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  As Of               Filer                 Filing     As/For/On Docs:Pgs              Issuer               Agent

 4/15/03  Deltagen Inc                      10-K       12/31/02   28:369                                    Donnelley R R & S..13/FA

Document/Exhibit                   Description                      Pages   Size 

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                          Matthews Dated January 20, 2003                        
16: EX-10.54    Separation Agreement and Release With Michael         13     59K 
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Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2002

Commission File Number 000-31147

DELTAGEN, INC.

(Exact name of registrant as specified in its charter)

700 Bay Road Redwood City, California 94063

(Address of principal executive offices) (Zip Code)

Telephone Number: (650) 569-5100

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

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

Common Stock $0.001 Par Value

(Title of Class)

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, computed by reference to $2.45, the closing price of Deltagen common stock as reported on the NASDAQ National Market on June 30, 2002, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $49,838,000. Shares of common stock held by each officer and director and by each person who owned 5% or more of the registrant’s outstanding common stock on that date have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

At March 31, 2003, the number of shares outstanding of registrant’s Common Stock was 39,144,337.

DOCUMENTS INCORPORATED BY REFERENCE

The registrant intends to file a definitive proxy statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended December 31, 2002. Portions of such proxy statement are incorporated by reference into Part III (Items 10, 11, 12 and 13) of this Annual Report on Form 10-K. In the event that the registrant is unable to file such definitive proxy statement by such time, it intends to file an amendment to this Annual Report on 10-K to provide certain disclosures required in Part III (Items 10, 11, 12 and 13) of this Report.

Table of Contents

DELTAGEN, INC.

 INDEX TO ANNUAL REPORT ON FORM 10-K

For the fiscal year ended December 31, 2002

Table of Contents

INFORMATION REGARDING FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements. The forward-looking statements are contained principally in the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” These statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performances or achievements expressed or implied by the forward-looking statements. Forward-looking statements include, but are not limited to, statements about:

This report contains information regarding the biotechnology and pharmaceutical industries that we obtained from private and public industry publications. These publications generally indicate that they have obtained their information from sources believed to be reliable, but do not guarantee the accuracy and completeness of their information. Although we believe that the publications are reliable, we have not independently verified their data.

In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “potential” and similar expressions intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We discuss many of these risks in this prospectus in greater detail under the heading “Risk Factors.” Also, these forward-looking statements represent our estimates and assumptions only as of the date of this report.

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 PART I

Item 1.      Business

Overview

Deltagen is a leader in using in vivo derived mammalian gene function information to define the function and disease relevance of mammalian genes for the purposes of discovering and validating novel drug targets. Our proprietary information platform serves our major pharmaceutical partners and customers in their efforts to discover potential new drug therapies.

Our products, based on our platform technology, provide databases of in vivo mammalian gene function information on target genes of interest to drug researchers. We delete, or “knock out”, these genes in mice and then utilize an extensive, integrated analysis program to assess the function and potential pharmaceutical relevance of these genes and the proteins these genes encode.

Our current customers and partners include many of the world’s largest pharmaceutical companies, such as Eli Lilly and Company, GlaxoSmithKline plc, Merck & Co., Inc., Pfizer Inc. and Schering-Plough Research Institute as well as significant biotechnology and biopharmaceutical companies including Millennium Pharmaceuticals, Tanox, Inc., Nuvelo, Inc. and Lexicon Genetics Incorporated.

We are implementing a strategy to integrate our:

We believe that our ability to determine gene function is a result of our leveraging of our technology platforms. Our genomics technologies, processes and information systems are integrated with one another and generate information on the function and relationships between genes and the proteins these genes encode and the usefulness of genes as new drug targets and proteins as new drug candidates. We have used these systems to establish and develop our products and programs that include our:

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Background

Overview

Pharmaceutical and biotechnology companies are continually challenged to develop and market increased numbers of drugs. This challenge has led to increased research and development spending and the development of a new research focus called genomics-based drug discovery. This new research effort involves understanding the relationship between genes and the functions they regulate. An organism’s genetic information, or genome, is comprised of deoxyribonucleic acid, or DNA molecules. DNA itself is comprised of four different chemical subunits called nucleotide bases that are strung together in a precise sequence. Encoded within a DNA sequence are discrete sets of instructions, or genes, that collectively serve to regulate our biological processes by producing proteins. Alterations or mutations in these gene sequences form the basis of many diseases.

Understanding the critical role that genes play in regulating biological processes and disease has led to efforts to obtain information on all the genes contained within the human genome and the genomes of other organisms. International public and private genomics projects have generated vast amounts of data and identified many of the genes within the human genome. The human genome is believed to be comprised of approximately three billion nucleotide bases that encode approximately 30,000 to 40,000 genes. Approximately 3,000 to 10,000 of these genes and the proteins these genes encode may have potential as drug targets and drug candidates. Seeking to capitalize upon the opportunity to discover new drug targets, pharmaceutical, biotechnology and genomic companies are rapidly pursuing genomics-based drug discovery programs. We believe that a system that will enable a more rapid commercialization of these newly discovered genes and the proteins these genes encode can be of significant value to drug manufacturers.

Genomics-based drug discovery generally consists of:

Pharmaceutical, biotechnology and academic researchers have performed the initial task of identifying genes. However, identifying the genes is only the first hurdle of several significant current impediments to genomics-based drug discovery. The next key hurdles are determining gene function, identifying which genes can serve as viable drug targets and which proteins encoded by these genes can serve as viable drug candidates. Determining gene function with respect to a biological process or disease is a complex undertaking that requires extensive and detailed physiological analysis.

Discovering Gene Function

The scientific community has attempted to find efficient methods of determining the functions of individual genes for several decades. This process is particularly challenging for the pharmaceutical industry because drug development requires a very precise understanding of potential drug discovery targets. It is important that a pharmaceutical or biotechnology researcher understands all the possible ramifications of targeting a gene or its associated protein with a drug, including any potentially serious side effects of drug administration.

The drug discovery and development process is an expensive, time-consuming and lengthy process. Before a gene can be selected as a candidate for the drug discovery and development process, its complete functional role must be determined as thoroughly as possible. Determining whether a gene is a relevant target for drug discovery is a process termed target validation. Currently, researchers generally use the standard or genetic approaches to drug target discovery and validation described below.

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Standard Approach to Target Discovery and Validation

The objective of the standard approach to target discovery is to sort through the tens of thousands of gene sequences to find ones that can be analyzed using current techniques for determining in vivo biology, or the function of the gene in a living organism. Under the standard approach, researchers:

The standard approach to target discovery is a time consuming, expensive and multi-staged process in which only a limited number of genes reach the final steps of the validation process. The lack of in vivo data early in this process can lead to the selection of genes based on criteria that do not necessarily or accurately reflect their functions in a living organism. This can lead to significant wasted time, effort and expense in selecting genes that represent valid targets.

Genetic Approach to Target Discovery and Validation

Since the function of a gene in an animal can vary widely from its function as determined by in vitro studies, it is preferable to obtain in vivo data at an early stage in the drug discovery process. To accomplish this, some pharmaceutical and biotechnology companies have employed a genetic approach that initially uses non-mammalian organisms to determine in vivo function. Under the genetic approach, researchers:

The genetic approach to target discovery is subject to a number of limitations. Under the genetic approach, researchers randomly mutate the genome. This may result in the identification of genes with interesting functions; however, these genes may not become valid drug targets because only certain subsets of genes are amenable to current drug discovery methods. In addition, since lower organisms are far less complex than mammals, they do not have many of the mammalian genes and their corresponding physiological functions. Thus, while lower organisms can provide information on gene function similarity with humans, their ability to provide information concerning how genes control mammalian physiology is limited. As a result, validation typically requires mammalian studies that are traditionally time-consuming and costly.

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Determining Mammalian Gene Function

During the past decade, the preferred method for determining a gene’s function in mammals has been to disrupt, or knock out, the gene in a mouse and to assess the physiological, pathological and behavioral consequences of removing the gene from the animal. The results of this analysis can determine the function and disease relevance of a particular gene and the potential of the gene and the protein encoded by that gene as a drug target or drug candidate.

Mice and humans are both higher mammals, and their genomes are similar in size and gene content. Therefore, performing knockouts of genes in mice has advantages over studies in non-mammalian organisms for defining the function and disease relevance of human genes. Additionally, mice are one of the few mammals for which approaches to genetic manipulation have been established. Because of the high degree of physiological and genetic similarity between mice and humans, the mouse gene knockout system has the potential to become an effective and widely accepted model for target validation studies.

A drawback of this model though has been the low-volume, high-cost and commercially unfeasible time-frames for production. Traditional approaches to create mouse knockouts allow a research team to create only a limited number of knockouts per year. As a result, mouse knockouts have often been used as the last step of the target validation process, if at all.

Despite the time-frame and labor intensive nature of the process, the academic scientific community has adopted the mouse knockout as a model for gene function studies. Information from these studies is often publicly available. However, this information is often fragmentary, difficult to obtain and is selectively and non-uniformly reported. In addition, when such information is available, it can be difficult to cross-reference or compare using standardized medical/scientific vocabulary or to compare with pre-existing models of disease.

Collectively, these limitations have made mouse knockouts difficult to use as a first-line drug discovery tool despite their utility in determining gene function.

Our Solution

We have developed an integrated target validation system that provides gene function information based on mouse knockouts at early stages of drug target discovery. Our solution moves directly from gene identification to determination of gene function in a mammalian organism on a commercially viable scale. Through our high-throughput system, targets are more readily identified and made available to our pharmaceutical partners and customers.

We utilize proprietary molecular biology systems to more efficiently knock out genes in mice on a large scale and conduct a detailed analysis of the resulting physiological, pathological and behavioral effects in these mice. As a result, we assess the function of the gene in a mammal that is closely related genetically and physiologically to humans.

We believe our technology platform and approach offers significant advantages over the standard and genetic approaches, including:

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In addition to our gene function database programs, we have collaborative programs to discover novel, commercially relevant secreted proteins. Secreted proteins are proteins that play an important role in the formation, regulation, growth and maintenance of multi-cellular organisms. Examples of well-known secreted proteins discovered by other companies include insulin, human growth hormone, or HGH, and erythropoeitin, or EPO. Using our core technology platforms, along with our other proprietary technologies, we have developed a secreted protein program that identifies and defines the mammalian in vivo function of mammalian secreted proteins. Specifically, we have proven genetic technologies that allow us to more rapidly identify and knock out secreted proteins in mice. We believe that our secreted protein discovery programs provide a foundation for developing and commercializing proprietary therapeutic protein products.

Our Strategy

Over the past six months we have undertaken significant cost reduction actions. These actions will reduce the number of employees from a peak of approximately 450 in 2002 to approximately 150 by April 2003 and reduce the number of facilities from ten in 2002 to two facilities by April 2003 with the announced intention of

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having a single facility by mid 2003. The remaining facility will be 132,000 square feet and includes state-of-the-art animal vivarium and laboratory space as well as housing our sales and administrative personnel. At the same time we have discontinued our internal drug discovery efforts and have refocused our strategies and operations on providing drug discovery services to the biopharmaceutical industry utilizing our proprietary core mammalian in vivo transgenic technologies.

In April 2003, we secured a minimum commitment for $10 million in equity capital from existing institutional investors to purchase preferred stock in a transaction referred to here in as the private placement. The private placement is subject to shareholder approval and the satisfaction of closing conditions. In addition to the terms of the private placement, our stockholders will be asked to approve a number of other matters including a reverse stock split.

Under the terms of the private placement, the investors have agreed to purchase $10 million of preferred stock. The preferred stock is convertible into common stock on a 1:1 basis. The preferred stock will be issued at a 25% discount to the five-day average closing common stock price for the period ending three days prior to closing. The preferred stock bears no dividend, has a liquidation preference right equal to the amount invested in the preferred stock and standard and-dilution protections. The terms of the preferred stock agreement include the right to appoint designees to a total of three seats on the Board of Directors.

In connection with the private placement, we have agreed to use reasonable best efforts, as soon as reasonably practicable after the closing of the private placement, to offer stockholders of record as of the last business day prior to the closing of the private placement (other than the investors in such financing) non-transferable rights to purchase newly issued preferred stock at the same purchase price paid by the investors. The amount of preferred shares so offered to each stockholder would be sufficient to allow each such stockholder to maintain the percentage ownership interest in Deltagen, held by each such stockholder as of the last business day prior to the closing of the private placement.

Our goal is to continue to be a leader in providing in vivo derived gene function information to define the function and disease relevance of mammalian genes for the purpose of discovering and validating novel drug targets for the pharmaceutical and biotechnology industries. We believe our data will improve the speed, efficiency and effectiveness of drug discovery, thereby benefiting our pharmaceutical partners and customers. As we have a limited operating history and an unproven business strategy, we cannot assure you that we will succeed in achieving our goals. The key elements of our strategy include:

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Our Products and Programs

We have developed and plan to continue to develop technologies, products and programs that elucidate the function and disease relevance of genes in mammalian organisms. We are developing, refining and expanding the following products and programs:

DeltaBase

Overview

DeltaBase is our proprietary database that provides information, based on knockout mouse studies, on gene function for drug discovery. We created DeltaBase to be marketed to the pharmaceutical and biotechnology industries to help define the role that genes play in biological processes and disease. We believe that DeltaBase is a valuable resource for mammalian gene function information.

DeltaBase has been expanding by the addition of approximately 250 different mammalian genes each year. Genes are selected for DeltaBase based on their potential to become useful drug targets. We generate information on these genes by comprehensively analyzing knockout mice generated through our proprietary, gene knockout methods. Each knockout mouse undergoes a standardized, detailed and extensive analysis in order to determine the function and role that a particular gene plays in the mouse. We believe that the body of gene function information delivered under DeltaBase provides an advantage to the drug discovery efforts of pharmaceutical and biotechnology companies by reducing the time required for target validation.

Additionally, DeltaBase subscribers have access to the knockout mice used to generate this data. Access to these animals will allow DeltaBase subscribers to more rapidly pursue specific areas of interest.

DeltaBase Technologies

We designed DeltaBase to provide our subscribers with the ability to compare resulting phenotypic and gene function data across hundreds of different mammalian genes from different gene families selected for their potential commercial relevance to drug discovery. In order to generate, analyze, store, manipulate and deliver such large volumes of data and information, we have developed proprietary, high-volume, assembly-line methods to:

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Marketing and Customer Agreements

As of the end of 2002, we had DeltaBase agreements with GlaxoSmithKline, Merck, and Pfizer. Each of these agreements provides for payments aggregating approximately $15 million for non-exclusive access to information related to 750 genes selected for their biological interest that have been functionally characterized and entered into DeltaBase. Under the current DeltaBase agreements, GlaxoSmithKline, Pfizer, and Merck have the right to access DeltaBase information on gene function based upon knockout mouse studies. As of December 31, 2002, information related to 125-150 genes remain to be provided under these agreements.

During 2002, we entered into two DeltaBase access agreements with Schering-Plough Research Institute (“Schering-Plough”) and Tanox, Inc. (“Tanox.”) These agreements provide for payments aggregating approximately $3.2 million and $545,000, respectively. Under the agreements, Schering-Plough and Tanox have non-exclusive access to a subset of DeltaBase that contains in vivo mammalian gene function information on certain genes.

In September 2001, Lexicon Genetics became a subscriber to DeltaBase as part of our litigation settlement with Lexicon. Lexicon’s subscription to DeltaBase includes non-exclusive, perpetual licenses to the 250 drug targets represented in DeltaBase as of September 2001 and the approximately 1,000 drug targets that were and are expected to be added to DeltaBase over the subsequent four years. Lexicon pays no subscription fees but will make certain milestone and royalty payments to us for therapeutic and diagnostic products developed from Lexicon’s use of DeltaBase.

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In May 2001, we entered into a DeltaBase access agreement with Vertex. Under the agreement, Vertex received non-exclusive access to a subset of DeltaBase that contains in vivo mammalian gene function information on kinases, proteases and certain other gene families. In February 2003, we received notice that Vertex was terminating the agreement.

The DeltaBase agreements grant certain non-exclusive, worldwide licenses to knockout mice, materials and intellectual property rights under DeltaBase. In addition to the foregoing subscription licensing fees, we may receive additional payments based upon the achievement of designated milestones. We cannot assure you that we will receive any milestone payments since payments are dependent upon the research, development and commercialization activities of our customers; and Deltagen’s intellectual property position.

DeltaOne

We recently launched a product line known as DeltaOne that offers access to our extensive DeltaBase portfolio of knockout mice and/or accompanying phenotypic data, as well as any corresponding intellectual property, on a gene-by-gene basis. Our current customers include Aventis Pharmaceuticals, Euroscreen S.A. and Millennium Pharmaceuticals. Through December 31, 2002, we have recognized revenue of $400,000 related to our DeltaOne program.

Secreted Protein Program

Overview

Secreted proteins represent proteins that are synthesized for export from the cell or to the surface membrane of the cell where they play a role in the communication between cells. These communication roles are essential for the formation, regulation, growth and maintenance of multi-cellular organisms. Examples of well-known secreted proteins discovered by other companies include insulin, human growth hormone and erythropoeitin, or EPO.

Secreted Protein Agreements and Collaborations

In August 2001, we entered into a secreted protein agreement with Eli Lilly (“Lilly”) to evaluate, and potentially develop and commercialize, therapeutic secreted proteins. Under the terms of the agreement, Lilly has provided potential targets from its secreted protein pipeline for which we will further evaluate the therapeutic potential in mammalian models. Among those secreted proteins with potential therapeutic value, each company may select proteins for commercial development, with each company receiving royalties based on sales of therapeutic products. The agreement provides Lilly with certain acquisition, co-promotion, co-marketing and profit-sharing options with respect to therapeutic products developed and commercialized by us. The agreement also provides us with certain co-promotion, co-development and profit-sharing opportunities.

In October 2001, we entered into a collaboration agreement with Nuvelo, formerly Hyseq, to research, develop and commercialize biopharmaceutical products based on secreted proteins. Under the terms of the agreement, Nuvelo has provided us with gene sequences encoding secreted proteins and we will utilize our proprietary in vivo mammalian gene knockout technology to discover and validate potential commercially relevant biopharmaceutical drug targets. We and Nuvelo will each have certain joint development and commercialization rights around potential biopharmaceutical drug targets discovered through the collaboration. We and Nuvelo will share the collaboration’s costs; Nuvelo will provide us with approximately $8 million in research and development payments over two years. In addition, we received $10 million in equity proceeds from the sale of shares of our common stock to George B. Rathmann, Ph.D., chairman of the Board of Directors of Nuvelo.

DeltaSelect

Overview

DeltaSelect is our custom gene knockout program that uses the platform technology employed in our DeltaBase database program. Our DeltaSelect program is different, however, because our customers select and

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identify to us the particular genes that they wish to have knocked out in mice. We provide customers with access to our gene knockout technologies and the resulting knockout mice, data and information generated under each DeltaSelect program. The revenues generated from the DeltaSelect program have been $585,000, $1.3 million and $926,000 in 2002, 2001 and 2000, respectively, and since 2000 have become a lower percentage of total revenues per year. We anticipate that revenues from DeltaSelect will continue to become less significant to total revenues and that DeltaSelect will be utilized only under very limited circumstances to develop new technologies, product offerings and programs in collaboration with pharmaceutical companies.

We have produced customized knockout mice at the direction of our customers for a limited number of pharmaceutical companies. Currently, we have outstanding DeltaSelect knockout programs under agreements with Eli Lilly, GlaxoSmithKline, Merck and Schering-Plough Research Institute.

DeltaSelect Technology

In addition to the proprietary platform technology developed by us, we are currently employing and developing additional technologies that can be used to create conditional knockout mice. Conditional knockout mice are mice where the gene of interest is removed under unique conditions in a specific tissue or cell type at selected and controlled times. We are currently developing conditional knockout systems for our DeltaSelect program using Cre/lox and FLP/FRT recombinase technologies.

Research Collaborations

We also enter into various research collaborations with select leading academic and other research institutions. In these research collaborations, we offer access to knockout mice to the institutions so that they can perform additional studies and analysis.

On February 19, 2002, we announced that we had signed a target validation and research collaboration agreement with Stanford University. Under the terms of the three-year collaboration, we and Stanford will mutually develop research projects for jointly selected genes under which we will provide Stanford non-exclusive access to knockout mice models using our proprietary high-throughput technology and Stanford will evaluate and conduct research on such materials. We will have options to obtain exclusive licenses to commercially develop in any and all fields certain inventions developed by Stanford. We will have rights to use, commercialize and sublicense results developed by Stanford under the research projects.

Customers

In 2000, we entered into DeltaBase Agreements with GlaxoSmithKline and Pfizer that provide these companies the right to access DeltaBase information on gene function. In 2001, as part of our litigation settlement, we entered into a DeltaBase Agreement with Lexicon Genetics Incorporated. Also, in 2001, we entered into secreted protein agreements with Lilly and Nuvelo. In early 2002, we entered into a DeltaBase Agreement with Merck.

In 2002, we entered into DeltaOne agreements with Aventis Pharmaceuticals, Euroscreen S.A. and Millennium Pharmaceuticals that offer access to our DeltaBase portfolio of knockout mice and/or accompanying phenotypic data, as well as any corresponding intellectual property on a gene-by-gene basis.

Under our DeltaSelect program, we have entered into arrangements with major pharmaceutical companies where we produce customized standard, or unconditional, knockout mice. We have performed services or have continuing obligations under our DeltaSelect program for Schering-Plough Research Institute, Merck, Tularik, Inc. and GlaxoSmithKline. However, we plan to pursue future DeltaSelect arrangements only in very limited circumstances; therefore, we expect that there will be few, if any, new DeltaSelect customers.

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GlaxoSmithKline, Merck and Pfizer accounted for 23%, 35% and 25%, respectively, of our revenues in 2002.

Research and Development

Including our subsidiaries, as of December 31, 2002, we employed a total of 290 full-time equivalent employees, of which 210 were dedicated to research and development activities. We have spent substantial funds over the past three years to develop our database and other programs and expect to continue to do so in the future. Research and development expenses were $71.3 million, $45.0 million, and $26.3 million in 2002, 2001 and 2000, respectively. Since December 31, 2002 we have had reductions-in-force and now employ a total of 150 full-time equivalent employees, of which approximately 120 were dedicated to research and development activities.

Closure of Arcaris, Inc.

On July 30, 2001, we acquired Arcaris, Inc. (“Arcaris”). Located in Salt Lake City, Utah, Arcaris had developed technologies consisting of genetic, proteomic and cell-biological systems for identification and validation of drug targets and the creation of small molecule screens. The total purchase price of approximately $3,931,000 consisted of cash of approximately $450,000 and 766,894 shares of common stock valued at approximately $6,751,000 and 77,329 vested stock options valued at approximately $418,000 and direct acquisition costs of approximately $312,000. In October 2002, we issued an additional 94,095 shares of common stock related to certain earn out provisions. The acquisition was accounted for using the purchase method of accounting. The subsidiary was renamed Deltagen Proteomics, Inc.

On January 6, 2002 we announced a cost savings and business realignment plan to reduce our cash expenditures. As part of this realignment plan, we closed the Salt Lake City facility that housed the Deltagen Proteomics, Inc. operations. As a result of the realignment plan, substantially all Deltagen Proteomics, Inc. activities and capabilities have ceased or been eliminated.

Acquisition and of Closure of BMSPRL, L.L.C. (formerly CombiChem, Inc.)

On February 16, 2002, we acquired the California-based BMSPRL, formerly known as CombiChem, Inc., from Bristol-Myers Squibb Company for 2,647,481 unregistered shares of our common stock valued at approximately $23,510,000 and paid certain transaction expenses of approximately $465,000. The subsidiary was renamed Deltagen Research Laboratories (“DRL”).

On October 2, 2002 we announced a cost savings and business realignment plan to reduce our cash burn rate. As part of this realignment plan, we closed the San Diego facility that housed the DRL operations. As a result of the realignment plan, substantially all DRL activities and chemistry capabilities have ceased or been eliminated.

Acquisition of XenoPharm, Inc.

On March 14, 2002, we acquired XenoPharm, a San Diego, California-based private company for 498,236 shares of our unregistered common stock valued at approximately $3.6 million and paid certain transaction expenses. Up to an additional 1,449,262 shares of common stock may be issued upon the achievement of certain key milestones. The entity became our wholly-owned subsidiary. XenoPharm, which was incorporated in November 2000, provides a proprietary technology platform to pharmaceutical, biotechnology, chemical and agricultural companies to better understand and predict reactions of foreign substances, named “xenobiotics” in human systems. XenoPharm’s XenoSensor Mice, implanted with human SXR and CAR, coupled with XenoPharm’s CleanScreen high-thoughput screening assays provide a proprietary technology platform to improve the predictive value of cell- and animal-based biomedical research.

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Intellectual Property

Our policy is to pursue patent protection in the United States around our commercially relevant products, techniques and methods. We cannot assure you, however, that we will have the financial and staffing resources to pursue patent production on all of our commercially relevant products and methods, or that any of our applications on file with the USPTO will result in the issuance of any patents, that our patent applications will have priority over others’ applications, or that, if issued, any of our patents will offer protection against our competitors. Additionally, we cannot assure you that any patent issued to us will not be challenged, invalidated or circumvented in the future or that the rights created thereunder will provide a competitive advantage. Litigation may be necessary to enforce any patents issued to us, to protect trade secrets or know-how owned by us or to determine the enforceability, scope and validity of the proprietary rights of others.

