CURIS INC - Quarter Report: 2005 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005

OR

Commission File Number: 000-30347

CURIS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s Telephone Number, Including Area Code: (617) 503-6500

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.    x  Yes    ¨  No

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12(b)-2 of the Exchange Act).    x  Yes    ¨  No

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

As of November 11, 2005, there were 49,339,994 shares of the Registrant’s common stock outstanding.

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CURIS, INC. AND SUBSIDIARY

QUARTERLY REPORT ON FORM 10-Q

INDEX

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Item 1. FINANCIAL STATEMENTS

CURIS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to unaudited condensed consolidated financial statements.

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CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

Curis, Inc. (the “Company” or “Curis”) is 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. The Company’s product development approach involves using small molecules, proteins or antibodies to modulate these regulatory signaling pathways. The Company’s lead product candidate, a topical therapy for the treatment of basal cell carcinoma, is currently in a phase I clinical trial and is being co-developed with Genentech, Inc., or Genentech, a collaborator. The Company is sharing equally in all U.S. development costs and will share equally in any future U.S. net profits and/or losses, should its basal cell carcinoma product candidate be successfully developed and marketed. The Company operates in a single reportable segment: developmental biology products. The Company expects 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.

The Company is subject to risks common to companies in the biotechnology industry including, but not limited to, development by its competitors of new technological innovations, dependence on key personnel, its ability to protect proprietary technology, reliance on corporate collaborators and licensors to successfully research, develop and commercialize products based on the Company’s technologies, its ability to comply with FDA government regulations and approval requirements as well as its ability to grow its business and obtain adequate financing to fund this growth.

The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. These statements, however, are condensed and do not include all disclosures required by accounting principles generally accepted in the United States for complete financial statements and should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2004, as filed with the Securities and Exchange Commission on March 15, 2005.

In the opinion of the Company, the unaudited consolidated financial statements contain all adjustments (all of which were considered normal and recurring) necessary to present fairly the Company’s financial position at September 30, 2005, the results of operations for the three- and nine-month periods ended September 30, 2005 and 2004, and cash flows for the nine-month periods ended September 30, 2005 and 2004. The preparation of the Company’s consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts and disclosure of certain assets and liabilities at the balance sheet date. Such estimates include the carrying value of property and equipment and intangible assets and the value of certain liabilities. Actual results may differ from such estimates.

These interim results are not necessarily indicative of results to be expected for the full year or subsequent interim periods.

The Company has reclassified $368,000 and $1,059,000, respectively, for the three- and nine-month periods ended September 30, 2004 from Stock-based compensation expense to Research and development expenses and General and administrative expenses in the Company’s costs and expenses section of its consolidated statements of operations and comprehensive loss to conform with the current period presentation. Of these amounts, $342,000 and $864,000 were reclassified to Research and development

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(continued)

expenses and $26,000 and $195,000 were reclassified to General and administrative expenses for the three- and nine-month periods ended September 30, 2004, respectively.

During the third quarter of 2005, the Company updated its disclosure relating to its revenue recognition policies that were previously presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004. In addition, in the third quarter of 2005, the Company recorded adjustments to correct errors in recording the fair value of shares issued in connection with its collaborations with Genentech and Wyeth. The shares were valued using the contractually-negotiated trailing average of closing prices, pursuant to the terms of the stock purchase agreements. The Company has determined that it should have valued the shares using the quoted market price on the dates of issuance and, as a result, additional paid-in capital was understated and deferred revenues were overstated. The effect of these adjustments was to increase additional paid-in-capital by $1,629,000, decrease noncurrent deferred revenue by $1,169,000 and to reverse $460,000 of revenue in the third quarter of 2005 to correct for the cumulative overstatement of revenues from June 2003 through June 30, 2005. The impact of these errors, if recorded in the periods to which they related, would not effect the net loss per share previously reported by the Company for any prior year or quarter, nor, Company believes, otherwise have a material impact on previously reported financial information. In addition, the Company does not believe that the impact of these adjustments is material to the financial statements for the quarter ended September 30, 2005 or to the projected results of operations for the year ending December 31, 2005.

The Company’s business strategy includes entering into collaborative license and development agreements with biotechnology and pharmaceutical companies for the development and commercialization of the Company’s 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. The Company follows the provisions of the Securities and Exchange Commission’s Staff Accounting Bulletin (SAB) No. 104 (SAB No. 104), Revenue Recognition, Emerging Issues Task Force (EITF) Issue No. 00-21 (EITF 00-21), Accounting for Revenue Arrangements with Multiple Deliverables, EITF Issue No. 99-19 (EITF 99-19), Reporting Revenue Gross as a Principal Versus Net as an Agent, and EITF Issue No. 01-9 (EITF 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 the Company has a contractual right to receive such payment, the contract price is fixed or determinable, the collection of the resulting receivable is reasonably assured and the Company has no further performance obligations under the license agreement. Multiple element arrangements, such as license and development arrangements are analyzed to determine whether the elements (the license and the performance obligations) can be separated or whether they must be accounted for as a single unit of accounting in accordance with EITF 00-21. The Company recognizes 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 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 stand-alone 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.

When the Company determines that an arrangement should be accounted for as a single unit of accounting, it must determine the period over which the performance obligations will be performed and

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(continued)

revenue will be recognized. Revenue will be recognized using either a relative performance or straight-line method. The Company recognizes revenue using the relative performance method provided that the Company can reasonably estimate the level of effort required to complete its 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 the Company’s 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.

If the Company cannot reasonably estimate the level of effort required to complete its performance obligations under an arrangement and the performance obligations are provided on a best-efforts basis, 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 the Company expects to complete its 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.

Significant management judgment is required in determining the level of effort required under an arrangement and the period over which the Company is expected to complete its performance obligations under an arrangement. In addition, if the Company is involved in a steering committee under a research arrangement, the Company assesses whether its 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 the Company expects to complete its aggregate performance obligations.

Collaboration agreements may also contain substantive milestones. 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 milestone meets the aforementioned conditions involves management’s judgment. If any of these conditions are not met, the milestone payment would not be considered a substantive milestone, and the resulting payment would 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.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(continued)

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 the Company has no remaining performance obligations under the arrangement. If royalties are received when the Company has remaining performance 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 the Company, as a vendor, provides consideration to a licensor or collaborator, as a customer, the Company applies 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 the Company receives an identifiable benefit for the payment and the Company 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 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 September 30, 2006 are classified as long-term deferred revenue. As of September 30, 2005, the Company has short- and long-term deferred revenue of $2,152,000 and $7,291,000, respectively, related to its collaborations.

On September 18, 2005, the Company entered into a collaboration, research and license agreement with the Procter & Gamble Company, or P&G, to evaluate and seek to develop potential treatments for hair growth regulation and skin disorders utilizing the Company’s Hedgehog agonist technology.

Under the terms of the agreement, the Company granted P&G an exclusive, worldwide, royalty-bearing license for the development and commercialization of topical dermatological and hair growth products that incorporate the Company’s 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 P&G. P&G is solely responsible for the cost of worldwide development and commercialization of any product candidates developed pursuant to the research program. At the time that P&G determines to file the first investigational new drug application with the U.S. Food and Drug Administration for a product candidate, the Company shall have the option, at its sole discretion, to co-develop a product candidate through phases I and II of clinical development at a 20% or 50% participation rate. Should the Company elect to exercise its co-development option, the Company will forego development milestones that would otherwise be payable during the period from investigational new drug application filing through the completion of a phase II clinical trial. The Company, however, would receive a higher royalty in the event that it exercises its co-development option and subsequently shares in

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development expense through phase II clinical trials. The amount of the royalty increase is based on the co-development percentage elected by the Company. Under the agreement, P&G paid the Company an up-front license fee of $500,000 and has agreed to fund up to $600,000 for two Curis full-time equivalents providing research and development activities during the initial one-year research term, subject to its termination rights. P&G has an option to extend the initial one-year research term for up to three additional years in one-year increments. P&G has also agreed to make cash payments to the Company that are contingent upon the successful achievement of certain research, development, clinical and drug approval milestones, including $2,800,000 in preclinical milestones. P&G will also pay the Company royalties on net product sales if product candidates derived from the collaboration are successfully developed.

Unless terminated earlier in accordance with the terms of the agreement, the agreement shall continue until six months after the expiration of the last to expire of any patent rights covering a product being sold under the agreement. Early termination rights are as follows:

If P&G terminates the agreement without cause or the Company terminates the agreement as a result of P&G’s material breach, then, among other things, all licenses granted to P&G shall terminate. The Company shall have the exclusive option to acquire from P&G all data generated by P&G and all regulatory approvals and other regulatory filings and submissions, clinical data, promotional, advertising, marketing and distribution rights or contracts, and other similar information and items related to the compounds developed during the collaboration by P&G, on commercially reasonable terms to be mutually agreed to by the parties. Upon termination of the agreement by P&G as a result of a material breach by the Company, all rights and licenses granted to P&G under the agreement shall terminate.

The Company considers its arrangement with P&G to be a revenue arrangement with multiple deliverables. The Company’s deliverables under this collaboration include an exclusive license to evaluate and develop potential treatments for hair growth regulation and skin disorders and certain performance obligations, including research and development services for at least one year and participation on at least one steering committee. The Company applied the provisions of Emerging Issues Task Force Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (EITF 00-21) to determine whether the performance obligations under this collaboration can be accounted for separately or as a single unit or multiple units of accounting. The Company determined that these performance obligations represented a single unit of accounting, since the Company believes that the license does not have stand-alone value to P&G without the Company’s research services and steering committee participation during certain phases of the development process and because objective and reliable evidence of the fair value of the Company’s research and steering committee participation could not be determined.

The Company’s ongoing performance obligations under this collaboration consist of participation on a steering committee and the performance of preclinical research services. The Company cannot reasonably

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(continued)

estimate the total level of effort required over the performance period and, therefore, is recognizing revenue on a straight-line basis over the performance period, which it has estimated to be six years. In developing its estimate of the period to complete its performance obligations, the Company estimates the time required to complete phase II clinical trials of a product candidate under the collaboration to be six years. The performance period was determined based on management’s estimate of its involvement through co-development of phase IIB clinical trials since, should Curis exercise its co-development option, Curis’ last deliverable under this arrangement would be its participation on the clinical development steering committee through phase IIB. The steering committee effort is also expected to be consistent over the six-year period.

The Company has attributed the $500,000 up-front fee plus $600,000, the total amount of currently committed research funding which the Company expects to receive for providing two full-time equivalents at $300,000 each over the first year of the collaboration, to the undelivered research and steering committee services. The $1,100,000 in total payments is being recognized as revenue over the Company’s performance period of six years under the collaboration. If the research period, number of full-time equivalents requested by P&G, or the estimate to complete phase II clinical trials changes, then the Company will update its estimated level of effort and total expected payments under the arrangement. During the three months ended September 30, 2005, the Company recorded revenue of approximately $10,000. Of this amount, approximately $3,000 was attributed to the amortization of the up-front license fee and is included in the “License fees” line item within the Revenues section of the Company’s Consolidated Statement of Operations for the three months ended September 30, 2005. The remaining $7,000 was related to research services performed by the Company’s two full-time equivalents and is included within the “Research and development contracts” line item within the Revenues section of the Company’s Consolidated Statement of Operations.

The Company views the preclinical and clinical development milestones, as well as the drug approval milestones under its collaboration with P&G to be substantive in nature since the successful achievement of these milestones involves significant risk and uncertainty and a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between each subsequent milestone payment. Should the Company ever successfully achieve any preclinical or clinical development milestones or drug approval milestones under this collaboration agreement, any related milestone payments would be recorded as revenue within the “Substantive milestones” line item within the Company’s Revenues section of its Consolidated Statement of Operations.

As of September 30, 2005, the Company has not provided any consideration, such as payments under co-development arrangements, to P&G.

On April 1, 2005, the Company entered into a drug discovery collaboration agreement with Genentech for the 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 formation and repair, the abnormal activation of which is associated with certain cancers. Under the terms of the agreement, the Company has granted Genentech an exclusive, royalty-bearing license to make, use and sell the small molecule compounds that are modulators of the pathway. Curis has retained the rights for ex vivo cell therapy, except in the areas of oncology and hematopoiesis.

Under the terms of the agreement, the Company will have primary responsibility for research and development activities and Genentech will be responsible for clinical development, manufacturing, and commercialization of products that may result from the collaboration. Genentech paid the Company an

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up-front license fee of $3,000,000 and has agreed to fund up to $6,000,000 for research and development activities during the initial two-year research term, subject to its termination rights described below. Genentech will also make cash payments to the Company that are contingent upon the successful achievement of certain preclinical and clinical development milestones and drug approval milestones. 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 the Company royalties on net product sales if product candidates derived from the collaboration are successfully developed.

Each party has the right to terminate the agreement for uncured material breach by the other party. Genentech has the right to terminate the agreement without cause at any time after the first anniversary of the effective date, upon six months prior written notice, if such termination is to be effective prior to the end of the initial research term, and upon sixty days prior written notice otherwise. In the event of termination by Genentech without cause or if the agreement is terminated by Genentech due to material breach, the Company would be entitled to receive only a reduced royalty for those products that are covered by a subset of certain intellectual property rights, in lieu of the standard contract royalties that would otherwise apply.

The Company considers this arrangement with Genentech to be a revenue arrangement with multiple deliverables. The Company’s deliverables under this collaboration include an exclusive license to its technologies in this signaling pathway and certain performance obligations, including research services for at least two years and participation on a steering committee. The Company applied the provisions of EITF 00-21 to determine whether the performance obligations under this collaboration can be accounted for separately or as a single unit or multiple units of accounting. The Company determined that these deliverables represented a single unit of accounting, since the Company believes that the license does not have stand-alone value to Genentech without the Company’s research services and steering committee participation during certain phases of research and because objective and reliable evidence of the fair value of the Company’s research and steering committee participation could not be determined.

The Company’s ongoing performance obligations under this collaboration consist of participation on a steering committee and the performance of research services. Because the Company can reasonably estimate its level of effort over the term of the arrangement, the Company is accounting for the arrangement under the relative performance method. In developing its estimate of the Company’s level of effort required to complete its performance obligations, the Company estimated that Genentech would elect twice to extend the research service period and related funding, each in one-year increments, although there can be no assurance Genentech will, in fact, make such an election. The Company estimates that it will provide an equal number of full-time equivalents for the four-year research and development service term. In developing this estimate, the Company assumed that Genentech will maintain its initially elected number of twelve full-time equivalent researchers throughout the four-year period. The steering committee effort is also expected to be consistent over the four-year period. The $3,000,000 up-front fee plus $12,000,000, the total amount of research funding which the Company will be entitled to for providing twelve full-time equivalents at $250,000 each over four years, is therefore being attributed to the research services. Revenue is being recognized as the research services are provided over the four-year period through March 2009 at a rate of $312,500 per full-time equivalent. If the research period is changed or the number of full-time equivalents requested by Genentech changes, then the Company will update its estimated level of effort and total expected payments under the arrangement.

The Company recorded revenue under this collaboration of $944,000 and $1,533,000, respectively, during the three- and nine-month periods ended September 30, 2005. Of this amount, approximately $187,000 and $375,000, respectively, was attributed to the amortization of the up-front license fee and is

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included in the “License fees” line item within the Revenue section of the Company’s Consolidated Statement of Operations for the three-and nine-month periods ended September 30, 2005, respectively. The remaining $757,000 and $1,158,000, respectively, were related to research services performed by the Company’s full-time equivalent researchers and are included within the “Research and development contracts” line item within the Revenues section of the Company’s Consolidated Statement of Operations.

The Company views the preclinical and clinical development milestones and drug approval milestones under this collaboration with Genentech to be substantive in nature since the successful achievement of these milestones involves significant risk and uncertainty and a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between each subsequent milestone payment. Should the Company ever successfully achieve any preclinical or clinical development milestones or drug approval milestones under this collaboration agreement, any related milestone payments would be recorded as revenue within the “Substantive milestones” line item within the Company’s Revenues section of its Consolidated Statement of Operations.

As of September 30, 2005, the Company has provided cash consideration to Genentech in the form of co-development payments for the Company’s equal share of U.S. development costs of a basal cell carcinoma product candidate that is being developed under a separate collaboration with Genentech.

