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Osiris Therapeutics, Inc. – IPO: ‘424B4’ on 8/4/06

On:  Friday, 8/4/06, at 7:28am ET   ·   Accession #:  1047469-6-10364   ·   File #:  333-134037

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 8/04/06  Osiris Therapeutics, Inc.         424B4                  1:970K                                   Merrill Corp/New/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 424B4       Prospectus                                          HTML    909K 

Filed pursuant to Rule 424(b)(4)
Registration No. 333-134037

PROSPECTUS

3,500,000 Shares

Common Stock

        This is the initial public offering of Osiris Therapeutics, Inc. We are offering 3,500,000 shares of our common stock. The initial public offering price is $11.00 per share. Our common stock has been approved for listing on the NASDAQ Global Market under the symbol "OSIR."

Investing in our common stock involves risk.
See "Risk Factors" beginning on page 8.

        Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

        We have granted the underwriters the right to purchase up to 525,000 additional shares of common stock to cover over-allotments.

The date of this prospectus is August 3, 2006.

        You should rely only on the information contained in this prospectus. We have not authorized anyone to provide information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of our common stock.

TABLE OF CONTENTS

        Through and including August 28, 2006 (25 days after the date of this prospectus), federal securities laws may require all dealers that effect transactions in our common stock, whether or not participating in this offering, to deliver a prospectus. This is in addition to the dealers' obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions.

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PROSPECTUS SUMMARY

        This summary highlights information appearing elsewhere in this prospectus. It may not contain all of the information that is important to you in deciding whether to invest in our common stock. You should read the entire prospectus carefully, including the "Risk Factors" section and the financial statements and related notes appearing at the end of this prospectus, before making an investment decision.

Our Business

        We are a leading stem cell therapeutic company focused on developing and marketing products to treat medical conditions in the inflammatory, orthopedic and cardiovascular areas. We have one marketed product, Osteocel, and three biologic drug candidates in clinical development. Osteocel and our biologic drug candidates utilize human mesenchymal stem cells, or MSCs. We obtain MSCs for use in our biologic drug candidates from the adult bone marrow of volunteer donors. MSCs are progenitor cells that have strong anti-inflammatory properties, prevent scarring, and can regenerate and repair damaged tissue. We are a fully integrated company having developed stem cell capabilities in research and development, manufacturing, marketing and distribution.

        We currently market and sell Osteocel for regenerating bone in orthopedic indications. It is the only commercially available product in the United States containing viable stem cells. Prochymal, our lead biologic drug candidate, for the treatment of inflammatory disease, is the only stem cell therapeutic for which patients are being enrolled in Phase III clinical trials and is the only stem cell therapeutic currently designated by the FDA as both an Orphan Drug and Fast Track product candidate. Our pipeline of internally developed biologic drug candidates also includes Chondrogen, for regenerating cartilage in the knee, and Provacel, for repairing heart tissue following a heart attack.

Biologic Drug Candidates

        We believe that our biologic drug candidates have advantages over other stem cell therapeutics in development for the following reasons:

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Stem Cell Source. Our stem cells are obtained from adult bone marrow, a readily available source. We obtain this bone marrow from volunteer donors between the ages of 18 and 30.



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Ability to Mass Produce. Through our proprietary manufacturing methods, we can grow MSCs in a controlled fashion to produce up to 5,000 treatments from a single bone marrow donation.



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Universal Compatibility. Many stem cell therapies under development can elicit a rejection response in the recipient and therefore require donor-to-recipient matching or potentially harmful immunosuppression. Based on our clinical experience, we believe that our biologic drug candidates are not rejected by the patient's immune system and therefore do not require matching.



•

Treatment on Demand. Our biologic drug candidates can be stored frozen at the point of care and, therefore, can be readily available to treat patients on demand. In contrast, other stem cell technologies under development require weeks to prepare after a patient's need is identified.

        We have leveraged our MSC manufacturing, clinical and preclinical experience and proprietary know-how to advance three biologic drug candidates into the clinic.

Prochymal

        We are currently enrolling patients in a pivotal Phase III clinical trial for Prochymal, our biologic drug candidate for the treatment of steroid refractory Graft versus Host Disease, or GvHD. GvHD is a life threatening immune system reaction that commonly affects the skin, gastrointestinal tract, and liver in patients who have received a bone marrow transplant. Due to a lack of adequate treatments, a large

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majority of steroid refractory GvHD patients die within six months. We have also completed enrollment of a Phase II trial evaluating Prochymal as an add-on therapy to steroids for the first-line treatment of acute GvHD.

        Based on our clinical observations of the effects of Prochymal on the gastrointestinal symptoms of patients with GvHD, we opened a Phase II trial for the treatment of Crohn's disease under a separate Investigational New Drug application. Crohn's Disease is a chronic condition that results in inflammation of the gastrointestinal tract. Enrollment for this trial was recently completed.

Chondrogen

        We recently completed enrollment in a Phase I/II clinical trial for Chondrogen, our biologic drug candidate for the regeneration of meniscus, a type of cartilage that cushions the knee joint. According to a 2005 article in the American Journal of Sports Medicine, approximately 1.0 million people have surgery to remove damaged or torn meniscus in the United States each year. As noted in a 1999 article in the journal Sports Medicine, patients who have had this procedure are ten to 15 times more likely to develop osteoarthritis, a highly debilitating orthopedic condition. In several preclinical studies, Chondrogen regenerated meniscal tissue and prevented osteoarthritis. Currently, there are no FDA approved products to regenerate meniscal tissue.

Provacel

        We recently completed enrollment in a Phase I clinical trial for Provacel, our biologic drug candidate for the repair of heart muscle in patients who have suffered a heart attack. Based on statistics published in 2005 by the American Stroke Association and the American Heart Association, in the United States approximately 700,000 individuals each year experience their first heart attack. Despite the utilization of current treatments, these statistics also indicate that many of these patients become disabled with heart failure within six years. In preclinical studies in animal models, Provacel targeted the damaged area of the heart following a single treatment. These studies also indicate that Provacel prevents scar formation that typically occurs after a heart attack and significantly improves cardiac function eight to ten weeks after its administration.

Osteocel

        We launched Osteocel in July 2005. To date, it has been used in over 1,250 surgical procedures. Osteocel consists of a matrix of cancellous bone containing mesenchymal stem cells and is used in spinal fusion and other orthopedic surgical procedures. As Osteocel does not require an additional surgery, it overcomes the disadvantages of autograft, principally post-operative pain. Autograft is a procedure to harvest bone from another site within the same patient and is the current standard of care for the regeneration of bone. Osteocel is currently distributed exclusively by us for orthopedic indications and jointly with Blackstone Medical for spinal procedures.

The Mesenchymal Stem Cell

        We believe mesenchymal stem cells, or MSCs, found in adult bone marrow will be a more promising therapeutic option than other stem cell types, including the most basic stem cell type, embryonic stem cells, or ESCs. ESCs give rise to all cell types found within the human body, but difficulties in expanding and ethical controversies surrounding the sourcing of ESCs have limited their therapeutic development. MSCs are one of two populations of stem cells that exist in adult bone marrow. The other population of stem cells found in adult bone marrow, hematopoietic stem cells, or HSCs, give rise to most types of blood cells. However, the therapeutic potential of HSCs has been limited to hematological disorders because of their ability to differentiate only into blood cells.

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        In contrast, MSCs are progenitor cells that differentiate into various connective tissues, such as bone, muscle, fat, tendon, ligament, cartilage and bone marrow stroma when they receive appropriate biochemical and biomechanical signals. Other biochemical stimuli cause MSCs to mobilize to areas of injury or inflammatory disease where they interact with local cells to reduce inflammation and scarring. In our preclinical and clinical studies, this ability has demonstrated potential therapeutic benefits in a broad range of inflammatory, orthopedic and cardiovascular diseases and disorders. MSCs also have low immunogenicity because they do not express certain cell surface molecules essential for the activation of immune cells. This allows MSCs to be utilized as a potential therapeutic treatment in patients without donor matching.

Our Business Strategy

        We are striving to be the first company to receive FDA marketing approval and to commercialize a stem cell therapy. Our goal is to be the leading stem cell therapy company through the development and commercialization of stem cell therapies to address disease areas with significant unmet medical need and commercial potential. To achieve this goal, we are pursuing the following strategies:

•

Successfully commercialize our lead stem cell therapy, Prochymal.



•

Leverage Osteocel's orthopedic sales infrastructure for our biologic drug candidate Chondrogen.



•

Expand our pipeline of biologic drug candidates where our stem cell technology has a therapeutic potential.



•

Exploit our MSC technology, manufacturing ability and proprietary know-how to advance our pipeline.



•

Internally develop and commercialize future biologic drug candidates.

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Risks Associated with Our Business

        Our business is subject to numerous risks, as more fully described in the section entitled "Risk Factors" immediately following this prospectus summary. We may be unable, for many reasons, including those that are beyond our control, to implement our current business strategy. Those reasons could include delays in obtaining, or a failure to obtain, regulatory approval for our biologic drug candidates which are based on novel technology; our failure to maintain and to protect our intellectual property assets; and our failure to obtain additional capital as needed, among others. We have a limited operating history as a stem cell therapeutic company, and as of March 31, 2006 we had an accumulated deficit of $147.7 million. We expect losses to continue for at least the next several years. Our net loss was $20.0 million for the fiscal year ended December 31, 2005 and $5.1 million for the three months ended March 31, 2006. We are unable to predict the extent of any future losses or when we will become profitable, if at all. We do not anticipate generating significant revenues from sales of our biologic drug candidates, if approved for marketing, for at least several years, if at all. All of our biologic drug candidates are in development and none have been approved by the FDA for commercial sale. Even if we succeed in developing and commercializing one or more of our biologic drug candidates, we may never generate sufficient sales revenue to achieve and then sustain profitability. Before this offering, our Chairman of the Board of Directors, Peter Friedli, beneficially owned greater than 50% of our outstanding common stock. After this offering, Mr. Friedli will beneficially own 48% of our outstanding common stock and will continue to have a significant influence over corporate actions requiring stockholder approval through his significant beneficial ownership.

Our Corporate Information

        We were incorporated in Delaware in April 2002. Our predecessor company was organized in 1992. Our principal executive offices are located at 2001 Aliceanna St., Baltimore, Maryland 21231, and our telephone number is (410) 522-5005. We maintain an Internet website at www.OsirisTx.com. We have not incorporated by reference into this prospectus the information on our website, and you should not consider it to be a part of this prospectus.

        As used in this prospectus, references to "we," "our," "us" and "Osiris" refer to Osiris Therapeutics, Inc. and its subsidiaries, unless the context requires otherwise.

        Osiris®, Osteocel®, Prochymal™, Chondrogen™, and Provacel™ are trademarks of Osiris Therapeutics, Inc. Other trademarks and service marks appearing in this prospectus are the property of their respective owners.

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The Offering

        The number of shares of our common stock outstanding after this offering is based on 9,176,247 shares outstanding as of June 30, 2006. Unless otherwise indicated, all information in this prospectus reflects the following:

•

a one-for-four reverse split of our common stock to be completed before the closing of this offering;



•

the conversion of all outstanding shares of our preferred stock into 10,867,284 shares of our common stock, as adjusted for the stock split, upon the closing of this offering;



•

the conversion of $21.8 million of our convertible notes into 2,720,909 shares of our common stock (based upon a public offering price of $11.00 per share and including interest as of June 30, 2006), as adjusted for the stock split, upon the closing of this offering; and



•

the exercise of warrants for 875,000 shares of common stock at $0.40 per share concurrent with this offering.

        The number of shares of our common stock to be outstanding immediately after this offering excludes:

•

736,378 shares of our common stock issuable upon exercise of options outstanding as of June 30, 2006, at a weighted average exercise price of $0.44 per share, of which, as of that date;



•

options to purchase 173,400 shares were exercisable; and



•

management-owned options to purchase 410,000 shares were outstanding and will be exercisable upon the closing of this offering; and



•

1,000,000 shares of our common stock issuable upon exercise of warrants outstanding as of June 30, 2006, at the per share price for which shares will be sold in this offering, all of which warrants will be exercisable as of the date of this offering; and



•

850,000 shares of our common stock available for future grant under our 2006 Omnibus Plan as of June 30, 2006.

        Unless we specifically state otherwise, the information in this prospectus assumes that the underwriters do not exercise their option to purchase up to 525,000 shares of our common stock to cover over-allotments, if any.

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Summary Financial Data

        The following tables summarize our financial data. The following summary financial data for the three-month periods ended March 31, 2006 and 2005 is constructed from our unaudited financial statements included elsewhere in this prospectus. Operating results for the three months ended March 31, 2006 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2006, or any other period. This information is only a summary and should be read together with our financial statements and the related notes included in this prospectus and the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section and other financial information included in this prospectus.

        The pro forma net loss attributable to common stockholders per share information is computed using the weighted average number of common shares outstanding, after giving pro forma effect to the conversion of all outstanding shares of our convertible preferred stock into 10,867,284 shares of common stock, the conversion of certain convertible notes into 2,630,347 shares of common stock (based upon a public offering price of $11.00 per share and including interest as of March 31, 2006), and the exercise of warrants for 875,000 shares of common stock, all concurrently with the completion of this offering, as if the conversion had occurred at the dates of the original issuances.

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        The following table presents an unaudited summary of our balance sheet as of March 31, 2006:

•

on an actual basis;



•

on a pro forma basis to give effect to the conversion of all outstanding shares of our preferred stock into 10,867,284 shares of common stock, the conversion of $21.8 million of our convertible notes into 2,630,347 shares of common stock (based upon a public offering price of $11.00 per share and including interest as of March 31, 2006), and the exercise of warrants for 875,000 shares of common stock at $0.40 per share concurrent with this offering, each of which will become effective upon the closing of this offering; and



•

on a pro forma as adjusted basis to give effect to the sale of 3,500,000 shares of common stock by us in this offering at an initial public offering price of $11.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses to be paid by us.

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RISK FACTORS

        Before you invest in our common stock, you should understand the high degree of risk involved. You should consider carefully the description of those risks set forth below as well as the other information in this prospectus, including the historical financial statements and related notes, before you decide to purchase shares of our common stock. If any of the following risks actually occurs, our business, financial condition and operating results could be adversely affected. As a result, the trading price of our common stock could decline and you could lose part or all of your investment.

Risks Related To Our Business

We have a history of operating losses and may not achieve or sustain profitability.

        We have incurred losses in each year since our inception and expect to experience losses over the next several years. As of March 31, 2006, we had an accumulated deficit of $147.7 million. These losses resulted principally from costs incurred in our research and development programs and from our general and administrative expenses. These losses, among other things, have had and will continue to have an adverse effect on our stockholders' equity, total assets and working capital.

        We expect to continue to incur significant operating expenses and anticipate that our expenses and losses will increase in the foreseeable future as we seek to:

•

complete our Phase II and III clinical trials for Prochymal;



•

complete our Phase I/II clinical trial for Chondrogen and, if supported by the Phase I/II clinical trial, initiate additional clinical trials;



•

complete our Phase I clinical trial for Provacel and, if supported by the Phase I clinical trial, initiate Phase II clinical trials;



•

maintain and expand our network of sales professionals for the distribution of Osteocel, and further expand and train our sales network in anticipation of the approval of our biologic drug candidates for commercial sale;



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expand our manufacturing capacity, which will require that we obtain additional administrative and manufacturing space and build-out a portion of that space as a Food and Drug Administration, or FDA, compliant and validated product manufacturing facility;



•

relocate some or all of our business operations to a newly leased facility;



•

maintain, expand and protect our intellectual property portfolio;



•

hire additional clinical, quality control, scientific and management personnel; and



•

add operational, financial, accounting, facilities engineering and information systems personnel, consistent with expanding our operations and our status as a public company.

        In addition, Osteocel is our only commercially available product. While revenue from Osteocel has increased since its commercial introduction in July 2005, our ability to scale up our production capabilities for commercial quantities of this product are limited, and our costs in marketing and distributing this product will also increase as production increases.

        The extent of our future operating losses or profits is highly uncertain, and we may not achieve or sustain profitability. If we are unable to achieve and then maintain profitability, the market value of our common stock will decline and you could lose part or all of your investment.

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We may not be able to raise additional capital necessary to fund our operations.

        Our future capital requirements will depend on many factors, including:

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the level of cash flows from Osteocel sales;



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the scope and results of our research and preclinical development programs;



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the scope and results of our clinical trials, particularly regarding the number of patients required for our Phase III trial for Prochymal;



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the timing of and the costs involved in obtaining regulatory approvals for our biologic drug candidates, which could be more lengthy or complex than obtaining approval for a new conventional drug, given the FDA's limited experience with late-stage clinical trials and marketing approval for stem cell therapeutics;



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the costs of building and operating our manufacturing facilities, both in the near term to support Osteocel sales and our clinical activities and also in anticipation of expanding our commercialization activities;



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the costs of maintaining, expanding and protecting our intellectual property portfolio, including potential litigation costs and liabilities;



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our debt repayment obligations; and



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the costs of enlarging our work force consistent with expanding our business and operations and status as a public company, and as necessary to enhance and train our sales network in anticipation of the approval of our biologic drug candidates for commercial sale.

        As a result of these factors, we may need or choose to seek additional funding prior to our becoming cash flow positive on an operational basis. We would likely seek such funding through public or private financings or some combination of them. Although not our current focus, we might also seek funding through collaborative arrangements if determined to be necessary or appropriate. Additional funding may not be available to us on acceptable terms, or at all. If we obtain capital through collaborative arrangements, these arrangements could require us to relinquish rights to our technologies or biologic drug candidates. If we raise capital through the sale of equity, or securities convertible into equity, dilution to our then existing stockholders would result. If we raise additional capital through the incurrence of debt, we would likely become subject to covenants restricting our business activities, and holders of debt instruments would have rights and privileges senior to those of our equity investors. In addition, servicing the interest and repayment obligations under these borrowings would divert funds that would otherwise be available to support research and development, clinical or commercialization activities.

        If we are unable to obtain adequate financing on a timely basis, we may be required to delay, reduce the scope of or eliminate one or more of our programs, any of which could have a material adverse effect on our business, financial condition and results of operations.

If the potential of our stem cell therapies to treat diseases is not realized, the value of our technology and our development programs could be significantly reduced.

        The potential of our stem cell therapies to treat diseases is currently being explored by us. We have not proven in clinical trials that our stem cell therapy will be a safe and effective treatment for any disease. Our stem cell therapies are susceptible to various risks, including undesirable and unintended side effects, unintended immune system responses, inadequate therapeutic efficacy or other

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characteristics that may prevent or limit their marketing approval or commercial use. We have not treated a sufficient number of patients to allow us to make a determination that serious unintended consequences will not occur. If the potential of our stem cell therapies to treat disease is not realized, the value of our technology and our development programs could be significantly reduced. Because our biologic drug candidates are based on MSCs, any negative developments regarding the therapeutic potential or side effects of MSCs could have a material adverse effect on our business, financial condition and results of operations.

Our product development programs are based on novel technologies and are inherently risky.

        We are subject to the risks of failure inherent in the development of products based on new technologies. The novel nature of our therapeutics creates significant challenges in regards to product development and optimization, manufacturing, government regulation, third-party reimbursement and market acceptance. For example, the FDA has relatively limited experience with stem cell therapies. None has been approved by the FDA for commercial sale, and the pathway to regulatory approval for our biologic drug candidates may accordingly be more complex and lengthy. Additionally, stem cells are subject to donor-to-donor variability, which can make standardization more difficult. As a result, the development and commercialization pathway for our therapies may be subject to increased uncertainty, as compared to the pathway for new conventional drugs.

There are no FDA approved treatments for some of the disease indications we are pursuing. This could complicate and delay FDA approval of our biologic drug candidates.

        There are no drugs or therapies currently approved with stated indications for the first-line treatment of acute GvHD or the treatment of steroid refractory GvHD. As a result, the clinical efficacy endpoints, or the criteria to measure the intended results of treatment, for our biologic drug candidate Prochymal for the treatment of GvHD may be difficult to determine. In addition, patients battling GvHD and who, therefore, are candidates for treatment with Prochymal, are typically very ill as a result of an underlying genetic or oncologic condition. Due to the graveness of their underlying disease and the very serious complications and disorders that often accompany acute GvHD, many of these patients will die from causes other than GvHD prior to the completion of the study even if their GvHD responds favorably to treatment with Prochymal. The resulting reduction in the number of patients available for evaluation at the end of the study may make it more difficult for us to demonstrate efficacy, as necessary to obtain FDA approval to market Prochymal for commercial sale.

        There are also no drugs or therapies currently approved with stated indications for the regeneration of meniscal tissue or the repair of heart muscle following heart attack. As a result, the clinical endpoints for our biologic drug candidates Chondrogen and Provacel may be difficult to determine. In the case of Prochymal for the treatment of Crohn's Disease, there are other products approved for the treatment of this disease, so it is expected that the clinical efficacy endpoints for Prochymal for this indication will be established by comparison with these already approved treatments. In order to obtain FDA approval for this indication, we will have to demonstrate, among other things, that our biologic drug candidate is safe and effective. The results of our clinical trials must be statistically significant, meaning that there must be sufficient data to indicate that it is unlikely the outcome occurred by chance. These challenges may prevent us from developing and commercializing products on a timely or profitable basis, or at all.

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Our biologic drug candidates represent new classes of therapy that the marketplace may not understand or accept.

        Even if we successfully develop and obtain regulatory approval for our biologic drug candidates, the market may not understand or accept them. We are developing biologic drug candidates that represent novel treatments and will compete with a number of more conventional products and therapies manufactured and marketed by others, including major pharmaceutical companies. The degree of market acceptance of any of our developed and potential products will depend on a number of factors, including:

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the clinical safety and effectiveness of Osteocel and our biologic drug candidates and their perceived advantage over alternative treatment methods;



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our ability to demonstrate that Prochymal can have a clinically significant effect on steroid refractory GvHD;



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our ability to separate ourselves from the ethical controversies associated with stem cell drug candidates derived from human embryonic or fetal tissue;



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ethical controversies that may arise regarding the use of stem cells or human tissue of any kind, including adult stem cells, adult bone marrow and other adult tissues derived from donors, in the manufacture and sale for profit of Osteocel and our biologic drug candidates;



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adverse events involving our biologic drug candidates or the products or product candidates of others that are stem cell based;



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our ability to supply a sufficient amount of our product to meet regular and repeated demand in order to develop a core group of medical professionals familiar with and committed to the use of our products; and



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the cost of our products and the reimbursement policies of government and third-party payors.

        If the health care community does not accept Osteocel or our potential products for any of the foregoing reasons, or for any other reason, it could affect our sales, having a material adverse effect on our business, financial condition and results of operations.

The successful commercialization of our biologic drug candidates, or any of our other potential stem cell therapeutics, will depend on obtaining reimbursement from third-party payors.

        If we successfully develop and obtain necessary regulatory approvals, we intend to sell our biologic drug candidates initially in the United States and Europe. In the United States, the market for any pharmaceutical product is affected by the availability of reimbursement from third-party payors, such as government health administration authorities, private health insurers, health maintenance organizations and pharmacy benefit management companies. Stem cell therapies like Prochymal, Chondrogen and Provacel may be expensive compared with standard pharmaceuticals, due to the higher cost and complexity associated with the research, development and production of stem cell therapies, the small size and large geographic diversity of the target patient population for some indications, and the complexity associated with distribution of stem cell therapies which require special handling and shipment procedures and protocols. This, in turn, may make it more difficult for us to obtain adequate reimbursement from third-party payors, particularly if we cannot demonstrate a favorable cost-benefit relationship. Third-party payors may also deny coverage or offer inadequate levels of reimbursement for our potential products if they determine that the product has not received appropriate clearances from the FDA or other government regulators or is experimental, unnecessary or inappropriate. For example, patients battling GvHD and who, therefore, are candidates for treatment with Prochymal, are

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typically very ill as a result of an underlying genetic or oncologic condition. Because these patients have a low probability of survival (whether or not their GvHD is successfully treated), third-party payors may resist reimbursing the cost of treatment.

        In the countries of Europe and in some other countries, the pricing of prescription pharmaceutical products and services and the level of government reimbursement are subject to governmental control. In these countries, pricing negotiations with governmental authorities can take six to 12 months or longer after the receipt of marketing approval for a product. To obtain reimbursement or pricing approval in some countries, we may be required to conduct one or more clinical trials that compares the cost effectiveness of our biologic drug candidates or products to other available therapies. Conducting one or more clinical trials would be expensive and result in delays in commercialization of our products.

        Managing and reducing health care costs has been a general concern of federal and state governments in the United States and of foreign governments. Although we do not believe that any recently enacted or presently proposed legislation should impact our business, we might be subject to future regulations or other cost-control initiatives that materially restrict the price we receive for our products. In addition, third-party payors are increasingly challenging the price and cost-effectiveness of medical products and services, and many limit reimbursement for newly approved health care products. In particular, third-party payors may limit the indications for which they will reimburse patients who use any products that we may develop. Cost control initiatives could decrease the price for products that we may develop, which would result in lower product revenues to us.

Our dependence upon a limited supply of adult marrow-rich bone necessary to produce Osteocel may impact our ability to produce Osteocel on a large scale.

        The production of Osteocel does not involve an expansion of MSCs and is therefore limited by the amount of adult human marrow-rich bone donations that are available to us. Since the introduction of Osteocel into the marketplace in July 2005, we have been unable to obtain quantities of adult human marrow-rich bone sufficient to meet the demand for Osteocel. Specifically, the demand for Osteocel in 2005 was approximately five times greater than our ability to supply the product, inhibiting our ability to maximize revenue from Osteocel. Osteocel consists of primary, or unexpanded, MSCs in a matrix of viable cancellous bone. Cancellous bone is the porous and spongy inner structure of bones accounting for approximately 20% of total bone mass. The bone and cells are derived from human organ and tissue donors. We rely on the efforts of not-for-profit donor procurement agencies to educate the public and foster an increased willingness to donate bone tissue. These organizations may not be able to provide us with sufficient amounts of viable cancellous bone to meet present or future demand for Osteocel. Our inability to secure enough viable cancellous bone to meet our Osteocel demands limits our ability to successfully market and drive market acceptance of Osteocel and may limit our potential revenues from Osteocel.

Our dependence upon a limited supply of bone marrow donors may impact our ability to produce sufficient quantities of our biologic drug candidates as necessary to complete our clinical trials, and if our trials are successful, to meet product demand.

        The population of acceptable bone marrow donors is limited to volunteers between the ages of 18 and 30. In addition, potential donors are prescreened for a variety of health conditions and are only allowed to donate bone marrow a total of six times in their lifetime, further limiting the total number of potential donors. The amount of bone marrow donated may be insufficient for us to mass produce our biologic drug candidates. Future government regulation or health concerns may also reduce the number of donors or otherwise limit the amount of bone marrow available to us. If we cannot secure quantities of bone marrow sufficient to meet the manufacturing demands for our clinical trials, we

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might not be able to complete our clinical trials and obtain marketing approval for our biologic drug candidates. Moreover, even if our clinical trials are successful and we obtain marketing approval for our biologic drug candidates, our inability to secure enough bone marrow to meet product demand would limit our potential revenues.

Osteocel and our biologic drug candidates are derived from human tissue and bone marrow sources and therefore have the potential for disease transmission.

        The utilization of donated adult human cancellous bone and bone marrow creates the potential for transmission of communicable disease, including but not limited to human immunodeficiency virus, or HIV, viral hepatitis, syphilis, Creutzfeldt-Jakob disease, or the human form of "mad cow" disease, and other viral, fungal or bacterial pathogens. Although we are required to comply with federal and state regulations intended to prevent communicable disease transmission, and our suppliers of adult human bone and bone marrow are also required to comply with such regulations in connection with their collection, storage and supply to us:

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we or our suppliers may fail to comply with such regulations;



•

even with compliance, our products might nevertheless be viewed by the public as being associated with transmission of disease; and



•

a patient that contracts an infectious disease might assert that the use of our products resulted in disease transmission, even if the patient became infected through another source.

        Any actual or alleged transmission of communicable disease could result in patient claims, litigation, distraction of management's attention and potentially increased expenses. Further, any failure in screening, whether by us or other manufacturers of similar products, could adversely affect our reputation, the support we receive from the medical community and overall demand for our products. As a result, such actions or claims, whether or not directed at us, could have a material adverse effect on our reputation with our customers and our ability to market our products, which could have a material adverse effect on our business, financial condition and results of operations.

We have only limited experience manufacturing Osteocel and our biologic drug candidates. We may not be able to manufacture Osteocel in quantities sufficient to expand our market for the product and may not be able to manufacture our biologic drug candidates in quantities sufficient for later stage clinical studies or for commercial sale.

        We may encounter difficulties in the production of Osteocel and our biologic drug candidates due to our manufacturing capabilities. We have not built commercial-scale manufacturing facilities, and we have limited manufacturing experience with Osteocel and our biologic drug candidates. These difficulties could reduce sales of our products, increase our costs or cause production delays, any of which could damage our reputation and hurt our profitability. Even if we were to obtain access to quantities of adult marrow-rich bone sufficient to allow us otherwise to expand our Osteocel manufacturing capabilities, we may not be able to produce sufficient quantities of the product at an acceptable cost, or at all.

        If we successfully obtain marketing approval for one of our biologic drug candidates, we may not be able to produce sufficient quantities of the product at an acceptable cost. Commercial-scale production of therapies made from live human mesenchymal stem cells involves production in small batches and strict adherence to complex manufacturing and storage protocols and procedures. Our biologic drug candidates are inherently more difficult to manufacture at commercial-scale than chemical pharmaceuticals, which are manufactured using precise chemical formulations and operational methods.

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We use third-party collaborators to help us develop and commercialize our products, and our ability to commercialize such products may be impaired or delayed if collaborations are unsuccessful.

        We have arrangements in place with third-party collaborators as a means to help us with research and development efforts or marketing and distribution. For example:

•

we currently sell a large majority of our Osteocel product through a distribution arrangement with Blackstone Medical, Inc., which sells this product under the Blackstone brand "Trinity";



•

we have a collaboration with Boston Scientific Corporation for cardiovascular applications of our MSC technology; and



•

we have a collaboration with JCR Pharmaceuticals Co., Ltd. granting to JCR an exclusive right to Prochymal for the treatment of GvHD in Japan.

        Although we have no current intention to do so, we may enter into additional collaborations in the future. We are dependent upon the success of our current and any future collaborators in performing their responsibilities and their continued cooperation. Our collaborators may not cooperate with us or perform their obligations under our agreements with them. We cannot control the amount and timing of our collaborators' resources that will be devoted to performing their responsibilities under our agreements with them. Our collaborators may choose to pursue alternative technologies in preference to those being developed in collaboration with us. The development and commercialization of our potential products will be delayed if collaborators fail to conduct their responsibilities in a timely manner or if they breach or terminate their collaboration agreements with us. Disputes with our collaborators could result in product development delays, decreased revenues and litigation expenses. In addition, because our products may be marketed under a different brand name by our collaborators, as is the case in our relationship with Blackstone, should the relationship be terminated for any reason, our product recognition could be adversely impacted, affecting our product and potentially causing brand confusion in the market.

We are dependent upon third-party suppliers for services and raw materials needed for the manufacture, and we are dependent upon third parties for the distribution, of Osteocel and our biologic drug candidates. If any of these third parties fail or are unable to perform in a timely manner, our ability to manufacture and deliver will be compromised.

        In order to produce our biologic drug candidates for use in clinical studies, and to produce Osteocel and any other of our biologic drug candidates that may be approved for commercial sale, we require biological media, reagents and other highly specialized materials. This is in addition to the adult marrow-rich bone donations used in the manufacture of Osteocel, and the bone marrow aspirate used in the manufacture of our biologic drug candidates. These items must be manufactured and supplied to us in sufficient quantities and in compliance with current Good Manufacturing Practices, or cGMP. To meet these requirements, we have entered into supply agreements with firms which manufacture these components to cGMP standards. Our requirements for these items are expected to increase if and when we transition to the manufacture of commercial quantities of our biologic drug candidates. In addition, as we proceed with our clinical trial efforts, we must be able to demonstrate to the FDA that we can manufacture our biologic drug candidates with consistent characteristics. Accordingly, we are materially dependent on these suppliers for supply of cGMP-grade components of consistent quality. Our ability to complete ongoing clinical trials may be negatively affected in the event that we are forced to seek and validate a replacement source for any of these critical components. If we are not able to obtain adequate supplies of these items of consistent quality from our third-party suppliers, it will also be more difficult to manufacture commercial quantities of Osteocel or any of our current biologic drug candidates that may subsequently be approved for commercial sale.

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        In addition, we rely on third parties to distribute Osteocel and, if approved, our biologic drug candidates. Proper shipping and distribution requires compliance with specific storage and shipment procedures. For example, our products must be placed in a freezer within 72 hours of shipment. Failure to comply with these procedures or the occurrence of inadvertent damage to the shipping container will necessitate return and replacement, potentially resulting in additional cost and causing us to fail to meet supply requirements.

Use of third-party manufacturers may increase the risk that we will not have adequate quantities of our biologic drug candidates.

        We have used third-party manufacturers to supply our biologic drug candidates for clinical trials. Reliance on third-party manufacturers entails risks to which we would not be subject if we manufactured such components ourselves, including:

•

reliance on the third party for regulatory compliance and quality assurance;



•

the possible breach of the manufacturing agreement by the third party; and



•

the possible termination or nonrenewal of the agreement by the third party, based on its own business priorities, at a time that is costly or inconvenient for us.

        Our contract manufacturers are subject to all of the risks and uncertainties that we have when we manufacture on our own. Similar to us, they are subject to ongoing, periodic, unannounced inspection by the FDA and corresponding state and foreign agencies or their designees to ensure strict compliance with cGMP regulations and other governmental regulations and corresponding foreign standards. However, we do not control compliance by our contract manufacturers with these regulations and standards. Our present or future manufacturers might not be able to comply with these regulatory requirements. If our third-party manufacturers fail to comply with applicable regulations, the FDA or other regulatory authorities could impose sanctions on us, including fines, injunctions, civil penalties, denial of marketing approval of our biologic drug candidates, delays, suspension or withdrawal of approvals, license revocation, seizures or recalls of biologic drug candidates or our other products, operating restrictions and criminal prosecutions. Any of these actions could significantly and adversely affect supplies of our biologic drug candidates or other products and could have a material adverse effect on our business, financial condition and results of operations.

        We recently delivered a notice of termination to the contract manufacturer that we had been using to manufacture our biologic drug candidates under development. As a result, this contract terminates in September 2006. We anticipate either renegotiating our contract with this contract manufacturer or negotiating a new agreement with another contract manufacturer. The transition to a replacement contract manufacturer has additional risks, including those risks associated with the development by the replacement contract manufacturer of sufficient levels of expertise in the manufacturing process. If we are unable to renegotiate this agreement or enter into a replacement agreement with another contract manufacturer on reasonable terms and in a timely manner, or if any replacement contract manufacturer is unable to develop sufficient manufacturing expertise in a timely manner, we could experience shortages of clinical trial materials, which would negatively impact our ability to complete our clinical trials and obtain marketing approval for the commercial sale of our biologic drug candidates.

If our processing and storage facility or our clinical manufacturing facilities are damaged or destroyed, our business and prospects would be negatively affected.

        If our processing and storage facility or the equipment in the facility were to be significantly damaged or destroyed, we could suffer a loss of some or all of the stored units of our biologic drug candidates and it would force us to halt our clinical trial processes.

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        We have a manufacturing facility located in Baltimore, Maryland at which we produce and store stem cells for our clinical trials and Osteocel prior to sale. If this facility or the equipment in it is significantly damaged or destroyed, we may not be able to quickly or inexpensively replace our manufacturing capacity. This facility is located on the Baltimore harbor, and in September 2003 it was flooded by Hurricane Isabel. This event resulted in a temporary suspension of our manufacturing operations. In the event of another temporary or protracted loss of this facility or equipment, we may be able to transfer manufacturing to a third party, but the shift would likely be expensive, and the timing would depend on availability of third-party resources and the speed with which we could have a new facility comply with the necessary regulatory requirements. Such an event could halt our clinical trials and distribution of Osteocel due to a lack of available product. In addition, we have subleased a portion of our facility which requires approval under our lease. We are seeking approval from our landlord for this sublease.

        We have entered into an agreement to sublease approximately 61,203 square feet of space in Columbia, Maryland beginning August 2006, and plan to begin manufacturing in this facility in early 2007.

        Currently, we maintain insurance coverage totaling $12.3 million against damage to our property and equipment, an additional $4.0 million to cover business interruption and extra expenses, and $5.6 million to cover R&D restoration expenses. If we have underestimated our insurance needs, we will not have sufficient insurance to cover losses above and beyond the limits on our policies.

We have experienced significant management turnover.

        Our current Chief Executive Officer, C. Randal Mills, began service in July 2004. All of our executive officers have joined us since then. Since 1999, we have experienced significant management turnover. Including three interim appointees, we have had six chief executive officers since 1999. The departure of two of these resulted in litigation against us. Both of these matters have been settled. This lack of management continuity, and the resulting lack of long-term history with our company, could result in operational and administrative inefficiencies and added costs. If we were to experience additional turnover at the executive level, these risks would be exacerbated.

If we are not able to recruit and retain qualified management and scientific personnel, we may fail in developing our technologies and biologic drug candidates.

        Our future success depends to a significant extent on the skills, experience and efforts of the principal members of our scientific, management and sales personnel. These members include C. Randal Mills, Ph.D., Harry E. Carmitchel, Cary J. Claiborne, Earl R. Fender and Lode Debrabandere. The loss of any or all of these individuals could harm our business and might significantly delay or prevent the achievement of research, development or business objectives. We have entered into employment agreements with Dr. Mills and Messrs. Carmitchel, Claiborne, Fender and Debrabandere for an initial term of three years. The existence of an employment agreement does not, however, guarantee retention of these employees, and we may not be able to retain those individuals for the duration of or beyond the end of their respective terms. Except for Dr. Mills and Messrs. Claiborne, Carmitchel, Fender and Debrabandere, none of our employees is employed for a specified term. Competition for personnel is intense. We may be unable to retain our current personnel or attract or integrate other qualified management and scientific personnel in the future.

        We also rely from time-to-time on outside advisors who assist us in formulating our research and development and clinical strategy. We may not be able to attract and retain these individuals on acceptable terms, which could have a material adverse effect on our business, financial condition and results of operations.

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Ethical and other concerns surrounding the use of stem cell therapy or human tissue may negatively affect public perception of us or our products or biologic drug candidates, or may negatively affect regulatory approval of our products or biologic drug candidates, thereby reducing demand for our products and adversely affecting the market price for our common stock.

        The commercial success of Osteocel and our biologic drug candidates will depend in part on general public acceptance of the use of stem cell therapy and donated human tissue for the prevention or treatment of human diseases. The use of embryonic stem cells and fetal tissue for research and stem cell therapy has been the subject of substantial national and international debate regarding related ethical, legal and social issues. In the U.S., for example, federal government funding of embryonic stem cell research has been limited to specifically identified cell lines and is not otherwise available. We do not use embryonic stem cells or fetal tissue, but the public may not be able to, or may fail to, differentiate our use of adult stem cells from the use by others of embryonic stem cells or fetal tissue. This could result in a negative perception of our company or our products or biologic drug candidates.

