CURIS INC - Annual Report: 2005 (Form 10-K)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark one)

  For the fiscal year ended December 31, 2005

OR

Commission File Number 000-30347

CURIS, INC.

(Exact Name of Registrant as Specified in Its Charter)

61 Moulton Street

Cambridge, Massachusetts 02138

(Address of principal executive offices) (Zip Code)

617-503-6500

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.01 par value per share

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.     Yes   ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.     Yes  ¨    No  x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

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

Large accelerated filer    ¨         Accelerated filer    x         Non-accelerated filer    ¨

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

As of June 30, 2005, the aggregate market value of the common stock held by non-affiliates of the registrant was approximately $161,929,000 based on the closing sale price of the registrant’s common stock on The Nasdaq National Market on such date.

As of March 22, 2006, there were 48,996,294 shares of the registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Specified portions of the registrant’s proxy statement for the annual meeting of stockholders scheduled to be held on June 1, 2006, which are to be filed with the Commission not later than 120 days after the close of the Registrant’s fiscal year ended December 31, 2005 pursuant to Regulation 14A, have been incorporated by reference in Item 5 of Part II and Items 10-14 of Part III of this Annual Report on Form 10-K.

Table of Contents

CURIS, INC.

TABLE OF CONTENTS

Form 10-K

Table of Contents

PART I

This annual report on Form 10-K contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause the results of Curis to differ materially from those expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including any projections of revenue, expenses, earnings or losses from operations, or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning product research, development and commercialization timelines; any statements of expectation or belief; and any statements of assumptions underlying any of the foregoing. The risks, uncertainties and assumptions referred to above include risks that are described in Item 1A “Risk Factors” and elsewhere in this annual report and that are otherwise described from time to time in our Securities and Exchange Commission reports filed after this report.

The forward-looking statements included in this annual report represent our estimates as of the date of this annual report. We specifically disclaim any obligation to update these forward-looking statements in the future. These forward-looking statements should not be relied upon as representing our estimates or views as of any date subsequent to the date of this annual report.

Our Company

We are a therapeutic drug development company principally focused on the discovery, development and future commercialization of products that modulate key regulatory signaling pathways controlling the repair and regeneration of human tissues and organs. Our product development approach involves using small molecules, proteins or antibodies to modulate these regulatory signaling pathways, for example, to increase the pathway signals when they are insufficient or to decrease them when they are excessive.

We were organized as a Delaware corporation in February 2000. We began our operations in July 2000 upon the completion of the merger of Creative BioMolecules, Inc., Ontogeny, Inc. and Reprogenesis, Inc. Our principal executive office is located at 61 Moulton Street, Cambridge, Massachusetts, 02138 and our telephone number is (617) 503-6500.

Curis^™ and the Curis logo are our trademarks. This annual report on Form 10-K may also contain trademarks and trade names of others.

Our lead product candidate is a topical therapy for the treatment of basal cell carcinoma and, as part of our June 2003 Hedgehog antagonist collaboration, is currently under development with Genentech. On January 28, 2005, under the terms of the Hedgehog antagonist collaboration agreement with Genentech, we exercised our co-development option in the basal cell carcinoma program in the U.S. market pursuant to which we are now sharing equally in the U.S. development costs and will share equally in any future U.S. net profits and/or losses in this program. As a result of participating in co-development, we will forego U.S. development milestone and royalty payments on potential future U.S. sales of the basal cell carcinoma product candidate. On June 8, 2005, we announced that the dosing of the first patient in the Phase I clinical trial for basal cell carcinoma was completed. This Phase I clinical trial is being conducted by Genentech and Curis, and is expected to be completed in the first half of 2006. The Phase I clinical trial is a double-blind, randomized, placebo-controlled study that is expected to enroll approximately 60 patients with a single or multiple basal cell carcinoma. The primary objective of the Phase I clinical trial is to obtain data about the safety and tolerability of a four-week regimen of the drug candidate. In addition, Genentech and we are evaluating the clinical activity of the drug candidate, where activity is defined as the complete eradication of the treated basal cell carcinoma lesion and is determined by clinical and microscopic examinations of the lesions. At the conclusion of this Phase I clinical

1

Table of Contents

trial, we and Genentech plan to make a decision about whether to advance the drug candidate, a topical antagonist of the Hedgehog signaling pathway, into a Phase II clinical trial.

On January 23, 2006, we provided an update on this Phase I clinical trial. At that time, 29 of the Phase I clinical trial patients had participated in a dose-escalation segment, in which seven patients were randomized to receive treatment in each of four dose levels. The dose-escalation segment of the Phase I clinical trial had recently been completed, and the preliminary data had been reviewed by an internal Genentech data review board. The preliminary data from the dose-escalation segment suggested that the drug candidate appeared likely to be safe, well tolerated, and had shown signs of activity. However, there had been less clinical activity observed to date than anticipated. Based on these data, the internal data review board recommended that Genentech and we temporarily suspend further enrollment in the second segment of the trial, in which additional patients were to be treated at the highest dose level from the dose escalation segment. Genentech and we will determine whether to re-open enrollment in this segment based on a secondary interim analysis that will occur at a later date. The internal data review board also recommended that a third segment of the trial that evaluates biological activity using a pharmacodynamic endpoint be enrolled as planned. This third segment, among other things, may shed light on the extent to which the active compound in the drug candidate as formulated is penetrating the patients’ skin.

We expect the Phase I clinical trial to be completed during the first half of 2006. When the final results of the clinical trial are obtained, we will determine in conjunction with Genentech whether this drug candidate should proceed to Phase II clinical trials. Should this drug candidate not progress into Phase II clinical trials, we will evaluate in conjunction with Genentech various criteria, including the data from the biological activity segment of the trial, and determine the alternatives for the basal cell carcinoma program. Possible scenarios include, but are not limited to the following: extending the duration of the treatment regimen of the existing drug candidate, developing a new topical formulation of the existing drug candidate, selection of a new drug candidate, negotiation of the return of the compounds to us for our further development, or termination of the basal cell carcinoma drug program.

In addition to our lead basal cell carcinoma product candidate, we have successfully used our product development approach to produce multiple compounds with the potential for use in several different disease indications including preclinical product candidates in the fields of cancer, neurological disorders, and hair growth regulation. We also possess robust small molecule drug screening technologies and preclinical scientific expertise that we believe may enable us to create a sustainable drug candidate pipeline, including, for example, our efforts in the development of drug candidates to treat spinal muscular atrophy, or SMA.

Regulatory signaling pathways, also referred to as signaling pathways, are prominent regulators of specific tissue and organ formation during prenatal development and are used by the body throughout life to repair and regulate human tissue. We, together with collaborators and licensors, are developing our product candidate programs around several major signaling pathways including the Hedgehog and Bone Morphogenetic Protein, or BMP, pathways. We have substantial intellectual property rights and know-how in these signaling pathways, which we believe will enable us to have a technological and competitive advantage in developing therapeutic products based upon these pathways. We have also used our knowledge about the Hedgehog and BMP pathways to begin researching additional signaling pathways. In addition to expanding our internal research capacities, we may seek to expand our technology offerings and associated intellectual property portfolio through in-licensing arrangements and the acquisition of complimentary technologies.

Our research programs are conducted both internally and through strategic collaborations. We currently have strategic collaborations with Genentech, The Procter & Gamble Company, or Procter & Gamble, and Wyeth Pharmaceuticals, or Wyeth, to develop therapeutics, which modulate the signaling of the Hedgehog pathway. We have a second collaboration with Genentech focusing on the discovery and development of small molecule modulators of another signaling pathway. We have licensed our BMP pathway patent portfolio to Ortho Biotech Products L.P., a subsidiary of Johnson & Johnson, for systemic administration in all non-orthopedic and

2

Table of Contents

non-dental therapeutic applications. This program is under development at Centocor, another subsidiary of Johnson & Johnson. In 2005, Centocor entered into an agreement with us pursuant to which Centocor will fund a portion of a new Curis BMP small molecule agonist screening program. Lastly, a majority of our SMA research is funded through a sponsored research agreement with the SMA Foundation.

Our strategic collaborations and license agreements generally provide for our research, development and commercialization programs to be wholly or the majority funded by our collaborators and licensors and provide us with the opportunity to receive additional payments if specified milestones are achieved, as well as royalty payments upon the successful commercialization of any products under the collaboration. In some cases, we have retained rights under such programs, including co-development rights and development and commercialization rights in specific therapeutic areas where we believe we can attain additional value through the application of our own internal resources. Examples of retained rights within our programs under collaboration include co-development rights for the development of a basal cell carcinoma product candidate under our Hedgehog antagonist collaboration with Genentech, as well as retained rights to our Hedgehog agonist for topical applications, ex vivo use and for local delivery in cardiovascular applications under our Hedgehog agonist collaboration with Wyeth. In September 2005, we licensed the topical applications of the Hedgehog agonist, including for use in hair growth, to Procter & Gamble. Under the terms of the agreement, we granted Procter & Gamble an exclusive, worldwide, royalty-bearing license for the non-systemic, dermatological use of our Hedgehog agonist technology, via topical administration. We will have an option to co-develop a development candidate from investigational new drug filing through Phase II clinical trials.

We believe that our various collaborative structures provide additional opportunities for our licensed assets. We believe that our approach allows us to augment our development capabilities and capacities through collaborations with leading pharmaceutical and biotechnology companies. For example, under our co-development arrangement with Genentech, we are able to retain a significant percentage of ownership of our basal cell carcinoma product candidate, while working with Genentech, a company with established clinical development, regulatory, and commercialization skills. Also, through our retained rights to specific fields under our broad Hedgehog agonist collaboration with Wyeth, we were able to secure an additional collaboration relating to the Hedgehog agonist through our September 2005 collaboration with Procter & Gamble. We believe that developing our assets in collaboration with companies possessing clinical development expertise increases the likelihood of development success. For products under collaborative development in a milestone and royalty structure, we are provided with the opportunity to discover and develop products while reducing our internal product development costs and related financial risks.

Our sponsored research agreement with the SMA Foundation provides for support of a majority of our SMA research program costs. We will own any compounds that we generate under this collaboration and will also have the ability to bring such compounds into the clinic, either using our own resources or with a collaborating third party. If any drug candidates developed under the agreement are successfully commercialized, we will be required to make limited payments to the SMA Foundation if cumulative revenues from the sales of such products exceed $100,000,000.

In the future, we plan to continue to seek corporate collaborators and licensors for the further development and commercialization of some of our technologies. We also may continue to seek sponsored research funding from foundations or other non-profit entities, similar to our existing sponsored research agreement with the SMA Foundation.

Recent Development – Restatement of Financial Statements

As described in Note 2 of the Notes to our consolidated financial statement included elsewhere in this annual report on Form 10-K, we have restated our financial results for 2004 and 2003. The restatement adjusts our consolidated balance sheets contained herein:

3

Table of Contents

As a result of these restatements, amounts in the consolidated statements of cash flows for the years periods ended December 31, 2004 and 2003 have also been corrected.

Our annual reports on Form 10-K and our quarterly reports on Form 10-Q from the second quarter of 2003 through fiscal 2004 have not been revised to reflect the restatement and the consolidated financial statements contained in those reports should not be relied upon. Instead, the consolidated financial statements for fiscal 2004 and 2003 included in this annual report on Form 10-K should be relied upon. For additional information regarding the restatement, refer to Note 2 “Restatement of Financial Statements” in the notes to the consolidated financial statements in this annual report on Form 10-K.

Regulatory Signaling Pathways Background

Regulatory signaling pathways are the means by which cells exchange instructional messages that regulate specific biological functions. Early in prenatal development, the instructional messages that direct the formation of tissues and organs are controlled by master pathways, including the Hedgehog, BMP, and other pathways, which act by initiating cascades of gene signaling required for tissue formation and regulation. The body also uses these master pathways to repair damage and regenerate tissues. For example, in damaged nerve tissue, our preclinical models demonstrate that activation of the Hedgehog pathway promotes repair and regeneration of nerve function, in part, by inducing the activation of a cascade of secondary signaling that promotes the growth of new cells and blood vessels.

The ability to modulate certain signaling pathways is of great interest to biotechnology and pharmaceutical companies as many diseases and disorders are now known to be associated with components of these signaling pathways. For example, there is significant pharmaceutical interest in the inhibition of abnormally or inappropriately activated signaling pathways that have been implicated in certain cancers.

Abnormal activation of the Hedgehog signaling pathway has been shown to be associated with certain cancers, including basal cell carcinoma, small cell lung cancer, pancreatic cancer and others. We have developed small molecule Hedgehog pathway antagonists and Hedgehog blocking antibodies. Our small molecule Hedgehog pathway antagonists and antibodies, which we are developing are under collaboration with Genentech, have been demonstrated to slow or halt the growth of several cancers in preclinical models of tumor growth. Because the Hedgehog signaling pathway appears to control the expression of tissue growth factors and blood vessel growth factors, we believe that our Hedgehog pathway inhibitors may be applicable to a broad array of cancers.

Our Strategy

Our goal is to become a leading therapeutic drug development company focusing on regulatory signaling pathways. Our strategy to accomplish this goal includes the following:

4

Table of Contents

Product Development Programs and Strategic Collaborations and License Agreements

We are developing product candidates in several important medical fields where there are substantial unmet therapeutic needs. These product development initiatives, described in the chart below, are being pursued using our internal resources or through collaborations and licensing arrangements with pharmaceutical or biotechnology companies that are able to dedicate additional resources and clinical development expertise, and, in return, provide us with potential revenue from development milestones and royalties on future product sales. These product development initiatives are derived primarily from our substantial intellectual property portfolio in key regulatory signaling pathways.

Most of our programs are in various stages of preclinical drug development. In the table below, the term discovery means that we are searching for compounds that may be relevant for treating a particular disease area, early preclinical means we are seeking to obtain initial demonstrations of therapeutic efficacy in preclinical models of human disease, mid-preclinical means we are seeking to obtain multiple demonstrations of efficacy in preclinical models of human disease, late preclinical means we are seeking to obtain both multiple demonstrations of efficacy in preclinical models of human disease and relevant toxicology and safety data required for an investigational new drug, or IND, application filing with the FDA seeking to commence a Phase I clinical trial to assess safety and tolerability in humans, and Phase I means that we are currently treating human patients in a Phase I clinical trial, the principal purpose of which is to evaluate safety of the compound being tested.

5

Table of Contents

All of our estimates below regarding the status of our product development programs are solely our judgments. These estimates may not reflect the beliefs or expectations of our corporate collaborators or licensors, if applicable. Moreover, because of the early stages of development of these programs, our ability and that of our collaborators and licensors to successfully complete preclinical or clinical studies of these product candidates, and the timing of completion of such programs, is highly uncertain.

There is a risk that any drug discovery and development program may not produce products or revenues. Due to uncertainties inherent in drug discovery and development, including those factors described below under Item 1A “Risk Factors,” we and our collaborators may not be able to successfully develop and commercialize any of the product candidates included in the table above.

Our strategy for development and commercialization of products depends in part upon successful strategic collaborations with third parties. We use strategic collaborations and license agreements as a means to provide us with the requisite capital, as well as the necessary preclinical and clinical development and manufacturing and marketing capabilities to commercialize product candidates produced by our discovery and preclinical programs. In evaluating possible strategic collaborations, we consider the following criteria:

Since inception in 2000, substantially all of our revenues have been derived from our collaborations and other agreements with third parties. We anticipate that for the next several years substantially all of our revenues

6

Table of Contents

will continue to be generated from these sources. For the year ended December 31, 2005, Genentech accounted for $6,419,000, or 49%, of our gross revenues, Wyeth accounted for $2,849,000, or 22%, of our gross revenues, Procter & Gamble accounted for $289,000, or 2%, of our gross revenues, and the SMA Foundation grant accounted for $1,955,000, or 15%, of our gross revenues. In addition, Micromet, a former collaborator, accounted for $1,400,000, or 11%, of our revenues for 2005. Co-development costs incurred under our Genentech collaboration accounted for $6,999,000 in contra-revenue that offset our gross revenues and, as a result, net revenues from Genentech were negative for 2005.

The following provides brief summaries of each of our product development programs and, when applicable, a description of the corporate collaboration, license agreement or sponsored research agreement under which product candidates under the program are being developed.

Hedgehog Topical Small Molecule Antagonist Program

Under Collaboration with Genentech

Program Summary

The Hedgehog signaling pathway controls the development and growth of many kinds of tissues in the body by directly promoting cell division in specific cell types, and by activating other secondary signaling pathways that control the synthesis of growth factors and angiogenic factors. The growth factors stimulate new tissue formation, and the angiogenic factors stimulate new blood vessel growth to nourish the newly formed tissue.

Several years ago, our scientists and scientists at independent academic and medical research laboratories discovered that the Hedgehog signaling pathway is activated at very high levels in the vast majority of basal cell carcinomas. Basal cell carcinoma, a skin cancer, is the most common form of all human cancers with approximately 800,000 to 1,000,000 new cases every year in the U.S. In many of these cases, excessive unregulated Hedgehog signaling activity is due to the presence of inactivating mutations in “patched,” or Ptch, a negative regulator of the pathway, or to constitutively activating mutations in “smoothened,” or Smo, an activator of the pathway. Unregulated activation of Hedgehog signaling in the outer layer of skin cells leads to increased rates of cell division resulting in tumor formation. Thus, we believe that our small molecule Hedgehog signaling antagonists directly target the known mechanism of action underlying the formation of basal cell carcinomas.

Our preclinical evidence indicates that inhibition of the Hedgehog pathway with our topically applied Hedgehog antagonists in various models of basal cell carcinoma results in the selective death of tumor cells while sparing adjacent normal cells and maintaining the typical architecture of the skin at the treatment site. In contrast, most basal cell carcinoma patients are currently treated with surgery, which often results in significant scarring at the treatment site. We believe that the selective action of our Hedgehog antagonists in cancer cells may result in a better cosmetic outcome than that of other basal cell carcinoma treatments, particularly in the case of surgery, and therefore may represent a significant competitive advantage for our basal cell carcinoma product candidate.

Collaboration Summary

In June 2003, we established a broad collaboration with Genentech around our Hedgehog antagonist technologies, including the continued development of our basal cell carcinoma product candidate. Under the terms of the collaboration, we retained a co-development option in the basal cell carcinoma program in the U.S. market that enables us to share in U.S. development costs and future U.S. net profits or losses in this program. On January 28, 2005, we elected to exercise this co-development option and are now sharing equally in the U.S. development costs and will share equally in any future U.S. net profits or losses of the basal cell carcinoma program. On June 8, 2005, we announced that the dosing of the first patient in the Phase I clinical trial for basal cell carcinoma was completed. This Phase I trial is being conducted by Genentech and Curis and we currently

7

Table of Contents

expect that the trial will be completed during the first half of 2006. Upon the completion of the Phase I clinical trial, Genentech and we will determine whether to advance the product candidate into Phase II clinical trials. Assuming the successful advancement of the basal cell carcinoma product candidate through Phase I and Phase II clinical trials, we expect that we will incur approximately $20,000,000 in development costs and that the Phase II clinical trial will be completed in mid-2007.

In addition to our U.S. co-development rights, in certain international markets, we will receive milestone payments if specific clinical development objectives are achieved and a royalty on any international sales of the topical Hedgehog antagonist.

Hedgehog Systemic Small Molecule Antagonist and Antibody Antagonist Cancer Programs

Under Collaboration with Genentech

Program Summary

Scientists have discovered that abnormal Hedgehog signaling may be contributing to the growth of certain cancers, including, for example, small cell lung cancer, pancreatic cancer, prostate cancer, colon cancer and medulloblastoma, an aggressive form of childhood brain cancer.

Our preclinical evidence suggests that Hedgehog protein produced by tumor cells may signal certain adjacent cells within the tumor environment to produce various growth and angiogenic, or blood vessel forming, factors that can positively influence tumor maintenance and growth. Systemic administration of our Hedgehog signaling pathway inhibitors has been shown to slow or halt the progression of various types of tumors in our preclinical models of cancer. We believe that our Hedgehog pathway antagonists are selectively targeting fundamental mechanisms involved in the maintenance and progression of tumor growth, and as such, may represent a new generation of cancer therapeutics.

Collaboration Summary

In June 2003, we established a collaboration with Genentech for the continued development of Hedgehog systemic antagonist drug candidates, in addition to the development of a topical treatment for basal cell carcinoma. The current focus of the collaboration, excluding the basal cell carcinoma clinical development, is to develop systemically administered Hedgehog antagonists for cancer indications. Pursuant to the collaboration agreement, Genentech agreed to make specified cash payments, including up-front payments of $8,500,000, which consisted of a $3,509,000 non-refundable license fee payment and $4,991,000 in exchange for 1,323,835 shares of our common stock. Genentech also agreed to make license maintenance fee payments totaling $4,000,000 over the first two years of the collaboration and cash payments at various intervals during the clinical development and regulatory approval process of small molecule and antibody Hedgehog antagonist product candidates, assuming specified clinical development and regulatory approval objectives are met. In addition, Genentech will pay a royalty to us on potential future net product sales, which will increase with increasing sales volume.

We have entered into two amendments to the June 2003 collaboration agreement related to the Hedgehog antagonist. Pursuant to the amendments, Genentech increased the number of researchers that it would fund and extended its funding obligation through June 2006. As part of these amendments, Genentech committed to provide us with up to $5,250,000 in incremental research funding over the period of December 2004 to June 2006.

8

Table of Contents

Discovery Research on an Undisclosed Signaling Pathway

Under Collaboration with Genentech

Program Summary

We established a drug discovery program for the discovery and subsequent development of small molecule compounds that modulate a signaling pathway that plays an important role in cell proliferation. This pathway is a regulator of tissue growth, formation and repair, the abnormal activation of which is associated with certain cancers.

Collaboration Summary

On April 1, 2005, we entered into a drug discovery collaboration agreement with Genentech to further our discovery research and development of drug candidates that modulate this signaling pathway. Under the terms of the agreement, we granted Genentech an exclusive, royalty-bearing license to make, use and sell small molecule compounds that are modulators of the pathway. We have retained the rights for ex vivo cell therapy uses, except in the areas of oncology and hematopoiesis. We have primary responsibility for drug discovery and research activities and Genentech will be responsible for clinical development, manufacturing, and commercialization of products that may result from the collaboration.

Genentech paid us an up-front license fee of $3,000,000 and has agreed to fund up to $6,000,000 for research activities during the initial two-year research term, subject to certain termination rights. Genentech has also agreed to make cash payments to us that are contingent upon the successful achievement of certain preclinical and clinical development and drug approval objectives. Excluding royalties on potential net product sales, the total potential cash payments from this collaboration could exceed $140,000,000, assuming that two products are commercialized in two indications each. Genentech has an option to extend the initial two-year research term for up to two additional years in one-year increments. Genentech will also pay us royalties on net product sales if product candidates derived from the collaboration are successfully developed.

Hedgehog Small Molecule Agonist Neurological Disorders Programs

Under Collaboration with Wyeth

Program Summary

The Hedgehog signaling pathway is essential for the formation of normal nerves and nerve networks in the central and peripheral nervous systems. Our scientists and academic collaborators have shown that treatment with a Hedgehog protein appears to accelerate the restoration of nerve function in models of nerve trauma and disease. This finding suggests that the Hedgehog pathway may have a potential therapeutic effect in treating certain human neurological disorders.

Our scientists have developed a series of small molecule Hedgehog agonists that, in preclinical models, have been shown to be capable of activating the Hedgehog pathway. Many of these small molecule Hedgehog agonists are orally available and can cross the blood brain barrier, a protective barrier formed by blood vessels and brain tissue that prevents most substances in the blood from entering the central nervous system. Small molecules that cross this blood brain barrier can potentially reach and treat the central nervous system, therefore making them attractive product development candidates for certain brain disorders.

We believe that the positive effects of the Hedgehog agonists in neuronal disease models are due to neuroprotection that is induced by activation of the Hedgehog signaling pathway. Neuroprotection is the prevention of the progressive death of cells in the brain caused by disease or injury. In addition, we believe that activation of the Hedgehog pathway results in an increased proliferation of stem cells in the brain. We are currently exploring the possibility that this may enable us to develop drugs that can promote the replacement of cells lost as a result of injury or disease.

9

Table of Contents

Collaboration Summary

In January 2004, we licensed our Hedgehog proteins and small molecule Hedgehog pathway agonists to Wyeth for therapeutic applications in the treatment of neurological diseases and other disorders. Wyeth is one of the world’s largest research-driven pharmaceutical companies with broad expertise in the development of drugs to treat neurological disorders and other diseases. Pursuant to the collaboration agreement, Wyeth agreed to make specified cash payments, including up-front payments of $3,000,000, which consisted of a $1,362,000 non-refundable license fee payment and $1,638,000 in exchange for 315,524 shares of our common stock.

Wyeth has agreed to assume all future responsibility for clinical development of the Hedgehog small molecule and protein agonists as systemic treatments for neurological and other disorders. Wyeth is also obligated to make cash payments if the licensed programs successfully achieve clinical development and drug approval objectives and to pay us a royalty on net product sales, if any should occur, that escalates with increasing sales volume. Our agreement with Wyeth would result in more than $170,000,000 in contingent cash payments, assuming at least two products are successfully developed and commercialized.

In addition to these initial and potential future contingent cash payments, Wyeth is obligated to provide financial support of our research under the collaboration, at $250,000 per full-time equivalent researcher, for an initial period of up to two years based on the number of full-time equivalent researchers performing services under the collaboration. We are obligated to dedicate between five and ten full-time equivalents to this program, as determined by the steering committee in six-month intervals, for two years. After the initial two-year period, Wyeth can, at its option, elect to extend our research obligation, and Wyeth’s funding thereof, for an initial one-year extension on the same terms and conditions as the initial two-year term. In November 2005, Wyeth exercised this option to extend the initial term. By exercising this option, Wyeth agreed to extend the research term by one year through February 9, 2007. After the initial one-year extension, the agreement may be extended for additional one-year periods upon recommendation of the steering committee with such full-time equivalent researchers and related Wyeth funding obligations as may be consistent with fulfilling the objectives of the research plan.

As part of the agreement, we have retained development and licensing options for certain therapeutic applications of the Hedgehog agonist technologies, including topical treatment for skin diseases and disorders including hair growth regulation, ex vivo cell therapy, local delivery applications for treatment of cardiovascular disease, and those applications that qualify as orphan drug indications. Wyeth has a right of first negotiation to obtain an exclusive license to the orphan drug indications and the cardiovascular applications. If Wyeth declines to exercise its right, or if we are unable to reach an agreement with Wyeth on terms within the contractually specified period, we are free to seek another collaborator for these programs.

Hedgehog Agonist Hair Growth Program

Under collaboration with Procter and Gamble

Program Summary

Our scientists have demonstrated that small molecule Hedgehog agonists can induce hair growth in preclinical models. Some of our recent results were presented in February 2005 at the annual meeting of the American Academy of Dermatology in New Orleans, Louisiana. In October 2005, we published data in the Journal of Investigational Dermatology, reporting on the therapeutic efficacy of one of our proprietary Hedgehog pathway activators in a preclinical model of hair growth. The results of the study show that a topically applied small molecule agonist of the Hedgehog signaling pathway can stimulate the transition of hair follicles from the resting to the growth stage of the hair cycle.

10

Table of Contents

Collaboration Summary

The Hedgehog agonist program was exclusively licensed to Wyeth in February 2004. Under the terms of the license agreement, we retained the right to develop Hedgehog agonists for topical treatment of hair growth and other dermatological disorders. The terms of the agreement include Wyeth’s right to authorize the reversion of any compounds that we will develop in this area. In December 2004 and in August 2005, Wyeth approved the reversion of a group of Hedgehog agonist compounds for use in our hair program thereby inducing hair growth. On September 18, 2005, we entered into a collaboration, research and license agreement with Procter & Gamble, to evaluate and develop potential treatments for hair growth regulation and skin disorders utilizing these reverted Hedgehog agonist compounds.

Under the terms of the agreement, we granted to Procter & Gamble an exclusive, worldwide, royalty-bearing license for the development and commercialization of topical dermatological and hair growth products that incorporate our Hedgehog agonist technology. In accordance with the terms of the agreement, the parties shall jointly undertake a research program with the goal of identifying one or more compounds to be developed and commercialized by Procter & Gamble. Procter & Gamble is solely responsible for the cost of worldwide development and commercialization of any product candidates developed pursuant to the research program, provided however, that at the time that Procter & Gamble determines to file the first IND application with the FDA for a product candidate, we shall have the option, at our sole discretion, to co-develop a product candidate through Phases I and II of clinical development. We would receive a higher royalty in the event that we exercise our co-development option and subsequently share in development expense through Phase II clinical trials. Should we elect to exercise this co-development option, we will forego contingent cash payments that would otherwise be payable for the achievement of certain development objectives during the period from IND application filing through the completion of a Phase II clinical trial. Procter & Gamble has paid us an up-front license fee of $500,000 and has agreed to fund up to $600,000 for two of our full-time equivalent employees to provide research and development activities during the initial one-year research term, subject to its termination rights. Procter & Gamble has an option to extend the initial one-year research term for up to three additional years in one-year increments.

Procter & Gamble has also agreed to make cash payments to us that are contingent upon the successful achievement of certain research, development, clinical and drug approval milestones. Procter & Gamble will also pay us royalties on net product sales if product candidates derived from the collaboration are successfully developed. We will receive a higher royalty in the event that we exercise our co-development option and subsequently share in development expenses through Phase II clinical trials.

In March of 2006, we reached the first preclinical development objective in our hair growth program with Procter & Gamble Pharmaceuticals, a division of The Procter & Gamble Company. The program is focused upon the potential development of a topical Hedgehog agonist for hair growth disorders, such as male pattern baldness and female pattern hair loss. As part of the initial agreement signed in September of 2005, P&G agreed to pay Curis up to $2,800,000 in cash payments that are contingent upon the certain achievement of certain preclinical development objectives. The first of two preclinical development objectives was successfully completed and resulted in a payment to Curis of $1,000,000.

BMP-7 Program

Licensed to Ortho Biotech Products, a Subsidiary of Johnson & Johnson and under development at Centocor, also a subsidiary of Johnson & Johnson

Program Summary

BMP-7 is a signaling protein that is expressed in the kidney and in other tissues and organs and has been implicated in the maintenance of the normal health of the kidney, the skeleton, and the vascular system. In recent years, several academic researchers have demonstrated the potential of using BMP-7 as a treatment for chronic kidney disease and systemic complications, such as renal osteodystrophy, a form of bone disease, and blood vessel complications that are associated with chronic kidney disease.

11

Table of Contents

License Agreement Summary

In November 2002, we entered into an agreement with Ortho Biotech Products, a subsidiary of Johnson & Johnson, pursuant to which Ortho Biotech obtained the license rights to our BMP-7 technology and assumed control of the continued development of this product candidate. Ortho Biotech Products is a pharmaceutical company with broad expertise in protein-based therapeutic drug development and has an established presence in the kidney disease marketplace. In 2005, Johnson & Johnson moved responsibility for the further development of BMP-7 to Centocor, another subsidiary of Johnson & Johnson, and Centocor has assumed all future costs and responsibility for BMP-based product development. We are entitled to receive a series of contingent cash payments that are tied to the achievement of clinical development and regulatory objectives, and royalties on product sales if any BMP-based products are successfully commercialized. Centocor has sole responsibility for deciding if and when human clinical trials of BMP-7 will begin.

Other Programs

Spinal Muscular Atrophy Program (Retained by Curis).    On September 7, 2004, we entered into a sponsored research agreement with the SMA Foundation. Under the agreement, the SMA Foundation will grant us up to $5,364,000 over a three-year period for the identification of therapeutic compounds to treat spinal muscular atrophy, a neurological disease that is the leading genetic cause of infant and toddler death.

The research will utilize our proprietary technologies and expertise to develop and refine assays in motor neurons and then use those assays to screen for potential drug candidates. We will own any compounds that we generate under this collaboration and will also have the ability to bring any such compounds into the clinic, either using our own resources or with a collaborating third party. If any drug candidates developed under the agreement are successfully commercialized, we will be required to make cash payments to the SMA Foundation if cumulative revenues from the sales of such products exceed $100,000,000. Unless terminated earlier, the agreement will continue until the expiration of the research activities.