Others may have filed and in the future are likely to file patent applications that are similar or identical to ours. To determine the priority of inventions, we may have to participate in interference proceedings declared by the USPTO that could result in substantial cost to us. We cannot assure you that any patent application of another will not have priority over patent applications filed by us. Our commercial success depends in part on our neither infringing patents or proprietary rights of third parties nor breaching any licenses that may relate to our technologies and products.

In addition, in certain patent offices around the world, third parties may institute opposition proceedings against our patent applications, in an effort to prevent their issuance as patents, or against issued patents that we may obtain. Such opposition proceedings may involve substantial costs and time to defend. In these instances, we cannot assure you that such third parties will not succeed in opposing the issuance of our patents or prevent the continued validity of our issued patents.

We have obtained licenses for certain technologies. However, we cannot assure you that we will be able to obtain licenses for technology patented by others on commercially reasonable terms, if at all, that we will be able to develop alternative approaches if unable to obtain licenses, or that our current and future licenses will be adequate for the operation of our business. Our failure to obtain necessary licenses or to identify and implement alternative approaches could have a material adverse effect on our business, financial condition and results of operations.

We also rely upon trade secrets, technical know-how and continuing invention to develop and maintain our competitive position. We cannot assure you that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or disclose such technology, or that we can meaningfully protect our trade secrets, or that we will be capable of protecting our rights to our trade secrets.

On May 24, 2000, Lexicon Genetics Incorporated filed a lawsuit against us in the United States District Court for the District of Delaware. The complaint in the lawsuit alleged that our methods of making knockout mice infringed United States Patent No. 5,789,215, the ’215 patent, under which Lexicon claimed to be an exclusive licensee. In addition, on October 13, 2000, Lexicon and the University of Utah Research Foundation filed a lawsuit against us in the United States District Court for the Northern District of California. The complaint in this lawsuit alleged that we infringed United States Patents Nos. 5,631,153, 5,464,764, 5,627,059 and 5,487,992, or the Capecchi patents, under which Lexicon claimed to be an exclusive licensee. On September 20, 2001, we and Lexicon announced the settlement of the litigation. Under the terms of the settlement, we obtained a commercial license under the ’215 patent and the Capecchi patents, Lexicon obtained a subscription to our DeltaBase product, and all of the claims and counterclaims in the litigation were dismissed with prejudice. Lexicon’s subscription to DeltaBase includes non-exclusive, perpetual licenses to the 250 drug targets represented in DeltaBase as of September 2001 and the approximately 1,000 drug targets that were and are expected to be added to DeltaBase over the subsequent four years. Lexicon will make certain milestone and royalty payments to us for therapeutic and diagnostic products developed from Lexicon’s use of DeltaBase. We will make payments to Lexicon for knockout mice generated by us on a fee-for-service basis. Neither we nor Lexicon will pay the other party any subscription or license fees.

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Competition

We face significant competition in the area of genomics-based research from for-profit companies such as Celera Genomics, Curagen, Inc., Exelixis, Inc., GeneLogic, Inc., Human Genome Sciences, Inc., Incyte Pharmaceuticals, Inc., Lexicon Genetics Incorporated and Millennium Pharmaceuticals, Inc., among others, many of which have substantially greater financial, scientific and human resources than we do. In addition, the Human Genome Project and a large number of universities and other not-for-profit institutions, many of which are funded by the U.S. and foreign governments, are also conducting research to discover genes and their function.

We face, and will continue to face, significant competition in our efforts to validate drug targets and to secure funding for research. Many other companies have or are developing capabilities in the use of living organisms, including the analysis of human genetic profiles, to define gene function. These competitors include such companies as Lexicon Genetics Incorporated, Exelixis, Inc., Nuvelo, Inc., deCODE Genetics Inc. and Devgen N.V. Additionally, many genomics companies may expand their capabilities to determine gene function. We also believe that some pharmaceutical and biotechnology companies are discussing the possibility of working together to discover the functions of genes and share gene function-related data among themselves. The formation of this type of consortium could reduce the customer base for our gene function-related business. Further, as we expand our range of programs, products and services, such as our secreted protein program, we will compete with additional companies, many of which have substantially greater financial, scientific and human resources than we do and some of which may be our customers at that time or potential customers including, Merck, GlaxoSmithKline and Pfizer. We may also be competing directly with biotechnology drug companies, such as Genentech Inc., Amgen Inc. and Abgenix Inc., that have significantly greater experience and expertise in discovering and developing biopharmaceuticals, such as secreted proteins.

Companies focused specifically on other organisms, such as fruit flies, worms and yeast, use methods of identifying potential drug targets that are different than ours. In addition, pharmaceutical, biotechnology and other genomics companies, as well as a number of universities and other not-for-profit institutions, are seeking to develop competing technologies. Many of these competitors have substantially greater financial, scientific and human resources than we do. Many of these competitors also have substantially greater experience than we do in their respective fields. As a result, our competitors may succeed in developing products and technologies earlier than we do or in developing products and technologies that are more effective than ours.

We believe that the principal competitive factors in selling our products and services are the quality and reliability of the gene function information, the volume of the gene function information, the features and ease of use of database products and the cost and pricing of competing products. We believe that we compete favorably with respect to these factors; however, our market is rapidly changing and we expect to face further competition from new market entrants and consolidation of our existing competitors.

Government Regulation

Regulation of Animal Use

The federal Animal Welfare Act, or AWA, governs the humane handling, care, treatment and transportation of some animals used in research activities in the United States. Rats, birds and mice, including the mice in our knockout programs, are currently excluded from the definition of “animal” and, therefore, are not subject to regulation under the AWA. However, the United States Department of Agriculture, which enforces the AWA, has been sued on this matter and agreed, as part of the settlement of this lawsuit on September 25, 2000, to begin the process of changing the regulations issued under the AWA to include rats, mice and birds within its coverage. Congress subsequently prohibited, in the Agricultural Appropriations Act for fiscal year 2001 and again for fiscal year 2002, the expenditure of any money or the commencement rulemaking for the purpose of changing the regulations with respect to including rats, mice and birds prior to October 1, 2002. We cannot predict whether mice will at any time after such date be included under the AWA.

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The AWA imposes a wide variety of specific regulations on producers and users of animal subjects, most notably personnel, facilities and statistical standards, cage size, feeding, watering and shipping conditions and environmental enrichment methods. If the USDA decides to include mice in its regulations, we could be required to alter our production operation for these models, including adding production capacity, new equipment and additional employees. It is possible that the USDA’s actions will negatively affect our operations. In addition, although we do not anticipate the addition of mice to the AWA, if such addition were to happen, to require significant expenditures, it is possible that the AWA, when amended, may be more stringent than we expect and require significant expenditures. Any future amendments to the AWA or other laws or regulations may also require significant expenditures by us.

Furthermore, some states have their own regulations, including general anti-cruelty legislation, which establish certain standards in handling animals. To the extent that we provide products and services overseas, we also have to comply with foreign laws, such as the European Convention for the Protection of Animals During International Transport and other anti-cruelty laws. The Council of Europe is presently considering proposals to more stringently regulate animal research.

Regulation of Genetically Modified Organisms

Since we are in the business of developing animals containing changes in their genetic make-up, we may become subject to a variety of laws, guidelines, regulations and treaties specifically directed at genetically modified organisms, or GMOs. The area of environmental releases of GMOs is rapidly evolving and is currently subject to intense regulatory scrutiny, particularly internationally. Current laws, guidelines and other requirements typically include confinement requirements for preventing the spread of GMOs into the environment. Examples of these guidelines in the U.S. include the National Institutes’ of Health “Guidelines for Research Involving Recombinant DNA Molecules” and the USDA’s “Guidelines for Research Involving the Planned Introduction into the Environment of Genetically Modified Organisms”. Although these guidelines typically apply only to federally-funded activities, if we were to become subject to similar laws in the future, we could incur compliance costs.

The Biosafety Protocol, or the BSP, is also of particular importance to our international operations. The BSP, a treaty adopted in Montreal, Canada in late 1999, is expected to be ratified in many countries, although the timeframe is uncertain. Many industrialized and non-industrialized countries will be signatories to the BSP. Although the U.S. is not subject to the BSP, if ratified, the BSP is expected to cover shipments from the U.S. to countries abroad that have signed the BSP. The BSP is also expected to cover the importation of living modified organisms, a category that could include our animals. If our animals are not contained as described in the BSP, our animals could be subject to the potentially extensive import requirements of countries that are signatories to the BSP.

Other Regulations

We are also subject to a variety of other federal and state laws and regulations in the U.S. and in other countries pertaining to our facilities, the shipment, exportation and importation of various articles and health and safety matters. For example, the Department of Transportation and various international guidelines and regulations govern the transport of different types of materials. The Bureau of Export Administration of the Department of Commerce exercises export controls over technology such as our gene database. The Department of Health and Human Services and USDA both regulate various types of articles that present the possibility of spreading communicable and other diseases, including the regulation of vectors, such as animals and articles that present risks of other harm to plants, human beings and other animals. The Environmental Protection Agency has responsibility for facility emissions and other environmental matters, including the regulation of new chemical substances, which could include gene sequences.

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Employees

As of December 31, 2002, we employed 268 employees. After taking into account part-time employees and contractors, we employed 290 full-time equivalent employees as of that date. Of these, 41 hold Ph.D.s and 15 hold other advanced degrees. None of our employees are represented by a labor union. We consider our relations with our employees to be good. Reductions-in-force subsequent to December 31, 2002 have reduced the number of employees to approximately 150.

Executive Officers of Registrant

Joseph M. Limber has served as our Interim Chief Executive Officer since April 2, 2003. Mr. Limber will assume the position of President and Chief Executive Officer and will join the board of directors contemporaneously with the closing of our preferred stock private placement announced on April 4, 2003. Prior to joining us, Mr. Limber was President and Chief Executive Officer of ACLARA BioSciences, Inc., from 1998 to 2002. Prior to that time, he served as President and Chief Operating Officer of Praecis Pharmaceuticals, Inc. from 1996 to 1998. He was with Sequus Pharmaceutical as Executive Vice President and Vice President, Marketing and Sales from 1993 to 1996. He was with Syntex International, Inc. as International Marketing Director and Group Product Director from 1987 to 1992, and with Ciba-Geigy Corporation in various commercial positions including sales management and marketing from 1975 to 1987. Mr. Limber received his B.A. in Liberal Arts from Duquesne University. He is currently a member of the board of directors of ACLARA BioSciences, Inc. and VITEX.

Mark W. Moore, Ph.D., a co-founder of our company, has served as our Chief Scientific Officer and Treasurer since February 1997. Prior to founding our company, Dr. Moore worked from August 1991 to January 1997 at Genentech, Inc. where he established and directed Genentech’s gene knockout program in mice. Dr. Moore was a Leukemia Society of America post-doctoral fellow in molecular and cellular immunology in the laboratory of Dr. Michael Bevan at Scripps Clinic. Following his post-doctoral work, Dr. Moore served on the faculty of the Norris Cancer Center at the University of Southern California. Dr. Moore received his A.B. in biochemistry from Princeton University and his Ph.D. in biology from Brandeis University.

Richard H. Hawkins has served as our Chief Financial Officer since September 2000. Prior to joining us, Mr. Hawkins was an independent consultant. From March 1984 until July 1999, Mr. Hawkins was employed by McKesson Corporation where he served as Chief Financial Officer from September 1996 until July 1999. Mr. Hawkins received his B.S. in Chemistry from Stanford University and his M.B.A. from the University of Chicago. He is a licensed Certified Public Accountant. In April 2003, Mr. Hawkins announced that he will be leaving the Company once the transition to a new Chief Financial Officer has been completed.

Other Key Employees

Terry R. Coley, Ph.D., has served as our Vice President of Information Technology since September 1999. Prior to joining us, Dr. Coley was co-founder and Chief Executive Officer of Virtual Chemistry, Inc., from January 1996 to August 1999. At Virtual Chemistry, Dr. Coley established software teams to engineer custom software for biotechnology and pharmaceutical companies. Prior to that time, Dr. Coley worked as a molecular modeling software development project leader at Molecular Simulations Inc. Dr. Coley received his B.S. in chemistry and computer science from the University of Illinois and his Ph.D. in computational chemistry from the California Institute of Technology.

Robert J. Driscoll, J.D., Ph.D., currently serves as our Associate General Counsel and Senior Director of Intellectual Property, having previously served from 1999 to 2001 as our Technology Counsel. Prior to joining us, Dr. Driscoll was a patent and intellectual property attorney with the law firm of Pillsbury Madison & Sutro LLP, where he represented clients in the biotechnology, chemistry and pharmaceutical industries. From 1993 through 1996, Dr. Driscoll was a law clerk and scientific consultant with the law firm of Lyon & Lyon LLP.

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Dr. Driscoll received his J.D. from Loyola Law School, his Ph.D. in chemistry from the California Institute of Technology and his B.Sc. in chemistry from the State University of New York at Purchase. Dr. Driscoll is a registered patent attorney, admitted to practice before the United States Patent & Trademark Office, and is a member of the California state bar.

Robert Klein, Ph.D., has served as Vice President of Technology Development since June 2000. Prior to that time, Dr. Klein held positions as Director of Molecular Biology from June 1998 through June 2000 and Senior Scientist from May 1997 through June 1998 at Deltagen. Prior to joining Deltagen, Dr. Klein worked at Genentech, Inc. from August 1993 through May 1997 where he was involved in Genentech’s functional genomics program. Dr. Klein also served as a project team leader for Genentech’s lead protein therapeutic for treatment of Parkinson’s disease. Dr. Klein received his A.B. in biochemistry from the University of California at Berkeley and his Ph.D. in biology from the Massachusetts Institute of Technology.

Kay Slocum has served as our Vice President of Human Resources since March 2001. Prior to joining us, Ms. Slocum was Vice President of Human Resources at Coulter Pharmaceuticals, Inc. from 1996 until February 2001. She served as an independent consultant from 1995 to 1996. From 1993 to 1995, Ms. Slocum was Manager, Corporate Employee Development of Varian Associates, Inc. Ms. Slocum holds a B.A. in Sociology from Southern Illinois University and a M.S. in Industrial Relations from Loyola University of Chicago.

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RISKS

We may be unable to complete the private placement.

As more fully described in Part I of this report under the heading “Overview,” on April 2, 2003, we entered into a definitive purchase agreement with certain investors to raise a minimum of $10 million through the issuance of Series A Preferred Stock. Consummation of the transactions contemplated by the purchase agreement is subject to our obtaining stockholder approval and other closing conditions. If we are not able to complete the private placement on time, it is likely that we will cease our operations. Our inability to obtain additional funding through the private placement would likely cause us to explore liquidation alternatives, including the initiation of bankruptcy proceedings. If this were to occur, after repayment of our obligations including the bridge loan received from the private placement investors, any investment in us would likely decline to zero.

We expect to continue to incur substantial losses and we may never achieve profitability, which in turn may harm our future operating performance and may cause the market price of our stock to decline.

We have had net losses every year since our inception in 1997 and, as of December 31, 2002, had an accumulated deficit of $206.3 million. We had net losses of $107.2 million, $48.5 million and $32.2 million in 2002, 2001 and 2000, respectively. The 2000 net loss is before a $22.4 million deemed dividend-related to the beneficial conversion of our preferred stock. Because we anticipate significant expenditures for our research and development programs and for the development, implementation and support of our gene function database, we may report substantial net losses through at least the next several years. We may never achieve profitability. If we do not become profitable within the time frame expected by securities analysts or investors, the market price of our stock will likely decline. If we do achieve profitability, we may not sustain or increase profitability in the future.

Our expenditures increased in 2002 due in part to:

We will need to raise additional capital that may not be available, which if not available, will adversely affect our operations.

With our acquisitions in 2001 and 2002 and the corresponding expansion of the scope of our activities, our expenditures and our underlying burn rate increased significantly in 2002. In that same time, our products and services have not produced revenues sufficient to fund our expanded activities for an adequate period of time into the future to continue to execute our business plan. In addition, our products and services may not in the future produce revenues that, together with our existing cash and other resources, are adequate to meet our anticipated cash needs. We plan to continue to fund our operations from our existing cash balances and cash flows, but expect to seek to raise additional funds from the sale of stock, either through private financing and/or a public offering, or from debt financing. Our cash requirements depend on numerous factors, including:

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Substantial capital has been used to fund our operating losses. Since inception, we have experienced negative cash flows from operations and expect to experience negative cash flows from operations for the near future.

We have required substantial amounts of capital, and though operating costs have been significantly reduced over the past six months, we will continue to require additional capital in the future, to fund our business operations. The rate at which our capital is utilized is affected by the operational and developmental costs incurred and the extent to which our products gain acceptance.

We continue to evaluate alternative means of financing to meet our needs on terms that are attractive to us. Although we have recently implemented a business realignment and staff reductions to reduce our cash burn rate, if we are not able to obtain needed capital, we will have to take additional actions to conserve our cash balances, including further reductions in our operating expenses, downsizing of our staff and reduction in facilities, all of which may have a material adverse effect on our business, financial condition and our ability to reduce losses or generate profits.

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

If we complete the private placement and the related rights offering, our current stockholders will experience substantial dilution.

Consummation of the private placement will have a highly dilutive effect on our current stockholders. The number of shares issued pursuant to the private placement will increase substantially the number of shares of our capital stock currently outstanding and thereby the percentage ownership of our current stockholders will significantly decline as a result of the private placement. Further, the conversion of the preferred stock issued in the private placement would increase substantially the number of shares of our common stock currently outstanding. The percentage represented by the shares issued in the private placement could be higher or lower depending on the per share purchase price to be determined just prior to the closing. By way of example, based on the currently committed amount of $10 million plus certain shares to be issued to Charles Rivers Labratories, a per share purchase price of $0.20 would mean a percentage ownership of 57%, whereas a per share purchase price of $0.40 would mean a percentage ownership of 40%. In addition, the committed amount could increase, which would increase the percentage ownership associated with the newly issued shares. If the per share purchase price was $0.20, a committed amount of $15 million would mean a percentage ownership of 66%, and a committed amount of $25 million would mean a percentage ownership of 76%. For purposes of example only, based on a committed amount of $10 million and a per share purchase price of $0.20, a stockholder who owned approximately 10% of our outstanding stock prior to the private placement, would own approximately 4.3% of our outstanding stock immediately after consummation of the private placement.

Following consummation of the private placement, we will conduct a registered rights offering to our other shareholders that would enable them to purchase a number of shares of preferred stock sufficient to maintain their percentage ownership in Deltagen at the same per share price as is paid by the investors in the private placement. The more shares purchased in the rights offering, the lower the percentage ownership of the private placement investors, although we expect they will continue to have a significant ownership percentage going

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forward. This rights offering will represent further dilution to those stockholders who do not choose to participate by buying shares of preferred stock in that offering.

We have recently implemented business realignments and several staff reductions, and may need to do so again in order to further reduce burn rate and operating expenses.

In October 2002, we instituted a cost savings and business realignment plan to reduce our cash burn rate in response to market conditions. As part of the realignment, we reduced our staff by approximately 130 employees, a reduction of about 30%. The plan also included the closing of facilities, including our DRL site in San Diego, California, and the consolidation of certain core activities into our Redwood City, California and Salt Lake City, Utah facilities. In January 2003, we decided to close additional operations and facilities including Salt Lake City, Utah and Deltagen Europe and reduce our staff to approximately 200 employees. A further workforce reduction to 150 employees was announced in April 2003. The benefit of implementing this plan is expected to be realized over the first half of 2003. As a result of these actions, we recorded charges in 2002 for the impairment of goodwill and intangible assets related to activities that will no longer be pursued or that will be scaled back, for the impairment of fixed assets including leasehold improvements and equipment and restructuring charges for severance and other employee related costs, costs associated with lease obligations and other costs. We expect to record further charges for impairment of fixed assets, restructuring charges for severance and other employee related costs, costs associated with lease obligations and other costs in the first and second quarters of 2003.

Due to the uncertainties in predicting our future revenues and our ability to obtain additional financing, we may need to consider and implement another business realignment, which may also comprise staff reductions in order to further reduce our cash burn rate and to maintain viability.

We have recently experienced a significant reduction in our workforce, which may have a material impact on our operations and our ability to meet our existing contractual obligations

In October 2002, we announced that we were reducing our staff by approximately 130 employees, a reduction of about 30%. In January 2003, we decided to close additional facilities and reduce our staff to approximately 200 employees. Further staff reductions were announced in April 2003 in order to reduce our work force to approximately 150 employees. Because of the magnitude of the workforce reductions, it is uncertain whether these layoffs will have a material adverse impact on our ability to meet our existing contractual obligations and whether we will be able to expand our operations in the future to meet customers’ or partners’ needs.

We have experienced problems managing our growth, and if we fail to properly manage our growth in the future, our business could be adversely materially affected.

From 2000 through September 30, 2002, we had experienced significant growth in the number of our employees to approximately 450 employees and the scope of our operations, including acquisitions of Arcaris (renamed Deltagen Proteomics) and BMSPRL (renamed Deltagen Research Laboratories), and an increase in the scale of our mouse knockout program, as well as our secreted protein and biopharmaceutical drug discovery and development programs. As of December 31, 2002, we had approximately 290 full-time equivalent employees.

As of December 31, 2002, we also had multiple offices and facilities in North America and Europe, which presented significant challenges and strain on our management and operations. In addition to our corporate headquarters in Redwood City, California, we had offices or facilities in Menlo Park, Alameda and San Carlos, California, as well as facilities in Strasbourg, France for Deltagen Europe, S.A., in Salt Lake City, Utah for Deltagen Proteomics and in San Diego, California for Deltagen Research Laboratories.

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In response to market conditions, our cash position, and the cost and challenges associated with multiple facilities and a rapidly growing workforce and operational scope, we announced in October 2002, that we were implementing a cost savings and business realignment plan to reduce our cash burn rate. As part of the realignment, we reduced our staff by approximately 130 employees, a reduction of about 30%. The plan also included the closing of facilities, including our DRL site in San Diego, California, and the consolidation of certain core activities into our Redwood City, California and Salt Lake City, Utah facilities. In January 2003, we decided to close additional facilities, including our Deltagen Europe, S.A. site in Strasbourg, France and Deltagen Proteomics site in Salt Lake City, Utah. We reduced our staff to approximately 200 employees. Subsequently we further consolidated our facilities to one site in Redwood City, California and one site in San Carlos, California. In April 2003 we announced further staff reductions that are expected to bring our head count to 150 employees.

We may need in the future to again increase our workforce, acquire additional businesses or technologies, expand the size and number of our offices and facilities, and broaden the scope of our operations. It is uncertain whether we will be able to accomplish those objectives and, further, we may not be able to manage our future growth successfully. If we are unable to manage our future growth successfully, our business could be adversely materially affected.

We are a relatively new public company with an unproven and evolving business strategy, and our limited history of operations makes evaluation of our business and prospects difficult.

We have had a limited operating history and are at an early stage of development. Our pricing models for offering our products and services are unproven. We currently have four full subscribers for our DeltaBase gene function database, only three of which are paying subscription fees. We have generated only limited revenues amounting to approximately $17.7 million, $9.9 million and $2.1 million for the fiscal years 2002, 2001 and 2000, respectively. Our success will depend on, among other things, our ability to enter into future licensing and other agreements on favorable terms, our ability to determine and generate information on those genes that have potential use as drug targets and the commercialization of products using our data. Our sales force may not succeed in marketing our DeltaBase and DeltaOne products, and our employees may not succeed in implementing and operating our database products in a manner that is satisfactory to our subscribers. Furthermore, the plans for our secreted protein and conditional knockout programs are unproven, and we cannot be sure that we will ever be able to develop these programs or that any program that we develop will be commercially successful. As a result of these factors, it is difficult to evaluate our prospects, and our future success is more uncertain than if we had a longer or more proven history of operations.

We currently have only four DeltaBase subscribers, two customers for a subset of DeltaBase and three DeltaOne customers and will not succeed unless we can attract more customers.

DeltaBase has been our principal source of revenue. We also expect a significant portion of our revenues for at least the next six months will be derived from fees under our DeltaBase agreements.

We currently have only four DeltaBase customers (including Lexicon, which does not involve the receipt of any subscription fees) and two customers for a subset of DeltaBase. Because of our reliance on revenue generated under our DeltaBase agreements, we will likely not succeed unless we can attract more DeltaBase customers. In addition, we cannot be sure of the terms under which we may enter into future agreements, such as fees payable to us or the term of the agreements, if any, or whether existing customers will continue as customers once their DelatBase agreements end. Also, if our database is not acceptable to our prospective customers, it may not generate revenues and our business and financial condition will be materially harmed.

We may not be able to comply with minimum performance levels or restrictive provisions or other obligations that may be contained in any agreements, such as minimum data delivery requirements. In addition, we may experience unforeseen technical complications in the processes we use to generate functional data for our gene database and functional genomics resources. These complications could materially delay or

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limit the use of our gene function database, substantially increase the anticipated cost of generating data or prevent us from implementing our processes at appropriate quality and scale levels, thereby causing our business to suffer.

We currently have only four customers for our DeltaSelect program and only three DeltaOne customers. Revenues from our DeltaSelect program have historically not been significant, and we expect to enter into only a limited number, if any, of future DeltaSelect agreements. To succeed we must attract customers for our DeltaBase and other programs. DeltaOne is a new program and it is uncertain whether we can attract customers or whether it will affect our ability to attract further DeltaBase customers. Our existing and future agreements may not be renewed and may be terminated without penalty in the event either party fails to fulfill its obligations under one of these agreements. Failure to renew or the cancellation of these agreements by one of our customers could result in a significant loss of revenues.

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

There have been very few drugs developed and commercialized using genomics-based research and, therefore, the future of our products and programs is uncertain.

Very few of the limited number of drugs developed to date using genomics-based research have reached the commercial market. We cannot assure you that genomics-based drug development efforts will ultimately be commercially successful. We have not proven our ability either to identify drug targets with definite commercial potential or commercialize drug targets that we do identify. We cannot assure you that a particular gene function in a mouse will have any correlation to a human patient’s response to a particular drug. It is difficult to successfully select those genes with the most potential for commercial development. Furthermore, we do not know that any products based on genes that are the subject of our research can be successfully developed or commercialized. If commercial opportunities are not realized from genomics-based research, our existing customers could stop using our products or we could have difficulty attracting or retaining customers and, in any event, we would not realize any product royalties.

There may be ethical and other concerns surrounding the use of genetic information that could limit our ability to develop and sell our existing products and new products.

The genetic screening of humans has raised ethical issues regarding the confidentiality and appropriate uses of the resulting information. Government authorities may regulate or prohibit the use of genetic testing to determine genetic predispositions to certain conditions. The FDA currently is considering different mechanisms for regulating certain types of genetic tests. To the extent any of our technology or products based on our technology involve human genetic testing, such products could be subject to additional FDA regulation in the future. Additionally, the public may disfavor and reject the use of genetic testing. It is possible that the government authorities and the public may fail to distinguish between the genetic screening of humans and genomic and proteomic research. If this occurs, our products and the processes for which our products are used may be subject to government regulations intended to affect genetic screening. Further, if the public fails to distinguish between the two fields, it may pressure our customers to discontinue the research and development initiatives for which our products are used. If this occurs, the potential market for our products could be reduced, which could seriously harm our financial condition and results of operations.

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Our DeltaBase customers will control the development and commercialization of products, which may mean that our research efforts will never result in any royalty payments or third party product sales.

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

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

Our ability to discover, develop or commercialize products could be adversely affected if our research and marketing collaborations are terminated.

Under certain of our agreements, particularly our secreted protein collaboration agreements, we share with our collaborators certain co-development, co-promotional and co-marketing rights to pharmaceutical products based on our discoveries. Many of these collaborators have much greater financial, scientific and human resources capabilities and more experience than us in developing, marketing, promoting and selling pharmaceutical products. As a result, our ability to discover, develop and commercialize products will depend on the continuation of these collaborations. If any of these collaborations are terminated, we may not be able to enter into acceptable collaborations with other collaborators that have similar resources or experience. In addition, our existing collaborations may not be successful. Disputes may arise between us and our collaborators as to a variety of matters, including financing obligations under our agreements and ownership of intellectual property rights. These disputes may be both costly and time-consuming and may result in delays in the development and commercialization of products.

There are a finite number of gene families upon which pharmaceutical and biotechnology companies focus their research, which limits our potential revenue and growth.

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

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We may fail to meet market expectations, which could cause our stock price to decline.

The following are among the factors that could cause our operating results to vary significantly from market expectations:

Our revenues will be unpredictable and this may harm our financial condition.

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

As a result, our results may be below market expectations. If this happens, the price of our common stock may decline.

We expect that our sales cycle will be lengthy, which will cause our revenues to be unpredictable and our business to be difficult to manage.

Our ability to identify and obtain subscribers for our gene function database product and other services depends upon whether customers believe that our products and services can help accelerate drug discovery efforts. Our sales cycle will be lengthy because of the need to educate potential customers and sell the benefits of our products and services to a variety of constituencies within potential subscriber companies. These companies are typically large organizations with many different layers and types of decision-makers. In addition, each database subscription and development program or services agreement will involve the negotiation of unique

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terms and issues which will take a significant amount of time. We may expend substantial funds and management effort with no assurance that a subscription program or services agreement will result. Actual or proposed mergers or acquisitions of our prospective customers may also affect the timing and progress of our sales efforts. Any of these developments could harm our business or financial condition.

We may have conflicts or be in competition with our customers, which will hurt our business prospects.

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

We experience intense competition from other entities engaged in the study of genes, and this competition could adversely affect our business.

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

A number of companies, institutions and government-financed entities are engaged in gene sequencing, gene discovery, gene expression analysis, gene function determination and other gene-related service businesses. Many of these companies, institutions and entities have greater financial and human resources than we do and have been conducting research longer than we have. In particular, a significant portion of this research is being conducted by private companies and under the international Human Genome Project, a multi-billion dollar program funded, in part, by the U.S. government, which completed and released its initial rough draft of the human genome in June 2000; a final, high-quality sequence analysis is expected as early as 2003. Furthermore, other entities have and will continue to discover and establish a patent position in genes or gene sequences that we wish to study. Significant competition also arises from entities using standard target identification approaches, traditional knockout mouse technology and other functional genomics technologies. These competitors may have or may acquire intellectual property rights in functional or other data that are superior to or dominant over our rights. These competitors may also develop products earlier than we do, obtain regulatory approvals faster than we can and invent products and techniques that are more effective than ours. Furthermore, other methods for conducting functional genomics research may ultimately prove more advanced, in some or all respects, to the use of knockout mice. In addition, technologies more advanced than or superior to our gene function identification technology may be developed, thereby rendering our gene trap and gene function identification technologies obsolete. As we expand our range of products and services, such as our secreted protein and biopharmaceutical development programs, we will compete with additional companies, some of which may be our customers at that time or our potential customers.

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

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in our gene function-related business. Moreover, the pharmaceutical industry has undergone significant mergers and this trend is expected to continue. This concentration of the industry could further limit our potential customer base and therefore materially harm our business.

Our acquisition of XenoPharm might not produce the expected benefits.

It may turn out that there are no advantages or “synergies” to adding XenoPharm’s research capabilities to Deltagen’s product line and technology platform. XenoPharm continues to incur legal expenses in connection with its patent applications and the patent applications of its licensors. It is expected that these expenses will increase as the level of patent prosecution increases. In the case of certain of these patent applications, it is our understanding that several major pharmaceutical companies have also filed patent applications covering such technologies and these pharmaceutical companies have sufficient capital resources to withstand potentially costly and lengthy patent interference and opposition proceedings, if they should choose to challenge these applications or any patents issuing there from. We cannot assure that we will prevail in any such proceedings. If we do not prevail, the value of these technologies will likely be significantly reduced.

We may engage in future acquisitions or licenses, which could adversely affect your investment in us as we may never realize any benefits from such acquisitions or licenses, which also could be expensive and time consuming.

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

We depend on key employees, and without the services of our key employees, we may not achieve profitability or remain viable.

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

We currently do not have any issued U.S. patents relating to knockout mice or therapeutics, and if we are unable to protect our proprietary information, our business will be adversely affected.

Our business and competitive position depends upon our ability to protect and exploit our proprietary techniques, methods, compositions, inventions, database information and software technology. However, our strategy of obtaining such proprietary rights around as many genes as possible is unproven. Protecting our intellectual property rights is costly and we may not therefore be in a position to obtain protection around all of our inventions and other intellectual property rights. Unauthorized parties may attempt to obtain and use information that we regard as proprietary. Although we intend for our gene function database subscription agreements to require our potential subscribers to control access to our database and information, policing unauthorized use of our database information and software may be difficult.

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Although we currently have certain issued United States patents, none of these relate to knockout mice or therapeutics. Patents have been issued to other entities based on claims relating to knockout mice or therapeutics. In addition, many applications have been filed seeking to protect partial human gene sequences, many of which are based primarily on gene sequence information alone. Some of these applications have issued as patents. Some of these may claim sequences that we have used or may use in the future to generate knockout mice in our gene knockout program or that we have used or may use in the future to discover and develop biopharmaceutical products. In addition, other applications have been filed which seek to protect methods of using genes and gene expression products, some of which attempt to assign biological function to the DNA sequences based on laboratory experiments, computer predictions, mathematical algorithms and other methods.

The issuance of these applications as patents will depend, in part, upon whether practical utility can be sufficiently established for the claimed sequences and whether sufficient correlation exists between the experimental results, predictions, algorithms and other methods and actual functional utility. The patent application process before the U.S. Patent and Trademark Office and other similar agencies in other countries is confidential in nature. Although certain patent applications are published prior to issuance, as each application is evaluated independently and confidentially, we cannot predict whether applications have been filed or which, if any, will ultimately issue as patents. However, it is probable that patents will be issued to our competitors claiming knockout mice, partial human gene sequences and methods of using genes and gene expression products.

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

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

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

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

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

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We may be subject to litigation and infringement claims that may harm our business or reputation, be costly and divert management’s attention.

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

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

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

Whether or not meritorious, litigation brought against us could result in substantial costs, divert management’s attention and resources, and harm our financial condition and results of operations.

Because our issued U.S. patents are not related to knockout mice or therapeutics, and because knockout mouse and gene-related patents even if obtained may not be enforceable, our intellectual property may not have any material value, which would diminish our business prospects.

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

Our rights to the use of technologies licensed to us by third parties are not within our control, and without these technologies, our products and programs may not be successful and our business prospects could be harmed.

We rely, in part, on licenses to use certain technologies that are material to our business, including a secreted protein gene trap that we license exclusively from the University of Edinburgh. We do not own the patents that underlie these licenses. Our rights to use these technologies and employ the inventions claimed in the licensed patents are subject to our licensors abiding by the terms of those licenses and not terminating them. In many cases, we do not control the prosecution or filing of the patents to which we hold licenses. Some of the licenses under which we have rights, such as the license from the University of Edinburgh, provide us with

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exclusive rights in specified fields, but we cannot assure you that the scope of our rights under these and other licenses will not be subject to dispute by our licensors or third parties.

Our activities involve hazardous material and may subject us to environmental liability, which would seriously harm our financial condition.

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

Compliance with governmental regulations regarding animal welfare and genetically modified organisms could increase our operating costs or adversely affect our customers’ ability to obtain governmental approval of gene based products, which would adversely affect the commercialization of our technology.

The Animal Welfare Act, or AWA, is the federal law that currently covers animals in laboratories. It applies to institutions or facilities using any regulated live animals for research, testing, teaching or experimentation, including diagnostic laboratories and private companies in the pharmaceutical and biotechnology industries. Rats, birds and mice, including the mice in our knockout programs, are currently excluded from the definition of “animal” and, therefore, are not subject to regulation under the AWA. However, the United States Department of Agriculture, which enforces the AWA, has been sued on this matter and agreed, as part of the settlement of this lawsuit on September 25, 2000, to begin the process of changing the regulations issued under the AWA to include rats, mice and birds within its coverage. Congress subsequently prohibited, in the Agricultural Appropriations Act for fiscal year 2001 and again for fiscal year 2002, the expenditure of any money or commencing rulemaking for the purpose of changing the regulations with respect to including rats, mice and birds prior to October 1, 2002. We cannot predict whether mice will at any time after such date be included under the AWA.

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

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

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Ethical and social issues may limit or discourage the use of knockout mice or other genetic processes, which could reduce our revenues and adversely affect our business.

Governmental authorities could, for social or other purposes, limit the use of genetic processes or prohibit the practice of our gene trap and knockout mouse technologies. Public attitudes may be influenced by claims that genetically engineered products are unsafe for consumption or pose a danger to the environment. The subject of genetically modified organisms, like knockout mice, has received negative publicity and aroused public debate. In addition, animal rights activists could protest or make threats against our facilities, which may result in property damage. Ethical and other concerns about our methods, particularly our use of knockout mice, could adversely affect our market acceptance.

Almost all of our knockout mouse research and storage is conducted at our San Francisco Bay Area facilities in San Carlos and Redwood City, and a natural disaster at one or more of these facilities is possible and could result in a prolonged interruption of our business.

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

Security risks in electronic commerce or unfavorable internet regulations may deter future use of our products and services.

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

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

We rely on third-party data sources, and without these sources, our products and programs would be incomplete and less appealing to customers, seriously harming our business prospects.

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

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Our common stock may continue to experience extreme price and volume fluctuations, which could lead to costly litigation for us and make an investment in us less appealing.

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

Over the past two years our stock price has been, and in the future may be, highly volatile and could continue to decline. Since the close of the quarter ended September 30, 2002, our stock has had minimum closing bid prices of less than $1.00 per share, which is the minimum bid price requirement for continued listing with the Nasdaq National Market. Nasdaq may commence delisting proceedings and we may be delisted from the Nasdaq National Market. Our shares will continue to trade on the Nasdaq National Market unless and until the delisting proceedings have commenced and been completed and the Nasdaq National Market has made a determination to delist us. In the event our shares are delisted from the Nasdaq National Market, we will attempt to have our common stock traded on the Nasdaq Small Cap Market. If our common stock is delisted, it could seriously limit the liquidity of our common stock and would limit our potential to raise future capital through the sale of our common stock, which could seriously harm our business.

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

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The future sale of common stock could negatively affect our stock price.

We had 40,986,893 shares of common stock outstanding at December 31, 2002.

If our common stockholders sell substantial amounts of common stock in the public market, or the market perceives that such sales may occur, the market price of our common stock could fall. The holders of approximately 13.0 million shares of our common stock have rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or other stockholders. Furthermore, if we were to include in a company-initiated registration statement shares held by those holders pursuant to the exercise of their registration rights, those sales could impair our ability to raise needed capital by depressing the price at which we could sell our common stock.

In April 2003, we secured a minimum commitment for $10 million in equity capital from existing institutional investors to purchase preferred stock in a private placement. The private placement is subject to shareholder approval and the satisfaction of closing conditions. In addition to the terms of the private placement, our stockholders will be asked to approve a number of other matters including a reverse stock split.

In connection with the private placement, we have agreed to use reasonable best efforts, as soon as reasonably practicable after the closing of the private placement, to offer stockholders of record as of the last business day prior to the closing of the private placement (other than the investors in such financing) non-transferable rights to purchase newly issued preferred stock at the same purchase price paid by the investors. The amount of preferred shares so offered to each stockholder would be sufficient to allow each such stockholder to maintain the percentage ownership interest in Deltagen, held by each such stockholder as of the last business day prior to the closing of the private placement.

Our principal stockholders, executive officers and directors own a significant percentage of our stock, and as a result, the trading price for our shares may be depressed and these stockholders can take actions that may be adverse to your interests.

As of December 31, 2002, our executive officers and directors, and entities affiliated with them, beneficially own, in the aggregate, approximately 50.9% of our common stock. This significant concentration of share ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling shareholders. These stockholders, acting together, will have the ability to exert substantial influence over all matters requiring approval by our stockholders, including the election and removal of directors and any proposed merger, consolidation or sale of all or substantially all of our assets. In addition, they could dictate the management of our business and affairs. This concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding a merger or consolidation, takeover or other business combination that could be favorable to you.

Our incorporation documents and Delaware law may inhibit a takeover that stockholders consider favorable and could also limit the market price of your stock.

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

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

Item 2.      Properties

Our operating facilities include corporate headquarters, principal executive offices and research facilities as follows:

In the fourth quarter of 2002, we substantially completed animal and laboratory facility improvements in Redwood City, California, (700 Bay Road). We cancelled the construction of a new 50,000 square foot research facility in France.

We believe that our current facilities will be adequate for our current needs and that suitable additional space or alternative space, if necessary, will be available in the future on commercially reasonable terms.

Item 3.      Legal Proceedings

On May 24, 2000, Lexicon Genetics Incorporated filed a lawsuit against us in the United States District Court for the District of Delaware. The complaint in the lawsuit alleged that our methods of making knockout mice infringed United States Patent No. 5,789,215, or the ’215 patent, under which Lexicon claimed to be an exclusive licensee. In addition, on October 13, 2000, Lexicon and the University of Utah Research Foundation filed a lawsuit against us in the United States District Court for the Northern District of California. The complaint in this lawsuit alleged that we infringed United States Patents Nos. 5,631,153, 5,464,764, 5,627,059 and 5,487,992, or the Capecchi patents, under which Lexicon claimed to be an exclusive licensee. On September 20, 2001, we and Lexicon announced the settlement of the litigation. Under the terms of the settlement, we obtained a commercial license under the ’215 patent and the Capecchi patents, Lexicon obtained a subscription to our DeltaBase product, and all of the claims and counterclaims in the litigation were dismissed with prejudice. Lexicon’s subscription to DeltaBase includes non-exclusive, perpetual licenses to the 250 drug targets represented in DeltaBase as of September 2001 and the approximately 1,000 drug targets that were and are expected to be added to DeltaBase over the subsequent four years. Lexicon will make certain milestone and

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royalty payments to us for therapeutic and diagnostic products developed from Lexicon’s use of DeltaBase. We will make payments to Lexicon for knockout mice generated by us on a fee-for-service basis. Neither we nor Lexicon will pay the other party any subscription or license fees.

Deltagen is a party to two civil actions filed March 12, 2003 in the Superior Court of California, County of San Mateo, entitled Willow Park Holding Company II v. Deltagen, Inc., Case No. 429871 (the “Willow Park Action”) and AMB Property, L.P. v. Deltagen, Inc., Case No. 429872 (the “AMB Action”). The plaintiff in the AMB Action is the owner of real property located at 1210 and 1255 Hamilton Court, in Menlo Park, California. The plaintiff in the Willow Park Action is the owner of real property located at 1003 Hamilton Court, also in Menlo Park, California. We did not timely pay our rent on the 1003 and 1210 Hamilton Court premises for March 2003, or our rent on the 1255 Hamilton Court premises for February and March 2003.

The complaints allege that we breached our leases for the three properties. In the AMB Action, the plaintiff seeks past due rent and additional rent in the amount of $88,211, late charges in the amount of $8,821, and future rent and additional rent in the amount of $1,773,266. In the Willow Park Action, the plaintiff seeks past due rent and additional rent in the amount of $75,946, late charges in the amount of $7,594, and future rent and additional rent in the amount of $921,898.

On March 14, 2003, the plaintiffs in both actions applied for an ex parte right to attach order, writ of attachment, and temporary protective order. The plaintiff sought to attach $1,873,794 in the AMB Action, and $1,168,845 in the Willow Park Action. On March 14, 2003, the court granted the plaintiffs’ applications in part, and denied them in part. In the AMB Action, the court ordered that the plaintiff has a right to attach our property in the amount of $97,032. In the Willow Park Action, the court ordered that the plaintiff has a right to attach our property in the amount of $83,541. The court also issued a temporary protective order in each case, restricting us from transferring interests in specified property, and from disposing of the proceeds of any transfer of inventory. The temporary protective orders will expire no later than April 23, 2003. We executed a Lease Termination Agreement with the plaintiffs effective March 31, 2003. Under this agreement the plaintiffs agreed to dismiss these actions promptly after June 30, 2003 except under certain circumstances as defined in the agreement.

We may be involved in additional litigation, investigations or proceedings in the future. Any litigation, investigation or proceeding, with or without merit, could be costly and time-consuming and could divert our management’s attention and resources, which in turn could harm our business and financial results and cash flows.

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

None.

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 PART II

Item 5.      Market for the Registrant’s Common Equity and Related Stockholder Matters

Our common stock has been traded on the Nasdaq National Market under the symbol DGEN since our initial public offering on August 3, 2000. The following table sets forth, for the periods indicated, the highest and lowest closing sale prices for our common stock, as reported by the Nasdaq National Market.

Holders

As of December 31, 2002, there were approximately 164 holders of record of our common stock.

Dividends

We have not paid any cash dividends on our common stock in the past. We currently intend to retain any earnings for use in our business and do not anticipate paying any cash dividends on our common stock in the foreseeable future.

Sale of Unregistered Securities

Use of Proceeds from the Sale of Registered Securities

On August 2, 2000, our Registration Statement on Form S-1 (File No. 333-34668), the IPO Registration Statement, was declared effective by the Securities and Exchange Commission. The IPO Registration Statement registered a total of 7,000,000 shares of common stock, all of which were issued and sold by us. The offering was led by a group consisting of Salomon Smith Barney Inc., FleetBoston Robertson Stephens, Inc. and U.S. Bancorp Piper Jaffray Inc. The offering commenced on August 3, 2000, and was closed on August 8, 2000. The shares sold by us were sold at an aggregate offering price of $105.0 million, netting proceeds of approximately $95.9 million to us after underwriting fees of approximately $7.4 million and other offering expenses of approximately $1.7 million. On August 30, 2000, the underwriters’ exercised their over-allotment option for the purchase of approximately 1,025,000 shares. The shares sold by us were sold at an aggregate offering price of $15.4 million, netting proceeds of approximately $14.3 million to us after underwriting fees of approximately $1.1 million and other offering expenses.

Since the effective date of the IPO Registration Statement, the net offering proceeds of $110.2 million have been invested in bank deposits, money market funds, corporate debt securities and obligations of government agencies.

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None of the net offering proceeds have been paid to any director, officer, or 10% or greater stockholder of the Company or an affiliate of these persons.

Item 6.      Selected Consolidated Financial Data

SELECTED CONSOLIDATED FINANCIAL DATA

The consolidated statement of operations data for each of the three years in the period ended December 31, 2002 and the consolidated balance sheet data at December 31, 2002 and 2001 are derived from the audited consolidated financial statements included in this report. The statement of operations data for the years ended December 31, 1999 and 1998 and the balance sheet data at December 31, 2000, 1999 and 1998 are derived from audited financial statements not included in this report. Our historical results are not necessarily indicative of results to be expected for future periods. The consolidated financial data set forth below should be read in conjunction with the accompanying consolidated financial statements of the Company and related notes thereto, and Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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Item 7.      Management’s Discussion and Analysis of Financial Condition and Results of Operations

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read this report and the documents that we reference in this report completely and with the understanding that our actual future results may be materially different from what we expect. We qualify all of our forward-looking statements by these cautionary statements.

YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH “SELECTED CONSOLIDATED FINANCIAL DATA” AND OUR CONSOLIDATED FINANCIAL STATEMENTS AND THE ACCOMPANYING NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS.

Overview

Deltagen, founded in 1997, is a leader in using in vivo derived mammalian gene function information to define the function and disease relevance of mammalian genes for the purposes of discovering and validating novel drug targets. Our proprietary information platform serves our pharmaceutical partners and customers in their efforts to discover potential new drug therapies.

Our products, based on our platform technology, provide databases of in vivo mammalian gene function information on target genes of interest to drug researchers. We delete, or “knock out,” these genes in mice and then utilize an extensive, integrated analysis program to assess the function and potential pharmaceutical relevance of these genes and the proteins these genes encode. We also focus our efforts to determine the function of secreted proteins. We are undertaking the discovery and development of biotechnology drug candidates in collaboration with other parties.

Our current customers and partners include many of the world’s largest pharmaceutical companies, Eli Lilly and Company, GlaxoSmithKline plc, Merck & Co., Inc., Pfizer Inc., and Schering-Plough Research Institute, as well as significant biotechnology and biopharmaceutical companies including Lexicon Genetics Incorporated, Millennium Pharmaceuticals, Nuvelo, Inc. and Tanox, Inc.

We also have the capability to conduct further target discovery and validation efforts through our Target Research and Development, or TRD, program. Our TRD program adds comprehensive in-depth analysis to further characterize and identify potential key targets for the treatment of disease. The program currently focuses on the identification and validation of targets in metabolism and inflammatory diseases.

A principal goal of Deltagen is to validate and characterize potential drug targets through our phenotypic analysis and TRD programs in an effort to further identify and validate potential drug candidates for our biopharmaceutical customers.

We are implementing a strategy to identify, validate and commercialize potential drug targets through our:

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Our recent acquisition of XenoPharm, Inc. (“XenoPharm,”) further complements our target validation and characterization technologies. XenoPharm provides a proprietary technology platform to evaluate the metabolism of drug candidates, to improve the predictive value of cell- and animal-based biomedical research and predict the reaction of a drug candidate in a human system, thereby screening candidates for improved chances of clinical success.

We believe that our ability to determine gene function, to develop products and to identify and validate potential drug targets is a result of our leveraging of our technology platforms. Our genomics technologies, processes and information systems are integrated with one another and generate information on the function and relationships between genes and the proteins these genes encode and the usefulness of genes as new drug targets and proteins as new drug candidates. We have used these systems to establish and develop our products and programs that include our:

DeltaBase is our proprietary database that provides information, based on knockout mouse studies, on gene function for drug discovery. We created DeltaBase to be marketed to the pharmaceutical and biotechnology industries to help define the role that genes play in biological processes and disease. We select genes for DeltaBase based upon what we believe to be their potential to become useful drug targets. We generate information on these genes by comprehensively analyzing knockout mice generated through our proprietary gene knockout methods. Each knockout mouse undergoes a standardized, detailed and extensive analysis in order to determine the function and role that a particular gene plays in the mouse. Additionally, DeltaBase subscribers will have access to the knockout mice used to generate this data.

The DeltaSelect program was our initial program. Customers received phenotypic target validation information for selected genes on a fee-for-service basis. This program was provided to validate our proprietary technology and promote interest in the DeltaBase product that became available in 2000. We believe that the DeltaSelect program has provided validation of our proprietary platform technology and promoted interest in DeltaBase, however, the revenues generated from the DeltaSelect program have to date not been significant and have with time become historically less significant. We anticipate that revenues from DeltaSelect will continue to become less significant and that DeltaSelect will be utilized only under very limited circumstances to develop new technologies, product offerings and programs in collaboration with pharmaceutical companies.

We recently launched a product line known as DeltaOne that offers access to our extensive portfolio of knockout mice and/or accompanying phenotypic data, as well as any corresponding intellectual property, on a gene-by-gene basis. Our current customers include Aventis Pharmaceuticals, Inc., Euroscreen, S.A. and Millennium Pharmaceuticals.

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We have DeltaBase agreements with GlaxoSmithKline, Pfizer and Merck. Each of these agreements provides for payments aggregating approximately $15 million in exchange for three years’ worth of DeltaBase targets. In addition, we may receive additional fees for access to certain corresponding intellectual property. We began recognizing revenue from the GlaxoSmithKline agreement in the fourth quarter of 2000. Revenue from the Pfizer agreement began to be recognized in the first quarter of 2001. We began to recognize revenue from the Merck agreement in the second quarter of 2002. We anticipate that a significant portion of our revenues for at least the next six months will be derived from fees under agreements with DeltaBase subscribers and access to information and tools related to the DeltaBase product offering. Our current DeltaBase agreements with GlaxoSmithKline and Pfizer are coterminous, each terminating upon our delivery of DeltaBase in June 2003, and, although renewable beyond such date, may not be renewed. The Merck agreement provides for payments on 600 genes (through our delivery of DeltaBase in December 2002) with payments for the remaining 150 genes to be paid upon delivery of initial gene data that may be delivered to Merck subsequent to June 2003.

We also have secreted protein agreements with Eli Lilly and Nuvelo.

Secreted Protein Agreements and Collaborations

In August 2001, we entered into a secreted protein agreement with Eli Lilly (“Lilly”) to evaluate, and potentially develop and commercialize, therapeutic secreted proteins. Under the terms of the agreement, Lilly has provided potential targets from its secreted protein pipeline for which we will further evaluate the therapeutic potential in mammalian models. Among those secreted proteins with potential therapeutic value, each company may select proteins for commercial development, with each company receiving royalties based on sales of therapeutic products. The agreement provides Lilly with certain acquisition, co-promotion, co-marketing and profit-sharing options with respect to therapeutic products developed and commercialized by us. The agreement also provides us with certain co-promotion, co-development and profit-sharing opportunities.

In October 2001, we entered into a collaboration agreement with Nuvelo to research, develop and commercialize biopharmaceutical products based on secreted proteins. Under the terms of the agreement, Nuvelo has provided us with gene sequences encoding secreted proteins and we will utilize our proprietary in vivo mammalian gene knockout technology to discover and validate potential commercially relevant biopharmaceutical drug targets. We and Nuvelo will each have certain joint development and commercialization rights around potential biopharmaceutical drug targets discovered through the collaboration. We and Nuvelo will share the collaboration’s costs; Nuvelo will provide us with approximately $8 million in research and development payments over two years. In addition, we received $10 million in equity proceeds from the sale of shares of our common stock to George B. Rathmann, Ph.D., chairman of the Board of Directors of Nuvelo.

Revenue for the years ended December 31, is as follows (in thousands):

Under our revenue recognition policy, revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered and meet all customer-specified criteria, the price is fixed and determinable and collectibility is reasonably assured. Revenue derived from DeltaBase agreements is

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recognized on a straight-line basis over the term in which services are to be provided. Research and development collaboration agreements specify milestones to be met and the payments associated with meeting each milestone. Revenue derived from these contracts is recognized upon completion of the milestone. The amount of revenue recognized upon completion of each milestone is such that the earned revenue, as a percentage of total anticipated revenue, approximates the costs incurred in achieving the related milestone, as a percentage of the total anticipated costs. Where the contract does not specify milestones and payment is upon completion of the contract, revenue is recognized based on the percentage-of-completion method of accounting. Any payments received in advance of the completion of a milestone or services performed are recorded as deferred revenue.

We had net losses of $107.2 million, $48.5 million and $32.2 million in 2002, 2001 and 2000, respectively. The net loss attributable to common stockholders for the year ended December 31, 2000, was $54.6 million, after deducting a dividend of $22.4 million relating to a beneficial conversion feature on our Series C redeemable convertible preferred stock. Our losses have resulted primarily from costs incurred in connection with research and development activities, from selling, general and administrative costs associated with our operations and non-cash charges for amortization of unearned stock-based compensation costs and amortization of intangibles. Amortization totaled $5.2 million and $4.5 million for the years ended December 31, 2002 and 2001, respectively. The year ended December 31, 2002 included a $28.9 million charge for the impairment of goodwill and other long-lived assets and restructuring charges of $7.9 million. Research and development expenses consist primarily of salaries and related personnel costs, material costs, legal expenses resulting from intellectual property filings and other expenses related to the development of our DeltaBase, DeltaSelect and secreted protein programs. We expense our research and development costs as they are incurred. Selling, general and administrative expenses consist primarily of salaries and related expenses for executive, finance and other administrative personnel, professional and other corporate expenses including business development, marketing, litigation costs and general legal activities. In connection with the development and expansion of our gene function database and our secreted protein program, we may incur research and development and selling, general and administrative costs that may exceed revenues. As a result, we may report net losses through the next several years.

We account for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees” and related interpretations and comply with the disclosure provisions of Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation.”

Under APB 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of our stock and the exercise price. SFAS 123 defines a “fair value” based method of accounting for an employee stock option or similar equity investment.

We account for equity instruments issued to non-employees in accordance with the provisions of SFAS 123 and Emerging Issues Task Force Issue No. 96-18 (“EITF 96-18”), “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and Financial Accounting Standards Board Interpretation No. 28 (“FIN 28”), “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.”

During 2000, we recorded unearned stock-based compensation of approximately $12.0 million. This amount is being amortized as charges to operations over the respective vesting period of the individual stock options, generally four years. During 2002 and 2001, we reversed approximately $1.0 million and $1.8 million of unearned stock-based compensation related to unvested stock options due to employee terminations and changes in the fair market value of our common stock.

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

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We had federal net operating loss carryforwards as of December 31, 2002 and 2001, of approximately $150.4 million and $79.2 million, respectively. We had state net operating loss carryforwards as of December 31, 2002 and 2001, of approximately $115.6 million and $79.2 million, respectively. We also had federal and state research and development tax credit carryforwards as of December 31, 2002 and 2001, of approximately $10.7 million and $6.9 million, respectively. The net operating loss and credit carryforwards will expire at various dates beginning in 2005, if not utilized. Due to the uncertainty regarding the ultimate utilization of the net operating loss carryforwards, we have not recorded any benefit for losses, and a valuation allowance has been recorded for the entire amount of the net deferred asset. Utilization of net operating losses and credits may be substantially limited due to the change in ownership provisions of the Internal Revenue Code of 1986 and similar state provisions. Certain future sales of our stock could restrict our ability to utilize our net operating loss carryforwards. The annual limitation may result in the expiration of net operating losses and credits before utilization.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenue and expenses and disclosures at the date of the financial statements. On an on-going basis, we evaluate our estimates, including those related to accounts receivable, income taxes, impairment of long-lived assets, goodwill and intangible assets and restructuring costs. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from those estimates.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

We recognize revenue when there is pervasive evidence that an arrangement exists, delivery has occurred, the price is fixed or determinable and collection is reasonably assured. We maintain an accounts receivable allowance for an estimated amount of losses that may result from customer’s inability to pay for product purchased. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

We have established a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

We perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment at many points during the analysis. In estimating the fair value of the businesses with recognized goodwill for the purposes of our fiscal 2002 consolidated financial statements, we made estimates and judgments about the future cash flows of these businesses. Our cash flow forecasts were based on assumptions that are consistent with the plans and estimates we are using to manage the underlying businesses. In addition, we made certain judgments about allocating shared assets such as accounts receivable to the estimated balance sheet for those businesses. We also considered our market capitalization on the dates of our impairment tests under SFAS 142, in determining the fair value of the respective businesses.

As required by SFAS 142, we performed our annual goodwill impairment test in the third quarter of 2002. As a result of this impairment test, we recorded a goodwill impairment charge of $9.4 million.

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We currently have three active restructuring plans—one initiated in the fourth quarter of fiscal 2002 and the others initiated in the first and second quarters of fiscal 2003 after it became clear that actions taken in the previous year would not be sufficient to return the company to profitability. The plans were designed to reduce costs and expenses in order to return the company to profitability.

The current accounting for restructuring costs requires us to record provisions and charges when we have incurred a liability. In connection with these plans, we have recorded estimated expenses for severance and outplacement costs, asset write-offs and other restructuring costs. Given the significance of, and the timing of the execution of such activities, this process is complex and involves periodic reassessments of estimates made at the time the original decisions were made. We continually evaluate the adequacy of the remaining liabilities under our restructuring initiatives. Although we believe that these estimates accurately reflect the costs of our restructuring plans, actual results may differ, thereby requiring us to record additional provisions or reverse a portion of such provisions.

Major Developments since December 31, 2001

Merck DeltaBase Agreement

On February 8, 2002, we entered into a license agreement to provide Merck & Co., Inc. (“Merck”) with access to our proprietary DeltaBase product, a resource tool for the understanding of in vivo mammalian gene function information. Merck will have non-exclusive access to information related to 750 genes selected for their biological interest that have been functionally characterized and entered into DeltaBase. Merck will also have access to certain of the corresponding DeltaBase intellectual property rights.

Closure of Arcaris, Inc.

On July 30, 2001, we acquired Arcaris, Inc. (“Arcaris”). Located in Salt Lake City, Utah, Arcaris had developed technologies consisting of genetic, proteomic and cell-biological systems for identification and validation of drug targets and the creation of small molecule screens. The total purchase price of approximately $8.0 million consisted of cash of approximately $450,000 and 766,894 shares of common stock valued at approximately $6.7 million and 77,329 vested stock options valued at approximately $418,000 and direct acquisition costs of approximately $312,000. In October 2002, we issued an additional 94,095 shares of common stock valued at approximately $112,000 related to certain earn out provisions. The acquisition was accounted for using the purchase method of accounting. The subsidiary was renamed Deltagen Proteomics, Inc.

On January 6, 2003, we announced a cost savings and business realignment plan to reduce our cash expenditures. As part of this realignment plan, we closed the Salt Lake City facility that housed the Deltagen Proteomics, Inc. operations. As a result of the realignment plan, substantially all Deltagen Proteomics, Inc. activities and capabilities have ceased or been eliminated.

Acquisition and Closure of BMSPRL, L.L.C. (formerly CombiChem, Inc.)

On February 16, 2002, we acquired the California-based BMSPRL, formerly known as CombiChem, Inc., from Bristol-Myers Squibb Company for 2,647,481 unregistered shares of our common stock valued at approximately $23.5 million and paid certain transaction expenses of approximately $465,000. The subsidiary was renamed Deltagen Research Laboratories (“DRL”).

On October 2, 2002, we announced a cost savings and business realignment plan to reduce our cash burn rate. As part of this realignment plan, we closed the San Diego facility that housed the DRL operations. As a result of the realignment plan, substantially all DRL activities and chemistry capabilities have ceased or been eliminated.

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Stanford Collaboration Agreement

On February 19, 2002, we announced that we had signed a target validation and research collaboration agreement with Stanford University. Under the terms of the three-year collaboration, Stanford and the Company will mutually develop research projects for jointly selected genes under which we will provide Stanford non-exclusive access to knockout mice models using its proprietary high-throughput technology and Stanford will evaluate and conduct research on such materials. We will have options to obtain exclusive licenses to commercially develop in any and all fields certain inventions developed by Stanford. We will have rights to use, commercialize and sublicense results developed by Stanford under the research projects.

Acquisition of XenoPharm, Inc.

On March 14, 2002, we acquired XenoPharm, a San Diego, California-based private company for 498,236 shares of our unregistered common stock valued at approximately $3.6 million and paid certain transaction expenses. Up to an additional 1,449,262 shares of common stock may be issued upon the achievement of certain key milestones. The entity became our wholly-owned subsidiary. XenoPharm, which was incorporated in November 2000, provides a proprietary technology platform to pharmaceutical, biotechnology, chemical and agricultural companies to better understand and predict reactions of foreign substances, termed “xenobiotics,” in human systems. XenoPharm’s XenoSensor Mice, implanted with human SXR and CAR, coupled with XenoPharm’s CleanScreen high-throughput screening assays provide a proprietary technology platform to improve the predictive value of cell- and animal-based biomedical research. The operating expenses of XenoPharm were insignificant in 2002.

Restructuring Activities

With the acquisitions of Arcaris, Inc. and BMSPRL, L.L.C. and the expansion of our internal drug development efforts, the number of employees peaked at 450 by September 30, 2002 and we were leasing ten facilities. Given the significant net cash outflow from operations and the difficulty in accessing additional capital, we undertook a series of cost cutting measures beginning in October 2002. These included workforce reductions in October 2002, January 2003 and April 2003 and the closure of our operations outside of the San Francisco Bay Area, including the closure of Arcaris, BMSPRL and Europe operations. Remaining operations are being consolidated into our recently renovated 132,000 square foot facility in Redwood City, California. We discontinued our internal drug discovery efforts and refocused our strategies and operations on providing drug discovery services to the biopharmaceutical industry utilizing the Company’s proprietary core mammalian in vivo transgenic technologies. In addition to the workforce reduction and cost cutting actions, we negotiated settlement of obligations with certain landlords, lenders and vendors.

Facility Leases

In March and April 2003, we entered into agreements with landlords or guarantors of several excess facilities in San Diego, California; Menlo Park, California; Alameda, California; and Redwood City, California to terminate remaining lease obligations. Certain of the terminations are contingent on the closing of the Series A Preferred Stock financing described below. These agreements require us to forfeit lease deposits or restricted cash underlying letters of credit totaling $2.5 million in 2003, make lease termination payments totaling $2.3 million in 2003 and $200,000 in 2004 and issue warrants to purchase 1,150,000 shares of our Series A Preferred Stock plus additional warrants equal to 0.05 warrants per dollar for each dollar of Series A preferred stock issued in excess of $10 million. The value of these settlements was expensed in 2002.

In addition, in April 2003 we entered into a forbearance agreement related to the lease of our principal operating and administrative facility in Redwood City, California. This agreement provides for lease rent and certain facility operating expenses to be paid from the $1.5 million cash security deposit or the $500,000 restricted cash related to letters of credit in 2003. Lease rent is also reduced by approximately 25% during the

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forbearance period. The agreement has certain default criteria that if breeched would cause the lease rent to revert to prior levels retroactively.

Lending Arrangements

In March 2003, we repaid in full, without penalty, the outstanding balance of $10 million under a term loan facility. As a result of this payment, we are no longer required to maintain restricted cash balances of $10.5 million as security for the loan facility.

In March 2003, we reached an agreement with a financial institution to restructure our existing loan agreements. The existing loan agreements had outstanding balances at March 15, 2002 of $5.0 million and were payable in monthly installments at interest rates ranging from 8.87% to 12.75% with maturities to July 2005. Under the terms of the restructuring, we forfeited letters of credit totaling $2.3 million to the lender in partial payment of the loans and entered into a new loan for the remaining balance of $2.7 million. The new loan will bear an interest rate of 10.50% and is required to be repaid in 18 monthly installments beginning in April 2003. The loan is collateralized by a first position security interest in certain fixed assets and a second position security interest in substantially all of our other assets.

Vendor Arrangements

In April 2003, we settled a $1.2 million obligation with a vendor for $434,000 in current cash payments, $144,000 to be paid upon completion of the Series A Preferred Stock financing described below and $290,000 in Series A Preferred Stock to be issued upon closing of the private placement. The remaining $290,000 balance is to be forgiven once the preferred financing is complete.

Bridge Loan and Commitment for Equity Financing

In April 2003, we secured a minimum commitment for $10 million in equity capital from existing institutional investors to purchase preferred stock in a transaction referred to here in as the private placement. The private placement is subject to shareholder approval and the satisfaction of closing conditions. In addition to the terms of the private placement, our stockholders will be asked to approve a number of other matters including a reverse stock split.

Under the terms of the private placement, the investors have agreed to purchase $10 million of preferred stock. The preferred stock is convertible into common stock on a 1:1 basis. The preferred stock will be issued at a 25% discount to the five-day average closing common stock price for the period ending three days prior to closing. The preferred stock bears no dividend, has a liquidation preference right equal to the amount invested in the preferred stock and standard anti-dilution protections. The terms of the preferred stock agreement include the right to appoint designees to a total of three seats on the Board of Directors.

We also obtained a secured bridge loan commitment of $5 million from the same investors. This facility can be increased to $6 million upon the occurrence of certain events and milestones and is secured by all of our assets not pledged to the equipment loans. The loan bears interest at 10% per annum. The principal and interest on the bridge loan will be repaid upon the earlier of the closing of the private placement with the proceeds thereof or August 31, 2003.

In connection with the private placement, we have agreed to use reasonable best efforts, as soon as reasonably practicable after the closing of the preferred stock financing, to offer stockholders of record as of the last business day prior to the closing of the private placement (other than the investors in such financing) non-transferable rights to purchase newly issued preferred stock at the same purchase price paid by the investors. The amount of preferred shares so offered to each stockholder would be sufficient to allow each such stockholder to maintain the percentage ownership interest in Deltagen held by each such stockholder as of the last business day prior to the closing of the private placement.

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RESULTS OF OPERATIONS

Revenue for the years ended December 31, is as follows (in thousands):

Costs and expenses for the years ended December 31, are as follows (in thousands):

Years Ended December 31, 2002 and 2001

Revenues

Contract revenue increased by $7.8 million to $17.7 million in 2002 from $9.9 million in 2001. The increase was due primarily to increased revenue from our DeltaBase gene function database product. DeltaBase revenue in 2002 was $15.0 million compared to $8.6 million in 2001. In 2002, our DeltaBase, DeltaOne and DeltaSelect revenue came principally from contracts with GlaxoSmithKline, Merck, Millennium Pharmaceuticals, Pfizer and Schering-Plough Research Institute.

Costs and Expenses

Costs and expenses for the year ended December 31, 2002 were $125.5 million compared to $62.1 million in 2001. Costs and expenses for the year ended December 31, 2002 include charges of $36.8 million for restructuring charges and the impairment of goodwill and other assets. These charges are associated with our strategic business realignments announced in October 2002 and January 2003 and include severance costs; impairment charges for goodwill, intangibles and fixed assets. We will record additional charges for severance

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and other employee related costs, lease related costs and other asset disposal costs related to the January 2003 operating reductions in the first quarter of 2003. Further charges will be recorded in the second quarter of 2003 for the cost reduction actions announced on April 10, 2003.

Excluding the restructuring and impairment charges, costs and expenses for the year ended December 31, 2002 were $88.7 million, compared to $62.1 million in 2001. Also excluding non-cash charges for depreciation, amortization of intangibles and amortization of unearned stock compensation, costs and expenses for 2002 were $77.3 million, including $18.1 million in costs for operations that have subsequently been closed, compared to $53.6 million in 2001. The increase in costs and expenses was due primarily to the increased costs of our internal drug discovery efforts following the acquisition of chemistry capabilities in February 2002. These internal drug discovery efforts were reduced in the October 2002 business realignment and discontinued following the January 2003 workforce reductions.

Research and development expenses before non-cash charges increased by $23.4 million to $61.3 million in 2002 from $37.9 million in 2001. This increase included $11.5 million in costs associated with the BMSPRL (Deltagen Research Laboratories or “DRL”) operations acquired in February 2002 and substantially closed down by December 31, 2002. In addition, research and development expenses in 2002 before non-cash charges included $4.5 million from the Deltagen Proteomics and Deltagen Europe operations that were closed down in the first quarter of 2003. The related costs from these operations were $1.2 million in 2001. The remaining increase in costs and expenses is due primarily to the ramp-up during 2002 of our now discontinued internal small molecule drug discovery efforts and costs associated with our secreted protein programs with Eli Lilly and Nuvelo. The increase in depreciation and amortization is due primarily to an increase in property, plant and equipment resulting from the acquisition of BMSPRL. The increase in intangible amortization is due to the acquisition of BMSPRL in February 2002 and XenoPharm in March 2002.

General and administrative expenses before non-cash charges increased by $400,000 to $16.1 million in 2002 from $15.7 million in 2001. This increase included $700,000 in costs associated with the DRL operations acquired in February 2002 and substantially closed down by December 31, 2002. In addition, general and administrative expenses in 2002 before non-cash charges included $1.4 million from the Deltagen Proteomics and Deltagen Europe operations that were closed down in the first quarter of 2003. The related costs from these operations were $1.1 million in 2001. The increase also included $1.0 million related to staffing and infrastructure costs offset by a decrease of $2.8 million related to legal and business consulting fees.

Impairment of Goodwill and Other Long-Lived Assets

Due to current operating losses, the absence of positive cash flows, recent significant declines in our common stock price and uncertainties resulting from the business realignment plan, we assessed the recoverability of the long-lived assets related to DRL and Arcaris in accordance with SFAS 144 and tested goodwill for impairment in accordance with SFAS No. 142 during the year ended December 31, 2002. Based upon our projection of significantly reduced future cash flows related to the long-lived assets, an impairment loss of $7.1 million was recognized for completed technology and $12.4 million for property and equipment during the year ended December 31, 2002. The carrying value of the long-lived assets has been written down to expected fair value based on appraisals. The impairment test under SFAS 142 was based on a two-step process involving; comparing the estimated fair value of the related reporting unit to its net book value and comparing the estimated implied fair value of goodwill to its carrying value. As a result of the test, we wrote down goodwill by $9.4 million in the year ended December 31, 2002.

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Restructuring Charges

In 2002 we recorded restructuring charges of $7.9 million. These charges include the following (in thousands):

These charges relate primarily to the closedown of the DRL operations and workforce reductions in 2002.

Net Interest Income

Net interest income decreased by $3.0 million to $687,000 in 2002 from $3.7 million in 2001. This decrease resulted from reduced average cash and investment balances, lower interest rates on cash investments and increased borrowings during 2002 and as compared to 2001.

Years Ended December 31, 2001 and 2000

Contract revenue increased by $7.8 million to $9.9 million in 2001 from $2.1 million in 2000. The increase was due primarily to increased revenue from our DeltaBase gene function database product. DeltaBase revenue in 2001 was $8.6 million compared to $1.2 million in 2000. In 2001, all of our DeltaBase and DeltaSelect revenue came from contracts with GlaxoSmithKline, Merck, Pfizer, Schering-Plough Research Institute and Tularik, Inc.

Research and development expenses increased by $18.7 million to $45.0 million in 2001 from $26.3 million in 2000. The increase was attributable to continued growth of research and development activities, including $15.1 million related to increased personnel and laboratory supply costs to support development of our gene function database and our DeltaSelect and secreted protein programs and $6.5 million in higher depreciation and amortization and facilities expenses related to the addition of facilities in 2001. The amortization of unearned stock-based compensation decreased by $3.0 million to $2.9 million in 2001 from $5.9 million in 2000.

General and administrative expenses increased by $5.9 million to $17.0 million in 2001 from $11.1 million in 2000. The increase included $5.3 million related to staffing and infrastructure costs, $3.7 million related to legal and business consulting fees and $1.1 million in higher depreciation and amortization and facilities expenses related to the addition of facilities in 2001. The amortization of unearned stock-based compensation decreased by $4.0 million to $1.0 million from $5.0 million in 2000.

Net interest income increased by $675,000 to $3.7 million in 2001 from $3.0 million in 2000. This change resulted from increased average cash and investment balances during 2001 as a result of the completion of our initial public offering during the third quarter of 2000 partially offset by lower interest rates on cash investments.

Business Realignment

On October 2, 2002, we announced a business realignment and plan to reduce expenses. Our business strategy will focus on tools, services and targets for the discovery and development of small molecule drugs. These products and services will be marketed to drug researchers in the biopharmaceutical industry. We also expect to continue to pursue our internal drug discovery and development in secreted proteins through current and potential future collaborations.

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As part of this realignment, we reduced our staff by over 130 employees. The plan includes the closing of our San Diego operations acquired in the acquisition of the DRL operations, the planned exit from our operations in Europe and the planned consolidation of core activities into our Redwood City, California and Salt Lake City, Utah facilities.

As result of these actions, we recorded a charge in 2002 for impairment of the intangible assets related to activities that will no longer be pursued or that will be scaled back, for the impairment of fixed assets including leasehold improvements and equipment, for severance and other employee related costs and restructurings and other costs. These costs and impairments relate primarily to our operations in San Diego (DRL acquired in 2002), Salt Lake City (Arcaris acquired in 2001) and Europe.

The following table sets forth certain details associated with the business realignment charges (in thousands of dollars):