On April 13, 2005, the Company entered into a second amendment to the Collaborative Research, Development and License Agreement with Genentech dated June 11, 2003. The effective date of the amendment was April 11, 2005. The Company considered the provisions of EITF 00-21 and determined that this agreement is a separate contract from its June 2003 agreement since it was not contemplated at the time of the June 2003 arrangement, was 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 was not entered into at or near the time of the June 2003 agreement.

Under the terms of the amendment, Genentech will provide to the Company $2,000,000 of funding to continue development of therapeutics to treat solid tumor cancers, and the research term has been extended until December 11, 2005 (previously June 11, 2005). At Genentech’s option, the research term may be extended for an additional six-month period to June 11, 2006, upon written notice delivered to the Company by October 2005. Genentech notified the Company in October 2005 of its decision to extend the research term, and will now fund ten Curis full-time equivalents through June 11, 2006. Genentech will pay the Company $1,250,000 in June 2006, provided that Curis has performed the required research services. Other than the change to the period of the research term and payments associated with such research, the amendment has not changed the terms of the June 2003 agreement, which remains in full force and effect.

The Company considers the April 2005 amendment to be a separate agreement and unit of accounting from the June 2003 agreement, and a previous amendment entered into between the Company and Genentech in December 2004. The Company’s performance obligations under this agreement are to provide research services and xenograft tumor samples to Genentech through June 11, 2006. Since Genentech elected to exercise its option and extend the research services, the Company’s performance obligations would extend for an additional period from December 2005 through June 2006. The Company has applied the provisions of SAB No. 104 and is recognizing the research funding as revenues under this collaboration as such research services are performed. The amount payable to the Company and, accordingly, the amount of revenue to be recognized will vary if the Company provides less than the required sixteen full-time equivalents through December 2005 or the ten full-time equivalents through June 2006. As of September 30, 2005, the Company had recorded $1,188,000 as accounts receivable from Genentech in the Company’s Current Assets section of its Consolidated Balance Sheet.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(continued)

During the third quarter of 2005, the Company updated certain aspects of its disclosures related to its research and development collaborations entered into prior to January 1, 2005. The disclosures previously presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004, are updated and presented within this Note.

In June 2003, the Company licensed its proprietary Hedgehog pathway antagonists to Genentech for human therapeutic use. The primary focus of the collaborative research plan has been to develop these molecules for cancer indications. The collaboration consists of two main 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 an up-front payment of $5,000,000, license maintenance fee payments totaling $4,000,000 over the first two years of the collaboration and substantive milestone 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 on potential future net product sales, which increases with increasing sales volume.

Under the collaboration agreement, the Company has the option to elect to co-develop Hedgehog antagonist products in the field of basal cell carcinoma in the U.S. In January 2005, the Company elected to exercise this co-development option and will now share equally in both U.S. development costs and any future U.S. net profits and/or losses resulting from the development and commercialization of its basal cell carcinoma product candidate. This co-development right includes basal cell carcinoma and any additional indications for which this product candidate may be developed in the U.S. As a result of participating in co-development, the Company will forego U.S. development milestone and royalty payments on potential future U.S. sales of the basal cell carcinoma product candidate. Should the Company determine that it cannot continue funding its equal share of the development expenses, the Company may opt out of the co-development structure and receive certain development and regulatory approval milestones and royalties on sales of the basal cell carcinoma product candidate, should any ever occur. In addition, in certain major international markets, the Company will receive substantive milestone payments if specific clinical development objectives are achieved and a royalty on any international sales of any basal cell carcinoma product candidate.

Under the systemic Hedgehog antagonist program of the collaboration, Genentech is also obligated to make substantive milestone payments to the Company 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 volume.

Unless terminated earlier, the agreement shall expire six months after the later of the expiration of Genentech’s obligation to pay royalties to the Company under the agreement or such time as no activities have occurred under the agreement for a period of twelve months. Early termination provisions are as follows:

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As a result of its licensing agreements with various universities, the Company is obligated to make payments to these university licensors when certain payments are received from Genentech.

In the quarter ended September 30, 2005, the Company recorded an adjustment to correct an error in recording the fair value of shares issued in connection with its collaboration with Genentech. On June 11, 2003, in connection with the collaboration agreement, the Company sold to Genentech 1,323,835 shares of its common stock. The shares were recorded at a price of $2.644 per share based on a 30-day trailing average of closing prices prior to June 11, 2003, pursuant to the terms of a stock purchase agreement. Therefore, the Company allocated $3,500,000 as stockholders’ equity in the Company’s consolidated balance at December 31, 2003. The fair market value of the Company’s common stock was $3.77 per share on June 11, 2003, as determined by the quoted closing price on the NASDAQ national market. During the third quarter of 2005, the Company determined that it should have ascribed $4,991,000 in value to the common stock, calculated as the $3.77 per share closing price multiplied by 1,323,835 shares sold to Genentech. Consequently, the Company recorded a credit of $1,491,000 to additional-paid-in capital to correct the understatement in the fair value of the shares issued, a $1,072,000 reduction in deferred revenue to correct the overstatement of deferred revenue, and a $419,000 reduction in license fee revenue to correct the cumulative overstatement of revenue. The Company also entered into a registration rights agreement with Genentech pursuant to which, at the request of Genentech, the Company shall use its reasonable best efforts to register the shares of common stock for resale in the future under specified conditions.

The Company considers its June 2003 arrangement with Genentech to be a revenue arrangement with multiple deliverables. The Company’s deliverables, or performance obligations, under this collaboration include an exclusive license to its Hedgehog antagonist technologies and performance obligations, including

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research and development services for the first two years of the collaboration and participation on steering committees. The Company applied the provisions of EITF 00-21 to determine whether the performance obligations under this collaboration could be accounted for separately or should be accounted for as a single unit of accounting. The Company determined that the performance obligations, the license and the research and steering committee services, represented a single unit of accounting because the Company believes that the license, although delivered at the inception of the arrangement, does not have stand-alone value to Genentech without the Company’s research services and steering committee participation and because objective and reliable evidence of the fair value of the Company’s research and steering committee services could not be determined.

The Company had attributed the $5,000,000 up-front fee and the $4,000,000 of maintenance fees to the undelivered research and steering committee services. The $9,000,000 in total payments was being recognized as revenue over the Company’s performance period under the collaboration, which the Company estimates to be through June 2011, the estimated date that the products under the collaboration may receive regulatory approval. The Company cannot reasonably estimate the total level of effort required over the performance period and, therefore, is recognizing the $9,000,000 on a straight-line basis over the performance period. During the third quarter of 2005, the Company recorded a cumulative adjustment reduction to its License fee revenue of $419,000. This cumulative adjustment was recorded to correct license revenues that it had previously recorded relating to $1,491,000 in consideration that had been allocated to the $5,000,000 up-front license payment. As noted above, this consideration was reclassified from deferred revenue to additional-paid-in capital accounts. As a result of a cumulative adjustment, the Company recorded negative revenues under this collaboration related to the license and maintenance fees of $206,000 during the third quarter of 2005. During the nine-month periods ended September 30, 2005, the Company recorded $340,000 in license revenues. These amounts are included in “License fees” in the Company’s Revenues section of its Consolidated Statement of Operations. The $4,000,000 in maintenance fees were not considered substantive milestones because receipt of the payments did not involve significant risk at the inception of the arrangement and the receipt of such payments is not tied to the achievement of any specific developmental objectives under the arrangement. Therefore, these payments were also attributed to the research and steering committee service performance obligations. The Company’s ongoing performance obligations under this collaboration consist of participation on two steering committees, one for BCC and one for solid tumors. The steering committees are comprised of an equal number of employees from the Company and Genentech. Each member of the steering committees receives the right to cast one vote, but Genentech generally has the final decision making authority. While the Company is obligated to serve on the steering committees as long as any drug covered under the collaboration is being developed or commercialized, the Company believes that it will provide significant contributions under its steering committee services only through the first product approved in both the basal cell carcinoma and systemic Hedgehog antagonist programs. The Company has no manufacturing or selling capabilities and, as such, believes that its participation in the steering committees after regulatory approval would be inconsequential and does not represent a performance obligation.

In July 2004, the Company received the first maintenance fee payment in the amount of $2,000,000. The second $2,000,000 maintenance payment was replaced by a $2,000,000 payment for research services in December 2004 as part of an amendment to the collaboration in December 2004. The Company considers the December 2004 amendment to be a separate agreement and unit of accounting from the June 2003 agreement. However, because the $2,000,000 payment received in December 2004 was paid to the Company in exchange for research services conducted prior to the execution of the December 2004 agreement, the Company determined it would amortize this payment over the remaining period in which the Company expects to fulfill its performance obligations under the collaboration (e.g., June 2011).

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The Company views the clinical development and drug approval milestones under this collaboration with Genentech to be substantive milestones since the successful achievement of these milestones involves significant risk and uncertainty and a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between each subsequent milestone payment. Should the Company ever successfully achieve any clinical development or drug approval milestones under this collaboration agreement, any related milestone payments would be recorded as revenue upon achievement of the milestone in “Substantive milestones” in the Revenues section of its Consolidated Statement of Operations.

The Company considered the provisions of EITF 99-19 and recorded $91,000 and $130,000, respectively, during the three- and nine-month periods ended September 30, 2005, as revenue related to expenses incurred on behalf of Genentech that were paid by the Company and for which Genentech is obligated to reimburse the Company. The Company will continue to recognize revenue for expense reimbursement as such expenses are incurred, provided that such expense reimbursement meets the revenue criteria established under EITF 99-19.

The Company’s right to co-develop the Hedgehog antagonist products in the field of basal cell carcinoma was not considered a deliverable under EITF 00-21 and was exercisable only at the Company’s option and, therefore, did not impact the initial accounting for this arrangement. As a result of its decision to exercise its right to co-develop the basal cell carcinoma product candidate, the Company expects to make significant cash payments to Genentech during the period of clinical development. The Company has recorded $820,000 and $5,698,000, respectively, in co-development payments to Genentech for the three- and nine-months periods ended September 30, 2005, as contra-revenues at its Consolidated Statement of Operations. The Company will follow the provision of EITF 01-09 and expects to record its future co-development payments first as a reduction of revenue, to the extent of both cumulative revenue recorded to date and probable future revenues, which includes any unamortized deferred revenue balances under all arrangements with such customer, and then as an expense.

On December 10, 2004, the Company entered into an amendment to its June 2003 agreement with Genentech. The Company considered the provisions of EITF 00-21 and determined that this agreement should be accounted for as a separate agreement and not part of its June 2003 agreement since it was not contemplated at the time of the June 2003 arrangement, was separately negotiated in order to increase the number of full-time equivalents providing research and development services, included a separate performance obligation for the Company to provide xenograft tumor samples to Genentech, and was not entered into at or near the time of the June 2003 agreement.

The December 2004 amendment, effective from June 12, 2004 to June 11, 2005, increases the Company’s commitment of full-time equivalents providing research and development services for the systemic Hedgehog antagonist program from eight to sixteen and increases Genentech’s funding commitment from $2,000,000 to $4,000,000 for this period. The agreement also provides for the Company to provide xenograft tumor samples to Genentech during the period from June 12, 2004 to June 11, 2005, for which Genentech paid the Company $100,000 in December 2004. In addition, 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 the Company in December 2004. The remaining $2,000,000 for subsequent research services was paid in June 2005.

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The Company considers the December 2004 amendment to be a separate agreement and unit of accounting from the June 2003 agreement. The Company’s performance obligations under this agreement are to provide research services and xenograft tumor samples to Genentech through June 2005. The Company has applied the provisions of SAB No. 104 and is recognizing the $2,000,000 in incremental funding as revenues under this collaboration as the incremental research services are performed from December 2004 through June 2005. The amount payable to the Company and, accordingly, the amount of revenue to be recognized will vary if the Company provides less than sixteen full-time equivalents through June 2005. In April 2005, the Company entered into a second amendment with similar performance obligations. During the three- and nine-month periods ended September 30, 2005, the Company recorded $973,000 and $2,861,000 respectively, related to its research and development services under both this agreement and the April 2005 amendment as revenue in “Research and development contracts” in the Company’s Revenues section of its Consolidated Statement of Operations.

On January 12, 2004, the Company licensed its Hedgehog proteins and small molecule Hedgehog pathway agonists to Wyeth Pharmaceuticals, or Wyeth, for therapeutic applications in the treatment of neurological and other disorders. Under the terms of the agreement, Wyeth paid the Company a $1,500,000 non-refundable license fee and $1,500,000 to purchase 315,524 unregistered shares of the Company’s common stock. at a purchase price of $4.754 per share. The common stock purchase price was calculated as the 15-day trailing average closing price of the Company’s common stock immediately prior to January 12, 2004. In the quarter ended September 30, 2005, the Company recorded an adjustment to correct an error in recording the fair value of these shares issued to Wyeth. As noted above, in connection with the collaboration agreement, the Company sold to Wyeth 315,524 shares of its common stock. The shares were recorded at a price of $4.754 per share based on a 15-day trailing average of closing prices prior to January 12, 2004, pursuant to the terms of a stock purchase agreement and, therefore, the Company allocated $1,500,000 as stockholders’ equity in the Company’s Consolidated Balance Sheet at December 31, 2004. The fair market value of the Company’s common stock was $5.19 per share on January 12, 2004, as determined by the quoted closing price on the NASDAQ national market. During the third quarter of 2005, the Company determined that that it should have ascribed $1,638,000 in value to the common stock, calculated as the $5.19 per share closing price multiplied by 315,524 shares sold to Wyeth. Consequently, the Company recorded a credit of $138,000 to additional-paid-in capital to correct the understatement in the fair value of the shares issued, a $97,000 reduction in deferred revenue to correct the overstatement of deferred revenue; and a $41,000 reduction in license fee revenue to correct the cumulative overstatement of revenue.

In addition to these initial payments, Wyeth is obligated to provide financial support of the Company’s 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. The Company is obligated to dedicate between five and ten full-time equivalents to this program, as determined by Wyeth in six-month intervals, for two years. After the initial two-year period, Wyeth can, at its option, elect to extend the Company’s research obligation, and Wyeth’s funding thereof, for two one-year increments. The agreement provides for a one-year evaluation period immediately following the end of the

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research term, during which the Company may be obligated to serve on the steering committee and may be required, at Wyeth’s expense, to perform additional research and development services. The Company currently estimates that it will only be required to provide steering committee services during the evaluation period if it is also performing research services during that period. Wyeth is also obligated to make substantive milestone payments if the licensed programs successfully achieve clinical development and drug approval objectives and to pay the Company a royalty on net product sales, if any should occur, that escalates with increasing sales volume.

As part of the agreement, the Company has retained development and licensing options for certain therapeutic applications of the Hedgehog agonist technologies, including topical applications for hair growth and local delivery applications for treatment of cardiovascular disease. 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 the Company is unable to reach an agreement with Wyeth on terms within the contractually specified period, the Company is free to seek another collaborator for this program.

Unless terminated earlier, the agreement shall expire upon the expiration of Wyeth’s obligation to pay royalties to the Company under the agreement. Early termination provisions are as follows:

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In addition, as part of a termination agreement entered into between the Company and Élan Corporation, the Company will pay Élan royalty payments related to any revenues in excess of the first $1,500,000 received by the Company from Wyeth, other than revenues received as direct reimbursement for research, development and other expenses that the Company receives from Wyeth. The Company and Élan had previously collaborated on the development of the Hedgehog agonist technologies currently under development with Wyeth. The Company is also obligated to make payments to various university licensors when certain payments are received from Wyeth. To date, all amounts have been paid to the university licensors.

The Company considers its arrangement with Wyeth to be a revenue arrangement with multiple deliverables, or performance obligations. The Company’s performance obligations under this collaboration include an exclusive license to its Hedgehog agonist technologies and performing services, including research and development services for at least two years and participation on a steering committee. The Company applied the provisions of EITF 00-21 to determine whether the performance obligations under this collaboration could be accounted for separately or as a single unit or multiple units of accounting. The Company determined that these performance obligations and research and steering committee services represented a single unit of accounting, since the Company believes that the license does not have stand-alone value to Wyeth without its research services and steering committee participation and because objective and reliable evidence of the fair value of the Company’s research and steering committee participation could not be determined.

The Company’s ongoing performance obligations under this collaboration consist of participation on a steering committee and the performance of research services. Because the Company can reasonably estimate its level of effort over the term of the arrangement, the Company is accounting for the arrangement under the relative performance method. In developing its estimate of the Company’s level of effort required to complete its performance obligations, the Company estimated that Wyeth would elect twice to extend the research and development service period and related funding, each in one-year increments, for a total of four years. The agreement provides for a one-year evaluation period immediately following the end of the research term, during which time the Company may be obligated to serve on the steering committee and

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may be required, at Wyeth’s expense, to perform additional research and development services. The Company estimates that it will provide an equal number of full-time equivalents for the four-year research and development service term plus the one-year evaluation period. In developing this estimate, the Company assumed that Wyeth will maintain its initially elected number of eight full-time equivalents throughout the five-year period. The steering committee effort is also expected to be consistent over the five-year period. The $1,500,000 up-front fee plus $10,000,000, the total amount of research funding which the Company will be entitled to for providing eight full-time equivalents at $250,000 each over five years, is therefore being attributed to the research services. Revenue is being recognized as the research services are provided over the five- year period through February 2009 at a rate of $287,500 per full-time equivalent. If the research period is shortened or the number of full-time equivalents requested by Wyeth changes, then the Company will update its estimated level of effort and total expected payments under the arrangement.

During the third quarter of 2005, the Company recorded a reduction to its License fee revenue of $41,000 to record the cumulative adjustment to license revenues that it had previously recorded relating to $138,000 in consideration that had been allocated to the up-front license payment. As noted above, this consideration was reclassified from deferred revenue to additional-paid-in capital accounts. During the three- and nine- month periods ended September 30, 2005, the Company recorded revenue of $585,000 and $2,169,000, respectively, related to the Company’s research efforts under the Wyeth arrangement, of which $24,000 and $174,000, respectively, were recorded in “License Fees” and $561,000 and $1,745,000, respectively, were recorded in “Research and development contracts” in the Company’s Revenues section of its Consolidated Statement of Operations. Additionally, for the nine-month period ended September 30, 2005, the Company recorded $250,000 in the “Substantive milestones” section of it Consolidated Statement of Operations. Included within “Research and development contracts”, the Company recorded $61,000 and $245,000 for the three- and nine- months ended September 30, 2005 as revenue related to expenses incurred on behalf of Wyeth that were paid by the Company and for which Wyeth is obligated to reimburse the Company. The Company will continue to recognize revenue for expense reimbursement as such reimbursable expenses are incurred, provided that the provisions of EITF 99-19 are met. As of September 30, 2005, the Company had recorded $142,000 as amounts receivable from Wyeth in “Accounts receivable” in the Company’s Current Assets section of its Consolidated Balance Sheets.

The Company views the clinical development and drug approval milestones under its collaboration with Wyeth to be substantive in nature since the successful achievement of these milestones involves significant risk and uncertainty and a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between each subsequent milestone payment. Should the company ever successfully achieve any clinical development or drug approval milestones under this collaboration agreement, any related milestone payments would be recorded as revenue in “Substantive milestones” in the Company’s Revenues section of its Consolidated Statement of Operations.

As of September 30, 2005, the Company has not provided any consideration to Wyeth.

In November 2002, the Company licensed its broad bone morphogenetic protein, or BMP, technology portfolio to Ortho Biotech Products, L.P., a member of the Johnson & Johnson family of companies. Two of Ortho Biotech Products’ research affiliates, Johnson & Johnson Pharmaceutical Research & Development, L.L.C. and Centocor Research & Development, also members of the Johnson & Johnson family of companies, will have joint responsibility for further research and development of the Company’s licensed BMP technology portfolio.

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The transaction relates to all of the Company’s proprietary BMP compounds including BMP-7, which has been studied in animal models 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 the Company’s 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.

The agreement provides for Ortho Biotech to pay the Company an up-front payment of $3,500,000, which was paid in December 2002, and substantive milestone payments at various intervals during the U.S. and European regulatory approval process assuming the first two therapeutic indications are successfully developed. These substantive milestone 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 the Company will receive a royalty on net sales of products that incorporate the Company’s BMP technologies.

Unless terminated earlier, the agreement shall remain in effect until the expiration of Ortho Biotech’s obligation to pay royalties to the Company under the agreement. Early termination provisions are as follows:

If Ortho Biotech terminates the agreement for cause, the licenses granted by the Company to Ortho Biotech shall survive such termination and the royalty rates owed to the Company would be reduced. If the Company terminates the agreement for cause or if Ortho Biotech terminates upon thirty days written notice without cause, the licenses granted by the Company to Ortho Biotech shall terminate.

The Company has no future deliverables under this license agreement and has applied the provisions of SAB No. 104 for recognizing revenue under this collaboration. The Company recognized the up-front payment of $3,500,000 as revenue in the fourth quarter of 2002 because the Company has no continuing performance obligations under the contract.

The Company views the clinical development and drug approval milestones under its collaboration with Ortho Biotech to be substantive in nature since the successful achievement of these milestones involves significant risk and uncertainty and a reasonable amount of time passes between the up-front license payment and the first milestone payment as well as between each subsequent milestone payment. Should the

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Company ever successfully achieve any clinical development or drug approval milestones under this collaboration agreement, any related milestone payments would be recorded as revenue in “Substantive milestones” in the Company’s Revenues section of its Consolidated Statement of Operations. The Company has not recognized any revenues under its arrangement with Ortho Biotech in either the three- or nine- month periods ended September 30, 2005.

As of September 30, 2005, the Company has not provided any consideration to Ortho Biotech Products.

Effective September 7, 2004, the Company entered into a sponsored research agreement with the Spinal Muscular Atrophy Foundation. Under the agreement, the Foundation will grant the Company 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 the Company’s proprietary technologies and expertise to develop and refine assays in motor neurons and then use those assays to screen for potential drug candidates. The Company will own any compounds that it generates under this collaboration and will also have the ability to bring any such compounds into the clinic, either using the Company’s own resources or with a collaborating third party. If any drug candidates developed under the agreement are successfully commercialized, the Company 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. The Company or the SMA Foundation may terminate this agreement upon sixty days’ prior written notice upon the occurrence of bankruptcy, insolvency, dissolution or winding up of the other party; or upon the breach of any material provision of the sponsored research agreement by the other party, provided that the other party has not cured such breach within the 60-day period following written notice of termination. Termination of the agreement will not relieve either party of obligations that have accrued prior to termination, including the SMA Foundation’s obligation to make payments for research activities. In addition, the Company remains obligated to make payments to the SMA Foundation in the event the Company recognizes an aggregate of $100,000,000 in revenues on products containing any drug candidates developed under the agreement.

The Company’s sole deliverable under this sponsored research agreement is to provide research services. The Company has applied the provisions of SAB No. 104 for recognizing revenue under this collaboration. The Company is recognizing revenues under this collaboration as the services are performed, provided that payment is reasonably assured under the terms of the grant. For the three- and nine-month periods ended September 30, 2005, the Company recognized $205,000 and $1,425,000, respectively, related to the reimbursement of our research and development efforts under this sponsored research agreement. This amount is included in “Research and development contracts” in the Company’s Revenues section of its Consolidated Statement of Operations. As of September 30, 2005, the Company had recorded $127,000 in amounts due from the Spinal Muscular Atrophy Foundation in “Accounts receivable” in the Company’s Current Assets section of its Consolidated Balance Sheets.

Should the Company ever generate over $100,000,000 in cumulative future revenues from products developed under this agreement, we expect to record any payments to the SMA Foundation as contra-revenues in accordance with EITF 01-9.

As of September 30, 2005, the Company has not provided any consideration to the SMA Foundation.

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In connection with its election to exercise its co-development option related to its basal cell carcinoma program under development with Genentech (see Note 6(a)), the Company has applied the provisions of EITF Issue No. 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products), or EITF 01-9, which addresses the accounting for revenue arrangements where both the vendor and the customer make cash payments to each other for services and/or products, as is the case with the Company’s collaboration agreements with Genentech. EITF 01-9 states that situations in which a vendor (the Company) is paying its customer (Genentech) must be evaluated in order to determine if the vendor payment can be treated as expense or as a reduction to revenues generated by the customer relationship. EITF 01-9 also requires that all transactions with a customer be considered when determining the appropriate accounting treatment, including separate collaborations with the same customer.

The Company has entered into two collaborations with Genentech, including the June 2003 license to its Hedgehog antagonist technologies and an April 2005 license relating to another signaling pathway. Under these collaboration agreements with Genentech, the Company, as the vendor, sold licenses to Genentech and received or may receive from Genentech, as the customer, license fees, development and drug approval milestones, royalties on potential future product sales, payments for research services, and reimbursement for certain patent expenses and other costs. In addition, the Company also makes co-development payments to Genentech in connection with the basal cell carcinoma product candidate. The payments made by the Company to reimburse Genentech for co-development payments are considered by the Company to be within the scope of EITF 01-9 because the Company considers these payments to be payments from a vendor made to a customer, and the Company has concluded that such payments did not meet any of the scope exceptions outlined in EITF 01-9.

Because the Company concluded that its co-development payments are within the scope of EITF 01-9, the Company is required to record all co-development costs as contra revenues, provided that the cumulative co-development costs do not exceed both cumulative revenues recognized to date and probable future revenues, which includes unamortized deferred revenue balances, under both of our collaborations with Genentech. Any future co-development costs incurred by the Company in excess of the total cumulative revenues recognized and probable future revenues under the Genentech collaborations will then be recorded against research and development expenses.

As of September 30, 2005, cumulative co-development costs of $5,698,000 incurred by the Company did not exceed cumulative revenues recorded related to its collaborations with Genentech of $7,870,000. Therefore, in accordance with EITF 01-9, the co-development costs have been recorded as a reduction to revenues, or contra-revenue, of $820,000 and $5,698,000 in the Company’s Consolidated Statement of Operations for the three- and nine-month periods ended September 30, 2005, respectively.

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The Company believes that the carrying value of its debt obligations approximate the market value since the underlying interest rates approximate the current market rates for similar debt securities. Long-term debt obligations consisted of the following at September 30, 2005 and December 31, 2004:

Effective June 9, 2005, the Company entered into a loan agreement with the Boston Private Bank & Trust Company to finance up to $1,450,000 in purchases of equipment and facility leasehold improvements. Under the terms of the loan agreement, the Company can request periodic financings for qualifying purchases of equipment and leasehold improvements during the period from June 9, 2005 until December 9, 2005. Until December 9, 2005, the Company will pay interest only on any borrowings on a monthly basis in arrears. On or before December 9, 2005, the Company will convert the then outstanding balance into a 36-month term note that bears interest at either a variable rate (7.75% as of September 30, 2005) or a fixed rate (7.66% as of September 30, 2005) for the repayment period. The loan will be collateralized by any equipment and leasehold improvements financed thereunder. As of September 30, 2005, the Company has financed $866,000 in equipment purchased under this loan agreement.

Effective January 7, 2005, the Company entered into an amendment with the Boston Private Bank & Trust Company to extend the drawdown date by which it can request periodic financings up to $2,250,000 for qualifying purchases of equipment and leasehold improvements through April 30, 2005. On March 23, 2005, the Company drew down the remaining balance under this agreement bringing the total amount financed to $2,250,000 and exercised its option to convert the outstanding balance into a 36-month term note that bears interest at a fixed rate of 7.36% for the repayment period. Under the terms of the note payable, the Company is required to make equal monthly payments of $62,500 plus any accrued interest beginning on May 1, 2005 extending through the 36-month term. The loan is collateralized by all of the Company’s property, plant and equipment assets, except for fixtures and those that are purchased after March 23, 2005 under purchase money arrangements with equipment lenders. As of September 30, 2005, the Company was in compliance with the sole covenant under this agreement. This covenant requires the Company to maintain a minimum modified working capital ratio. Should the Company fail to pay amounts when due or fail to maintain compliance with the covenant under this agreement, the entire obligation becomes immediately due at the option of the Boston Private Bank & Trust Company.

On January 7, 2005, Elan Pharma International Limited, or EPIL, elected to convert the entire balance of its outstanding convertible note into shares of the Company’s common stock. As of January 7, 2005, the outstanding balance of the EPIL note, including interest, was $3,305,523. In accordance with the terms of

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the amended and restated convertible note payable with EPIL, 330,552 shares of the Company’s common stock were issued to EPIL based on a conversion rate of $10.00 per share. The Company has no further obligations to EPIL.

The Company has two stock option plans. In December 2004, the FASB issued SFAS No. 123(R), Accounting for Stock-Based Compensation, which establishes standards for the accounting of transactions in which an entity exchanges its equity instruments for goods or services. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires that the fair value of such equity instruments be recognized as an expense in the historical financial statements as services are performed. Prior to adopting SFAS No. 123(R), only certain pro forma disclosures of fair value are required. The provisions of SFAS No. 123(R) are effective for the first annual reporting period beginning after June 15, 2005. Early adoption is encouraged and retroactive application of the provisions of SFAS 123(R) to the beginning of the fiscal year that includes the effective date is permitted, but not required. The Company will implement the revised standard in the first quarter of fiscal year 2006. Currently, the Company accounts for its share-based payment transactions under the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, which does not necessarily require the recognition of compensation cost in the financial statements. The Company is evaluating its current compensation strategies as they relate to stock-based compensation. Management is assessing the implications of this revised standard which will materially impact the Company’s results of operations in the first quarter of fiscal year 2006 and thereafter.

For the three- and nine-month periods ended September 30, 2005, the Company applied APB No. 25 and related interpretations, including FASB Interpretation No. 44, in accounting for qualifying options granted to its employees and directors under its plans and applies SFAS No. 123, as amended by FASB No. 148, for disclosure purposes only. The SFAS 123 disclosures include pro forma net loss and net loss per share as if the fair value method of accounting had been used. Stock issued to non-employees is accounted for in accordance with SFAS 123 and related interpretations.

The following are the pro forma net loss and net loss per share, as if compensation expense for the option plans had been determined based on the fair value at the date of grant, consistent with SFAS 123:

The effects on the three- and nine–month periods ended September 30, 2005 and 2004 pro forma net loss and net loss per share of the estimated fair value of stock options are not necessarily representative of the effects on the results of operations in the future. In addition, the estimates made utilize a pricing model

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developed for traded options with relatively short lives. The Company’s option grants typically have a life of up to ten years and are generally not transferable, therefore, the actual fair value of a stock option grant may be different from these estimates. The Company believes that its estimates incorporate all relevant information and represent a reasonable approximation in light of the difficulties involved in valuing non-traded stock options.

Effective August 15, 2002, the Company sublet approximately 12,000 square feet, or 67%, of the rentable square footage of its facility at 61 Moulton Street, Cambridge, MA. The original subtenant’s lease bears a contracted rate of $40.00 per square foot through the end of the Company’s lease term of April 30, 2007. In addition to the sublease payments, the subtenant is required to pay its pro rata share of all building operating costs. The sublease income exceeded the Company’s cost of the sublet space so the Company did not record a loss on the lease at the time the Company ceased using the space. The Company has continued to use a portion of the remaining 33% of the leased space.

In July 2005, the subtenant notified the Company that it expected that it would no longer be able to meet its obligations under the sublease. Effective August 1, 2005, the Company amended its sublease agreement to lower the monthly sublease rent payments to an amount equal to the rate the Company must pay through the remainder of the lease term of April 30, 2007. No other terms of the sublease agreement were changed. Should the tenant fail to comply with the lease as amended, the Company will seek to sublease the 61 Moulton Street facility to a new subtenant but is uncertain that its efforts will be successful. Further, the Company expects that, should it be successful in its subleasing efforts, the sublease rent may be lower than the Company’s cost to lease the space, based on an analysis of rental rates for similar space in the area.

The Company does not expect to utilize the space, if vacated by the current tenant due to default of the amended sublease terms, for its current or future operations. In addition, the Company believes that its costs under the lease will exceed any future sublease income for the duration of the lease. Based on these factors and on the potential for future default by the subtenant, the Company recorded a charge of $500,000 in the “General and administrative expense” line item of its Consolidated Statement of Operations during the second quarter of 2005. This amount represents the Company’s estimate of the total expected loss on the subleased space over the remaining term of the lease. There has been no change in the Company’s estimate of the $500,000 liability, approximately $350,000 and $150,000 are included as current and long-term liabilities, respectively, in the Company’s balance sheet as of September 30, 2005.

In October 2005, Genentech exercised its option under the April 2005 Hedgehog antagonist collaboration amendment with the Company to extend funding of ten full-time equivalents performing research services to continue development of therapeutics to treat solid tumor cancers. Genentech had previously supported a total of sixteen Curis and additional third party resources managed by Curis scientists. The progress made by the two companies had reduced the need for the third party resources. By exercising this option, Genentech has agreed to extend the research term by six months through June 11, 2006 (previously December 11, 2005). As a result of the extension, Genentech will provide to the Company an additional $1,250,000 of funding for research services performed from December 12, 2005 through June 11, 2006 payable in June 2006.

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CURIS, INC. AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)—(continued)

On October 21, 2004, the Company amended a note receivable with Micromet, a former collaborator. Under the amended note, Micromet is obligated to pay Curis a total amount of EUR 4,500,000, subject to certain conditions, of which EUR 1,250,000 was paid in November 2004. Pursuant to the payment terms of the amended note, 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. This gain will be recorded in the “Other income” line item at the Other Income (Expense) section of the Company’s Consolidated Statement of Operations during the fourth quarter of 2005. The future amounts due to the Company under the amended note payable are dependent upon certain events and will be recorded in other income when and if such amounts are collected.

On June 2, 2005, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 154, Accounting Changes and Error Corrections (FAS 154), which will require entities that voluntarily make a change in accounting principle to apply that change retrospectively to prior periods’ financial statements, unless this would be impracticable. FAS 154 supersedes Accounting Principles Board Opinion No. 20, Accounting Changes (APB 20), which previously required that most voluntary changes in accounting principle be recognized by including in the current period’s net income the cumulative effect of changing to the new accounting principle. FAS 154 also makes a distinction between “retrospective application” of an accounting principle and the “restatement” of financial statements to reflect the correction of an error. Another significant change in practice under the FAS 154 will be that if an entity changes its method of depreciation, amortization, or depletion for long-lived, non-financial assets, the change must be accounted for as a change in accounting estimate. Under APB 20, such a change would have been reported as a change in accounting principle. FAS 154 applies to accounting changes and error corrections that are made in fiscal years beginning after December 15, 2005.

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The following discussion of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the related notes appearing 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, Inc., or Genentech, a collaborator. We have also developed several promising preclinical product candidates in various fields, including cancer, neurological disorders, hair growth regulation and cardiovascular disease. 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 $676,391,000 as of September 30, 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.

We currently have strategic collaborations with Genentech, Wyeth Pharmaceuticals, or Wyeth, and the Procter & Gamble Company, or P&G, to develop therapeutics which modulate the signaling of the Hedgehog, or Hh, pathway and an additional collaboration with Genentech to develop therapeutics that modulate another signaling pathway that plays an important role in cell proliferation. We have also licensed our bone morphogenetic protein, or BMP, pathway portfolio to Ortho Biotech Products, a subsidiary of Johnson & Johnson, for systemic administration for all applications excluding orthopedic and dental therapeutic applications. Our strategic collaborations and license agreements generally provide for our research, development and commercialization programs to be either a majority or wholly 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 potential future clinical development and regulatory approval milestones of approximately $750,000,000 in the aggregate, 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 successful completion of specified research and/or development objectives and regulatory approvals. In the future, we plan to continue to seek corporate collaborators for the further development and commercialization of some of our other technologies.

In January 2005, pursuant to the terms of our Hedgehog pathway collaboration agreement with Genentech, we exercised a co-development option pursuant to which we will share equally in all U.S. development costs and will also share equally in any future net profits and/or losses derived from sales in the U.S. of a therapeutic product candidate for the topical treatment of basal cell carcinoma should this product be successfully developed and marketed. Genentech has primary responsibility for clinical trial design and management and we participate

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on a steering committee that oversees the clinical development of the basal cell carcinoma product candidate. As a result of our election to exercise our co-development option, we will forego U.S. development and drug approval milestones and royalty payments on potential future U.S. sales of the basal cell carcinoma product candidate. On March 31, 2005, Genentech filed an investigational new drug application with the FDA in order to initiate human clinical investigation of the basal cell carcinoma product candidate and, in the second quarter of 2005, the first patient was enrolled in our phase I clinical trial. We expect that by exercising this co-development and equal cost-sharing option we will incur approximately $20,000,000 in development expenses through the planned completion of phase II clinical trials. We anticipate that the phase II clinical trials will be completed in mid-2007, assuming that the basal cell carcinoma product candidate successfully completes its phase I clinical trial. 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.

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 September 30, 2005, together with the payment of all contractually-defined payments under our collaborations and research programs with Genentech, Wyeth, P&G 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 into 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 below under the heading “Risk Factors that May Affect Results.”

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, and P&G, as well as royalty revenue and payments received upon monetization of certain royalty rights from Stryker Corporation. 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 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.

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

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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 application filing with the FDA, referred to as an IND in the table below, seeking to commence a phase I clinical trial to assess safety 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.

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 “Risk Factors That May Affect Future Results,” 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 will forego U.S. development and drug approval milestones and royalty payments on potential future U.S. sales of the basal cell carcinoma product candidate. On March 31, 2005, Genentech filed an investigational new drug application with the FDA and, in the second

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quarter of 2005, the first patient was treated in an ongoing phase I clinical trial. We expect that we will incur approximately $20,000,000 in development expenses 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 these programs, the successful development of our preclinical 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 below in “Risk Factors That May Affect Future Results.”

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 facility costs, we have recorded a $500,000 charge resulting from our expected loss of subtenant income on an operating lease for the remainder of our lease term ending on April 30, 2007.

Strategic Alliances 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, P&G 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 have potential future clinical development milestones of approximately $750,000,000 in the aggregate, 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.

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The collaborations and licenses are summarized as follows:

Genentech Hedgehog Antagonist Collaboration.    In June 2003, we licensed our proprietary Hedgehog pathway antagonists to Genentech for human therapeutic use. The primary focus of the collaborative research plan has been to develop these molecules for cancer indications. The collaboration consists of two main 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 an up-front payment of $5,000,000, license maintenance fee payments totaling $4,000,000 over the first two years of the collaboration and milestone 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 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 which modified the maintenance and the payment arrangement.

On June 11, 2003, in connection with the collaboration agreement, we sold to Genentech 1,323,835 shares of our common stock. We also entered into a registration rights agreement with Genentech pursuant to which, at the request of Genentech, we shall use our reasonable best efforts to register the shares of common stock for resale in the future under specified conditions. The shares were initially recorded at a price of $2.644 per share based on a 30-day trailing average of closing prices prior to June 11, 2003, pursuant to the terms of a stock purchase agreement and, therefore, we allocated $3,500,000 as stockholders’ equity in our consolidated balance at December 31, 2003. The fair market value of our common stock was $3.77 per share on June 11, 2003, as determined by the quoted closing price on the NASDAQ national market. During the third quarter of 2005, we determined that we should have used the closing market price to calculate the value of the shares rather than the contractually agreed-upon price. Accordingly, we should have ascribed $4,991,000 in value to the common stock, calculated as the $3.77 per share closing price multiplied by 1,323,835 shares sold to Genentech. Consequently, in the quarter ended September 30, 2005, we recorded a credit of $1,491,000 to additional-paid-in capital to correct the understatement in the fair value of the shares issued, a $1,072,000 reduction in deferred revenue to correct the overstatement of deferred revenue; and a $419,000 reduction in revenue to correct the cumulative overstatement of revenue in the periods from June 2003 to June 2005.

In January 2005, pursuant to the collaboration agreement we exercised an option to co-develop Hedgehog antagonist products in the field of basal call carcinoma in the U.S. We are now sharing equally in both U.S. development costs and any future U.S. net profits and/or losses resulting from the development and commercialization of our basal cell carcinoma product candidate. This co-development right includes basal cell carcinoma and any additional indications for which this product candidate may be developed in the U.S. 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. Should we determine that we cannot continue funding our equal share of the development expenses, we may opt out of the co-development structure and receive certain development and regulatory approval milestones and royalties on sales of the basal cell carcinoma product candidate, should any ever occur. On March 31, 2005, Genentech filed an investigational new drug application for the basal cell carcinoma product candidate with the FDA and began enrollment of a phase I clinical trial for a basal cell carcinoma product candidate during the second quarter of 2005. In addition to our co-development rights in the U.S. marketplace, in certain major international markets, we will receive milestones 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 also obligated to make milestone 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.

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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.

The December 2004 amendment, effective from June 12, 2004 to June 11, 2005, increases 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 increases 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, provided for 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. The $2,000,000 is due 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, for work on the program from December 12, 2005 until June 11, 2006, in exchange for $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 have 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, except in the areas of oncology and hematopoiesis.

Under the terms of the agreement, we will 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 milestones and drug approval milestones. Excluding royalties on potential net product sales, the total potential cash payments from this collaboration could exceed $140 million, 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.    In January 2004, we licensed our Hedgehog proteins and small molecule Hedgehog pathway agonists to Wyeth Pharmaceuticals, or Wyeth, for therapeutic

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applications in the treatment of neurological diseases and other disorders. Under the terms of the agreement, Wyeth paid us $3,000,000 in up-front consideration, of which we had originally allocated $1,500,000 to a non-refundable license fee and $1,500,000 to the purchase of 315,524 unregistered shares of our common stock. In determining the allocation of the up-front consideration, we had previously used a purchase price of $4.754 per share for the common stock, which was based on the contractually negotiated 15-day trailing average closing price of our common stock in the 15-day period prior to the January 12, 2004 date of the common stock sale. The fair market value of our common stock was $5.19 per share on January 12, 2004, as determined by the quoted closing price on the NASDAQ national market. During the third quarter of 2005, we determined that we should have used the closing market price on the date of sale to calculate the value of the shares rather than the contractually agreed-upon price. Accordingly, we should have ascribed $1,638,000 in value to the common stock, calculated as the $5.19 per share closing price multiplied by 315,524 shares sold to Wyeth. Consequently, in the quarter ended September 30, 2005, we recorded a credit of $138,000 to additional-paid-in capital to correct the understatement in the fair value of the shares issued, a $97,000 reduction in deferred revenue to correct the overstatement of deferred revenue; and a $41,000 reduction in revenue to correct the cumulative overstatement of revenue in the periods from January 2004 to June 2005.

Wyeth is also obligated to make milestone 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 includes more than $170 million in milestone payments, assuming at least two products are successfully developed and commercialized.

In addition to these initial and potential future milestone 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. Thereafter, the agreement may be extended for additional one-year periods 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. The senior Wyeth representative on the Joint Steering Committee has the deciding vote in the event the parties disagree on matters relating to the research program. The agreement provides for a one-year evaluation period immediately following the end of the research term, during which we may be obligated to serve on the steering committee and may be required, at Wyeth’s expense, to perform additional research and development services. We currently estimate we will only be required to provide steering committee services during the evaluation period if we are also performing research services during that period.

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 P&G, 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 P&G an exclusive, worldwide, royalty-bearing license for the development and commercialization of topical dermatological and hair growth products that

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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 P&G. P&G 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 P&G determines to file the first investigational new drug application with the U.S. Food and Drug Administration 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 expense through phase II clinical trials. Should we elect to exercise this co-development option, we will forego development milestones that would otherwise be payable during the period from investigational new drug application filing through the completion of a phase II clinical trial. P&G 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. P&G has an option to extend the initial one-year research term for up to three additional years in one-year increments.

P&G 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. P&G 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.

Ortho Biotech Products BMP License.    In November 2002, we licensed our broad bone morphogenetic protein, or BMP, technology portfolio to Ortho Biotech Products, L.P., a member of the Johnson & Johnson family of companies. Two of Ortho Biotech Products’ research affiliates, Johnson & Johnson Pharmaceutical Research & Development, L.L.C. and Centocor Research & Development, also members of the Johnson & Johnson family of companies, will have joint responsibility for further research and development of our licensed BMP technology portfolio.

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 milestone payments at various intervals during the U.S. and European regulatory approval process assuming the first two therapeutic indications are successfully developed. These milestones 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.

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 revenue recognition, the carrying value of property and equipment and intangible assets and the value of certain liabilities. We base our estimates on historical experience and on various other factors that we believe are 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.

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We believe the following accounting policies to be critical to understanding the judgments and estimates we use in preparing our financial statements:

Revenue recognition.    Revenue is a key component of our results of operations. We follow the provisions of the Securities and Exchange Commission’s Staff Accounting Bulletin (SAB) No. 104 (SAB No. 104), Revenue Recognition, Emerging Issues Task Force (EITF) Issue No. 00-21 (EITF 00-21), Accounting for Revenue Arrangements with Multiple Deliverables, EITF Issue No. 99-19 (EITF 99-19), Reporting Revenue Gross as a Principal Versus Net as an Agent, and EITF Issue No. 01-9 (EITF 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 elements, the license and the performance obligations, 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 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 stand-alone 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.

If we cannot reasonably estimate the level of effort required to complete our performance obligations under an arrangement and the performance obligations are provided on a best-efforts basis, 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.

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 under a research arrangement, 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.

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Collaboration agreements may also contain substantive milestones. 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 milestone meets the aforementioned conditions involves management’s judgment. If any of these conditions are not met, the milestone payment would not be considered a substantive milestone, and the resulting payment would 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.

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 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 September 30, , 2006 are classified as long-term deferred revenue. As of September 30, 2005, we have short- and long-term deferred revenue of $2,152,000 and $7,291,000, 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 September 30, 2006. Amounts that we expect will not be recognized prior to September 30, 2006 are classified as long-term deferred revenue. However, this estimate is

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based on our current operating plan as of September 30, 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 October 1, 2005 through September 30, 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. Since the timing of clinical development is difficult to estimate, 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.

Goodwill.    We assess the impairment of goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. In addition, we perform a goodwill impairment test annually. If we determined that the carrying value of goodwill might not be recoverable based upon the existence of one or more indicators of impairment, we would measure any impairment based on a projected cash flow method.

Valuation of investments in privately held companies.    We have investments in Aegera, Micromet and ES Cell International with carrying values of $167,000, $100,000 and $150,000, respectively. These investments are included in the “Deposits and other assets” category of our consolidated balance sheets. At each balance sheet date, we review these investments to determine whether the fair value of these investments is less than the carrying value and, if so, whether we should write-down the investment. These companies are not publicly traded and, therefore, determining the fair value of our investments in these companies involves significant judgment. We consider available information in estimating the fair value of these investments and, as of September 30, 2005, we believe that the fair value of these investments is not less than their carrying value.

If the financial condition or results of Aegera, Micromet or ES Cell decline significantly, the fair value of these investments would likely decline and, as a result, we may have to record an impairment charge to the extent such impairment is deemed other than temporary.

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.

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Results of Operations

Three-Month Periods Ended September 30, 2005 and September 30, 2004

Revenues.    Total revenues are summarized as follows:

The 77% increase in gross revenues for the third quarter of 2005 as compared to the same period in the prior year, was primarily due to increased revenues from our Genentech collaborations of $1,490,000 offset by a $460,000 cumulative reduction in license revenues attributable to the correction of an error in recording equity related to the June 2003 Hedgehog antagonist collaboration agreement with Genentech and the January 2004 Hedgehog agonist collaboration with Wyeth . For the three-month period ending September 30, 2005, we also recorded $820,000 in contra-revenue, or a reduction to gross revenues, related to our co-development payments to Genentech. This reduction in 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.

Research and Development Expenses.    Research and development expenses are summarized as follows:

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The increase of $532,000 in research and development expenses for the three-month period ended September 30, 2005 was primarily due to an increase in spending of $568,000 on our discovery research programs, one of which is under a grant with the Spinal Muscular Atrophy Foundation and another of which is under collaboration with Genentech.

General and Administrative Expenses.    General and administrative expenses are summarized as follows: