to test two of them, 17-AAG, which is in Phase II, Phase I and Phase Ib clinical trials, and DMAG, which is in Phase I. 17-AAG is in Phase II clinical trials as monotherapy in several cancers and in several Phase Ib combination trials. In collaboration with the NCI, we expect to announce interim results for several of these trials over the course of 2005. We are also developing our own proprietary formulation of 17-AAG, which we refer to as KOS-953. KOS-953 is in Phase I clinical trials as monotherapy in multiple myeloma and we expect to announce interim results in mid-2005. In combination Phase Ib trials, KOS-953 is being used with Velcade and Gleevec; we expect to announce interim results from one or more of these trials in the second half of 2005. We also have additional product candidates in the areas of infectious disease and gastrointestinal motility that are undergoing preclinical evaluation and several early stage product and research technology development programs.

We have incurred significant losses since our inception. As of September 30, 2004, our accumulated deficit was approximately $94.3 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

Critical accounting policies are those that require significant judgment and/or estimates by management at the time that the financial statements are prepared such that materially different results might have been reported if other assumptions had been made. We consider certain accounting policies related to revenue recognition, clinical trial accruals and stock-based compensation to be critical policies. The basis of our current estimates or assumptions has not changed since we filed our 2003 Annual Report on Form 10-K with the SEC on March 15, 2004 and, in the past, there have not been significant adjustments to the actual results of our estimates.

Results of Operations

Revenues

Revenues were approximately $6.8 million and $19.1 million for the three and nine months ended September 30, 2004, respectively, compared to approximately $6.3 million and $20.8 million for the same

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periods in 2003. For the quarter ended September 30, 2004, the increase in quarterly revenue over the same period last year was primarily due to additional revenue under Kosan’s epothilone global development and commercialization agreement with Roche, reflecting additional reimbursement of costs related to work performed under the terms of the amended agreement and continued progress in the partners’ clinical development programs. For the nine months ended September 30, 2004, the decrease in revenue from the same period last year was primarily due to a $2.0 million non-recurring milestone payment from Roche that was recognized in 2003. Included in total contract revenue for 2004 was $4.2 million related to the ratable portion of a $25.0 million initial fee that is being recognized through the second half of 2007, the remaining estimated clinical development period. The remaining amount consisted of reimbursement of research and development expenses, including expenses associated with clinical trials conducted by us and clinical materials purchased by Roche from us. Included in Roche-related contract revenue for 2003 was $2.0 million related to the ratable portion of the first of two $12.5 million installments of the initial fee and a $2.0 million non-recurring milestone. As of September 30, 2004, Roche has fulfilled its obligation to reimburse us for expenses related to epothilone analog research and production related activities. For the nine months ended September 30, 2004 and 2003, such revenue approximated $7.2 million and $8.8 million, respectively. Total contract revenues under our former collaboration with J&J were approximately $993,000 for the nine months ended September 30, 2003. The collaboration expired in December 2003, and no additional revenues will be generated under this agreement. If we do not maintain or further extend our agreement with Roche, our revenues will significantly decrease unless we enter into additional collaborations that provide substantial revenues.

In addition, we recognized approximately $915,000 and $2.0 million in grant revenue for the three and nine months ended September 30, 2004, respectively, compared to approximately $766,000 and $2.3 million for the same periods last year. For the three months ended September 30, 2004, the increase was primarily due to additional government grants awarded during the quarter. For the nine months ended September 30, 2004, the decrease was primarily due to the timing of government grant awards and a decrease in the level of effort expended on government grant awards in the first half of 2004.

Research and Development Expenses

Our research and development expenses increased to approximately $11.3 million and $30.6 million for the three and nine months ended September 30, 2004, respectively, from approximately $11.2 million and $26.8 million for the same periods in 2003. For the quarter ended September 30, 2004, the approximately $100,000 increase over the same three month period in 2003 was primarily due to an approximately $1.2 million increase in outside services related to the advancement of KOS-862 into Phase II and Phase Ib clinical trials, the advancement of KOS-953 into Phase Ib clinical trials and the related production of clinical material and preclinical development of our epothilone and geldanamycin analogs. This increase was partially offset by an approximately $1.1 million in reduced licensing related fees. For the nine months ended September, 30, 2004, the approximately $3.8 million increase over the same period in 2003 was due in large part to an increase in outside services related to the advancement of KOS-862 into Phase II and Phase Ib clinical trials, the advancement of KOS-953 (17-AAG) into Phase I and Phase Ib clinical trials, the related production of clinical material and preclinical development of our epothilone and geldanamycin analogs, which totaled approximately $3.3 million. Additionally, $1.4 million of the increase was due to higher research and development salaries and other personnel-related expenses and an approximately $1.0 million increase in facility and expansion costs. These increases were partially offset by approximately $1.9 million in reduced licensing-related fees. We expect our research and development expenses will increase substantially as our epothilone and geldanamycin product candidates advance further into the clinic, and as we advance our research programs into later stages of development.

General and Administrative Expenses

General and administrative expenses were approximately $1.6 million and $4.4 million for the three and nine months ended September 30, 2004, respectively, compared to approximately $1.3 million and

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$3.8 million for the same periods last year. For the quarter and nine months ended September 30, 2004, the approximately $300,000 and $600,000 increases over the same periods in 2003 were primarily due to increased costs to associated with key management terminations and increased costs to support our efforts related to the Sarbanes-Oxley Act of 2002 compliance and business development. We expect our general and administrative expenses will increase in the future to support the anticipated growth of our research and development efforts and to ensure continued compliance with requirements related to Sarbanes-Oxley.

Other Income, net

Interest income increased to approximately $367,000 and $1.1 million for the three and nine months ended September 30, 2004, respectively, from approximately $255,000 and $925,000 for the same periods in 2003. These increases were primarily attributed to higher average investment balances in the first nine months of 2004 that resulted from our registered direct offering in December 2003, partially offset by lower average interest rates compared to the same period in 2003.

Interest expense increased to approximately $89,000 and $267,000 for the three and nine months ended September 30, 2004, from approximately $84,000 and $252,000 for the same periods in 2003. These increases resulted from additional debt financing of property and equipment over the past year. We expect our interest expense will increase in the future resulting from additional property and equipment-related debt financings combined with anticipated higher interest rates.

Liquidity and Capital Resources

Since inception, we have financed our operations primarily through sales of our convertible preferred stock and common stock, contract payments received under our corporate collaboration agreements and government grant awards, interest income and equipment financing arrangements. As of September 30, 2004, we had received approximately $149.6 million from the sale of convertible preferred stock and common stock, approximately $90.2 million from contract payments received under our corporate collaboration agreements and government grant awards, approximately $13.8 million from interest income and approximately $11.7 million from equipment financing arrangements. As of September 30, 2004, we had approximately $93.1 million in cash and investments, compared to approximately $105.3 million as of December 31, 2003. Our funds are currently invested in U.S. Treasury and government agency obligations and corporate obligations.

Our operating activities used cash of approximately $9.9 million for the nine months ended September 30, 2004, compared to cash provided by operating activities of approximately $4.7 million for the same period in 2003. Our net loss of approximately $15.2 million for the nine months ended September 30, 2004 was partially offset by non-cash charges of approximately $3.9 million related to stock-based compensation, depreciation and amortization of investment premiums and discounts. Cash provided by operations in the same period in 2003 was primarily attributable to the receipt of the second of two $12.5 million installments of an initial fee from Roche, partially offset by a net loss of $9.1 million.

Our investing activities, excluding changes in our investments, for the nine months ended September 30, 2004, used cash of approximately $1.7 million, compared to approximately $3.5 million for the same period in 2003, reflecting facility and capital expenditures as we continued to improve upon our laboratory capabilities.

Cash provided by financing activities was approximately $1.2 million for the nine months ended September 30, 2004, compared to approximately $2.5 million for the same period in 2003. This decrease was primarily attributed to a lower level of equipment loans in 2004 that resulted from reduced spending on property and equipment. Financing activities for 2004 included approximately $227,000 in scheduled payments on existing debt, net of proceeds from equipment loans, and $1.4 million in proceeds from the sale of our common stock related to stock option exercises and stock purchases made under our 2000 Employee Stock Purchase Plan. Financing activities for 2003 included approximately $1.0 million in proceeds from equipment loans, net of scheduled payments on existing debt, $758,000 in proceeds from the sale of our common stock related to stock option exercises and stock purchases made under our 2000 Employee Stock Purchase Plan and $774,000 related to proceeds from the repayment of notes receivable from stockholders.

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In April 2003, we entered into a $3.5 million equipment line of credit agreement for facility improvements and capital purchases. As of June 30, 2004, we had utilized approximately $3.3 million of the line of credit, and the remaining $200,000 was allowed to expire. In April 2004, we entered into a new $3.5 million line of credit agreement, which expires in April 2005. As of September 30, 2004, we had utilized approximately $359,000 of this line of credit.

We believe that our existing cash, investments and anticipated cash flow from our existing collaboration will be sufficient to support our current operating plan into 2006. Our future capital uses and requirements depend on numerous forward-looking factors. These factors include, but are not limited to, the following:

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. In September 2003, we filed a registration statement on Form S-3 to offer to sell common stock in one or more offerings up to a dollar amount of $75.0 million. In December 2003, we completed a registered direct offering of 3,115,000 shares of common stock at a price of $9.00 per share. We received approximately $26.0 million in net proceeds after placement agent fees and other offering costs. As of September 30, 2004, approximately $47.0 million of our securities remained available to offer on the Form S-3. We have no current commitments to offer and sell any securities that may be offered or sold pursuant to such registration statement. Additional financing or collaboration and licensing arrangements may not be available when needed or, if available, may not 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 “Risk Factors That May Affect Results of Operations and Financial Condition”.

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As of September 30, 2004, our obligations and commitments to make future payments under contracts, such as debt and lease agreements, and under contingent commitments were as follows:

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Risk 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 anticipate the need to raise additional capital to fund our activities.

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, 2004, we had an accumulated deficit of approximately $94.3 million. To date, our revenues have been solely from collaborations and government grant awards. 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 $15.2 million for the nine months ended September 30, 2004. 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 and research programs. The amount of time necessary to commercialize successfully any of our drug candidates is long and uncertain, and commercialization may not occur at all. As a result, we may never become profitable.

We will need to raise additional capital in order to fund our future research and development activities. Our future capital uses and requirements depend on numerous forward-looking factors, including the following:

We do not know if whether additional financing will be available when needed, or that, if available, we will obtain financing on terms favorable to our stockholders or us. If adequate funds are not available, we may be required 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. See “Item 2. Management’s Discussion and Analysis of Financial Condition and Result of Operations - Liquidity and Capital Resources”.

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If our current collaborations are unsuccessful or if conflicts develop with these relationships or under our license agreements, our research and development efforts could be delayed, curtailed or terminated, our revenues could significantly decrease and our operations may be adversely affected.

We have a corporate research and commercialization collaboration with Roche in the field of epothilones. We also have collaborations with, or have licenses to technology and compounds from, several research groups, including the Sloan-Kettering Institute for Cancer Research, or Sloan-Kettering, in the field of epothilones, the NCI in the field of geldanamycin analogs and Stanford University in the field of polyketide technology. The agreements permit our collaborators or licensors to terminate the agreement under certain circumstances. We may not be able to maintain or extend these collaborations or license agreements on acceptable terms, if at all. If we do not maintain, extend or replace our corporate collaboration with Roche, our research and development efforts could be delayed, our revenues would significantly decrease and our operations could be adversely affected. If we are unable to maintain our research collaborations or if our license agreements are terminated, our research and development efforts could be delayed, curtailed or terminated or we could lose our rights to use the licensed technology and compounds. Loss of these rights could also result in termination of, curtailment of or a delay of research and development efforts under our corporate collaboration, under some circumstances.

We do not control the amount and timing of resources that our collaborators devote to our programs or potential products, nor the scope, content and timing of the efforts that they conduct or permit under the collaborations. As a result, we do not know if our collaborators will dedicate sufficient resources or if the development or commercialization efforts by our corporate partners will be successful, or if the development or commercialization efforts that our collaborators make or authorize will be the same as those we would choose to devote if we solely controlled the development and commercialization of our programs and product candidates. In particular, in our collaboration with Roche, we do not control the amount and timing of resources that Roche devotes to the epothilone program beyond limited funding for certain Kosan activities in the amount specified under the contract, and we do not control the scope, content and timing of the preclinical studies, clinical trials and other development efforts that Roche conducts or permits under the program. In our collaboration with the NCI, we do not control the selection, conduct, timing and resources provided to clinical trials of geldanamycin analogs sponsored by the NCI. 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 a business combination involving our existing collaboration with Roche were to occur, the effect could diminish, terminate or cause delays in the epothilone program corporate collaboration. Should our corporate partners fail to develop or commercialize a compound or product for which they have rights from us, we may not receive any future milestones and will not receive any royalties associated with such compound or product.

If our collaborators fail to conduct the collaborative activities successfully and in a timely manner or if they or our licensors were to breach or terminate their agreements with us, the development or commercialization of the affected product candidates, technology or research program could be delayed or terminated. Conflicts might also arise with collaborators or licensors concerning rights to particular compounds or technologies. If we are unable to resolve these conflicts in our favor, we could lose our rights to use those compounds or technologies.

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

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arrangements will ultimately be successful. There have been, and may continue to be, a significant number of 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 be able to 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, or FDA, and international regulatory authorities for commercial use. We will need to conduct significant additional research, preclinical testing and clinical trials, before we or our collaborators can file applications with the FDA and other regulatory agencies 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 or our collaborators 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 demonstrate 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. Also, preclinical and clinical data can be interpreted in different ways, which could delay, limit or prevent further testing or regulatory approval.

We do not know whether planned clinical trials (including ongoing and anticipated clinical trials of KOS-862, KOS-1584, 17-AAG, KOS-953, DMAG or other product candidates) will begin on time or whether any of our clinical trials (including ongoing and anticipated clinical trials of KOS-862, KOS-1584, 17-AAG, KOS-953, DMAG or other product candidates) 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. Certain of the clinical trials of our product candidates are designed to include two stages, with the decision whether to proceed to the second stage dependent on results obtained in the first stage. Failure to achieve predetermined response rates as defined in the protocol may result in the decision not to proceed into the second stage of the related trial.

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We have three product candidates in human clinical trials for the treatment of cancer. Anticancer drugs generally have a narrow therapeutic window between efficacy and toxicity. If unacceptable toxicity is observed in a clinical trial, the trial may be terminated at an early stage. Drug-related deaths may occur in clinical trials with anticancer drugs, because drugs for the treatment of cancer are typically dangerous and 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 (including ongoing and anticipated clinical trials of KOS-862, KOS-1584, 17-AAG, KOS-953, DMAG or other product candidates) may be suspended at any time, if we, the FDA, or other regulatory authorities 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:

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. If any current or future clinical trials (including ongoing and anticipated clinical trials of KOS-862, KOS-1584, 17-AAG, KOS-953, DMAG or other product candidates) are not successful, our business, financial condition and results of operations will be harmed.

If we are not able to obtain required regulatory approvals, we will not be able to commercialize our product candidates, and our ability to generate revenue will be materially impaired.

Our product candidates and the activities associated with their development and commercialization are subject to comprehensive regulation by the FDA and other regulatory agencies in the United States, and by comparable authorities in other countries. Failure to obtain regulatory approval for a product candidate will prevent us from commercializing the product candidate. We have not received regulatory approval to market any of our product candidates in any jurisdiction and have only limited experience in preparing and filing the applications necessary to gain regulatory approvals. The process of obtaining regulatory approvals is expensive, often takes many years, if approval is obtained at all, and can vary substantially based upon the type, complexity and novelty of the product candidates involved.

Changes in the regulatory approval policy during the development period, changes in or the enactment of additional regulations or statutes, or changes in regulatory review for each submitted product

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application, may cause delays in the approval or rejection of an application. Even if the FDA or other regulatory authorities approves a product candidate, the approval may impose significant restrictions on the indicated uses, conditions for use, labeling, advertising, promotion, marketing and/or production of such product, and may impose ongoing requirements for post-approval studies, including additional research and development and clinical trials. The FDA or other regulatory authorities also may impose various civil or criminal sanctions for failure to comply with regulatory requirements, including withdrawal of product approval.

Furthermore, the approval procedure and the time required to obtain approval varies among countries and can involve additional testing beyond that required by the FDA. Approval by one regulatory authority does not ensure approval by regulatory authorities in other jurisdictions.

The FDA and other regulatory authorities have substantial discretion in the approval process and may refuse to accept any application or may decide that our data is insufficient for approval and require additional preclinical, clinical or other studies. Any clinical trial may fail to produce results satisfactory to the FDA or other regulatory authorities. Preclinical and clinical data can be interpreted in different ways, which could delay, limit or prevent regulatory approval. Furthermore, even if we file an application with the FDA or other regulatory authorities for marketing approval of a product candidate, it may not result in marketing approval from the FDA or other regulatory authorities.

We do not know whether our existing or any future clinical trials (including ongoing and anticipated clinical trials of KOS-862, KOS-1584, 17-AAG, KOS-953, DMAG or other product candidates) 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 and foreign approvals and, ultimately, commercialization of our 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 or may be delayed in obtaining regulatory approvals for our product candidates and will not be able to or may be delayed in our efforts to successfully commercialize our product candidates for targeted diseases. We do not have the ability to independently conduct clinical trials for our products, 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 our manufacturing or formulation facilities encounter delays or set-backs or become unavailable and our inventories are insufficient to meet our needs during the time required to overcome a problem or establish alternative arrangements, then clinical development of our product candidates may be delayed or suspended, submissions for their regulatory approval may be delayed and we may be unable to meet demand for any products that we may successfully develop and lose potential revenue.

We rely in some cases, and in the future may rely upon, single sources for key intermediates, active pharmaceutical ingredients and formulated drug product for our product candidates. Currently, we are the sole manufacturer of the active pharmaceutical ingredient for KOS-862, and we use a single outside contractor to formulate drug product for KOS-862. We (or, with respect to KOS-862, Roche) currently maintain limited inventories of the active pharmaceutical ingredient for KOS-862 at our facilities in Hayward, California and of formulated drug product for KOS-862 at a total of three locations (including our facility in Hayward). In our geldanamycin program, we currently use a single manufacturer to make the active pharmaceutical ingredient 17-AAG and DMAG and formulate drug product for KOS-953 both at our own facility and through a contract manufacturer. We currently maintain a limited inventory of KOS-953 in two locations. The NCI is responsible for formulation of drug product for its clinical work with 17-AAG and DMAG, and the NCI is not obligated to maintain an inventory of either the active pharmaceutical ingredient or formulated drug product for 17-AAG or DMAG. If any of our manufacturing or inventory facilities or relationships encounter delays, are destroyed or otherwise become unavailable, then the clinical development of our product candidates (including KOS-862, KOS-1584, 17-AAG, KOS-953 and DMAG) or submissions for their regulatory approval could be delayed or precluded, and our ability to deliver on a timely basis any products that we may develop could be impaired or precluded. Adverse effects would be particularly acute if problems arise with our sole sourcing and inventory relationships.

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A number of factors could cause prolonged interruptions, including the inability of a supplier to provide raw materials used for manufacture of our products, equipment malfunctions or failures, changes in FDA or other regulatory authority requirements or standards that require modifications to the manufacturing processes or facilities used in the production of our products, action by the FDA, other regulatory authorities or us that results in the halting or slowdown of production of one or more of our products due to regulatory issues, a contract manufacturer going out of business or failing to produce product as contractually required or other similar factors. In addition, our facilities in Hayward, California are located within the San Francisco Bay area, an area that is subject periodically to earthquakes. Our access to any key intermediates, active pharmaceutical ingredient or formulated drug product for our product candidates sourced or inventoried solely through our facilities in Hayward may be subject to interruption in the event of an earthquake.

We currently rely upon in some cases, and in the future may rely upon, outside contractors to manufacture and supply to us key intermediates, active pharmaceutical ingredients and formulated drug product for our product candidates. Our future contract manufacturers may not be in the United States, and some of our current manufacturers are not in the United States. Our current dependence upon others for the manufacture of our product candidates and components thereof, and our anticipated dependence upon others for the manufacture of any products that we may develop, may adversely affect our ability to continue in a timely manner clinical development of our product candidates and may adversely affect any future profit margins and our ability to commercialize any products that we may develop on a timely and competitive basis. In addition, when we use contract manufacturers outside the United States, the certainty of our supply may be diminished due to importation and customs issues and a potentially limited ability to enforce our contractual rights against parties not located within the United States.

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 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 and products 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:

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We apply for patents covering 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 and technologies. For example, our lead product in our geldanamycin analog program, 17-AAG, is not covered by a composition of matter patent, and thus others could develop 17-AAG based 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, consultants and others. 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 possess filed patent applications and issued patents, and in the future are likely to continue to file patent applications and cause to be issued 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 commercialize products based on the drug candidates that we are developing or pursue our PKS (polyketide synthase) gene manipulation and production technologies. 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 to. Others may sue us in the future to challenge our patent or other intellectual property rights or claim infringement or misappropriation of their patents or other intellectual property rights or a breach of license agreements, or we may be required to commence legal proceedings to resolve our patent or other intellectual property rights. An adverse determination in any litigation or in administrative proceeding to which we may become a party could subject us to significant liabilities to others, result in our patents being deemed invalid, unenforceable or revoked, require us to license disputed

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rights from others or require us to cease using the disputed technology. In addition, our involvement in any of these proceedings may cause us to incur substantial costs and result in diversion of management and technical personnel.

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 or other proceeding before a patent agency or court to determine priority of invention or which party was first to invent 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; patent applications believed by us to be licensed to Bristol-Myers Squibb relating to epothilones; and patents and applications owned by Abbott Laboratories and Biotica relating to erythromycin polyketide synthase genes, methods for altering polyketide synthase genes and erythromycin analogs and derivatives. In addition, the European Patent Office has recently granted a European patent that we believe to be licensed to Bristol-Myers Squibb and that if issued, valid and enforceable in individual European countries would cover Epothilone D in those countries. We intend to and are preparing to oppose the grant of this patent. 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. Companies and others developing products that could compete with our product candidates, such as Bristol-Myers Squibb and Novartis in the area of potential epothilone products, may be particularly unwilling to grant us a license at any price.

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 claims that the use of our technologies infringes any patents, defending ourselves against any claim that we are employing any proprietary technology without authorization 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:

We may not be able to obtain licenses from other parties at a reasonable cost, or at all. If we are not able to obtain necessary licenses at a reasonable cost or at all, 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 the failure to obtain licenses could prevent us from commercializing products.

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If we are unable to recruit and retain skilled employees, we may not be able to achieve our objectives.

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, Daniel V. Santi, M.D., Ph.D., our chairman and chief executive officer, and Chaitan S. Khosla, Ph.D., a director and consultant, we do not believe the proceeds would be adequate to compensate us for their loss.

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. For example, competing epothilones in clinical development include those being developed by Bristol-Myers Squibb (reported to be in Phase III clinical trials) and Novartis AG (reported to be in Phase II clinical trials). Further, our competitors in the polyketide gene-engineering field may be more effective at implementing their technologies to develop commercial products or may hold or develop patents or other proprietary rights that may prevent us from practicing our technologies and pursuing our programs. 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. In addition, to compete effectively, our products must be easy to use, cost-effective and economical to manufacture on a commercial scale. 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 discovery and developing drugs, 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.

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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. In addition, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors. This is because our board of directors is responsible for appointing the members of our management team.

We have adopted a rights agreement under which all 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. In addition, the existence of the rights plan itself may deter a potential acquiror from acquiring us. As a result, either by operation of the rights plan or by its potential deterrent effect, mergers and acquisitions of us that our stockholders may consider in their best interests may not occur.

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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 their affiliates together controlled approximately 24% of our outstanding common stock as of September 30, 2004. 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. During the period from September 30, 2003 through September 30, 2004, our common stock traded between $5.71 and $14.77 on the Nasdaq National Market. The trading price of our common stock could be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including:

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.

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:

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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.

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. 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 our existing cash and investment securities and anticipated cash flow from our existing collaboration will be sufficient to support our current operating plan into 2006. 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 “Item 2. 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 or licensing arrangements or any combination of the foregoing. 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 or financing our operations.

If we are unable to favorably assess the effectiveness of internal controls over financial reporting, or if our independent auditors are unable to provide an unqualified attestation report on our assessment, our stock price could be adversely affected.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and beginning with our Annual Report on Form 10-K for the year ending December 31, 2004, our management will be required to report on, and our independent auditors to attest to, the effectiveness of our internal controls over financial reporting as of the end of 2004. The rules governing the standards that must be met for management to assess the effectiveness of our internal controls over financial reporting are new and complex and require significant documentation, testing and possible remediation. We are currently in the process of reviewing, documenting and testing our internal controls over financial reporting, which has and may continue to result in increased expenses and the devotion of significant management resources. We may encounter problems or delays in completing the implementation of any changes necessary to make a favorable assessment of our internal controls over financial reporting. In addition, in connection with the attestation process by our independent auditors, we may encounter problems or delays in completing the implementation of any requested improvements and receiving a favorable attestation. If we cannot favorably assess the effectiveness of our internal controls over financial reporting, or if our independent auditors are unable to provide an unqualified attestation report on our assessment, investor confidence and our stock price could be adversely affected.

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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 investments 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. Through our money managers, we maintain risk management control systems to monitor interest rate risk. The risk management control systems use analytical techniques, including sensitivity analysis. If market interest rates were to increase by 100 basis points, or 1%, as of September 30, 2004 rates, the fair value of our portfolio would decline by approximately $595,000 on that date.

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, 2004 (dollars in thousands):

We did not hold any derivative instruments as of September 30, 2004, and we have never held such instruments in the past. In addition, we had outstanding debt, consisting of borrowings under equipment financings, of $4.3 million as of September 30, 2004, with a range of interest rates from 6.31% to 9.40%.

Item 4: Controls and Procedures

Evaluation of Disclosure Controls and Procedures. Based on the evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) required by Rules 13a-15(b) or 15d-15(b) of the Exchange Act, our chief executive officer and chief financial officer have concluded that as of the end of the period covered by this report, Kosan’s disclosure controls and procedures were sufficiently effective to ensure that the information required to be disclosed by Kosan in the reports that it files under the Exchange Act is gathered, analyzed and disclosed with adequate timeliness, accuracy and completeness.

Changes in Internal Controls. There have been no changes in our internal controls over financial reporting during the period covered by this report, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Limitations on the Effectiveness of Controls. 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

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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. Accordingly, our disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the objectives of our disclosure control system are met and, as set forth above, our chief executive officer and chief financial officer have concluded, based on their evaluation, that our disclosure controls and procedures were sufficiently effective as of the end of the period covered by this report to provide reasonable assurance that the objectives of our disclosure control system were met.

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PART II. OTHER INFORMATION

Item 1: Legal Proceedings

Not applicable.

Item 2: Unregistered Sales of Equity Securities and Use of Proceeds

b) 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.

As of September 30, 2004, all net offering proceeds have been applied with approximately $8.2 million used to purchase property and equipment and approximately $65.2 million used for general corporate purposes.

Item 3: Defaults Upon Senior Securities

Not applicable.

Item 4: Submission of Matters to a Vote of Security Holders

None.

Item 5: Other Information

In July 2004, the audit committee approved $30,000 for non-audit services related to Section 404 of the Sarbanes-Oxley Act of 2002.

(a) Item 6: Exhibits

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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.

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EXHIBIT INDEX