CURIS INC - Quarter Report: 2005 June (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 JUNE 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

As of August 5, 2005, there were 48,190,334 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 STATEMENT S

CURIS, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to unaudited condensed consolidated financial statements.

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CURIS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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CURIS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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CURIS, INC. AND SUBSIDIARY

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 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 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 June 30, 2005, the results of operations for the three- and six-month periods ended June 30, 2005 and 2004, and cash flows for the six-month periods ended June 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.

On April 1, 2005, the Company 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 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

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CURIS, INC. AND SUBSIDIARY

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

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 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. Genentech will also make cash payments to the Company that are contingent upon the successful achievement of certain research, development, clinical 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 on 60 days’ notice for an uncured material breach by the other party.

The Company is recognizing the up-front license fee as revenue over its estimated period of involvement under the collaboration of four years. During the three-month period ended June 30, 2005, the Company recorded $188,000 as revenue related to its $3,000,000 up-front license fee. The Company is recognizing amounts received for research and development activities as such services are performed by the Company since Genentech is obligated to pay these amounts and no other performance obligations exist. As of June 30, 2005, the Company has received $750,000 in funding of such research and development activities, of which $401,000 has been recognized for the three-month period ended June 30, 2005.

In June 2003, as amended in December 2004 and April 2005, the Company entered into a collaborative research, development and license agreement with Genentech in which the Company licensed its proprietary Hedgehog pathway antagonists to Genentech for human therapeutic use. This collaboration with Genentech is generally divided between two development programs—the systemic treatment of solid tumor cancers and topical therapy for the treatment of basal cell carcinoma.

Under the systemic treatment of solid tumor cancer program, Genentech reimburses the Company for research services that the Company performs under the collaboration, as defined in the agreement. In addition, Genentech reimburses the Company for certain of the Company’s patent and other expenses and will pay the Company development and drug approval milestones, should certain development objectives be achieved, and royalties, should any commercial sales occur.

In January 2005, the Company elected to exercise a co-development option under the basal cell carcinoma program, pursuant to which it will forego U.S. development and drug approval milestones and royalty payments on potential future U.S. sales. The Company will now share equally in all U.S. development costs and any future net profits and/or losses derived from sales in the U.S. of a product candidate for the topical treatment of basal cell carcinoma. Under this co-development arrangement, the Company reimburses Genentech for its equal share of the basal cell carcinoma program development costs incurred and invoiced by Genentech.

In connection with its election to exercise its co-development option, 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

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CURIS, INC. AND SUBSIDIARY

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

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 its 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 payments to Genentech in connection with the basal cell carcinoma program co-development arrangement. The payments made by the Company to reimburse Genentech for co-development expenses 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 cumulative revenues recognized under both of our collaborations with Genentech. Accordingly, the Company has consolidated cumulative revenues generated from both of its collaborations with Genentech in order to determine if cumulative negative revenue exists. The Company is currently recording revenues under its two collaborations equal to the amounts earned for research, development, patent and other costs, as well as for the amortization of license fees received from Genentech. These license fees are being recognized on a straight-line basis through June 11, 2011 as the remaining services are performed. The amount of revenues recognized by the Company from these collaborations with Genentech is then reduced by the Company’s share of the co-development expenses that the Company pays to Genentech, up to the total cumulative revenues recognized under these 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 first be recorded against any remaining Genentech-related deferred revenue recorded by the Company. Once all Genentech-related deferred revenue balances have been reduced to zero, co-development costs will then be recognized first as an off-set against any future revenue recognized under those collaborations and then as research and development expenses.

As of June 30, 2005, cumulative co-development costs of $4,879,000 incurred by the Company did not exceed cumulative revenues recorded related to its collaborations with Genentech of $5,618,000. Therefore, in accordance with EITF 01-9, the co-development costs have been recorded as a reduction to revenues, or contra-revenue, of $1,574,000 and $4,879,000 in the Company’s consolidated statement of operations and comprehensive loss for the three- and six-month periods ended June 30, 2005, respectively.

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CURIS, INC. AND SUBSIDIARY

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

Long-term debt and capital lease obligations consisted of the following at June 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 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 (7.25% as of June 30, 2005) or a fixed rate (7.13% as of June 30, 2005) for the repayment period. The loan will be collateralized by any equipment and leasehold improvements financed thereunder. As of June 30, 2005, the Company had not drawn any amounts 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 in 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 those that are affixed to the property and those that are purchased after March 23, 2005 under purchase money arrangements with equipment lenders. As of June 30, 2005, the Company was in compliance with the sole covenant under this agreement. This covenant requires the Company to maintain a minimum 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 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.

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CURIS, INC. AND SUBSIDIARY

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

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 six-month periods ended June 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 six–month periods ended June 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 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.

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CURIS, INC. AND SUBSIDIARY

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

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 subtenant’s lease currently 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 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 and was seeking to amend the sublease terms to lower the sublease rent and to terminate the sublease on or about December 31, 2005. The Company will seek to sublet 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 will be lower than the Company’s cost to lease the space, based on an analysis of rental rates for similar space in the area.

Because the Company does not expect to utilize the vacated space for its current or future operations and because the Company believes that its costs under the lease will exceed any future sublease income for the duration of the lease, the Company has recorded a charge of $500,000 in the “general and administrative expense” line item of its consolidated statement of operations for the three- and six-month periods ended June 30, 2005. This amount represents the Company’s estimate of the total expected loss on the subleased space over the remaining term of the lease. 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 June 30, 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 repair and regeneration of human tissues and organs. Our product development approach involves using small molecules, proteins or antibodies to modulate these regulatory signaling pathways, for example, to increase the pathway signals when they are insufficient or to decrease them when they are excessive. We 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 the fields of cancer, neurological disorders, kidney disease, cardiovascular disease and hair growth regulation. We operate in a single reportable segment: developmental biology products. We expect that any successful products would be used in the health care industry and would be regulated in the United States by the U.S. Food and Drug Administration, or FDA, and in overseas markets by similar regulatory agencies.

Since our inception, we have funded our operations primarily through license fees, research and development funding from our strategic collaborators, the private and public placement of our equity securities, debt financings and the monetization of certain royalty rights. We have never been profitable and have incurred an accumulated deficit of $672,761,000 as of June 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 and Wyeth Pharmaceuticals, or Wyeth, 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 BMP pathway portfolio to Ortho Biotech Products, a subsidiary of Johnson & Johnson, for systemic administration for all non-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 $18,000,000 in up-front payments, of which we received $5,000,000 from the sale of shares of our common stock, and also include potential future clinical development and regulatory approval milestones of approximately $650,000,000 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.

Pursuant to the terms of our Hedgehog pathway collaboration agreement with Genentech, in January 2005, we exercised a co-development option with Genentech 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. 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

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candidate and, in the second quarter of 2005, the first patients were 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. We expect to incur additional costs to complete phase III clinical trials and the remainder of the regulatory approval process, assuming that we and Genentech 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 on, 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 June 30, 2005, together with the payment of all contractually-defined payments under our collaborations and research programs with Genentech, Wyeth and the SMA Foundation, assuming these programs continue as planned, should enable us to maintain current and planned operations into mid-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 mid-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, and other amounts that we have received from our strategic collaborators and licensees, including Genentech, Wyeth, and Ortho Biotech Products, as well as royalty revenue and payments received upon monetization of certain royalty rights from Stryker Corporation. Since our 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, 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 below, the term discovery means that we are searching for compounds that may be relevant for treating a particular disease area, early preclinical means we are seeking to obtain initial demonstrations of therapeutic efficacy in preclinical models of human disease, mid-preclinical means we are seeking to obtain multiple demonstrations of efficacy in preclinical models of human disease, late preclinical means we are seeking to obtain both multiple demonstrations of efficacy in preclinical models of

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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 planned filing dates for investigational new drug applications for our product development programs are solely our judgments. These estimates may not reflect the plans 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 studies of these product candidates, and the timing of completion of such programs, is highly uncertain. Accordingly, the estimated period in which we or our collaborators or licensors may file an IND application for any of these product candidates, if at all, may vary materially from the estimates set forth below:

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 Results,” we and our collaborators may not be able to successfully develop and commercialize any of the product candidates included in the table above.

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We and Genentech are co-developing a hedgehog topical small molecule antagonist formulated for the topical treatment of basal cell carcinoma. We and Genentech will share equally in all U.S. development costs. On March 31, 2005, Genentech filed an investigational new drug application with the FDA and, in the second 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 we and Genentech 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.

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 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 loss on an operating lease resulting from the loss of subtenant income for the remainder of our lease term of 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 and Ortho Biotech Products. These strategic license and collaboration agreements included $18,000,000 in up-front payments, including

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$5,000,000 from the sale of shares of our common stock, and have potential future clinical development milestones of approximately $650,000,000 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, development and regulatory approval objectives.

The collaborations and licenses are summarized as follows:

Genentech Hedgehog Antagonist Collaboration.    In June 2003, as amended in December 2004 and April 2005, we entered into a collaborative research, development and license agreement with Genentech in which we granted an exclusive royalty bearing license to our proprietary Hedgehog pathway antagonists to Genentech for human therapeutic use. The primary focus of our collaboration has been to develop these molecules for cancer indications. The collaboration consists of two main programs: the development of a small molecule product candidate formulated for topical treatment of basal cell carcinoma and the development of systemically administered small molecule and antibody Hedgehog antagonists for the treatment of certain other solid tumor cancers. The topical Hedgehog antagonist for basal cell carcinoma is subject to a co-development arrangement with Genentech in which we will forego U.S. development and drug approval milestones and royalty payments on potential future U.S. sales. We will now share equally in both the U.S. development costs and any future U.S. net profits and/or losses of the product candidate should any sales ever occur.

Under the terms of the agreement, as amended, Genentech paid us a license payment of $9,000,000, purchased 1,323,835 shares of our common stock at a price of $2.644 per share for aggregate proceeds of $3,500,000, and has agreed to fund, through December 2005, up to $4,000,000 for the research and development of systemically-administered small molecule and antibody hedgehog antagonists for the treatment of solid tumors, of which $2,000,000 has been paid to date. Genentech has the option to extend the research funding for this program until June 30, 2006. Genentech will make cash payments to us contingent upon the successful achievement of certain research, development, clinical and drug approval milestones. Genentech will also pay us royalties on net product sales if product candidates derived from the collaboration are successfully developed.

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 formation and repair and its abnormal activation is associated with certain cancers. Under the terms of the agreement, we granted Genentech an exclusive royalty-bearing license to make, use and sell the small molecule compounds that are modulators of the pathway. We have 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 research and development activities and Genentech will be responsible for clinical development, manufacturing, and commercializing 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 and development activities during the initial two-year research term, subject to its termination rights. Genentech will also make cash payments to us contingent upon the successful achievement of certain research, development, clinical 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 us royalties on net product sales if product candidates derived from the collaboration are successfully developed

Wyeth Hedgehog Agonist Collaboration.    Effective February 2004, as amended in May 2005, we entered into a collaboration, research and license agreement with Wyeth in which we licensed our Hedgehog proteins and small molecule Hedgehog pathway agonists to Wyeth on an exclusive worldwide, royalty-bearing basis for the development and commercialization of pharmaceutical products for therapeutic applications in the treatment of diseases and disorders in humans with the primary focus of the research program on the treatment of neurological disorders, including neurological damage resulting from stroke, as well as other neurodegenerative diseases and neuropathies. Under the terms of the agreement, Wyeth paid us

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a license fee of $1,500,000 and purchased 315,524 shares of our common stock for an aggregate purchase price of $1,500,000. Wyeth will also provide us with research funding for a minimum of two years.

In addition, Wyeth is obligated to make cash payments to us upon the successful achievement of development and drug approval milestones and is obligated to pay a royalty on net product sales, if any, that escalates with increasing sales volume. On March 23, 2005, we achieved a preclinical development milestone under the Wyeth collaboration which triggered a $250,000 payment from Wyeth.

As part of our collaboration with Wyeth, we have retained development and licensing options for certain therapeutic applications of the Hedgehog agonist technologies, including topical applications for the treatment of skin diseases and disorders, 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 cardiovascular applications. If Wyeth declines to exercise its option, or if we are unable to reach an agreement with Wyeth on terms within the contractually specified period, we are free to seek another collaborator for this program.

Ortho Biotech Products BMP License.    In November 2002, we entered into an agreement with Ortho Biotech Products, a subsidiary of Johnson & Johnson, in which we licensed our broad BMP technology portfolio to Ortho Biotech Products on an exclusive, worldwide royalty-bearing basis, for all non-orthopedic and non-dental therapeutic applications in exchange for a $3,500,000 fee, a series of cash milestones if specified clinical research objectives and regulatory approvals are achieved, including a $30,000,000 milestone payment upon U.S. regulatory approval of a product for the treatment of kidney disease, and a royalty on potential future product sales. Earlier in 2005, Johnson & Johnson transferred the primary development responsibility of this program from Ortho Biotech Products to Centocor, another one of Johnson & Johnson’s subsidiaries. Under this new arrangement, Curis and Centocor expect to establish a cross-company team to share information on the development and progress of the BMP-7 program. Ortho Biotech Products and Centocor have assumed all future costs and responsibility for BMP-based product development and have sole responsibility for deciding if and when human clinical trials of BMP-based product candidates will begin.

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires that we make estimates and assumptions that affect the reported amounts and disclosure of certain assets and liabilities at our balance sheet date. Such estimates and judgments include the carrying value of property and equipment and intangible assets, revenue recognition and the value of certain liabilities. We base our estimates on historical experience and on various other factors 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.

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

Long-Lived Assets.     Long-lived assets consist of goodwill, long-term receivables, equity securities held in Micromet, ES Cell International and Aegera Therapeutics, and long-term deposits. We assess the impairment of identifiable intangibles and long-lived assets 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 intangible or long-lived assets 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.

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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 June 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, ES Cell or Micromet 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.

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 No. 104 (SAB No. 104), Revenue Recognition, EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, and EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).

In accordance with SAB No. 104, we recognize revenue related to research activities as they are performed, so long as there is persuasive evidence of an arrangement, the fee is fixed or determinable and collection of the related receivable is probable.

We analyze our multiple-element arrangements to determine whether the elements can be separated and accounted for individually as separate units of accounting in accordance with EITF No. 00-21. We recognize license payments as revenue when received if the license has stand-alone value and the fair value of the undelivered items can be determined. If the license is considered to have stand-alone value but the fair value on any of the undelivered items cannot be determined, the license payments are recognized as revenue over the period of performance for such undelivered items or services. We recognize revenues from reimbursable research and development activities at the time these activities are performed under the terms of the related agreement, when the collaborator is obligated to pay and when no future performance obligations exist.

Amounts received for license fees are deferred and recognized as services are performed over the estimated performance period of the contract. Any obligations related directly to the receipt of a license fee are also deferred and recognized as services are performed over the performance period of the contract. Amounts received for milestones are recognized upon achievement of the milestone, as long as the milestone is deemed to be substantive and we have no other performance obligations with respect to that milestone. In the event that we have remaining performance obligations, the portion of the milestone payment equal to the lesser of the non-refundable cash received or the percentage of the services performed through that date multiplied by the total milestone payment would be recognized as revenue. Revenue received under grants is being recognized as the services are provided and payment is assured under the terms of the grant.

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 June 30, 2006. Amounts that we expect will not be recognized prior to June 30, 2006 are classified as long-term deferred revenue. However, this estimate is based on our current operating plan as of June 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 July 1, 2005 through June 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

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steering committees and the performance of other research and development services. Our period of involvement, for example, is largely determined by the time to commercialize our basal cell carcinoma clinical candidate that we are co-developing with Genentech, our estimate of the period that we are providing research services, and the time to reach clinical development for candidates under our collaboration with Wyeth. 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.

We apply EITF 01-9 for revenue arrangements where both parties make payments to each, such as our two collaboration agreements with Genentech, which includes payments from Genentech to us for license fees, research and development services, and development milestones as well as payments from us to Genentech for our equal share of costs incurred by Genentech for the co-development of a therapeutic product candidate for the topical treatment of basal cell carcinoma. We record revenues equal to the amounts reimbursable by Genentech for research, development, patent and other costs as well as the amortization of the license payments received from Genentech under both of our collaborations with Genentech. In accordance with EITF 01-9, we then record as a reduction to revenue, or contra-revenue, our share of the co-development expenses, which we pay to Genentech up to the total cumulative revenue recognized under both collaborations with Genentech since inception. Costs incurred in excess of the total cumulative revenues recognized and probable future revenues under these collaborations are first recorded against any remaining Genentech-related deferred revenue recorded on our balance sheet. Once the Genentech-related deferred revenue balances have been reduced to zero, these costs are then recognized, first as off-sets against any future revenue recognized under these two collaborations and any excess thereof as research and development expenses.

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.

Results of Operations

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

Revenues.    Total revenues are summarized as follows:

Gross revenues generated under our ongoing collaborations with Genentech, Wyeth and our grant from the Spinal Muscular Atrophy Foundation, were $3,095,000 for the second quarter of 2005 as compared to $1,120,000 for the same period in the prior year, an increase of $1,975,000, or 176%. Gross revenues are summarized as follows:

Genentech Collaborations.    We recognized $1,811,000 in gross revenues related to our collaborations with Genentech for the three months ended June 30, 2005, including our new discovery research collaboration

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established on April 1, 2005. Of this amount, $460,000 was recognized from the amortization of $12,000,000 in license and up-front payments received from Genentech. In addition, we recognized gross revenues of $1,335,000 for the reimbursement for support of full-time equivalent employees and $16,000 relating to other research and development services performed under the collaboration agreement with Genentech for the three months ended June 30, 2005. We recognized $481,000 in revenue for the three months ended June 30, 2004.

Wyeth Collaboration.    We recognized $652,000 in gross revenues related to our collaboration with Wyeth for the three months ended June 30, 2005. This amount included revenue of $75,000 from the amortization of a $1,500,000 license fee payment received from Wyeth in February 2004. In addition, we recognized gross revenues of $500,000 for the reimbursement for support of full-time equivalent employees and $77,000 related to other research and development services performed under the collaboration agreement with Wyeth for the three months ended June 30, 2005. We recognized $639,000 in revenue for the three months ended June 30, 2004.

Spinal Muscular Atrophy Foundation.    We recognized $632,000 in gross revenues relating to research and development services performed under the three-year, $5,364,000 grant from the Spinal Muscular Atrophy Foundation for the three months ended June 30, 2005. Since this grant was not received until September 2004, no revenue related to the Spinal Muscular Atrophy Foundation grant was recognized in the second quarter of 2004.

For the three-month period ending June 30, 2005, we also recorded $1,574,000 in contra-revenue, or a reduction to gross revenues, related to our co-development option with 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:

The increase of $857,000 in research and development expenses for the three-month period ended June 30, 2005 was primarily due to an increase in spending of $1,007,000 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. Neither of these agreements were in effect during the three-month period ended June 30, 2004.

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

The increase in general and administrative expenses of $368,000 for the three-month period ended June 30, 2005 was primarily due to the recognition of a $500,000 loss on an operating lease resulting from the loss of subtenant income for the remainder of our lease term. In addition, personnel costs increased $300,000 from the prior year. These increases were offset by decreases in legal services of $267,000 and professional services of $93,000.

Stock-based Compensation.    Stock-based compensation for the three-month period ended June 30, 2005 was $77,000 as compared to $389,000 for the three-month period ended June 30, 2004, a decrease of $312,000, or 80%. The decrease was primarily attributable to a decrease of compensation expense recorded on options to purchase common stock that were issued to employees with exercise prices below fair market value in August 2000 that became fully vested as of August 2004. No related additional expense was recognized for these August 2000 stock options beyond August 2004. We recorded $254,000 in stock-based compensation related to these options for the three-months ended June 30, 2004. We also recorded $135,000 in stock-based compensation related to non-employee options for the period ended June 30, 2004 as compared to $76,000 for the same period ended June 30, 2005.

Amortization of Intangibles.    Amortization of intangible assets was $19,000 for each of the three-month periods ended June 30, 2005 and 2004.

Interest Income.    Interest income for the three-month period ended June 30, 2005 was $283,000 as compared to $109,000 for the three-month period ended June 30, 2004, an increase of $174,000, or 160%. The increase in interest income resulted from higher interest rates and a higher available investment balance for the period ended June 30, 2005.

Other Income.    Other income was $40,000 for the three-month period ended June 30, 2004, which primarily consisted of a gain recognized on currency rate fluctuations on a euro-denominated note receivable from a former collaborator. We recorded no other income for the three months ended June 30, 2005.

Interest Expense.    Interest expense of $89,000 for the three-month period ended June 30, 2005, was comparable to interest expense of $93,000 for the three-month period ended June 30, 2004.

Net Loss.    As a result of the foregoing, we incurred a net loss of $4,675,000 for the three-month period ended June 30, 2005 as compared to a net loss of $4,301,000 for the three-month period ended June 30, 2004.

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Six-Month Periods Ended June 30, 2005 and June 30, 2004

Revenues.    Total revenues are summarized as follows:

Gross revenues generated under our ongoing collaborations with Genentech, Wyeth and our grant from the Spinal Muscular Atrophy Foundation were $5,867,000 for the first six months of 2005 as compared to $1,976,000 for the same period in the prior year, an increase of $3,891,000, or 197%. Gross revenues are summarized as follows:

Genentech Collaborations.    We recognized $3,062,000 in gross revenues related to our collaborations with Genentech for the six months ended June 30, 2005, including our new discovery research collaboration established on April 1, 2005. Of this amount, $734,000 was recognized from the amortization of $12,000,000 in license and up-front payments received from Genentech. In addition, we recognized gross revenues of $2,289,000 for the reimbursement for support of full-time equivalent employees and $39,000 relating to other research and development services performed under the collaboration agreements with Genentech for the six months ended June 30, 2005. We recognized $945,000 in revenue for the six months ended June 30, 2004.

Wyeth Collaboration.    We recognized $1,584,000 in gross revenues related to our collaboration with Wyeth for the six months ended June 30, 2005. This amount includes revenue of $150,000 from the amortization of a $1,500,000 license fee payment received from Wyeth in February 2004. In addition, we recognized gross revenues of $1,000,000 for the reimbursement for support of full-time equivalent employees, $250,000 for the achievement of a preclinical development milestone, and $184,000 related to other research and development services performed under the collaboration agreement with Wyeth for the six months ended June 30, 2005. We recognized $981,000 in revenue for the six months ended June 30, 2004.

Spinal Muscular Atrophy Foundation.    We recognized $1,221,000 in gross revenue relating to research and development services performed under the three-year, $5,364,000 grant from the Spinal Muscular Atrophy Foundation for the six months ended June 30, 2005. Since this grant was not received until September 2004, no revenue related to the Spinal Muscular Atrophy Foundation grant was recognized for the six months ended June 30, 2004.

For the six-month period ending June 30, 2005, we also recorded $4,879,000 in contra-revenue, or a reduction to gross revenues, related to our co-development option with Genentech. This reduction in gross revenue represents amounts paid or 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.

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

The increase of $1,165,000 in research and development expenses for the six-month period ended June 30, 2005, was primarily due to an increase in spending of $1,468,000 on one of our discovery research programs which is under a sponsored research agreement with the Spinal Muscular Atrophy Foundation. As this agreement was not entered into until September 2004, we incurred no expenses for this program during the six-month period ended June 30, 2004. Reduced spending in other programs, particularly decreases of $185,000 and $197,000 in our Hedgehog small molecule agonist program for nervous system disorders and Hedgehog small molecule and antibody antagonist for cancer programs, respectively, offset this increase.

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

The increase of $151,000 in general and administrative expenses for the six-month period ended June 30, 2005 was primarily due to the recognition of a $500,000 loss on an operating lease resulting from the loss of subtenant income for the remainder of our lease term offset by decreases in all other cost categories, except personnel.

Stock-based Compensation.    Stock-based compensation for the six-month period ended June 30, 2005 was $28,000 as compared to $691,000 for the six-month period ended June 30, 2004, a decrease of $663,000, or 96%. The decrease was primarily attributable to a decrease of compensation expense recorded on options to purchase common stock that were issued to employees with exercise prices below fair market value in August 2000 that became fully vested as of August 2004. No related additional expense was recognized for these August 2000 stock options beyond August 2004. We recorded $509,000 in stock-based compensation related to these options for the six-months ended June 30, 2004. We also recorded $182,000 in stock-based compensation related to non-employee options for the period ended June 30, 2004 as compared to $24,000 for the comparable period ended June 30, 2005.

Amortization of Intangibles.    Amortization of intangible assets was $38,000 for each of the six-month periods ended June 30, 2005 and 2004.

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Interest Income.    Interest income for the six-month period ended June 30, 2005 was $543,000 as compared to $216,000 for the six-month period ended June 30, 2004, an increase of $327,000, or 151%. The increase in interest income resulted from higher interest rates and a higher available investment balance for the period ended June 30, 2005.

Other Income.    Other income for the six-month period ended June 30, 2005 was $25,000 as compared to $193,000 for the six-month period ended June 30, 2004. For the six-month period ended June 30, 2004, other income primarily consisted of an adjustment to an estimate of an amount payable to a former collaborator.

Interest Expense.    Interest expense for the six-month period ended June 30, 2005 was $171,000 as compared to $204,000 for the six-month period ended June 30, 2004, a decrease of $33,000, or 16%. The decrease resulted from lower outstanding debt obligations at June 30, 2005 as compared to June 30, 2004.

Net Loss.    As a result of the foregoing, we incurred a net loss of $9,788,000 for the six-month period ended June 30, 2005 as compared to a net loss of $8,339,000 for the six-month period ended June 30, 2004.

Liquidity and Capital Resources

We have financed our operations primarily through license fees, research and development funding from our collaborative partners, the private and public placement of our equity securities, debt financings and the monetization of certain royalty rights.

At June 30, 2005, our principal sources of liquidity consisted of cash, cash equivalents, and marketable securities of $48,529,000, excluding restricted long-term investments of $193,000. Our cash and cash equivalents are highly liquid investments with a maturity of three months or less at date of purchase and consist of time deposits and investments in money market funds with commercial banks and financial institutions, short-term commercial paper, and government obligations. We also maintain cash balances with financial institutions in excess of insured limits. However, we do not anticipate any losses with respect to such cash balances because the balances are invested in highly rated securities. Our marketable securities are investments with original maturities of greater than three months, but less than twelve months, and consist of commercial paper, corporate debt securities, and government obligations.

The use of our cash flows for operations has primarily consisted of salaries and wages for our employees, facility and facility-related costs for our office and laboratory, fees paid in connection with clinical trials, preclinical studies, laboratory supplies, consulting fees, and legal fees. To date, the source of our cash flows from operations has been payments received from our collaborators. In general, our only source of cash flows from operations for the foreseeable future will be the up-front license payments, if any, payments for the achievement of milestones, if any, and funded research and development that we may receive under collaboration agreements. The timing of any new collaboration agreements and any payments under existing collaboration agreements cannot be easily predicted and may vary significantly from quarter to quarter.

Net cash used in operating activities was $3,715,000 for the six-month period ended June 30, 2005 as compared to $4,939,000 for the six-month period ended June 30, 2004. Cash used in operating activities during the six-month period ended June 30, 2005 was primarily the result of our net loss for the period partially offset by non-cash charges including stock-based compensation, depreciation and non-cash interest expense. In addition, increases in operating cash resulted from changes in certain current assets and liabilities during the six-month period ended June 30, 2005, including receipt of $5,750,000 from Genentech consisting of a $3,000,000 license fee associated with our April 2005 discovery research agreement and $2,750,000 in reimbursement of research and development services. Net cash used in operating activities during the six-month period ended June 30, 2004 was primarily the result of our net loss for the period partially offset by non-cash charges including stock-based compensation, depreciation and non-cash interest expense. In addition, increases in operating cash as a result of changes in certain current assets and liabilities during the six-month period ended

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June 30, 2004, including a $1,500,000 up-front payment received for a licensing agreement with Wyeth, further offset our net loss.

We expect to continue to use cash in operations as we continue to develop our products in clinical trials and advance new products into preclinical development. In addition, in the future we may owe royalties and other contingent payments to our licensees based on the achievement of developmental milestones, product sales and specified other objectives.

Investing activities used cash of $1,254,000 for the six-month period ended June 30, 2005 as compared to $11,045,000 used in the six-month period ended June 30, 2004. Cash used in investing activities resulted principally from $68,000 in net investment sales offset by $1,322,000 in fixed asset purchases for the six-month period ended June 30, 2005. For the six-month period ended June 30, 2004, cash used in investing activities resulted principally from $10,262,000 in net investment purchases and $783,000 in fixed asset purchases.

Financing activities provided approximately $1,426,000 of cash for the six-month period ended June 30, 2005, resulting from net proceeds of $997,000 from the issuance of debt for the purchase of fixed assets and proceeds of $429,000 received upon stock option exercises. Financing activities provided approximately $3,067,000 of cash for the six-month period ended June 30, 2004 resulting primarily from the sale of $2,802,000 of our common stock, including $1,500,000 from the sale of 315,524 shares to Wyeth and $1,222,000 in proceeds received upon stock option exercises. In addition, proceeds from the issuance of debt for the purchase of fixed assets provided $592,000 for the six-month period ended June 30, 2004. These increases were offset by $327,000 in repayments of obligations under capital leases.

Pursuant to our co-development arrangement with Genentech, under which we will forego U.S. development and drug approval milestones and royalty payments on potential future U.S. sales. We will now share equally in U.S. development costs and 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, we expect that we will incur approximately $20,000,000 in development expenses through phase II clinical trials, of which $3,305,000 was paid during the first half of 2005 and an additional $1,574,000 has been accrued. Genentech filed an investigational new drug application with the FDA on March 31, 2005 in order to initiate human clinical investigation of the basal cell carcinoma product candidate. The basal cell carcinoma product candidate is currently being tested in a phase I clinical trial. Assuming the successful advancement of the basal cell carcinoma product candidate through phase I and phase II clinical trials, we expect that the phase II clinical trial will be completed in mid-2007. We expect to incur additional costs to complete phase III clinical trials and complete the regulatory approval process, assuming that Genentech and we successfully complete phase II clinical trials.

Effective June 9, 2005, we 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, we 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, we will pay interest only on any borrowings on a monthly basis in arrears. On December 9, 2005, we will convert the then outstanding balance into a 36-month term note that bears interest at either a variable rate (7.25% as of June 30, 2005) or a fixed rate (7.13% as of June 30, 2005) for the repayment period. The loan will be secured by any equipment and leasehold improvements financed thereunder. As of June 30, 2005, we have not drawn any amounts under this loan agreement.

Effective January 7, 2005, we entered into an amendment with the Boston Private Bank & Trust Company to extend the drawdown date in which we 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, we drew down the remaining balance under this agreement bringing the total amount financed to $2,250,000 and exercised our 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, we are 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

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collateralized by all of our property, plant and equipment assets, except for those that are affixed to the property and those that are purchased after March 23, 2005 under purchase money arrangements with equipment lenders. As of June 30, 2005, we were in compliance with the sole covenant under this agreement. This covenant requires us to maintain a minimum working capital ratio. Should we 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 June 26, 2001, we received $2,000,000 from Becton Dickinson under a convertible subordinated note payable in connection with the exercise by Becton Dickinson of an option to negotiate a collaboration agreement. The note is repayable at any time up to its maturity date of June 26, 2006 by us, at our discretion, in either cash or upon issuance to Becton Dickinson of shares of our common stock. The note bears interest at 7%. As of June 30, 2005, there was approximately $2,562,000, including approximately $562,000 in accrued interest, outstanding under the note agreement.

Since August 2002, we have sublet 11,980 of the 17,600 square fee of our facility at 61 Moulton Street in Cambridge, Massachusetts. Under the terms of our sublease, we receive sublease payments which total $692,000 per year. In addition, we receive approximately $50,000 for facilities-related services and a pro-rata portion of the 61 Moulton Street facility overhead, including real estate taxes and utilities. In July 2005, our subtenant informed us that it would like to amend the terms of our sublease to reduce its sublease rate and that it would likely vacate the space in December 2005. While we have not amended our sublease to date, we expect that any amendment or early termination of our sublease would result in an increase of our net cash obligations under our lease. Our lease obligation on our 61 Moulton Street facility extends to April 2007 and our lease obligation from July 2005 to April 2007 is approximately $850,000. Should our current subtenant vacate the 61 Moulton facility as expected, we will seek to sublet all or part of the facility. However, there is no guarantee that we will be able to do so or at terms which are similar to our current sublease.

Contractual Obligations

In addition to our loan agreement with Boston Private Bank & Trust Company, we also have contractual obligations related to our facility lease, research services agreements, consulting agreements, and license agreements. The following table summarizes our contractual obligations due by the period indicated at June 30, 2005: