SHARES of VaxGen, a small biotechnology company that has developed an experimental AIDS vaccine, have soared recently, despite skepticism among researchers and many investors about the company's main product.

VaxGen announced ''encouraging'' findings on May 29, suggesting that its AIDSvax vaccine stimulated an immune response to more strains of H.I.V. than was initially expected. The stock price of the company, based in Brisbane, Calif., jumped 26 percent that day, to roughly $23 a share. It is now trading at $24.95, still below a high of $36.87 last October.

VaxGen's vaccine is the first in the United States to begin large-scale tests, known as Phase 3 studies, involving people in high-risk groups, gay men and drug users. ''In reality, there's only one way to find out whether a vaccine works, and that's to test it,'' said [Dr. Donald Pinkston Francis (born 1942)], VaxGen's president.

Researchers are at odds over whether VaxGen's approach, using a protein from the coating of H.I.V. to stimulate antibodies, is the most effective way to stop AIDS.

''I think there is a feeling in the community that vaccines of this type are not capable of generating an appropriate immune response, that while a vaccine may be able to block the virus, there's skepticism about its chances of catching it once it gets into cells,'' said Dr. Dino Dina, who was president of Chiron when it and Genentech ran H.I.V. vaccine trials using a similar approach in the mid-1990's.

Other vaccines are being developed; some are in early stages of testing. Merck has begun pilot studies of a vaccine that takes a different approach. GlaxoSmithKline is testing a vaccine in a laboratory setting and expects to begin its own pilot studies later this year. Dr. Dina's new company, Dynavax, is collaborating with Aventis on an H.I.V.-AIDS vaccine, as is VaxGen, which would offer AIDSvax as a booster for the Aventis treatment.

Largely bypassed by institutional investors and ignored by analysts, VaxGen shares have become a favorite of short-sellers, investors who profit from the declining value of a stock. They are betting that the clinical trials will fail.

''This is not the type of company I typically recommend, but there is a huge first-mover advantage in developing vaccines,'' said Sharon Seiler, a securities analyst at Punk, Ziegel & Company, which helped VaxGen go public when it was spun off from Genentech in 1995.

VaxGen's announcement on May 29 came shortly after the company sold $20 million in convertible stock to the Halifax Fund.

Critics questioned the timing of the two events, saying the announcement of the test results was intended to increase the stock price. But VaxGen executives said they were not related. ''It was important information,'' Dr. Francis said.

Interim results of the Phase 3 tests are scheduled to be released in November. The trials are required before the Food and Drug Administration reviews the drug for possible approval.

But the future of VaxGen is uncertain, many investors said, and Wall Street has showed unusual caution.

''The issue of AIDS vaccines is an area where there's been a lot of controversy and disappointment," Ms. Seiler said. VaxGen's vaccine, she said, is based on a cloned version of a sugar protein called glycoprotein 120, which fell out of favor after failed tests in the mid-1990's.

The history of problems is fueling short-sellers, who have amassed a position of nearly one million VaxGen shares.

''What Vaxgen is doing is really old technology,'' said Jim McCamant, the editor at large of the Medical Tech Stock Letter. ''There are other companies doing new-generation things. I think we'll end up with a vaccine that works but that will take at least five years. It won't be a protein envelope, though maybe it could be used as a booster.''

THE stock was also hurt by the resignation in December of [Dr. Robert Charles Nowinski (born 1945)], VaxGen's chief executive and, along with Dr. Francis, a founder of the company. Mr. Nowinski, 55, said he was leaving for health reasons. Dr. Francis is serving as interim chief executive until a successor is found.

VaxGen is continuing two separate three-year trials -- one in North America and Europe, the other in Thailand -- involving almost 8,000 people. The final analysis is expected in November 2002.

While many fund managers have avoided the stock, Paul Sonz, manager of Paul Sonz Partners, a hedge fund, was an early investor and is sticking with it.

''There are one million shares held short that may have to be covered before November, and a lot of smart people who have looked at the science have put money behind this,'' Mr. Sonz said. ''For all of these reasons, the risk-reward picture here is compelling.''

As anthrax exposures continue and the specter of smallpox has loomed on the horizon, many officials have begun discussing widespread vaccination against the two diseases in an effort to reduce public concern about terrorist threats.

But the vaccines now in use present a number of problems--ranging from lack of manufacturing capacity to side effects--that render large-scale vaccination programs problematic.

Medical researchers have been working on efforts to produce safer vaccines. But until now, drug companies have put relatively little money into what has been considered a low-margin, low-priority part of the business.

For both anthrax and smallpox, the side effects of the vaccines are serious enough that widespread vaccination could cause more damage than the diseases themselves unless the vaccines are used only after a major outbreak has begun.

Anthrax vaccination of soldiers has produced reports of severe side effects, such as bleeding and thyroid malfunction, and has been linked to six deaths.

Just what degree of risk there is from the vaccine, however, is unclear. Many medical authorities say it is safe, but some doctors have suggested it could be one of the causes of the mysterious Gulf War syndrome, which some troops sent to the Persian Gulf in the early 1990s have said they suffer from

Fear of the vaccine is perhaps greater than fear of anthrax. As many as 400 members of the U.S. military have been court-martialed or have resigned rather than submit to the vaccination because of the perceived risks. Some physicians share their misgivings.

“You won’t see me getting in line for the vaccine,” says [Meryl Jae Nass, MD (born 1951)], a longtime critic.

The vaccine is produced by only one manufacturer, BioPort Corp. of Lansing, Mich., and the technology is nearly 40 years old. Although the company is currently producing the vaccine, the Food and Drug Administration will not allow it to be shipped because of various deficiencies in quality control and manufacturing at the plant.

The vaccine is unusual in that it is not targeted at the bacterium itself, as are most vaccines, but at the toxin produced by the bacteria as they grow. That toxin produces the cellular damage that can lead to death from an anthrax infection.

The toxin has three major components: protective antigen, lethal factor and edema factor. When the toxin is released in the body, individual molecules of the protective antigen clump together on the surface of target cells to form a doughnut-shaped pore. This pore is then used by the other two components to enter the cell, where they are lethal.

The vaccine is designed to stimulate antibodies to the protective antigen, preventing it from attaching to cells. In theory, if the action of the toxin is blocked, then the immune system can eradicate the bacteria or they can be killed with antibiotics.

“We buy the individual some time to fight off the infection,” said microbiologist [Dr. Darrell Ray Galloway (born 1946)] of Ohio State University.

BioPort grows a strain of Bacillus anthracis that secretes only protective antigen. The bacterial culture is filtered--in a process much like making coffee in a filter pot--to collect the antigen along with any other materials that are secreted by the bacterium. The material that drips through the filter becomes the vaccine. It contains no bacteria, either dead or alive.

But the antigen does not stimulate a strong immune response. To get good immunity, six doses of the vaccine must be given at two-week intervals.

Critics fear that the other bacterial components collected along with the antigen may cause side effects, so research has focused on eliminating them.

“The interest is in more highly defined vaccines so one knows precisely what one is being immunized with,” Galloway said.

The Army has been working with the National Institutes of Health to use genetic engineering techniques to produce a pure antigen. Although both the military and the NIH have consistently refused to talk about their work, other experts say that human tests will begin early next year. That vaccine will also require multiple doses.

In his research, [Dr. Darrell Ray Galloway (born 1946)] also is targeting the toxin. But instead of using the antigen protein itself, he is injecting mice with the gene that causes the body to produce the protein. Researchers have been producing such DNA vaccines against a variety of diseases, and they are generally thought to produce a more powerful immune response and fewer side effects than standard protein vaccines.

He also uses the gene for the lethal factor in his vaccine. “We get a greater response with both than with one alone,” he said. Preliminary results in mice reported earlier this year indicate that the DNA vaccine can blunt anthrax infections, but Galloway must conduct many more tests, including vaccination of primates, before use of the vaccine in humans can be considered.

The most optimistic estimate would be 18 to 24 months before clinical trials could begin, he said.

The smallpox vaccine produces a different set of problems. Like the anthrax vaccine, it employs old technology--dating back to experiments by Edward Jenner, the pioneer of vaccines, in 1796.

Smallpox is produced by a virus called variola, but researchers do not use it to produce the vaccine. Instead, they use a related virus called vaccinia, which produces a disease called cowpox.

The normally mild infection produced in humans by the live vaccinia provides very good protection against smallpox--so good that the disease has been eradicated from nature. Today, variola is known to exist only in one laboratory each in the United States and Russia, although U.S. officials suspect that Iraq and perhaps other nations may also possess some virus stocks.

“The risk of its being used as a weapon is not very high, but it’s there,” said [Dr. Donald Ainslie Henderson (born 1928)] of Johns Hopkins University, who ran the global smallpox eradication campaign. “And if you got an outbreak, it would be a terrible global catastrophe.”

Existing stocks of the smallpox vaccine were grown in calf cells, collected and freeze-dried more than 30 years ago.

The vaccines are believed to still be effective, but they are contaminated with proteins and other materials from the cow cells that may produce adverse reactions in some individuals.

New Rules From the FDA

The FDA no longer allows vaccines to be grown in animal cells. The new contracts for vaccine production recently signed with several companies require that vaccinia be grown in human cells. That process is straightforward and should not introduce difficulties, and manufacturers assume that the new vaccine will be as effective as the old one.

“There are no technical hurdles here,” said Lance Gordon, chief executive of vaccine manufacturer [VaxGen, Incorporated]. “Everything that has to be done to make a state-of-the-art smallpox vaccine is technology already in use.”

But critics caution that a smallpox vaccine grown in human cells has never been tested and that assumptions don’t always hold up.

Vaccinia, moreover, can itself produce problems ranging from open sores all over the body to death.

The death rate is estimated to be as high as 2 in a million cases, meaning that if the entire U.S. population were vaccinated, about 600 people would die of the vaccine.

Inadvertent contamination of the eye--caused perhaps by touching the vaccination site and then the eye--can produce severe problems, including blindness.

Vaccinia itself is infectious. That’s a valuable trait in a vaccination program because it provides protection to people who weren’t directly vaccinated.

But in a modern society with large numbers of people whose immune systems have been damaged, by HIV infections or as a result of drugs taken for organ transplants, that contagion could be a major problem that likely would lead to additional deaths.

All told, vaccinating all Americans against smallpox could cause 3,000 severe adverse reactions and a much larger number of lesser problems, according to [Dr. Thomas Patrick Monath (born 1940)], an executive at British vaccine manufacturer Acambis.

If a terrorist group actually launched a smallpox attack, however, “we don’t have any choice as a society” other than to use the vaccinia vaccine, said [Dr. Darrell Ray Galloway (born 1946)].

The U.S. population now is almost entirely unvaccinated--the effect of the vaccine largely wears off after about 20 years, so most people who received the vaccine as children are no longer immune. An unprotected outbreak of smallpox potentially could kill millions of people, experts say.

A small number of researchers have been exploring the possibility of using a different type of vaccine, a killed-virus vaccine, which would eliminate the danger to immunosuppressed individuals.

But development of such a vaccine, like that for anthrax, has been hindered by lack of a market, and any product is still at least a couple of years from human tests.

For that reason, officials have pushed for a major expansion of the current smallpox vaccine supply. Right now, the country has about 15 million doses, not nearly enough to contain a major outbreak.

The World Health Organization once had 200 million doses in storage in Switzerland, but the international body ran out of money to keep them, and they were destroyed after President Reagan reduced U.S. payments to the United Nations. ‘

SOUTH SAN FRANCISCO, Calif., July 28 /PRNewswire-FirstCall/ -- VaxGen, Inc. (OTC Bulletin Board: VXGN) announced today the completion of its merger transaction with diaDexus, Inc., a diagnostics company focused on the development and commercialization of patent-protected in vitro diagnostic products addressing unmet needs in cardiovascular disease.  

As consideration in the transaction, VaxGen issued approximately 19,960,534 shares to certain diaDexus stockholders and officers. As a result, VaxGen now has 53,067,057 shares of common stock issued and outstanding, of which pre-transaction diaDexus stockholders and officers own approximately 38% and pre-transaction VaxGen stockholders continue to own approximately 62%. diaDexus, LLC (as the successor entity to diaDexus, Inc. in the transaction) will operate as a wholly-owned subsidiary of VaxGen. 

"The Board of Directors and I are very pleased to announce the completion of this transaction," said Patrick Plewman, the new President and Chief Executive Officer of VaxGen. "We believe the company has the opportunity for strong revenue growth based on the potential of the PLAC Test and on the cash assets that are being combined in this merger. The PLAC ELISA Test for Lp-PLA2 is the only blood test cleared by the FDA to assess risk for coronary heart disease and ischemic stroke, the #1 and #3 cause of death, respectively, in the United States."