BMP Agonist Small Molecule Screening Program (Retained by Curis/Centocor Right of First Negotiation).    In December 2005, we expanded our relationship with Centocor. Under the new agreement, we will screen for small molecule agonists that mimic the bioactivity of BMP-7 and activate the bone morphogenetic pathway. The term of the agreement is expected to last fifteen months. We will own any small molecule BMP agonist compounds that are discovered as part of this screening and Centocor will have an exclusive option to first negotiate a new collaboration and exclusive license agreement for the development of such small molecules.

Hedgehog Agonist Cardiovascular Disease Program (Retained by Curis/Wyeth Right of First Negotiation).    As part of our collaboration with Wyeth, we have retained the right to locally deliver Hedgehog agonists for the treatment of cardiovascular diseases including peripheral vascular disease and acute myocardial infarction, or heart attack. Wyeth has a right of first negotiation to obtain an exclusive license to the cardiovascular applications. If Wyeth declines to exercise its option, or if we are unable to reach an agreement with Wyeth on terms within the contractually specified period, we will actively explore other licensing opportunities for this program.

We have incurred nominal expenses related to our cardiovascular disease program for the year ended December 31, 2005. Our preclinical data relating to this program has been derived from studies conducted at Caritas St. Elizabeth’s Medical Center in Boston, Massachusetts. We are exploring collaborative opportunities where a potential collaborator would utilize this biological property of the Hedgehog pathway to develop locally administered drug candidates to treat cardiovascular disorders such as heart attacks and peripheral vascular disease.

Discovery Research (Retained by Curis).    In addition to the research and development programs listed above, we also plan to bolster our pipeline by expanding into other signaling pathways by utilizing our proprietary screening technologies and know-how to find potential new therapeutic product candidates.

12

Table of Contents

Website Access to Reports

We maintain a website with the address www.curis.com. We are not including the information contained in our website as part of, or incorporating it by reference into, this annual report on Form 10-K. Our website address is included in this annual report on Form 10-K as an inactive textual reference only. We make available free of charge through our website our annual reports on Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K and any such amendments to those reports as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. The Securities and Exchange Commission maintains a website, www.sec.gov, that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The public may read and copy any materials we file with the Securities and Exchange Commission at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. In addition, we provide paper copies of our filings free of charge upon request. We also make available on our website our corporate governance guidelines, the charters for our audit committee, compensation committee and nominating and corporate governance committee, and our code of business conduct and ethics, and such information is available in print to any stockholder of Curis who requests it.

Intellectual Property

Our policy is to prosecute and enforce the patents and proprietary technology rights that are key to our business. We intend to continue to file United States and foreign patent applications to protect technology, inventions and improvements that are considered important to the development of our business. We will be able to protect our proprietary technologies from unauthorized use by third parties only to the extent that our proprietary rights are covered by valid and enforceable patents or are effectively maintained as trade secrets.

We have issued patents in the United States expiring on various dates between 2006 and 2022 with pending United States and foreign counterpart patent filings for most of these patents and patent applications. These patents and patent applications are directed to compositions of matter, methods of making and using these compositions, methods of repairing, replacing, augmenting and creating tissue for multiple applications, methods for drug screening and discovery, developmental biological processes, and patents relating to our proprietary technologies.

Hedgehog Pathway.    We have issued U.S. patents and allowed U.S. applications expiring on various dates between 2014 and 2021, which relate to the Hedgehog pathway. These patents and patent applications cover proteins, nucleic acids, antibodies, and certain small molecule agonists and antagonists of the Hedgehog pathway, drug screening and discovery methods, methods of protein manufacturing, as well as methods of using the aforementioned proteins, nucleic acids, antibodies or small molecules to activate or inhibit the Hedgehog pathway for a variety of therapeutic indications or diagnostic uses. In addition, we have filed foreign patent applications corresponding to many of the aforementioned U.S. filings that could provide additional patent protection for products that activate or inhibit the Hedgehog pathway.

Bone Morphogenetic Pathway.    We have issued U.S. patents expiring on various dates between 2006 and 2022, which relate to the BMP pathway. These patents and patent applications cover certain BMP proteins, nucleic acids, antibodies, drug screening and discovery methods, methods of protein manufacturing, as well as methods of using these BMP proteins, nucleic acids or antibodies for a variety of therapeutic indications or diagnostic uses. In addition, we have filed foreign patent applications corresponding to many of the aforementioned U.S. filings that could provide additional patent protection for BMP-related products.

Our academic and research institution collaborators have certain rights to publish data and information regarding their discoveries to which we have rights. While we believe that the prepublication access to the data developed by our collaborators pursuant to our collaboration agreements will be sufficient to permit us to apply for patent protection in the areas in which we are interested in pursuing further research, there is considerable pressure on such institutions to rapidly publish discoveries arising from their efforts. This may affect our ability

13

Table of Contents

to obtain patent protection in the areas in which we may have an interest. In addition, these collaboration agreements typically contain provisions that provide us with, at a minimum, an option to license the institution’s rights to intellectual property arising from the collaboration.

We are party to various license agreements that give us rights to commercialize various technologies and to use technologies in our research and development processes. The consideration payable in exchange for these licenses includes up-front fees, issuances of shares of common stock, annual royalties, milestone payments and running royalties on net sales by our sub-licensees and us. The licensors may terminate these agreements if we fail to meet certain diligence requirements, fail to make payments or otherwise commit a material breach that is not cured after notice.

In addition, we depend upon trade secrets, know-how and continuing technological advances to develop and maintain our competitive position. To maintain the confidentiality of trade secrets and proprietary information, we require our employees, scientific advisors, consultants and collaborators, upon commencement of a relationship with us, to execute confidentiality agreements and, in the case of parties other than our research and development collaborators, to agree to assign their inventions to us. These agreements are designed to protect our proprietary information and to grant us ownership of technologies that are developed in connection with their relationship with us.

Research Program

We have a research group that seeks to identify and develop new therapeutic applications for our existing patent portfolio and seeks to identify new signaling pathways that may have therapeutic potential. Our research group, working closely with our business development group, also strives to identify external technologies that might provide in-licensing or acquisition opportunities, consistent with our broad interest in regulatory signaling pathways. As of December 31, 2005, our research group consists of 47 employees, consisting of molecular biologists, cell biologists, pharmacologists and other scientific disciplines.

During the years ended December 31, 2005, 2004 and 2003, our total company-sponsored research and development expenses were approximately $705,000, $9,000,000 and $4,000,000, respectively, and our collaborator-sponsored research and development expenses were approximately $13,000,000, $3,700,000 and $10,400,000, respectively. In addition, we incurred costs of $6,999,000 for our portion of co-development costs of the basal cell carcinoma product candidate that are reported as contra-revenues.

Regulatory Matters

FDA Requirements for New Drug Compounds

Numerous governmental authorities in the United States and other countries extensively regulate the research, testing, manufacture, import and export and marketing of drug products. In the United States, drugs are subject to rigorous regulation by the FDA. The Federal Food, Drug, and Cosmetic Act, and other federal and state statutes and regulations, govern, among other things, the research, development, testing, manufacture, storage, recordkeeping, labeling, promotion, sampling and marketing and distribution of pharmaceutical products. Failure to comply with applicable regulatory requirements may subject a company to a variety of administrative or judicially-imposed sanctions. These sanctions could include the FDA’s refusal to approve pending applications, withdrawal of approvals, clinical holds, warning letters, product recalls, product seizures, total or partial suspension of our operations, injunctions, fines, civil penalties or criminal prosecution.

The steps ordinarily required before a new pharmaceutical product may be marketed in the United States include preclinical laboratory tests, animal tests and formulation studies, under the FDA’s good laboratory practice regulations, the submission to the FDA of a notice of claimed investigational exemption or an investigational new drug application, which must become effective before clinical testing may commence,

14

Table of Contents

adequate and well-controlled clinical trials to establish the safety and effectiveness of the drug for each indication for which FDA approval is sought, submission to the FDA of a new drug application, satisfactory completion of an FDA inspection of the manufacturing facility or facilities at which the product is produced to assess compliance with current good manufacturing practice, or cGMP, and FDA review and approval of the new drug application. Satisfaction of FDA pre-market approval requirements typically takes several years and the actual time required may vary substantially based upon the type, complexity and novelty of the product or disease. Government regulation may delay or prevent marketing of potential products for a considerable period of time and impose costly procedures upon a manufacturer’s activities. Success in early stage clinical trials does not assure success in later stage clinical trials. Data obtained from clinical activities is not always conclusive and may be susceptible to varying interpretations that could delay, limit or prevent regulatory approval. Even if a product receives regulatory approval, later discovery of previously unknown problems with a product may result in restrictions on the product or even complete withdrawal of the product from the market.

Preclinical tests include laboratory evaluation of product chemistry and formulation, as well as animal trials to assess the potential safety and efficacy of the product. The conduct of the preclinical tests and formulation of compounds for testing must comply with federal regulations and requirements including the FDA’s good laboratory practice regulations. Preclinical testing may not be completed successfully within any specified time period, if at all, and may not assure success in clinical trials. The results of preclinical testing are submitted to the FDA as part of an investigational new drug application, together with manufacturing information and analytical and stability data. The investigational new drug application must become effective before clinical trials can begin in the United States. An investigational new drug application becomes effective 30 days after receipt by the FDA unless before that time the FDA raises concerns or questions about issues such as the proposed clinical trials outlined in the investigational new drug application. In that case, the investigational new drug application sponsor and the FDA must resolve any outstanding FDA concerns or questions before clinical trials can proceed. If these concerns or questions are unresolved, the FDA may not allow the clinical trials to commence.

Clinical trials involve the administration of the investigational new drug to healthy volunteers or patients under the supervision of a qualified investigator. Clinical trials must be conducted in compliance with federal regulations and requirements, under protocols detailing the objectives of the trial, the parameters to be used in monitoring safety and the effectiveness criteria to be evaluated. Each protocol involving testing on U.S. subjects must be submitted to the FDA as part of the investigational new drug application. The study protocol and informed consent information for patients in clinical trials must be submitted to institutional review boards for approval.

Clinical trials to support new drug applications for marketing approval are typically conducted in three sequential phases, but the phases may overlap. In Phase I, the initial introduction of the drug into healthy human subjects or patients, the drug is tested to assess metabolism, pharmacokinetics and pharmacological actions and safety, including side effects associated with increasing doses. Phase II usually involves trials in a limited patient population, to determine dosage tolerance and optimum dosage, identify possible adverse effects and safety risks, and provide preliminary support for the efficacy of the drug in the indication being studied. If a compound demonstrates evidence of effectiveness and an acceptable safety profile in Phase II evaluations, Phase III trials are undertaken to further evaluate clinical efficacy and to further test for safety within an expanded patient population, typically at geographically dispersed clinical trial sites. Phase I, Phase II or Phase III testing of any product candidates may not be completed successfully within any specified time period, if at all. The FDA closely monitors the progress of each of the three phases of clinical trials that are conducted in the United States and may, at its discretion, reevaluate, alter, suspend or terminate the testing based upon the data accumulated to that point and the FDA’s assessment of the risk/benefit ratio to the patient. The FDA, an institutional review board, or a clinical trial sponsor may suspend or terminate clinical trials at any time for various reasons, including a finding that the subjects or patients are being exposed to an unacceptable health risk. The FDA can also request additional clinical trials be conducted as a condition to product approval.

15

Table of Contents

After successful completion of the required clinical testing, generally a new drug application is prepared and submitted to the FDA. FDA approval of the new drug application is required before marketing of the product may begin in the United States. The new drug application must include the results of extensive preclinical and clinical testing and a compilation of data relating to the product’s pharmacology, chemistry, manufacture, and controls. In most cases, the new drug application must be accompanied by a substantial user fee.

If the FDA’s evaluation of the new drug application and inspection of the manufacturing facilities are favorable, the FDA may issue an approval letter, or, in some cases, an approvable letter followed by an approval letter. An approvable letter generally contains a statement of specific conditions that must be met in order to secure final approval of the new drug application. If and when those conditions have been met to the FDA’s satisfaction, the FDA will typically issue an approval letter. An approval letter authorizes commercial marketing of the drug with specific prescribing information for specific indications. As a condition of new drug application approval, the FDA may require post approval testing and surveillance to monitor the drug’s safety or efficacy and may impose other conditions, including labeling restrictions which can materially impact the potential market and profitability of the drug. Once granted, product approvals may be withdrawn if compliance with regulatory standards is not maintained or problems are identified following initial marketing.

Once the new drug application is approved, a product will be subject to certain post-approval requirements, including requirements for adverse event reporting and submission of periodic reports and drug sampling and distribution requirements. Additionally, the FDA also strictly regulates the promotional claims that may be made about prescription drug products. In particular, the FDA requires substantiation of any claims of superiority of one product over another including, in many cases, requirements that such claims be proven by adequate and well-controlled head-to-head clinical trials. After approval, some types of changes to the approved product, such as adding new indications, manufacturing changes and additional labeling claims, are subject to FDA review and approval. Quality control and manufacturing procedures must continue to conform to cGMPs after approval. Drug manufacturers and their subcontractors are required to register their facilities with the FDA and are subject to periodic unannounced inspections by the FDA to assess compliance with cGMPs. Accordingly, manufacturers must continue to expend time, money and effort in the area of production and quality control to maintain compliance with cGMPs and other aspects of regulatory compliance.

If the FDA’s evaluation of the new drug application submission or manufacturing facilities is not favorable, the FDA may refuse to approve the new drug application or issue a not approvable letter. The not approvable letter outlines the deficiencies in the submission and often requires additional testing or information in order for the FDA to reconsider the application. Even with submission of this additional information, the FDA ultimately may decide that the application does not satisfy the regulatory criteria for approval. With limited exceptions, FDA may withhold approval of a new drug application regardless of prior advice it may have provided or commitments it may have made to the sponsor.

Foreign Regulation of New Drug Compounds

Approval of a product by comparable regulatory authorities will be necessary in foreign countries prior to the commencement of marketing of the product in those countries, whether or not FDA approval has been obtained. The approval procedure varies among countries and can involve requirements for additional testing. The time required may differ from that required for FDA approval. There can be substantial delays in obtaining required approvals from foreign regulatory authorities after the relevant applications are filed.

In Europe, marketing authorizations may be submitted under a centralized or decentralized procedure. The centralized procedure is mandatory for the approval of biotechnology products and provides for the grant of a single marketing authorization which is valid in all European Union member states. The decentralized procedure is a mutual recognition procedure that is available at the request of the applicant for all medicinal products which are not subject to the centralized procedure.

16

Table of Contents

Hazardous Materials

Our research and development processes involve the controlled use of hazardous materials, chemicals and radioactive materials and produce waste products. We are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of hazardous materials and waste products. We do not expect the cost of complying with these laws and regulations to be material.

Competition

Our product candidates will compete with existing and new products being developed by others for treatment of the same indications. Competition in the development of human therapeutics and, in particular, human therapeutics based upon signaling pathways, is intense. Our competitors may include many large pharmaceutical and biopharmaceutical companies, as well as specialized biotechnology and medical device firms. For example, we have identified biotechnology companies that claim to have intellectual property rights relating to compounds that modulate the Hedgehog pathway.

Many of the companies competing against us have financial, marketing and human resource capacities that are substantially greater than our own, which may provide these competitors significant competitive advantages over us. Others have extensive experience in undertaking clinical trials, in obtaining regulatory approval to market products and in manufacturing products on a large scale, which may enhance their competitive position relative to ours. In addition to competing with pharmaceutical, biotechnology and medical device companies, the products we are developing would also compete with those being developed by academic and research institutions, government agencies and other public organizations. Any of these organizations may discover new therapies, seek patent protection or establish collaborative arrangements for products and technologies that are competitive with our products and technologies.

The technologies underlying the development of human therapeutic products are expected to continue to undergo rapid and significant advancement and change. Accordingly, our technological and commercial success will be based, among other things, on our ability to develop proprietary positions in key scientific areas and efficiently evaluate potential product opportunities.

The timing of a product’s introduction may be a major factor in determining eventual commercial success and profitability. Early entry may have important advantages in gaining product acceptance and market share. Accordingly, we believe the relative speed with which our collaborators or we can complete preclinical and clinical testing, obtain regulatory approvals, and supply commercial quantities of a product will have an important impact on our competitive position, both in the United States and abroad. Other companies may succeed in developing similar products that are introduced earlier, are more effective, or are produced and marketed more effectively. For example, our competitors may discover, characterize and develop important inducing molecules before we do, which could have a material adverse effect on any of our related research programs. If research and development by others renders any of our products obsolete or noncompetitive, then our potential for success and profitability may be adversely affected.

We rely on or will rely on our strategic collaborators for support in our disease research programs and for preclinical evaluation and clinical development of our potential products and manufacturing and marketing of any products. Some of our strategic collaborators are conducting multiple product development efforts within each disease area that is the subject of our strategic collaboration with them. Our strategic collaboration agreements may not restrict the strategic collaborator from pursuing competing internal development efforts. Any of our product candidates, therefore, may be subject to competition with a product candidate under development by a strategic collaborator.

Our lead product candidate, a topical therapy for the treatment of basal cell carcinoma under co-development with Genentech, will face competition from both surgical and medical alternatives. Surgery is

17

Table of Contents

currently the standard of care, is typically performed by dermatologists and has an efficacy rate of approximately 90%. The American Cancer Society describes the four main surgical treatment alternatives and their drawbacks as follows:

In addition to surgery, certain types of basal cell carcinomas can be treated using other FDA-approved topical treatments, including 3M’s Aldara^® (Immiquimod) and ICN’s Efudex^® (Flouruoracil). These FDA-approved topical treatments are limited to a subset of basal cell carcinomas, called superficial basal cell carcinoma, which is the least severe form of basal cell carcinoma and is not as prevalent as the more serious form of the disease, nodular basal cell carcinoma. A market assessment that we completed during 2004 estimates that approximately 35% of basal cell carcinomas are superficial basal cell carcinomas, 55% are nodular basal cell carcinomas, and 10% are associated with other types of basal cell carcinomas. Aldara is an immune response modulator that was approved in July 2004 for the treatment of a subset of superficial basal cell carcinoma lesions. Its mechanism of curing superficial basal cell carcinoma will generally result in skin irritation including possible scabbing, flaking, burning or itching of the skin. Efudex’s active ingredient, Flouruoracil, or 5FU, is chemotherapy that is given as a treatment for some types of cancer including bowel, breast and stomach cancer. Because Efudex is a chemotherapeutic agent, we believe that there may be side effects which are greater than our basal cell carcinoma product candidate.

We believe that our basal cell carcinoma product candidate directly targets the known mechanism of action underlying the formation of basal cell carcinomas and that our product may be superior because we believe that it induces selective death of tumor cells while sparing adjacent normal cells and maintaining the typical architecture of the skin at the treatment site. Because of this, we believe that our product may produce minimal scarring when compared to the treatments described above and may be more effective than any of the topical treatments listed above. However, we acknowledge that our basal cell carcinoma product candidate, if approved by FDA, will face the challenge of displacing entrenched competition from at least the surgical and topical treatments listed above.

Manufacturing

We have no experience or capabilities in manufacturing. We have no current plans to develop manufacturing capability and instead plan to rely on our corporate collaborators or subcontractors to manufacture products.

18

Table of Contents

Sales and Marketing

We have no sales, marketing or distribution experience or infrastructure and we have no current plans to develop a sales, marketing and distribution capability. We currently plan to rely on our corporate collaborators for product sales, marketing and distribution.

Scientific Advisory Board

We have established a scientific advisory board made up of leading scientists and physicians in the field of signaling pathways. Members of our scientific advisory board consult with us on matters relating to our research and development programs, new technologies relevant to our research and development programs and other scientific and technical issues relevant to our business.

The current members of our scientific advisory board are as follows:

Employees

As of December 31, 2005, we had 68 full-time employees, of whom 36 hold Ph.D. or other advanced degrees. Of these employees, 47 are currently involved in research and development. None of our employees is a party to a collective bargaining agreement, and we consider our relations with our employees to be good.

19

Table of Contents

Factors That May Affect Results

RISKS RELATING TO OUR FINANCIAL RESULTS AND NEED FOR FINANCING

We have recently determined that certain accounting errors in our financial statements had a material impact on our previously reported financial information. As a result of this determination, we have restated our financial results for 2003, 2004 and for the quarters ended March 31, 2005, June 30, 2005 and September 30, 2005. The restatement could cause our stock price to decline and could subject us to securities litigation.

As discussed in Note 2 of the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, we have recently concluded that we made accounting errors in prior periods primarily relating to our revenue recognition accounting for $7,509,000 in license and maintenance fee payments paid by Genentech as part of our June 2003 Hedgehog antagonist collaboration with Genentech. We had been recognizing revenue in connection with the $7,509,000 in payments over an eight-year period based on our estimate that our participation on the steering committees would become inconsequential after the first product was approved in each of the two programs covered under this collaboration, and would therefore no longer represent a performance obligation. Accordingly, from fiscal year 2003 through the third quarter of 2005, we had recognized $2,239,000 in license fee revenue related to these payments. Following discussions with the SEC, we determined we should not have recognized any of this revenue in 2005, 2004 or 2003. Instead, we will defer the $7,509,000 in payments and recognize this amount as revenue only when we can reasonably estimate when our contractual steering committee obligations will cease or after we no longer have contractual steering committee obligations under this agreement with Genentech. The contractual term of our steering committee obligations extends for as long as Hedgehog antagonist products subject to this collaboration are being developed or commercialized by either of the parties. Accordingly, the contractual term of our steering committee obligations is indefinite and we expect that we will not record any revenue related to these payments for at least several years.

We are also restating previously reported research and development expenses associated with $410,000 in license fee payments that were payable to university licensors in connection with the June 2003 Hedgehog antagonist collaboration with Genentech. We had previously capitalized this amount as “Prepaid expenses and other current assets” and “Deposits and other assets” in our consolidated balance sheets and amortized this amount to research and development expense as the related license fee was recognized. We have determined that we should have instead recognized the entire $410,000 immediately as research and development expense in June 2003.

In connection with the restatement, we have also corrected other previously identified immaterial errors which had previously been corrected through a cumulative adjustment to the consolidated financial statements in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2005. The restatement allocates the adjustment among the correct periods.

The restatement could result in a decline in our stock price and securities class action litigation. In the past, securities class action litigation has often been brought in connection with restatements of financial statements. Defending against such potential litigation relating to a restatement of our financial statements will be expensive and will require significant attention and resources of our management. Moreover, our insurance to cover our obligations with respect to the ultimate resolution of any such litigation may be inadequate. As a result of these factors, any such potential litigation could have a material adverse effect on our business, results of operations and financial condition.

20

Table of Contents

We have incurred substantial losses, we expect to continue to incur substantial losses and we may never achieve profitability.

We expect to incur substantial operating losses for the foreseeable future, and we have no current sources of material ongoing revenue. As of December 31, 2005, we had an accumulated deficit of approximately $680,054,000. If we are not able to commercialize any products, whether alone or with a collaborator, we will not achieve profitability. Other than OP-1, which we and Stryker discovered under a former collaboration and Stryker has subsequently commercialized, we have not commercialized any products to date, either alone or with a third-party collaborator. All of our product candidates are in early stages of development. As a result, for the foreseeable future, we will need to spend significant capital on our research and development programs in order to produce products which we can commercialize. Even if our collaboration agreements provide funding for a portion of our research and development expenses, we will need to generate significant revenues in order to fund our operation and achieve profitability. We cannot be certain whether or when this will occur because of the significant uncertainties that affect our business, including the various risks described in this section “Factors That May Affect Results”. Our failure to become and remain profitable may depress the market price of our common stock and could impair our ability to raise capital, expand our business, diversify our product offerings or continue our operations.

We will require additional financing, which may be difficult to obtain and may dilute our existing shareholder ownership interest in us.

We will require substantial funds to continue our research and development programs and to fulfill our planned operating goals. In particular, our currently planned operating and capital requirements primarily include the need for working capital to:

We believe that our existing cash and working capital should be sufficient to fund our operations until mid-2007; however, our future capital requirements may vary from what we expect. There are factors that may affect our planned future capital requirements and accelerate our need for additional financing. These factors, many of which are outside our control, include the following:

21

Table of Contents

We expect to seek additional funding through public or private financings of debt or equity and may seek additional funding from additional strategic collaborators or additional foundations, such as the funding that we were awarded under our Spinal Muscular Atrophy Foundation research grant. However, the market for biotechnology stock in general, and the market for our common stock in particular, is highly volatile. Due to various factors, including market conditions and the status of our development pipeline, additional funding may not be available to us on acceptable terms, if at all. If we fail to obtain such additional financing on a timely basis, our ability to continue all of our research and development activities will be adversely affected.

If we raise additional funds by issuing equity securities, dilution to our stockholders will result. In addition, the terms of such a financing may adversely affect other rights of our stockholders. We also could elect to seek funds through arrangements with collaborators or others that may require us to relinquish rights to certain technologies, product candidates or products.

If the estimates we make and the assumptions on which we rely in preparing our financial statements prove inaccurate, our actual results may vary significantly.

Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses, the amounts of charges taken by us and related disclosure. Such estimates and judgments include the carrying value of our property, equipment and intangible assets, revenue recognition and the value of certain liabilities. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. However, these estimates and judgments, or the assumptions underlying them, may change over time. Accordingly, our actual financial results may vary significantly from the estimates contained in our financial statements. For example, as discussed in Note 2 of the notes to consolidated financial statements included elsewhere in this annual report on Form 10-K, we have recently determined to restate our consolidated financial statements for 2004 and 2003 and for the quarters ended March 31, 2005, June 30, 2005 and September 30, 2005 to correct errors in prior periods including the following:

For a further discussion of the estimates and judgments that we make and the critical accounting policies that affect these estimates and judgments, see “Critical Accounting Policies and Estimates” below.

RISKS RELATING TO OUR COLLABORATIONS

We are dependent on collaborators for the development and commercialization of many of our product candidates and for a significant portion of our revenue. If we lose any of these collaborators, of if they fail or delay in developing or commercializing our product candidates, our anticipated product pipeline and operating results would suffer.

The success of our strategy for development and commercialization of product candidates depends upon our ability to form and maintain productive strategic collaborations. We currently have strategic collaborations with Genentech, Wyeth, Procter & Gamble, Centocor, and Ortho Biotech Products. During the years ended December 31, 2005 and 2004, $9.6 million and $3.1 million, or 85% and 74%, respectively, of our gross revenue was derived from licensing and research and development payments received from these collaborators. We hope

22

Table of Contents

to enter into additional collaborations in the future. Our existing and any future collaborations may not be scientifically or commercially successful.

The risks that we face in connection with these collaborations include the following:

We may not be successful in establishing additional strategic collaborations, which could adversely affect our ability to develop and commercialize products.

As an integral part of our ongoing research and development efforts, we periodically review opportunities to establish new strategic collaborations for the development and commercialization of products in our development pipeline. We face significant competition in seeking appropriate collaborators and the negotiation process is time-consuming and complex. We may not be successful in our efforts to establish additional strategic collaborations or other alternative arrangements. Our research and development pipeline may be insufficient or our programs may be deemed too early for collaborative effort. Even if we are successful in our efforts to establish new collaborations, the terms that we agree upon may not be favorable to us. Finally, any such strategic alliances or other arrangements may not result in the successful development and commercialization of products and associated revenue.

RISKS RELATED TO OUR BUSINESS, INDUSTRY, STRATEGY AND OPERATIONS

We face substantial competition, which may result in our competitors discovering, developing or commercializing products before or more successfully than we do.

Our product candidates face competition from existing and new technologies and products being developed by biotechnology, medical device and pharmaceutical companies, as well as universities and other research institutions. For example, research in the fields of regulatory signaling pathways and functional genomics, which includes our work with Genentech in the field of cancer, with Wyeth in the field of neurology, with Procter & Gamble in the field of hair growth regulation, is highly competitive. A number of entities are seeking to identify and patent randomly sequenced genes and gene fragments, typically without specific knowledge of the function

23

Table of Contents

that such genes or gene fragments perform. Our competitors may discover, characterize and develop important inducing molecules or genes before we do. We also face competition from these and other entities in gaining access to DNA samples used in our research and development projects.

Many of our competitors have substantially greater capital resources, research and development staffs and facilities than we have. Efforts by other biotechnology, medical device and pharmaceutical companies could render our programs or products uneconomical or result in therapies superior to those that we develop alone or with a collaborator.

For those programs that we have selected for internal development, we face competition from companies that are more experienced in product development and commercialization, obtaining regulatory approvals and product manufacturing. As a result, they may be more successful in commercialization and/or may develop competing products more rapidly and at a lower cost. For those programs that are subject to a collaboration agreement, competitors may discover, develop and commercialize products which render our products non-competitive or obsolete.

We expect competition to intensify in genomics research and regulatory signaling pathways as technical advances in the field are made and become more widely known.

While many of our technologies are subject to collaborations, our remaining technologies that are available for internal programs have several potential applications. We have limited resources and are pursuing a strategy of undertaking foundation-funded research for orphan disease indications. The limited markets that are associated with such indications as well as conditions of funding arrangements may result in our failure to capitalize on other potentially profitable applications of our technologies.

We have limited financial and managerial resources to devote to new internal programs. These limitations have led us to adopt a strategy where we have undertaken funded research for certain orphan disease indications and to forego the exploration of other product opportunities. While our new technologies may permit us to work in multiple areas, resource commitments may require trade-offs resulting in delays in the development of certain programs or research areas, which may place us at a competitive disadvantage. In addition, our funded research includes screening of compounds that are not proprietary to us and may result in identification of a drug candidate that would not result in a commercially viable product and/or may divert resources away from other market opportunities, which ultimately prove to be more profitable.

If we or any of our collaborators fail to achieve market acceptance for our products under development, our future revenue and ability to achieve profitability may be adversely affected.

Our future products, if any are successfully developed, may not gain commercial acceptance among physicians, patients and third-party payors, even if necessary marketing approvals have been obtained. We believe that recommendations and endorsements by physicians will be essential for market acceptance of any products we successfully develop. If we are not able to obtain market acceptance for such products, our expected revenues from sales of these products would be adversely affected.

We could be exposed to significant monetary damages and business harm if we are unable to obtain or maintain adequate product liability insurance at acceptable costs or otherwise protect ourselves against potential product liability claims.

Product liability claims, inherent in the process of researching and developing human health care products, could expose us to significant liabilities and prevent or interfere with the development or commercialization of our product candidates. Product liability claims would require us to spend significant time, money and other resources to defend such claims and could ultimately lead to our having to pay a significant damage award. Product liability insurance is expensive to procure for biopharmaceutical companies such as ours. Although we

24

Table of Contents

maintain product liability insurance coverage for the clinical trials of our products under development, it is possible that we will not be able to obtain additional product liability insurance on acceptable terms, if at all, and that our product liability insurance coverage will not prove to be adequate to protect us from all potential claims.

If we are not able to attract and retain key management and scientific personnel and advisors, we may not successfully develop our product candidates or achieve our other business objectives.

We highly depend upon our senior management and scientific staff. The loss of the service of any of the key members of our senior management may significantly delay or prevent the achievement of product development and other business objectives. Key members of our senior management team include Daniel R. Passeri, our president and Chief Executive Officer and Dr. Lee L. Rubin, our Executive Vice President and Chief Scientific Officer. Our executive officers, including these individuals, can terminate their employment with us at any time. The loss of the services of any of our executive officers may significantly delay or prevent the achievement of product research and development and other business objectives. We are not aware of any present intention of any of these individuals to leave our company. Replacing key employees may be difficult and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to research, develop and successfully commercialize products in our areas of core competency. We do not maintain key man life insurance on any of these executive officers.

Our ability to operate successfully will depend on our ability to attract and retain qualified personnel, consultants and advisors. We face intense competition for qualified individuals from numerous pharmaceutical and biotechnology companies, universities, governmental entities and other research institutions. We may be unable to attract and retain these individuals, and our failure to do so would have an adverse effect on our business.

If we make any acquisitions, we will incur a variety of costs and may never successfully integrate the acquired business into ours.

We may attempt to acquire businesses, technologies, services or products that we believe are a strategic complement to our business model. We may encounter operating difficulties and expenditures relating to integrating an acquired business, technology, service or product. These acquisitions may also 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. We may also make dilutive issuances of equity securities, incur debt, experience a decrease in the cash available for our operations, or incur contingent liabilities in connection with any future acquisitions.

RISKS RELATING TO INTELLECTUAL PROPERTY

If we or any of our licensees and assignees breach any of the agreements under which we license or transfer intellectual property to others, we could be deprived of important intellectual property rights and future revenue.

We are a party to intellectual property out-licenses, collaborations and agreements that are important to our business and expect to enter into similar agreements with third parties in the future. Under these agreements, we license or transfer intellectual property to third parties and impose various research, development, commercialization, sublicensing, royalty, indemnification, insurance, and other obligations on them. If a third party fails to comply with these requirements, we generally retain the right to terminate the agreement, and to bring a legal action in court or in arbitration. In the event of breach, we may need to enforce our rights under these agreements by resorting to arbitration or litigation. During the period of arbitration or litigation, we may be unable to effectively use, assign or license the relevant intellectual property rights and may be deprived of current or future revenues that are associated with such intellectual property.

25

Table of Contents

We may not be able to obtain patent protection for our technologies and the patent protection we do obtain may not be sufficient to stop our competitors from using similar technology.

The patent positions of pharmaceutical and biotechnology companies, including ours, are generally uncertain and involve complex legal, scientific and factual questions. The standards which the United States Patent and Trademark Office uses to grant patents, and the standards which courts use to interpret patents, are not always applied predictably or uniformly and can change, particularly as new technologies develop. Consequently, the level of protection, if any, that will be provided by our patents if we attempt to enforce them, and they are challenged, is uncertain. The long-term success of our enterprise depends in significant part on our ability to:

Patents may not issue from any of the patent applications that we own or license. If patents do issue, the type and extent of patent claims issued to us may not be sufficiently broad to protect our technology from exploitation by our competitors. In addition, issued patents that we own or license may be challenged, invalidated or circumvented. Our patents also may not afford us protection against competitors with similar technology. Because patent applications in the United States are maintained in secrecy until 18 months after filing, it is possible that third parties have filed or maintained patent applications for technology used by us or covered by our pending patent applications without our knowledge.

We may not have rights under patents which may cover one or more of our product candidates. In some cases, these patents may be owned or controlled by third party competitors and may impair our ability to exploit our technology. As a result, we or our collaborative partners may be required to obtain licenses under third-party patents to develop and commercialize some of our product candidates. If we are unable to secure licenses to such patented technology on acceptable terms, we or our collaborative partners will not be able to develop and commercialize the affected product candidate or candidates.

We may become involved in expensive and unpredictable patent litigation or other intellectual property proceedings which could result in liability for damages or stop our development and commercialization efforts.

There have been substantial litigation and other proceedings regarding patent and other intellectual property rights in the pharmaceutical and biotechnology industries. We may become a party to patent litigation or other proceedings regarding intellectual property rights.

Situations which may give rise to patent litigation or other disputes over the use of our intellectual property include:

26

Table of Contents

The costs associated with any patent litigation or other proceeding, even if resolved favorably, will likely be substantial. Some of our competitors may be able to sustain the cost of such litigation or other proceedings more effectively than we can because of their substantially greater financial resources. If a patent litigation or other intellectual property proceeding is resolved unfavorably, we or our collaborative partners may be enjoined from manufacturing or selling our products and services without a license from the other party and be held liable for significant damages. Moreover, we may not be able to obtain required licenses on commercially acceptable terms or any terms at all. In addition, we could be held liable for lost profits if we are found to have infringed a valid patent, or liable for treble damages if we are found to have willfully infringed a valid patent. Litigation results are highly unpredictable and we or our collaborative partners may not prevail in any patent litigation or other proceeding in which we may become involved. Any changes in, or unexpected interpretations of, the patent laws may adversely affect our ability to enforce our patent position. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could damage our ability to compete in the marketplace. Patent litigation and other proceedings may also absorb significant management time and expense.

If we are unable to keep our trade secrets confidential, our technology and proprietary information may be used by others to compete against us.

We rely significantly upon proprietary technology, information, processes and know-how that are not subject to patent protection. We seek to protect this information through confidentiality agreements with our employees, consultants and other third-party contractors as well as through other security measures. These confidentiality agreements and security measures may be breached, and we may not have adequate remedies for any such breach. In addition, our trade secrets may otherwise become known or be independently developed by competitors.

RISKS RELATING TO CLINICAL AND REGULATORY MATTERS

We expect to rely heavily on third parties for the conduct of clinical trials of our product candidates as well as certain preclinical testing. If clinical trials are not successful, or if our collaborators decide to terminate development efforts for a particular compound, or if we or our collaborators are not able to obtain required regulatory approvals, we will not be able to commercialize our product candidates.

In order to obtain regulatory approval for the commercial sale of our product candidates, we and our collaborators will be required to complete extensive preclinical studies as well as clinical trials in humans to demonstrate to the FDA and foreign regulatory authorities that our product candidates are safe and effective. We have limited experience in conducting clinical trials and expect to rely primarily on collaborative partners and contract research organizations for their performance and management of clinical trials of our product candidates.

Clinical development, including preclinical testing, is a long, expensive and uncertain process. Accordingly, preclinical testing and clinical trials, if any, of our product candidates under development may not be successful. We and our collaborators could experience delays in preclinical or clinical trials of any of our product candidates which obtain unfavorable results in a development program, or fail to obtain regulatory approval for the commercialization of a product. Preclinical studies or clinical trials may produce negative, inconsistent or inconclusive results, and we or our collaborators may decide, or regulators may require us, to conduct additional preclinical studies or clinical trials or terminate testing for a particular product candidate. The results from early clinical trials may not be statistically significant or predictive of results that will be obtained from expanded, advanced clinical trials. Furthermore, the timing and completion of clinical trials, if any, of our product candidates depend on, among other factors, the number of patients we will be required to enroll in the clinical trials and the rate at which those patients are enrolled.

Any increase in the required number of patients, decrease in recruitment rates or difficulties retaining study participants may result in increased costs, program delays or program termination. Also, our products under

27

Table of Contents

development may not be effective in treating any of our targeted disorders or may prove to have undesirable or unintended side effects, toxicities or other characteristics that may prevent or limit their commercial use. Institutional review boards or regulators, including the FDA, or our collaborators may hold, suspend or terminate our clinical research or the clinical trials of our product candidates for various reasons, including failure to achieve established success criteria, noncompliance with regulatory requirements or if, in their opinion, the participating subjects are being exposed to unacceptable health risks. Additionally, the failure of third parties conducting or overseeing the operation of the clinical trials to perform their contractual or regulatory obligations in a timely fashion could delay the clinical trials.

Failure of clinical trials can occur at any stage of testing for a variety of reasons. Any of these events would adversely affect our ability to market a product candidate.

The development process necessary to obtain regulatory approval is lengthy, complex and expensive. If we and our collaborative partners do not obtain necessary regulatory approvals, then our business will be unsuccessful and the market price of our common stock will substantially decline.

To the extent that we, or our collaborative partners, are able to successfully advance a product candidate through the clinic, we, or such partner, will be required to obtain regulatory approval prior to marketing and selling such product.

The process of obtaining FDA and other required regulatory approvals is expensive. The time required for FDA and other approvals is uncertain and typically takes a number of years, depending on the complexity and novelty of the product. The process of obtaining FDA and other required regulatory approvals for many of our products under development is further complicated because some of these products use non-traditional or novel materials in non-traditional or novel ways, and the regulatory officials have little precedent to follow. With respect to internal programs to date, we have limited experience in filing and prosecuting applications to obtain marketing approval.

Any regulatory approval to market a product may be subject to limitations on the indicated uses for which we, or our collaborative partners, may market the product. These limitations may restrict the size of the market for the product and affect reimbursement by third-party payors. In addition, regulatory agencies may not grant approvals on a timely basis or may revoke or significantly modify previously granted approvals.

We, or our collaborative partners, also are subject to numerous foreign regulatory requirements governing the manufacturing and marketing of our potential future products outside of the United States. The approval procedure varies among countries, additional testing may be required in some jurisdictions, and the time required to obtain foreign approvals often differs from that required to obtain FDA approvals. Moreover, approval by the FDA does not ensure approval by regulatory authorities in other countries, and vice versa.

As a result of these factors, we or our collaborators may not successfully begin or complete clinical trials and/or obtain regulatory approval to market and sell our product candidates in the time periods estimated, if at all. Moreover, if we or our collaborators incur costs and delays in development programs or fail to successfully develop and commercialize products based upon our technologies, we may not become profitable and our stock price could decline.

Even if marketing approval is obtained, any products we or our collaborators develop will be subject to ongoing regulatory oversight which may affect the successful commercialization of such products.

Even if regulatory approval of a product candidate is obtained by us or our collaborators, the approval may be subject to limitations on the indicated uses for which the product is marketed or require costly post-marketing follow-up studies. After marketing approval for any product is obtained, the manufacturer and the manufacturing facilities for that product will be subject to continual review and periodic inspections by the FDA and other

28

Table of Contents

regulatory agencies. The subsequent discovery of previously unknown problems with the product, or with the manufacturer or facility, may result in restrictions on the product or manufacturer, including withdrawal of the product from the market.

If there is a failure to comply with applicable regulatory requirements, we or our collaborator may be subject to fines, suspension or withdrawal of regulatory approvals, product recalls, seizure of products, operating restrictions, and criminal prosecution.

We and our collaborators are subject to governmental regulations other than those imposed by the FDA. We and our collaborators may not be able to comply with these regulations, which could subject us, or such collaborators, to penalties and otherwise result in the limitation of our or such collaborators’ operations.

In addition to regulations imposed by the FDA, we and our collaborators are subject to regulation under the Occupational Safety and Health Act, the Environmental Protection Act, the Toxic Substances Control Act, the Research Conservation and Recovery Act, as well as regulations administered by the Nuclear Regulatory Commission, national restrictions on technology transfer, import, export and customs regulations and certain other local, state or federal regulations. From time to time, other federal agencies and congressional committees have indicated an interest in implementing further regulation of biotechnology applications. We are not able to predict whether any such regulations will be adopted or whether, if adopted, such regulations will apply to our business, or whether we or our collaborators would be able to comply with any applicable regulations.

Our research and development activities involve the controlled use of hazardous materials and chemicals. Although we believe that our safety procedures for handling and disposing of such materials comply with all applicable laws and regulations, we cannot completely eliminate the risk of accidental contamination or injury caused by these materials.

RISKS RELATING TO PRODUCT MANUFACTURING AND SALES

We will depend on our collaborators and third-party manufacturers to produce most, if not all, of our products under development, and if these third parties do not successfully manufacture these products our business will be harmed.

We have no manufacturing experience or manufacturing capabilities. In order to continue to develop products, apply for regulatory approvals, and commercialize our products, we or our collaborators must be able to manufacture products in adequate clinical and commercial quantities, in compliance with regulatory requirements, at acceptable quality and cost and in a timely manner. The manufacture of our product candidates may be complex, difficult to accomplish and difficult to scale-up when large-scale production is required. Manufacture may be subject to delays, inefficiencies and poor or low yields of quality products. The cost of manufacturing some of our products may make them prohibitively expensive. If supplies of any of our product candidates or related materials become unavailable on a timely basis or at all or are contaminated or otherwise lost, clinical trials by us and our collaborators could be seriously delayed. This is due to the fact that such materials are time-consuming to manufacture and cannot be readily obtained from third-party sources.

To the extent that we or our collaborators seek to enter into manufacturing arrangements with third parties, we and such collaborators will depend upon these third parties to perform their obligations in a timely and effective manner and in accordance with government regulations. Contract manufacturers may breach their manufacturing agreements because of factors beyond our control or may terminate or fail to renew a manufacturing agreement based on their own business priorities at a time that is costly or inconvenient for us.

Any contract manufacturers that we enter into manufacturing arrangements with will be subject to ongoing periodic, unannounced inspection by the FDA and corresponding state and foreign agencies or their designees to

29

Table of Contents

ensure strict compliance with current good manufacturing practices and other governmental regulations and corresponding foreign standards. Failure of contract manufacturers or our collaborators or us to comply with applicable regulations could result in sanctions being imposed, including fines, injunctions, civil penalties, failure of regulatory authorities to grant marketing approval of our product candidates, delays, suspension or withdrawal of approvals, seizures or recalls of product candidates, operating restrictions and criminal prosecutions, any of which could significantly and adversely affect our business. If we need to change manufacturers, the FDA and corresponding foreign regulatory agencies must approve these manufacturers in advance. This would involve testing and pre-approval inspections to ensure compliance with FDA and foreign regulations and standards.

If third-party manufacturers fail to perform their obligations, our competitive position and ability to generate revenue may be adversely affected in a number of ways, including;

We have no sales or marketing experience and, as such, will depend significantly on third parties who may not successfully sell our products.

We have no sales, marketing or product distribution experience. If we receive required regulatory approvals, we plan to rely primarily on sales, marketing and distribution arrangements with third parties, including our collaborative partners. For example, as part of our agreements with Genentech, Wyeth, Procter & Gamble and Ortho Biotech Products, we have granted our collaborators exclusive rights to distribute certain products resulting from such collaborations, if any are ever successfully developed. We may have to enter into additional marketing arrangements in the future and we may not be able to enter into these additional arrangements on terms which are favorable to us, if at all. In addition, we may have limited or no control over the sales, marketing and distribution activities of these third parties and sales through these third parties could be less profitable to us than direct sales. These third parties could sell competing products and may devote insufficient sales efforts to our products. Our future revenues will be materially dependent upon the success of the efforts of these third parties.

We may seek to independently market products that are not already subject to marketing agreements with other parties. If we determine to perform sales, marketing and distribution functions ourselves, we could face a number of additional risks, including:

RISKS RELATED TO OUR COMMON STOCK

Our stock price will fluctuate significantly and the market price of our common stock could drop below the price paid.

The trading price of our common stock has been volatile and may continue to be volatile in the future. For example, our stock has traded as high as $6.59 and as low as $2.46 per share for the period January 1, 2004 through December 31, 2005. The stock market, particularly in recent years, has experienced significant volatility

30

Table of Contents

with respect to pharmaceutical- and biotechnology-based company stocks. Prices for our stock will be determined in the marketplace and may be influenced by many factors, including:

While we cannot predict the individual effect that these factors may have on the price of our common stock, these factors, either individually or in the aggregate, could result in significant variations in price during any given period of time. Moreover, in the past, securities class action litigation has often been instituted against companies following periods of volatility in their stock price. This type of litigation could result in substantial costs and divert our management’s attention and resources.

Substantially all of our outstanding common stock may be sold into the market at any time. This could cause the market price of our common stock to drop significantly.

Sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell such shares, could reduce the market price of our common stock. As of December 31, 2005, we had outstanding approximately 48.3 million shares of common stock. Substantially all of these shares may also be resold in the public market at any time. In addition, we have a significant number of shares that are subject to outstanding options and warrants. The exercise of these options and warrants and the subsequent sale of the underlying common stock could cause a further decline in our stock price. These sales also might make it difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.

We have anti-takeover defenses that could delay or prevent an acquisition that our stockholders may consider favorable and the market price of our common stock may be lower as a result.

Provisions of our certificate of incorporation, our bylaws and Delaware law may have the effect of deterring unsolicited takeovers or delaying or preventing changes in control of our management, including transactions in which our stockholders might otherwise receive a premium for their shares over then current market prices. In addition, these provisions may limit the ability of stockholders to approve transactions that they may deem to be in their best interest. For example, we have divided our board of directors into three classes that serve staggered

31

Table of Contents

three-year terms, we may issue shares of our authorized “blank check” preferred stock and our stockholders are limited in their ability to call special stockholder meetings.

In addition, we are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibits a publicly-held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns, or within the last three years has owned, 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. These provisions could discourage, delay or prevent a change in control transaction.

None.

We have three facilities which are located at 25, 45 and 61 Moulton Street in Cambridge, Massachusetts and which consist of 1,526, 35,095, and 17,800 square feet, respectively. The facilities at 25 and 61 Moulton Street are leased until April 2006 and April 2007, respectively. In August 2004, we extended the lease for the 45 Moulton Street location until December 2010. Except for 11,980 square feet at our 61 Moulton Street facility that we have sublet until April 2007, we currently use our space to conduct research and development initiatives and to manage the administrative aspects of our business. We believe that our existing facilities will be suitable and adequate to meet our needs for the foreseeable future.

We are currently not a party to any material legal proceedings.

We did not submit any matter to a vote of security holders during the fourth quarter of the fiscal year covered by this annual report.

32

Table of Contents

EXECUTIVE OFFICERS OF THE REGISTRANT

Our executive officers are as follows:

33

Table of Contents

34

Table of Contents

PART II

(a) Market Information.    Our common stock is traded on the NASDAQ National Market under the trading symbol “CRIS.” The following table sets forth, for the fiscal periods indicated, the high and low sales prices per share of our common stock as reported on the NASDAQ National Market:

(b) Holders of Record.    On March 22, 2006, the last reported sale price of our common stock on the NASDAQ National Market was $2.29 and there were 306 holders of record of our common stock. The number of record holders may not be representative of the number of beneficial owners because many of the shares of our common stock are held by depositories, brokers or other nominees.

(c) Dividends.    We have never declared or paid any cash dividends on our common stock. We currently intend to retain earnings, if any, to support our business strategy and do not anticipate paying cash dividends in the foreseeable future. Payment of future dividends, if any, will be at the sole discretion of our board of directors after taking into account various factors, including our financial condition, operating results, capital requirements and any plans for expansion.

(d) Changes in Securities and Use of Proceeds.    None.

35

Table of Contents

The selected consolidated financial data set forth below have been derived from our consolidated financial statements. These historical results are not necessarily indicative of results to be expected for any future period. You should read the data set forth below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this report. As described in Note 2 to our consolidated financial statements, we have restated our consolidated financial statements for the years ended December 31, 2004 and 2003.

36

Table of Contents

37

Table of Contents

The following discussion and analysis of financial condition and results of operations should be read together with “Selected Financial Data,” and our financial statements and accompanying notes appearing elsewhere in this annual report on Form 10-K. This discussion contains forward-looking statements, based on current expectations and related to future events and our future financial performance, that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many important factors, including those set forth under Item 1A, “Risk Factors” and elsewhere in this report.

Overview

We are a therapeutic drug development company principally focused on the discovery, development and future commercialization of products that modulate key regulatory signaling pathways controlling the growth, repair and regeneration of human tissues and organs. Our product development approach involves using small molecules, proteins or antibodies to modulate these regulatory signaling pathways, for example, to increase the pathway signals when they are insufficient or to decrease them when they are excessive or unregulated. We have successfully used our product development approach to produce multiple compounds with potential use for several different disease indications. For example, we have developed a product candidate for the topical treatment of basal cell carcinoma, which is currently in a Phase I clinical trial and under co-development with Genentech, a collaborator. We have also developed several promising preclinical product candidates in various fields, including cancer, neurological disorders and hair growth regulation. We operate in a single reportable segment: developmental biology products. We expect that any successful products would be used in the health care industry and would be regulated in the United States by the U.S. Food and Drug Administration, or FDA, and in overseas markets by similar regulatory agencies.

Since our inception, we have funded our operations primarily through license fees, research and development funding from our strategic collaborators, the private and public placement of our equity securities, debt financings and the monetization of certain royalty rights. We have never been profitable and have incurred an accumulated deficit of $680,054,000 as of December 31, 2005. We expect to incur significant operating losses for the next several years as we devote substantially all of our resources to research and development of our product candidates. We will need to generate significant revenues to achieve profitability and do not expect to achieve profitability in the foreseeable future, if at all.

Our research programs are conducted both internally and through strategic collaborations. We currently have strategic collaborations with Genentech, Procter & Gamble, and Wyeth Pharmaceuticals, or Wyeth, to develop therapeutics, which modulate the signaling of the Hedgehog pathway. We have a second collaboration with Genentech focusing on the discovery and development of small molecule modulators of another signaling pathway. We have licensed our bone morphogenetic protein, or BMP, pathway patent portfolio to Ortho Biotech Products, a subsidiary of Johnson & Johnson, for systemic administration in all non-orthopedic and non-dental therapeutic applications. This program is under development at Centocor, another subsidiary of Johnson & Johnson. In 2005, Centocor entered into an agreement with us whereby Centocor will fund a portion of a new Curis BMP small molecule screening program. Lastly, a majority of our spinal muscular atrophy, or SMA, research is funded through a sponsored research agreement with the SMA Foundation.

Our current strategic collaborations and license agreements generally provide for our research, development and commercialization programs to be wholly or the majority funded by our collaborators and provide us with the opportunity to receive additional payments if specified milestones are achieved, as well as royalty payments upon the successful commercialization of any products based upon the collaboration. These strategic license and collaboration agreements included $18,500,000 in up-front payments, of which we received $6,629,000 from the sale of shares of our common stock, and also include approximately $750,000,000 in contingent cash payments

38

Table of Contents

that are tied to future clinical development and regulatory approval objectives, assuming that all of the collaborations continue for their full terms, multiple products for multiple indications are developed, and all milestone payments are received upon the successful completion of specified research and/or development objectives and regulatory approvals. In January 2005, we exercised a co-development option with Genentech pursuant to which we are now sharing equally in the U.S. development costs and will share equally in any future U.S. net profits and/or losses in this program. Through December 31, 2005, we had incurred $6,999,000 in co-development costs under this program. In the future, we plan to continue to seek corporate collaborators for the further development and commercialization of some of our other technologies.

In some cases, we have retained rights under such programs, including co-development rights and development and commercialization rights in specific therapeutic areas where we believe we can attain additional value through the application of our own internal resources. Examples of retained rights within our programs under collaboration include co-development rights for the development of a basal cell carcinoma product candidate under our Hedgehog antagonist collaboration with Genentech, as well as retained rights to our Hedgehog agonist for topical applications, for local delivery in cardiovascular applications and for ex vivo use under our broad Hedgehog agonist collaboration with Wyeth.

Restatement of Financial Statements

As described in Note 2 of our consolidated financial statements, we have restated our financial results for 2004 and 2003.

The restatement adjusts our consolidated 2004 balance sheet contained herein to correct amounts in prepaid expenses and other current assets, deposits and other assets, short-term and long-term deferred revenues, additional paid-in capital, and accumulated deficit and to restate our consolidated 2004 and 2003 statements of operations to correct amounts reported in gross revenues and research and development expenses. As a result of these restatements, amounts in the consolidated statement of cash flows for the years ended December 31, 2004 and 2003 have also been corrected. These adjustments are more fully described below:

39

Table of Contents

These errors relate our sale of shares of our common stock in connection with the June 2003 Genentech and January 2004 Wyeth collaboration agreements. In each case, we calculated the value of the common stock using the negotiated price, which was less than the closing market price on the agreement date. Because of this, we understated additional paid-in capital and overstated deferred revenues by $1,629,000. The overstatement of deferred revenues resulted in an overstatement of license fee revenues in 2004 and 2003 because, in each case, we amortized deferred revenue over the estimated performance period to revenues in our consolidated statements of operations. The consolidated financial statements for 2004 and 2003 have been restated to: (i) reverse all revenue recognized related to the amortization of the deferred revenue related to the June 2003 Genentech Hedgehog antagonist collaboration, (ii) correct revenue recognized related to the amortization of the deferred revenue related to the 2004 Wyeth collaboration, (iii) correct additional paid-in capital at December 31, 2004 and 2003, to reflect the fair value on the date of issuance of the common stock issued to Genentech and Wyeth and (iv) correct deferred revenue at December 31, 2004, to reflect the impact of these adjustments. The correction of the accounting for the January 2004 Wyeth collaboration agreement resulted in a $138,000 increase in net cash used in operating activities and a corresponding increase in net cash provided by financing activities for the year ended December 31, 2004. The correction of the accounting for the June 2003 Genentech collaboration agreement resulted in a $1,491,000 increase in net cash used in operating activities and a corresponding increase in net cash provided by financing activities for the year ended December 31, 2003.

As a result of this restatement, we have filed amendments No. 1 on Forms 10-Q/A to restate our March 31, 2005, June 30, 2005 and September 30, 2005 financial statements. We do not anticipate filing amended annual reports on Form 10-K or quarterly reports on Form 10-Q for any periods prior to the first quarter of 2005. Accordingly, our annual reports on Form 10-K and our quarterly reports on Form 10-Q from the second quarter of 2003 through fiscal 2004 have not been revised to reflect the restatement and the financial statements for fiscal 2004 and 2003 included in this annual report on Form 10-K should be relied upon. Management’s discussion and analysis of the financial condition and our results of operations for the years ended December 31, 2004 and 2003 have been updated to reflect these restated amounts.

Recent Developments

Phase I Basal cell carcinoma clinical trial update. A Phase I clinical trial of topically-applied small molecule antagonist of the Hedgehog signaling pathway is being conducted by Genentech and Curis. The Phase I clinical trial is a double-blind, randomized, placebo-controlled study that is expected to enroll approximately 60 patients with a single or multiple basal cell carcinoma. The primary objective of the Phase I clinical trial is to obtain data about the safety and tolerability of a four-week regimen of the drug candidate. In addition, Genentech and Curis are evaluating the clinical activity of the drug candidate, where activity is defined as the complete eradication of the treated basal cell carcinoma lesion and is determined by clinical and microscopic examinations of the lesions. At the conclusion of this Phase I clinical trial, Genentech and we plan to make a decision about whether to advance the drug candidate into a Phase II clinical trial.

40

Table of Contents

On January 23, 2006, we provided an update on the Phase I clinical trial. At that time, 29 of the Phase I clinical trial patients had participated in a dose-escalation segment, in which seven patients were randomized to receive treatment in one of four dose levels. The dose-escalation segment of the Phase I clinical trial had recently been completed, and the preliminary data had been reviewed by an internal Genentech data review board. The preliminary data from the dose-escalation segment suggested that the drug candidate appeared likely to be safe, well tolerated, and had shown signs of activity. However, there had been less clinical activity observed to date than anticipated. Based on these data, the internal data review board recommended that Genentech and we temporarily suspend further enrollment in the second segment of the trial, in which additional patients were to be treated at the highest dose level from the dose escalation segment. Genentech and we will determine whether to re-open enrollment in this segment based on a secondary interim analysis that will occur at a later date. The internal data review board also recommended that a third segment of the trial that is evaluating biological activity using a pharmacodynamic endpoint be enrolled as planned. This third segment, among other things, may shed light on the extent to which the active compound in the drug candidate as formulated is penetrating the patients’ skin.

Genentech and we expect to have final results from the Phase I clinical trial during the first half of 2006. When the final results are obtained, Genentech and we will determine whether this drug candidate should proceed to Phase II clinical trials. Should this drug candidate not progress into Phase II clinical trials, Genentech and we will evaluate various criteria, including the data from the biological activity segment of the trial, and determine the alternatives for the basal cell carcinoma program. Possible scenarios include, but are not limited to the following: extending the duration of the treatment regimen of the existing drug candidate, developing a new topical formulation of the existing drug candidate, selection of a new drug candidate, negotiation of the return of the compounds to us for our further development, or termination of the basal cell carcinoma drug program development.

Preclinical milestone received from Proctor & Gamble. In March of 2006, Curis reached the first preclinical development objective in our hair growth program with Procter & Gamble Pharmaceuticals, a division of The Procter & Gamble Company. The program is focused upon the potential development of a topical Hedgehog agonist for hair growth disorders, such as male pattern baldness and female pattern hair loss. As part of the initial agreement signed in September of 2005, P&G agreed to pay Curis up to $2,800,000 in cash payments that are contingent upon the achievement of certain preclinical development objectives. The first of two preclinical development objectives was successfully completed and resulted in a payment to Curis of $1,000,000.

2005 Business Summary

2005 was an important year for Curis. During 2005, with our basal cell carcinoma program, we moved our first product candidate into clinical testing since 2001. Genentech selected a lead candidate for clinical development under the systemic Hedgehog antagonist program, and we entered into new corporate collaborations with Genentech and Procter & Gamble. We also expanded our existing relationship with Centocor and two of our collaborators, Genentech and Wyeth, extended their contractual commitments under their respective programs. We believe that these extensions of these research collaborations demonstrate the contribution of our scientists to each of these programs. The year was not without its challenges. Two of our product development programs experienced delays during 2005, including our Hedgehog agonist under collaboration with Wyeth and our BMP-7 protein product candidate under development with Centocor. The following provides additional information on key events in 2005:

41

Table of Contents

42

Table of Contents

Financial Operations Overview

General.    Our future operating results will largely depend on the magnitude of payments from our current and potential future corporate collaborators and the progress of other product candidates currently in our research and development pipeline. The results of our operations will vary significantly from year to year and quarter to quarter and depend upon, among other factors, the timing of our entry into new collaborations, the timing of the receipt of payments from collaborators and the cost and outcome of clinical trials. We believe that our existing capital resources at December 31, 2005, together with the payment of all contractually-defined payments under our collaborations and research programs with Genentech, Wyeth, Procter & Gamble and the SMA Foundation, assuming these programs continue as planned, should enable us to maintain current and planned operations into the second half of 2007, including expected spending related to our co-development of our lead product candidate for the treatment of basal cell carcinoma. Our ability to continue funding our planned operations beyond the second half of 2007 is dependent upon the success of our collaborations, our ability to control our cash burn rate and our ability to raise additional funds through equity, debt or other sources of financing. A discussion of certain risks and uncertainties that could affect our liquidity, capital requirements and ability to raise additional funds is set forth under Item 1A, “Risk Factors.”

Revenue.    We do not expect to generate any revenue from the sale of products for several years, if ever. Substantially all of our gross revenues to date have been derived from license fees, research and development payments, milestone payments and other amounts that we have received from our strategic collaborators and licensees, including Genentech, Wyeth, Ortho Biotech Products/Centocor, Procter & Gamble and the SMA Foundation as well as royalty revenue and payments received upon monetization of certain royalty rights from Stryker Corporation, under the terms of which Stryker paid us $14,000,000 in cash in 2002 in exchange for the termination of Stryker’s future royalty obligations. Since our equal share of the basal cell carcinoma co-development costs will be recorded as a reduction to any revenue recognized under our collaborations with Genentech in accordance with EITF 01-9, we do not expect to generate any net revenue from our two collaborations with Genentech until we obtain FDA approval to commercialize our basal cell carcinoma product candidate. In the future, we will seek to generate revenues from a combination of license fees, research and development funding and milestone payments, royalties resulting from the sale of products that incorporate our intellectual property in connection with strategic licenses and collaborations, and sales of any products we successfully develop and commercialize, either alone or in collaboration with third parties. We expect that any

43

Table of Contents

revenues we generate will fluctuate from quarter to quarter as a result of the timing and amount of payments received under our strategic collaborations, and the amount and timing of payments we receive upon the sale of our products, to the extent that any are successfully commercialized.

Research and Development.    Research and development expense consists of costs incurred to discover, research and develop our product candidates. These expenses consist primarily of salaries and related expenses for personnel, supplies and reagents, outside service costs including medicinal chemistry, consulting and sponsored research collaborations, and occupancy and depreciation charges. We expense research and development costs as incurred.

Most of our programs are in various stages of preclinical drug development. The following table summarizes our primary research and development programs, including the current development status of each program. In the table, the term discovery means that we are searching for compounds that may be relevant for treating a particular disease area, early preclinical means we are seeking to obtain initial demonstrations of therapeutic efficacy in preclinical models of human disease, mid-preclinical means we are seeking to obtain multiple demonstrations of efficacy in preclinical models of human disease, late preclinical means we are seeking to obtain both multiple demonstrations of efficacy in preclinical models of human disease and relevant toxicology and safety data required for an investigational new drug, or IND, application filing with the FDA seeking to commence a Phase I clinical trial to assess safety and tolerability in humans, and Phase I means that we are currently treating human patients in a Phase I clinical trial, the principal purpose of which is to evaluate safety of the compound being tested.

All of our estimates below regarding the status of our product development programs are solely our judgments. These estimates may not reflect the beliefs or expectations of our corporate collaborators or licensors, if applicable. Moreover, because of the early stages of development of these programs, our ability and that of our collaborators and licensors to successfully complete preclinical or clinical studies of these product candidates, and the timing of completion of such programs, is highly uncertain.

44

Table of Contents

There is a risk that any drug discovery and development program may not produce products or revenues. Due to uncertainties inherent in drug discovery and development, including those factors described under Item 1A, “Risk Factors,” we and our collaborators may not be able to successfully develop and commercialize any of the product candidates included in the table above.

Genentech and we are co-developing a Hedgehog small molecule antagonist formulated for the topical treatment of basal cell carcinoma. Genentech and we will share equally in all U.S. development costs. As a result of our election to exercise our co-development option, we expect that we would incur approximately $20,000,000 in development costs through Phase II clinical trials and we anticipate that these trials will be completed in mid-2007, assuming the successful advancement of the basal cell carcinoma product candidate through Phase I and Phase II clinical trials. We expect to incur additional costs to complete Phase III clinical trials and the remainder of the regulatory approval process, assuming that Genentech and we successfully complete Phase II clinical trials. Due to the uncertainties that are inherent to the drug discovery process, as more fully described below, we are not currently able to estimate the cost and timing to complete the Phase III trial and receive regulatory approval of this product candidate, if ever.

Except for our basal cell carcinoma product candidate, all of our product development initiatives are in various stages of preclinical testing. Because of the early stages of all of our programs, including our basal cell carcinoma program, the successful development of our product candidates is highly uncertain. We cannot reasonably estimate or know the nature, timing and estimated costs of the efforts necessary to complete the development of, or the period in which material net cash inflows are expected to commence from any of our product candidates due to the numerous risks and uncertainties associated with developing drugs, including the uncertainty of:

Any failure to complete the development of our product candidates in a timely manner could have a material adverse effect on our operations, financial position and liquidity. A discussion of risks and uncertainties associated with completing our projects on schedule, or at all, and some consequences of failing to do so, are set forth in Item 1A, “Risk Factors.”

General and Administrative.    General and administrative expense consists primarily of salaries and other related costs for personnel in executive, finance, accounting, business development, legal, information technology, corporate communications and human resource functions. Other costs include facility costs not otherwise included in research and development expense, insurance, and professional fees for legal, patent and accounting services. Within general and administrative expenses, we have recorded a $500,000 charge resulting from a reduction in our expected loss of subtenant income on an operating lease for the remainder of the lease term at our facility at 61 Moulton Street, Cambridge, MA. This lease term ends on April 30, 2007.

45

Table of Contents

Strategic Collaborations and License Agreements.    Since inception, substantially all of our revenues have been derived from collaborations and other research and development arrangements with third parties. Our current strategic collaborations and key license agreements are with Genentech, Wyeth, Procter & Gamble and Ortho Biotech Products. These strategic license and collaboration agreements included $18,500,000 in up-front payments, including $6,629,000 from the sale of shares of our common stock, and also include approximately $750,000,000 in contingent cash payments that are tied to future clinical development and regulatory approval objectives, assuming that all of the collaborations continue for their full terms, multiple products for multiple indications are successfully developed, and all milestone payments are received upon successful completion of specified research, development and regulatory approval objectives.

The collaborations and licenses are summarized as follows:

Genentech Hedgehog Antagonist Collaboration.    In June 2003, we licensed our proprietary Hedgehog pathway technologies to Genentech for human therapeutic use. The primary focus of the collaborative research plan has been to develop molecules that inhibit, or antagonize, the Hedgehog pathway for the treatment of various cancers. The collaboration consists of two programs: the development of a small molecule Hedgehog antagonist formulated for the topical treatment for basal cell carcinoma; and the development of systemically administered small molecule and antibody Hedgehog antagonists for the treatment of certain other solid tumor cancers. Pursuant to the collaboration agreement, Genentech agreed to make specified cash payments including up-front payments of $8,500,000, which consisted of a $3,509,000 non-refundable license fee payment and $4,991,000 in exchange for shares of the Company’s common stock. Genentech also agreed to make license maintenance fee payments totaling $4,000,000 over the first two years of the collaboration and contingent cash payments at various intervals during the clinical development and regulatory approval process of small molecule and antibody Hedgehog antagonist product candidates, assuming specified clinical development and regulatory approval objectives are met. In addition, Genentech will pay us a royalty on potential future net product sales, which increases with increasing sales volume. As described below, in December 2004, we entered into an amendment to this agreement that modified the maintenance fee payment arrangement.

In January 2005, pursuant to the collaboration agreement, we elected to exercise our co-development option and are now sharing equally in the U.S. development costs and will share in any future U.S. net profits or losses of the basal cell carcinoma program. As a result of participating in co-development, we will forego U.S. development contingent cash payments and royalty payments on potential future U.S. sales of the basal cell carcinoma product candidate. On June 8, 2005, we announced that the dosing of the first patient in the Phase I clinical trial for basal cell carcinoma was completed. This Phase I trial is being conducted by Genentech and Curis.

In addition to our co-development rights in the U.S. marketplace, in certain major international markets, we will receive cash payments if specific clinical development objectives are achieved and a royalty on any international sales of a basal cell carcinoma product candidate.

Under the systemic Hedgehog antagonist program of the collaboration, Genentech is obligated to make cash payments to us assuming the successful achievement of clinical development and drug approval objectives. In addition, Genentech will pay a royalty on potential future net product sales, which increases with increasing sales.

Amendments to the Genentech Hedgehog Antagonist Collaboration.    In December 2004 and April 2005, we entered into separate amendments to our June 2003 agreement with Genentech. We considered the provisions of EITF 00-21 and determined that these agreements were separate contracts from our June 2003 agreement since these agreements were not contemplated at the time of the June 2003 arrangement, were separately negotiated in order to increase the number of full-time equivalents providing research and development services and to provide xenograft tumor samples to Genentech, and were not entered into at or near the time of the June 2003 agreement.

46

Table of Contents

The December 2004 amendment, effective from June 12, 2004 to June 11, 2005, increased our commitment of full-time equivalents providing research and development services for the systemic Hedgehog antagonist program from eight to sixteen, including six full-time equivalents that are employed by a third party but are managed by us, and increased Genentech’s funding commitment from $2,000,000 to $4,000,000 for this period of which Genentech paid us $2,000,000 for research services in December 2004 and the remaining $2,000,000 for subsequent research services was paid in June 2005. Pursuant to the agreement, we also agreed to provide xenograft tumor samples to Genentech during the research period for which Genentech paid us $100,000 in December 2004. Also in accordance with the amendment, the second $2,000,000 maintenance payment due under the June 2003 arrangement was removed with no economic effect since it was replaced by a $2,000,000 payment for research services made to us in December 2004.

The April 2005 amendment, effective from June 12, 2005 to June 11, 2006, provides for up to sixteen of our full-time equivalent researchers, including six full-time equivalents that are employed by a third party but are managed by us, to provide research and development services for the systemic Hedgehog antagonist program for the period of June 12, 2005 until December 11, 2005, in exchange for an additional $2,000,000, which was paid in December 2005. The agreement also provided Genentech with the option to request that we provide up to sixteen full-time equivalent researchers to perform research services during the period of December 12, 2005 until June 11, 2006, provided that Genentech supplies us with adequate notice. In October 2005, Genentech requested that we provide ten full-time equivalent researchers, all of which are Curis employees, to work on the program from December 12, 2005 until June 11, 2006, in exchange for up to $1,250,000. The six full-time third party equivalents that were previously involved in the program are no longer needed, based on the progress made under the program, which included the selection of a lead clinical candidate, a small molecule antagonist of the Hedgehog pathway. The remaining $1,250,000 for subsequent research services is payable by Genentech in June 2006.

Genentech Discovery Research Collaboration.    On April 1, 2005, we entered into a drug discovery collaboration agreement with Genentech for discovery and development of small molecule compounds that modulate a signaling pathway that plays an important role in cell proliferation. This pathway is a regulator of tissue growth, formation and repair, the abnormal activation of which is associated with certain cancers. Under the terms of the agreement, we granted Genentech an exclusive, royalty-bearing license to make, use and sell the small molecule compounds that are modulators of the pathway. We have retained the rights for ex vivo cell therapy uses, except in the areas of oncology and hematopoiesis. Under the terms of the agreement, we have primary responsibility for drug discovery and research activities and Genentech will be responsible for clinical development, manufacturing, and commercialization of products that may result from the collaboration.

Genentech paid us an up-front license fee of $3,000,000 and has agreed to fund up to $6,000,000 for research activities during the initial two-year research term, subject to certain termination rights. Genentech has also agreed to make cash payments to us that are contingent upon the successful achievement of certain preclinical and clinical development and drug approval milestones. Excluding royalties on potential net product sales, the total potential cash payments from this collaboration could exceed $140,000,000, assuming that two products are commercialized in two indications each. Genentech has an option to extend the initial two-year research term for up to two additional years in one-year increments. Genentech will also pay us royalties on net product sales if product candidates derived from the collaboration are successfully developed.

Wyeth Hedgehog Agonist Collaboration.    On January 12, 2004, we licensed our Hedgehog proteins and small molecule Hedgehog pathway agonists to Wyeth for therapeutic applications in the treatment of neurological and other disorders. Pursuant to the collaboration agreement, Wyeth agreed to make specified cash payments, including up-front payments of $3,000,000, which consisted of a $1,362,000 non-refundable license fee payment and $1,638,000 in exchange for 315,524 shares of our common stock.

Wyeth has agreed to assume all future responsibility for clinical development of the Hedgehog small molecule and protein agonists as systemic treatments for neurological and other disorders. Wyeth is also obligated to make cash payments that are contingent upon the successful achievement of clinical

47

Table of Contents

development and drug approval objectives and to pay us a royalty on net product sales, if any should occur, that escalates with increasing sales volume. Our agreement with Wyeth includes more than $170,000,000 in such contingent cash payments, assuming at least two products are successfully developed and commercialized.

In addition to these initial and potential future cash payments, Wyeth is obligated to provide financial support of our research under the collaboration, at $250,000 per full-time equivalent researcher, for a period of up two years based on the number of full-time equivalent researchers performing services under the collaboration. We are obligated to dedicate between five and ten full-time equivalents to this program, as determined by the steering committee in six-month intervals, for two years. After the initial two-year period, Wyeth can, at its option, elect to extend our research obligation, and Wyeth’s funding thereof, for an initial one-year extension on the same terms and conditions as the initial two-year term. In November 2005, Wyeth exercised this option to extend the initial term. By exercising this option, Wyeth agreed to extend the research term by one year through February 9, 2007. After the initial one-year extension, the agreement may be extended for additional one-year periods with our consent upon recommendation of the steering committee with such full-time equivalent resources and related Wyeth funding obligations as may be consistent with fulfilling the objectives of the research plan.

As part of the agreement, we have retained development and licensing options for certain therapeutic applications of the Hedgehog agonist technologies, including topical treatment for skin diseases and disorders including hair growth regulation, ex vivo cell therapy, local delivery applications for treatment of cardiovascular disease, and those applications that qualify as orphan drug indications. Wyeth has a right of first negotiation to obtain an exclusive license to the orphan drug indications and the cardiovascular applications. If Wyeth declines to exercise its right, or if we are unable to reach an agreement with Wyeth on terms within the contractually specified period, we are free to seek another collaborator for these programs.

Procter & Gamble Hedgehog Agonist Collaboration for Hair Growth and Skin Disorders.    On September 18, 2005, we entered into a collaboration, research and license agreement with Procter & Gamble, to evaluate and develop potential treatments for hair growth regulation and skin disorders utilizing our Hedgehog agonist technology.

Under the terms of the agreement, we granted to Procter & Gamble an exclusive, worldwide, royalty-bearing license for the development and commercialization of topical dermatological and hair growth products that incorporate our Hedgehog agonist technology. In accordance with the terms of the agreement, the parties shall jointly undertake a research program with the goal of identifying one or more compounds to be developed and commercialized by Procter & Gamble. Procter & Gamble is solely responsible for the cost of worldwide development and commercialization of any product candidates developed pursuant to the research program, provided however, that at the time that Procter & Gamble determines to file the first IND application with the FDA for a product candidate, we shall have the option, at our sole discretion, to co-develop a product candidate through Phases I and II of clinical development. We, however, would receive a higher royalty in the event that we exercise our co-development option and subsequently share in development expenses through Phase II clinical trials. Should we elect to exercise this co-development option, we will forego contingent cash payments that would otherwise be payable for the achievement of certain development objectives during the period from investigational new drug application filing through the completion of a Phase II clinical trial. Procter & Gamble has paid us an up-front license fee of $500,000 and has agreed to fund up to $600,000 for two of our full-time equivalent employees providing research and development activities during the initial one-year research term, subject to its termination rights. Procter & Gamble has an option to extend the initial one-year research term for up to three additional years in one-year increments.

Procter & Gamble has also agreed to make cash payments to us that are contingent upon the successful achievement of certain research, development, clinical and drug approval objectives. Procter & Gamble will also pay us royalties on net product sales if product candidates derived from the collaboration are successfully developed.

48

Table of Contents

In March of 2006, we reached the first preclinical development objective in our hair growth program with Procter & Gamble Pharmaceuticals, a division of The Procter & Gamble Company. The program is focused upon the potential development of a topical Hedgehog agonist for hair growth disorders, such as male pattern baldness and female pattern hair loss. As part of the initial agreement signed in September of 2005, P&G agreed to pay Curis up to $2,800,000 in cash payments that are contingent upon the achievement of certain preclinical development objectives. The first of two preclinical development objectives was successfully completed and resulted in a payment to Curis of $1,000,000.

Ortho Biotech Products BMP License.    In November 2002, we entered into an agreement with Ortho Biotech Products, a subsidiary of Johnson & Johnson, pursuant to which Ortho Biotech obtained the license rights to our BMP-7 technology and assumed control of the continued development of this product candidate. In 2005, Johnson & Johnson moved responsibility for the further development of BMP-7 to Centocor, another subsidiary of Johnson & Johnson, and Centocor has assumed all future costs and responsibility for BMP-based product development. We are entitled to receive a series of contingent cash payments that are tied to the achievement of clinical development and regulatory objectives payments, and royalties on product sales if any BMP-based products are successfully commercialized. Centocor has sole responsibility for deciding if and when human clinical trials of BMP-7 will begin.

The transaction relates to all of our proprietary BMP compounds including BMP-7, which has been studied in animal models in various disease indications, including as a treatment for chronic kidney disease and systemic complications, such as renal osteodystrophy, a form of bone disease, and blood vessel complications that have been associated with chronic kidney disease. Use of our BMPs for the repair or regeneration of local musculoskeletal tissue defects and dental defects is the subject of an exclusive agreement with Stryker and is not included as part of this transaction.

Pursuant to the agreement, Ortho Biotech paid us an up-front payment of $3,500,000, in December 2002, and has agreed to make contingent cash payments at various intervals during the U.S. and European regulatory approval process assuming the first two therapeutic indications are successfully developed. These contingent cash payments include a $30,000,000 payment if Ortho Biotech achieves U.S. regulatory approval of a product for the treatment of kidney disease or associated complications. The agreement further specifies that we will receive a royalty on net sales of products that incorporate our BMP technologies. Unless terminated earlier, the agreement shall remain in effect until the expiration of Ortho Biotech’s obligation to pay royalties to us under the agreement.

Centocor BMP Agonist Small Molecule Screening Program.    In December 2005, we expanded our relationship with Centocor. Under a new agreement, we will screen for small molecule agonists that mimic the bioactivity of BMP-7 and activate the bone morphogenetic pathway. The screening effort is expected to last fifteen months. We will own any small molecule BMP agonist compounds that are discovered as part of this screening and Centocor will have an exclusive option to first negotiate a new collaboration and exclusive license agreement for the development of the small molecules.

Spinal Muscular Atrophy Program.    Effective September 7, 2004, we entered into a sponsored research agreement with the Spinal Muscular Atrophy, or SMA, Foundation. Under the agreement, the SMA Foundation will grant Curis up to $5,364,000 over a three-year period for the identification of therapeutic compounds to treat SMA, a neurological disease that is the leading genetic cause of infant and toddler death. The research will utilize our proprietary technologies and expertise to develop and refine assays in motor neurons and then use those assays to screen for potential drug candidates. We will own any compounds that we generate under this collaboration and will also have the ability to bring any such compounds into the clinic, either using our own resources or with a collaborating third party. If any drug candidates developed under the agreement are successfully commercialized, we will be required to make payments to the SMA Foundation if cumulative revenues from the sales of such products exceed $100,000,000. Unless terminated earlier, the agreement will continue until the expiration of the research activities.

49

Table of Contents

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires that we make estimates and assumptions that affect the reported amounts and disclosure of certain assets and liabilities at our balance sheet date. Such estimates and judgments include the carrying value of property and equipment and intangible assets, revenue recognition, the value of certain liabilities and stock-based compensation. We base our estimates on historical experience and on various other factors that we believe to be appropriate under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

While our significant accounting policies are more fully described in our consolidated financial statements, we believe the following accounting policies to be critical to understanding the judgments and estimates we use in preparing our financial statements:

Revenue recognition.    Our business strategy includes entering into collaborative license and development agreements with biotechnology and pharmaceutical companies for the development and commercialization of our product candidates. The terms of the agreements typically include non-refundable license fees, funding of research and development, payments based upon achievement of clinical development milestones and royalties on product sales. We follow the provisions of the Securities and Exchange Commission’s Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, Emerging Issues Task Force, or EITF, Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, EITF Issue No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, and EITF Issue No. 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).

Non-refundable license fees are recognized as revenue when we have a contractual right to receive such payment, the contract price is fixed or determinable, the collection of the resulting receivable is reasonably assured and we have no further performance obligations under the license agreement. Multiple element arrangements, such as license and development arrangements are analyzed to determine whether the deliverables, which often include a license and performance obligations such as research and steering committee services, can be separated or whether they must be accounted for as a single unit of accounting in accordance with EITF 00-21. We recognize up-front license payments as revenue upon delivery of the license only if the license has stand-alone value and the fair value of the undelivered performance obligations, typically including research and/or steering committee services, can be determined. If the fair value of the undelivered performance obligations can be determined, such obligations would then be accounted for separately as performed. If the license is considered to either (i) not have stand-alone value or (ii) have standalone value but the fair value of any of the undelivered performance obligations cannot be determined, the arrangement would then be accounted for as a single unit of accounting and the license payments and payments for performance obligations are recognized as revenue over the estimated period of when the performance obligations are performed.

Whenever we determine that an arrangement should be accounted for as a single unit of accounting, we must determine the period over which the performance obligations will be performed and revenue will be recognized. Revenue will be recognized using either a relative performance or straight-line method. We recognize revenue using the relative performance method provided that we can reasonably estimate the level of effort required to complete our performance obligations under an arrangement and such performance obligations are provided on a best-efforts basis. Direct labor hours or full-time equivalents are typically used as the measure of performance. Revenue recognized under the relative performance method would be determined by multiplying the total payments under the contract, excluding royalties and payments contingent upon achievement of substantive milestones, by the ratio of level of effort incurred to date to estimated total level of effort required to complete our performance obligations under the arrangement. Revenue is limited to the lesser of the cumulative amount of payments received or the cumulative amount of revenue earned, as determined using the relative performance method, as of each reporting period.

50

Table of Contents

If we cannot reasonably estimate the level of effort required to complete our performance obligations under an arrangement, the performance obligations are provided on a best-efforts basis and we can reasonably estimate when the performance obligation ceases or becomes inconsequential, then the total payments under the arrangement, excluding royalties and payments contingent upon achievement of substantive milestones, would be recognized as revenue on a straight-line basis over the period we expect to complete our performance obligations. Revenue is limited to the lesser of the cumulative amount of payments received or the cumulative amount of revenue earned, as determined using the straight-line basis, as of the period ending date.

If we cannot reasonably estimate when our performance obligation either ceases or becomes inconsequential, then revenue is deferred until we can reasonably estimate when the performance obligation ceases or becomes inconsequential.

Significant management judgment is required in determining the level of effort required under an arrangement and the period over which we are expected to complete our performance obligations under an arrangement. In addition, if we are involved in a steering committee as part of a multiple element arrangement that is accounted for as a single unit of accounting, we assess whether our involvement constitutes a performance obligation or a right to participate. Steering committee services that are not inconsequential or perfunctory and that are determined to be performance obligations are combined with other research services or performance obligations required under an arrangement, if any, in determining the level of effort required in an arrangement and the period over which we expect to complete our aggregate performance obligations.

Collaboration agreements may also contain substantive milestone payments. Substantive milestone payments are considered to be performance bonuses that are recognized upon achievement of the milestone only if all of the following conditions are met:

Determination as to whether a payment meets the aforementioned conditions involves management’s judgment. If any of these conditions are not met, the resulting payment would not be considered a substantive milestone, and therefore the resulting payment would be considered part of the consideration for the single unit of accounting and be recognized as revenue as such performance obligations are performed under either the relative performance or straight-line methods, as applicable, and in accordance with these policies as described above. In addition, the determination that one such payment was not a substantive milestone would prevent us from concluding that subsequent milestone payments were substantive milestones and, as a result, any additional milestone payments would also be considered part of the consideration for the single unit of accounting and would be recognized as revenue as such performance obligations are performed under either the relative performance or straight-line methods, as applicable.

Reimbursement of costs is recognized as revenue provided the provisions of EITF 99-19 are met, the amounts are determinable, and collection of the related receivable is reasonably assured.

Royalty revenue is recognized upon the sale of the related products, provided that the royalty amounts are fixed or determinable, collection of the related receivable is reasonably assured and we have no remaining performance obligations under the arrangement. If royalties are received when we have remaining performance

51

Table of Contents

obligations, the royalty payments would be attributed to the services being provided under the arrangement and therefore would be recognized as such performance obligations are performed under either the relative performance or straight line methods, as applicable, and in accordance with these policies as described above.

For revenue generating arrangements where we, as a vendor, provide consideration to a licensor or collaborator, as a customer, we apply the provisions of EITF 01-9. EITF 01-9 addresses the accounting for revenue arrangements where both the vendor and the customer make cash payments to each other for services and/or products. A payment to a customer is presumed to be a reduction of the selling price unless we receive an identifiable benefit for the payment and we can reasonably estimate the fair value of the benefit received. Payments to a customer that are deemed a reduction of selling price are recorded first as a reduction of revenue, to the extent of both cumulative revenue recorded to date and of probable future revenues, which include any unamortized deferred revenue balances, under all arrangements with such customer and then as an expense. Payments that are not deemed to be a reduction of selling price would be recorded as an expense.

Amounts received prior to satisfying the above revenue recognition criteria are recorded as deferred revenue in the accompanying consolidated balance sheets. Amounts not expected to be recognized during the twelve-month period ended December 31, 2006 are classified as long-term deferred revenue. As of December 31, 2005, we have short-term and long-term deferred revenue of $1,757,000 and $10,237,000, respectively, related to our collaborations.

Although we follow detailed guidelines in measuring revenue, certain judgments affect the application of our revenue policy. For example, in connection with our existing collaboration agreements, we have recorded on our balance sheet short- and long-term deferred revenue based on our best estimate of when such revenue will be recognized. Short-term deferred revenue consists of amounts that are expected to be recognized as revenue, or applied against future co-development costs, by December 31, 2006. Amounts that we expect will not be recognized prior to December 31, 2006 are classified as long-term deferred revenue. However, this estimate is based on our current operating plan as of December 31, 2005. If our operating plan should change in the future, we may recognize a different amount of deferred revenue over the twelve-month period from January 1, 2006 through December 31, 2006.

The estimate of deferred revenue also reflects management’s estimate of the periods of our involvement in certain of our collaborations. Our performance obligations under these collaborations consist of participation on steering committees and the performance of other research and development services. In certain instances, the timing of satisfying these obligations can be difficult to estimate. Accordingly, our estimates may change in the future. Such changes to estimates would result in a change in revenue recognition amounts. If these estimates and judgments change over the course of these agreements, it may affect the timing and amount of revenue that we recognize and record in future periods.

Stock-based compensation.    We issue stock options to employees under our stock option and employee stock purchase plans. These options are accounted for under APB Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations, including FASB Interpretation No. 44. All stock-based awards to non-employees are accounted for at their fair value in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, as amended by Financial Accounting Standards Board, or FASB, Interpretation No. 148, and EITF Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees.

SFAS 123 requires that companies either recognize compensation expense for grants of stock options and other equity instruments based on fair value, or provide pro forma disclosure of net loss and net loss per share in the notes to the financial statements. At December 31, 2005, we had two stock-based compensation plans. We account for these plans under the recognition and measurement principles of APB Opinion No. 25 and related interpretations. Accordingly, no compensation cost has been recognized under SFAS 123 for our employee stock option plans.

52

Table of Contents

Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from our stock option awards. These models also require subjective assumptions, including risk-free interest rates, future stock price volatility and expected time to exercise, which greatly affect the calculated values. We calculate compensation cost with the Black-Scholes option-pricing model.

Goodwill. At December 31, 2005, we have recorded $8,982,000 in goodwill. As a result of the adoption of Statement of Financial Accounting Standards, or SFAS, No. 142, Goodwill and Other Intangibles, effective January 1, 2002, we ceased amortization of goodwill and have since performed at least annual assessments of goodwill impairment by comparing our fair value to our net assets. SFAS No. 142 requires us to perform an impairment assessment annually or whenever events or changes in circumstances indicate that our goodwill may be impaired. We completed our annual goodwill impairment tests in December 2005, 2004 and 2003, and determined that as of those dates our fair value exceeded the carrying value of our net assets. Accordingly, no goodwill impairment was recognized in 2005, 2004 or 2003.

Long-term receivables. During the year ended December 31, 2003, we recorded, in other expense, charges of $1,708,000 related to the write-off of previously recorded interest income and foreign exchange gains on a euro-denominated note receivable that was originally due in June 2005 from Micromet, a former collaborator to whom we had licensed technology, and $286,000 related to a reduction in the carrying value of Micromet equity securities held by us. We determined that this charge was necessary due to Micromet’s announcement that it was terminating one-third of its workforce as the result of a contract dispute with a collaborator. Micromet had stated that this dispute would result in a significant decrease in previously budgeted cash inflows in 2004. We also wrote-off the note receivable and reduced deferred revenue by $3,407,000 because we concluded that we were not reasonably assured of collecting the note.

On October 21, 2004, we amended our note receivable with Micromet, and, under the amended note, Micromet is obligated to pay us a total amount of EUR 4,500,000, subject to certain conditions. As a result of Micromet’s financing in October 2004, we received a EUR 1,250,000 payment in November 2004, resulting in a gain of $1,604,000 based on the EURO-to-US dollar foreign exchange rate on the date of payment. The gain was recorded in other income as it related to a recovery of previously written-off interest income and foreign exchange gains related to the note.

As a result of completing additional financings in 2005, Micromet made a second payment of EUR 1,250,000 on October 27, 2005, which resulted in a gain of $1,500,000 based on the EUR-to-US dollar foreign exchange rate on such date. $1,400,000 of the gain was recorded as license fee revenue for the year ended December 31, 2005 because it represented the recovery of a previously written-off note that we had received from Micromet in exchange for the assignment of technology. The remaining $100,000 was recorded in other income as it is related to a recovery of previously written-off interest income and foreign exchange gains related to the note. The future amounts due to us under the amended note are not considered reasonably assured of collection at December 31, 2005 and, therefore, have not been recorded as revenue. We will record revenue when, and if, we conclude such amounts are reasonably assured of collection.

The above list is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result.

53

Table of Contents

Results of Operations

Years Ended December 31, 2005 and 2004

Revenues

Total revenues are summarized as follows:

The 62% increase in net revenues for the year ended December 31, 2005 as compared to the same period in the prior year, was primarily due to gross revenues from our research and development contracts, which increased from $3,407,000 for the year ended December 31, 2004 to $10,493,000 for the year ended December 31, 2005, an increase of $7,086,000. Research and development contract revenues for the year ended December 31, 2005 increased $2,141,000 from three new collaborations entered into during 2005—a new collaboration with Genentech entered into April 2005, a collaboration with Procter & Gamble entered into September 2005, and a collaboration with Centocor entered into December 2005. In addition, research services provided under our June 2003 collaboration, as amended in 2004 and 2005, with Genentech were $4,006,000 for the year ended December 31, 2005 as compared to $600,000 for the year ended December 31, 2004. In addition, our license fee revenues increased by $2,016,000, to $2,258,000 for the year ended December 31, 2005 as compared to $242,000 for the same period in the prior year. This increase was mainly due to a $1,400,000 payment received from Micromet, a former collaborator. This increase was offset by $6,999,000 in contra-revenue, or a reduction to gross revenues, related to our co-development payments to Genentech. This reduction to gross revenue represents amounts owed for the reimbursement of our equal share of costs incurred by Genentech under our collaboration related to the co-development of a basal cell carcinoma therapeutic product candidate.

54

Table of Contents

Operating Expenses

Research and development expenses are summarized as follows:

The increase of $1,043,000, or 8%, in research and development expenses for the year ended December 31, 2005 was primarily due to increased spending on our discovery research programs of $2,419,000 offset by decreased spending of $722,000 on the Hedgehog, or Hh, small molecule and antibody antagonist program under collaboration with Genentech. In addition, stock-based compensation expense decreased $961,000 during the year ended December 31, 2005 as compared to the prior year. The decrease in stock-based compensation was primarily attributable to a decrease of compensation expense recorded on options to purchase common stock that were issued to employees below fair market value on August 18, 2000. As of August 18, 2004, all of these options became fully vested; therefore, no related additional expense was recognized beyond August 2004. The decrease was also attributable to options issued to non-employees that are marked-to-market liabilities. As our stock price fluctuates, the liability and related expense either increases or decreases. Because our stock price declined, we recorded less stock-based compensation expense related to these options.

General and administrative expenses are summarized as follows:

The increase of $333,000, or 4%, in total general and administrative expenses for the year ended December 31, 2005 was primarily due to an increase in personnel costs of $292,000 and occupancy costs of $470,000, offset by decreases in legal, professional and consulting services of $581,000. Occupancy costs for the year ended December 31, 2005 include the recognition of a $500,000 charge resulting from the expected decrease in estimated subtenant income under an operating lease for the remainder of our lease term. The decrease in legal, professional and consulting services principally resulted from costs associated with various technology acquisition evaluations and expenses associated with financing-related activities during the first half of 2004. Stock-based compensation expense also decreased $190,000 during the year ended December 31, 2005 as compared to the prior year period. The decrease in stock-based compensation was primarily attributable to a

55

Table of Contents

decrease of compensation expense recorded on options to purchase common stock that were issued to employees below fair market value on August 18, 2000. As of August 18, 2004, all of these options became fully vested; therefore, no related additional expense was recognized beyond August 2004. We received $558,000 from the settlement of notes receivable from former officers of a predecessor company that had a carrying value of $110,000, resulting in a net gain of $448,000 for the year ended December 31, 2004.

Amortization of intangible assets was $75,000 for each of the years ended December 31, 2005 and 2004.

Other Income (Expense)

For the year ended December 31, 2005, interest income was $1,196,000 as compared to $540,000 for the year ended December 31, 2004, an increase of $656,000, or 121%. The increase in interest income resulted from higher interest rates and a higher available investment balance for the year ended December 31, 2005, as compared to the year ended December 31, 2004.

For the year ended December 31, 2005, other income was $125,000 as compared to $1,592,000 for the year ended December 31, 2004, a decrease of $1,467,000, or 92%. Other income for both years is primarily comprised of gains recognized on the collection of a note receivable from Micromet, a former collaborator.

For the year ended December 31, 2005, interest expense was $308,000, as compared to $411,000 for the year ended December 31, 2004, a decrease of $103,000, or 25%. The decrease resulted from lower outstanding debt obligations during the year primarily due to the conversion of the note payable to Elan in January 2005.

Net Loss Applicable to Common Stockholders

As a result of the foregoing, we incurred a net loss applicable to common stockholders of $14,855,000 for the year ended December 31, 2005, as compared to $15,075,000 for the year ended December 31, 2004.

Years Ended December 31, 2004 and 2003

Revenues

Total revenues are summarized as follows:

56

Table of Contents

Revenues from research and development contracts increased by $1,778,000 for the year ended December 31, 2004, as compared to the year ended December 31, 2003. Research and development contract revenues for the year ended December 31, 2004 were primarily derived from revenue recognized under our collaborations with Genentech and Wyeth of $600,000 and $2,256,000, respectively. In addition, we recognized revenue of $551,000 for the year ended December 31, 2004 under our sponsored research agreement with the SMA Foundation.

For the year ended December 31, 2003, research and development contract revenues primarily consisted of $1,470,000 recognized under a licensing agreement with ES Cell International. Effective December 2003, and consistent with the terms of this agreement, we are no longer providing research and development services for ES Cell International and will therefore not recognize future revenues related to this collaboration.

The decrease in revenue from license fees of $8,507,000 for the year ended December 31, 2004, as compared to the year ended December 31, 2003, primarily consisted of $8,555,000 in previously deferred revenue which was recognized upon the termination of our collaboration with Micromet during the third quarter of 2003. License fee revenues for the year ended December 31, 2004 were derived from revenue recognized under our collaboration with Wyeth of $242,000.

Operating Expenses

Research and development expenses are summarized as follows: