DELTAGEN INC, 10-Q, 2000-11-13

DELTAGEN INC
10-Q, 2000-11-13
COMMERCIAL PHYSICAL & BIOLOGICAL RESEARCH

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

FORM 10-Q

[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000

[ ] 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 000-31147

DELTAGEN, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 94-3260659
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

1003 HAMILTON AVENUE, MENLO PARK, CA 94025
(Address of principal executive offices) (Zip code)

(650) 752-0200
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.

YES X NO
------- -------

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

<TABLE>
<CAPTION>
Common Stock $0.001 par value 29,873,027
----------------------------- ---------------------------------------------------
<S> <C>
Class Outstanding at November 6, 2000
</TABLE>

<PAGE>

DELTAGEN, INC.

FORM 10-Q

QUARTERLY REPORT

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
PART I - FINANCIAL INFORMATION
<S> <C> <C>
Item 1. Financial Statements

Balance Sheets (unaudited) 3
Statements of Operations (unaudited) 4
Statements of Cash Flows (unaudited) 5
Notes to Financial Statements (unaudited) 6

Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 10

Item 3. Quantitative and Qualitative Disclosures about Market Risk 12

PART II - OTHER INFORMATION

Item 1. Legal Proceedings 26

Item 2. Changes in Securities and Use of Proceeds 26

Item 3. Defaults Upon Senior Debt 27

Item 4. Submission of Matters to a Vote of Security Holders 27

Item 5. Other Information 27

Item 6. Exhibits and Reports on Form 8-K 27

Signatures 28
</TABLE>

2
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS

DELTAGEN, INC.
BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
2000 1999
------------- ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $116,298 $ 848
Accounts receivable , net 1,774 585
Other current assets 1,893 205
------------- ------------
Total current assets 119,965 1,638

Property and equipment, net 7,641 4,973
Other assets 304 163
------------- ------------
Total assets $127,910 $ 6,774
============= ============

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK
AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $ 1,567 $ 2,976
Accrued liabilities 2,477 984
Current portion of capital lease obligations 32 30
Current portion of loans payable 1,474 503
Deferred revenue 2,329 946
------------- ------------
Total current liabilities 7,879 5,439

Capital lease obligations, less current portion 15 22
Loans payable, less current portion 3,586 2,233
------------- ------------
Total liabilities 11,480 7,694
------------- ------------
Commitments and Contingencies (Note 6)
Redeemable convertible preferred stock:
Authorized: 18,995,920 shares
Issued and outstanding: none at September 30, 2000
and 10,938,777 shares at December 31, 1999
(Liquidation value: $14,500 at December 31, 1999) - 14,447
------------- ------------
Stockholders' equity (deficit):
Common stock, $0.001 par value:
Authorized: 61,004,082 shares
Issued and outstanding: 29,873,825 at September 30, 2000
and 2,069,685 shares at December 31, 1999 30 2
Additional paid-in capital 172,204 10,695
Unearned stock-based compensation (11,797) (7,610)
Notes receivable from stockholders (805) -
Accumulated deficit (43,202) (18,454)
------------- ------------
Total stockholders' equity (deficit) 116,430 (15,367)
------------- ------------
Total liabilities, redeemable convertible preferred
stock and stockholders' equity (deficit) $127,910 $ 6,774
============= ============

</TABLE>

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS

3
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DELTAGEN, INC.
STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2000 1999 2000 1999
-------------- ------------- -------------- -------------
<S> <C> <C> <C> <C>
Contract Revenue $ 206 $ 244 $ 760 $ 922
-------------- ------------- -------------- -------------
Operating expenses:
Research and development 7,008 3,412 19,475 8,066

General and Administrative 2,791 764 7,253 1,647
-------------- ------------- -------------- -------------
Total operating expenses 9,799 4,176 26,728 9,713
-------------- ------------- -------------- -------------
Loss from operations (9,593) (3,932) (25,968) (8,791)
Interest income 1,194 54 1,592 233
Interest expense (190) (79) (372) (174)
-------------- ------------- -------------- -------------
Net loss (8,589) (3,957) (24,748) (8,732)

Deemed dividend related to
beneficial conversion feature
of preferred stock - - (22,360) -
-------------- ------------- -------------- -------------
Net loss attributable to
common stockholders $ (8,589) $ (3,957) $ (47,108) $ (8,732)
============== ============= ============== =============
Net loss per share attributable to
common stockholders,
basic and diluted $ (0.44) $ (3.52) $ (5.65) $ (11.91)
============== ============= ============== =============
Weighted average shares
used in computing net loss per
share, basic and diluted 19,437 1,123 8,332 733
============== ============= ============== =============
</TABLE>

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS

4
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DELTAGEN, INC.
STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)

<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------------------
2000 1999
--------------- ----------------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (24,748) $(8,732)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 1,032 490
Amortization of warrants issued in connection
with loans 30 18
Stock-based compensation expense 8,991 1,433
Changes in operating assets and liabilities:
Accounts receivable (1,189) (586)
Other assets (1,829) 64
Accounts payable (1,409) 671
Accrued liabilities 1,493 799
Deferred revenue 1,383 (336)
--------------- ----------------
Net cash used in operating activities (16,246) (6,179)
--------------- ----------------
Cash flows from investing activities:
Acquisition of property and equipment (2,872) (1,612)
Leasehold improvements (808) (449)
--------------- ----------------
Net cash used in investing activities (3,680) (2,061)
--------------- ----------------
Cash flows from financing activities:
Principal payments under capital lease obligations (24) (36)
Repayment of loans payable (618) (472)
Proceeds from the issuance of debt 2,911 2,718
Proceeds from the issuance of common stock, net of
issuance costs 110,162 145
Proceeds from the issuance of preferred stock, net of
issuance costs 22,360
Proceeds from the issuance of common stock under
stock option plan, net of issuance costs and stock
repurchased 585 45
--------------- ----------------
Net cash provided by financing activities 135,376 2,400
--------------- ----------------
Net increase (decrease) in cash and cash equivalents 115,450 (5,840)
Cash and cash equivalents, beginning of period 848 8,635
--------------- ----------------
Cash and cash equivalents, end of period $ 116,298 $ 2,795
=============== ================
Supplemental disclosures of non-cash investing and
financing activities:
Unearned stock-based compensation $ 12,913 $ 5,573
Issuance of notes receivable in exchange for common
stock $ 805 -

Additions to property and equipment acquired $ 20 -
under capital lease obligations
</TABLE>

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS

5
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DELTAGEN, INC.

NOTES TO FINANCIAL STATEMENTS
(UNAUDITED)
SEPTEMBER 30, 2000

1. FORMATION AND BUSINESS OF THE COMPANY

Deltagen, Inc., (the "Company") was incorporated in Delaware on January
28, 1997. The Company's primary business is the determination of the therapeutic
potential of genes by using mammalian genetics to discover the IN VIVO function
of genes and the development and marketing of a database containing these
findings. Deltagen identifies novel gene targets through the use of advanced
bioinformatics. Genetically altered mice are then produced that contain
disruptions or deletions of the targeted gene and proprietary analysis is
performed on such mice to determine the potential function of the targeted gene.

2. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying interim balance sheet as of September 30, 2000, the
statements of operations for the three and nine months ended September 30, 1999
and 2000 and the statements of cash flows for the nine months ended September
30, 1999 and 2000 are unaudited and have been prepared in accordance with
generally accepted accounting principles for interim financial information, the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not contain all of the information and footnotes required by generally accepted
accounting principles for complete financial statements. The unaudited interim
financial statements have been prepared on the same basis as the annual
financial statements and, in the opinion of management, reflect all adjustments,
which include only normal recurring adjustments, necessary to present fairly the
Company's financial position and its results of operations and its cash flows
for the three and nine months ended September 30, 1999 and 2000. The results for
the three and nine months ended September 30, 2000 are not necessarily
indicative of the results to be expected for the year ending December 31, 2000.

These interim financial statements should be read in conjunction with
the annual audited financial statements included in the Company's Registration
Statement on Form S-1 (File No. 333-34668) which was declared effective by the
Securities and Exchange Commission (the "SEC") on August 2, 2000.

REVENUE RECOGNITION

Revenues are recognized when persuasive evidence of an arrangement
exists, delivery has occurred or services have been rendered, the price is fixed
and determinable and collectibility is reasonably assured. For database
agreements, revenue is recognized on a straight-line basis over the term in
which services are to be provided. Other contracts specify milestones to be met
and the payments associated with meeting each milestone. Revenue for these
contracts is recognized upon completion of the milestone. The amount of revenue
recognized upon completion of each milestone is such that the earned revenue, as
a percentage of total anticipated revenue, approximates the costs incurred in
achieving the related milestone, as a percentage of the total anticipated costs.
Where the contract does not specify milestones and payment is upon completion of
the contract, revenue is recognized based on the percentage-of-completion method
of accounting. Contract billings in excess of revenue earned are reflected in
deferred revenue.

ACCOUNTING FOR STOCK-BASED COMPENSATION

The Company accounts for stock-based employee compensation arrangements
in accordance with the provisions of Accounting Principles Board Opinion No. 25
("APB No. 25"), "Accounting for Stock issued to Employees" and Financial
Accounting Standards Board Interpretation No. 28 ("FIN No. 28"), "Accounting for
Stock Appreciation Rights and Other Variable Stock Option or Award Plans" and
complies with the disclosure provisions of Statements of Financial Accounting
Standards No. 123 ("SFAS No. 123"), "Accounting for Stock-Based Compensation."

Under APB No. 25, compensation expense is based on the difference, if
any, on the date of the grant, between the fair value of the Company's stock and
the exercise price. SFAS No. 123 defines a "fair value" based method of
accounting for an employee stock option or similar equity investment.

6
<PAGE>

The Company accounts for equity instruments issued to non-employees in
accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force
Issue No. 96-18, "Accounting for Equity Instruments That Are Issued to Other
Than Employees for Acquiring, or in Conjunction with Selling, Goods or
Services."

3. NET LOSS PER SHARE

Basic earnings per share is calculated based on the weighted-average
number of common shares outstanding during the period. Diluted earnings per
share would give effect to the dilutive effect of common stock equivalents
consisting of stock options and warrants. Potentially dilutive securities of
approximately 3.3 million and 13.2 million have been excluded from the
diluted earnings per share calculations for the periods ended September 30,
2000 and 1999, respectively, as they have an antidilutive effect due to the
Company's net losses.

A reconciliation of shares used in the calculations is as follows:

<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2000 1999 2000 1999
------------- -------------- --------------- --------------
(IN THOUSANDS) (UNAUDITED) (UNAUDITED) (UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C>
Basic and diluted:
Net loss $ (8,589) $ (3,957) $ (24,748) $ (8,732)
Deemed dividend related to beneficial
conversion of preferred stock - - (22,360) -
------------- -------------- --------------- --------------
Net loss attributed to common
stockholders $ (8,589) $ (3,957) $ (47,108) $ (8,732)
============= ============== =============== ==============
Weighted-average shares of common stock
outstanding 21,217 1,808 9,522 1,808
Less: Weighted-average shares subject to
repurchase (1,780) (685) (1,190) (1,075)
------------- -------------- --------------- --------------
Weighted-average shares used in basic and
diluted net loss per share 19,437 1,123 8,332 733
============= ============== =============== ==============
Net loss per share attributable to
common stockholders $ (0.44) $ (3.52) $ (5.65) $ (11.91)
============= ============== =============== ==============
</TABLE>

4. LOANS PAYABLE

In June 2000, the Company entered into a loan agreement with a
financial institution to obtain one or more loans totaling up to $6,500,000. A
corresponding amount of machinery, equipment and other property is pledged as
collateral for each loan.

During June 2000, the Company incurred loans under the above noted
credit facility of $1,262,000 and $1,649,000 for a total financing of
$2,911,000. These loans bear respective interest rates of 12.75% and 12.49% and
are required to be repaid in 36 and 48 monthly installments, respectively,
beginning in July 2000.

5. REDEEMABLE CONVERTIBLE PREFERRED STOCK.

BENEFICIAL CONVERSION FEATURE

In January 2000, the Company issued 7,198,709 of Series C redeemable
convertible preferred stock at $3.13 per share for proceeds of $22,360,000. The
issuance resulted in a beneficial conversion feature of $22,360,000, calculated
in accordance with Emerging Issues Task Force No. 98-5 ("EITF No. 98-5"),
"Accounting for Convertible Securities with Beneficial Conversion Features." The
beneficial conversion feature is reflected as a preferred dividend in the
Statement of Operations for the nine months ended September 30, 2000.

6. COMMITMENTS AND CONTINGENCIES

On May 24, 2000, Lexicon Genetics Incorporated filed a lawsuit against
the Company in the United States District Court for the District of Delaware.
The complaint in the lawsuit alleges that the Company's methods of making
knockout mice infringe United States Patent No. 5,789,215, under which Lexicon
claims to be an exclusive licensee. The complaint seeks a judgment that the
Company infringed this patent, a permanent injunction against further
infringement of the patent and an award of damages in an unspecified amount
that, under certain circumstances, may be trebled. The Company believes that the
patent in question is invalid and, even if the patent is found to be valid, that
the methods employed by the Company do not infringe the patent. On June 13,
2000, the Company responded to Lexicon's complaint by filing an answer and
seeking a declaratory judgment in its favor. The response seeks a judgment
declaring the patent invalid and that the Company has not infringed and is not
infringing the patent. The Company intends to defend the action vigorously.

The litigation is in the early stages and its outcome cannot be
predicted. If Lexicon prevails and obtains an injunction, the Company would be
required to obtain a license in order to continue to use the methods covered by
the patent. The Company may not be able to obtain this license on favorable
terms or at all. If unable to obtain a license, the Company would be required to
redesign its processes to use alternative methods of making knockout mice and
would experience a significant disruption in its ability to generate revenue
during this redesign period and as it develops a gene function database

7
<PAGE>

using these new methods. This redesign and development would involve significant
time and costs, and the alternative methods available may not be as effective as
current methods. The Company estimates that the average time from the date the
Company begins to create a knockout mouse until the date the data from that
knockout mouse is added to the gene function database is 12 months. The addition
of new data points to the Company's gene function database could be
significantly delayed. If Lexicon prevails, the Company could also incur
significant financial liabilities that could materially affect its business and
operating results.

In addition, on October 13, 2000, Lexicon filed a lawsuit against
the Company in the United States District Court for the Northern District of
California. The complaint in this lawsuit alleges that the Company is
infringing United States Patents Nos. 5,631,153, 5,464,764, 5,627,059 and
5,487,992, under which Lexicon claims to be an exclusive licensee. All of
these patents relate to the use of a positive-negative selection vector in
gene targeting. The compliant seeks a judgment that the Company infringed
these patents, a preliminary and permanent injunction against further
infringement of the patents and an award of damages in an unspecified amount
that, under certain circumstances, may be trebled.

The Company believes that the methods employed by the Company do
not infringe these patents. However, if Lexicon prevails in any such lawsuit,
the Company would be prevented from using its current methods unless it
obtained a license. The Company may be unable to obtain a license on
favorable terms or at all, or it may choose not to seek a license. In that
event, the Company believes that it can employ and use alternative methods,
with which it has experience and which it believes are as effective as its
current methods. Developing a gene function database using these alternative
methods would involve significant time and costs. An adverse determination of
any lawsuit with Lexicon involving these patents could also significantly
affect the development and marketing of its existing gene function database
and DeltaSelect programs. The Company expects that, during the period prior
to development of a comparable gene function database using these alternative
methods, it would experience a significant disruption in its ability to
generate revenue. If Lexicon prevails in any lawsuit involving these patents,
the Company could also incur significant financial liabilities that could
materially affect its business and operating results.

At this time no estimate can be made of the outcome or any possible
loss that may be incurred. The litigation is in the early stages and its
outcome cannot be predicted.

7. CUSTOMER AGREEMENTS

On June 27, 2000, the Company entered into its first DeltaBase-TM-
database subscription agreement with Glaxo Wellcome. Under the DeltaBase
agreement, Glaxo Wellcome has the right to access DeltaBase database information
on gene function and validated gene targets based upon knockout mouse studies.
The DeltaBase agreement also grants Glaxo Wellcome non-exclusive, worldwide
licenses to knockout mice, materials and intellectual property rights under
DeltaBase. The Company will receive aggregate cash payments of $5,000,000 in
subscription licensing fees during each year of the three-year term. In
addition, the Company may receive additional licensing fees for access to its
intellectual property and additional payments on milestones achieved and on
products developed by Glaxo Wellcome, if any, using DeltaBase information,
materials and related intellectual property. Glaxo Wellcome may, however,
terminate the agreement for any reason within the first three months after the
one year anniversary of the effective date upon payment of a specified
termination fee.

8. STOCKHOLDERS' EQUITY (DEFICIT)

REGISTRATION

In March 2000, the Company's Board of Directors authorized management
to file a registration statement with the Securities and Exchange Commission to
permit the Company to sell its common stock to the public. Upon completion of
the Company's initial public offering in August 2000, all of the outstanding
preferred stock was converted into shares of common stock.

STOCK SPLIT

In May 2000, the board of directors approved an 8-for-7 forward
split of its preferred and common stock which was effective on July 12, 2000.
All common stock data in this report has been restated to reflect the split.

INITIAL PUBLIC OFFERING

On August 3, 2000, the Company commenced an initial public offering
in which it sold 7,000,000 shares of common stock at $15.00 per share for net
proceeds of approximately $95.9 million, net of underwriting discounts,
commissions and other offering costs. Upon the closing of the offering, all
the Company's redeemable convertible preferred stock converted

8
<PAGE>

into 18,137,486 shares of common stock. On August 30, 2000, the underwriters
exercised an over-allotment option to purchase an additional 1,025,000 shares,
resulting in net proceeds of an additional $14.3 million.

CONSULTING AND RESEARCH COLLABORATION CONTRACT

On March 15, 2000, the Company negotiated the basic terms of a three
year consulting arrangement research collaboration agreement with Institute
Genetique Biologie Moleculaire et Cellulaire (IGBMC), a scientific institution.
Deltagen determines which projects are to be conducted by IGBMC in the area of
functional genomics and particularly knockout animals and disruption
technologies. The costs and expenses related to the projects will be shared by
Deltagen and IGBMC. In conjunction with this agreement, a three year warrant to
purchase 457,143 shares of Series C preferred stock of Deltagen at a price of
$3.13 per share was granted to IGBMC as of July 25, 2000. The warrant will vest
in its entirety on the four month anniversary of the commencement date of the
agreement. The Chief Executive Officer of IGBMC is the father of one of the
members of Deltagen's board of directors. The agreement has not yet become
effective. For the purpose of valuing the warrants in accordance with EITF 96-18
"Accounting for Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services" no measurement
date has occurred. As a result, no value has yet been attributed to these
warrants.

OPTION GRANTS

On July 7, 2000, options to purchase 621,313 shares of common stock
under the 1998 Plan were granted at an exercise price of $12.60 per share. The
total unearned compensation related to these grants amounts to $249,000, of
which $56,000 was amortized to expense in the third quarter of fiscal year 2000.

9. RECENT ACCOUNTING PRONOUNCEMENTS

In March 2000, the Financial Accounting Standards Board issued
Interpretation No. 44 ("FIN No. 44") "Accounting for Certain Transactions
Involving Stock Compensation," an interpretation of the Accounting Practice
Board Opinion No. 25 ("APB No. 25"). This interpretation clarifies the
definition of an employee for purposes of applying APB No. 25, "Accounting for
Stock Issued to Employees," the criteria for determining whether a plan
qualifies as a noncompensatory plan, the accounting consequence of various
modifications to the terms of a previously fixed stock option or award, and the
accounting for an exchange of stock compensation awards in a business
combination. This Interpretation is effective July 1, 2000, but certain
conclusions in this Interpretation cover specific events that occur after either
December 15, 1998, or January 12, 2000. The adoption of the provisions of FIN
No. 44 did not have a material effect on the financial statements

In December 1999, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin No. 101 ("SAB No. 101"), "Revenue Recognition in
Financial Statements," which provides guidance on the recognition, presentation,
and disclosure of revenue in financial statements filed with the SEC. SAB No.
101 outlines the basic criteria that must be met to recognize revenue and
provides guidance for disclosures related to revenue recognition policies. The
Company has complied with the guidance in SAB No. 101 for all periods presented.

In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 133 ("SFAS No. 133"), "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 133 establishes new
standards of accounting and reporting for derivative instruments and hedging
activities. SFAS No. 133 requires that all derivatives be recognized at fair
value in the statement of financial position, and that the corresponding gains
or losses be reported either in the statement of operations or as a component of
comprehensive income, depending on the type of relationship that exists. SFAS
No. 133 will be effective for fiscal years beginning after June 15, 2000. The
Company does not believe that the implementation of SFAS No. 133 will have any
significant impact on its financial position or results of operations.

9
<PAGE>

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND
RESULTS OF OPERATIONS

The statements in this quarterly report that are not descriptions of
historical facts may be forward-looking statements that are subject to risks and
uncertainties. Actual results could differ materially from those currently
anticipated due to a number of factors, including those identified below and in
our other publicly available documents. We are under no obligation to update any
of these forward-looking statements after the filing of this quarterly report to
reflect actual results or changes in our expectations.

The following information should be read in conjunction with the
consolidated financial statements and notes thereto included in Item 1 of this
quarterly report. We also urge readers to review and consider our disclosures
describing various factors that affect our business, including the disclosures
under Management's Discussion and Analysis of Financial Condition and Results of
Operations and Risk Factors and the audited financial statements and notes
thereto contained in our Registration Statement on Form S-1, filed with the SEC
in the form in which it became effective on August 2, 2000.

OVERVIEW

We were formed in 1997 to discover and provide mammalian gene function
information for use by pharmaceutical and biotechnology companies to expedite
the drug discovery process. Since our inception, we have engaged primarily in
research and development efforts related to our technology which enables us to
select genes with therapeutic potential and delete, or knockout, these genes in
mice. We then use an extensive, integrated analysis program to determine the
function and potential pharmaceutical relevance of these genes. We have a
limited operating history and are at an early stage of development. Our strategy
and pricing models related to offering our products and programs are unproven.

To date we have derived all of our revenue from the development and
analysis of knockout mice under our DeltaSelect-TM- program. As of September
30, 2000, we had an accumulated deficit of $43.2 million. We had net losses
of $8.6 million and $4.0 million for the three months ended September 30,
2000 and 1999, respectively. The net loss attributable to common stockholders
for the nine months ended September 30, 2000 was $24.7 million, before
deducting a deemed dividend of $22.4 million relating to a beneficial
conversion feature of our preferred stock. Our losses have resulted primarily
from costs incurred in connection with research and development activities
and from general and administrative costs associated with our operations.
Research and development expenses consist primarily of salaries and related
personnel costs, material costs, legal expenses resulting from intellectual
property filings and other expenses related to the development of our gene
function database products, DeltaSelect and our gene trap program. We expense
our research and development costs as they are incurred. General and
administrative expenses consist primarily of salaries and related expenses
for executive, finance and other administrative personnel, professional and
other corporate expenses including business development and general legal
activities. In connection with the development and expansion of our gene
function database products, DeltaSelect and our gene trap program, we expect
to incur increasing research and development and general and administrative
costs. As a result, we will need to generate significantly higher revenues to
achieve profitability. We expect to report substantial net losses through the
next several years. We had DeltaSelect agreements as of September 30, 2000
with the following companies: Glaxo Wellcome, Merck & Co., Pfizer, Inc.,
Roche Biosciences and Schering-Plough Research Institute. Under these
agreements, we create knockout mice and perform phenotypic analysis of these
mice when requested by our customers. A customer compensates us based on
milestones reached in the creation and analysis of each knockout mouse it
requests.

Revenues are recognized when persuasive evidence of an arrangement
exists, delivery has occurred or services have been rendered, the price is
fixed and determinable and collectibility is reasonably assured. For database
agreements, revenue is recognized on a straight-line basis over the term in
which services are to be provided. Other contracts specify milestones to be
met and the payments associated with meeting each milestone. Revenue for
these contracts is recognized upon completion of the milestone. The amount of
revenue recognized upon completion of each milestone is such that the earned
revenue, as a percentage of total anticipated revenue, approximates the costs
incurred in achieving the related milestone, as a percentage of the total
anticipated costs. Where the contract does not specify milestones and payment
is upon completion of the contract, revenue is recognized based on the
percentage-of-completion method of accounting. Contract billings in excess of
revenue earned are reflected in deferred revenue.

We anticipate that the majority of our future revenues will be derived
from periodic subscription fees under agreements with subscribers to our
DeltaBase-TM- gene function database. However, Glaxo Wellcome is currently our
only subscriber to DeltaBase. Our future operating results will depend upon many
factors, including the initiation and expiration of subscriptions to our gene
function database and other customer agreements and general and
industry-specific economic conditions which may

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affect pharmaceutical and biotechnology companies' research and development
expenditures. As a consequence, our operating results have fluctuated in the
past and are likely to do so in the future.

We account for stock-based employee compensation arrangements in
accordance with provisions of Accounting Principles Board Opinion No. 25 (APB
No. 25), "Accounting for Stock issued to Employees" and Financial Accounting
Standards Board Interpretation No. 28, "Accounting for Stock Appreciation Rights
and Other Variable Stock Option or Award Plans" and comply with the disclosure
provisions of Statement of Financial Accounting Standards No. 123 (SFAS No.
123), "Accounting for Stock-Based Compensation."

Under APB No. 25, compensation expense is based on the difference, if
any, on the date of the grant, between the fair value of our stock and the
exercise price. SFAS No. 123 defines a "fair value" based method of accounting
for an employee stock option or similar equity investment.

We account for equity instruments issued to non-employees in accordance
with the provisions of SFAS No. 123 and Emerging Issues Task Force Issue No.
96-18, "Accounting for Equity Instruments That Are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services."

During the three months ended September 30, 2000 and 1999, we recorded
unearned stock compensation of approximately $1.5 million and $3.2 million,
respectively. We recorded unearned stock compensation of $13.2 million and $5.6
million for the nine months ended September 30, 2000 and 1999, respectively.
These amounts are being amortized as charges to operations over the respective
vesting period of the individual stock options, generally four years. During the
three months ended September 30, 2000 and 1999, we recorded amortization of
unearned compensation of $2.9 million and $826,000, respectively. We recorded
amortization of unearned compensation of $9.0 million and $1.4 million for the
nine months ended September 30, 2000 and 1999, respectively.

We may incur additional stock-based compensation expense in the future
as a result of both options or other securities granted at below fair market
value and fluctuations in the market value of our stock which have a direct
impact on the value of options and warrants held by non-employees.

RESULTS OF OPERATIONS

Contract revenue decreased by $38,000 to $206,000 for the three months
ended September 30, 2000 from $244,000 in the comparable period of 1999.
Contract revenues for the nine months ended September 30, 2000 and 1999 were
$760,000 and $922,000, respectively. The decrease in third quarter revenue was
related entirely to revenue associated with agreements for the development and
analysis of knockout mice. In the third quarter of 2000 and 1999, all of our
revenue came from contracts with Merck, Pfizer, Roche, Schering-Plough and
Tularik. Our contract with Schering-Plough produced no revenue in 1999. Our
Tularik agreement expired in February 2000.

Research and development expenses increased by $3.6 million to $7.0
million for the three months ended September 30, 2000 from $3.4 million in
the comparable period of 1999. Research and development expenses for the nine
months ended September 30, 2000 and 1999 were $19.5 million and $8.1 million,
respectively. The increase in third quarter research and development expenses
was attributable to continued expansion of research and development
activities, including increased personnel and laboratory supply costs to
support development of our gene function database products and our
DeltaSelect and gene trap programs and higher depreciation and amortization
and facilities expenses related to the addition of a second facility in July
1999. The amortization of unearned stock compensation represents $1.1 million
of the increase in research and development expenses in the three months
ended September 30, 2000 and $4.1 million of the increase in the nine months
ended September 30, 2000.

General and administrative expenses increased by $2.0 million to $2.8
million during the three months ended June 30, 2000 from $764,000 for the
comparable period of 1999. General and administrative expenses for the nine
months ended September 30, 2000 and 1999 were $7.3 million and $1.6 million,
respectively. The increase in the third quarter related to compensation for
business development, finance and administrative personnel and legal and
business consulting fees. The amortization of unearned stock compensation
contributed to $1.1 million of the increase in general and administrative
expenses in the three months ended September 30, 2000 and $3.5 million of the
increase in the nine months ended September 30, 2000.

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Interest income (expense), net, increased to $1.0 million in the three
months ended September 30, 2000 from $(25,000) for the comparable period of
1999. Interest income (expense), net, for the nine months ended September 30,
2000 and 1999 was $1.2 million and $59,000, respectively. This increase resulted
from increasing cash and investment balances as a result of additional private
equity financing and the completion of an initial public offering during 2000.
Interest expense was $190,000 in the third quarter of 2000, as compared to
$79,000 in the third quarter of 1999. This increase resulted from higher average
debt balances in 2000.

A dividend relating to a beneficial conversion feature of our preferred
stock of $22.4 million was recorded in the quarter ended March 31, 2000. This
arose due to the issuance of 7,198,709 shares of Series C redeemable convertible
preferred stock in January 2000, for net proceeds of $22.4 million.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our operations from inception primarily through the
sale of stock and contract payments to us under our DeltaSelect agreements,
as well as, and equipment financing arrangements. As of September 30, 2000,
we had received net proceeds of $147.7 million from issuances of stock and
$2.9 million in cash payments from our agreements for the development and
analysis of knockout mice

As of September 30, 2000, we had $116.3 million in cash and cash
equivalents, as compared with $848,000 as of December 31, 1999. We used $16.2
million for operating activities during the first nine months of 2000. This
consisted of the net loss for the period of $24.7 million offset in part by
non-cash charges of $1.0 million related to depreciation and amortization
expenses and $9.0 million related to the amortization of unearned stock
compensation. We used $3.7 million for capital expenditures during the first
nine months of 2000. We received $135.4 million from financing activities during
the first nine months of 2000, which consisted of $133.1 million raised from the
issuance of stock and net loan proceeds of $2.9 million partially offset by loan
repayments of $642,000.

On August 2, 2000, our Registration Statement on Form S-1 (File No.
333-34668) was declared effective by the Securities and Exchange Commission.
The IPO Registration Statement registered a total of 7,000,000 shares of
common stock, all of which were issued and sold by us upon the termination of
the offering in August 2000. The shares were sold at an aggregate offering
price of $105 million, with net proceeds of approximately $95.9 million after
underwriting fees of approximately $7.4 million and other offering expenses
of approximately $1.7 million.

On August 30, 2000, the underwriters' exercised their over-allotment
for the purchase of approximately 1,025,000 shares. The shares were sold at an
aggregate offering price of $15.4 million, with net proceeds of approximately
$14.3 million after underwriting fees of approximately $1.1 million and other
offering expenses.

Our capital requirements depend on numerous factors, including our
ability to obtain gene function database subscriptions and DeltaSelect
agreements, the amount and timing of payments under these subscriptions and
agreements, the level and timing of our research and development expenditures,
market acceptance of our product, the resources we devote to developing and
supporting our products and other factors, many of which are outside of our
control. We expect to devote substantial capital resources to continue and
expand our research and development efforts, to expand our sales and marketing
organization and for other general corporate activities. We believe that our
current cash balances, together with the revenues we believe will be derived
from subscriptions to our gene function database and collaborative research
agreements, will be sufficient to fund our operations through 2001. During or
after this period, if cash generated by operations is insufficient to satisfy
our liquidity requirements or we make acquisitions or other investments, we may
need to sell additional equity or debt securities or obtain additional credit
arrangements. Additional financing may not be available on terms acceptable to
us or at all. The sale of additional equity or convertible debt securities may
result in additional dilution to our stockholders. Any debt financing may have
restrictive covenants that adversely affect our operating plans and flexibility.
The rights of any debt or preferred stockholders will be senior to those of our
common stockholders.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We invest our excess cash primarily in U.S. government securities and
marketable debt securities of financial institutions and corporations with
strong credit ratings. These instruments have maturities of three months
or less when acquired. We do not utilize derivative financial instruments,
derivative commodity instruments or other market risk sensitive

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instruments, positions or transactions in any material fashion. Accordingly, we
believe that, while the instruments we hold are subject to changes in the
financial standing of the issuer of such securities, we are not subject to any
material risks arising from changes in interest rates, foreign currency exchange
rates, commodity prices, equity prices or other market changes that affect
market risk sensitive instruments. Therefore, no quantitative tabular disclosure
is included in this report.

To date, we have operated solely in the United States and all sales
have been made in U.S. dollars. Accordingly, we have not had any material
exposure to foreign currency rate fluctuations.

RECENT ACCOUNTING PRONOUNCEMENTS

In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101 (SAB No. 101), "Revenue Recognition in Financial
Statements," which provides guidance on the recognition, presentation, and
disclosure of revenue in financial statements filed with the Securities and
Exchange Commission. SAB No. 101 outlines the basic criteria that must be met to
recognize revenue and provides guidance for disclosures related to revenue
recognition policies. We have complied with the guidance in SAB No. 101 for all
periods presented.

In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 133 (SFAS No. 133), "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 133 establishes new
standards of accounting and reporting for derivative instruments and hedging
activities. SFAS No. 133 requires that all derivatives be recognized at fair
value in the statement of financial position, and that the corresponding gains
or losses be reported either in the statement of operations or as a component of
comprehensive income, depending on the type of relationship that exists. SFAS
No. 133 will be effective for fiscal years beginning after June 15, 2000. We do
not believe that the implementation of SFAS No. 133 will have any significant
impact on our financial position or results of operations.

In March 2000, the Financial Accounting Standards Board issued
Interpretation No. 44 (FIN No. 44) "Accounting for Certain Transactions
Involving Stock Compensation," an interpretation of the Accounting Practice
Board Opinion No. 25 (APB No. 25). This interpretation clarifies the definition
of employee for purposes of applying APB No. 25, "Accounting for Stock Issued to
Employees," the criteria for determining whether a plan qualifies as a
noncompensatory plan, and the accounting for an exchange of stock compensation
awards in a business combination. This interpretation is effective July 1, 2000,
but certain conclusions in this interpretation cover specific events that occur
after either December 15, 1998 or January 12, 2000. The adoption of the
provisions of FIN No. 44 did not have a material effect on the financial
statements.

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RISK FACTORS

WE EXPECT TO CONTINUE TO INCUR SUBSTANTIAL LOSSES AND WE MAY NEVER ACHIEVE
PROFITABILITY, WHICH IN TURN MAY HARM OUR FUTURE OPERATING PERFORMANCE AND MAY
CAUSE THE MARKET PRICE OF OUR STOCK TO DECLINE

We have had net losses every year since our inception in 1997 and, as
of September 30, 2000, had an accumulated deficit of $43.2 million. We had net
losses of $24.7 million and $8.7 million during the nine months ended September
30, 2000 and 1999, respectively. The net loss for the nine months ended
September 30, 2000 was calculated before a deemed dividend related to the
beneficial conversion of our preferred stock of $22.4 million. Because we
anticipate significant additional expenditures for our research and development
programs and for the development, implementation and support of our gene
function database, we expect to report substantial net losses through at least
the next several years. We may never achieve profitability. If we do not become
profitable within the time frame expected by securities analysts or investors,
the market price of our stock will likely decline. If we do achieve
profitability, we may not sustain or increase profitability in the future.

We expect that our expenditures will continue to increase, due in part
to:

- continued investment in the research and development of our
new and existing products and our technology, including
increased investment for the development, implementation and
support of our gene function database, our standard and
conditional knockout programs and our gene trap programs;

- obligations under existing and future fee-for-service
agreements; and

- our increasing investment in management and other employees,
sales and marketing programs, customer service and operational
and financial controls.

WE HAVE AN UNPROVEN BUSINESS STRATEGY, AND OUR LIMITED HISTORY OF OPERATIONS
MAKES EVALUATION OF OUR BUSINESS AND PROSPECTS DIFFICULT

We have had a limited operating history and are at an early stage of
development. Our strategy of offering a gene function database and using
knockout mice to enable our customers to pursue promising candidates for drug
target development is unproven. Additionally, our pricing models for offering
our products and services are unproven. We currently have one subscriber for our
gene function database. We have generated only limited revenues from customers
for the development and analysis of knockout mice, amounting to approximately
$1.2 million and $381,000 for the fiscal years ended 1999 and 1998,
respectively. For the nine months ended September 30, 2000 and 1999, we
recognized revenues of $760,000 and $922,000, respectively. We recognized no
revenue in 1997. Our success will depend upon, among other things, our ability
to enter into licensing and other agreements on favorable terms, our ability to
determine and generate information on those genes which have potential use as
drug targets and the commercialization of products using our data. Moreover, we
have no experience selling our data, and we have never provided a gene database
before. Our sales force may not succeed in marketing our database product, and
our employees may not succeed in implementing and operating our database in a
manner that is satisfactory to our subscribers. Furthermore, the plans for our
gene trap and conditional knockout programs are unproven, and we cannot be sure
that we will ever be able to develop these programs or that any program that we
develop will be commercially successful. As a result of these factors, it is
difficult to evaluate our prospects, and our future success is more uncertain
than if we had a longer or more proven history of operations.

WE CURRENTLY HAVE ONLY FIVE CUSTOMERS AND WILL NOT SUCCEED UNLESS WE CAN ATTRACT
MANY MORE CUSTOMERS

We currently have only one subscriber to our DeltaBase gene function
database, and we have only five customers for our DeltaSelect knockout program.
We expect to enter into only a limited number of future DeltaSelect agreements.
To succeed we must attract customers for our database and other programs. Our
existing and future agreements may not be renewed and may be terminated without
penalty in the event either party fails to fulfill its obligations under one of
these agreements. Failure to renew or the cancellation of these agreements by
one of our customers could result in a significant loss of revenues. In 1999,
Pfizer accounted for 64% of our revenues and two of our other current customers
each accounted for greater than 10% of our revenues. Our current customers are
Merck, Pfizer, Roche Biosciences, Schering-Plough and Glaxo Wellcome. An
agreement with Tularik expired in February 2000 and our agreements with Roche
and Pfizer expire in November and December 2000, respectively. In the first nine
months of 2000, Schering-Plough accounted for 33% of our revenues and three
other customers accounted for the remaining 21%, 20% and 15%, respectively.

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Over the past several years, companies in the pharmaceutical industry
have undergone significant consolidation. If two or more of our present or
future customers merge, we may not be able to receive the same fees under
agreements with the combined entities that we were able to receive under
agreements with these customers prior to their merger. Moreover, if one of our
customers merges with an entity that is not a customer, the new combined entity
may prematurely terminate our agreement. Any of these developments could harm
our business or financial condition.

BECAUSE WE HAVE ONLY RECENTLY BEGUN TO OFFER OUR DATABASE, WHICH WE EXPECT TO BE
OUR PRINCIPAL PRODUCT, OUR FUTURE PROSPECTS ARE UNCERTAIN

We believe the majority of our revenues will be derived from fees under
agreements with our database users. We may also derive revenues from royalties
received from these users. We have entered into one agreement with a subscriber
to our database, however, we cannot be sure of the terms under which we may
enter into future agreements, such as fees payable to us or the term of the
agreements, if any. Our agreement which expires three years after our first
delivery of data to Glaxo Wellcome provides for termination for any reason
within the first three months after the one-year anniversary of the effective
date upon the payment of a specified termination fee.

Our database has not been tested by customers, and it may not perform
adequately or provide information in a manner that is useful for our customers.
If our database is not acceptable to our prospective customers, it may not
generate revenues and our business and financial condition will be materially
harmed.

We may not be able to comply with minimum performance levels or
restrictive provisions or other obligations that may be contained in any
agreements, such as minimum data delivery requirements. In addition, we may
experience unforeseen technical complications in the processes we use to
generate functional data for our gene database and functional genomics
resources. These complications could materially delay or limit the use of our
gene function database, substantially increase the anticipated cost of
generating data or prevent us from implementing our processes at appropriate
quality and scale levels, thereby causing our business to suffer.

NO DRUGS HAVE BEEN DEVELOPED AND COMMERCIALIZED USING GENOMICS-BASED RESEARCH
AND THEREFORE THE FUTURE OF OUR PRODUCTS AND PROGRAMS IS UNCERTAIN

None of the limited number of drugs developed to date using
genomics-based research have reached the commercial market. We cannot assure you
that genomics-based drug development efforts will ultimately be successful. We
have not proven our ability either to identify drug targets with commercial
potential or commercialize drug targets that we do identify. We cannot assure
you that a particular gene function in a mouse will have any correlation to a
patient's response to a particular drug. It is difficult to successfully select
those genes with the most potential for commercial development. Furthermore, we
do not know that any products based on genes that are the subject of our
research can be successfully developed or commercialized. If commercial
opportunities are not realized from genomic-based research, our existing
customers could stop using our products or we could have difficulty attracting
or retaining customers and, in any event, we would not realize any product
royalties.

OUR CUSTOMERS WILL CONTROL THE DEVELOPMENT AND COMMERCIALIZATION OF PRODUCTS
BASED ON GENES THAT WE IDENTIFY, WHICH MAY MEAN THAT OUR RESEARCH EFFORTS WILL
NEVER RESULT IN ANY ROYALTY PAYMENTS OR THIRD PARTY PRODUCT SALES

We intend for our agreements with our customers to provide us with
rights to obtain royalties from the commercial development of compounds or
therapeutic approaches derived from access to our database, technology or
intellectual property. We may not be able to obtain these rights under future
agreements. Our ability to obtain these rights depends in part on the advantages
and novelty of our technologies, the validity of our intellectual property, the
usefulness of our data and our negotiating position relative to each potential
customer.

We will have limited or no control over the resources that any customer
may devote to the development of compounds or therapeutic approaches derived
from our access to our database. These customers may breach or terminate their
agreements with us, and they are not obligated to conduct any product discovery,
development or commercialization activities at all. Further, our customers may
decide not to develop products arising out of our customer agreements or may not
devote sufficient resources to the development, approval, manufacture, marketing
or sale of these products. If any of these events occurs, our customers may not
develop or commercialize any products based on our gene function research,
technologies or intellectual property, and we would not receive royalties on
product sales and our results of operations would suffer. Furthermore, our
customers may resist

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sharing revenue derived from the successful commercialization of a drug through
royalty payments or others may have competing claims to all or a portion of such
revenues.

THERE ARE A FINITE NUMBER OF GENE FAMILIES UPON WHICH PHARMACEUTICAL AND
BIOTECHNOLOGY COMPANIES FOCUS THEIR RESEARCH, WHICH LIMITS OUR POTENTIAL REVENUE
AND GROWTH

Our current and potential subscribers and customers traditionally focus
their research and development efforts on a finite number of gene families that
they view as reliable drug targets. Once we provide functional information on
these gene families, our ability to attract and retain subscribers to our
database will depend, in part, on the willingness of our subscribers to expand
their research and development activities to other gene families. If our
customers do not do this, we may lose existing subscribers or fail to attract
new subscribers for our database services, and as a result, our business and
financial condition may be harmed. In addition, we have made and will continue
to make significant investments in our database and knockout programs which we
may not recoup if we cannot find additional target opportunities.

WE MAY FAIL TO MEET MARKET EXPECTATIONS BECAUSE OF FLUCTUATIONS IN OUR QUARTERLY
OPERATING RESULTS, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE

The following are among the factors that could cause our operating results to
fluctuate significantly from period to period:

- changes in the demand for and pricing of our products and
services;

- the nature, pricing and timing of other products and services
provided by us or our competitors;

- changes in the research and development budgets of our
customers;

- acquisition, licensing and other costs related to the
expansion of our operations;

- the timing of milestones, licensing and other payments under
the terms of our customer agreements and agreements pursuant
to which others license technology to us;

- expenses related to, and the results of, patent filings and
other proceedings relating to intellectual property rights;
and

- our unpredictable revenue sources as described below.

We anticipate significant fixed expenses due in part to our need to
continue to invest in product development and potential extensive support for
our gene function database subscribers. We may be unable to adjust our
expenditures if revenues in a particular period fail to meet our expectations,
which would harm our operating results for that period.

As a result of these fluctuations, we believe that period-to-period
comparisons of our financial results will not necessarily be meaningful, and you
should not rely on these comparisons as an indication of our future performance.

OUR REVENUES WILL BE UNPREDICTABLE AND THIS MAY HARM OUR FINANCIAL CONDITION

The amount and timing of revenues that we may have from our business
will be unpredictable because:

- the timing of our DeltaSelect program agreements, gene
function database subscriber agreements and installations are
determined by our customers and subscribers;

- whether any products are commercialized and generate royalty
payments depends on the efforts, timing and willingness of our
customers;

- we do not expect to receive any milestone or royalty payment
under licenses and other arrangements for a substantial period
of time, if ever;

- to date, we have entered into only one customer agreement for
our gene function database and may not enter into any
additional agreements;

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- the time required to complete custom orders for our database
programs can vary significantly; and

- our sales cycle is lengthy, as described below.

As a result, our revenue may significantly vary from quarter to
quarter, and our quarterly results may be below market expectations. If this
happens, the price of our common stock may decline.

WE EXPECT THAT OUR SALES CYCLE WILL BE LENGTHY, WHICH WILL CAUSE OUR REVENUES TO
BE UNPREDICTABLE AND OUR BUSINESS TO BE DIFFICULT TO MANAGE

Our ability to identify and obtain subscribers for our gene function
database product and other services depends upon whether customers believe that
our products and services can help accelerate drug discovery efforts. Our sales
cycle will be lengthy because of the need to educate potential customers and
sell the benefits of our products and services to a variety of constituencies
within potential subscriber companies. These companies are large organizations
with many different layers and types of decision-makers. In addition, each
database subscription and development program or services agreement will involve
the negotiation of unique terms and issues which will take a significant amount
of time. We may expend substantial funds and management effort with no assurance
that a subscription program or services agreement will result. Actual or
proposed mergers or acquisitions of our prospective customers may also affect
the timing and progress of our sales efforts. Any of these developments could
harm our business or financial condition.

WE MAY HAVE CONFLICTS OR BE IN COMPETITION WITH OUR CUSTOMERS, WHICH WILL HURT
OUR BUSINESS PROSPECTS

We may pursue opportunities in fields, such as secreted proteins, that
could conflict with those of our customers. Moreover, disagreements could arise
with our customers or their partners over rights to our intellectual property or
our rights to share in any of the future revenues of compounds or therapeutic
approaches developed by our customers. These kinds of disagreements could result
in costly and time-consuming litigation and could have a negative impact on our
relationship with existing customers. Any conflict with our customers could
reduce our ability to attract additional customers or enter into future customer
agreements. Some of our customers could also become competitors in the future.
Our customers could develop competing products, preclude us from entering into
agreements with their competitors or terminate their agreements with us
prematurely.

WE EXPERIENCE INTENSE COMPETITION FROM OTHER ENTITIES ENGAGED IN THE STUDY OF
GENES, AND THIS COMPETITION COULD ADVERSELY AFFECT OUR BUSINESS

The human and mouse genomes contain a finite number of genes. The human
genome has been mapped and identified. Our competitors have identified and will
continue to identify the sequence of numerous genes in order to obtain
proprietary positions with respect to those genes. In addition, our competitors
may seek to identify and determine the biological function of numerous genes in
order to obtain intellectual property rights with respect to specific uses of
these genes, and they may accomplish this before we do. We believe that the
first company to determine the functions of commercially relevant genes or the
commercially relevant portions of the genome will have a competitive advantage.

A number of companies, institutions and government-financed entities
are engaged in gene sequencing, gene discovery, gene expression analysis, gene
function determination and other gene-related service businesses. Many of these
companies, institutions and entities have greater financial and human resources
than we do and have been conducting research longer than we have. In particular,
a significant portion of this research is being conducted by private companies
and under the international Human Genome Project, a multi-billion dollar program
funded, in part, by the U.S. government, which completed and released its
initial rough draft of the human genome in June of this year. Furthermore, other
entities have and will continue to discover and establish a patent position in
genes or gene sequences that we may wish to study. Significant competition also
arises from entities using standard target identification approaches,
traditional knockout mouse technology and other functional genomics
technologies. These competitors may have intellectual property rights in
functional or other data which are superior to our rights. These competitors may
also develop products earlier than we do, obtain regulatory approvals faster
than we can and invent products and techniques that are more effective than
ours. Furthermore, other methods for conducting functional genomics research may
ultimately prove more advanced, in some or all respects, to the use of knockout
mice. In addition, technologies more advanced than or superior to our gene trap
technology and gene function identification technology may be developed, thereby
rendering our gene trap and gene function identification technologies obsolete.
As we expand our range of products and

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services, such as our gene trap program, we will compete with additional
companies, some of which may be our customers at that time or our potential
customers.

Some of our competitors have developed commercially available databases
containing gene sequence, gene expression, gene function, genetic variation or
other functional genomic information and are marketing or plan to market their
data to pharmaceutical and biotechnology companies. Additional competitors may
attempt to establish databases containing this information in the future. We
expect that competition in our industry will continue to intensify. We also
believe that some pharmaceutical and biotechnology companies are discussing the
possibility of working together to discover the functions of genes and share
gene function-related data among themselves. The formation of this type of
consortium could reduce the prospective customer base for our gene
function-related business. Moreover, the pharmaceutical industry has undergone
significant mergers and this trend is expected to continue. This concentration
of the industry could further limit our potential customer base and therefore
harm our business.

IF WE FAIL TO PROPERLY MANAGE OUR GROWTH, OUR BUSINESS COULD BE ADVERSELY
AFFECTED

We expect to continue to experience significant growth in the number of
our employees and the scope of our operations, including an increase in the
scale of our mouse knockout program. As of December 31, 1999, we had 113
full-time employees, and as of September 30, 2000, we had 177 full-time
employees. We expect our number of employees to continue to increase for the
foreseeable future. In addition, we have substantially increased the scale of
our knockout mouse production in the last year and expect to continue doing so
for the foreseeable future. Our overall growth and need to develop many
different areas of our company have placed, and may continue to place, a strain
on our management and operations. If we are unable to manage our growth
effectively, our losses could increase. The management of our growth will
depend, among other things, upon our ability to broaden our management team and
attract, hire, train and retain skilled employees. Our success will also depend
on the ability of our officers and key employees to continue to implement and
improve our operational and other systems. We will also be required to expend
funds, which may be substantial, to improve our operational, financial and
management controls, reporting systems and procedures.

In addition, we will have to invest in additional customer support
resources. Our current and potential database subscribers typically have
worldwide operations and may require support at multiple U.S. and foreign sites
and in multiple languages. To provide this support, we may need to open offices
in addition to our Menlo Park and San Carlos, California facilities, which will
result in additional burdens on our systems and resources and require additional
capital expenditures.

WE MAY ENGAGE IN FUTURE ACQUISITIONS, WHICH COULD ADVERSELY AFFECT YOUR
INVESTMENT IN US AS WE MAY NEVER REALIZE ANY BENEFITS FROM SUCH ACQUISITIONS,
WHICH ALSO COULD BE EXPENSIVE AND TIME CONSUMING

We intend to acquire and license additional products and programs, if
we determine that these products or programs complement our existing technology
or augment our existing information technology platforms. We currently have no
commitments or agreements with respect to any material acquisitions. If we do
undertake any transactions of this sort, the process of integrating an acquired
business, technology, service or product may result in operating difficulties
and expenditures and may absorb significant management attention that would
otherwise be available for ongoing development of our business. Moreover, we may
never realize the anticipated benefits of any acquisition. Future acquisitions
could result in potentially dilutive issuances of equity securities, the
incurrence of debt and contingent liabilities and amortization expenses related
to goodwill and other intangible assets, which could adversely affect our
results of operations and financial condition.

WE MAY NEED TO RAISE ADDITIONAL CAPITAL THAT MAY NOT BE AVAILABLE, WHICH COULD
ADVERSELY AFFECT OUR OPERATIONS.

Our products and services may not produce revenues that, together with
our existing cash and other resources, are adequate to meet our cash needs.
Initially, we plan to fund our operations with proceeds from our initial public
offering, and we may in the future seek to raise additional funds from the sale
of stock or from debt financing. Our cash requirements depend on numerous
factors, including:

- our ability to attract and retain customers for our gene
function database and other products and services;

- unexpected expenses in connection with the development of our
gene function database, our gene trap program or other
products and services;

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- expenditures in connection with license agreements and
acquisitions of and investments in complementary technologies
and businesses;

- the need to increase research and development spending to keep
up with competing technologies and market developments; and

- unexpected expenditures as we expand our sales, marketing and
customer service organizations and improve our management,
operational and financial systems.

If we need additional funding, we may be unable to obtain it on
favorable terms, or at all. If adequate funds are not available, we may have to
curtail operations significantly or obtain funds by entering into arrangements
requiring us to relinquish rights to certain technologies, products or markets.
In addition, if we raise funds by selling stock or convertible securities, our
existing stockholders could suffer dilution.

WE DEPEND ON KEY EMPLOYEES IN A COMPETITIVE MARKET FOR SKILLED PERSONNEL, AND
WITHOUT ADDITIONAL EMPLOYEES, WE CANNOT GROW OR ACHIEVE PROFITABILITY

We are highly dependent on the principal members of our management,
operations and scientific staff, including William Matthews, Ph.D., our
President and Chief Executive Officer, and Mark W. Moore, Ph.D., our Chief
Scientific Officer. The loss of either of their services would harm our
business.

Our future success also will depend in part on the continued service of
our key scientific, software, consultant and management personnel and our
ability to identify, hire and retain additional personnel, including customer
service, marketing and sales staff. We experience intense competition for
qualified personnel. We may be unable to attract and retain personnel necessary
for the development of our business. Moreover, our business is located in the
San Francisco Bay Area of California, where demand for personnel with the skills
we seek is extremely high and is likely to remain high. Because of this
competition, our compensation costs may increase significantly.

WE CURRENTLY HAVE NO PATENTS, AND IF WE ARE UNABLE TO PROTECT OUR PROPRIETARY
INFORMATION, OUR BUSINESS WILL BE ADVERSELY AFFECTED

Our business and competitive position depends upon our ability to
protect and exploit our proprietary techniques, methods, compositions,
inventions, database information and software technology. However, our strategy
of obtaining such proprietary rights around as many genes as possible is
unproven. Unauthorized parties may attempt to obtain and use information that we
regard as proprietary. Although we intend for our gene function database
subscription agreements to require our potential subscribers to control access
to our database and information, policing unauthorized use of our database
information and software may be difficult.

We currently have no issued patents or registered copyrights. Patents
have issued to other entities based on claims relating to knockout mice. In
addition, many applications have been filed seeking to protect partial human
gene sequences, many of which are based primarily on gene sequence information
alone. Some of these applications have issued as patents. Some of these may
claim sequences which we have used or may use in the future to generate knockout
mice in our gene knockout program. In addition, other applications have been
filed which seek to protect methods of using genes and gene expression products,
some of which attempt to assign biological function to the DNA sequences based
on laboratory experiments, computer predictions, mathematical algorithms and
other methods. The issuance of these applications as patents will depend, in
part, upon whether practical utility can be sufficiently established for the
claimed sequences and whether sufficient correlation exists between the
experimental results predictions, algorithms and other methods and actual
functional utility. The patent application process before the United States'
Patent and Trademark Office and other similar agencies in other countries is
confidential in nature. As each application is evaluated independently and
confidentially, we cannot predict whether applications have been filed or which,
if any, will ultimately issue as patents. However, it is probable that patents
will be issued to our competitors claiming knockout mice, partial human gene
sequences and methods of using genes and gene expression products.

Numerous applications have been filed by other entities claiming gene
sequences. Many patents have already issued and we expect more will issue in the
future. In addition, others may discover uses for genes or proteins other than
uses covered in any patents issued to us, and these other uses may be separately
patentable. We may not be able to obtain issued patents on our patent
applications because our patent applications may not meet the requirements of
the patent office. The holder of a patent covering a particular use of a gene or
a protein, isolated gene sequence or deduced amino acid sequence could exclude
us from

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using that gene, protein or sequence. In addition, a number of entities make
gene information, techniques and methods publicly available, which may affect
our ability to obtain patents.

Some of our patent applications may claim compositions, methods or uses
that may also be claimed in patent applications filed by others. In some or all
of these applications, a determination of priority of inventorship may need to
be decided in an interference proceeding before the U.S. Patent and Trademark
Office. Regardless of determined outcome, this process is time-consuming and
expensive.

Issued patents may not provide commercially-meaningful protection
against competitors. Other companies or institutions may challenge our or our
customers' patents or independently develop similar products that could result
in an interference proceeding in the U.S. Patent and Trademark Office or a legal
action. In the event any researcher or institution infringes upon our or our
customers' patent rights, enforcing these rights may be difficult and can be
time-consuming. Others may be able to design around these patents or develop
unique products providing effects similar to our products.

Our ability to use our patent rights to limit competition in the
creation and use of knockout mice, as well as our ability to obtain patent
rights, may be more limited in certain markets outside of the United States
because the protections available in other jurisdictions may not be as extensive
as those available domestically.

We pursue a policy of having our employees, consultants and advisors
execute proprietary information and invention agreements when they begin working
for us. However, these agreements may not be enforceable or may not provide
meaningful protection for our trade secrets or other proprietary information in
the event of unauthorized use or disclosure. We also cannot prevent others from
independently developing technology or software that might be covered by
copyrights issued to us, and trade secret laws do not prevent independent
development.

WE MAY BE SUBJECT TO LITIGATION AND INFRINGEMENT CLAIMS WHICH MAY BE COSTLY AND
DIVERT MANAGEMENT'S ATTENTION

The technology we use in our business may subject us to claims that we
infringe on the patents or proprietary rights of others. The risk of this
occurring will tend to increase as the genomics, biotechnology and software
industries expand, more patents are issued and other companies attempt to
discover gene function through mouse gene knockouts and engage in other
genomics-related businesses. Furthermore, many of our competitors and other
companies performing research on genes have already applied for patents covering
some of the genes upon which we perform research, and many patents have already
been issued which cover these genes, as well as genes we may wish to use in the
future.

In 1998, Lexicon Genetics Incorporated, one of our competitors,
informed us that it was a coexclusive licensee under a patent covering
certain isogenic DNA technology that may be used to modify the genome of a
target cell. On May 24, 2000, Lexicon filed a lawsuit against us in the
United States District Court for the District of Delaware. The complaint in
the lawsuit alleges that our methods of making knockout mice infringe United
States Patent No. 5,789,215, under which Lexicon claims to be an exclusive
licensee. The complaint seeks a judgment that we have infringed this patent,
a permanent injunction against further infringement of the patent and an
award of damages in an unspecified amount that, under certain circumstances,
may be trebled. On June 13, 2000, we responded to Lexicon's complaint by
filing an answer and seeking a declaratory judgment in our favor. Our
response seeks a judgment declaring the patent invalid and that we have not
infringed and are not infringing the patent. We intend to defend the action
vigorously.

The litigation against us is in the early stages and its outcome cannot
be predicted. If Lexicon prevails and obtains an injunction, we would be
required to obtain a license in order to continue to use the methods covered by
the patent. We may not be able to obtain this license on favorable terms or at
all. If we are unable to obtain a license, we would be required to redesign our
processes to use alternative methods of making knockout mice and expect we would
experience a significant disruption in our ability to generate revenue during
this redesign period and as we develop a gene function database using these new
methods. This redesign and development would involve significant time and costs,
and the alternative methods available to us may not be as effective as our
current methods. We estimate the average time from the date we begin to create a
knockout mouse until the date the data from that knockout mouse is added to the
gene function database to be 12 months. The addition of new data points to our
gene function database could be significantly delayed. We may fail to attract
customers for a gene function database that uses the alternative methods, and
the marketing of our existing database and DeltaSelect program may be
significantly affected. If Lexicon prevails, we could also incur significant
financial liabilities which could materially affect our business and operating
results.

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At this time no estimate can be made of the outcome or any possible
loss that may be incurred. The litigation is in the early stages and its
outcome cannot be predicted.

We may be involved in future lawsuits alleging patent infringement or
other intellectual property rights violations. In addition, litigation may be
necessary to:

- assert claims of infringement;

- enforce our patents, if any;

- protect our trade secrets or know-how; and

- determine the enforceability, scope and validity of the
proprietary rights of others.

We may be unsuccessful in defending or pursuing these lawsuits.
Regardless of the outcome, litigation, including our litigation with Lexicon,
can be very costly, can divert management's efforts and could materially affect
our business and operating results. An adverse determination may subject us to
significant liabilities or restrict or prohibit us from selling our products.

BECAUSE WE DO NOT HAVE ANY ISSUED PATENTS, AND BECAUSE KNOCKOUT MOUSE AND
GENE-RELATED PATENTS EVEN IF OBTAINED MAY NOT BE ENFORCEABLE, OUR INTELLECTUAL
PROPERTY MAY NOT HAVE ANY MATERIAL VALUE, WHICH WOULD DIMINISH OUR BUSINESS
PROSPECTS

One of our strategies is to obtain proprietary rights around as many
gene knockouts as possible. Although we have filed patent applications covering
the knockout mice we produce, we do not currently have any issued patents. We
rely on a combination of copyright and trademark law, trade secrets,
non-disclosure agreements and contractual provisions in our agreements with our
customers to establish and maintain intellectual property rights. While the U.S.
Patent and Trademark Office in the past has issued patents to others covering
function of genes, knockout mice, types of cells, gene sequences and methods of
testing cells, we do not know whether or how courts may enforce those patents,
if that becomes necessary. If a court finds these types of inventions to be
unpatentable, or interprets them narrowly, the benefits of our strategy may not
materialize and our business and financial condition could be harmed.

OUR RIGHTS TO THE USE OF TECHNOLOGIES LICENSED TO US BY THIRD PARTIES ARE NOT
WITHIN OUR CONTROL, AND WITHOUT THESE TECHNOLOGIES, OUR PRODUCTS AND PROGRAMS
MAY NOT BE SUCCESSFUL AND OUR BUSINESS PROSPECTS COULD BE HARMED

We rely, in part, on licenses to use certain technologies which are
material to our business, including a secreted protein gene trap which we
license exclusively from the University of Edinburgh. We do not own the patents
that underlie these licenses. Our rights to use these technologies and employ
the inventions claimed in the licensed patents are subject to our licensors
abiding by the terms of those licenses and not terminating them. In most cases,
we do not control the prosecution or filing of the patents to which we hold
licenses. Instead we rely upon our licensors to prevent infringement of those
patents. Some of the licenses under which we have rights, such as the license
from the University of Edinburgh, provide us with exclusive rights in specified
fields, but we cannot assure you that the scope of our rights under these and
other licenses will not be subject to dispute by our licensors or third parties.

OUR ACTIVITIES INVOLVE HAZARDOUS MATERIAL AND MAY SUBJECT US TO ENVIRONMENTAL
LIABILITY, WHICH WOULD SERIOUSLY HARM OUR FINANCIAL CONDITION

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Our research and development activities involve the controlled use of
hazardous and radioactive materials and generate biological waste. We are
subject to federal, state and local laws and regulations governing the storage,
handling and disposal of these materials and waste products. Although we believe
that our safety procedures for handling and disposing of these materials and
wastes comply with legally prescribed standards, the risk of accidental
contamination or injury from these materials cannot be completely eliminated. We
may be sued for any injury or contamination that results from our use or the use
by third parties of these materials, and our liability may exceed our insurance
coverage and our total assets. Future environmental regulations could require us
to incur significant costs.

COMPLIANCE WITH GOVERNMENTAL REGULATIONS COULD INCREASE OUR OPERATING COSTS OR
ADVERSELY AFFECT OUR CUSTOMERS' ABILITY TO OBTAIN GOVERNMENTAL APPROVAL OF GENE
BASED PRODUCTS, WHICH WOULD ADVERSELY AFFECT THE COMMERCIALIZATION OF OUR
TECHNOLOGY

The Animal Welfare Act, or AWA, is the federal law that currently
covers animals in laboratories. It applies to institutions or facilities
using any regulated live animals for research, testing, teaching or
experimentation, including diagnostic laboratories and private companies in
the pharmaceutical and biotechnology industries. The AWA currently does not
cover rats, mice or birds. However, the United States Department of
Agriculture, which enforces the AWA, has been sued on this matter and
recently agreed, as part of the settlement of this lawsuit, to begin the
process of changing the regulations issued under the AWA to include rats,
mice and birds within its coverage. Congress subsequently prohibited, for the
next fiscal year ending September 30, 2001, the expenditure of any money for
the purpose of changing the regulations with respect to including rats, mice
and birds.

Currently, the AWA imposes a wide variety of specific regulations
which govern the humane handling, care, treatment and transportation of
certain animals by producers and users of research animals, most notably
personnel, facilities, sanitation, cage size, feeding, watering and shipping
conditions. We cannot assure you that the USDA will not in the future include
rats, mice and birds in its regulations and that we will not become subject
to registration, inspections and reporting requirements. Compliance with the
AWA could be expensive, and current or future regulations could impair our
research and production efforts.

Since we develop animals containing changes in their genetic make-up,
we may become subject to a variety of laws, guidelines, regulations and treaties
specifically directed at genetically modified organisms, or GMOs. The area of
environmental releases of GMOs is rapidly evolving and is currently subject to
intense regulatory scrutiny, particularly internationally. If we become subject
to these laws we could incur substantial compliance costs. For example, the
Biosafety Protocol, or the BSP, a recently adopted treaty, is expected to cover
certain shipments from the U.S. to countries abroad that have signed the BSP.
The BSP is also expected to cover the importation of living modified organisms,
a category that could include our animals. If our animals are not contained as
described in the BSP, our animals could be subject to the potentially extensive
import requirements of countries that are signatories to the BSP.

We also are subject to a variety of other federal, state and local laws
and regulations in the U.S. and in other countries pertaining to our facilities,
the shipment, exportation and importation of various articles, safe working
conditions, production practices, fire hazard control and other health concerns.
There can be no assurance that we will avoid incurring significant costs to
comply with these laws and regulations or that we will be able to comply with
them in the future. Failure to comply with relevant laws and regulations may
have a material adverse effect on our business, financial condition and results
of operation. Unanticipated changes in existing legal and regulatory
requirements or the adoption of new requirements also could have a material
adverse effect on us.

Drugs and diagnostic products are subject to an extensive and uncertain
regulatory approval process by the Food and Drug Administration and comparable
agencies in other countries. Regulatory requirements ultimately imposed on our
products or products developed by our customers could limit our or our
customers' ability to test, manufacture and, ultimately, commercialize products,
including products for which we are entitled to receive royalty payments.

ETHICAL AND SOCIAL ISSUES MAY LIMIT OR DISCOURAGE THE USE OF KNOCKOUT MICE OR
OTHER GENETIC PROCESSES WHICH COULD REDUCE OUR REVENUES AND ADVERSELY AFFECT OUR
BUSINESS

Governmental authorities could, for social or other purposes, limit the
use of genetic processes or prohibit the practice of our gene trap and knockout
mouse technologies. Public attitudes may be influenced by claims that
genetically engineered products are unsafe for consumption or pose a danger to
the environment. The subject of genetically modified organisms, like knockout
mice, has received negative publicity and aroused public debate. In addition,
animal rights activists could protest or

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make threats against our facilities, which may result in property damage.
Ethical and other concerns about our methods, particularly our use of knockout
mice, could adversely affect our market acceptance.

ALL OUR RESEARCH IS CONDUCTED AT TWO FACILITIES, AND A NATURAL DISASTER AT THESE
FACILITIES IS POSSIBLE AND COULD RESULT IN A PROLONGED INTERRUPTION OF OUR
BUSINESS

We conduct all our scientific and management activities at two
facilities in California. Both locations are in seismically active areas. We
have taken precautions to safeguard our mouse colony including through
insurance, storage of animals off-site at a back-up facility in Massachusetts,
the freezing of sperm and the storing of embryonic stem cells, or ES cells, to
allow for the regeneration of mice. However, a natural disaster, such as an
earthquake, fire, flood or outbreak of infectious disease, could cause
substantial delays. This could interrupt mouse breeding, cause us to incur
additional expenses and adversely affect our reputation with customers.

SECURITY RISKS IN ELECTRONIC COMMERCE OR UNFAVORABLE INTERNET REGULATIONS MAY
DETER FUTURE USE OF OUR PRODUCTS AND SERVICES

We may provide access to our gene function database on the Internet. A
fundamental requirement to conduct our business over the Internet is the secure
transmission of confidential information over public networks. Advances in
computer capabilities, new discoveries in the field of cryptography or other
developments may result in a compromise or breach of the security measures we
use to protect the content in our gene function database. Anyone who is able to
circumvent our security measures could misappropriate our proprietary
information or confidential customer information or cause interruptions in our
operations. We may be required to incur significant costs to protect against
security breaches or to alleviate problems caused by breaches, and these efforts
may not be successful. Further, a well-publicized compromise of security could
deter people from using the Internet to conduct transactions that involve
transmitting confidential information. For example, attacks earlier this year by
computer hackers on major e-commerce web sites have heightened concerns
regarding the security and reliability of the Internet.

Because of the growth in electronic commerce, the U.S. Congress has
held hearings on whether to further regulate providers of services and
transactions in the electronic commerce market, and federal and state
authorities could enact laws, rules and regulations affecting our business and
operations. If enacted, these laws, rules and regulations could make our
business and operations more costly and burdensome as well as less efficient.

WE RELY ON THIRD-PARTY DATA SOURCES, AND WITHOUT THESE SOURCES, OUR PRODUCTS AND
PROGRAMS WOULD BE INCOMPLETE AND LESS APPEALING TO CUSTOMERS, SERIOUSLY HARMING
OUR BUSINESS PROSPECTS

We may rely on scientific and other data supplied by third parties, and
all of our gene sequence data comes from public genomics data. This data could
be defective, be improperly generated or contain errors or other defects, which
could corrupt our gene function database and our other programs and services. In
addition, we cannot guarantee that our sources acquired this data in compliance
with legal requirements. In the event of any such defect, corruption or finding
of nonconformance, our business prospects could be adversely affected.

OUR COMMON STOCK MAY EXPERIENCE EXTREME PRICE AND VOLUME FLUCTUATIONS, WHICH
COULD LEAD TO COSTLY LITIGATION FOR US AND MAKE AN INVESTMENT IN US LESS
APPEALING

The market price of our common stock may fluctuate substantially due to a
variety of factors, including:

- announcements of technological innovations or new products by
us or our competitors;

- developments or disputes concerning patents or proprietary
rights, including announcements with respect to our litigation
with Lexicon or of infringement, interference or other
litigation against us or our licensors;

- the timing and development of our products and services;

- media reports and publications about genetics and gene-based
products;

- changes in pharmaceutical and biotechnology companies'
research and development expenditures;

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- announcements concerning our competitors, or the biotechnology
or pharmaceutical industry in general;

- changes in government regulation of genetic research or
gene-based products, and the pharmaceutical or medical
industry in general;

- general and industry-specific economic conditions;

- actual or anticipated fluctuations in our operating results;

- changes in financial estimates or recommendations by
securities analysts;

- changes in accounting principles; and

- the loss of any of our key scientific or management personnel.

In addition, the stock market has experienced extreme price and volume
fluctuations. The market prices of the securities of biotechnology companies,
particularly companies like ours without consistent product revenues and
earnings, have been highly volatile and may continue to be highly volatile in
the future. This volatility has often been unrelated to the operating
performance of particular companies. For example, the stock prices of many
biotechnology companies, even those that would benefit from publicly available
gene sequence information, declined on news of the announcement by President
Clinton and British Prime Minister Blair that, as their respective governments
had each advocated before, gene sequence information should be freely available
in the public domain. In the past, securities class action litigation has often
been brought against companies that experience volatility in the market price of
their securities. Moreover, market prices for stocks of biotechnology-related
and technology companies, particularly following an initial public offering,
frequently reach levels that bear no relationship to the operating performance
of such companies. These market prices generally are not sustainable and are
subject to wide variations. Whether or not meritorious, litigation brought
against us could result in substantial costs, divert management's attention and
resources and harm our financial condition and results of operations.

THE FUTURE SALE OF COMMON STOCK COULD NEGATIVELY AFFECT OUR STOCK PRICE

After the close of our public offering on August 8, 2000 we had
approximately 28,804,437 shares of common stock outstanding, and approximately
29,829,437 shares when the underwriters' exercised their over-allotment for
approximately 1,025,000 shares. The 8,025,000 shares sold in the offering are
freely tradable without restriction or further registration under the federal
securities laws unless purchased by our affiliates. The remaining 21,804,437
shares of common stock outstanding will be available for sale in the public
market 180 days after the effective date of the registration statement, subject
in some cases to volume and other limitations.

The previous sentence assumes the effectiveness of the lock-up
agreements with the underwriters under which holders of substantially all of our
common stock have agreed not to sell or otherwise dispose of their shares of
common stock. Most of the shares that will be available for sale after the
expiration of the lock-up period will be subject to volume restrictions because
they are held by our affiliates. In addition, Salomon Smith Barney Inc. may
waive these lock-up restrictions prior to the expiration of the lock-up period
without prior notice. Salomon Smith Barney Inc. has informed us that it has no
current intentions of releasing any shares subject to the lock-up agreements.
Any determination by Salomon Smith Barney Inc. to release any shares subject to
the lock-up restrictions would be based on a number of factors at the time of
determination, including the market price of the common stock, the liquidity of
the trading market for the common stock, the general market conditions, the
number of shares proposed to be sold and the timing, purpose and terms of the
proposed sale.

If our common stockholders sell substantial amounts of common stock in
the public market, or the market perceives that such sales may occur, the market
price of our common stock could fall. The holders of approximately 18,180,856
shares of our common stock have rights, subject to some conditions, to require
us to file registration statements covering their shares or to include their
shares in registration statements that we may file for ourselves or other
stockholders. Furthermore, if we were to include in a company-initiated
registration statement shares held by those holders pursuant to the exercise of
their registration rights, those sales could impair our ability to raise needed
capital by depressing the price at which we could sell our common stock.

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OUR PRINCIPAL STOCKHOLDERS, EXECUTIVE OFFICERS AND DIRECTORS OWN A SIGNIFICANT
PERCENTAGE OF OUR STOCK, AND AS A RESULT, THE TRADING PRICE FOR OUR SHARES MAY
BE DEPRESSED AND THESE STOCKHOLDERS CAN TAKE ACTIONS THAT MAY BE ADVERSE TO YOUR
INTERESTS

Our executive officers and directors and entities affiliated with them,
in the aggregate, beneficially own approximately 67.6% of our common stock
following our public offering. This significant concentration of share ownership
may adversely affect the trading price for our common stock because investors
often perceive disadvantages in owning stock in companies with controlling
shareholders. These stockholders, acting together, will have the ability to
exert substantial influence over all matters requiring approval by our
stockholders, including the election and removal of directors and any proposed
merger, consolidation or sale of all or substantially all of our assets. In
addition, they could dictate the management of our business and affairs. This
concentration of ownership could have the effect of delaying, deferring or
preventing a change in control, or impeding a merger or consolidation, takeover
or other business combination that could be favorable to you.

OUR INCORPORATION DOCUMENTS AND DELAWARE LAW MAY INHIBIT A TAKEOVER THAT
STOCKHOLDERS CONSIDER FAVORABLE AND COULD ALSO LIMIT THE MARKET PRICE OF YOUR
STOCK

Our amended and restated certificate of incorporation and bylaws
contain provisions that could delay or prevent a change in control of our
company. Some of these provisions:

- authorize the issuance of preferred stock which can be created
and issued by the board of directors without prior stockholder
approval, commonly referred to as "blank check" preferred
stock, with rights senior to those of common stock;

- provide for a classified board of directors; and

- prohibit stockholder action by written consent.

In addition, we are governed by the provisions of Section 203 of
Delaware General Corporate Law. These provisions may prohibit large
stockholders, in particular those owning 15% or more of our outstanding voting
stock, from merging or combining with us. These and other provisions in our
amended and restated certificate of incorporation and bylaws and under Delaware
law could reduce the price that investors might be willing to pay for shares of
our common stock in the future and result in the market price being lower than
it would be without these provisions.

WE MAY SPEND THE NET PROCEEDS OF OUR INITIAL PUBLIC OFFERING IN WAYS WITH WHICH
YOU DO NOT AGREE AND WHICH ARE NOT BENEFICIAL TO YOUR INVESTMENT IN US

We have not designated any specific uses for the initial public
offering proceeds. Accordingly, management will have significant flexibility in
applying the net proceeds of the initial public offering. The failure of
management to apply the net proceeds effectively could have a material adverse
effect on our business, financial condition and results of operations.

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PART II. OTHER INFORMATION
ITEM 1. - LEGAL PROCEEDINGS

In 1998, Lexicon Genetics Incorporated, one of our competitors, informed
us that it was a coexclusive licensee under a patent covering certain
isogenic DNA technology that may be used to modify the genome of a target
cell. On May 24, 2000, Lexicon filed a lawsuit against us in the United
States District Court for the District of Delaware. The complaint in the
lawsuit alleges that our methods of making knockout mice infringe United
States Patent No. 5,789,215, under which Lexicon claims to be an exclusive
licensee. The complaint seeks a judgment that we have infringed this patent,
a permanent injunction against further infringement of the patent and an
award of damages in an unspecified amount that, under certain circumstances,
may be trebled. On June 13, 2000, we responded to Lexicon's complaint by
filing an answer and seeking a declaratory judgment in our favor. Our
response seeks a judgment declaring the patent invalid and that we have not
infringed and are not infringing the patent. We intend to defend the action
vigorously.

The litigation against us is in the early stages and its outcome cannot be
predicted. If Lexicon prevails and obtains an injunction, we would be required
to obtain a license in order to continue to use the methods covered by the
patent. We may not be able to obtain this license on favorable terms or at all.
If we are unable to obtain a license, we would be required to redesign our
processes to use alternative methods of making knockout mice and expect we would
experience a significant disruption in our ability to generate revenue during
this redesign period and as we develop a gene function database using these new
methods. This redesign and development would involve significant time and costs,
and the alternative methods available to us may not be as effective as our
current methods. We estimate the average time from the date we begin to create a
knockout mouse until the date the data from that knockout mouse is added to the
gene function database to be 12 months. The addition of new data points to our
gene function database could be significantly delayed. We may fail to attract
customers for a gene function database that uses the alternative methods, and
the marketing of our existing database and DeltaSelect program may be
significantly affected. If Lexicon prevails, we could also incur significant
financial liabilities which could materially affect our business and operating
results.

At this time no estimate can be made of the outcome or any possible
loss that may be incurred. The litigation is in the early stages and its
outcome cannot be predicted.

ITEM 2. - CHANGES IN SECURITIES

a) Not applicable.

b) Not applicable.

c) On various dates from July 1, 2000 through September 30, 2000, the
Company issued 41,036 shares of its common stock to various officers,
employees and consultants pursuant to the exercise of warrants or
options granted under its 1998 Stock Plan. The exercise price per share
ranged from $0.31 to $13. The Company relied on the exemption provided
by Rule 701 promulgated under the Securities Act of 1933, as amended,
in issuing these shares.

d) On August 2, 2000, our Registration Statement on Form S-1 (File No.
333-34668), the IPO Registration Statement, was declared effective by
the Securities and Exchange Commission. The IPO Registration Statement
registered a total of 7,000,000 shares of common stock all of which
were issued and sold by us. The offering was led by a group consisting
of Salomon Smith Barney Inc., FleetBoston Robertson Stephens, Inc. and
U.S. Bancorp Piper Jaffray Inc. The offering commenced on August 3,
2000 and was closed on August 8, 2000. The shares sold by us were sold
at an aggregate offering price of $105 million, netting proceeds of
approximately $95.9 million to us after

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underwriting fees of approximately $7.4 million and other offering
expenses of approximately $1.7 million. None of these fees and expenses
were paid to any director, officer, or 10% or greater stockholder of
the Company or an affiliate of these persons.

e) On August 30, 2000 the underwriters' exercised their over-allotment for
the purchase of approximately 1,025,000 shares. The shares sold by us
were sold at an aggregate offering price of $15.4 million, netting
proceeds of approximately $14.3 million to us after underwriting fees
of approximately $1.1 million and other offering expenses. None of
these fees and expenses were paid to any director, officer, or 10% or
greater stockholder of the Company or an affiliate of these persons.

Since the effective date of the IPO Registration Statement, the net
offering proceeds have been invested in highly liquid instruments,
which include marketable debt securities of financial institutions
and corporations with strong credit ratings with maturities of
ninety days or less when acquired.

ITEM 3. - DEFAULTS UPON SENIOR SECURITIES

Not applicable.

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

A majority of the Company's stockholders, by written consent,
approved: (i) an amendment and restatement to the Company's Certificate of
Incorporation, providing for, among other things, an 8-for-7 forward stock
split and an increase in the Company's authorized capital stock; (ii)
conditioned upon consummation of the Offering, an amendment and restatement
of the Company's Certificate of Incorporation to, among other things, set the
authorized "blank check" preferred stock at 5,000,000 shares, provided for a
classified Board of Directors, eliminate the right of stockholders to act by
written consent and provide for certain supermajority voting provisions;
(iii) conditioned upon consummation of the Offering, an amendment and
restatement of the Company's by-laws, to, among other things, eliminate the
right of stockholders to act by written consent and provide for certain
supermajority voting provisions; (iv) the adoption of the 2000 Stock
Incentive Plan; and (v) the adoption of the 2000 Employee Stock Purchase Plan.

ITEM 5. - OTHER INFORMATION

Not applicable.

ITEM 6. -- EXHIBITS AND REPORTS ON FORM 8-K

a) Exhibits

27.1 Financial Data Schedule

b) Reports on Form 8-K

No reports on Form 8-K were filed during the three months ended September
30, 2000.

27
<PAGE>

DELTAGEN, INC.

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.

DELTAGEN, INC.

Date:
------------------------------- ---------------------------------------
William Matthews, Ph.D.
President and Chief Executive Officer

Date:
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Richard H. Hawkins
Chief Financial Officer