STEMCELLS INC - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K

/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

OR

/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER 0-19871
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STEMCELLS, INC.
(Exact name of Registrant as specified in its charter)

DELAWARE 94-3078125
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)

3155 PORTER DRIVE, PALO ALTO, CA 94304
(Address of principal offices) (zip code)

Registrant's telephone number, including area code: (650) 475 3100

Securities registered pursuant to Section 12(b) of the Act:
NONE

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

COMMON STOCK, $.01 PAR VALUE
JUNIOR PREFERRED STOCK PURCHASE RIGHTS
Title of class
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /

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

Aggregate market value of Common Stock held by non-affiliates at
February 25, 2002: $66,606,700. Inclusion of shares held beneficially by any
person should not be construed to indicate that such person possesses the power,
direct or indirect, to direct or cause the direction of management policies of
the registrant, or that such person is controlled by or under common control
with the Registrant. Common stock outstanding at February 25, 2002: 24,220,618
shares

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive Proxy Statement relating to the
registrant's 2002 Annual Meeting of Stockholders to be filed with the Commission
pursuant to Regulation 14A are incorporated by reference in Part III of this
report.

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FORWARD LOOKING STATEMENTS

THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS AS DEFINED UNDER THE FEDERAL
SECURITIES LAWS. ACTUAL RESULTS COULD VARY MATERIALLY. FACTORS THAT COULD CAUSE
ACTUAL RESULTS TO VARY MATERIALLY ARE DESCRIBED HEREIN AND IN OTHER DOCUMENTS
FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. READERS SHOULD PAY PARTICULAR
ATTENTION TO THE CONSIDERATIONS DESCRIBED IN THE SECTION OF THIS REPORT ENTITLED
"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS" AS WELL AS EXHIBIT 99 TO THIS REPORT, ENTITLED "CAUTIONARY FACTORS
RELEVANT TO FORWARD-LOOKING INFORMATION." READERS SHOULD ALSO CAREFULLY REVIEW
ANY RISK FACTORS DESCRIBED IN OTHER DOCUMENTS WE FILE FROM TIME TO TIME WITH THE
SECURITIES AND EXCHANGE COMMISSION.

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ITEM 1. BUSINESS

OVERVIEW

We are engaged in research aimed at the development of therapies that would
use stem and progenitor cells derived from fetal or adult sources to treat, and
possibly cure, human diseases and injuries such as Parkinson's disease,
hepatitis, diabetes, and spinal cord injuries. The body uses certain key cells
known as stem cells to produce all the functional mature cell types found in
normal organs of healthy individuals. Progenitor cells are cells that have
already developed from the stem cells, but can still produce one or more types
of mature cells within an organ. We are not developing embryonic stem cells for
therapeutic use.

Many diseases, such as Alzheimer's, Parkinson's, and other degenerative
diseases of the brain or nervous system, involve the failure of organs that
cannot be transplanted. Other diseases, such as hepatitis and diabetes, involve
organs such as the liver or pancreas that can be transplanted, but there is a
very limited supply of those organs available for transplant. We estimate, based
on information available to us from the Alzheimer's Association, the National
Institutes of Health, the Centers for Disease Control and Prevention, and the
Parkinson's Action Network, that these conditions affect more than 20 million
people in the United States and account for more than $190 billion annually in
health care costs.

We believe that our stem cell technologies, if successfully developed, may
provide the basis for effective therapies for these and other conditions. Our
aim is to return patients to productive lives and significantly reduce the
substantial health care costs often associated with these diseases and
disorders. We have made significant progress toward developing stem cell
therapies for the nervous system by identifying and characterizing the human
central nervous system stem cell. We have also made significant advances in our
search for the stem cells of the liver and the pancreas by identifying markers,
some of which are novel, on the surface of cells so they can be isolated and
tested to determine whether they are stem cells. We have established an
intellectual property position in all three areas of our stem cell research--the
nervous system, the liver and the pancreas--by patenting our discoveries and
entering into exclusive in-licensing arrangements. We believe that, if
successfully developed, our platform of stem cell technologies may create the
basis for therapies that would address a number of conditions with significant
unmet medical needs. We intend to concentrate our in-house efforts on our neural
and liver programs and, for the present, to pursue work on the pancreas
primarily through external collaborators.

CELL THERAPY BACKGROUND

ROLE OF CELLS IN HUMAN HEALTH AND TRADITIONAL THERAPIES

Cells maintain normal physiological function in healthy individuals by
secreting or metabolizing substances, such as sugars, amino acids,
neurotransmitters and hormones, which are essential to life. When cells are
damaged or destroyed, they no longer produce, metabolize or accurately regulate
those substances. Impaired cellular function is associated with the progressive
decline common to many degenerative diseases of the nervous system, such as
Parkinson's disease and Alzheimer's disease. Recent advances in medical science
have identified cell loss or impaired cellular function as leading causes of
degenerative diseases. Biotechnology advances have led to the identification of
some of the specific substances or proteins that are deficient. While
administering these substances or proteins as medication does overcome some of
the limitations of traditional pharmaceuticals such as lack of specificity,
there is no existing technology that can deliver them to the precise sites of
action and in the appropriate physiological regulation and quantities or for the
duration required to cure the degenerative condition. Cells, however, can do
this naturally. As a result, investigators have considered supplementing the
failing cells that are no longer producing the needed substances or proteins by
implanting stem or progenitor cells. Where there has been irreversible tissue
damage or organ failure,

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transplantation of these stem or progenitor cells offers the possibility of
generating new and healthy mature cells, thus potentially restoring the organ
function and the patient's health.

THE POTENTIAL OF OUR STEM CELL-BASED THERAPY

We believe that, if successfully developed, stem cell-based therapy--the use
of stem or progenitor cells to treat diseases--has the potential to provide a
broad therapeutic approach comparable in importance to traditional
pharmaceuticals and genetically engineered biologics.

Stem cells are rare and only available in limited supply, whether from the
patients themselves or from donors. Cells obtained from the same person who will
receive them may be abnormal if the patient is ill or the tissue is contaminated
with disease-causing cells. Also, the cells can often be obtained only through
significant surgical procedures. The challenge, therefore, has been three-fold:

1) to identify the stem cells;

2) to create techniques and processes that can be used to expand these
rare cells in sufficient quantities for effective transplants; and

3) to establish a bank of normal human stem or progenitor cells that
can be used for transplantation into individuals whose own cells are not
suitable because of disease or other reasons.