Effective upon the closing of the transaction, VaxGen's board was reconstituted and new officers were appointed. Patrick Plewman will serve as President and Chief Executive Officer, David J. Foster will serve as Executive Vice President, Chief Financial Officer and Secretary, Robert L. Wolfert will serve as Executive Vice President and Chief Scientific Officer, and Bernard M. Alfano will serve as Executive Vice President and Chief Commercial Officer. The new VaxGen Board of Directors is comprised of Patrick Plewman, Louis C. Bock, Charles W. Patrick, Lori F. Rafield and James P. Panek. 

About VaxGen and diaDexus, LLC (formerly diaDexus, Inc.)

VaxGen is based in South San Francisco, California and is focused on the development and commercialization of patent-protected in vitro diagnostic products addressing unmet needs in cardiovascular disease. On July 28, 2010, VaxGen acquired diaDexus, Inc. and merged it into its wholly-owned subsidiary diaDexus, LLC. At a future date to be determined, diaDexus, LLC expects to merge into VaxGen and change the company name to diaDexus, Inc. For more information, including links to SEC public filings, please visit VaxGen's web site at http://www.vaxgen.com. For more information about the diaDexus diagnostic business, please visit http://www.diadexus.com.

AS FILED WITH THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION ON MAY 7,  1999

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 VAXGEN, INC.    (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

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PROSPECTUS

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 3,100,000 Shares   /   [VAXGEN LOGO]   /    Common Stock

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VaxGen, Inc. is offering 3,100,000 shares of its common stock in an initial public offering. Prior to this offering, there has been no public market for VaxGen's common stock.

VaxGen is developing preventive vaccines for worldwide use against HIV. We are conducting two large-scale Phase III clinical trials, one in North America and one in Thailand.

It is anticipated that the public offering price will be between $13.00 and $15.00 per share. The shares of VaxGen will be quoted, subject to approval, in the Nasdaq National Market under the symbol "VXGN".

[...]

THE COMPANY

We are developing preventive vaccines for worldwide use against HIV. We are conducting two large-scale Phase III clinical trials of our AIDSVAX vaccines, one principally in North America and one in Thailand. To date, we are the only company to advance an HIV vaccine into Phase III clinical trials. If the Phase III clinical trials are successful, we will apply to the United States Food and Drug Administration and foreign regulatory authorities for licenses to manufacture and sell AIDSVAX in the United States and abroad. 

Initial development of AIDSVAX was funded by Genentech at a cost of over $50 million during a period of nearly ten years. We were formed in November 1995 to complete the development of, and commercialize, AIDSVAX in partnership with Genentech. Genentech licensed to us the technology necessary for development and commercialization of AIDSVAX. 

The HIV/AIDS Epidemic 

HIV/AIDS is one of the largest epidemics in human history. According to the World Health Organization and UNAIDS:

• in just two decades, over 47 million people have been infected with HIV worldwide;

• 14 million lives have been claimed by AIDS; 

• each day approximately 16,000 individuals become infected with HIV; and 

• AIDS is one of the top five fatal diseases worldwide.

We believe that, because of the magnitude and severity of the epidemic, an HIV vaccine would have one of the largest population-based markets in the history of modern medicine. 

Our Vaccines 

Our vaccines are designed to prevent infection by HIV, rather than treat established infection. Because AIDSVAX contains synthetic copies of proteins from the surface of HIV, it is incapable of causing HIV infection. Humans vaccinated with AIDSVAX form antibodies against HIV which, in laboratory tests, bind to the virus and neutralize its infectivity. Vaccination with AIDSVAX also stimulates immune memory, training the immune system to mobilize rapidly in the event of future exposure to HIV.

We believe that AIDSVAX will be successful for the following reasons: 

• EFFICACY: In Phase II clinical trials, all human volunteers vaccinated with AIDSVAX developed neutralizing antibodies to HIV. In chimpanzees, vaccination with AIDSVAX protected chimps against infection upon subsequent injection with infectious HIV. The level of neutralizing antibodies in humans vaccinated with AIDSVAX equaled or exceeded that observed in vaccinated chimps.

• SAFETY: In Phase I/II clinical trials, none of the 2,000 human volunteers vaccinated with AIDSVAX had serious side effects.

• HIV COVERAGE: AIDSVAX is designed to neutralize the majority of HIV subtypes and strains encountered during natural infection in the regions where we are conducting Phase III clinical trials.

• BROAD USE: AIDSVAX has no clinical impact on people previously infected with HIV. We believe, therefore, that AIDSVAX will be used without requiring the prescreening of recipients. This is particularly advantageous in populations where there is a high rate of HIV-infected people.

• MANUFACTURING: Genentech has manufactured AIDSVAX in commercial quantities.

• VACCINE RATIONALE: The design of AIDSVAX follows that of previous successful vaccines, such as hepatitis B vaccine. The blocking of HIV infection by neutralizing antibody conforms with generally accepted principles of vaccinology.

Our Clinical Trials

We are conducting Phase III clinical trials of AIDSVAX to determine whether AIDSVAX protects humans from HIV infection by sexual transmission or injection drug use. The North American Phase III trial is designed for 5,400 volunteers. It is being conducted in 56 clinics across the United States. It is also being tested in one clinic in Puerto Rico, one clinic in Canada and one clinic in The Netherlands. In Thailand, the Phase III clinical trial is designed for 2,500 volunteers and is being conducted in 17 clinical sites in Bangkok.

To gain regulatory approval for AIDSVAX, we believe the vaccine must reduce the level of HIV infection by 30% or more. This is based on meetings and documented discussions we have had with the FDA and its Vaccines and Related Biological Products Advisory Committee.

Our clinical protocol provides for two opportunities to measure efficacy: 

• An independent monitoring board will conduct an interim analysis approximately midway through the observation period of each clinical trial. Should AIDSVAX meet the 30% threshold, the independent monitoring board will stop the trial and we will submit an application for regulatory approval.

• If the 30% threshold is not met at the interim analysis, we will have a second opportunity to determine the vaccine's efficacy at the completion of the trial.

Our Strategic Relationships 

We intend to use Genentech as our partner to manufacture and distribute AIDSVAX. Genentech has exclusive options to manufacture and market AIDSVAX on specified financial terms. If Genentech does not exercise its options, we have the right to pursue third party arrangements, with Genentech providing the transfer of technology necessary to manufacture AIDSVAX.

We will work with two federal agencies in relation to our North American Phase III trial: the Centers for Disease Control and Prevention and the National Institute for Allergy and Infectious Diseases. The Centers for Disease Control and Prevention have proposed to co-sponsor the Phase III trial and to fund $8.0 million over a period of four years. The National Institute for Allergy and Infectious Diseases is working with us on a $4.6 million program related to the Phase III clinical trial. The purpose of this program is to obtain and store specimens for studies on the immune system.

We also intend to work selectively with other companies that are developing vaccines for HIV. For example, we are working with Pasteur Merieux Connaught to co-develop an alternative HIV vaccine. This vaccine will combine technologies and components provided by Pasteur Merieux Connaught and us. We anticipate that such a combination vaccine could enter Phase III clinical trials by 2001.

We believe we have a strong competitive lead in the development of an HIV vaccine. We are the only company worldwide with Phase III clinical trials of an HIV vaccine underway. In addition to having the advantage of lead-time, we also have an exclusive license from Genentech to a portfolio of U.S. and foreign patents on AIDSVAX and associated technology, consisting of 52 issued patents and 44 pending patent applications.

Our Management Team 

Our management team, together with Genentech, has extensive experience in the international arena of HIV research, public health policy, and the practical aspects of developing, manufacturing and marketing biological products. Our President is Donald Francis, M.D. During his 20-year tenure at the Centers for Disease Control, he was involved in the control or eradication of several epidemics, including a major epidemic of cholera in Africa, smallpox in India and the first known outbreak of the Ebola virus. He subsequently was the lead clinician for the Phase III trial of the hepatitis B vaccine. Our Chairman of the Board and Chief Executive Officer is Robert Nowinski, Ph.D. Dr. Nowinski is a pioneering executive in the biotechnology industry, having founded three publicly-traded biotechnology companies (Genetic Systems Corp., 1981, ICOS Corp., 1989, and PathoGenesis Corp., 1991). Our Senior Vice President, Research & Development is Phillip Berman, Ph.D., who is an inventor of AIDSVAX and a former senior scientist at Genentech.

VaxGen, Inc. was incorporated in Delaware in November 1995. Our principal executive offices are located at 1000 Marina Boulevard, Suite 200, Brisbane, CA 94005, and our telephone number is (650) 624-1000.

RISK FACTORS

You should carefully consider the following risk factors, in addition to the other information set forth in this prospectus, before purchasing shares of common stock of VaxGen. Each of these risk factors could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our common stock.

OUR SUCCESS IS ENTIRELY DEPENDENT UPON OUR ONLY PRODUCT CANDIDATE, AIDSVAX. AIDSVAX is our only product candidate. We do not know whether AIDSVAX will be effective in preventing HIV infection. Our success will depend entirely on the success of AIDSVAX. In particular, we must be able to:

• establish the safety and efficacy of AIDSVAX in humans; 

• obtain regulatory approvals for AIDSVAX; and 

• successfully commercialize AIDSVAX through collaborative relationships.

If AIDSVAX does not obtain regulatory approval, we do not have other products from which to derive revenue.

WE CANNOT BE CERTAIN WHEN OUR PHASE III CLINICAL TRIALS WILL BE COMPLETED, OR WHETHER THEY WILL BE SUCCESSFUL. We must provide the FDA and foreign regulatory authorities with clinical data that demonstrate the safety and efficacy of AIDSVAX before it can be approved for commercial sale. Clinical testing is a long, expensive and uncertain process. We cannot assure you that our clinical trials will be completed on schedule, that the clinical data will be adequate for regulatory submission or that regulatory authorities will approve AIDSVAX.

Our trials could be delayed for a variety of reasons, including:

•  delays in enrolling volunteers;

• lower than anticipated retention rate of volunteers in the trial; or 

• serious adverse events related to the vaccine.

Results of previous animal trials may not be relevant for determining the protective effect of AIDSVAX against HIV infection in humans. Preclinical and clinical data can be interpreted in different ways, which could delay, limit or prevent regulatory approval. Serious adverse events related to the vaccine during the trial could cause the trial to be prematurely terminated. Negative or inconclusive results could cause the trial to be unacceptable for submission to regulatory authorities.

WE ARE SUBJECT TO EXTENSIVE REGULATIONS BY DOMESTIC AND FOREIGN REGULATIONS. AIDSVAX is subject to extensive government regulations related to: development, clinical trials, manufacturing and commercialization. The process of obtaining FDA and other regulatory approvals is costly, time consuming, uncertain and subject to unanticipated delays. With regard to the clinical trials, we cannot assure you that clinical data will be acceptable to regulatory authorities, if at all. We cannot assure you that regulatory authorities will approve AIDSVAX at our protocol established minimum efficacy threshold of 30%.

The FDA may refuse to approve an application if it believes that applicable regulatory criteria are not satisfied. The FDA may also require additional testing for safety and efficacy. Moreover, if regulatory approval of a product is granted, the approval may be limited to specific indications. For instance, the FDA may approve the licenses for only high risk populations. Foreign regulatory authorities may apply similar limitations or may refuse to grant any approval.

There can be no assurance that the FDA will approve AIDSVAX manufacturing processes and facilities. Should Genentech elect not to manufacture AIDSVAX, we must secure a third party manufacturer. We cannot assure you that we will successfully identify a third party manufacturer or that such third party manufacturing process and facilities will be granted FDA approval. At a minimum, the FDA will require equivalence testing between Genentech produced AIDSVAX and third party produced AIDSVAX. Depending upon differences in manufacturing processes, the FDA may also require additional clinical studies for safety and efficacy. Any failure to obtain or delay in obtaining such approvals would have a material adverse effect on our business, financial condition and results of operation.

Even after regulatory approval for AIDSVAX is obtained, the AIDSVAX manufacturing facilities are subject to continual review and periodic inspection. Domestic manufacturing facilities are subject to preapproval and biennial inspections by the FDA and must comply with the FDA's Good Manufacturing Priorities regulations. In complying with these regulations, manufacturers must spend funds, time and effort in the area of production and quality control to ensure full technical compliance. The FDA stringently applies regulatory standards for manufacturing.

WE DO NOT EXPECT AIDSVAX TO BE COMMERCIALLY AVAILABLE FOR AT LEAST FOUR YEARS. AIDSVAX has not received regulatory approval for commercial sale. The Phase III clinical testing necessary before we can file an application with the FDA for product approval will take at least 36 months from the date of this prospectus. The FDA review process could take at least six months. We anticipate that it will take at least six months after obtaining regulatory approval for Genentech or another third party to begin commercialization of AIDSVAX. As a result, we do not believe that AIDSVAX will be on the market before 2003.

WE HAVE ONLY A LIMITED OPERATING HISTORY AND WE EXPECT TO CONTINUE TO GENERATE LOSSES. To date we have engaged primarily in research, development and clinical testing. At March 31, 1999, we had an accumulated deficit of approximately $18.1 million. We sustained net losses of approximately $2.1 million in 1996, $3.1 million in 1997 and $9.2 million in 1998, and $3.8 million for the three months ended March 31, 1999. We expect to incur substantial losses for at least an additional four to five years. 

WE MAY NEED ADDITIONAL FUNDS. We cannot be certain that our existing capital resources, together with the net offering proceeds and anticipated funding from the Centers for Disease Control and Prevention and the National Institutes of Health, will be sufficient to support our current and planned operations for at least the next four years. We may need to raise additional funds if:

• AIDSVAX is not sufficiently effective to commercialize in its current formulation;

• our Phase III clinical trials are delayed, are not successful or are more costly than currently estimated;

• commercialization of AIDSVAX is delayed for any other reason; 

• additional trials are required; or 

• we do not receive the anticipated funding from the Centers for Disease Control or the National Institutes of Health.

We cannot assure you that we will be able to raise sufficient funds in the future.

WE RELY ON GENENTECH FOR THE MANUFACTURE OF AIDSVAX. OUR INABILITY TO MANUFACTURE AIDSVAX, AND OUR DEPENDENCE ON GENENTECH, MAY ADVERSELY IMPACT OUR BUSINESS. We have no manufacturing facilities. We are entirely dependent on third parties to produce AIDSVAX. To date, we have relied on Genentech for this purpose. Genentech currently has an exclusive option to manufacture AIDSVAX. We believe that Genentech is the manufacturer best able to produce AIDSVAX. Our license agreement with Genentech does not specify the price we will be required to pay Genentech for AIDSVAX.

If Genentech does not manufacture AIDSVAX, we will need to locate and engage another manufacturer. The cost and time to establish manufacturing facilities to produce AIDSVAX would be substantial. As a result, using a manufacturer other than Genentech could delay bringing AIDSVAX to market. This delay could require us to raise additional funds. 

We cannot assure you that we will be able to enter into an agreement with a third party to manufacture AIDSVAX. We also have no way to determine the price we would be charged by a third party to manufacture AIDSVAX if Genentech does not manufacture AIDSVAX. Any manufacturer other than Genentech would have to prove both to us and to the FDA and to other regulatory authorities that its manufacturing process complies with government regulations.

WE RELY ON GENENTECH FOR THE SALE, MARKETING AND COMMERCIALIZATION OF AIDSVAX. OUR LACK OF SALES AND MARKETING PERSONNEL, AND OF DISTRIBUTION RELATIONSHIPS, MAY ADVERSELY IMPACT OUR BUSINESS. We have no sales, marketing or commercialization capability. Genentech currently has an exclusive option to market and distribute AIDSVAX. We intend to rely on Genentech to provide an established distribution system and sales force to market AIDSVAX. If Genentech does not elect to exercise its option to market and distribute the product, we will need to locate and engage another partner to market and commercialize AIDSVAX. We cannot assure you that we will be able to establish marketing or commercialization arrangements with third parties on favorable terms.

POLITICAL OR SOCIAL FACTORS MAY DELAY OR ADVERSELY AFFECT OUR ABILITY TO BRING AIDSVAX TO MARKET. Products developed for use in addressing the HIV/AIDS epidemic have been, and will continue to be, subject to competing and changing political and social pressures. The political and social response to the HIV/AIDS epidemic has been politically charged and unpredictable. These pressures can transcend national barriers. They may delay or cause resistance to bringing our product to market or limit pricing of our product. 

IF WE LOSE OUR LICENSE AGREEMENT WITH GENENTECH, OUR BUSINESS WILL BE ADVERSELY AFFECTED. We cannot conduct our business without the technology we license from Genentech. Our license agreement with Genentech permits Genentech to terminate the agreement, or terminate the exclusivity of our license, if we:

• fail to use due diligence in developing, seeking regulatory approval for, marketing or commercializing products covered by the Genentech license agreement;

• fail to file the first market approval application for AIDSVAX with the FDA prior to May 2002, subject to potential extension for up to two years in certain circumstances, any other extension being Genentech's sole decision;

• breach the license agreement and fail to cure the breach within the time period provided in the agreement; 

and we are not able to cure these breaches within the period provided in the Genentech license agreement. Genentech may also terminate the agreement at any time if we fail to maintain a tangible net worth of at least $1 million.

VACCINES ARE DIFFICULT TO DEVELOP. Vaccine development is inherently difficult. It is often characterized by incremental, methodical advances before a highly effective vaccine is available. The HIV epidemic has occurred in a period of two decades. Consequently, the overall scientific knowledge of HIV is limited. While our research has indicated that gp120 is a critical protein in developing a preventive vaccine, other proteins may be necessary to develop a more potent vaccine. Also, we have selected alum as adjuvant for our vaccine. Other formulations of the vaccine may prove to be superior. 

FAILURE TO RETAIN KEY MANAGEMENT EMPLOYEES COULD ADVERSELY AFFECT OUR BUSINESS. We are highly dependent on our senior management and scientific staff, particularly Dr. Donald Francis, our President, [Dr. Robert Charles Nowinski (born 1945)], our Chairman and Chief Executive Officer, and Dr. Phillip Berman, our Senior Vice President, Research & Development. These individuals have played a critical role in developing the vaccine, raising financing and conducting clinical trials. The loss of the services of any of these key members of senior management may prevent us from achieving our business objectives.

WE MAY NOT BE ABLE TO PROTECT OUR INTELLECTUAL PROPERTY OR OPERATE OUR BUSINESS WITHOUT INFRINGING INTELLECTUAL PROPERTY RIGHTS OF OTHERS. We rely on patent and other intellectual property protection to prevent our competitors from manufacturing and marketing AIDSVAX. Our technology, including technology licensed from Genentech, will be protected from unauthorized use by others only to the extent that it is covered by valid and enforceable patents or effectively maintained as trade secrets. As a result, our success depends on our ability, and Genentech's ability, to:

• obtain patents; 

• protect trade secrets; 

• operate without infringing upon the proprietary rights of others; and 

• prevent others from infringing on our proprietary rights.

We cannot be certain that our patents or patents that we license from Genentech will be enforceable and afford protection against competitors. We cannot assure you that our operations or technology will not infringe intellectual property rights of others. 

A FORMER BOARD MEMBER HAS MADE ALLEGATIONS AND CLAIMS AGAINST US. Mr. Daniel Reiner was a member of our board of directors from March 1998 to April 1999. After being notified that he would not be renominated to the board of directors in 1999, he notified our board of directors that he believed that:

• we had entered into an employment agreement with him; 

• we were in breach of the alleged employment agreement; 

• we breached an agreement to keep him on the board of directors; 

• management of VaxGen had wasted corporate assets; and 

• members of management made misrepresentations of fact in connection with our private placement in 1997.

In response to Mr. Reiner's allegations, we formed a special committee of the board of directors, consisting entirely of non-employee directors, to investigate his claims. As part of its investigation, the special committee interviewed several officers and board members, including Mr. Reiner. The special committee presented its findings to the board of directors on March 11, 1999. The special committee concluded that it was not necessary for the board of directors to take any action in response to any of the claims made.

We believe Mr. Reiner's claims are without merit. However, there can be no assurance that Mr. Reiner will not continue to pursue these claims. Nor can there be any assurance that if he did pursue these claims further that they would be resolved in our favor. If Mr. Reiner pursues these claims further, we intend to vigorously defend the claims.

WE MAY BECOME SUBJECT TO PRODUCT LIABILITY CLAIMS. We face an inherent risk of exposure to product liability suits in connection with AIDSVAX vaccines being tested in human clinical trials and products that may be sold commercially. We may be subject to a product liability suit if AIDSVAX causes injury, or if vaccinated individuals subsequently become infected with HIV. Product liability claims may result in decreased demand for a vaccine, even if the claims have no merit. A liability claim, regardless of merit or eventual outcome, could materially adversely affect our business, results of operation and financial condition.

THIS OFFERING'S NET PROCEEDS MAY BE ALLOCATED IN WAYS WITH WHICH YOU AND OTHER STOCKHOLDERS MAY NOT AGREE. Management will have significant flexibility in applying the net proceeds of this offering. See "Use of Proceeds" for a discussion of our intended uses of the net proceeds of this offering.

PURCHASERS OF COMMON STOCK IN THIS OFFERING WILL EXPERIENCE IMMEDIATE AND SUBSTANTIAL DILUTION. Investors in this offering will contribute $43,400,000 of the total amount paid by all investors in our company but will own only 3,100,000 of the shares outstanding.

BUSINESS

We were formed in November 1995 to complete the development of, and commercialize, AIDSVAX, a preventive HIV vaccine. The original AIDSVAX technology was developed by Genentech and then licensed exclusively to us. We are currently testing AIDSVAX in humans in two large-scale Phase III clinical trials. These are the first Phase III clinical trials ever conducted for an HIV vaccine. If the Phase III clinical trials are considered successful, we plan to apply to the FDA and foreign regulatory authorities for licenses to manufacture and sell AIDSVAX in the United States and abroad.  

Our vaccine is designed to prevent infection by HIV, rather than treat established infection. AIDSVAX contains synthetic copies of the proteins from the surface of HIV. Since the vaccine contains no genetic material, vaccination with AIDSVAX is incapable of causing HIV infection. Instead, humans vaccinated with AIDSVAX form antibodies against HIV. Our laboratory tests demonstrate that these antibodies bind to the virus and neutralize its infectivity. Vaccination with AIDSVAX stimulates immune memory, training the immune system to mobilize rapidly upon exposure to HIV.  

We are conducting two Phase III clinical trials of AIDSVAX to determine if AIDSVAX will prevent infection by HIV. Our North American Phase III clinical trial of AIDSVAX is being conducted in 56 clinics across the United States, as well as in one clinic in Puerto Rico, one clinic in Canada and one clinic in The Netherlands. This trial is designed for 5,400 volunteers. In Thailand, we are conducting a second Phase III clinical trial designed for 2,500 volunteers in 17 clinical sites in Bangkok. Based on meetings and documented discussions with the FDA and its Vaccines and Related Biological Products Advisory Committee, we believe that the minimum threshold for regulatory approval is a 30% reduction, at statistical significance, of HIV infection in volunteers vaccinated with AIDSVAX.  

Our strategy is to develop, test and obtain regulatory approval for various formulations of AIDSVAX. We intend to use Genentech as our partner for manufacturing and distribution. Genentech has exclusive options to manufacture and market AIDSVAX products. If Genentech does not exercise its options, we have the right to pursue third party arrangements, with Genentech providing the transfer of technology necessary for manufacturing the vaccine. 

VACCINES

Vaccines are preventive, not curative. As a result, vaccines are particularly suited to address epidemics, even those the magnitude of HIV/AIDS.  

Vaccines prevent infection by activating the immune system to neutralize infectious viruses. The immune system's initial response to a virus is to produce antibodies. The antibodies bind to the virus and prevent it from entering cells. If a virus cannot enter a cell, it is unable to multiply and dies within a few hours in the host. This protection against infection is called neutralization.  

Most virus infections cause lifelong immunity after natural infection. This is because the immune system remembers that it has seen the virus before. Upon a subsequent encounter, it mounts such a rapid immune response that it kills the virus before it can establish a productive infection.  

Vaccines also induce long term memory against viruses. The immune system is trained by vaccination with viral proteins or live viruses to rapidly respond to and prevent subsequent viral infection. 

HIV AND AIDS

HIV is the virus that causes AIDS, a lethal disease characterized by the gradual deterioration of the human immune system. Although the disease is manifested in many ways, the problem common to all patients is the destruction of essential immune cells known as T lymphocytes, or T cells. Destruction of these T cells by HIV makes the body particularly vulnerable to opportunistic infections and cancers that typify AIDS and ultimately cause death. Blocking HIV infection would prevent AIDS. 

HIV is transmitted by three predominant means. One is sexual contact. The second is exposure to blood from an infected person, such as sharing needles in drug use. The third is transmission from infected mothers to their newborns.  

The HIV/AIDS epidemic is one of the largest epidemics in human history. Its spread across the world has been documented by UNAIDS and the World Health Organization. All statistics presented below are from their 1998 reports. 

• in 1998, 1.1% of the world's adult population was living with HIV/AIDS; 

• approximately 16,000 new infections occur each day worldwide; 

• in Sub Saharan Africa, 8.0% of the adult population is infected with HIV; and

• in several African countries, HIV has infected between 20% and 26% of the adult population.

 In Thailand, initial infections with HIV were not reported until the mid-1980s. It is now estimated that almost 800,000 people (2.3% of the country's adult population) have already been infected. HIV infection has now penetrated China, India and Indonesia, some of the most populated areas of the world. AIDS is currently one of the top five fatal diseases worldwide.

An estimated 860,000 people in North America are currently infected with HIV. In North America, 44,000 new infections occur each year. According to an earlier independent report, AIDS is one of the leading causes of death in adults ages 25 to 44 in the United States.

[....]

Progress has recently been made in treating HIV infection. Current therapies, combining the use of reverse transcriptase inhibitors with protease inhibitors, slow multiplication of the virus and delay onset of AIDS. They do not cure HIV infection or AIDS. Costs of these drugs generally exceed $15,000 per year per patient. Considering costs, difficulties in compliance with complex drug regimens and the development of resistance to these drugs, we believe such therapies will be available only to a small fraction of the HIV-infected population. Thus, we believe they will probably have a minimal impact on the worldwide epidemic.

THE HIV INFECTION PROCESS

A virus cannot replicate without entering a host cell. To make new infectious virus particles, a virus must enter a cell and overtake its metabolic machinery. If a virus cannot gain entry into a cell, it is incapable of surviving for more than a few hours in the body.

Viruses are varied in their structure and use different ways to enter cells. HIV is a spherical virus that maintains its genetic information inside its protein core. This core is surrounded by an outer coat called the envelope (Figure 1). The envelope has protein projections, called glycoproteins, that extend out from its surface. Glycoproteins enable HIV to bind to, and subsequently enter, human cells. The principal glycoprotein on the envelope of HIV is called gp120. To present the proper orientation for infection, the gp120 proteins are organized on the virus surface in clusters of three.

                  FIGURE 1. DIAGRAMMATIC REPRESENTATION OF HIV

               [GRAPHIC DEPICTING HIV VIRUS WITH GP120 PROTEINS]

 HIV uses gp120 to bind to the surface of cells through a specific sequence of interactions between the virus and its target cell (Figure 2). This involves a two-step "lock and key" mechanism. The first step in this process involves the attachment of gp120 onto a part of the target cell's surface called the CD4 receptor (Panel 2, below). A second step occurs soon thereafter, as the gp120 protein changes shape and then interacts with another target cell molecule called the chemokine receptor (Panel 3). When this two-step process has been completed, the virus gains entry by fusing through the target cell membrane  (Panel 4).

                      FIGURE 2. INFECTION OF CELLS BY HIV

       [FOUR GRAPHICS DEPICTING THE STAGES OF INFECTION OF CELLS BY HIV]

Once inside the cell, the viral envelope opens and the core of the virus is released. The release of the viral core into the cell initiates a replication cycle that produces thousands of new virus particles per infected cell. As it multiplies, HIV kills infected T cells and releases new infectious virus into fluid or blood surrounding the cell. This cycle of: (1) T cell infection; (2) viral multiplication; (3) T cell death; and (4) re-infection of new T cells leads to the destruction of an essential line of immunologic defense. Substantial reduction of T cells ultimately causes increased susceptibility to the opportunistic infections and cancers that are characteristic of AIDS.

In addition to T cells, HIV also infects, and may reside in, blood scavenger cells called macrophages. While infection of macrophages is not a primary cause of AIDS, it is important in the biology of HIV and in our strategy to prevent infection by the virus.

GENETIC VARIATION IN HIV

AIDS is a single disease throughout the world. At the beginning of the epidemic, probably all HIV was limited to Africa. HIV, like any other virus, underwent mutation to create distinct subtypes. People infected with a single subtype of HIV then exported their infection to other places, such that different subtypes became predominant in different geographical areas. Subsequently, HIV underwent further mutation to create individual strains of each subtype. 

Although the potential genetic variation in HIV might appear limitless, only a small number of mutations confer advantage to the virus. As a result, there are a limited number of viral subtypes and strains. We believe these fall into particular patterns providing a logical basis to formulating a vaccine for HIV. We also believe that the major subtypes of gp120 have been identified. Although minor subtypes are identified periodically, no new major subtypes have been identified in the last 15 years.

• SUBTYPES.

  • • There are five major subtypes of HIV. These are labeled "A" through "E," according to their order of discovery. The major difference between each subtype is a genetic variation in a region of the gp120 protein known as the chemokine-binding site.

    • The major subtypes of HIV tend to be distributed along geographical lines. This is consistent with the general understanding of how HIV has spread throughout the world. Virtually all HIV in the Americas, Europe, the Caribbean and Australia is subtype B. The vast majority of HIV in Thailand and in the Pacific Rim countries is subtype E. Subtype C virus has emerged as the most rapidly expanding HIV in Africa, China and India. The remaining subtypes A and D occur primarily in Africa and in limited areas around the world.

• STRAINS.

  • • Each subtype of HIV is further subdivided into strains. Four strains arise from two mutations in specific regions of the gp120 protein: a subregion in the chemokine-binding site and a subregion in the CD4-binding site. These strains are of key importance in that they have different patterns of infection and they each react with different antibodies.

      • • Chemokine-binding site. HIV has mutated at the chemokine-binding site to yield two distinct strains. Each strain binds to a chemokine receptor on a target cell. The gp120 protein of T-tropic strains binds to a chemokine receptor on T cells. The gp120 protein of M-tropic strains binds to a chemokine receptor found on macrophages, as well as on T cells.

        • CD4-binding site. HIV has also mutated at the CD4-binding site to yield two additional strains. Each of these strains binds to a counterpart CD4 receptor which occurs on human T cells. The gp120 protein of one viral strain binds to the CD4(a) receptor on T cells, while the gp120 protein of the other strain binds to the alternative form of the CD4 receptor, CD4(b), which is also on T cells.

• SUBTYPE/STRAIN COMBINATIONS.

  • • In summary, there are five major worldwide subtypes of HIV (A through E). Each subtype has two different strains that bind to chemokine receptors on different cells (T cells and macrophages). These strains are further subdivided by two variations in the CD4-binding site on T cells. Each of these strains requires different antibodies for neutralization.

As shown in Figure 3, a single subtype of HIV (e.g. subtype B) may have as many as four different strains. We believe other subtypes of HIV have similar types of variations at their receptor-binding sites.

     FIGURE 3. GENETIC VARIATION IN SUBTYPE B HIV THAT INFLUENCE INFECTION

                     [Graphic depicting subtype B strains]  

To construct a successful vaccine, we need to consider the entire range of variation in gp120 and assure that we cover each of the sites on the gp120 protein that are open to attack by antibodies. Fortunately, as indicated above, most of the variable sites on gp120 have only one or two principal forms. By careful examination, we have been able to identify pairs of HIV viruses whose gp120 proteins, when combined together in a vaccine, enhance the overall antibody response. We believe this antibody response covers virtually the entire range of HIV genetic variations currently known in North America and in countries of South Asia and the Pacific Rim.

THE DESIGN OF AIDSVAX

AIDSVAX is designed to stimulate antibodies to cell receptor-binding sites on gp120. Figure 4 shows how we believe antibodies block the HIV infection process. As depicted in Panels 2 and 3 below, there are several sites on gp120 that bind to individual cell receptors. The attachment of antibodies to these specific gp120 sites blocks the binding of the virus to these receptors on the cell surface (Panels 3 and 4). The result is that HIV cannot attach to the cell surface and its infectivity is neutralized.

            FIGURE 4. DEPICTION OF ANTIBODIES BLOCKING HIV INFECTION

   [Four graphics depicting the stages of antibodies blocking HIV infection]

In 1992, Genentech genetically engineered a version of the gp120 protein. Antibodies to this gp120 protein bound to a neutralizing site found on 65% of subtype B viruses. This virus was labeled B(MN) and was believed to represent the majority of HIV in the United States.

Subsequently, synthetic gp120 of HIV B(MN) was incorporated into a monovalent AIDSVAX formulation. Genentech used this AIDSVAX B formulation to vaccinate humans in Phase I and Phase II clinical trials. Antibodies obtained from 100% of those vaccinated with AIDSVAX B neutralized the B(MN) virus in laboratory tests. Further tests demonstrated that these antibodies bound to the gp120 protein of all HIV subtype B viruses tested. However, in laboratory tests and Phase II clinical trials, antibodies to B(MN) neutralized, to a greater extent, HIV of T-tropic strains as compared to HIV of M-tropic strains.

To improve the breadth of the immune response, we identified a second virus, B(GNE8), from the M-tropic strain, and a synthetic version of its gp120 protein was added to the vaccine. The resulting bivalent vaccine, AIDSVAX B/B9, considerably expanded the vaccine's breadth of neutralization. While the monovalent vaccine could stimulate the production of four different types of antibodies that reacted with binding-sites to cell receptors, the bivalent vaccine could stimulate the production of seven. We believe that these seven antibodies cover virtually all known strains of HIV in North America. 

As a general strategy, we plan to develop AIDSVAX formulations that will stimulate antibodies against multiple binding sites on gp120. Our goal is to expand the range of antibodies that are stimulated by a vaccine to neutralize a broader group of HIV. A practical application of this strategy has been the conversion of AIDSVAX from a monovalent to a bivalent formulation. 

STATISTICAL MODEL OF MONOVALENT AND BIVALENT AIDSVAX

We generated a statistical model based on the known distribution of the four receptor-binding sites on gp120 and their frequency in different HIV strains in the United States (Figure 5). A comparison was then made between the neutralizing antibodies which could be stimulated by vaccination with either a monovalent or bivalent formulation of AIDSVAX.

        FIGURE 5. RELATIVE ADVANTAGE OF BIVALENT VS. MONOVALENT VACCINES

[GRAPHIC DEPICTING NEUTRALIZATION OF MONOVALENT VACCINES (B(MN) AND B(GNE8)) AND

                     BIVALENT VACCINE (B(MN) PLUS B(GNE8))]

Each pie chart in Figure 5 represents the statistical equivalent of 100% of currently known HIV (i.e., the virus population) in the United States. Each chart also reflects the calculated frequency at which antibodies stimulated by the monovalent or bivalent vaccines would bind with HIV in this virus population. According to this statistical model, the percentage of HIV in the virus population that would fail to bind antibody is depicted by the white area. The percentage of HIV which would bind one neutralizing antibody is lightly shaded, while viruses which would bind two, three or four different neutralizing antibodies are shown in darker shaded areas.

 This analysis indicates that the monovalent B(MN) vaccine would fail to stimulate antibodies against 14% of HIV in the statistical virus population. The bivalent vaccine, which combines the gp120 proteins from B(MN) and B(GNE8), covers more than 99% of the statistical virus population, with at least two different neutralizing antibodies binding to each virus particle. According to this model, over 50% of the HIV viruses would react with four neutralizing antibodies, each antibody stimulated against different cell-binding sites on gp120 proteins.

While the statistical model indicates that bivalent AIDSVAX would induce a broader range of antibodies than monovalent AIDSVAX, there can be no assurance that the stastical model will predict the actual efficacy of AIDSVAX in human trials.

FORMULATIONS OF AIDSVAX 

AIDSVAX consists of two biologically active ingredients: (1) the antigens, which are synthetic gp120 proteins, to which neutralizing antibodies are directed, and (2) the adjuvant, which is aluminum hydroxide, or alum, in which the antigens are suspended. Alum activates the immune response by attracting immune cells into the region where the vaccine is injected. Since the vaccine contains only a synthetic fragment of the virus and no genetic material, it is incapable of causing HIV infection.  

Three different formulations of the AIDSVAX vaccine have been developed and clinically tested in Phase I/II trials. These include: monovalent AIDSVAX B for HIV infections in North America and Europe bivalent AIDSVAX B/B' for HIV infections in North America and Europe, and bivalent AIDSVAX B/E for HIV infections in Southeast Asia.

INITIAL TESTING OF AIDSVAX IN CHIMPANZEES

The chimpanzee is the only laboratory animal susceptible to HIV infection. In the initial protection trials conducted by Genentech, chimpanzees were vaccinated with three doses of monovalent AIDSVAX B. The vaccinated animals, along with unvaccinated control animals, were then injected intravenously with high doses of infectious HIV. None of the AIDSVAX vaccinated animals was infected. All of the unvaccinated control chimpanzees became infected with HIV.  

In subsequent trials, chimpanzees were vaccinated with AIDSVAX B(MN) and then infected with a different strain of HIV known as B(SF2). Despite this difference, vaccination with AIDSVAX B(MN) conferred immunity and protection against infection with the B(SF2) strain, while vaccination of control animals with a placebo had no protective effect. The cross-protection observed in this experiment documented that AIDSVAX could successfully protect animals from infectious HIV having a genetic composition distinctly different from the virus used to make the vaccine. Based on the results of the chimpanzee trials, Genentech sought and received regulatory approval to commence human clinical trials to test the safety and efficacy of AIDSVAX in humans.

 HUMAN CLINICAL TRIALS

 Human clinical trials for vaccines involve three steps:

•  Phase I -- tests for dosage and safety;

• Phase II -- larger-scale tests for safety, as well as a determination of whether the vaccine stimulates antibodies and immune memory; and

• Phase III -- multi-center, placebo-controlled, double-blind tests to determine protection conferred by vaccination. These efficacy tests are performed in volunteers who have a high risk of HIV infection.

PHASE I TRIALS -- DOSAGE AND SAFETY, MONOVALENT AIDSVAX B

Phase I trials with monovalent AIDSVAX B vaccine were conducted by Genentech. AIDSVAX B was clinically evaluated in 671 HIV-negative volunteers and 662 HIV-positive volunteers. None of the  vaccines had serious side effects. Some vaccinees occasionally experienced pain at the injection site, as is common with many vaccines.

     AIDSVAX B was tested at three doses: 100 eg, 300 eg and 600 eg of gp120.

The 300 eg dose was consistently found to be most effective, stimulating a

higher antibody response without serious side effects.

     The clinical trial results also indicated that monovalent AIDSVAX B, at all

three doses tested, did not alter the progression of ongoing HIV infection. We

intend to apply to the FDA for broad use of the vaccine in high-risk groups

without prescreening for HIV infection.

PHASE II TRIALS -- ANTIBODY STIMULATION, MONOVALENT AIDSVAX B  

One hundred forty HIV-negative volunteers were vaccinated and boosted three times with monovalent AIDSVAX B vaccine (given at time 0, 1 month and 6 months with an additional booster at 12 or 15 months). Antibodies stimulated by vaccination with AIDSVAX B were measured for their ability to neutralize HIV in culture tests. All of the vaccinated volunteers produced antibody in their blood that neutralized infectivity of HIV B(MN). These neutralization tests were considered of key importance since they measured the actual biological activity of the vaccine-stimulated antibodies.  

Memory of the immune response to HIV in the same volunteers was measured by examination of neutralizing antibody levels stimulated by sequential booster shots. All vaccine recipients produced high levels of neutralizing antibody with boosting. These antibody levels gradually declined with time. Each booster shot, however, resulted in a rapid antibody response of even higher concentration, demonstrating a memory recall of the antibody response. This is strong evidence of immune memory being stimulated by the vaccine. We believe that such memory will be key for protection, enabling the educated immune system to ward off HIV infection before it establishes itself.  

PHASE I/II TRIALS -- BIVALENT AIDSVAX

We believe that, since an antibody to a single receptor-binding site can cause neutralization, antibodies to multiple receptor-binding sites will result in yet broader neutralization. On this basis we developed and tested two formulations of bivalent AIDSVAX.  

We conducted two Phase II trials in the United States and Thailand in 214 HIV-negative volunteers. The trials used two bivalent formulations of AIDSVAX. The volunteers were vaccinated and then given one booster one month later. The vaccine tested in the United States was AIDSVAX B/B'. The vaccine tested in Thailand was AIDSVAX B/E. Each of the vaccines was selected for the known prevalence of these virus subtypes in the particular countries tested. The trials were also designed to compare the results of bivalent AIDSVAX to those of monovalent AIDSVAX. Four factors were monitored:

• safety; 

• dosage; 

• antibody stimulation; and 

• production of antibodies that would neutralize strains used in bivalent AIDSVAX.

The vaccine did not cause any serious side effects. Vaccinees occasionally experienced pain at the injection site, as is common with many vaccines. In a dose response study, the bivalent AIDSVAX demonstrated the same results as those observed with the monovalent vaccine.

The Phase II studies also demonstrated the stimulation of antibodies to receptor-binding sites on gp120 proteins that were contained in the respective vaccines. AIDSVAX B/B' stimulated antibodies to M-tropic and T-tropic HIV found in the United States. AIDSVAX B/E stimulated antibodies to M-tropic and T-tropic HIV found in Thailand. In contrast, the monovalent vaccine stimulated a narrower range of antibodies primarily to T-tropic strains.

 We believe these findings support our hypothesis that a combination of gp120 proteins in the bivalent vaccine would stimulate antibodies to a broad range of HIV strains. 

PHASE III CLINICAL TRIAL FOR AIDSVAX

In May 1998, the FDA informed us that the data from our Phase I/II studies were acceptable and that we could proceed to Phase III clinical trials principally in North America. The first volunteers in the Phase III clinical trial were vaccinated in June 1998.

The Thai FDA is the governmental body involved in final approval to manufacture and market medical products. As part of the Thai FDA review, the Thai Ministry of Public Health has several subcommittees involved in making key decisions. In the area of HIV/AIDS, this includes the Technical Subcommittee on AIDS Vaccine, the Ethical Review Committee of the Research Committee, Ministry of Public Health, and Institutional Review Boards from the participating institutions in the clinical trial.

In May 1998, we outlined our plans for Phase III clinical trials in Thailand and in February 1999, we received an import license from the Thai FDA with approval to begin Phase III clinical trials. In March 1999, the first volunteers in Bangkok were vaccinated, initiating the Phase III clinical trial. 

Based on discussions with the FDA and its Vaccine Advisory Boards and Related Biological Products Advisory Committee, we believe that the minimum threshold for regulatory approval is 30% reduction, at statistical significance, of HIV infection in volunteers vaccinated with AIDSVAX.

  Trial Design

We are currently conducting two large, placebo-controlled, double-blind, Phase III clinical trials, one principally in North America and the other in Thailand. The test group of volunteers receives AIDSVAX while the placebo group receives a comparable-appearing placebo containing alum alone. All vials of vaccine and placebo are coded. During the trials, neither volunteers nor researchers know which volunteers are given the vaccine or placebo until the Phase III clinical trials are completed or stopped by the independent review board. Each volunteer is vaccinated a total of seven times (six boosters) during a 30-month period. The purpose of the six boosters, one each six months, is to stimulate high antibody levels throughout the entire trial period. During each visit, the volunteers receive counseling on how to avoid the risk of HIV infection. Follow-up with volunteers will continue for at least six months after the last vaccination is administered.  

Volunteers in North America consist of HIV-negative homosexual men and HIV-negative women who have HIV-infected sexual partners or high risk sexual behavior. Volunteers in Thailand consist of HIV-negative intravenous drug users with a high risk for blood-borne transmission of HIV. In both North America and Thailand, the volunteers are recruited, vaccinated and monitored by clinics with HIV expertise and experience with these particular population groups.  

The size of each Phase III clinical trial was established by a statistical model that included: (1) the probability of measuring a protective endpoint of 30% inhibition of HIV infection; (2) the rate of infection of the volunteer group; and (3) assumptions concerning the rate of retention of the volunteers in the trial for a 36 month clinical observation period.  

Within these parameters, the clinical trial in North America is designed for 5,400 volunteers, randomized 2:1 for vaccine:placebo recipients. The trial in Thailand is designed for 2,500 volunteers, randomized 1:1 for vaccine:placebo recipients. The trial in North America is occurring in 56 clinical sites across the United States. It is also being conducted in one clinic in Puerto Rico, one clinic in Canada and one clinic in The Netherlands. The trial in Thailand is occurring in 17 methadone clinics under direction of the Bangkok Metropolitan Administration.  

Each Phase III clinical trial is conducted in two overlapping steps: (1) recruitment of volunteers during an estimated 12 to 14 month period; and (2) a 36 month clinical observation period. For each individual, the 36 month observation period begins on the day of their first vaccination. As a result, the entire clinical trial will be completed upon recruitment of the volunteers and completion of their collective 36 month observation periods.  

As part of the study design, an interim efficacy analysis will be performed in each clinical trial. In the Thai trial, the interim analysis will be conducted 18 months after recruitment has been completed. In our North American trial, the interim analysis will be conducted 24 months after recruitment has been completed (Figure 6). 

     FIGURE 6. DESIGN OF THE PHASE III CLINICAL TRIALS OF BIVALENT AIDSVAX

            [GRAPHIC DEPICTING TIMING OF PHASE III CLINICAL TRIALS]

  Enlistment of Clinical Sites and Volunteers

We enlist clinical sites based on their ability to perform clinical trials, and to recruit the appropriate type and number of volunteers for the Phase III clinical trials. Our North American trial calls for approximately 1,700 HIV-negative volunteers to be recruited from an already established group of at-risk individuals at 12 clinical centers. These centers, currently sponsored by the National Institutes of Health as part of a vaccine preparedness trial, have over the past four years established a system for the recruitment of at-risk volunteers. The trial design further calls for the remaining 3,700 HIV-negative volunteers to be recruited by the 47 additional clinical sites. Based on experience at the 12 clinical centers, we are assuming an incidence of 1.5% HIV infection per year, and a retention rate of at least 80% for volunteers for the entire 36 month observation period.  

In Thailand, a group of injection drug users is being recruited through a combined effort of the Bangkok Metropolitan Administration, Mahidol University and the Centers for Disease Control and Prevention. The trial design calls for an estimated 600 HIV-negative volunteers to be recruited from an already established group and for the remaining 1,900 HIV-negative volunteers to be recruited from injection drug users in the Bangkok population. Based on prior experience, we are assuming a 6% to 8% incidence of HIV in these groups, with a retention rate of over 75% during the 36 month observation period.  

Conduct of the Phase III Clinical Trials  

We have a clinical team of 24 full-time employees who assist and monitor the 59 clinical sites that are engaged in the North American AIDSVAX trials. This clinical team organizes and monitors: (1) the clinical testing sites; (2) data management; (3) the central contract laboratory for HIV testing; (4) sample handling and shipping; and (5) biostatistics. Audit and monitoring functions are conducted under contract to a clinical research organization, which audits the clinical sites for compliance with the Phase III procedures, data recording, medical records and the use of good clinical practice, as defined by the FDA.  

In Thailand, we have employed or have on contract a full-time staff of three. Our Bangkok office is directed by a project manager and a Thai physician who provide interface between us and Thai institutions involved in the Phase III clinical trials. In addition, through a grant to the Bangkok Municipal Authority, we support a nurse, clerk and social worker at each of the 17 clinical sites, for a total of 51 contract staff.  

Each clinical site has agreed to conduct its activities according to the United States and Thai FDA-reviewed Phase III protocol. The protocol sets standard procedures for all sites and laboratories. Following each visit of volunteers to the clinical site, data are recorded in both the volunteers' permanent medical chart, as well as on a case report form, which is forwarded to us. The trial design calls for over 500,000 case report forms to be gathered and entered into the database for the North American Phase III clinical trial alone.  

The Phase III protocol also requires clinical sites to report any serious adverse event to us within 24-hours. Any serious adverse events are to be immediately examined in detail by our clinical monitors. If deemed a serious event related to the vaccine, the event is to be promptly reported to the FDA. The protocol requires all other adverse events to be recorded on the case report forms and provided to the FDA for review on a periodic basis.  

Interim Analysis and Completion of the Phase III Clinical Trials  

A single independent data and safety monitoring board oversees the clinical trials in North America and Thailand. The ten-person monitoring board consists of prominent clinicians, AIDS specialists, vaccinologists and statisticians. The board contains seven members from the United States and three from Thailand. A former Deputy Director of the Centers for Disease Control and Prevention serves as Director of the monitoring board.  

The monitoring board will periodically evaluate the safety of the trial at 6, 12, 24 and 36 months. The initial six-month safety review was conducted in March 1999. No serious adverse events related to the vaccine were observed.  

If efficacy is observed at the time of a scheduled interim efficacy analysis, the monitoring board will recommend termination of the trial and vaccination of the placebo group in order to conform with ethical requirements. If the interim efficacy analysis does not demonstrate sufficient statistical power to halt the trial, it will continue until its scheduled completion.  

Following the close of the Phase III clinical trials, either at the time of the interim efficacy analysis or at the conclusion of the complete trial, the code for vaccine/placebo will be released. Analysis of the database will be performed independently by the external statistician. In addition to examining the data, the external statistician will prepare the final report which will be entered into the biologic license application. 

Determination of Efficacy  

The primary endpoint of the Phase III clinical trials will be to determine the quantitative effect of AIDSVAX in high risk volunteers. Based on meetings and documented discussions with the FDA, we believe that the threshold of success is a 30% reduction of infection at statistical significance.  

To determine efficacy, we will compare the rate of infection in the placebo group and the vaccine group. An example of how efficacy is calculated is as follows: if in Thailand the placebo group has 100 HIV infections after 36 months, while the vaccine group has 50 HIV infections during the same period, the protection conferred by the vaccine would be 50%. In the North American trial, the determination is similar, although the calculation is adjusted for the 2:1 ratio of vaccine:placebo.  

A secondary endpoint of the Phase III clinical trials will be to determine qualitative effects of AIDSVAX on potential HIV infections. This is performed in case the vaccine induces meaningful immunity, but the immune response is not of sufficient strength to fully prevent infection. For this purpose, multiple blood samples are drawn from each volunteer throughout the Phase III clinical trials. This allows us to determine more precisely the time of infection. Each of the blood samples also can be examined for levels of circulating virus, or viral load. From this, we can determine if vaccinated individuals have suppressed their HIV infections relative to those in the placebo group.  

If the infection is transient, or if the level of HIV is maintained in vaccine recipients at low levels, this might indicate that the vaccine is slowing the progression of HIV infection. In therapeutic studies it is known that suppression of viral load correlates with an extension of life. Therefore, should we find that AIDSVAX causes a qualitative reduction in HIV infection, we might submit this data to support our primary regulatory application or, if justified, as a stand-alone submission.  

In addition to HIV antibody testing of all blood samples, a subset of volunteers, 5% of the total, will be monitored throughout the trial period with a variety of immunological tests. These tests will be performed to determine details of the immune response, with the goal of identifying an immune correlate of protection against infection. Such a correlate might include, for example, a determination of the minimum antibody level required to obtain protection. We believe the finding of a correlate of protection both supports the scientific rationale of the vaccine and provides a measurement by which the vaccine may be improved. We believe finding a correlate of protection would be viewed favorably in the review of our regulatory applications submitted to the FDA.   

THE MARKET FOR AIDSVAX  

We have developed formulations of AIDSVAX which focus on HIV found in major regions of the world. Our first bivalent vaccine, AIDSVAX B/B9, is directed against the predominant HIV subtype in the Americas, Europe, the Caribbean and Australia. Our second bivalent vaccine, AIDSVAX B/E, is directed against the predominant HIV subtypes in Southeast Asia, the Pacific Rim, Indonesia and southern portions of China (Figure 7). Based on the populations of these regions, the market for the two current formulations of AIDSVAX could cover approximately half of the world's population, or nearly three billion people.

   FIGURE 7. POTENTIAL MARKETS FOR THE AIDSVAX B/B' AND AIDSVAX B/E VACCINES

 [GRAPHIC DEPICTING MAP OF THE WORLD AND WORLDWIDE MARKETS FOR AIDSVAX B/B' AND

                                  AIDSVAX B/E]

We also have plans to develop two additional AIDSVAX vaccines -- one for subtype C virus, which would be directed against viruses in China, India and Africa, and one for subtype A and D viruses, which are commonly found in Sub Saharan Africa and parts of South America. We believe that four vaccines directed against the A, B, C, D and E subtypes of HIV would effectively address the worldwide spread of the HIV/AIDS epidemic.  

Influence of Vaccine Improvements  

Our ability to address geographically defined markets is enhanced by our ability to rapidly develop new formulations of AIDSVAX. This process provides for a continued basis of product improvement. We have accomplished this with our two bivalent formulations of AIDSVAX. The change from a monovalent to a bivalent formulation was accomplished in less than 24 months.  

With successive formulations of AIDSVAX, we expect to improve product efficacy, as well as the breadth of protection against different HIV subtypes. In addition, we will seek to create vaccines that require fewer booster shots and that can be used over larger areas of the world. Thus, we expect that an initial vaccine will be gradually enhanced, resulting in corresponding increases in the size of the market for the vaccine.  

On the basis of our ongoing discussions with the FDA, we believe that improvements will be accomplished as amendments to our initial regulatory license, rather than as applications for entirely new products. This approach, if successful, would result in considerable savings of time and cost associated with future product development.  

Comparison to Other Vaccines  

We believe that hepatitis B vaccine serves as a useful model to predict demand for a prospective HIV vaccine. Hepatitis B is one of the most recent vaccines to be introduced on a worldwide basis. The pattern of infection and the at-risk groups with hepatitis B are comparable to those with HIV. Hepatitis B and HIV are transmitted by sexual contact and blood products. In the United States, the highest risk groups for hepatitis B and HIV are injection drug users and homosexual men.  

When initially introduced, the hepatitis B vaccine was used primarily by those with occupational risk of infection due to exposure to blood products. The average price of the initial vaccine was $200 per vaccine recipient. Within this population, the vaccine had a market of $100 million to $200 million per year. As demand for the vaccine increased, the price per dose dropped, further fueling demand. Recently, hepatitis B vaccine was recommended for standard pediatric use in the United States. The price of the vaccine is now approximately $15 per dose. The worldwide market for hepatitis B vaccine currently exceeds $1 billion annually. By the year 2002, it is likely that use of hepatitis B vaccine will exceed 300 million doses annually.  

We believe that, given the relative healthcare needs, the market for an HIV vaccine will be considerably larger than the market for hepatitis B vaccine. Further, we believe that adoption of an HIV vaccine will occur more rapidly, both domestically and worldwide. This conclusion is supported by a UNAIDS study, which predicts that, within a decade, the worldwide need for HIV vaccine will exceed 650 million doses annually.  

SALES AND MARKETING  

We intend to rely on third parties for sales and marketing of AIDSVAX. We believe that our resources are better utilized developing new formulations of AIDSVAX, rather than developing and maintaining a sales and marketing organization. Genentech currently has an option to obtain an exclusive worldwide license to use, market and sell AIDSVAX. If AIDSVAX is approved for sale and Genentech does not exercise its option to market AIDSVAX, we intend to enter into agreements for marketing and distribution with other partners and will pay a predetermined royalty to Genentech.  

We anticipate that AIDSVAX will be sold by Genentech or a licensed third party through existing vaccine distribution channels in the United States and the rest of the world. This would result in several tiers of pricing that range from private reimbursement in the United States to government reimbursement in Europe to purchase by the World Health Organization for distribution to nations with underdeveloped economies. In the United States, vaccine distribution is further divided among pediatricians, general practitioners and the public health service (as provided by the Centers for Disease Control and Prevention).  

Currently 83% of children worldwide receive the basic schedule of pediatric vaccines through a network of for-profit and non-profit institutions. We expect that an efficacious HIV vaccine will also be broadly distributed worldwide in a similar manner.  

Apart from distribution, a number of variables will influence price, including: (1) efficacy of the vaccine; (2) safety; (3) manufacturing cost; (4) recommendations from expert medical panels; (5) the perceived need in a particular population; and (6) in some cases, government regulations requiring vaccination. Due to these and other factors, we have not yet determined a pricing schedule for AIDSVAX.  

Several non-profit and government organizations have begun efforts to prepare for the eventual distribution of an HIV vaccine. For example, the State of California placed an open purchase order for one million doses of HIV vaccine if and when developed. In addition, the International AIDS Vaccine Initiative has started a campaign to fund the development and purchase of an HIV vaccine for the developing world. In meetings with us, the World Bank has indicated that it is exploring the potential for low-interest loans to support the purchase of vaccines in the developing world.  

MANUFACTURING  

We do not have any manufacturing facilities of our own. We intend to rely on third parties to manufacture AIDSVAX. We believe that our resources are better utilized developing new vaccines, rather than entering into the capital intensive business of manufacturing.  

Our license agreement with Genentech gives Genentech an option to manufacture any AIDSVAX formulation supplied beyond those it has already agreed to supply. If Genentech does not exercise its option to manufacture AIDSVAX, the license agreement allows us to enter into manufacturing agreements with third parties and pay a predetermined royalty to Genentech. If we utilize a third party, the license agreement provides that Genentech must transfer the required manufacturing technology and know-how to the third party.  

Genentech has developed a proprietary method for producing synthetic gp120 protein. This method has enabled Genentech to clone and express gp120 genes from two dozen HIV strains. Utilizing genetic engineering, a fragment of coding information from HIV, consisting of the gp120 gene, is cloned from HIV into mammalian cells. We have an exclusive license from Genentech to all of these genes and the technical know-how to produce the synthetic gp120 proteins.  

Specifically, for any formulation of AIDSVAX, the gp120 gene is inserted into Chinese hamster ovary cells which act as cellular factories that can produce commercial quantities (i.e., kilograms) of gp120 protein. The production of gp120 in Chinese hamster ovary cells assures both genetic consistency and structural integrity of the synthetic product. As a result, the synthetic form is virtually identical to the natural form of gp120 that occurs in HIV viral particles. Since only a fragment of HIV is used in this process, there is no production of infectious HIV, and the final product is incapable of causing infection or disease. In addition, Genentech's proprietary purification system provides us with gp120 protein that has purity exceeding 99.9%, which markedly decreases the likelihood of vaccine side effects caused by contaminating substances.  

LICENSE AND SERVICES AGREEMENTS WITH GENENTECH  

We have entered into a license agreement with Genentech which in part defines the working relationship between the companies. Genentech has granted us an exclusive license to all patents and proprietary know-how that Genentech is free to license or sublicense. Such licensed technology relates to the development of a vaccine based on, containing, incorporating or using the recombinant gp120 subunit protein developed by Genentech for use to prevent, but not treat, HIV infection and/or AIDS. Certain of the licensed technology is sublicensed to us under licenses from third parties to Genentech. We, as the exclusive licensee of Genentech, have assumed all of Genentech's obligations under these third-party license agreements. The initial term of the license agreement is 15 years from the commercial introduction date of a licensed product and will be determined on a country-by-country, product-by-product basis.

In addition to granting us rights to use Genentech's gp120 technology and

certain adjuvant technology for developing a licensed product, the license agreement provides for Genentech to have rights to elect to manufacture and supply AIDSVAX for clinical testing and commercial sale. In addition to its rights to elect to manufacture vaccine, Genentech supplied us, cost-free, with its stock (approximately 300,000 doses) of the B(MN) gp120 protein for testing in our Phase III clinical trials. We will use the B(MN) gp120 protein following successful completion of formulation with alum, vialing and quality assurance/control testing, for which we will bear Genentech's costs and expenses. Genentech also supplied us with agreed-upon amounts of up to two additional gp120 proteins, B(GNE8) and E(244) for use in combination with the currently manufactured B(MN) gp120 for clinical trials. For the additional antigens, we paid Genentech its fully burdened manufacturing costs. 

The license agreement provides for flexibility related to manufacturing. Should Genentech elect not to manufacture any vaccine supplies beyond those it has already agreed to supply, we may elect to use a third party for our manufacturing requirements. If we utilize a third party, Genentech must transfer the required manufacturing technology and know-how to the third party.

Genentech also has an option, exercisable for 90 days after we make our first filing with the FDA for market approval of a licensed product, to obtain an exclusive worldwide license to use, market and sell licensed products. If Genentech exercises the marketing option: (1) Genentech is required to pay us a fee equal to 33% of our total development costs (including clinical testing) to date for the licensed product; (2) we and Genentech will share net profits from sales of the licensed products, 30% and 70%, respectively, for sales within the United States and 70% and 30%, respectively, for sales outside the United States; (3) future developmental costs (e.g., clinical trials) will be apportioned between the parties based on their respective profit share in a particular country; and (4) the parties will establish a committee with an equal number of representatives from each company to oversee the development and commercialization of additional licensed products. In the event that Genentech does not exercise the marketing option, then, in lieu of sharing net profits from the licensed products, we will pay Genentech a royalty on all sales of licensed products equal to: (1) 25% of our net sales and our sublicensees' net sales of the licensed products worldwide, so long as any commercial vaccine component has been manufactured and supplied by Genentech; or otherwise (2) 15% of our total net sales and our sublicensees' net sales of the licensed products worldwide.

 Under the license agreement, we are required to use due diligence in developing, seeking regulatory approval for, marketing and commercializing licensed products. Development and commercialization of licensed products will be our sole business goal. In connection with reaching this goal, we are required to achieve the filing of the first market approval for a licensed product with the FDA no later than the fifth anniversary of the closing of our 1997 private placement. If we are unable to meet this milestone due to certain agreed-upon events or circumstances, we may request an extension from Genentech and we and Genentech can agree to a new date for the milestone, subject to a two-year limit on such extensions. If we are unable to meet a milestone for any reason other than the agreed-upon events or circumstances, any extension granted will be at Genentech's sole discretion. If we fail to exercise our due diligence, Genentech has the right to convert our exclusive license to a non-exclusive license, and may be entitled to terminate the license.  

Either party may terminate the license agreement upon the other party's default or bankruptcy. In addition, Genentech may terminate the license agreement if we fail to: (1) maintain a tangible net worth of at least $1 million; or (2) to meet a due diligence milestone (see above) within two years of the date originally set for such milestone, unless Genentech waives such two-year limit in its sole discretion.  

We have also entered into a services agreement with Genentech pursuant to which Genentech has agreed to provide us with administrative, research, process science, manufacturing, clinical and regulatory support, primarily by making the services of certain Genentech personnel available to us. We will reimburse Genentech for all of Genentech's costs and expenses relating to the provision of these services. Either party may terminate the services agreement upon a breach which continues uncured for more than 60 days or upon the occurrence of bankruptcy or similar events. In addition, the services agreement will automatically terminate upon any termination of the license agreement. The term of the services agreement was recently extended until December 31, 2000.

LICENSED PATENTS

 Under the license agreement, we have licensed or sublicensed from Genentech exclusive rights to a portfolio of six issued United States patents and eight pending United States patent applications. The licensed portfolio also includes 46 granted foreign patents and 36 pending foreign applications arising from the United States patents and applications. The technology claimed in these patents and applications involves a range of HIV vaccine product development activities, including the cloning and expression of recombinant virus glycoproteins for use as vaccine products and sustained release formulations of HIV gp120. Also claimed by patent filings are specific compositions of matter for the components of our vaccine products, and proprietary production, recovery and purification process technology. Together, these filings provide intellectual property that we believe will enhance the value of our products.  

Under the license agreement, Genentech has retained title to the licensed patents and patent applications and other licensed technology, while we will retain title to any improvements developed by us. Both parties will jointly own any improvements to the licensed patents and patent applications or other licensed technology developed or invented jointly. Genentech will remain responsible for the filing, prosecution and maintenance of all licensed patent rights, in consultation with us, at our expense.  

We have been informed that Chiron Corporation has filed oppositions against two of Genentech's European patents that are licensed to us. Genentech, with our assistance, has filed responses to both oppositions, but the outcome of each opposition has yet to be determined. We have also been informed by the United States Department of Health that we may need to obtain a license under one or more of its United States and foreign patents involving molecular clones of HIV-1 viral strains MN-STI and BA-L. We are currently exploring the advisability of obtaining such a license. In the interim, we have recently filed an opposition to a European equivalent of the United States Department of Health patent and are awaiting the outcome of the opposition.

GOVERNMENT COLLABORATIONS

We have collaborative activities with two federal government agencies: (1) The Centers for Disease Control and Prevention; and (2) National Institute of Allergy and Infectious Diseases.

 Our collaboration with the Centers for Disease Control and Prevention is conducted in both the United States and Thailand. In the United States, the Centers for Disease Control have proposed to co-sponsor our Phase III clinical trial, starting in the Fall of 1999. The Centers for Disease Control will fund $8.0 million over four years to support our Phase III clinical trial sites, as well as to provide funds for new research into our HIV vaccine trials. In Thailand, the Centers for Disease Control are assisting in the measurement of viral loads in vaccinees and placebos, as well as examining HIV subtypes and strains in the at-risk population.

The National Institute of Allergy and Infectious Disease is forming a collaboration with us to obtain and store clinical specimens from our North American Phase III clinical trial. It will provide $4.6 million of funding for this program. We also have an ongoing collaboration with the AIDS Vaccine Evaluation Group, a clinical consortium financed by the National Institute of Allergy and Infectious Disease. In this collaboration we are providing AIDSVAX to clinical sites for Phase I/II clinical trials of new combination vaccines.

COMMERCIAL RELATIONSHIP WITH PASTEUR MERIEUX CONNAUGHT

On April 10, 1998, we signed a non-binding letter of intent with Pasteur Merieux Connaught to co-develop an alternative vaccine regimen, called the prime/boost. The letter of intent has recently been extended through November 1999. The prime/boost utilizes two independent vaccines administered sequentially. A Pasteur Merieux Connaught vaccine would be administered initially, followed by a bivalent gp120 vaccine. Should it prove efficacious, the alternative vaccine regimen would be developed, clinically tested, and if\ approved by regulatory agencies, marketed by Pasteur Merieux Connaught. We would serve as a scientific co-developer and a source for bivalent formulations of AIDSVAX, a critical component of the regimen. We would share significantly in profits made from the sale of both vaccine components -- the Pasteur Merieux Connaught vaccine, as well as AIDSVAX.

Phase I human trials of the initial Pasteur Merieux Connaught prime/boost vaccine regimen have been conducted by the AIDS Vaccine Evaluation Group, an NIH-sponsored clinical consortium. In early studies of the Pasteur Merieux Connaught product, the combination vaccine incorporated monovalent gp120 provided by Chiron Vaccines as the boost. Subsequently, Pasteur Merieux Connaught and the AIDS Vaccine Evaluation Group altered their plans and requested us to provide our formulations of bivalent gp120 as a replacement for the Chiron product. From this request arose the letter of intent and a plan to co-develop a new vaccine regimen.

Currently, we and Pasteur Merieux Connaught are planning collaborative studies with our respective vaccines. During this time we are also negotiating a long-term co-development agreement with Pasteur Merieux Connaught. Should an agreement be reached on final terms, we will supply 100% of Pasteur Merieux Connaught's requirements for our bivalent gp120. Pasteur Merieux Connaught would pay our fully burdened costs plus 10% for all vaccines purchased from us. In addition, Pasteur Merieux Connaught would pay a royalty to us from Pasteur Merieux Connaught's sales of both vaccines in the regimen.

Genentech holds exclusive options for the manufacture and marketing of AIDSVAX. The non-binding letter of intent with Pasteur Merieux Connaught has certain conflicts with our license agreement with Genentech. This conflict will require resolution between us and Genentech. The issue is now under discussion, and we will resolve it prior to our entering a final business agreement with Pasteur Merieux Connaught. Upon resolution of the business issues with Genentech and the Pasteur Merieux Connaught agreement, Genentech will then join us in negotiations with Pasteur Merieux Connaught. 

COMPETITION

We estimate that approximately 30 other companies have been engaged in research to produce an HIV vaccine. Only AIDSVAX and a vaccine once developed by our former competitor, Chiron Vaccines, have progressed to, and completed, Phase II testing. Chiron Vaccines has since abandoned that particular vaccine effort. Subsequently, a combination vaccine developed by Chiron Vaccines and Pasteur Merieux Connaught, also competitors of ours, entered Phase I/II testing in 1997. That vaccine effort, too, has since been terminated.

Two other notable efforts at producing HIV vaccines have failed as well. A collaboration between Merck & Co., Inc. and Repligen Corporation was terminated because their vaccine failed to protect chimpanzees from live HIV infection. Similarly, MicroGeneSys, Inc. designed a vaccine that failed in early stage human testing. It appears that the principal differences between these vaccines and ours has been the choice of viral protein as antigen or the methods used for manufacturing.

We believe that we now lead all competitors worldwide in the development of an HIV preventive vaccine. Of the two HIV vaccines that have reached human clinical trials, we have full control of the leading product (AIDSVAX) and plan to become a partner in the second (the Pasteur Merieux Connaught/VaxGen combination regimen).

GOVERNMENT REGULATION

AIDSVAX is subject to federal regulation, by the federal government, principally by the FDA under the Food, Drug & Cosmetic Act and other laws, including the Public Health Services Act, and by state and local governments. Such regulations govern or influence, among other things, the testing, manufacture, safety, efficacy, labeling, storage, record keeping, approval, advertising and promotion of such products.

AIDSVAX is classified by the FDA as a biologic product. The steps ordinarily required before a biological product may be marketed in the United States include: (1) preclinical testing; (2) the submission to the FDA of an Investigative New Drug Application, which must become effective before clinical trials may commence; (3) adequate and well-contained clinical trials to establish the safety and efficacy of the biological; (4) the submission to the FDA of a Biologics License Application; and (5) FDA approval of the application, including approval of all product labeling.

Preclinical testing includes laboratory evaluation of product chemistry, formulation and stability, as well as animal studies to assess the potential safety and efficacy of each product. Preclinical safety tests must be conducted by laboratories that comply with FDA regulations regarding Good Laboratory Practices. The results of the preclinical tests together with manufacturing information and analytical data are submitted to the FDA as part of the Investigative New Drug Application and are reviewed by the FDA before the commencement of clinical trials. Unless the FDA objects to an Investigative New Drug Application, the Investigative New Drug Application will become effective 30 days following its receipt by the FDA. 

Clinical trials involve the administration of the investigational product to humans under the supervision of a qualified principal investigator. Clinical trials are conducted in accordance with Good Clinical Practices under protocols submitted to the FDA as part of the Investigative New Drug Application. In addition, each clinical trial is approved and conducted under the auspices of an institutional review board and with patient informed consent. The institutional review board will consider, among other things, ethical factors, the safety of human subjects and possibility of liability of the institutions conducting the trial.  

Clinical trials are conducted in three sequential phases; however, the phases may overlap. The goal of a Phase I clinical trial is to establish initial data about safety and tolerance of the biologic agent in humans. In Phase II clinical trials, evidence is sought about the desired immune response of a biological agent in a limited number of patients. Additional safety data are also gathered from these studies. The Phase III clinical trial program consists of expanded, large-scale, multi-center studies of persons who are susceptible to the targeted disease. The goal of these studies is to obtain definitive statistical evidence of the efficacy and safety of the proposed product and dosage regimen. Our Phase III clinical trials of AIDSVAX are being conducted on persons at risk for HIV infection but who test HIV negative prior to enrollment in the trial.  

All data obtained from this comprehensive program are submitted in a biologics license application to the FDA for review and approval for the manufacture, marketing and commercial shipments of AIDSVAX. FDA approval of the biologics license application is required before marketing may begin in the United States. Similar types of regulatory processes will be encountered as efforts are made to market the vaccine internationally. We will be required to assure product performance and manufacturing processes from one country to another.  

For commercialization of AIDSVAX, our manufacturing processes and the manufacturing facility must receive FDA approval for sale within the United States. If Genentech does not exercise its option to manufacture AIDSVAX, we must pursue third party manufacturing arrangements. For marketing outside the United States, we will be subject to the regulatory requirements of other countries, which vary from country to country. The regulatory approval process in other countries includes requirements similar to those associated with the FDA approval described above.

EMPLOYEES

As of April 15, 1999, we had 52 employees. None of our employees is subject to a collective bargaining agreement, and we believe that our relations with our employees are good. Five employees are bound by employment agreements with us that provide for employment of three years or more. 

FACILITIES 

Our executive offices are located in Brisbane, California, in an office building in which we lease approximately 16,000 square feet. The lease agreement terminates in July 2005, and we have an option to renew for a successive five-year period. For fiscal year 1999, our monthly rent is $45,785. We also lease approximately 10,000 square feet of laboratory space in South San Francisco under a lease agreement that terminates in March 2006. We have an option to renew for a successive five-year period. For fiscal year 1999, our monthly rent is $17,854. We believe that our facilities are sufficient to support our operations for at least the next 24 months.  

In Thailand, we lease office space at Mahidol University and at Taksin Hospital in Bangkok. We will lease this space through the duration of the Thai Phase III clinical trials.

LEGAL PROCEEDINGS

We are not currently subject to any material legal proceedings or claims.

 MANAGEMENT 

EXECUTIVE OFFICERS, DIRECTOR NOMINEES AND DIRECTORS

•  NAME         /         AGE        /         POSITION

  • • Robert C. Nowinski(1)(4)    /    52    /    Chairman, Chief Executive Officer

    • Donald P. Francis(1)(4)    /    56    /    President, Director

    • Phillip W. Berman(4)    /    49    /    Senior Vice President, Research &      Development -- Director

    • John G. Curd    /    53    /    Senior Vice President, Medical Affairs

    • Carter A. Lee    /    46    /    Senior Vice President, Finance & Administration

    • Stephen C. Francis(3)(4)    /    58    /    Director

    • Roberta R. Katz(5)    /    51    /    Director Nominee

    • William D. Young(1)(2)(3)    /    54    /     Director

• (1) Member of the Executive Committee
• (2) Member of the Compensation Committee
• (3) Member of the Audit Committee
• (4) Member of the Genentech Contract Committee
• (5) Ms. Katz is a director nominee who has agreed to join the board of directors shortly after consummation of the offering. We anticipate Ms. Katz will become a member of the Compensation, Audit and Genentech Contract Committees.

ROBERT C. NOWINSKI, PH.D. Dr. Nowinski co-founded VaxGen in November 1995 and has served as a director and Chairman of the Board since inception and our Chief Executive Officer since April 1999. In 1991, Dr. Nowinski founded PathoGenesis, Inc., a publicly-held biotechnology company and served as Chairman of the Board until 1995. In 1989, Dr. Nowinski founded ICOS Corporation, a publicly-held biotechnology company, where, from 1989 through 1991, Dr. Nowinski served as Chief Executive Officer and President. In 1981, Dr. Nowinski founded Genetic Systems Corporation, a publicly-held biotechnology company, where, from 1981 to 1985, Dr. Nowinski held various executive positions including Chairman of the Board, Chief Executive Officer, President and Scientific Director. Following the merger of Genetic Systems Corporation with Bristol-Meyers Company, from 1988 to 1989, Dr. Nowinski served as Vice-President of New Technology for Bristol-Meyers Company at its headquarters in New York. Prior to such time, Dr. Nowinski was a Professor of Microbiology and Immunology at the University of Washington and Head of the Virology Program at the Fred Hutchinson Cancer Research Center in Seattle, Washington. During his academic career, Dr. Nowinski authored over 100 scientific publications. Dr. Nowinski received a B.S. from Beloit College and a Ph.D. in immunology from Cornell University Sloan-Kettering Division.  

DONALD P. FRANCIS, M.D., D.SC. Dr. Francis co-founded VaxGen in November 1995 and has served as our President and as a director since inception. From 1993 to 1995, Dr. Francis directed HIV vaccine clinical research at Genentech. Prior to joining Genentech, Dr. Francis served from 1973 to 1993 in various positions at the Centers for Disease Control. During this period, Dr. Francis established and directed the HIV laboratory for the Centers for Disease Control and served as an Assistant Director, Viral Diseases Program. At that time, he was also a principal investigator in one of the two Phase III clinical trials that led to licensure of the hepatitis B vaccine in the United States. In 1976, Dr. Francis was the lead epidemiologist on the first clinical team to encounter and control Ebola virus. Prior to such time, Dr. Francis had a central role in the World Health Organization's smallpox eradication program, which eradicated smallpox from the world. Dr. Francis received an M.D. from Northwestern University and completed his training in pediatrics at Los Angeles County/USC Medical Center. Dr. Francis received a doctorate in virology from the Harvard School of Public Health. Dr. Francis is the brother of Stephen Francis.  

PHILLIP W. BERMAN, PH.D. Dr. Berman has served as our Senior Vice President, Research & Development since April 1999. Dr. Berman served as our Vice President of Research & Development from November 1997 to April 1999, and has served as a director since October 1997. From 1982 to 1997, Dr. Berman served in various capacities with Genentech, including Senior Scientist, Molecular Biology Department, and Staff Scientist, Department of Immunology and also Department of Process Sciences. Since 1984, Dr. Berman has had research responsibilities in Genentech's AIDS Vaccine Project and is an inventor of AIDSVAX. Dr. Berman received an A.B. in biology from the University of California, Berkeley, a Ph.D. in biochemistry from Dartmouth College and performed post doctoral research at the Neurobiology Laboratory of the Salk Institute and the Department of Biochemistry and Biophysics at the University of California, San Francisco.  

JOHN G. CURD, M.D. Dr. Curd has served as our Senior Vice President, Medical Affairs, since April, 1999. From 1991 to April 1999, Dr. Curd held various positions at Genentech, including Director, Immunology/Oncology/Infectious Disease, Senior Director and Head of Clinical Science and Vice President of Clinical Development. From 1978 to 1991, Dr. Curd held several research and clinical positions at The Scripps Clinic, a world-renowned research foundation and medical clinic, including Head, Division of Rheumatology and Vice Chairman, Department of Medicine. He received a B.A. from Princeton University and an M.D. from Harvard Medical School.  

CARTER A. LEE Mr. Lee has served as General Manager and Senior Vice President, Finance & Administration since September 1998. From 1991 to 1997, Mr. Lee served as Senior Vice President and Chief Financial Officer of Diefenbach Elkins International, Inc., a corporate branding consultancy. From 1990 to 1991, Mr. Lee served as Vice President, Finance & Administration of EDAW, Inc., a landscape architecture and planning firm. From 1987 to 1990, Mr. Lee served as Vice President and Corporate Controller of Landor Associates, a strategic design consulting firm. Prior to such time, Mr. Lee served in various positions at Coopers & Lybrand, including Senior Accountant and Supervising Consultant. Mr. Lee received a B.A. from the University of California, Berkeley, and an M.B.A. from California State University, Hayward.  

STEPHEN C. FRANCIS Mr. Francis has served as a director since October 1996. Mr. Francis has served as Vice-Chairman and Chief Risk Oversight Officer at Fischer, Francis, Trees & Watts, an investment management firm which he co-founded in 1972. Mr. Francis is a member and former chairman of the Treasury Borrowing Committee, which advises the United States Treasury, and is a member of the Stanford University Graduate School of Business Advisory Council. Mr. Francis received an A.B. from Dartmouth College and an M.B.A. from Stanford University. Mr. Francis is the brother of Donald Francis.  

ROBERTA R. KATZ Ms. Katz is a director nominee who will be elected shortly after consummation of the offering. Commencing in June 1999, Ms. Katz will become the Chief Executive Officer of The Technology Network. Ms. Katz joined Netscape Communications Corporation in May 1995 as Vice President, General Counsel and Secretary. From January 1996 to April 1999, Ms. Katz served as Senior Vice President, General Counsel and Secretary of Netscape, where she was a member of the team that negotiated the Netscape/America Online merger. From March 1993 until joining Netscape, Ms. Katz served as Senior Vice President and General Counsel of McCaw Cellular Communications, where she was a member of the team that negotiated the AT&T/McCaw merger. In addition, from March 1992 until joining Netscape, Ms. Katz served as Senior Vice President and General Counsel of LIN Broadcasting Company, a subsidiary of McCaw. In March 1998, Ms. Katz was named as one of the 50 Most Influential Women Attorneys in America by the National Law Journal. She is an author of Justice Matters: Rescuing the Legal System for the 21st Century. Ms. Katz received a B.A. from Stanford University, a Ph.D. in anthropology from Columbia University and a J.D. from the University of Washington School of Law.  

WILLIAM D. YOUNG Mr. Young has served as a director since November 1995. Since 1980, Mr. Young has served in various positions at Genentech, most recently as the Chief Operating Officer. Prior to such time, Mr. Young served in various positions at Eli Lilly and Co. for 14 years in the United States and Puerto Rico. In 1993, Mr. Young was elected to the United States National Academy of Engineering. Mr. Young serves on the board of directors of Energy Biosystems Corporation, a public company applying biotechnological advances to the field of energy utilization and environmental control. Mr. Young received a B.S. in chemical engineering from Purdue University and an M.B.A. from Indiana University.

BOARD OF DIRECTORS AND OFFICERS 

The size of the board of directors is currently set at six members. Directors hold office until the next annual meeting at which time their terms expire and their successors are elected. Officers are appointed by the board of directors for one year terms.

AUDIT COMMITTEE 

The audit committee makes recommendations to the board of directors about the selection of independent auditors, reviews the results and scope of the audit and other services provided by our independent auditors, and evaluates our internal controls. The audit committee consists of Mr. Stephen Francis and Mr. William Young. Upon joining the board of directors, Ms. Katz will become a member of this committee.

COMPENSATION COMMITTEE

The compensation committee reviews and approves the compensation and benefits for our executive officers, administers our stock option plans and makes recommendations to the board of directors about compensation matters. The compensation committee consists of Mr. William Young. Upon joining the board of directors, Ms. Katz will become a member of this committee.

EXECUTIVE COMMITTEE

The executive committee may act on behalf of the board of directors on all matters except those concerning filling vacancies on the board, executive compensation, audits or individual contracts or financial obligations exceeding $3,000,000. The executive committee consists of Dr. Robert Nowinski, Dr. Donald Francis and Mr. William Young.

GENENTECH CONTRACT COMMITTEE

The Genentech contract committee considers matters relating to agreements with Genentech. The Genentech contract committee consists of Dr. Robert Nowinski, Dr. Donald Francis, Dr. Phillip Berman and Mr. Stephen Francis. Upon joining the board of directors, Ms. Katz will become a member of this committee.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION 

Decisions about executive compensation are made by the compensation committee. No member of the compensation committee or executive officer of our company has an interlocking relationship with executive officers or directors of another company.

EXECUTIVE COMPENSATION 

The following table depicts amounts paid during the last fiscal year as compensation to our chief executive officer and our three most highly compensated executive officers (other than the chief executive officer) who were serving as executive officers at the end of fiscal 1998.

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EMPLOYMENT AGREEMENTS 

Dr. Nowinski's employment agreement provides for a base annual salary of $250,000 through 2002. On April 22, 1999, our board of directors approved an increase in Dr. Nowinski's annual salary to $300,000. Dr. Nowinski will receive a performance bonus of 125,000 shares of common stock if either the market value of our common stock reaches an average of $28.00 per share over a 30-day period or we are acquired in an acquisition that results in a purchase price of at least $28.00 per share. In the event of a change of control or termination prior to the end of the term of his employment agreement, we may be required to pay all salary due to Dr. Nowinski. Upon termination of employment, Dr. Nowinski has agreed not to compete with us for one year.  

Dr. Francis' employment agreement provides for a base salary of $250,000 through 2002. On April 22, 1999, our board of directors approved an increase in Dr. Francis' annual salary to $275,000. Dr. Francis may receive an annual bonus of up to 30% of his base salary as determined in the discretion of the board of directors. Dr. Francis will also receive a performance bonus of 125,000 shares of common stock if either the market value of our common stock reaches an average of $28.00 per share over a 30-day period or we are acquired in an acquisition that results in a purchase price of at least $28.00 per share. In the event of a change of control or termination of employment prior to the end of the five-year term, we may be required to pay all salary due to Dr. Francis. Upon termination of employment, Dr. Francis has agreed not to compete with us for one year.  

Dr. Berman's employment agreement provides for a base salary of $175,000 through November 2000. On April 22, 1999, our board of directors approved an increase in Dr. Berman's annual salary to $200,000. Dr. Berman may receive an annual bonus of up to 20% of his base salary as determined in the discretion of the board of directors. In the event of a change of control, Dr. Berman may receive a one-time bonus of 75,757 shares of common stock. In the event of termination of employment prior to the expiration of the three-year term, we may be required to pay Dr. Berman's base salary for twelve months following his termination. Upon termination of employment, Dr. Berman has agreed not to compete with us for one year.  

Dr. Curd's employment agreement provides for an annual base salary of $225,000 through May 2003. Dr. Curd may also receive an annual bonus of up to 30% of his base salary and up to 10,000 shares of stock options with an exercise price equal to fair market value, as determined in the discretion of the board of directors. We have agreed to pay Dr. Curd a bonus of up to $50,000, to be paid over the period of his four-year contract. We have also agreed to assume Dr. Curd's loan for $96,822 outstanding with Genentech and accept an interest-free promissory note from Dr. Curd. Dr. Curd agrees to retire the outstanding loan by the termination of this agreement. Dr. Curd has received an option to purchase up to 125,000 shares of common stock that vests over a four-year period. In the event of a change of control, Dr. Curd may receive a one-time bonus of 37,500 shares of common stock. In the event of termination prior to the expiration of the four-year term, we may be required to pay Dr. Curd's base salary for twelve months following his termination. Upon termination of employment, Dr. Curd has agreed not to compete with us for one year.  

Mr. Lee's employment agreement provides for a base salary of $185,000 through March 2003. Mr. Lee may also receive an annual bonus of up to 20% of his base salary, and 10,000 shares of stock options (exercise price at market value), as determined in the discretion of the board of directors. Mr. Lee has received an option to purchase up to 125,000 shares of common stock that vests over a four-year period. In the event of a change of control, Mr. Lee may receive a one-time bonus of 37,500 shares of common stock. In the event of termination prior to the expiration of the four-year term, we may be required to pay Mr. Lee's base salary for twelve months following his termination. Upon termination of employment, Mr. Lee has agreed not to compete with us for one year.

DIRECTOR COMPENSATION

We reimburse directors for out-of-pocket and travel expenses incurred while attending board of director and committee meetings. Directors are also paid $1,000 per meeting attended in person and $500 for participation by conference call. Directors who are not also employees receive an annual option to purchase up to the lesser of: (1) $20,000 worth of common stock at an exercise price equal to the fair market value of the stock on the date of grant; and (2) 2,857 shares of common stock. Employee directors are also eligible to receive option grants.