        We obtain our stem cells from volunteer adult bone marrow donors and we obtain cancellous human bone for the production of Osteocel from non-profit organizations that collect and process human organ and tissue donations. Bone marrow donors receive payment, but payment is not received by either human organ and tissue donors or their surviving family members. Ethical concerns have been raised by some about the use of donated human tissue in a for-profit setting, as we are doing.

        Future adverse events in the field of stem cell therapy or changes in public policy could also result in greater governmental regulation of our products and biologic drug candidates and potential regulatory delays relating to the testing or approval of our biologic drug candidates.

We compete with other companies for funding and product sales. Many of our competitors have greater resources or capabilities than we have, or may already have or succeed in developing better products or in developing products more quickly than we do, and we may not compete successfully with them.

        The pharmaceutical and biotechnology industries are highly competitive. We compete for funding and, if our products become available for commercial sale, we will compete in the market place. For funding, we compete primarily with other companies which, like us, are focused on developing novel products or therapies for the treatment of human disease based on stem cells or other novel scientific principles. These include Aastrom Biosciences, Advanced Cell Technology, Athersys, Cellerant Therapeutics, Cognate Therapeutics, Cytori Therapeutics, Gamida Cell, Geron, Mesoblast, MultiCell Technologies, Neuronyx, Theradigm, ViaCell, and StemCells.

        In the marketplace, we compete or may eventually compete with other companies and organizations that are marketing or developing therapies for our targeted disease indications, based on traditional pharmaceutical, medical device or other, non-cellular therapy and technologies. These include: Johnson & Johnson, the manufacturer of Cellect for the repair of bone, which competes with Osteocel; Medtronic and Stryker, the manufacturers of Infuse and OP-1, respectively, which compete with Osteocel; Novartis, the manufacturer of Neoral for the prevention of organ rejection in transplant patients, which would compete with Prochymal for the treatment of GvHD; and Centocor, the manufacturer of Remicade, which would compete with Prochymal for the treatment of Crohn's Disease. In addition to those listed above, we have other potential competitors developing a variety of therapeutics.

        We also face competition in the cell therapy field from academic institutions and governmental agencies. Many of our current and potential competitors have greater financial and human resources

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than we have, including more experience in research and development and more established sales, marketing and distribution capabilities.

        We anticipate that competition in our industry will increase. In addition, the health care industry is characterized by rapid technological change, resulting in new product introductions and other technological advancements. Our competitors may develop and market products that render our current product or any future product non-competitive or otherwise obsolete.

The use of our stem cell therapies in human subjects may expose us to product liability claims, and we may not be able to obtain adequate insurance.

        We face an inherent risk of product liability claims. Neither Osteocel nor any of our biologic drug candidates has been widely used over an extended period of time, and therefore our safety data are limited. We derive the raw materials for manufacturing Osteocel and our biologic drug candidates from human donor sources, the manufacturing process is complex, and the handling requirements are specific, all of which increase the likelihood of quality failures and subsequent product liability claims. We will need to increase our insurance coverage if and when we begin commercializing our biologic drug candidates. We may not be able to obtain or maintain product liability insurance on acceptable terms with adequate coverage or at all. If we are unable to obtain insurance, or if claims against us substantially exceed our coverage, then our business could be adversely impacted. Whether or not we are ultimately successful in any product liability litigation, such litigation could consume substantial amounts of our financial and managerial resources and could result in:

•

significant awards against us;



•

substantial litigation costs;



•

recall of the product;



•

injury to our reputation;



•

withdrawal of clinical trial participants; and



•

adverse regulatory action.

        Any of these results could have a material adverse effect on our business, financial condition and results of operations.

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Risks Related to Intellectual Property

If our patent position does not adequately protect Osteocel, our biologic drug candidates or any future products, others could compete against us more directly, which would harm our business and have a material adverse effect on our financial condition and results of operations.

        Our success depends, in large part, on our ability to obtain and maintain intellectual property protection for our biologic drug candidates. The patent position of biotechnology companies is generally highly uncertain, involves complex legal and factual questions and has been the subject of much litigation. Neither the U.S. Patent and Trademark Office nor the courts has a consistent policy regarding the breadth of claims allowed or the degree of protection afforded under many biotechnology patents.

        The claims of our existing U.S. patents and those that may issue in the future, or those licensed to us, may not confer on us significant commercial protection against competing products. Third parties may challenge, narrow, invalidate or circumvent any patents we own or may obtain in the future. Our patents on MSC technology, in particular, are quite broad in that they cover mesenchymal stem cells and the therapeutic use thereof. Patents with broad claims tend to be more vulnerable to challenge by other parties than patents with more narrowly written claims. Also, our pending patent applications may not issue, and we may not receive any additional patents. Further, the laws of foreign countries may not protect our intellectual property rights to the same extent as do laws of the United States. Our patents might not contain claims that are sufficiently broad to prevent others from utilizing our technologies. Consequently, our competitors may independently develop competing products that do not infringe our patents or other intellectual property. We have filed a patent application covering the composition of matter and methods of manufacture of our commercially available product, Osteocel. This patent has not yet issued and there can be no assurances that it will ever issue. Osteocel is different from our other biologic drug candidates in that it contains primary, or unexpanded, MSCs in a matrix of cancellous bone. Because we do not have a granted patent specifically directed to Osteocel, and because FDA approval is generally not required for tissue based products like Osteocel, competitors might choose to enter this market and produce a substantially similar product that is not covered by a granted patent, whereby we may not be able to prevent the marketing and sale of any such similar products by others. Should others produce a substantially similar product, we will be subject to increased competition and our potential revenues from Osteocel sales may be limited.

        Because of the extensive time required for development, testing and regulatory review of a potential product, it is possible that, before any of our products can be commercialized, any related patent may expire or remain in force for only a short period following commercialization, thereby reducing any advantages of the patent. For instance, one of our base patents on MSC technology will expire in 2013. To the extent our biologic drug candidates based on that technology are not commercialized significantly ahead of this date, or to the extent we have no other patent protection on such products, those products would not be protected by patents beyond 2013. The background technologies used in the development of our biologic drug candidates are known in the scientific community, and it is possible to duplicate the methods we use to create our biologic drug candidates.

If we are unable to protect the confidentiality of our proprietary information and know-how, our competitive position would be impaired and our business, financial condition and results of operations could be adversely affected.

        A significant amount of our technology, especially regarding manufacturing processes, is unpatented and is maintained by us as trade secrets. In an effort to protect these trade secrets, we require our employees, consultants, collaborators and advisors to execute confidentiality agreements upon the commencement of their relationships with us. These agreements require that all confidential information developed by the individual or made known to the individual by us during the course of

19

the individual's relationship with us be kept confidential and not disclosed to third parties. These agreements, however, may not provide us with adequate protection against improper use or disclosure of confidential information, and these agreements may be breached. For example, a portion of the manufacture of Osteocel is protected by trade secrets. A breach of confidentiality could affect our competitive position. In addition, in some situations, these agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants, collaborators or advisors have previous employment or consulting relationships. Also, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets.

        Adequate remedies may not exist in the event of unauthorized use or disclosure of our confidential information. The disclosure of our trade secrets would impair our competitive position and could have a material adverse effect on our business, financial condition and results of operations.

If we infringe or are alleged to infringe intellectual property rights of third parties, it will adversely affect our business, financial condition and results of operations.

        Our research, development and commercialization activities, including any biologic drug candidates or products resulting from these activities, may infringe or be claimed to infringe patents owned by third parties and to which we do not hold licenses or other rights. There may be applications that have been filed but not published that, when issued, could be asserted against us. These third parties could bring claims against us that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages. Further, if a patent infringement suit were brought against us, we could be forced to stop or delay research, development, manufacturing or sales of the product or biologic drug candidate that is the subject of the suit.

        For example, we are aware of patents owned by third parties that are directed toward mesenchymal stem cells and the use thereof. Our preliminary research suggests that our biologic drug candidates, upon commercialization, would not infringe a valid claim of these patents. However, our review of these patents is still at an early stage, and our views are subject to change.

        As a result of patent infringement claims, or in order to avoid potential claims, we may choose or be required to seek a license from the third party. These licenses may not be available on acceptable terms, or at all. Even if we are able to obtain a license, the license would likely obligate us to pay license fees or royalties or both, and the rights granted to us might be nonexclusive, which could result in our competitors gaining access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations, if, as a result of actual or threatened patent infringement claims, we are unable to enter into licenses on acceptable terms. All of the issues described above could also impact our collaborators, which would also impact the success of the collaboration and therefore us.

        There has been substantial litigation and other proceedings regarding patent and other intellectual property rights in the pharmaceutical and biotechnology industries. In addition to infringement claims against us, we may become a party to other patent litigation and other proceedings, including interference proceedings declared by the United States Patent and Trademark Office and opposition proceedings in the European Patent Office, regarding intellectual property rights with respect to our products and technology. For example, the patent that was granted to us in Europe for human mesenchymal stem cells has been opposed in the European Patent Office by two different companies. A hearing date for the opposition has not been set, and the losing party has the right to appeal the initial decision. If we do not prevail in the opposition proceedings, we will not have broad patent protection with respect to mesenchymal stem cells in Europe. The outcome of the proceedings is uncertain at this time. The cost to us of any patent litigation or other proceeding, even if resolved in our favor, could be substantial. Some of our competitors may be able to sustain the costs of such litigation or proceedings more effectively than we can because of their substantially greater financial

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resources. Patent litigation and other proceedings may also absorb significant management time. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to compete in the marketplace and, as a result, on our business, financial condition and results of operations.

We may become involved in lawsuits to protect or enforce our patents or the patents of our collaborators or licensors, which could be expensive and time consuming.

        Competitors may infringe our patents or the patents of our collaborators or licensors. As a result, we may be required to file infringement claims to counter infringement or unauthorized use. This can be expensive, particularly for a company of our size, and time-consuming. In addition, in an infringement proceeding, a court may decide that a patent of ours is not valid or is unenforceable, or may refuse to stop the other party from using the technology at issue on the grounds that our patents do not cover its technology. An adverse determination of any litigation or defense proceedings could put one or more of our patents at risk of being invalidated or interpreted narrowly and could put our patent applications at risk of not issuing. We are aware of several companies that are employing mesenchymal stem cell technology in their research and product development efforts. If such companies commercialize such products, there is no assurance that we would have a basis for initiating patent infringement proceedings or that if initiated we would prevail in such proceedings.

        Interference proceedings brought by the U.S. Patent and Trademark Office may be necessary to determine the priority of inventions with respect to our patent applications or those of our collaborators or licensors. Litigation or interference proceedings may fail and, even if successful, may result in substantial costs and distraction to our management. We may not be able, alone or with our collaborators and licensors, to prevent misappropriation of our proprietary rights, particularly in countries where the laws may not protect such rights as fully as in the United States.

        Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential information could be compromised by disclosure during this type of litigation. In addition, during the course of this kind of litigation, there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If investors perceive these results to be negative, the market price for our common stock could be significantly harmed.

Risks Related to Regulatory Approval and Other Government Regulations

If we are not able to successfully develop and commercialize our biologic drug candidates and obtain the necessary regulatory approvals, we may not generate sufficient revenues to continue our business operations.

        In order to generate sales revenue from our biologic drug candidates, we must conduct extensive preclinical studies and clinical trials to demonstrate that our biologic drug candidates are safe and effective and obtain required regulatory approvals. Our early stage biologic drug candidates may fail to perform as we expect. Moreover, our biologic drug candidates in later stages of development may fail to show the desired safety and efficacy traits despite having progressed successfully through preclinical or initial clinical testing. We will need to devote significant additional research and development, financial resources and personnel to develop commercially viable products and obtain the necessary regulatory approvals.

        If our biologic drug candidates do not prove to be safe and efficacious in clinical trials, we will not obtain the required regulatory approvals. If we fail to obtain such approvals, we may not generate sufficient revenues to continue our business operations.

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        Even if we obtain regulatory approval of a product, that approval may be subject to limitations on the indicated uses for which it may be marketed. Even after granting regulatory approval, the FDA and regulatory agencies in other countries continue to review and inspect marketed products, manufacturers and manufacturing facilities, which may create additional regulatory burdens. Later discovery of previously unknown problems with a product, manufacturer or facility, may result in restrictions on the product or manufacturer, including a withdrawal of the product from the market. Further, regulatory agencies may establish additional regulations that could prevent or delay regulatory approval of our products.

We cannot market and sell our biologic drug candidates in the United States or in other countries if we fail to obtain the necessary regulatory approvals or licensure.

        We cannot sell our biologic drug candidates until regulatory agencies grant marketing approval, or licensure. The process of obtaining regulatory approval is lengthy, expensive and uncertain. It is likely to take two to four years or more to obtain the required regulatory approvals for our lead stem cell biologic drug candidate, Prochymal, or we may never gain the necessary approvals. Any difficulties that we encounter in obtaining regulatory approval may have a substantial adverse impact on our operations and cause our stock price to decline significantly. Moreover, because our biologic drug candidates are all based on a single platform technology, MSCs, any adverse events in our clinical trials for one of our biologic drug candidates could negatively impact the clinical trials and approval process for our other biologic drug candidates.

        To obtain marketing approvals in the United States for MSC products, for instance, we must, among other requirements, complete carefully controlled and well-designed clinical trials sufficient to demonstrate to the FDA that the biologic drug candidate is safe and effective for each disease for which we seek approval. Several factors could prevent completion or cause significant delay of these trials, including an inability to enroll the required number of patients or failure to demonstrate adequately that MSCs are safe, effective and potent for use in humans. Negative or inconclusive results from or adverse medical events during a clinical trial could cause the clinical trial to be repeated or a program to be terminated, even if other studies or trials relating to the program are successful. The FDA can place a clinical trial on hold if, among other reasons, it finds that patients enrolled in the trial are or would be exposed to an unreasonable and significant risk of illness or injury. If safety concerns develop, we or the FDA could stop our trials before completion. Some participants in our MSC clinical trial have experienced serious adverse events, four of which have been determined to be possibly related to MSCs and one of which has been determined to be probably related. A serious adverse event is an event that results in significant medical consequences, such as hospitalization, disability or death, and must be reported to the FDA. We cannot assure you that safety concerns regarding MSCs will not develop.

        The pathway to regulatory approval for MSCs may be more complex and lengthy than for approval of a new conventional drug. Similarly, to obtain approval to market our stem cell products outside of the United States, we will need to submit clinical data concerning our products and receive regulatory approval from governmental agencies, which in certain countries includes approval of the price we intend to charge for our product. We may encounter delays or rejections if changes occur in regulatory agency policies during the period in which we develop a biologic drug candidate or during the period required for review of any application for regulatory agency approval. If we are not able to obtain regulatory approvals for use of our biologic drug candidates under development, we will not be able to commercialize such products, and therefore may not be able to generate sufficient revenues to support our business.

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If we are not able to conduct our clinical trials properly and on schedule, marketing approval by FDA and other regulatory authorities may be delayed or denied.

        The completion of our clinical trials may be delayed or terminated for many reasons, including, but not limited to, if:

•

the FDA does not grant permission to proceed and places the trial on clinical hold;



•

subjects do not enroll in our trials at the rate we expect;



•

subjects experience an unacceptable rate or severity of adverse side effects;



•

third-party clinical investigators do not perform our clinical trials on our anticipated schedule or consistent with the clinical trial protocol, Good Clinical Practice and regulatory requirements, or other third parties do not perform data collection and analysis in a timely or accurate manner;



•

inspections of clinical trial sites by the FDA or Institutional Review Boards (IRBs) of research institutions participating in our clinical trials, find regulatory violations that require us to undertake corrective action, suspend or terminate one or more sites, or prohibit us from using some or all of the data in support of our marketing applications; or



•

one or more IRBs suspends or terminates the trial at an investigational site, precludes enrollment of additional subjects, or withdraws its approval of the trial.

        Our development costs will increase if we have material delays in our clinical trials, or if we are required to modify, suspend, terminate or repeat a clinical trial. If we are unable to conduct our clinical trials properly and on schedule, marketing approval may be delayed or denied by FDA.

We may not be able to secure and maintain research institutions to conduct our clinical trials.

        We rely on research institutions to conduct our clinical trials. Specifically, the limited number of bone marrow transplant centers further heightens our dependence on such research institutions for the Phase III Prochymal trial. Our reliance upon research institutions, including hospitals and clinics, provides us with less control over the timing and cost of clinical trials and the ability to recruit subjects. If we are unable to reach agreement with suitable research institutions on acceptable terms, or if any resulting agreement is terminated, we may be unable to quickly replace the research institution with another qualified institution on acceptable terms. We may not be able to secure and maintain suitable research institutions to conduct our clinical trials.

Final marketing approval of our biologic drug candidates by the FDA or other regulatory authorities for commercial use may be delayed, limited, or denied, any of which would adversely affect our ability to generate operating revenues.

        Any of the following factors may cause final marketing approval for our biologic drug candidates to be delayed, limited or denied:

•

our biologic drug candidates require significant clinical testing to demonstrate safety and effectiveness before applications for marketing approval can be filed with the FDA;



•

data obtained from preclinical and nonclinical animal testing and clinical trials can be interpreted in different ways, and the FDA may not agree with our interpretations;



•

it may take many years to complete the testing of our biologic drug candidates, and failure can occur at any stage of the process;



•

negative or inconclusive results or adverse side effects during a clinical trial could cause us to delay or terminate development efforts for a biologic drug candidate; and

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•

commercialization may be delayed if the FDA requires us to expand the size and scope of the clinical trials.

        If marketing approval for our biologic drug candidates is delayed, limited or denied, our ability to market products, and our ability to generate product sales, would be adversely affected.

Should the FDA decide that Osteocel does not meet the appropriate regulatory requirements, we will be required to stop production, which will have a material adverse effect on our business, financial condition and results of operations.

        The FDA has developed a tiered, risk-based regulatory framework, which includes criteria for facility management, quality assurance, donor selection, and processing of human cells, tissues, and cellular and tissue based products. We believe that commercial sale of Osteocel does not require pre-market approval by the FDA because we believe that it meets the regulatory definition of human cells, tissue, and cellular and tissue-based products, or HCT/Ps. However, should the FDA decide that Osteocel does not meet the regulatory definition of HCT/Ps, we will not be able to produce and sell Osteocel until we obtain FDA approval, which could take years to obtain and which could have a material adverse effect on our business, financial condition and results of operations.

Producing and marketing an approved drug or other medical product is subject to significant and costly post-approval regulation.

        It is likely that Prochymal, if approved based on our currently contemplated Phase III trial, will receive conditional approval by the FDA, and we will be required to conduct Phase IV clinical trials to obtain full approval. Even if we obtain full approval of a product, that approval is subject to limitations on the indicated uses for which we can market it. After granting marketing approval, the FDA and regulatory agencies in other countries continue to review and inspect marketed products, manufacturers and manufacturing facilities, creating additional regulatory burdens. Later discovery of previously unknown problems with a product, manufacturer or facility may result in restrictions on the product or manufacturer, including a withdrawal of the product from the market. Further, regulatory agencies may establish additional regulations that could prevent or delay marketing approval of our products.

Our business involves the use of hazardous materials that could expose us to environmental and other liability.

        We have facilities in Maryland that are subject to various local, state and federal laws and regulations relating to safe working conditions, laboratory and manufacturing practices, the experimental use of animals and the use and disposal of hazardous or potentially hazardous substances, including chemicals, micro-organisms and various radioactive compounds used in connection with our research and development activities. In the United States, these laws include the Occupational Safety and Health Act, the Toxic Test Substances Control Act and the Resource Conservation and Recovery Act. We cannot assure you that accidental contamination or injury to our employees and third parties from hazardous materials will not occur. We do not have insurance to cover claims arising from our use and disposal of these hazardous substances other than limited clean-up expense coverage for environmental contamination due to an otherwise insured peril, such as fire.

We may not be able to obtain or maintain Orphan Drug designation for our biologic drug candidates.

        Some jurisdictions, including Europe and the United States, may designate drugs for relatively small patient populations as orphan drugs. Although the FDA has designated Prochymal for the treatment of steroid refractory GvHD as an orphan drug, none of our other biologic drug candidates have received such designation. Orphan Drug designation does not convey any advantage in, or shorten the duration of, the regulatory review and approval process, but does make the product eligible for

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orphan drug exclusivity, reduced filing fees and specific tax credits. Generally, if a company receives the first marketing approval for a product with an Orphan Drug designation in the clinical indication for which it has such designation, the product is entitled to orphan drug exclusivity. Orphan drug exclusivity means that the FDA will not approve another application to market the same drug for the same indication, except in limited circumstances, for a period of seven years in the United States. This exclusivity, however, could block the approval of our biologic drug candidates if a competitor obtains marketing approval before us. Even if we obtain orphan drug exclusivity for any of our biologic drug candidates, we may not be able to maintain it. For example, if a competitive product is shown to be clinically superior to our product, any orphan drug exclusivity we have will not block the approval of such competitive product.

The Fast Track designation for development of any of our products may not lead to a faster development or regulatory review or approval process, and it does not increase the likelihood the biologic drug candidate will receive marketing approval.

        If a drug is intended for the treatment of a serious or life-threatening condition and the drug demonstrates the potential to address unmet medical needs for this condition, the drug sponsor may apply for FDA Fast Track designation for a particular indication. Marketing applications filed by sponsors of products in Fast Track development may qualify for priority review under the policies and procedures offered by the FDA, but the Fast Track designation does not assure any such qualification. Although we have obtained a Fast Track designation from the FDA for Prochymal for the treatment of GvHD, receipt of Fast Track designation may not result in a faster development process, review or approval compared to drugs considered for approval under conventional FDA procedures. In addition, the FDA may withdraw our Fast Track designation at any time. If we lose our Fast Track designation, the approval process may be delayed. In addition, our Fast Track designation does not guarantee that we will qualify for or be able to take advantage of the expedited review procedures and does not increase the likelihood that Prochymal will receive regulatory approval for the treatment of steroid refractory GvHD.

Risks Related to this Offering

There has been no prior market for our common stock, and it may trade at prices below the initial public offering price.

        Prior to this offering, there has been no public market for our common stock. We cannot predict the extent to which a trading market for our common stock will develop or be sustained after this offering. The initial public offering price will be determined by negotiations between us and the representatives of the underwriters based on factors that may not be indicative of future performance, and may not bear any relationship to the price at which our common stock will trade upon completion of this offering. You may be unable to sell your shares of common stock at or above the initial public offering price.

The trading price of the shares of our common stock could be highly volatile, and purchasers of our common stock could incur substantial losses.

        Our stock price is likely to be volatile. The stock market in general and the market for biotechnology companies in particular have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. As a result of this volatility, investors may not be able to sell their common stock at or above the initial public offering price. The market price for our common stock may be influenced by many factors, including:

•

results of clinical trials of our biologic drug candidates or those of our competitors;



•

regulatory developments in the United States and foreign countries;

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•

variations in our financial results or those of companies that are perceived to be similar to us;



•

changes in the structure of healthcare payment systems;



•

announcements by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments;



•

market conditions in the pharmaceutical and biotechnology sectors and issuance of securities analysts' reports or recommendations;



•

sales of substantial amounts of our stock by existing stockholders;



•

sales of our stock by insiders and 5% stockholders;



•

general economic, industry and market conditions;



•

additions or departures of key personnel;



•

intellectual property, product liability or other litigation against us;



•

expiration or termination of our relationships with our collaborators; and



•

the other factors described in this "Risk Factors" section.

        In addition, in the past, stockholders have initiated class action lawsuits against biotechnology and pharmaceutical companies following periods of volatility in the market prices of these companies' stock. Such litigation, if instituted against us, could cause us to incur substantial costs and divert management's attention and resources, which could have a material adverse effect on our business, financial condition and results of operations.

Purchasers in this offering will suffer immediate dilution and may experience additional dilution in the future.

        If you purchase common stock in this offering, you will pay more for your shares than the amounts paid by existing stockholders for their shares. In addition, the net tangible book value of your shares based upon our actual book value will immediately be less than the offering price you paid. For more information, see the discussion under the caption "Dilution."

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

        If our existing stockholders sell a large number of shares of common stock, or the public market perceives that existing stockholders might sell shares of common stock, the market price of our common stock could decline significantly. These stockholders may sell their shares of our common stock starting at various times following this offering. We have agreed, under certain circumstances, to register the resale of shares held by our existing stockholders. In addition, we intend to register approximately 1.7 million shares of common stock that are reserved for issuance under our equity compensation plans. Once we register these shares, they can be freely sold in the public market upon issuance, subject to lock-up agreements and restrictions on our affiliates. For more information, see the discussion under the caption "Shares Eligible for Future Sale."

Contract rights may exist that grant third parties preemptive or registration rights.

        Prior to the appointment of our current management, we engaged in numerous financing transactions. In the course of these transactions, we are aware that we have granted to third parties contract rights to, among other things, cause us to sell to them additional equity or other securities or cause us to register the sale of shares previously sold to them. We may have granted similar rights to additional parties that we are not aware of. No one has made any claim against us in this regard, and we do not believe that any such rights are outstanding except to the extent contained in contracts we

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have filed as exhibits to this registration statement. Nevertheless, if there are other rights that can be proven by third parties to exist, our share capital could be diluted and we could incur additional expenses, and the market for our stock could be more volatile or depressed because of sales of stock pursuant to these rights.

Concentration of ownership of our common stock among our existing executive officers, directors and principal stockholders may prevent new investors from influencing significant corporate decisions.

        Upon completion of this offering, our executive officers, directors and beneficial owners of 5% or more of our common stock and their affiliates will, in aggregate, beneficially own approximately 50% of our outstanding common stock, after giving effect to the conversion of all outstanding shares of our convertible preferred stock into shares of our common stock, the conversion of $21.8 million of our convertible notes into 2,720,909 shares of our common stock (based upon a public offering price of $11.00 per share and including interest as of June 30, 2006), and the exercise of warrants for 875,000 shares of common stock, but assuming no exercise of the underwriters' over-allotment option. These persons, acting together, will be able to significantly influence all matters requiring stockholder approval, including the election and removal of directors and any merger or other significant corporate transactions. The interests of this group of stockholders may not coincide with our interests or the interests of other stockholders. For more information, see the discussion under the caption "Principal Stockholders."

        In addition, Peter Friedli, our Chairman of the Board of Directors, beneficially owned approximately 55% of our outstanding common stock as of June 30, 2006 and upon completion of this offering will beneficially own approximately 48% of our outstanding common stock. Accordingly, Mr. Friedli currently has, and will continue to have, a significant influence over the outcome of all corporate actions requiring stockholder approval.

Certain provisions of Delaware law and of our charter documents contain provisions that could delay and discourage takeover attempts and any attempts to replace our current management by stockholders.

        Certain provisions of our certificate of incorporation and bylaws, and applicable provisions of Delaware corporate law, may make it more difficult for or prevent a third party from acquiring control of us or changing our Board of Directors and management. These provisions include:

•

the ability of our board of directors to issue preferred stock with voting or other rights or preferences;



•

the inability of stockholders to act by written consent;



•

a classified Board of Directors with staggered three-year terms;



•

requirements that special meetings of our stockholders may only be called by the chairman of our Board of Directors, upon request of stockholders holding at least 20% of our capital stock issued and outstanding, or upon a resolution adopted by, or an affirmative vote of, a majority of our Board of Directors; and



•

requirements that our stockholders comply with advance notice procedures in order to nominate candidates for election to our Board of Directors or to place stockholders' proposals on the agenda for consideration at meetings of stockholders.

        We will also be afforded the protections of Section 203 of the Delaware General Corporation Law, which will prevent us from engaging in a business combination with a person who acquires at least 15% of our common stock for a period of three years from the date such person acquired such common stock, unless advance board or stockholder approval was obtained.

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        Any delay or prevention of a change of control transaction or changes in our Board of Directors or management could deter potential acquirors or prevent the completion of a transaction in which our stockholders could receive a substantial premium over the then current market price for their shares.

Our management has broad discretion over the use of proceeds from this offering and may invest or spend the proceeds in ways with which you do not agree and in ways that may not yield a return.

        Our management will have broad discretion over the use of proceeds from this offering. You may not agree with management's decisions, and our use of the proceeds may not yield any return on your investment in us. The failure of our management to apply the net proceeds of this offering effectively could have a material adverse effect on our business, financial condition and results of operations.

We do not expect to pay cash dividends on our common stock in the foreseeable future. As a result, you must rely on stock appreciation for any return on your investment.

        We do not anticipate paying cash dividends on our common stock in the foreseeable future. Any payment of cash dividends will depend upon our financial condition, results of operations, capital requirements and other factors and will be at the discretion of our Board of Directors. Accordingly, you will have to rely on capital appreciation, if any, to earn a return on your investment in our common stock. Furthermore, we may become subject to contractual restrictions or prohibitions on the payment of dividends.

The requirements of being a public company may strain our resources and distract management.

        As a public company, we will be subject to the reporting requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, and the related regulations of the SEC, as well as the rules of The NASDAQ Global Market. We have not previously been subject to these requirements, and they may place a strain on our systems and resources. The Exchange Act requires that we file annual, quarterly and current reports with respect to our business and financial condition. The Sarbanes-Oxley Act requires that we maintain effective disclosure controls and procedures and internal controls over financial reporting. In order to maintain and improve the effectiveness of our disclosure controls and procedures and internal control over financial reporting, significant resources and management oversight will be required. In addition, we will be required to have our independent public accounting firm attest to and report on management's assessment of the effectiveness of our internal controls over financial reporting. Implementing procedures to satisfy these requirements will be expensive and may divert management's attention from other business concerns, which could have a material adverse effect on our business, financial condition, results of operations and cash flows. Also, we will need to hire additional accounting and financial staff with appropriate public company experience and technical accounting knowledge, and we cannot assure you that we will be able to do so in a timely fashion. If we are unable to conclude that we have effective internal controls over financial reporting or, if our independent auditors are unable to provide us with an attestation and an unqualified report as to the effectiveness of our internal controls over financial reporting, investors could lose confidence in the reliability of our financial statements, and the market price for our common stock could be significantly harmed.

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

        This prospectus contains forward-looking statements. Forward-looking statements provide our current expectations or forecasts of future events. Forward-looking statements include statements about our expectations, beliefs, plans, objectives, intentions, assumptions and other statements that are not historical facts. Words such as "anticipate," "believe," "continue," "ongoing," "estimate," "expect," "intend," "may," "plan," "potential," "predict," "project" or similar words, or the negatives of those words, may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward-looking. Examples of forward-looking statements include, but are not limited to, statements regarding the following:

•

our product development efforts;



•

our clinical trials and anticipated regulatory requirements;



•

status of the regulatory process for our biologic drug candidates;



•

implementation of our corporate strategy;



•

our financial performance, including expectations for revenue growth from Osteocel and our biologic drug candidates;



•

our product research and development activities and projected expenditures, including our anticipated timeline and clinical strategy for MSCs and biologic drug candidates;



•

our use of the proceeds from this offering;



•

our cash needs;



•

patents and proprietary rights;



•

expected market sizes and growth;



•

ability of our potential products to treat disease;



•

our plans for sales and marketing; and



•

types of regulatory frameworks we expect will be applicable to our potential products.

        Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward-looking statements. Our actual results could differ materially from those anticipated in forward-looking statements for many reasons, including the factors described in the section entitled "Risk Factors" in this prospectus. Accordingly, you should not unduly rely on these forward-looking statements, which speak only as of the date of this prospectus. We undertake no obligation to publicly revise any forward-looking statement to reflect circumstances or events after the date of this prospectus or to reflect the occurrence of unanticipated events. You should, however, review the factors and risks we describe in the reports we will file from time to time with the SEC after the date of this prospectus.

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USE OF PROCEEDS

        We estimate that the net proceeds to us from this offering will be approximately $34.2 million, or $39.6 million if the underwriters exercise their over-allotment option in full, after deducting underwriting discounts and commissions and the estimated offering expenses payable by us.

        We intend to use the net proceeds to us from the offering to pay:

•

Approximately $13 million for conducting a Phase III clinical trial for Prochymal to treat steroid refractory GvHD;



•

Approximately $3 million for initiating a Phase III clinical trial for Chondrogen;



•

Approximately $10 million in total for completing separate Phase II clinical trials for Prochymal to treat acute GvHD and Crohn's disease, a Phase I/II clinical trial for Chondrogen and a Phase I clinical trial for Provacel; and



•

Approximately $3 million for preclinical and other clinical research and development relating to our biologic drug candidates.

        We intend to use the balance of the proceeds for other general corporate purposes, including working capital needs and potential acquisitions of technologies or businesses, and, if not required for other needs, for early repayment of principal and interest on a promissory note.

        We believe that the proceeds from this offering together with our current resources will allow us to complete a Phase III clinical trial for the use of Prochymal to treat steroid refractory Graft versus Host Disease, or GvHD, separate Phase II clinical trials for the use of Prochymal to treat acute GvHD and Crohn's Disease, a Phase I/II clinical trial for Chondrogen and a Phase I clinical trial for Provacel. We also intend to initiate and conduct additional clinical trials as discussed below under "Business." There can be no assurance that the proceeds of this offering will allow us to achieve any of these results. Our ability to complete each of these trials depends on factors outside of our control. These factors are described under "Risk Factors."

        The above-referenced promissory note matures on November 28, 2008 and is prepayable by us without penalty. The full $20.6 million of principal currently remains outstanding, and since its issuance on November 28, 2005, the note has accrued interest at a rate of 6% per annum. The note also has a redemption premium of 9%, which increases over time to 27% by maturity.

        We are not obligated to use the net proceeds from this offering for any particular purpose, and the amounts and timing of our actual use of proceeds will depend upon numerous factors, including the actual amount of net proceeds from this offering as well as cash flows from operations, the growth of our business and other factors described under "Risk Factors." Also, although we periodically evaluate acquisition and licensing opportunities, and we may choose to pursue an acquisition or licensing transaction, we currently have no commitments or agreements with respect to any specific acquisition or additional license. As a result, we cannot specify with certainty the amounts that we may allocate to the particular uses of the net proceeds of this offering. Our management will have significant flexibility and discretion in applying the net proceeds of this offering. Pending any use, we will invest the net proceeds of this offering generally in short-term, investment grade, interest bearing securities but cannot predict that these investments will yield a favorable return.

DIVIDEND POLICY

        We have never declared or paid cash dividends on our capital stock. We currently intend to retain any future earnings to finance the growth and development of our business. We do not intend to pay cash dividends on our common stock in the foreseeable future.

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CAPITALIZATION

        The following table presents our capitalization as of March 31, 2006:

•

on an actual basis;



•

on a pro forma basis to give effect to the conversion of all outstanding shares of our preferred stock into 10,867,284 shares of common stock, the conversion of $21.8 million of our convertible notes into 2,630,347 shares of common stock (based upon a public offering price of $11.00 per share and including interest as of March 31, 2006), and the exercise of warrants for 875,000 shares of common stock at $0.40 per share concurrent with this offering, each of which will become effective upon the closing of this offering; and



•

on a pro forma as adjusted basis to give effect to the sale of 3,500,000 shares of common stock by us in this offering at an initial public offering price of $11.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses to be paid by us.

        You should read this table together with our financial statements and the related notes included in this prospectus and the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section and other financial information included in this prospectus.

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        The table above does not include:

•

665,515 shares of our common stock issuable upon exercise of options outstanding as of March 31, 2006, at a weighted average exercise price of $0.40 per share, of which, as of that date;



•

options to purchase 138,360 shares were exercisable; and



•

management-owned options to purchase 410,000 shares were outstanding and will be exercisable upon the closing of this offering; and



•

1,000,000 shares of our common stock issuable upon exercise of warrants outstanding as of June 30, 2006, at the per share price for which shares will be sold in this offering, all of which warrants will be exercisable as of the date of this offering.

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DILUTION

        If you invest in our common stock, your interest will be diluted to the extent of the difference between the public offering price per share of our common stock and the pro forma as adjusted net tangible book value per share of our common stock after this offering.

        Our net tangible book value as of March 31, 2006 was a deficit of approximately $(78.6 million), or $(8.59) per share of common stock. Our pro forma net tangible book value as of March 31, 2006, after giving effect to the conversion of all of our preferred stock outstanding as of that date into 10,867,284 shares of common stock, the conversion of $21.8 million of our convertible notes into 2,630,347 shares of common stock (based upon an initial public offering price of $11.00 per share and including interest as of March 31, 2006), and the exercise of warrants for 875,000 shares of common stock at $0.40 per share concurrent with this offering, was approximately $9.6 million, or $0.41 per share of common stock. Net tangible book value per share is determined by dividing our total tangible assets less total liabilities by the number of shares of common stock outstanding at March 31, 2006.

        Our pro forma net tangible book value as of March 31, 2006 after this offering would have been $43.8 million or $1.62 per share. This represents an immediate increase in pro forma net tangible book value of $10.21 per share to existing stockholders and an immediate dilution in pro forma net tangible book value of $9.38 per share to new investors. Dilution in pro forma net tangible book value per share represents the difference between the amount per share paid by purchasers of shares of our common stock in this offering and the net tangible book value per share of our common stock immediately afterwards, after giving effect to the sale of 3,500,000 shares in this offering at a public offering price of $11.00 per share and after deducting estimated underwriting discounts and commissions and estimated offering expenses. The following table illustrates this per share dilution:

        The following table summarizes, on a pro forma basis as of March 31, 2006, after giving effect to this offering and a public offering price of $11.00 per share, the total number of shares of common stock purchased from us and the total consideration and the average price per share paid by existing shareholders and by new investors, calculated before deduction of underwriting discounts and commissions and estimated offering expenses.

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        The number of shares of common stock outstanding in the table above is based on the number of shares outstanding as of March 31, 2006 and excludes:

•

665,515 shares of our common stock issuable upon exercise of options outstanding as of March 31, 2006, at a weighted average exercise price of $0.40 per share, of which, as of that date;



•

options to purchase 138,360 shares were exercisable; and



•

management-owned options to purchase 410,000 shares were outstanding and will be exercisable upon the closing of this offering; and



•

1,000,000 shares of our common stock issuable upon exercise of warrants outstanding as of June 30, 2006, at the per share price for which shares will be sold in this offering, all of which warrants will be exercisable as of the date of this offering.

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SELECTED FINANCIAL DATA

        The following selected financial data for the years ended December 31, 2003, 2004 and 2005 has been derived from our audited financial statements included elsewhere in this prospectus. The following selected financial data for the years ended December 31, 2001 and 2002 has been derived from our audited financial statements not included in this prospectus. The statement of operations data for each of the three months ended March 31, 2005 and 2006 are derived from our unaudited financial statements. Operating results for the three months ended March 31, 2006 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2006, or any other period. This information is only a summary and should be read together with our financial statements and the related notes included in this prospectus and the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section and other financial information included in this prospectus.

        The pro forma net loss attributable to common stockholders per share information is computed using the weighted average number of common shares outstanding, after giving pro forma effect to the conversion of all outstanding shares of our convertible preferred stock into 10,867,284 shares of common stock, the conversion of certain convertible notes into 2,630,347 shares of common stock (based upon a public offering price of $11.00 per share and including interest as of March 31, 2006), and the exercise of warrants for 875,000 shares of common stock, all concurrently with the completion of this offering, as if the conversion had occurred at the dates of the original issuances.

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MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion and analysis by our management of our financial condition and results of operations should be read in conjunction with our financial statements and the accompanying notes included elsewhere in this prospectus. This discussion and other parts of this prospectus contain forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in "Risk Factors."

Overview

        We are a leading stem cell therapeutic company focused on developing and marketing products to treat medical conditions in the inflammatory, orthopedic and cardiovascular areas. Our marketed product, Osteocel, and our biologic drug candidates utilize mesenchymal stem cells, or MSCs. In July 2005, we launched Osteocel for regenerating bone in orthopedic indications. We currently have five clinical trials ongoing. We are currently enrolling patients in a Phase III clinical trial for Prochymal, our lead biologic drug candidate, for the treatment of steroid refractory Graft versus Host Disease, or GvHD. Prochymal is also in Phase II clinical trials for acute GvHD and Crohn's Disease. In addition, we have two other clinical stage biologic drug candidates, Chondrogen for regenerating cartilage in the knee, and Provacel for repairing heart tissue following a heart attack. We have developed stem cell capabilities in research and development, manufacturing, marketing and distribution. We manufacture Osteocel and clinical batches of our biologic drug candidates. We distribute Osteocel in orthopedic indications and jointly distribute Osteocel with Blackstone Medical, Inc. for spinal procedures.

        We have never been profitable. As of March 31, 2006, we had an accumulated deficit of $147.7 million. We have incurred annual operating losses since inception and expect to incur substantial operating losses in the future in connection with the development of our core products. As a result, we are dependent upon external financing to finance our operations. We intend to seek additional financing through public or private issuance of equity or through the debt market. We have two collaborative research arrangements that provide for the partial financing of research expenses. However, these arrangements do not cover the entire estimated costs of the pivotal clinical trials that are required to bring us to market. There can be no assurance that additional financing or partnering revenues will be available to us in the future or on terms that will be acceptable to us. Although we have sought collaborative relationships in the past, we do not anticipate seeking them in the future.

        We have historically financed the majority of our operations and capital expenditures through the issuance of privately placed debt and equity securities and, to a much lesser extent, through payments we have received from our collaborators.

        While we have achieved commercialization of our Osteocel product, our principal focus is on the successful development and commercialization of our biologic drug candidates, the most clinically advanced of which is Prochymal. We expect Osteocel sales to increase moderately as we achieve greater market penetration and increase our manufacturing capacity. We expect to incur increased capital and operating expenses relating to Osteocel to increase distribution capabilities and manufacturing capacity and, ultimately, move our manufacturing facilities to a new location. However, over the next several years, our principal capital requirements and greatest source of operating losses will likely relate to the continued preclinical and clinical development of our biologic drug candidates and related regulatory and pre-commercialization activities. We believe these potential products have the greatest long-term potential for revenue and profitability, and we expect to focus our management and financial resources principally on them.

        In connection with our initial public offering, a one-for-four reverse stock split of our common stock will be consummated simultaneously with the effectiveness of the registration statement and prior

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to the completion of the offering. All share and per share amounts related to common shares, options and warrants have been restated to reflect the reverse stock split, and the split has been retroactively applied to our financial statements.

Financial Operations Overview

Revenue

        Osteocel is our only commercial product. Sales of Osteocel generated revenue of approximately $1.0 million for the year ended December 31, 2005. We have entered into strategic agreements with other companies for the development and commercialization of select stem cell biologic drug candidates for specific indications and geographic markets. In 2003, we entered into an agreement with Boston Scientific Corporation relating to the development of our cardiac biologic drug candidate, and we received a $5.0 million fee for licensing the use of our technology. This fee is being recognized as revenue over a 63-month period, $0.9 million of which was recognized in each of 2004 and 2005 and $0.8 million was recognized in 2003. Also in 2003, we entered into an agreement with JCR Pharmaceuticals Co., Ltd. granting it exclusive rights to Prochymal for the treatment of GvHD in Japan. We recognized $0.5 million of revenue in 2005, $2.0 million in 2004, and $1.0 million in 2003 from our collaboration with JCR Pharmaceuticals. We do not expect to enter into collaborations in the future.

        Historically, we have also recognized revenue from governmental grants for research and in 2005, we recorded $1.4 million in grant revenues from three separate grants. We earned $0.8 million and $2.1 million from governmental research grants in 2004 and 2003, respectively. Revenue from research grants is recognized as the related research expenditures are incurred. We do not expect to solicit governmental grants in the future.

        Other than Osteocel, we have no commercial products for sale and do not anticipate that we will have any other commercial products for sale for at least the next several years. A substantial portion of our revenue in the future will be dependent on the approval and sale of our biologic drug candidates. Our revenue may vary substantially from quarter to quarter and from year to year. We believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indicative of our future performance.

Cost of Goods Sold

        Our cost of goods sold relate to direct costs of producing Osteocel, which we launched in July 2005. Cost of goods sold consist primarily of the costs of obtaining tissue and other chemicals and supplies. Our manufacturing processes are still being refined, and therefore, we expense manufacturing labor costs as incurred. These labor costs are reported as research and development costs. Because our production process currently relies significantly on third-party labor, we believe that classifying direct labor costs associated with our employees as research and development costs did not materially affect our financial statements for the year ended December 31, 2005. However, direct labor costs associated with our employees are included in inventory and cost of goods sold beginning in the first quarter of 2006. We expect that cost of goods sold as a percentage of product sales will improve due to continuing refinements in our Osteocel manufacturing processes as well as scale efficiencies resulting from increased production.

Research and Development Costs

        Our research and development costs consist of expenses incurred in identifying, developing and testing biologic drug candidates. These expenses consist primarily of salaries and related expenses for personnel, fees paid to professional service providers for independent monitoring and analysis of our clinical trials, costs of contract research and manufacturing, costs of facilities, and the costs of

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manufacturing clinical batches of biologic drug candidates, quality control supplies and material to expand biologic drug candidates.

        Consistent with our focus on the development of biologic drug candidates with potential uses in multiple indications, many of our costs are not attributable to a specifically identified product. We use our employee and infrastructure resources across several projects. Accordingly, we do not account for internal research and development costs on a project-by-project basis. As a result, we cannot state precisely the total costs incurred for each of our clinical and preclinical projects on a project-by-project basis. From inception through March 31, 2006, we incurred aggregate research and development costs of approximately $148 million.

        We expect our research and development expenses to increase substantially following the completion of this offering as we expand our clinical trial activity, as our biologic drug candidates advance through the development cycle and as we invest in additional product opportunities and research programs. Clinical trials and preclinical studies are time-consuming and expensive. Our expenditures on current and future preclinical and clinical development programs are subject to many uncertainties. We test our products in several preclinical studies, and we then conduct clinical trials for those biologic drug candidates that we determine to be the most promising. As we obtain results from clinical trials, we may elect to discontinue or delay trials for some biologic drug candidates in order to focus our resources on more promising biologic drug candidates. Completion of clinical trials may take several years or more, but the length of time generally varies substantially according to the type, size of trial and intended use of a biologic drug candidate. The cost of clinical trials may vary significantly over the life of a project as a result of a variety of factors, including:

•

the number of patients who participate in the trials;



•

the number of sites included in the trials;



•

the length of time required to enroll trial participants;



•

the duration of patient treatment and follow-up;



•

the costs of producing supplies of the biologic drug candidates needed for clinical trials and regulatory submissions;



•

the efficacy and safety profile of the biologic drug candidate; and



•

the costs and timing of, and the ability to secure, regulatory approvals.

        As a result of the uncertainties discussed above, we are unable to determine with any significant degree of certainty the duration and completion costs of our research and development projects or when and to what extent we will generate revenues from the commercialization and sale of any of our biologic drug candidates. However, while we do not have specific estimates for the costs of all of our projects, we currently estimate that it will cost approximately $17 million for to conduct a Phase III clinical trial for Prochymal to treat steroid refractory GvHD; approximately $6 million to initiate a Phase III clinical trial for Chondrogen; and approximately $18 million to complete separate Phase II clinical trials for Prochymal to treat acute GvHD and Crohn's disease, a Phase I/II clinical trial for Chondrogen and a Phase I clinical trial for Provacel.

General and Administrative Expenses

        General and administrative expenses consist primarily of the costs associated with our general management, including salaries, allocations of facilities and related costs, and professional fees such as legal and accounting expenses. Following this offering, we anticipate increases in our general and administrative expense for legal and accounting compliance costs, investor relations and other activities associated with operating as a publicly traded company. These increases will also likely include the hiring of additional operational, financial, accounting, facilities engineering and information systems personnel.

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Stock-Based Compensation Expenses

        We grant stock options to our employees, on the date of their employment and periodically thereafter, as incentives and to align our employees' interests with our success. We endeavor to grant these options with the exercise price equal to the estimated fair value of our common stock.

        Our Board of Directors has estimated the fair value of our common stock based upon several factors, including our financial condition, our cash burn rate and our informal analysis of the possible sources and costs of raising additional capital. The following factors were analyzed by our Board in determining the fair value of our common stock during 2005 and the first quarter of 2006:

•

At January 1, 2005, our cash and short-term investments were $488,000, or approximately six weeks' payroll.



•

During the first six months of 2005, we did not realize any commercial sales. Sales of our only currently offered commercial product, Osteocel, did not begin until July 2005. Of the $957,000 in sales recorded by us in 2005, $673,000 or 70% occurred in the fourth quarter of 2005.



•

From January 2005 through the end of the year, we obtained $40.0 million through the issuance of convertible promissory notes. However, of this amount, $32.9 million was not obtained until after May 2005 and $20.6 million was not obtained until December 20, 2005. The effective interest rate on these notes is 15%, with redemption premiums that could increase the future effective interest rate significantly.



•

During the first six months of 2005, we offered our Series D Mandatorily Redeemable Convertible Preferred Stock to third parties for $2.00 per share. This Series has a conversion ratio of one share for 2.5 shares of our common stock, or $0.80 per common stock equivalent. As an inducement for investors, the Series D included an $18 per share redemption premium, which becomes due on June 30, 2007 if a successful initial public offering is not consummated prior to that date. While we issued a total of 3,213,355 shares of our Series D, 1,352,325 of these shares were issued in the first quarter of 2005 at $2.00 per share to related parties in exchange for termination of our 10% Convertible Demand Notes held by such parties. As a result, the amount of new cash raised by the Series D offering was only approximately $3.3 million.



•

Beginning in July 2005, and continuing through year-end, we offered our Series E Convertible Preferred Stock for $2.50 per share and raised $17.5 million of additional equity, of which $13.3 million, or 76%, was received after October 15, 2005.



•

Our stockholders' deficit increased from $(55.3) million at the end of the first quarter of 2005 to $(78.6) million at the end of the first quarter of 2006. During the same period, the negative book value or deficit per common share increased from $(3.51) to $(8.59).

        Based on the specific factors listed above, during 2005 the Board determined that the fair value of our common stock was $0.40 per share. The Board's periodic determinations of the fair value of our common stock were typically not made contemporaneously with grants of stock-based compensation, although in some instances those determinations were made contemporaneously with decisions by the Board to grant stock options. Because there was no market for our common stock during 2005, the approval by the Board of option grants at the consistent exercise price of $0.40 per share is indicative of the Board's conclusion that its periodic fair value determinations were sufficient for stock-based compensation purposes throughout the period.

        For financial reporting purposes and in connection with preparing for this offering, we retrospectively analyzed the fair value of our common stock as of the dates of the issuance of equity instruments, and we determined that the fair value of our common stock from January 1, 2005 through September 30, 2005 was $0.40 per share because of the factors discussed above.

        We believe that the fair value of our common stock did not start to increase above $0.40 per share until the fourth quarter of 2005. First, in October 2005 we began to achieve success raising additional

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capital, as discussed above. Second, in the fourth quarter of 2005, we began to demonstrate the ability to consistently enroll the patients necessary to advance our clinical trials. Overall, from January through September 30, 2005, we had enrolled only 7% of the total number of patients required to complete enrollment in our clinical trials and there was significant risk that patient enrollment would not meet our business plan. By the end of 2005, as a result of enrolling 34 patients in the fourth quarter versus four patients in the third quarter, the percentage had increased four-fold to 28%. Third, sales of Osteocel, our only marketed product, did not become meaningful until after we executed our distribution agreement with Blackstone Medical, Inc., on November 10, 2005. The execution of this agreement, we believe, provided third party validation of the viability of Osteocel as a commercial product. Sales of Osteocel were $284,000 in the third quarter of 2005, but increased substantially to $673,000 in the fourth quarter. Therefore, we have retrospectively determined that the fair value of our common stock for financial reporting purposes was $3.36 per share as of October 1, 2005.

        In the middle of December 2005, a foreign investor invested $20.6 million in exchange for a 6% convertible promissory note. In addition, approximately $340,000 of the fourth quarter Osteocel sales, representing more than one third of all Osteocel sales for the year, occurred in December 2005. Finally, enrollments in our clinical trials started to meet our expectations in the first quarter of 2006, as 84 additional patients were enrolled, increasing our enrollment percentage to 79%. Therefore, we have since determined that the fair value of our common stock for financial reporting purposes was $6.84 per share as of December 20, 2005. From the middle of December 2005 through March 31, 2006, we did not experience significant changes in operations which we believed would increase share value. On April 5, 2006, we completed enrollment in a Phase I clinical trial for Provacel and on April 25, 2006, we completed enrollment in a Phase I/II clinical trial for Chondrogen. As a result of these events, we reviewed our determination of fair value and have determined retroactively for financial reporting purposes that the fair value of our common stock during the period from April 1, 2006 through July 27, 2006 was $12.00 per share.

        As described above, we subsequently determined retroactively for financial reporting purposes, that the fair value of our common stock at the time we issued equity instruments was $3.36 per share from October 1, 2005 through December 19, 2005, and $6.84 per share on and after December 20, 2005 and during the first quarter of 2006. We recorded $283,000 of additional deferred compensation relating to stock option grants made during the fourth quarter of 2005, and $924,000 of additional deferred compensation relating to stock option grants made during the first quarter of 2006. We are amortizing this deferred compensation into compensation expense over the four-year vesting period of the options. We recognized $6,000 of compensation expense related to deferred compensation in the fourth quarter of 2005, and $60,000 of compensation expense related to deferred compensation in the first quarter of 2006. As a result of our review of the fair value of our common stock during the period from April 1 through July 27, 2006 we have determined retroactively for financial reporting purposes that the fair value of our common stock during the period from April 1, 2006 through July 27, 2006 was $12.00 per share. We intend to record $744,000 of additional deferred compensation relating to stock option grants made during this period in our financial statements for the three-month period ending June 30, 2006 and $706,000 of additional deferred compensation relating to stock option grants made during this period in our financial statements for the three-month period ending September 30, 2006. We intend to amortize this deferred compensation into compensation expense over the four-year vesting period of the options.

        Based on an offering price of $11.00 per share of common stock, at March 31, 2006, the estimated intrinsic value of our vested options was approximately $1.5 million and the estimated intrinsic value of our unvested options was approximately $5.6 million. The intrinsic value of these options was computed using the difference between an assumed fair value and the exercise price of such options at the date of grant.

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Interest Expense

        Interest expense consists of interest incurred on our debt. We pay interest on our bank loan and capital leases and accrue non-cash interest on some of our convertible long-term debt. At December 31, 2005, we had debt of approximately $47.5 million that bears interest at stated rates between 5% and 8% per year and approximately $21.8 million of which is expected to be converted into equity upon successful completion of an initial public offering. Certain redemption of premiums result in an effective yield of 15% on certain issues. Upon conversion we expect that the majority of the $4.8 million of interest expense we incurred in 2005 will eventually be paid through the issuance of common stock, and not in cash. At December 31, 2004, we had debt of approximately $9.9 million that bears interest at between 5% and 10% per year resulting in interest expense of approximately $0.9 million in 2004. Approximately $12.3 million of the convertible promissory notes have beneficial conversion features that increase the amount of shares of our common stock to which the holder would be entitled upon conversion by an adjustment factor of between 109% and 127% based on dates specified within the notes. We expect to record a non-cash charge to interest expense in the amount of $1.8 million concurrent with the closing of the initial public offering at a price of $11.00 per share.

Income Taxes

        We have not recognized any deferred tax assets or liabilities in our financial statements since we cannot assure their future realization. Because realization of deferred tax assets is dependent upon future earnings, a full valuation allowance has been recorded on the net deferred tax assets, which relate primarily to net operating loss carryforwards. In the event that we become profitable within the next several years, we have net deferred tax assets of approximately $57.3 million that may be utilized prior to us having to recognize any income tax expense or make payments to the taxing authorities. Utilization of our net operating loss carryforwards in any one year may be limited however, and we could be subject to the alternative minimum tax.

Critical Accounting Policies

General

        Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which we have prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, deferred tax assets, stock-based compensation, and contingencies. We base our estimates on historical experience and on various other assumptions that we believe are reasonable. These results form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

Revenue Recognition

        Our revenue recognition policies are governed by the Securities and Exchange Commission's, or SEC, Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, as amended by SEC Staff Accounting Bulletin No. 104, Revenue Recognition.

        We have one commercial product on the market. We recognize revenue on sales when legal title to the product has passed to the customer, which is usually when the product is shipped from our Baltimore, Maryland facilities. We have agreements with our customers that specify the terms of sale, including price.

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        Revenues from collaborative agreements and grants are recognized as earned upon either the incurring of reimbursable expenses directly related to the particular research plan or the completion of certain development milestones as defined within the terms of the collaborative agreement. Payments received in advance of research performed are designated as deferred revenue. We recognize non-refundable upfront license fees and certain other related fees on a straight-line basis over the development period. Fees associated with substantive at risk, performance based milestones are recognized as revenue upon their completion, as defined in the respective agreements. Incidental assignment of technology rights is recognized as revenue at the time of receipt.

        Milestone payments that are based on designated achievement points and that are considered at risk and substantive at the inception of the collaboration are recognized as earned when the corresponding payment is considered reasonably assured. We evaluate whether milestone payments are at risk and substantive based on the contingent nature of the milestone, specifically reviewing factors such as the technological and commercial risk that must be overcome and the level of the investment required. Milestone payments that are not considered at risk and substantive are recognized, when achieved, in proportion to the percentage of the collaboration completed through the date of achievement. The remainder of the milestone payment is recognized as services are performed over the remaining term of the collaboration.

        Royalties for the use of our MSCs for clinical research purposes are recognized when earned, however, such amounts have not been material and are not expected to be material in the future. Additionally, we may receive royalty payments under our collaborative arrangements upon sales of product.

        We evaluate all collaborative agreements on a quarterly basis to determine the appropriate revenue recognition for that period. The evaluation includes all of the potential revenue components from each specific collaborative agreement.

Accounts Receivable

        Our accounts receivable are reported at their net realizable value. As of December 31, 2005 and 2004, there was no allowance for doubtful accounts as we believe the reported amounts are fully collectible. We did not recognize any bad debt expense for the years ended December 31, 2005, 2004 and 2003. Accounts receivable balances are not collateralized.

Stock-Based Compensation

        As permitted by the provisions of Statement of Financial Accounting Standards, SFAS, No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure," and SFAS No. 123, "Accounting for Stock-Based Compensation," our employee stock option plan is accounted for under Accounting Principles Board Opinion No. 25, APB 25, "Accounting for Stock Issued to Employees." We grant qualified stock options for a fixed number of shares to employees and directors with an exercise price equal to the fair market value of the shares at the date of grant. In these circumstances and in accordance with APB 25, we recognize no compensation expense for qualified stock option grants. We have issued non-qualified stock options for a fixed number of shares to employees and directors with an exercise price less than the fair market value of the shares at the date of grant. When such options vest, we will recognize the difference between the exercise price and fair market value at date of grant as compensation expense in accordance with APB 25. For share-grants of common stock to directors, we record the intrinsic value of the shares granted based upon the estimated fair value on the date of grant.

        In December 2004, FASB issued SFAS No. 123(R) (revised 2004), "Share-Based Payments." This Statement is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation." This Statement supersedes APB 25 and its related implementation guidance. We adopted SFAS No. 123(R) on January 1, 2006, and now expense stock options using a fair-value method in our Statement of

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Operations. Adoption of the expensing requirements has increased our net loss. See "Stock-based Compensation" in Note 1 of our financial statements for year ended December 31, 2005 for disclosures regarding the effect on net earnings and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123(R) prior to January 1, 2006. We use the modified prospective method. Under this method, compensation cost is recognized beginning with the effective date of adoption (a) based on the requirements of SFAS 123(R) for all share-based payments granted after the effective date of adoption and (b) based on the requirements of SFAS 123(R) for all awards granted to employees prior to the effective date of adoption that remain unvested on the date of adoption. We currently utilize the Black-Scholes option pricing model to estimate the fair value. The Black-Scholes model meets the requirements of SFAS 123(R), but the fair values generated by the model may not be indicative of the actual fair values of our stock-based awards. Actual compensation expense that is expected to be recorded in 2006 and thereafter will depend on several factors, including the amount of future option grants. Upon the occurrence of certain future events, the vesting of stock options may be accelerated which could affect future stock-based compensation expense.

Results Of Operations

Comparison of Quarters ended March 31, 2006 and 2005

Revenue

        Total revenues were $1.4 million for the quarter ended March 31, 2006, compared to $0.4 million in the prior year. Our revenues in 2006 resulted primarily from $1.1 million generated from the sale of Osteocel and the recognition of $0.3 million in licensing fees and royalties. In the quarter ended March 31, 2005, we recognized $0.4 million in licensing fees and royalties. Revenue from our Osteocel product in the prior year was $0.0, as the product had not been launched.

Cost of Goods Sold

        Cost of goods sold were $0.5 million for the quarter ended March 31, 2006 compared to $0.0 in the prior year. The cost of goods sold associated with sales of Osteocel was comprised of payments to tissue banks, direct labor costs and the costs of processing, testing and preserving Osteocel. We did not have any cost of goods sold from our Osteocel product in the prior year, as the product had not been launched.

Research and Development Expenses

        Research and development costs were approximately $4.4 million for the quarter ended March 31, 2006 compared to $2.7 million in the prior year. The increase in research and development costs in 2006 reflects the increased number of clinical trials in process versus the prior year. In the first quarter of 2006, we conducted a total of five trials enrolling patients versus two such trials in the prior year. In 2006, we incurred costs associated with the enrollment of a Phase II trial for Prochymal as an add-on therapy to steroids for the first-line treatment of acute GvHD, a Phase II trial for Prochymal for treatment of steroid refractory GvHD, a Phase II trial for Prochymal for treatment of Crohn's Disease, a Phase I/II clinical trial for Chondrogen, and a Phase I clinical trial for Provacel. Of the $4.4 million, approximately $1.9 million is attributable to external research and clinical trials, $1.3 million to the cost of science supplies including research materials for cell manufacture, media and testing supplies, $0.8 million to payroll and related expenses for personnel, and $0.3 million to facilities and equipment costs.

General and Administrative Expenses

        General and administrative expenses were $1.1 million for the quarter ended March 31, 2006 compared to $0.8 million in the prior year. The increase was primarily attributable to the payment of expense reimbursement relating to the fundraising efforts of Mr. Friedli.

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Interest Expense, Net

        Interest expense, net was $0.5 million for the quarter ended March 31, 2006 compared to $0.8 million in the prior year. The decrease was attributable to a lower average level of debt in 2006 than in the prior year, due to the conversion of 10% Convertible Demand Notes into shares of Series D mandatorily redeemable convertible preferred stock in the first quarter of 2005.

Comparison of Years ended December 31, 2005 and 2004

Revenue

        Total revenues were $4.0 million for the year ended December 31, 2005, compared to $3.9 million in the prior year. Our revenues in 2005 resulted primarily from $1.0 million generated from the sale of Osteocel, the recognition of $0.9 million in licensing fees resulting from our agreement with Boston Scientific for our cardiac technology, royalty fees of $0.5 million recognized upon completion of the transfer of technology to JCR Pharmaceuticals, and $1.4 million in revenues recognized upon completion of work in furtherance of governmental grants. In 2004, we recognized $2.0 million in license fees from JCR Pharmaceuticals for the future distribution of our products in Japan, $0.9 million in licensing fees from Boston Scientific, and $0.8 million relating to completion of work in furtherance of our grants from the U.S. government. These grants were completed during the second quarter of 2005. We do not expect that future grant revenue will be material.

Cost of Goods Sold

        Cost of goods sold were $0.4 million for the year ended December 31, 2005 compared to $0.0 in the prior year. We launched Osteocel in July 2005. The cost of goods sold associated with sales of Osteocel was comprised of payments to tissue banks and the costs of processing, testing and preserving Osteocel.

Research and Development Expenses

        Research and development costs were approximately $16.9 million for the year ended December 31, 2005 compared to $11.9 million in the prior year. The increase in research and development expenses in 2005 reflects the costs we incurred in the initiation of a Phase II trial for Prochymal as an add-on therapy to steroids for the first-line treatment of acute GvHD, a Phase II trial for Prochymal for treatment of steroid refractory GvHD, a Phase I/II clinical trial for Chondrogen, and a Phase I clinical trial for Provacel during the year. Of the $16.9 million in 2005 research and development costs, approximately $7.4 million is attributable to external research and clinical trials, $3.9 million to the cost of science supplies including research materials for cell manufacture, media and testing supplies, $3.4 million to payroll and related expenses for personnel, and $2.2 million to facilities and equipment costs.

General and Administrative Expenses

        General and administrative expenses were $2.3 million for the year ended December 31, 2005 compared to $1.7 million in the prior year. The increase in general and administrative expenses in 2005 compared to 2004 primarily reflects the costs of our new management team. In the third quarter of 2004, our Chief Executive Officer and Chief Operating Officer joined us and, in the fourth quarter of 2004, our Chief Financial Officer was hired. These three positions were previously vacant.

Interest Expense, Net

        Interest expense, net was $4.3 million for the year ended December 31, 2005 compared to $0.8 million in the prior year. The increase was attributable to a higher average level of debt in 2005 than in the prior year. The non-cash portion of our interest expense was $3.5 million in 2005 compared to $0.5 million in 2004.

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Comparison of Years ended December 31, 2004 and 2003

Revenues

        We had no product sales in 2004 or 2003. Revenues for the year ended December 31, 2004 were $3.9 million compared to $4.0 million in the prior year. Our revenues in 2004 resulted primarily from the recognition of license fees of $0.9 million, resulting from our agreement with Boston Scientific for our cardiac technology, license fees of $2.0 million from JCR Pharmaceuticals for the future distribution of our products in Japan, and $0.8 million in revenues recognized upon completion of work in furtherance of grants from the U.S. government. In 2003, we recognized $1.4 million relating to work on two grants with the U.S. Defense Advanced Research Projects Agency, DARPA, for research, license fees of $1.0 million from JCR Pharmaceuticals for the future distribution of our products in Japan, license fees of $0.8 million, resulting from our agreement with Boston Scientific for our cardiac technology, and $0.7 million in revenues recognized upon completion of work in furtherance of grants from the U.S. government.

Research and Development Expenses

        Research and development costs were approximately $11.9 million for the year ended December 31, 2004 compared to $18.6 million in the prior year. The decrease in research and development expenses in 2004 was driven by lower employee headcount and a reduction in research costs as we transitioned to a company centered on the development and commercialization of stem cell products. Additionally, in 2004 we began outsourcing the management of our clinical trials to third parties who we believe can achieve better results at a lower cost to us. This change helped further reduce our 2004 research and development expenses as compared to 2003. Of the $11.9 million in 2004 research and development costs, approximately $3.6 million is attributable to external research and clinical trials, $1.3 million to the cost of science supplies including research materials for cell manufacture, media and testing supplies, $4.8 million to payroll and related expenses for personnel, and $2.1 million to facilities and equipment costs.

General and Administrative Expenses

        General and administrative expenses were $1.7 million for the year ended December 31, 2004 compared to $4.5 million in the prior year. The decrease in general and administrative expenses in 2004 compared to 2003 primarily reflects vacancies in our executive officer positions, a reduction of our workforce and a focus on operational efficiency. Our Chief Executive Officer and Chief Operating Officer positions were vacant until the third quarter of 2004 and our Chief Financial Officer was hired in the fourth quarter of 2004.

Interest Expense, Net

        Interest expense, net was $0.8 million for the year ended December 31, 2004 compared to $0.6 million for 2003. The increase was attributable to an approximately $0.4 million non-cash charge to interest expense in 2004 as a result of 5,000,000 warrants issued in conjunction with certain debt financing.

Liquidity and Capital Resources

Sources of Liquidity

        We have historically financed the majority of our operations and capital expenditures though the issuance of privately placed debt and equity securities. Friedli Corporate Finance Inc. and its affiliates, and investors solicited by Friedli Corporate Finance, have provided funding for the majority of our operations to date. The sole owner of Friedli Corporate Finance is Peter Friedli, the chairman of our Board of Directors and the beneficial owner of approximately 55% of our common stock as of June 30, 2006. In addition to the sources described above, at June 30, 2006, we had drawn only $5.0 million of

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the $50.0 million line of credit available for the development of Provacel under a loan agreement with Boston Scientific. In connection with this line of credit, we have granted Boston Scientific a security interest in the intellectual property, equipment and books and records involved in the development, manufacture and distribution of Provacel. Boston Scientific is also obligated to make additional investments in us and pay licensing fees up to $45.0 million to us upon completion of certain milestones.

Cash Flows

        Net cash used in operating activities was $3.9 million for the quarter ended March 31, 2006, primarily reflecting our net loss of $5.1 million, partially offset by $0.6 million in non-cash interest expense and $0.3 million in depreciation and amortization. Net cash used for operating activities was $3.2 million for the quarter ended March 31, 2005. Net cash used in operating activities for 2005 primarily reflects our net loss of $3.9 million, partially offset by $0.8 million in non-cash interest expense.

        Net cash provided by investing activities was $4.5 million for the quarter ended March 31, 2006 and $0.0 for the quarter ended March 31, 2005. Net cash provided by investing activities in 2006 includes cash flows provided by the sale of $4.7 million of short-term investments.

        Net cash used in financing activities was $0.2 million for the quarter ended March 31, 2006. Net cash provided by financing activities was $8.5 million for the quarter ended March 31, 2005 and consisted principally of $7.1 million in net proceeds from the issuance of convertible notes and $1.6 million in net proceeds from the issuance of common and preferred stock.

        Net cash used in operating activities was $14.6 million for the year ended December 31, 2005 primarily reflecting our net loss of $20.0 million, partially offset by $3.5 million in non-cash interest expense. Net cash used for operating activities was $12.1 million for the year ended December 31, 2004. Net cash used in operating activities for 2004 primarily reflects our net loss of $10.5 million and previously deferred non-cash revenue of $3.0 million, associated with our collaboration agreements with JCR Pharmaceuticals and Boston Scientific. Net cash used for operating activities was $10.1 million for the year ended December 31, 2003 primarily reflecting our net loss of $19.7 million, partially offset by the receipt of $6.2 million from our collaborations with Boston Scientific and JCR Pharmaceuticals, which was deferred and will be recognized in accordance with the terms of those collaborations.

        Net cash used in investing activities was $43.1 million for the year ended December 31, 2005; $50,000 for the year ended December 31, 2004; and $1.2 million for the year ended December 31, 2003, respectively. Net cash used in investing activities in 2005 includes cash flows used to purchase $45.0 million of short-term investments.

        Net cash provided by financing activities was $57.8 million for the year ended December 31, 2005 and consisted principally of $40.0 million in net proceeds from the issuance of convertible notes and $21.4 million in net proceeds from the issuance of common and preferred stock, partially offset by $2.5 million in debt financing costs. Net cash provided by financing activities was $11.3 million for the year ended December 31, 2004 and consisted principally of $9.7 million in net proceeds from the issuance of convertible notes and $2.5 million in net proceeds from the issuance of common and preferred stock. Net cash provided by financing activities was $12.3 million for the year ended December 31, 2003 and consisted principally of $13.1 million in net proceeds from the issuance of common and preferred stock.

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Capital Resources

        Our future cash requirements will depend on many factors, including continued progress in our research and development programs, the scope and results of clinical trials, the time and costs involved in obtaining regulatory approvals, the costs involved in filing, prosecuting and enforcing patents, competing technological and market developments, and the cost of product commercialization. We do not expect to generate positive cash flow from operations for at least the next several years due to these factors. We intend to seek additional funding through public or private financing transactions and may seek research and development agreements or distribution and marketing agreements. In the past, we have entered into collaborative arrangements with partners relating to research and development and sales and marketing of our products, however, we do not intend to pursue this strategy going forward. The future success of our operations is subject to several technical and business risks, including our continued ability to obtain future funding, satisfactory product development, obtaining regulatory approval, and market acceptance for our products.

        We expect that our available cash and interest income, including the proceeds from this offering, will be sufficient to finance currently planned activities through early 2008. These estimates are based on certain assumptions, which could be negatively impacted by the matters discussed under "Risk Factors."

        If adequate funds are not available, we may be required to delay, reduce the scope of, or eliminate one or more of our research and development programs, which may have a material adverse affect on our business. See "Risk Factors."

Off-Balance Sheet Arrangements

        We have no off-balance sheet financing arrangements other than operating leases, and we have not entered into any transactions involving unconsolidated subsidiaries or special purpose entities.

Recent Accounting Pronouncements

        As permitted by SFAS No. 123, "Accounting for Stock-Based Compensation," through December 31, 2005 we accounted for share-based payments to employees using the intrinsic value method under Accounting Principles Board, or APB, Opinion No. 25. We grant qualified stock options for a fixed number of shares to employees with an exercise price equal to the fair market value of the shares at the date of grant. In these circumstances and in accordance with APB 25, we recognized no compensation expense for qualified stock option grants. We have issued non-qualified stock options for a fixed number of shares to employees with an exercise price less than the fair market value of the shares at the date of grant. When such options vest, we will recognize the difference between the exercise price and fair market value at date of grant as compensation expense in accordance with APB 25. For shares of common stock granted to directors, we record the intrinsic value of the shares granted based upon the estimated fair value on the date of grant.

        In December 2004, the Financial Accounting Standards Board issued Statement No. 123(R), "Share-Based Payment," which is a revision of Statement No. 123. We adopted the standard effective January 1, 2006. We use the modified prospective method of adoption and continue to use the Black-Scholes option pricing model to value share-based payments, although we are continuing to review our alternatives for calculating the estimated fair value under this new pronouncement. The modified prospective method requires companies to recognize compensation cost beginning with the effective date of adoption based on (a) the requirements of Statement No. 123(R) for all share-based payments granted after the effective date of adoption and (b) the requirements of Statement No. 123 for all unvested awards granted to employees prior to the effective date of adoption.

        Statement No 123(R) requires all share-based payments to employees and directors to be recognized in the financial statements based on their fair values, using prescribed option-pricing

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models. Upon adoption of Statement No. 123(R), pro forma disclosure is no longer an alternative to financial statement recognition. Accordingly, the adoption of the fair-value method prescribed by Statement No. 123(R) may have a significant impact on our results of operations, although it will not have an impact on our overall financial position or cash flows. Based upon the expected vesting of existing options, we estimate our stock-based compensation to be approximately $70,000 for the year ended December 31, 2006. Upon the occurrence of certain events, the vesting of stock options may be accelerated which could affect future stock-based compensation expense.

        In March 2005, the FASB issued Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations," which is an interpretation of Statement No. 143, "Accounting for Asset Retirement Obligations." The interpretation requires that a liability for the fair value of a conditional asset retirement obligation be recognized if the fair value of the liability can be reasonably estimated. The interpretation is effective for years ending after December 15, 2005. The interpretation did not have a material impact on our results of operations, financial position or cash flows.

        In May 2005, the FASB issued Statement No. 154, "Accounting Changes and Error Corrections." SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It established, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS No. 154 also provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The provisions of this Statement are effective for accounting changes and corrections of errors made in fiscal periods beginning after December 15, 2005.

Future Contractual Obligations

        The following table sets forth our estimates as to the amounts and timing of contractual payments for our most significant contractual obligations and commitments as of December 31, 2005. The information in the table reflects future unconditional payments and is based on the terms of the relevant agreements, appropriate classification of items under generally accepted accounting principles currently in effect, certain assumptions such as interest rates on our debt that accrues interest at variable rates, and the timing of conversion of our convertible debt. Future events could cause actual payments to differ from these amounts.

        The long-term debt balance principally includes $5.0 million outstanding under the loan agreement with Boston Scientific and approximately $42.3 million of convertible promissory notes due in 2008. The mandatorily redeemable Series D convertible preferred stock will convert into common stock upon closing of this offering, and is not expected to be redeemed in cash. In the event the offering does not take place and the mandatorily redeemable preferred stock is not otherwise converted, it must be redeemed for $20.00 per share in June 2007. Upon closing of this offering, approximately $21.8 million of the promissory notes will be concurrently converted into common shares. In addition, $2.0 million of the interest on long-term debt will also be concurrently converted into common shares upon the closing of this offering.

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Quantitative and Qualitative Disclosures about Market Risk

        Due to the short duration of our investment portfolio and the high quality of our investments, an immediate 10% change in interest rates would not have a material effect on the fair market value of our portfolio. Accordingly, we would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio.

        We believe that the interest rate risk related to our accounts receivable is not significant. We manage the risk associated with these accounts through periodic reviews of the carrying value for non-collectibility and establishment of appropriate allowances in connection with our internal controls and policies.

        We have not and do not expect to enter into hedging or derivative instrument arrangements.

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BUSINESS

Overview

        We are a leading stem cell therapeutic company focused on developing and marketing products to treat medical conditions in the inflammatory, orthopedic and cardiovascular areas. We currently market and sell Osteocel for regenerating bone in orthopedic indications. It is the only commercially available product in the U.S. containing viable stem cells. Our lead biologic drug candidate, Prochymal, for the treatment of inflammatory disease, is the only stem cell therapeutic for which patients are being enrolled in Phase III clinical trials and is the only stem cell therapeutic currently designated by the FDA as both an Orphan Drug and Fast Track product candidate. Our pipeline of internally developed biologic drug candidates also includes Chondrogen, for regenerating cartilage in the knee, and Provacel, for repairing heart tissue following a heart attack. We are a fully integrated company, having developed stem cell capabilities in research and development, manufacturing, marketing and distribution. We have developed an extensive intellectual property portfolio to protect our technology in the United States and a number of foreign countries including 45 U.S. and 153 foreign patents owned or licensed.

        Osteocel and our three biologic drug candidates utilize human mesenchymal stem cells, or MSCs. MSCs are progenitor cells that differentiate into various connective tissues when they receive appropriate biochemical and biomechanical signals. In addition, MSCs have anti-inflammatory properties and can prevent fibrosis or scarring. These characteristics give MSCs the potential to treat a wide variety of medical conditions. We believe that our biologic drug candidates have advantages over other stem cell therapeutics in development for the following reasons:

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Stem Cell Source. Our stem cells are obtained from adult bone marrow, a readily available source. The cells are drawn from the hips of volunteer donors between the ages of 18 and 30 years, using a simple needle and syringe aspiration. Because the cells are obtained from consenting adult donors, we are able to largely avoid the ethical controversy surrounding embryonic and fetal stem cell research.



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Ability to Mass Produce. Through our proprietary manufacturing methods, we can grow MSCs in a controlled fashion to produce up to 5,000 treatments of our biologic drug candidates from a single bone marrow donation. Our ability to produce a large quantity of treatments from one donation provides us with manufacturing efficiencies and product consistency that are essential to commercialization.



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Universal Compatibility. Many stem cell therapies under development can elicit a rejection response in the recipient and therefore require donor-to-recipient matching or potentially harmful immunosuppression. This greatly reduces manufacturing efficiencies and creates a risk of mismatch which can result in an acute inflammatory response and, potentially, in death. Based on our clinical experience, we believe that our biologic drug candidates are not rejected by the patient's immune system and so, like type O negative blood, do not require matching. This universal compatibility allows us to produce a standardized product available to all patients in almost any medical setting.



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Treatment on Demand. Our biologic drug candidates can be stored frozen at end-user medical facilities until they are needed. We anticipate that medical facilities will be able to prescribe and dispense this product in much the same way as conventional drugs. In contrast, other stem cell technologies under development require weeks to prepare after a patient's need is identified. This is a key feature of our technology, as many patients in the critical care setting require prompt treatment.

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        The following table summarizes key information about Osteocel and our biologic drug candidates.

        Osteocel consists of a matrix of cancellous bone containing mesenchymal stem cells and is used in spinal fusion and other orthopedic surgical procedures. Cancellous bone is the porous and spongy inner structure accounting for approximately 20% of total bone mass. Osteocel is the only commercially available product containing viable stem cells in the United States. We launched Osteocel in July 2005 and to date it has been used in over 1,250 surgical procedures. We produce Osteocel from the marrow-rich bone of organ and tissue donors, and we believe that it is properly characterized, and regulated by the FDA, as a human cell, tissue, and cellular and tissue-based product, or HCT/P, under section 361 of the Public Health Service Act. Unlike our biologic drug candidates, our ability to supply Osteocel is limited by the amount of marrow-rich bone that we are able to obtain from organ and tissue donors. Osteocel is currently distributed exclusively by us for orthopedic indications and jointly with Blackstone Medical for spinal procedures.

        Prochymal is our biologic drug candidate for the treatment of inflammatory disease. We are currently enrolling patients in a pivotal Phase III trial for the treatment of steroid refractory Graft versus Host Disease, or GvHD. GvHD is a life threatening immune system reaction that commonly affects the skin, gastrointestinal tract, and liver in patients who have received a bone marrow transplant. Although in the U.S. there are no drugs approved for treating GvHD, the disease is commonly treated off-label with steroids. GvHD that does not respond to this treatment is known as steroid refractory GvHD. A large majority of steroid refractory GvHD patients die within six months. In our Phase II trial for steroid refractory GvHD, we enrolled patients that did not respond to treatment with steroids and at least one other therapy. Of these patients, 59% responded to Prochymal. We have also completed enrollment of a Phase II trial evaluating Prochymal as an add-on therapy to steroids for the first-line treatment of acute GvHD.

        Based on our clinical observations of the effects of Prochymal on the gastrointestinal symptoms of patients with GvHD, we are developing Prochymal for the treatment of Crohn's Disease. Crohn's Disease is a chronic condition that results in inflammation of the gastrointestinal tract. We have completed Crohn's disease patient enrollment in a Phase II trial under a separate Investigational New Drug application.

        We were recently granted approval by the FDA to begin enrolling patients in a Phase III trial to evaluate Prochymal as a treatment for steroid refractory GvHD. This is a randomized, double blind, placebo controlled study designed to enroll up to 240 patients. The trial will investigate patient response to 2.0 million cells per kilogram of body weight administered twice per week for four consecutive weeks. The trial endpoint is complete resolution of GvHD for at least a 28 day duration. Each patient will also be monitored for safety for up to 180 days after their first treatment with Prochymal.

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        Chondrogen is our biologic drug candidate for regeneration of meniscus, a type of cartilage that cushions the knee joint. According to a 2005 article in the American Journal of Sports Medicine, approximately 1.0 million people have surgery to remove damaged or torn meniscus in the United States each year. As noted in a 1999 article in the journal Sports Medicine, patients who have had this procedure are ten to 15 times more likely to develop osteoarthritis, a highly debilitating orthopedic condition. There are currently no FDA approved products available to regenerate meniscal tissue. In several preclinical studies, Chondrogen regenerated meniscal tissue and prevented osteoarthritis in animal models. We recently completed enrollment in a Phase I/II clinical trial for Chondrogen to evaluate its safety and efficacy in patients following surgery to remove torn meniscus.

        Provacel is our biologic drug candidate for the repair of heart muscle in patients who have suffered a heart attack. Based on statistics published in 2005 by the American Stroke Association and the American Heart Association, approximately 700,000 individuals in the United States each year experience their first heart attack. According to these same statistics, approximately 20% of these patients suffer extensive damage to their heart muscle leading to heart failure within six years. In preclinical studies in animal models, Provacel targeted the damaged area of the heart following a single treatment. These studies also indicate that Provacel prevents scar formation that typically occurs after a heart attack and improves cardiac function eight to ten weeks after its administration. We recently completed enrollment in a Phase I clinical trial for Provacel to evaluate its safety and efficacy to restore heart function in patients experiencing a first time heart attack.

Scientific Background

        Stem cells are a special class of cells that can self-replicate and differentiate into multiple tissue types. Different populations of stem cells, also called progenitor or precursor cells, reside within the body. These cells are generally classified according to their differentiation potential, or ability to become distinct cell types. Embryonic stem cells are recognized as being totipotent, or unlimited, in terms of the number of different cell types they can become. Other stem cells are either multipotent, meaning capable of becoming two or more cell types, or unipotent, meaning preprogrammed for a single final cell type. Multipotent stem cells include the hematopoietic stem cells responsible for generating cells associated with the circulatory and immune systems, mesenchymal stem cells responsible for the formation of connective tissue cells, and neuronal stem cells dedicated to producing the different nervous system cell types. Stem cells participate in embryological and fetal development and orchestrate tissue repair following disease or injury in the adult. Though the precise mechanism of their activity has not yet been determined, experimental work has provided empirical evidence of the therapeutic benefit of various types of stem cells administered to animal and human subjects.

        The embryonic stem cell, or ESC, has the greatest differentiation potential and is capable of developing into all cell types found within the human body. ESCs must be harvested from human embryos, giving rise to ethical controversies surrounding the procurement of ESCs, which have hindered progress in ESC research. The United States government has significantly restricted the funding of ESC research. Also, technical difficulties in purifying and growing ESCs have prevented widespread experimental work capable of withstanding academic or regulatory scrutiny.

        In the adult, two major classes of stem cells exist in bone marrow, hematopoietic stem cells and mesenchymal stem cells. Throughout life, hematopoietic stem cells, or HSCs, located within the bone marrow give rise to most types of blood cells. HSC transplantation has served as the basis for a number of aggressive treatments for various types of cancer. However, therapies based on HSCs are largely limited to hematological disorders because HSCs can only differentiate into blood cells.

        In contrast to HSCs, mesenchymal stem cells, or MSCs, are progenitor cells that differentiate into various connective tissues, such as bone, muscle, fat, tendon, ligament, cartilage and bone marrow stroma when they receive appropriate biochemical and biomechanical signals. Other biochemical stimuli cause MSCs to mobilize to areas of injury or inflammatory disease. Once there, MSCs coordinate tissue

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regeneration at a local level by producing tissue growth factors and by interacting with local cells to reduce inflammation and scarring. Importantly, MSCs do not express markers on the surface of cells, known as HLA class II antigens, which are responsible for recognition of the cells by the immune system. Also, the cell surface markers, CD40, CD80 and CD86, which are essential for activation of immune cells, are not present on MSCs. These characteristics allow MSCs to:

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be transplanted into an unrelated patient without giving rise to an immune response;



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regenerate connective tissues like bone and cartilage;



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act as a potent anti-inflammatory agent; and



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exhibit anti-fibrotic activity to limit tissue damage.

        MSCs and HSCs are most readily isolated from bone marrow. Because MSCs represent a small fraction of bone marrow cells, they require amplification to be clinically useful. We have developed and optimized a proprietary process for isolating and expanding these cells using standardized cell culture methodologies. We can grow MSCs in a controlled fashion to produce up to 5,000 treatments of our biologic drug candidates from a single bone marrow donation.

        Stem cells can be derived from either the patient, referred to as an autologous source, or from a donor, referred to as an allogeneic source. For many cell therapies, allogeneic sourcing is not possible due to the immune response that typically occurs following the injection of unrelated cells. The non-immunogenic nature of MSCs permits allogeneic cell sourcing and carries significant advantages over autologous sourcing. Allogeneic cell sourcing from a healthy donor population allows for specific quality control measures to select therapeutically optimal stem cells. For example, if a patient's cells are of poor quality due to advanced age, disease or metabolic state, the product to be re-infused will likely be of similar poor quality. We believe that allogeneic sources used in large scale production will enable us to utilize quality control practices to ensure that product potency is reproducible from treatment to treatment. We have developed and continue to develop quality standards for our biologic drug candidates, including potency assays directed to the specific indications for use. To our knowledge, no patients participating in our clinical trials or who have used Osteocel to date have experienced an immunogenic response.

Strategy

        We are striving to be the first company to receive FDA marketing approval and to commercialize a stem cell therapy. Our goal is to be the leading stem cell therapy company through the development and commercialization of stem cell therapies to address disease areas with significant unmet medical need and commercial potential. To achieve this goal, we are pursuing the following strategies:

        Successfully commercialize our lead stem cell therapy, Prochymal.    We are currently enrolling patients in a pivotal Phase III clinical trial for Prochymal. It is our highest priority to complete the development of Prochymal and achieve marketing approval. Assuming marketing approval, we plan to develop a sales and marketing force to promote Prochymal initially for the treatment of steroid refractory GvHD. Based on the small number of bone marrow transplantation hospitals in the United States and the lack of effective treatments for this population, we believe we can successfully market Prochymal with a specialized sales force. To increase the probability of success, we intend to gain the support of key opinion leaders and to utilize our clinical investigator relationships to gain market adoption. We estimate that the clinical investigators that we are using in our pivotal Phase III clinical trial for steroid refractory GvHD treat a significant portion of the patients with this disease in the United States.

        Leverage Osteocel's orthopedic sales infrastructure for our biologic drug candidate Chondrogen.    In the field of orthopedics, we intend to expand our network of sales professionals for the distribution of Osteocel. We plan to use our commercial experience with Osteocel to build a specialized sales

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organization trained and experienced in stem cell orthopedic sales. Given the overlap of potential customers for Osteocel and Chondrogen, we believe our relationships with orthopedic surgeons established through sales of Osteocel will help drive commercial adoption of Chondrogen and other orthopedic biologic drug candidates.

        Expand our pipeline of biologic drug candidates where our stem cell technology has a therapeutic potential.    We intend to continue investing in our biologic drug candidate pipeline by pursuing additional diseases and disorders where we believe MSCs have potential therapeutic benefit. For example, Prochymal reduced gastrointestinal inflammation in some patients in our Phase II treatment refractory GvHD clinical trial. Therefore, we have begun a Phase II clinical trial for Prochymal in patients with Crohn's Disease. As we demonstrate a potential therapeutic benefit from our biologic drug candidates in preclinical studies and clinical trials, we will prioritize which biologic drug candidates to pursue based on the clinical and regulatory path and commercial opportunity.

        Exploit our MSC technology, manufacturing ability and proprietary know-how to advance our pipeline.    We intend to leverage our preclinical research, safety data and manufacturing ability to rapidly and efficiently grow our biologic drug candidate pipeline. Because we utilize MSCs as the active agent for all of our biologic drug candidates, we believe the accumulated safety data will reduce the time and cost associated with early stage clinical trials for new indications. We also believe our manufacturing experience can be applied across all of our current and future biologic drug candidates, enhancing manufacturing efficiencies.

        Internally develop and commercialize future biologic drug candidates.    We believe that we have the requisite experience to develop and commercialize our unpartnered biologic drug candidates and any future biologic drug candidates without the help of a strategic partner. Due to our experience with Osteocel and our current pipeline candidates, we believe we have gained the clinical, regulatory, manufacturing and commercial capabilities to successfully develop and commercialize biologic drug candidates.

Marketed Product

Osteocel

        Osteocel consists of a matrix of cancellous bone containing mesenchymal stem cells and is used in spinal fusion and other orthopedic surgical procedures. It is the only commercially available product in the United States containing viable stem cells. We launched Osteocel in July 2005 and to date it has been used in over 1,250 surgical procedures. Osteocel is currently distributed exclusively by us for orthopedic indications and jointly with Blackstone Medical for spinal procedures.

        According to data published by the Centers for Medicare and Medicaid Services, over 900,000 surgeries are performed in the United States each year that require the reconstruction or replacement of bone. The standard of care is a procedure known as autograft, in which bone is harvested from another site within the same patient and transferred to the site of injury. The harvested bone contains stem cells and is often an effective agent for regenerating bone. However, this procedure has significant disadvantages. An additional surgery is required to obtain the autograft bone, resulting in increased time under anesthesia, additional blood loss, and the costs associated with an additional surgery. These patients also face an increased risk of infection and may experience chronic post-operative pain from the harvest procedure. As noted in an article published by the UCLA Department of Orthopaedic Surgery, complications from the autograft harvest occur in up to 35% of patients having the procedure. As such, we believe there is a significant medical need for a product that can provide reliable bone forming characteristics and eliminate the need for autograft.

        Spinal fusion is used to treat damage to the intervertebral disc, including herniated discs, and is one of the most common and expensive surgeries in orthopedics. Based on data published by the Centers for Medicare and Medicaid Services, there were 450,000 spine fusion surgeries in 2003,

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associated with multi-billion dollar health care costs. All spinal fusion surgeries require autograft or other material to support bone formation. Non-viable bone sourced from cadavers, synthetic materials, and recombinant growth factors are used as alternatives to autograft. Each has significant limitations and none has the same regenerative characteristics of autograft. While Osteocel contains the same bone forming properties as autograft, it has several distinct advantages:

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Osteocel avoids the potential complications and expense of an additional surgical procedure.



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The availability of Osteocel during surgery is limited only by the in-house supply, while autograft availability is limited to the amount harvested from the patient in the prior surgical procedure.



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Every lot of Osteocel is tested to ensure consistent quality, while the quality of the autograft is dependent upon the health of the patient.



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Ease of use, storage characteristics, and shelf life allow Osteocel to be used in virtually any surgical setting where bone formation is needed.

        Osteocel works in three ways. The cancellous bone matrix of Osteocel is osteoconductive, meaning it encourages new bone growth by providing a scaffold to support bone formation. Osteocel is also inductive. Osteoinduction is the indirect promotion of bone formation by recruiting the patient's cells to the site through signaling mechanisms. Lastly, the stem cells contained in Osteocel make it osteogenic. Osteogenesis is the ability of certain cells to form bone directly. Only two current treatments contain all three of these necessary components for new bone growth: autograft and Osteocel. Over the past 10 years our scientists have published over 20 peer reviewed journal articles demonstrating the consistent osteogenic capabilities of the MSCs in Osteocel.

        We produce Osteocel from the marrow-rich bone of organ and tissue donors. Since its introduction in July 2005, we have been unable to produce quantities of Osteocel sufficient to meet surgeon demand. We are currently constrained by our manufacturing facility and limitations on the supply of marrow-rich bone obtainable from adult organ and tissue donors. To increase our ability to supply our customers, we are currently expanding our manufacturing capacity and increasing the number of organ and tissue agencies that supply us with tissue. We believe that Osteocel is properly characterized, and regulated by the FDA, as a HCT/P under section 361 of the Public Health Service Act.

        We are in the process of developing a second generation MSC product for bone repair, Osteocel-XC, as a long-term strategy to relieve supply constraints. Unlike Osteocel, Osteocel-XC will utilize culture-expanded MSCs like our other biologic drug candidates. Based on our clinical and preclinical experience with Osteocel and MSCs, we are preparing to submit an Investigational New Drug application to FDA to study Osteocel-XC. Our initial target indication for Osteocel-XC will be for the treatment of avascular necrosis, or AVN, of the femoral head, a disorder characterized by restriction or interruption of the blood supply to bone that results in death of bone cells. Without living bone cells, surrounding tissue erodes leading to mechanical failure of the bone and/or joint. As noted in a publication by the National Institute of Arthritis and Musculoskeletal and Skin Diseases, this condition afflicts approximately 10,000 to 20,000 people per year, resulting in significant morbidity. The 1997 edition of the textbook Osteonecrosis: Etiology, Diagnosis and Treatment, published by the American Academy of Orthopaedic Surgeons, estimates that without surgical intervention, 70 to 80% of patients diagnosed with AVN of the femur will progress to hip failure. Even with today's surgical standard of care, this textbook notes that over 40% of patients will require a total hip replacement. There is no drug therapy approved for the treatment of AVN.

Clinical Programs

Prochymal

        Prochymal is our biologic drug candidate for the treatment of inflammatory disease. We are currently enrolling patients in a pivotal Phase III trial for the treatment of steroid refractory GvHD. GvHD is a life threatening immune system reaction that commonly affects the skin, gastrointestinal

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tract, and liver in patients who have received a bone marrow transplant. We are also evaluating Prochymal as an add-on therapy to steroids for the first-line treatment of acute GvHD and as a therapy for the treatment of Crohn's Disease, a chronic condition that results in inflammation of the gastrointestinal tract.

        Bone marrow transplantation is a treatment of last resort for patients with certain cancers and some genetic diseases. This procedure can result in a particularly serious type of rejection referred to as Graft versus Host Disease. This condition gets its name because the bone marrow transplant, or the graft, begins to attack the recipient, or the host. As noted in an article published in the journal Biology of Blood and Marrow Transplantation in 2005, acute GvHD is one of the most common complications of allogeneic bone marrow or hematopoietic stem cell transplantation, affecting approximately 50% of transplant patients. Acute GvHD is graded for prognostic and treatment purposes on a four grade scale, with Grade I considered mild, Grade II moderate, and Grades III-IV considered severe and life-threatening. The onset of GvHD in patients who have received a bone marrow transplant leads to a poor prognosis because of the already weakened state of such patients. According to a 2002 article published in Biology of Blood and Marrow Transplantation, the estimated one year survival rate for patients with acute GvHD decreases drastically with increasing disease severity, as illustrated below:

        Typically, patients are treated aggressively with steroids when their GvHD reaches Grade II. A 2001 article published in the journal Blood noted that approximately 50% of these patients will not respond to treatment with steroids and approximately 50-80% of steroid refractory GvHD patients die of the disease.

        The current treatments available for acute GvHD are inadequate in several ways. First, mortality in patients with acute GvHD is unacceptably high. Second, most treatments for acute GvHD work by suppressing or destroying the immune system. This leads to a number of debilitating side effects, including severe and life threatening infection. Unlike steroids or other immunosuppressant drugs, which have a systemic effect, Prochymal's mechanism of action is designed to specifically target areas of inflammation. Therefore, we believe the use of Prochymal will result in a lower rate of life threatening infection.

        We initiated a Phase II trial to evaluate Prochymal as a first-line treatment for patients diagnosed with Grade II through Grade IV acute GvHD. Patients were treated with doses of 2.0 or 8.0 million cells per kilogram of body weight administered in two infusions of Prochymal 72 hours apart. The treatment commenced within 48 hours of GvHD diagnosis. In this study, we are evaluating safety, dose, and response to treatment by day 28. Patients will be followed for safety for two years after trial enrollment. A total of 32 patients have been treated under this protocol, and an interim review of the data revealed approximately 70% of the patients meet the study criteria for complete response and had no signs of acute GvHD at the end of the 28-day study treatment period. Because the trial only recently completed enrollment, an analysis of statistical significance has not yet been performed. Statistical significance is an assessment of the likelihood that the outcome occurred by chance.

        Starting in 2004, several requests were made by physicians to use Prochymal in a compassionate use setting for patients with acute severe treatment refractory GvHD and no remaining treatment options. A total of four patients that had failed to respond to steroids and other immunosuppressive agents were treated on an emergency-use basis, and clinical improvements were seen in gastrointestinal and skin GvHD.

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        As a result of the compassionate use requests, we initiated a second Phase II trial to investigate the use of Prochymal in patients diagnosed with Grade III or Grade IV GvHD that did not respond to treatment with steroids and at least one other therapy. This was an open label study in which we evaluated safety, dose, and response to treatment by day 28. Patients were treated with 8.0 million cells per kilogram every 72 hours as needed for response, for a maximum of eight treatments. Fourteen patients were treated under this protocol. The subjects enrolled in this trial had failed to respond to an average of 4.4 other drug therapies prior to enrollment. A 59% Prochymal response rate was observed in this treatment refractory population, defined as an improvement in at least one affected organ by at least one full GvHD stage without disease progression in any other organ. Because the patients in this trial had previously not responded to multiple lines of therapy and their condition was immediately life threatening, for ethical reasons the use of a placebo control was not possible. Therefore, further analysis of the statistical significance of our results was not performed. We are following patients for safety for one year after trial enrollment.

        In 2003 we completed a Phase I trial to determine the safety of Prochymal in patients who received hematopoietic stem cell transplants. The trial investigated patient response to doses of 1.0, 2.5, and 5.0 million cells per kilogram of body weight. No safety concerns related to the use of Prochymal were observed in the 46 subjects who were evaluated.

        We recently held an end of Phase II meeting with the FDA to discuss the results of the trials described above and seek FDA guidance on the design of our pivotal Phase III trial for the treatment of steroid refractory GvHD. Enrollment in the pivotal Phase III trial opened in July 2006.

        We obtained both Fast Track and Orphan Drug designation in 2005 for the use of Prochymal in GvHD patients. The FDA grants Fast Track designation to investigational drugs that have the potential to treat life-threatening diseases with unmet medical needs. Our Biologic License Application will be eligible for an expedited review process by the FDA as a result of this designation. Orphan Drug designation offers several benefits including eligibility for grants to fund studies, seven years of marketing exclusivity and a waiver of the Biologic License Application fee of approximately $700,000. Prochymal is the only stem cell therapeutic currently designated by the FDA as both an Orphan Drug and Fast Track product candidate.

        Based on our clinical observations of the effects of Prochymal on the gastrointestinal symptoms of patients with GvHD, we are developing Prochymal for the treatment of Crohn's Disease. Crohn's Disease is a chronic, life-long condition that features relapsing inflammation of the gastrointestinal tract. Severe Crohn's Disease can cause intractable diarrhea and abdominal pain, undesirable changes in lifestyle, hospitalization, and unwanted side effects from required medications. Approximately 60% of Crohn's Disease patients require at least one surgery to remove an affected portion of their intestine at some time during their lifetime, according to a 2002 article in the journal Alimentary Pharmacology & Therapeutics. This article further notes that there are over 500,000 cases of diagnosed Crohn's Disease in the United States, and at any given time approximately 10% of these have a severe exacerbation or relapse that does not respond to traditional immunosuppressive treatments. Standard treatments of steroids and other immune suppressants often cause secondary health problems. According to a 2003 article in the British Journal of Clinical Pharmacology, with current medical therapies about 50% of patients with severe Crohn's Disease will relapse within a year. Also, one year post-surgical recurrence rates of over 85% have been reported in such patients in a 1990 article published by The Medical Clinics of North America.

        We recently completed enrollment of a Phase II trial studying Prochymal as a treatment for moderate to severe Crohn's Disease that is refractory to steroids and other immune suppressants. We enrolled ten patients in this study and are investigating patient response to doses of 2.0 and 8.0 million cells per kilogram of body weight. We will evaluate patients for efficacy 28 days after treatment. The target response is a reduction of at least 100 points on the Crohn's Disease Activity Index, a patient assessment scale designed to measure the severity of Crohn's Disease. The study will also evaluate the

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ability of Prochymal to induce remission of Crohn's Disease. We plan on evaluating each patient for safety two years after the patient enrolled in the trial.

Chondrogen

        Chondrogen is our biologic drug candidate for regeneration of meniscus, a type of cartilage that cushions the knee joint. There are currently no FDA approved products available to regenerate meniscal tissue. In several preclinical studies, Chondrogen regenerated meniscus and prevented osteoarthritis in animal models. We recently completed enrollment in a Phase I/II clinical trial for Chondrogen. This trial is designed to evaluate the safety and efficacy of Chondrogen in patients following surgery to remove torn meniscus.

        The meniscus is a crescent-shaped cushion in the knee joint that protects cartilage and enables the knee to move smoothly. Injury and tears to the meniscus are common and can be traumatic, arising from sports injury for example, or degenerative, due to daily wear and tear. An injured or torn meniscus is painful and typically requires surgical intervention. The current standard of care for significant injuries is partial meniscectomy surgery, in which the damaged portion of the meniscus is permanently removed. According to a 2005 article in the American Journal of Sports Medicine, approximately 1.0 million people have surgery to remove damaged or torn meniscus in the United States each year. As noted in a 1999 article in the journal Sports Medicine, patients who have had this procedure are ten to 15 times more likely to develop osteoarthritis, a highly debilitating orthopedic condition. As a result, a significant medical need exists for a product that can regenerate the meniscal tissue removed during surgery and prevent cartilage degeneration.

        In November 2005, we began enrolling patients in a randomized, double blind, placebo controlled Phase I/II clinical trial evaluating Chondrogen. In this study, we are evaluating Chondrogen's ability to regenerate meniscus in patients who have had a significant portion of their meniscus surgically removed. Only patients with the surgical removal of at least 50% of the damaged portion of their medial meniscus and without major cartilage damage were eligible to participate in the study. The trial will investigate patient response to doses of 50 million cells, 150 million cells, or placebo. We completed enrollment for this trial at the end of the first quarter in 2006, treating a total of 55 patients. The endpoint of the trial is a six-month efficacy evaluation with magnetic resonance imaging to measure the regeneration of meniscus following treatment with Chondrogen. We plan on evaluating each patient for safety two years after the patient enrolled in the trial. The last patient treated in this trial will receive their six-month efficacy evaluation in October 2006, and we plan on conducting the final safety evaluation at the end of the first quarter of 2008. We plan to enter into a Phase III trial in the first half of 2007 if the efficacy evaluations are positive.

        In preclinical studies of Chondrogen, we demonstrated the potential for MSCs to regenerate mensicus. To date, we have studied the effect of MSCs in the knee in over 140 animals. In early studies, the entire meniscus was removed followed by an injection of MSCs or placebo to the joint space. Regeneration of a meniscus was seen in the MSC treated knees as early as six weeks after surgery. In the most severe model, new meniscus was found in 78% of joints at 20 weeks. Examination of the joints showed that the new meniscus had the correct anatomical location and geometry. Histology and biochemical analysis showed that the new meniscus also had similar composition to normal meniscus, predominantly type 1 collagen with smaller amounts of type II collagen and proteoglycan. Joints receiving injections of placebo regrew no functional mensical tissue.

        In later preclinical studies, time to treatment was evaluated between one and six weeks following surgery. Earlier delivery of MSCs at one week after surgery resulted in more meniscus regrowth compared to six weeks. Further studies evaluated meniscal regeneration following single and multiple injections of MSCs. A single high dose injection of MSCs resulted in a larger meniscus volume at three months than multiple low dose injections. Additionally, the joints receiving MSCs showed significantly

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fewer degenerative changes to the articular cartilage and the bone than placebo-treated joints, indicating the potential for Chondrogen to protect the joint from osteoarthritic-like changes.

Provacel

        Provacel is our biologic drug candidate for the repair of heart muscle in patients who have suffered a heart attack. Preclinical studies indicate that Provacel prevents scar formation that typically occurs after a heart attack and improves cardiac function eight to ten weeks after its administration. We recently completed enrollment in a Phase I clinical trial for Provacel. This trial is designed to evaluate the safety and efficacy of Provacel to restore heart function in patients experiencing a first time heart attack.

        A heart attack, or acute myocardial infarction (AMI), occurs when coronary arteries become blocked with fatty deposits, depriving the heart muscle of oxygen and nutrients. Based on statistics published in 2005 by the American Stroke Association and the American Heart Association, in the United States approximately 700,000 individuals each year experience their first heart attack. According to these same statistics, approximately 20% of patients experiencing their first heart attack suffer extensive damage to their heart muscle, leading to heart failure within six years. Furthermore, we believe the statistics indicate that despite improvements in the standard of care, this progression from myocardial infarction to heart failure remains largely unavoidable in patients with AMIs.

        Provacel is being developed for the treatment of heart muscle damage following AMI. Its primary indication is to treat post-AMI complications and prevent the formation of scar tissue and associated cardiac dysfunction. Our preclinical studies indicate that the mechanism by which Provacel improves myocardial function includes preventing pathological scarring of the heart muscle and growing new blood vessels. We are developing Provacel as a therapy to be delivered through a standard intravenous line up to 10 days post-myocardial infarction.

        In March 2006, we completed enrollment of a 53 patient Phase I randomized, double blind, placebo controlled clinical study to evaluate Provacel in patients following AMI. The trial is designed to investigate patient response to doses of 0.5, 1.6, and 5.0 million cells per kilogram of body weight or placebo. Exploratory efficacy endpoints include overall improvement in the function and remodeling of the heart muscle six months after treatment. A safety evaluation for each subject will be conducted two years after the subject is enrolled in the trial.

        In preclinical studies, Provacel selectively targeted the damaged area of the heart when a single infusion is administered. These studies also indicated that Provacel has the effect of retarding or stopping the progress of further cardiac tissue deterioration and limit the damage caused by an AMI. Significant improvements in cardiac function as demonstrated by increased ejection fraction, reduced end diastolic pressures, and reduced wall stress were observed eight to 10 weeks after administration of Provacel. A preclinical study was performed to determine if an intravenous infusion of MSCs following myocardial infarction would result in an improvement in cardiac function. Significant improvement in cardiac function as indicated by left ventricular ejection fraction was observed three months after infarct in those animals receiving intravenous delivery of MSCs when compared to control animals. MSCs were detected in the damaged area of the heart muscle of treated animals, but not in the remote, undamaged regions.

        We entered into a collaboration with Boston Scientific Corporation in 2003, and assuming successful completion of our clinical trials and regulatory approval, it will market and distribute Provacel.

Other

        In addition to the indications described above, we intend to investigate alternative uses for MSCs and our biologic drug candidates. For example, we intend to submit an Investigational New Drug application for Prochymal for the treatment of acute renal failure, the sudden inability of the kidneys to

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function properly. We may also evaluate the use of Provacel for additional cardiovascular indications and Chondrogen for the regeneration of cartilage in other areas of the body.

Safety Profile

        To date, we have collected safety data from over 200 patients enrolled in our stem cell clinical trials. Among other things, we monitor patients for the occurrence of serious adverse events, or SAEs. An adverse event is considered serious if it is life threatening or results in death, causes a disability or congenital abnormality, or results in hospitalization or medical intervention to prevent disability. All SAEs are recorded and analyzed regardless of the known or suspected cause. Each time an SAE arises, the investigator must determine the relationship between the study drug and the SAE. Categories for indicating the study drug causality include probably related, possibly related, and unlikely related, as discussed below.

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Probably related—the SAE follows a strong temporal relationship to the administration of the study drug and cannot be reasonably explained by the patient's clinical condition or other treatments.



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Possibly related—the SAE follows a reasonable temporal relationship to the administration of the study drug, but an alternative cause seems more likely.



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Unlikely related—the SAE does not follow a reasonable temporal relationship relative to the administration of the study drug and is readily produced by the patient's clinical condition or other treatments.

        Patients with GvHD are typically very ill as a result of their underlying genetic or oncologic condition. Similarly, patients who have had a heart attack face a number of health risks. As a result, unrelated SAEs are routinely observed in these patient populations. To date, there has been one SAE that has been deemed probably related, and a total of four SAEs that have been deemed possibly related to the infusion of our biologic drug candidates. The SAE deemed probably related was a case of ectopic calcifications in a GvHD patient with malignant osteopetrosis. Malignant osteopetrosis is a genetic disorder of the bone cells leading to bone overgrowth. Subsequent analysis of the biopsied calcifications indicated that no DNA from our stem cells was present. Although the physician deemed this SAE probably related to the administration of Prochymal, subsequent discussions with the FDA resulted in a conclusion that the study drug was likely not the cause of the ectopic calcifications. The first possibly related SAE was in a GvHD patient who had increased levels of cytomegalovirus in the blood, which is often seen in patients with acute GvHD. The second possibly related SAE was a case of chronic GvHD in a patient with acute GvHD. According to a 2001 article in the journal Experimental Hematology, chronic GvHD incidence is approximately 70% among those who develop acute GvHD. The third possibly related SAE was a case of deep vein thrombosis in a patient in the Provacel trial, however the study remains blinded and it is not known if the patient received MSC treatment or placebo. The fourth possibly related SAE was also in the blinded Provacel trial. The patient experienced atrial flutter, which, according to the American Heart Association, commonly occurs in the setting of acute myocardial infarction.

Collaborations

Boston Scientific Corporation—Research, Development and Commercialization Collaboration

        In March 2003, we entered into a collaboration with Boston Scientific Corporation, or Boston Scientific, to develop applications of our MSC technology to treat acute myocardial infarction and chronic ischemia. Our biologic drug candidate under development pursuant to this collaboration is Provacel.

        Under the terms of the collaboration, we are responsible for the preclinical development of an MSC biologic drug candidate having application in the covered field, and for associated regulatory filings, and Boston Scientific is responsible for the research and development activities performed

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following completion of preclinical development of a biologic drug candidate, including, without limitation, development of the clinical protocols, clinical trial management and Phase II efficacy research testing. The collaboration provides for us to manufacture the MSC clinical trial materials, and provides that, upon regulatory approval for commercial sale, we will manufacture and Boston Scientific will have exclusive rights to distribute and sell the product globally. Boston Scientific may also assume the manufacturing rights and responsibilities from us and if it does so the royalty rate payable to us is subject to increase. This collaboration may be terminated at any time upon mutual agreement of the parties. Also, Boston Scientific can terminate the collaboration prior to obtaining FDA approval of a product, provided that it gives us at least 120 days notice of such termination.

        In connection with this collaboration, we granted to Boston Scientific a worldwide, exclusive license to develop, market and distribute MSC products in the covered field. Unless earlier terminated, the license terminates on the expiration of the last to expire licensed patent covering the product, and with regard to member states of the European Economic Area, or EEA, on the later of the tenth anniversary of the commercial launch of a product in the EEA or the expiration of the last to expire patent. This license automatically terminates upon termination of the collaboration prior to FDA approval of a product as described above.

        Boston Scientific paid a $5.0 million licensing fee to us upon the effectiveness of the license. Boston Scientific is also required to pay to us up to $25.0 million in pre-commercialization milestones per product, as well as royalty payments for MSC products acquired or manufactured by Boston Scientific outside of the terms of the contract manufacturing agreement. In addition, any and all MSC products sold by us to parties other than Boston Scientific must be sold with a limited label license that states that the product may only be used in a specified field or application which does not fall within the exclusive field granted to Boston Scientific.

        We have a $50.0 million line of credit with Boston Scientific, of which we have drawn $5.0 million to date. Borrowings can only be used by us in connection with Provacel development efforts. Advances under the loan agreement are secured by an interest granted to Boston Scientific in the license agreement, including the right to develop, market and distribute MSC products in the covered field and our right to receive payments under the license; all equipment, books and records relating to the manufacture of Provacel; and all future proceeds or payments received in connection with such collateral. We must commence quarterly repayment of the advance during the first fiscal quarter following commercialization of Provacel up to a maximum of 2.5% of sales of Provacel per quarter. If commercialization has not occurred prior to December 31, 2008, we must issue shares of our common stock in repayment of the loan at a rate of 20% per year up to a maximum repayment term of five years. Alternatively, upon any termination of the collaboration with Boston Scientific or any default under the loan agreement, Boston Scientific may require us to satisfy the full balance of the outstanding loan through an issuance of shares of our common stock. We can elect to repay the amounts borrowed from Boston Scientific at any time.

        In conjunction with this collaboration, Boston Scientific made a $10.0 million investment in our preferred stock, which will convert at the closing of this offering into 500,000 shares of our common stock. Upon the enrollment of the first patient in a Phase III clinical trial for Provacel, Boston Scientific is obligated to purchase from us and we are obligated to sell, 166,667 shares of common stock for an aggregate purchase price of $10.0 million, or $60.00 per share. Upon FDA approval of Provacel, Boston Scientific is obligated to purchase from us and we are obligated to sell, 89,286 shares of common stock for an aggregate purchase price of $10.0 million, or $112.00 per share. Boston Scientific was granted registration rights in respect of the shares of our common stock received by it, which rights have been waived to the extent that they relate to this offering. Boston Scientific was also granted a preemptive right to purchase its pro rata share of securities issued and sold by us, which right has been permanently waived.

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JCR Pharmaceuticals Co., Ltd.—License Agreement

        In August 2003, we entered into a license agreement with JCR Pharmaceuticals Co., Ltd., or JCR, pursuant to which we granted to JCR an exclusive right in Japan to our MSC technology for use in connection with the use of hematopoietic stem cells derived from peripheral blood, cord blood or bone marrow in the treatment of hematological malignancies including the treatment of GvHD with Prochymal.

        The license agreement provided for a payment by JCR to us of an up-front license fee of $3.0 million and payment of an additional $500,000 upon certain technology transfer. In addition, if and when marketing approval is obtained in Japan, JCR is required to pay up to $7.0 million in pre-commercialization milestones per product and certain amounts for pre-determined thresholds of cumulative net sales. Lastly, JCR has an obligation to pay royalties to us, with such amount dependent upon the cumulative net sales.

        Under the terms of the collaborative arrangement, JCR is obligated to use its reasonable best efforts to develop and commercialize in Japan products covered under the terms of the license, including conducting clinical trials and procuring regulatory and other approvals. The license expires with respect to specific products on the later of 15 years from the date of the first sale of the product in Japan or the date on which our last patent in Japan covering that product expires. Also, the license and the collaboration can be terminated unilaterally by JCR upon 180 days notice to us or by mutual agreement between us and JCR.

        In conjunction with this collaboration, JCR made a $3.0 million investment in our preferred stock, which will convert at the closing of this offering into 136,363 shares of our common stock. JCR was granted registration rights in respect of the shares of our capital stock received by it, which rights have been waived to the extent that they relate to this offering. JCR was also granted a preemptive right to purchase its pro rata share of securities issued and sold by us, which right has been permanently waived.

Blackstone Medical, Inc.—Distribution Agreement

        In November 2005, we entered into a distribution and supply arrangement for Osteocel with Blackstone Medical, Inc., or Blackstone. Blackstone has the right to distribute Osteocel in the United States for the treatment of spinal injuries or diseases. In addition, we granted Blackstone an exclusive distribution right with regard to spinal implant manufacturers provided that it commits to purchase at least 80% of the quarterly production forecast of Osteocel at a stipulated price per unit.

        Blackstone markets Osteocel under the "Trinity" name. We have also retained the right to directly market and distribute Osteocel under the Osteocel brand.

        Blackstone is required to use its best efforts to distribute Osteocel. Unless earlier terminated, the agreement terminates on December 31, 2008; however, it can be renewed for one-year periods so long as Blackstone achieves certain predetermined performance objectives.

        Either party may terminate the agreement immediately upon written notice to the other party of the occurrence of certain bankruptcy events or failure to remedy a material breach that continues for more than 30 days.

Intellectual Property

        We have established a considerable patent position in adult stem cell technology. We currently own or have exclusive licenses to 45 issued U.S. patents. Foreign counterparts to these patents, including composition of matter claims, have been filed, and we own or hold licenses to 153 issued patents in Europe, Canada, Australia and other countries. The patents and patent licenses included in our portfolio address the composition and therapeutic use of mesenchymal stem cells. We are committed to protecting our intellectual property position and to aggressively pursue our patent portfolio, and have

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15 additional U.S. patent applications pending and 66 foreign patent applications on file but not yet allowed.

        For most of our biologic drug candidates, we rely on multiple patents in combination. The following provides a description of our key patents and pending applications and is not intended to represent an assessment of claims limitations or scope.