We have discovered markers on the cell surface that identify the human CNS
stem cells. This allows us to purify them and eliminate other unwanted cell
types. We have also developed a process, based on a proprietary IN VITRO culture
system in chemically defined media, and demonstrated that this process
reproducibly grows normal human central nervous system, or CNS, stem and
progenitor cells. We believe this is the first reproducible process for growing
normal human CNS stem cells. Together, these discoveries enable us to select
normal human CNS stem cells and to expand them in culture to produce a large
number of pure stem cells. This process facilitates the banking of large
quantities of individual vials of these cells which could then be used for
distribution to transplant centers worldwide for administration to patients.

Because these cells have not been genetically modified, they may be
especially suitable for transplantation and may provide a safer and more
effective alternative to therapies that are based on cells derived from cancer
cells, from cells modified by a cancer gene to make them grow, from an
unpurified mixture of many different cell types, or from animal derived cells.
We believe our proprietary stem cell technologies may enable therapies to
replace specific cells that have been damaged or destroyed, permitting the
restoration of function through the replacement of normal cells where this has
not been possible in the past. In our research, we have shown that stem cells of
the central nervous system transplanted into hosts are accepted, migrate, and
successfully specialize to produce mature neurons and glial cells.

More generally, because the stem cell is the pivotal cell that produces all
the functional mature cell types in an organ, we believe these cells, if
successfully identified and developed for transplantation, may serve as
platforms for five major areas of regenerative medicine and biotechnology:

- tissue repair and replacement,

- correction of genetic disorders,

- drug discovery and screening,

- gene discovery and use, and

- diagnostics.

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We intend to aggressively pursue a series of non-exclusive agreements
whereby third parties would have access to our cells for use in diagnostics,
gene discovery and use, drug discovery and screening, and correction of genetic
disorders, while in connection with tissue repair and replacement, we intend to
enter into exclusive agreements with larger entities for the development of the
technology and use of the cells in transplantation on a disease-specific basis.

OUR PLATFORM OF STEM CELL TECHNOLOGIES

Stem cells have two defining characteristics:

- some of the cells developed from stem cells produce all the kinds of
mature cells making up the particular organ; and

- they self renew--that is, other cells developed from stem cells are
themselves new stem cells, thus permitting the process to continue again
and again.

Stem cells are known to or thought to exist for many systems of the human
body, including the blood and immune system, the central and peripheral nervous
systems (including the brain), and the liver, pancreas endocrine, and the skin
systems. These cells are responsible for organ regeneration during normal cell
replacement and, to a more or less limited extent, after injury. We believe that
further research and development will allow stem cells to be cultivated and
administered in ways that enhance their natural function, so as to form the
basis of therapies that will replace specific subsets of cells that have been
damaged or lost through disease, injury or genetic defect.

We also believe that the person or entity that first identifies and isolates
a stem cell and defines methods to culture any of the finite number of different
types of human stem cells will be able to obtain patent protection for the
methods and the composition, making the commercial development of stem cell
treatment and possible cure of currently intractable diseases financially
feasible.

Our strategy is to be the first to identify, isolate and patent multiple
types of human stem and progenitor cells with commercial importance. Our
portfolio of issued patents includes a method of culturing normal human central
nervous system stem and progenitor cells in our proprietary chemically defined
medium, and our published studies show that these cultured and expanded cells
give rise to all three major cell types of the central nervous system. Also, a
separate study sponsored by us using these cultured stem and progenitor cells
showed that the cells are accepted, migrate, and successfully specialize to
produce neurons and glial cells.

We have published the results of a study that showed that human central
nervous system stem cells can be successfully isolated by markers present on the
surface of freshly obtained brain cells. We believe this is the first
reproducible process for isolating highly purified populations of
well-characterized normal human central nervous system stem cells, and have
applied for a composition of matter patent. Because the cells are highly
purified and have not been genetically modified, they may be especially suitable
for transplantation and may provide a safer and more effective alternative than
therapies that are based on cells derived from cancer cells, or from cells
modified by a cancer gene to make them grow, or from an unpurified mixture of
many different cell types or cells derived from animals. We have also filed an
improved process patent for the growth and expansion of these purified normal
human central nervous system cells.

More recently, we announced the results of a new study in which we used
novel human specific monoclonal antibodies to demonstrate the extent of
engraftment, migration and site-specific formation of the human neural stem
cells into mature neurons. These neuronal cells integrate in a 3-dimensional
array within the normal architecture of the mouse brain. Astrocytes and
oligodendrocytes, the other two principle types of central nervous system cells,
are also generated from the human neural stem cells.

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Neurological disorders such as Parkinson's disease, Alzheimer's disease, the
side effects of stroke, and the mental retardation that accompanies genetic
disorders such as Gaucher's Disease, Tay-Sachs Disease, and Batten's Disease
affect a significant portion of the U.S. population and there currently are no
effective long-term therapies for them. We believe that therapies based on our
process for identifying, isolating and culturing neural stem and progenitor
cells may be useful in treating such diseases. We are continuing our research
into, and have initiated the development of, human central nervous system stem
and progenitor cell-based therapies for some diseases of this kind.

We continue to advance our research programs to discover the liver stem cell
and, through our outside collaborators, the islet stem cell in the human
pancreas. Liver stem cells may be useful in the treatment of diseases such as
hepatitis, liver failure, blood-clotting disorder, cirrhosis of the liver and
liver cancer. Islet cells are the pancreas cells that produce insulin, so
pancreatic stem cells may be useful in the treatment of Type 1 diabetes and
those cases of Type 2 diabetes where insulin secretion is defective.

An important element of our stem cell discovery program is the further
development of intellectual property positions with respect to stem and
progenitor cells. We have also obtained rights to certain inventions relating to
stem cells from, and are conducting stem cell related research at, several
academic institutions. We expect to expand our search for new stem and
progenitor cells and to seek to acquire rights to additional inventions relating
to stem and progenitor cells from third parties.

EXPECTED ADVANTAGES OF OUR STEM CELL TECHNOLOGY

NO OTHER TREATMENT

To our knowledge, no one has developed an FDA-approved method for replacing
lost or damaged tissues from the human nervous system. Replacement of tissues in
other areas of the human body is mainly limited to those few sites, such as bone
marrow or peripheral blood cell transplants, where transplantation of the
patient's own cells is now feasible. In a few additional areas, including the
liver, transplantation of donor organs is now used, but is limited by the
scarcity of organs available through donation. We believe that our stem cell
technologies have the potential to reestablish function in at least some of the
patients who have suffered the losses referred to above.

REPLACED CELLS PROVIDE NORMAL FUNCTION

Because stem cells can duplicate themselves, or self-renew, and specialize
into the multiple kinds of cells that are commonly lost in various diseases,
transplanted stem cells may be able to migrate limited distances to the proper
location within the body, to expand and specialize and to replace damaged or
defective cells, facilitating the return to proper function. We believe that
such replacement of damaged or defective cells by functional cells is unlikely
to be achieved with any other treatment.

RESEARCH EFFORTS AND PRODUCT DEVELOPMENT PROGRAMS

OVERVIEW OF RESEARCH AND PRODUCT DEVELOPMENT STRATEGY

We have devoted substantial resources to our research programs to isolate
and develop a series of stem and progenitor cells that we believe can serve as a
basis for replacing diseased or injured cells. Our efforts to date have been
directed at methods to identify, isolate and culture large varieties of stem and
progenitor cells of the human nervous system, liver and pancreas and to develop
therapies utilizing these stem and progenitor cells.

The following table lists the potential therapeutic indications for, and
current status of, our primary research and product development programs and
projects. The table is qualified in its entirety by reference to the more
detailed descriptions of such programs and projects appearing elsewhere in this
report. We continually evaluate our research and product development efforts and
reallocate

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resources among existing programs or to new programs in light of experimental
results, commercial potential, availability of third party funding, likelihood
of near-term efficacy, collaboration success or significant technology
enhancement, as well as other factors. Our research and product development
programs are at relatively early stages of development and will require
substantial resources to commercialize.

RESEARCH AND PRODUCT DEVELOPMENT PROGRAMS

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(1) "Research" refers to early stage research and product development activities
IN VITRO, including the selection and characterization of product candidates
for preclinical testing. "Preclinical" refers to further testing of a
defined product candidate IN VITRO and in animals prior to clinical studies.

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RESEARCH AND DEVELOPMENT PROGRAMS

Our portfolio of stem cell technology results from our exclusive licensing
of central nervous system, stem and progenitor cell technology, animal models
for the identification and/or testing of stem and progenitor cells and our own
research and development efforts to date. We believe that therapies using stem
cells represent a fundamentally new approach to the treatment of diseases caused
by lost or damaged tissue. We have assembled an experienced team of scientists
and scientific advisors to consult with and advise our scientists on their
continuing research and development of stem and progenitor cells. This team
includes Irving L. Weissman, M.D., of Stanford University, Fred H. Gage, Ph.D.,
of The Salk Institute, David Anderson, Ph.D., of the California Institute of
Technology and Ben Barres, Ph.D., of Stanford University, as well as other
occasional consultants including William C. Mobley, M.D., Ph.D. and Seung Kim,
M.D., Ph.D., both of Stanford University.

BRAIN STEM AND PROGENITOR CELL RESEARCH AND DEVELOPMENT PROGRAM

We began our work with central nervous system stem and progenitor cell
cultures in collaboration with NeuroSpheres, Ltd., in 1992. We believe that
NeuroSpheres was the first to invent these cultures. We are the exclusive,
worldwide licensee from NeuroSpheres to such inventions and associated patents
and patent applications for all uses, including transplantation in the human
body, as embodied in these patents. See "License Agreements and Sponsored
Research Agreements--NeuroSpheres, Ltd."

In 1997, our scientists invented a reproducible method for growing human CNS
stem and progenitor cells in cultures. In preclinical IN VITRO and early IN VIVO
studies, we demonstrated that these cells specialize into all three of the cell
types of the central nervous system. Because of these results, we believe that
these cells may form the basis for replacement of cells lost in certain
degenerative diseases. We are continuing research into, and have initiated the
development of, our human CNS stem and progenitor cell cultures. We have
initiated the cultures and demonstrated that these cultures can be expanded for
a number of generations IN VITRO in chemically defined media. In collaboration
with us, Dr. Anders Bjorklund of Lund University, Sweden, showed that cells from
these cultures can be successfully transplanted and accepted into the brains of
rodents where they subsequently migrated and specialized into the appropriate
cell types for the site of the brain into which they were placed.

Since then, we have expanded our preclinical efforts in this area by
initiating programs aimed at the discovery and use of specific monoclonal
antibodies to facilitate identification and isolation of CNS and other stem and
progenitor cells or their specialized progeny. Our researchers have devised
methods to advance the IN VITRO culture and passage of human CNS stem cells that
resulted in a 100-fold increase in CNS stem and progenitor cell production after
6 passages. A U.S. patent on those methods issued in May, 2001 (patent No.
6238922, "Use of collagenase in the preparation of neural stem cell cultures").
We are expanding our preclinical efforts toward the goal of selecting the proper
indications to pursue.

In December 1998, the US Patent and Trademark Office granted patent
No. 5,851,832, covering our methods for the human CNS cell cultures containing
central nervous system stem cells, for compositions of human CNS cells expanded
by these methods, and for use of these cultures in human transplantation. These
human CNS stem and progenitor cells expanded in culture may be useful for
repairing or replacing damaged central nervous system tissue, including the
brain and the spinal cord. US Patent No. 5,968,829, entitled "Human CNS Neural
Stem Cells," which covers our composition of matter for human CNS stem cells,
was granted in 1999, and US Patent No. 6,103,530, covering our media for
culturing human CNS stem cells, was granted in 2000.

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We have a US patent application pending that covers our proprietary process
for the direct isolation of normal human CNS stem cells based on the markers
found to be present on the surface of freshly obtained brain cells. Since the
filing of this patent application, our researchers have completed a study
designed to identify, isolate and culture human CNS stem cells utilizing this
proprietary process. Using our proprietary markers on the surface of the cell,
our researchers have succeeded in identifying, isolating and purifying human CNS
stem cells from brain tissue, and were able to expand the number of these cells
in culture.

We believe that this was the first study to show a reproducible process for
isolating highly purified populations of well-characterized normal human CNS
stem cells. Because the cells are normal human CNS stem cells and have not been
genetically modified, they may be especially suitable for transplantation and
may provide a safer and more effective alternative to therapies that are based
on cells derived from cancer cells or from an unpurified mix of many different
cell types, or from animal derived cells. Even more importantly, in our view,
our researchers have been able to take these purified and expanded stem cells
and transplant them into the normal brains of immunodeficient mouse hosts, where
they take hold and grow into neurons and glial cells.

During the course of this long-term study, the transplanted human CNS stem
cells survived for as long as one year and migrated to specific functional
domains of the host brain, with no sign of tumor formation or adverse effects on
the animal recipients; moreover, the cells were still dividing. These findings
show that when CNS stem cells isolated and cultured with our proprietary
processes are transplanted, they adopt the characteristics of the host brain and
act like normal stem cells. In other words, the study suggests the possibility
of a continual replenishment of normal human brain cells.

In 2001, we assembled and evaluated our long-term transplantation data,
defined in-house disease targets for further evaluation for proof of principle,
and established external collaborations with a number of academic laboratories
to pursue other well-characterized disease models in small animals.

As noted above, human CNS stem and progenitor cells harvested and purified
and expanded using our proprietary processes may be useful for creating
therapies for the treatment of degenerative brain diseases such as Parkinson's
and Alzheimer's diseases. These conditions affect about 5 million people in the
United States and there are no effective long-term therapies currently
available. We believe the ability to purify human brain stem cells directly from
fresh tissue is important because:

- it provides an enriched source of normal stem cells, not contaminated by
other unwanted or diseased cell types, that can be expanded in culture
without fear of also expanding some unwanted cell types;

- it opens the way to a better understanding of the properties of these
cells and how they might be manipulated to treat specific diseases. For
example, in certain genetic diseases such as Tay Sachs and Gaucher's, a
key metabolic enzyme required for normal development and function of the
brain is absent. Brain-derived stem cells might produce enough enzyme
after transplantation to degrade the toxic product build-up, or, if not
enough enzyme is made naturally, the cells might be genetically modified
to produce those proteins. The native or modified brain stem cells could
be transplanted into patients with these genetic diseases;

- the efficient acceptance of these non-transformed normal human stem cells
into host brains means that the cell product can be tested in animal
models for its ability to correct deficiencies caused by various human
neurological diseases. This technology could also provide a unique animal
model for the testing of drugs that act on human brain cells either for
effectiveness of the drug against the disease or its toxicity to human
nerve cells.

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LIVER STEM CELLS DISCOVERY RESEARCH PROGRAMS

We initiated our discovery work for the liver stem and progenitor cell
through a sponsored research agreement with Markus Grompe, Ph.D., of Oregon
Health Sciences University. Dr. Grompe's work focuses on the discovery and
development of a suitable method for identifying and assessing liver stem and
progenitor cells for use in transplantation. We have also obtained rights to a
novel mouse model of liver failure for evaluating cell transplantation developed
by Dr. Grompe, and a worldwide exclusive license to U.S. Patent No. 6,132,708,
claiming a method of regenerating a functional liver by transplantation of
pancreas cells in mammals, including humans.

Approximately 1 in 10 Americans suffers from diseases and disorders of the
liver for many of which there are currently no effective, long-term treatments.
Our researchers continue to advance methods for establishing enriched cell
populations suitable for transplantation in preclinical animal models. We are
focused on discovering and utilizing proprietary methods to identify and isolate
liver stem and progenitor cells and to evaluate these cells in culture and in
preclinical animal models.

Our researchers have devised a culture assay that we will use in our efforts
to identify liver stem and progenitor cells. In addition to supporting the
growth of an early human liver bipotent progenitor cell, it is also possible to
infect this culture with human hepatitis virus, providing a valuable system for
study of the virus. This technology could also provide a unique IN VITRO model
for the testing of drugs that act on, or are metabolized by, human liver cells.

There have been reports in the scientific community that bone marrow
transplant patients show evidence of donor derived liver cells (hepatocytes).
Our scientists (in conjunction with Markus Grompe, OHSU) showed that bone marrow
derived hepatocytes are functional and can rescue mice in liver failure.
Moreover, the only cells within the mouse bone marrow that are able to produce
hepatocytes are highly purified hematopoietic stem cells--that is, stem cells of
the blood and immune system, often referred to as HSCs. We believe that these
studies in stem cell plasticity are the most rigorous studies performed to date
and show the possibility of transitioning from one cell type to another.

In parallel with the studies performed using mouse HSCs, our scientist have
performed IN VITRO studies on human liver cells. To date, they have identified
proprietary monoclonal antibodies that enrich for distinct subsets of fetal
and/or pediatric liver cells. These cells are currently being tested in our IN
VITRO and IN VIVO culture assays. Further analysis and enrichments are in
progress.

PANCREAS STEM CELLS DISCOVERY RESEARCH PROGRAMS

Our pancreas discovery research program is directed to the identification,
isolation and culturing of the pancreas stem and progenitor cells. We obtained
an exclusive, worldwide license from The Scripps Research Institute (Scripps),
to novel technology developed by Dr. Nora Sarvetnick, Ph.D., which may
facilitate the identification and isolation of those cells by using a mouse
model that continuously regenerates the pancreas. US patent number 6,242,666 was
issued on the animal model on June 5, 2001. We believe that stem cells produce
the regeneration, in which case this animal model may be useful for identifying
specific markers on the cell surface unique to the pancreas stem cells. We
believe this may lead to the development of cell-based treatments for Type 1
diabetes and that portion of Type 2 diabetes characterized by defective
secretion of insulin. We also obtained licenses from Scripps to novel markers on
the cell surface identified by Dr. Sarvetnick and her research team as being
unique to the pancreas islet stem cell, for which we have now filed a US patent
application. We have no current plans for further research collaborations with
Scripps or Dr. Sarvetnick.

In 2001, we established a consortium of academic investigators to work in
collaboration with us on the human pancreatic stem and progenitor cells. This
consortium includes Drs. Raphael Scharfmann and Bruno Peault of INSERM, in
Paris, France, and Dr. Seung Kim of Stanford University. Through this consortium
we have access to unique animal models for transplantation of candidate stem/

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progenitor cells. We have identified key monoclonal antibodies that identify a
rare subset of pancreatic cells that may be candidate stem cells. For the
present, we will be pursuing the program primarily through the external members
of the consortium.

WIND-DOWN OF ENCAPSULATED CELL THERAPY RESEARCH AND DEVELOPMENT PROGRAMS

Until mid-1999, our company, which was then known as CytoTherapeutics,
engaged in research and development in encapsulated cell therapy technology, or
ECT. In July 1999, we began the restructuring of our research operations to
abandon all further ECT research and to concentrate our resources on the
research and development of our proprietary platform of stem cell technology. We
sold our intellectual property assets related to the ECT, retaining certain
non-exclusive rights to use the ECT in combination with our proprietary stem
cell technology and in the field of vaccines for prevention and treatment of
infectious diseases, and a portion of certain revenues the buyer, Neurotech
S.A., might receive in the future. (Subsequently, we sold the retained rights to
such revenues to Modex Therapeutics, S.A.; see Note 5 to the Financial
Statements below.) We relocated to California, and have subleased the two
buildings that constituted our pilot manufacturing and cell processing facility
in Rhode Island and approximately one-third of our former corporate headquarters
building. We are actively seeking to sublease, assign or sell our remaining
interests in the Rhode Island real estate.

SUBSIDIARY

STEMCELLS CALIFORNIA, INC.

On September 26, 1997, we acquired by merger StemCells California, Inc., a
California corporation, in exchange for 1,320,691 shares of our common stock and
options and warrants for the purchase of 259,296 common shares. Simultaneously
with the acquisition, its President, Richard M. Rose, M.D., became our
President, Chief Executive Officer and a director, and Irving L. Weissman, M.D.,
a founder of StemCells California, became a member of our board of directors.

CORPORATE COLLABORATIONS

CORPORATE INVESTMENT

In July 1996, we, together with certain founding scientists, established
Modex Therapeutics SA (Modex), a Swiss biotherapeutics company, to pursue
extensions of our former technology of ECT for certain applications outside the
central nervous system. Modex, headquartered in Lausanne, Switzerland, was
formed to integrate technologies developed by us and by several other
institutions to develop products to treat diseases such as diabetes, obesity and
anemia. After our disposition of the encapsulated cell technology in
December 1999, we no longer had common research or development interests with
Modex, but we held approximate 17% of its stock. Modex completed an initial
public offering on June 23, 2000, in the course of which we realized a gain of
approximately $1.4 million from the sale of certain shares. By the end of
May 2001 we had sold all our shares in Modex for a realized gain of
approximately $7.8 million.

LICENSE AGREEMENTS AND SPONSORED RESEARCH AGREEMENTS

SPONSORED RESEARCH AGREEMENTS

Under Sponsored Research Agreements with The Scripps Research Institute and
Oregon Health Sciences University, we funded certain research in return for
licenses or options to license the inventions resulting from the research. We
have also entered into license agreements with the California Institute of
Technology. All of these agreements relate largely to stem or progenitor cells
and or to processes and methods for the isolation, identification, expansion or
culturing of stem or progenitor cells.

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Our research agreement with Scripps expired at the end of 2000, and we do
not intend to renew it at this time. It is our intention to pursue research on
human stem and progenitor cells of the pancreas primarily through the consortium
we have established with other academic researchers. Our license agreements with
Scripps are not affected by the expiration of the research agreement. They will
terminate upon expiration, revocation or invalidation of the patents licensed to
us, unless governmental regulations require a shorter term. These license
agreements also will terminate earlier if we breach our obligations under the
agreement and do not cure the breach, or if we declare bankruptcy, and we can
terminate the license agreements at any time upon notice. Upon the initiation of
the Phase II trial for our first product using Scripps licensed technology, we
must pay Scripps $50,000 and upon completion of that Phase II trial we must pay
Scripps an additional $125,000. Upon approval of the first product for sale in
the market, we must pay Scripps $250,000. Our license agreements with the
California Institute of Technology (Cal Tech) will expire upon expiration,
revocation, invalidation or abandonment of the patents licensed to us. We can
terminate any of these license agreements by giving 30 days' notice to Cal Tech.
Either party can terminate these license agreements upon a material breach by
the other party. Pursuant to the terms of our license agreement with Cal Tech
and our acquisition of our wholly owned subsidiary, StemCells California, we
issued 14,513 shares of our common stock to Cal Tech. We issued an additional
12,800 shares of common stock to Cal Tech with a market value of approximately
$40,000 in May 2000, upon execution of an amendment adding four families of
patent applications to the license agreement. We must pay an additional $10,000
upon the issuance of the patent licensed to us under the relevant agreement. We
also will pay $5,000 on the anniversary of the issuance of the patent licensed
to us under the relevant agreement. These amounts are creditable against
royalties we must pay under the license agreements. The maximum royalties that
we will have to pay to the California Institute of Technology will be
$2 million per year, with an overall maximum of $15 million. Once we pay the
$15 million maximum royalty, the licenses will become fully paid and
irrevocable.

We and our wholly-owned subsidiary, StemCells California have entered into
sponsored research and license agreements with the Oregon Health Sciences
University (OHSU) beginning in March 1997. Pursuant to the terms of the license
agreement and our acquisition of StemCells California, we issued 4,838 shares of
our common stock and an option to purchase up to 62,888 additional shares to
OHSU with an exercise price of $.01 per share. The option has vested as to 9,675
shares by passage of time and the others will vest, if at all, on the
achievement of specified milestones.

LICENSE AGREEMENTS

We have entered into a number of license agreements with commercial and
non-profit institutions, as well as a number of research-plus-license agreements
with academic organizations. The research agreements provide that we will fund
certain research costs, and in return, will have a license or an option for a
license to the resulting inventions. Under the license agreements, we will
typically be subject to obligations of due diligence and the requirement to pay
royalties on products that use patented technology licensed under such
agreements.

SIGNAL PHARMACEUTICALS, INC.

In December 1997, we entered into two license agreements with Signal
Pharmaceuticals, Inc. under which each party licensed to the other certain
patent rights and biological materials for use in defined fields. An initial
disagreement as to the interpretation of the licensed rights was resolved by the
parties, and the agreements are operating in accordance with their terms. Signal
has now been acquired by Celgene. Each agreement with Signal will terminate at
the expiration of all patents licensed under it, but the licensing party can
terminate earlier if the other party breaches its obligations under the
agreement or declares bankruptcy. Also, the party receiving the license can
terminate the agreement at any time upon notice to the other party. Under these
agreements, we must reimburse Signal for

12

payments it must make to the University of California based on products we
develop and for 50% of certain other payments Signal must make.

NEUROSPHERES, LTD.

In March 1994, we entered into a Contract Research and License Agreement
with NeuroSpheres, Ltd., which was clarified in a License Agreement dated as of
April 1, 1997. Under the agreement as clarified, we obtained an exclusive patent
license from NeuroSpheres in the field of transplantation, subject to a limited
right of NeuroSpheres to purchase a nonexclusive license from us, which right
was not exercised and has expired. We have developed additional intellectual
property relating to the subject matter of the license. We entered into an
additional license agreement with NeuroSpheres as of October 30, 2000, under
which we obtained an exclusive license in the field of non-transplant uses, such
as drug discovery and drug testing. Together, our rights under the licenses are
exclusive for all uses of the technology. We made up-front payments to
NeuroSpheres of 65,000 shares of our common stock in October 2000 and $50,000 in
January 2001, and we will make additional cash payments when milestones are
achieved in the non-transplant field, or in any products employing NeuroSpheres
patents for generating cells of the blood and immune system from neural stem
cells. In addition, in October 2000 we reimbursed Neurospheres for patent costs
amounting to $341,000. Milestone payments would total $500,000 for each product
that is approved for market. Our agreements with NeuroSpheres will terminate at
the expiration of all patents licensed to us, but can terminate earlier if we
breach our obligations under the agreement and do not cure the breach, or if we
declare bankruptcy. We would have a security interest in the licensed technology
in the event that NeuroSpheres declares bankruptcy.

MANUFACTURING

Because of the early stage of our stem and progenitor cell programs, we have
made no decisions about the means by which potential future cell products will
be manufactured, nor resolved the many issues that will affect our choices. We
believe that our new facility in Palo Alto, however, has the capacity to be used
for manufacture of cells under FDA-determined clinical Good Manufacturing
Practices conditions in quantities sufficient for clinical trials, and we have
developed a robust and replicable process for producing and processing the
cells.

MARKETING

Because of the early stage of our stem and progenitor cell programs, we have
not yet addressed questions of channels of distribution and commercialization of
potential future products.

PATENTS, PROPRIETARY RIGHTS AND LICENSES

We believe that proprietary protection of our inventions will be critical to
our future business. We vigorously seek out intellectual property that we
believe might be useful in connection with our products, and have an aggressive
program of protecting our intellectual property. We believe that our know-how
will also provide a significant competitive advantage, and we intend to continue
to develop and protect our proprietary know-how. We may also from time to time
seek to acquire licenses to important externally developed technologies.

We have exclusive or non-exclusive rights to a portfolio of patents and
patent applications related to various stem and progenitor cells and methods of
deriving and using them. These patents and patent applications relate mainly to
compositions of matter, methods of obtaining such cells, and methods for
preparing, transplanting and utilizing such cells. Currently, our U.S. patent
portfolio in the stem cell therapy area includes thirty issued U.S. patents,
five of which issued in 2001. An additional twenty-five patent applications are
pending, two of which have been allowed.

13

We own, or have filed, the following United States Patents and patent
applications: U.S. Patent Number 5,968,829 (Human CNS neural stem cells); U.S.
Patent Number 6,103,530 (Human CNS neural stem cells--culture media);
Application Number WO 99/11758 (Cultures of human CNS neural stem cells); U.S.
Patent Number 6,238,922 (Use of collagenase in the preparation of neural stem
cell cultures); U.S. Patent Application Number WO 00/50572 (Use of collagenase
in the preparation of neural stem cell cultures); Application Number WO 00/47762
(Enriched neural stem cell populations and methods of identifying, isolating,
and enriching neural stem cells); Application Number WO 00/52143 (Isolation and
enrichment of neural stem cells from uncultured tissue based on cell-surface
marker expression); and Application Number WO 01/28574 (Method for inducing IN
VIVO proliferation and migration of transplanted progenitor cells in the brain).

We have licensed the following United States Patents or pending patent
applications from NeuroSpheres Holdings Ltd.: U.S. Patent Number 5,851,832 (IN
VITRO proliferation); U.S. Patent Number 5,750,376 (IN VITRO genetic
modification); U.S. Patent Number 5,981,165 (IN VITRO production of dopaminergic
cells from mammalian central nervous system multipotent stem cell compositions);
U.S. Patent Number 6,093,531 (Generation of hematopoietic cells from multipotent
neural stem cells); U.S. Patent Number 5,980,885 (Methods for inducing IN VIVO
proliferation of precursor cells); U.S. Patent Number 6,071,889 (Methods for IN
VIVO transfer of a nucleic acid sequence to proliferating neural cells); U.S.
Patent Number 6,294,346 (Methods for screening biological agents); U.S. Patent
Number 6,165,783 (Methods of inducing differentiation of multipotent neural stem
cells); Application Number WO 93/01275 (Mammalian central nervous system
multipotent stem cell compositions); Application Number WO 94/09119
(Remyelination using mammalian central nervous system multipotent stem cell
compositions); Application Number WO 94/10292 (Biological factors useful in
differentiating mammalian central nervous system multipotent stem cell
compositions); Application Number WO 94/16718 (Genetically engineered mammalian
central nervous system multipotent stem cell compositions); Application Number
WO 96/15224 (Differentiation of mammalian central nervous system multipotent
stem cell compositions); Application Number WO 99/2196 (Erythropoietin-mediated
neurogenesis); Application Number WO 99/16863 (Generation of hematopoietic
cells); Application Number WO 98/22127 (Pretreatment with growth factors to
protect against CNS damage); Application Number WO 97/3560 (IN SITU manipulation
of cells of the hippocampus); Application Number WO 96/09543 (IN VITRO models of
CNS functions and dysfunctions); Application Number WO 95/13364 (IN SITU
modification and manipulation of stem cells of the CNS); Application Number WO
96/15226 (IN VITRO production of dopaminergic cells from mammalian central
nervous system multipotent stem cell composition); and Application Number WO
96/15266 (Regulation of neural stem cell proliferation).

We have licensed the following United States Patents or pending patent
applications from the University of California, San Diego: U.S. Patent Number
5,776,948 (Method of production of neuroblasts); U.S. Patent Number 6,265,175
(Method of production of neuroblasts); U.S. Patent Number 6,013,521 (Method of
production of neuroblasts); U.S. Patent Number 6,020,197 (Method of production
of neuroblasts); U.S. Patent Number 6,045,807 (Method of production of
neuroblasts); and Application Number WO 94/16059 (Method of production of
neuroblasts).

We have licensed the following United States Patents or pending patent
applications from the California Institute of Technology: U.S. Patent Number
5,629,159 (Immortalization and disimmortalization of cells); Application Number
WO 96/40877 (Immortalization and disimmortalization of cells); U.S. Patent
Number 6,270,990 (Neuron restrictive silencer factor proteins); U.S. Patent
Number 5,935,811 (Neuron restrictive silencer factor proteins); Application
Number WO 96/27665 (Neuron restrictive silencer factor proteins); U.S. Patent
Number 5,589,376 (Mammalian neural crest stem cells); U.S. Patent Number
5,824,489 (Methods for isolating mammalian multipotent neural crest stem cells);
Application Number WO 94/02593 (Mammalian neural crest stem cells); U.S. Patent
Number 5,654,183 (Genetically engineered mammalian neural crest stem cells);
U.S. Patent Number 5,928,947 (Mammalian multipotent neural crest stem cells);
U.S. Patent Number 5,693,482 (IN

14

VITRO neural crest stem cell assay); U.S. Patent Number 6,001,654 (Methods for
differentiating neural stem cells to neurons or smooth muscle cells (TGFb));
Application Number WO 98/48001 (Methods for differentiating neural stem cells to
neurons or smooth muscle cells (TGFb)); U.S. Patent Number 5,672,499 (Methods
for immortalizing multipotent neural crest stem cells); U.S. Patent Number
5,849,553 (Immortalizing and disimmortalizing multipotent neural crest stem
cells); and U.S. Patent Number 6,033,906 (Differentiating mammalian neural stem
cells to glial cells using neuregulins).

We have licensed the following United States Patents or pending patent
applications from the following other institutions: Number 6,242,666 (An animal
model for identifying a common stem/ progenitor to liver cells and pancreatic
cells) and Application Number WO 00/36091 (An animal model for identifying a
common stem/progenitor to liver cells and pancreatic cells), licensed from The
Scripps Research Institute; Application Number WO98/50526 (Generation,
characterization, and isolation of neuroepithelial stem cells and lineage
restricted intermediate precursor), licensed from the University of Utah; and
Number 6,132,708 (Liver regeneration using pancreas cells), licensed from Oregon
Health Sciences University.

We also rely upon trade-secret protection for our confidential and
proprietary information and take active measures to control access to that
information.

Our policy is to require our employees, consultants and significant
scientific collaborators and sponsored researchers to execute confidentiality
agreements upon the commencement of an employment or consulting relationship
with us. These agreements generally provide that all confidential information
developed or made known to the individual by us during the course of the
individual's relationship with us is to be kept confidential and not disclosed
to third parties except in specific circumstances. In the case of employees and
consultants, the agreements generally provide that all inventions conceived by
the individual in the course of rendering services to us shall be our exclusive
property.

We have obtained rights from universities and research institutions to
technologies, processes and compounds that we believe may be important to the
development of our products. These agreements typically require us to pay
license fees, meet certain diligence obligations and, upon commercial
introduction of certain products, pay royalties. These include exclusive license
agreements with NeuroSpheres, The Scripps Institute, the California Institute of
Technology and the Oregon Health Sciences University, to certain patents and
know-how regarding present and certain future developments in CNS, liver and
pancreas stem cells.

The patent positions of pharmaceutical and biotechnology companies,
including ours, are uncertain and involve complex and evolving legal and factual
questions. The coverage sought in a patent application can be denied or
significantly reduced before or after the patent is issued. Consequently, we do
not know whether any of our pending applications will result in the issuance of
patents, or if any existing or future patents will provide significant
protection or commercial advantage or will be circumvented by others. Since
patent applications are secret until the applications are published (usually
eighteen months after filing), and since publication of discoveries in the
scientific or patent literature often lags behind actual discoveries, we cannot
be certain that we were the first to make the inventions covered by each of our
pending patent applications or that we were the first to file patent
applications for such inventions. There can be no assurance that patents will
issue from our pending or future patent applications or, if issued, that such
patents will be of commercial benefit to us, afford us adequate protection from
competing products, or not be challenged or declared invalid.

In the event that a third party has also filed a patent application relating
to inventions claimed in our patent applications, we may have to participate in
interference proceedings declared by the United States Patent and Trademark
Office to determine priority of invention, which could result in substantial
uncertainties and cost for us, even if the eventual outcome is favorable to us.
There can be no assurance that our patents, if issued, would be held valid by a
court of competent jurisdiction.

15

A number of pharmaceutical, biotechnology and other companies, universities
and research institutions have filed patent applications or have been issued
patents relating to cell therapy, stem cells and other technologies potentially
relevant to or required by our expected products. We cannot predict which, if
any, of such applications will issue as patents or the claims that might be
allowed. We are aware that a number of companies have filed applications
relating to stem cells. We are also aware of a number of patent applications and
patents claiming use of genetically modified cells to treat disease, disorder or
injury. We are aware of two patents issued to a competitor claiming certain
methods for treating defective, diseased or damaged cells in the mammalian CNS
by grafting genetically modified donor cells from the same mammalian species.

If third party patents or patent applications contain claims infringed by
our technology and such claims or claims in issued patents are ultimately
determined to be valid, there can be no assurance that we would be able to
obtain licenses to these patents at a reasonable cost, if at all, or be able to
develop or obtain alternative technology. If we are unable to obtain such
licenses at a reasonable cost, we may not be able to develop certain products
commercially. There can be no assurance that we will not be obliged to defend
ourselves in court against allegations of infringement of third party patents.
Patent litigation is very expensive and could consume substantial resources and
create significant uncertainties. An adverse outcome in such a suit could
subject us to significant liabilities to third parties, require disputed rights
to be licensed from third parties, or require us to cease using such technology.

We have obtained rights from universities and research institutions to
technologies, processes and compounds that we believe may be important to the
development of our products. These agreements typically require us to pay
license fees, meet certain diligence obligations and, upon commercial
introduction of certain products, pay royalties. These include exclusive license
agreements with NeuroSpheres, The Scripps Institute, the California Institute of
Technology and the Oregon Health Sciences University to certain patents,
applications and know-how regarding neural, liver and pancreatic stem cells. Our
licenses may be canceled or converted to non-exclusive licenses if we fail to
use the relevant technology or if we breach our agreements. Loss of such
licenses could expose us to the risks of third party patents and/or technology.
There can be no assurance that any of these licenses will provide effective
protection against our competitors.

COMPETITION

The targeted disease states for our initial products in some instances
currently have no effective long-term therapies. However, we do expect that our
initial products will have to compete with a variety of therapeutic products and
procedures. Major pharmaceutical companies currently offer a number of
pharmaceutical products to treat neurodegenerative and liver diseases, diabetes
and other diseases for which our technologies may be applicable. Many
pharmaceutical and biotechnology companies are investigating new drugs and
therapeutic approaches for the same purposes, which may achieve new efficacy
profiles, extend the therapeutic window for such products, alter the prognosis
of these diseases, or prevent their onset. We believe that our products, when
and if successfully developed, will compete with these products principally on
the basis of improved and extended efficacy and safety and their overall
economic benefit to the health care system. The market for therapeutic products
that address degenerative diseases is large, and competition is intense. We
expect competition to increase. We believe that our most significant competitors
will be fully integrated pharmaceutical companies and more established
biotechnology companies. Smaller companies may also be significant competitors,
particularly through collaborative arrangements with large pharmaceutical or
biotechnology companies. Many of these competitors have significant products
approved or in development that could be competitive with our potential
products.

16

Competition for our stem and progenitor cell products may be in the form of
existing and new drugs, other forms of cell transplantation, ablative and
simulative procedures, and gene therapy. We believe that some of our competitors
are also trying to develop stem and progenitor cell-based technologies. We
expect that all of these products will compete with our potential stem and
progenitor cell products based on efficacy, safety, cost and intellectual
property positions.

We may also face competition from companies that have filed patent
applications relating to the use of genetically modified cells to treat disease,
disorder or injury. We may be required to seek licenses from these competitors
in order to commercialize certain of our proposed products, and such licenses
may not be granted.

If we develop products that receive regulatory approval, they would then
have to compete for market acceptance and market share. For certain of our
potential products, an important success factor will be the timing of market
introduction of competitive products. This is a function of the relative speed
with which we and our competitors can develop products, complete the clinical
testing and approval processes, and supply commercial quantities of a product to
market. These competitive products may also impact the timing of clinical
testing and approval processes by limiting the number of clinical investigators
and patients available to test our potential products.

While we believe that the primary competitive factors will be product
efficacy, safety, and the timing and scope of regulatory approvals, other
factors include, in certain instances, obtaining marketing exclusivity under the
Orphan Drug Act, availability of supply, marketing and sales capability,
reimbursement coverage, price, and patent and technology position.

GOVERNMENT REGULATION

Our research and development activities and the future manufacturing and
marketing of our potential products are, and will continue to be, subject to
regulation for safety and efficacy by numerous governmental authorities in the
United States and other countries.

In the United States, pharmaceuticals, biologicals and medical devices are
subject to rigorous Food and Drug Administration, or FDA, regulation. The
Federal Food, Drug and Cosmetic Act, as amended, and the Public Health Service
Act, as amended, the regulations promulgated thereunder, and other Federal and
state statutes and regulations govern, among other things, the testing,
manufacture, safety, efficacy, labeling, storage, export, record keeping,
approval, marketing, advertising and promotion of our potential products.
Product development and approval within this regulatory framework takes a number
of years and involves significant uncertainty combined with the expenditure of
substantial resources. In addition, the federal, state, and other jurisdictions
have restrictions on the use of fetal tissue.

FDA APPROVAL

The steps required before our potential products may be marketed in the
United States include:

After FDA approval for the product, the manufacturing and the initial
indications, further clinical trials may be required to gain approval for the
use of the product for additional indications. The FDA may also require unusual
or restrictive post-marketing testing and surveillance to monitor for adverse
effects, which could involve significant expense, or may elect to grant only
conditional approvals.

FDA MANUFACTURING REQUIREMENTS

Among the conditions for product licensure is the requirement that the
prospective manufacturer's quality control and manufacturing procedures conform
to the FDA's current good manufacturing practice (cGMP) requirement. Even after
product licensure approval, the manufacturer must comply with cGMP on a
continuing basis, and what constitutes cGMP may change as the state of the art
of manufacturing changes. Domestic manufacturing facilities are subject to
regular FDA inspections for cGMP compliance, which are normally held at least
every two years. Foreign manufacturing facilities are subject to periodic FDA
inspections or inspections by the foreign regulatory authorities with reciprocal
inspection agreements with the FDA. Domestic manufacturing facilities may also
be subject to inspection by foreign authorities.

ORPHAN DRUG ACT

The Orphan Drug Act provides incentives to drug manufacturers to develop and
manufacture drugs for the treatment of diseases or conditions that affect fewer
than 200,000 individuals in the United States. Orphan drug status can also be
sought for treatments for diseases or conditions that affect more than 200,000
individuals in the United States if the sponsor does not realistically
anticipate its product becoming profitable from sales in the United States. We
may apply for orphan drug status for certain of our therapies. Under the Orphan
Drug Act, a manufacturer of a designated orphan product can seek tax benefits,
and the holder of the first FDA approval of a designated orphan product will be
granted a seven-year period of marketing exclusivity in the United States for
that product for the orphan indication. While the marketing exclusivity of an
orphan drug would prevent other sponsors from obtaining approval of the same
compound for the same indication, it would not prevent other types of products
from being approved for the same use including, in some cases, slight variations
on the originally designated orphan product.

19

PROPOSED FDA REGULATIONS

Our research and development is based on the use of human stem and
progenitor cells. The FDA has published a "Proposed Approach to Regulation of
Cellular and Tissue-Based Products" which relates to the use of human cells. As
part of this approach, the FDA has published final rules for registration of
establishments that engage in the recovery, screening, testing, processing,
storage or distribution of human cells, tissues, and cellular and tissue-based
products, and for the listing of such products. These products specifically
include hematopoietic stem cells (stem cells that are progenitors of blood
cells); however, the FDA makes no explicit statement regarding the inclusion of
other types of stem cells. In addition, the FDA has published proposed rules for
making suitability determinations for donors of cells and tissue and for current
good tissue practice for manufacturers using them. We cannot now determine the
full effects of this regulatory initiative, including precisely how it may
affect the clarity of regulatory obligations and the extent of regulatory
burdens associated with pluripotent stem cell research (for stem cells that give
rise to various tissue types, including blood), and the manufacture and
marketing of stem cell products.

OTHER REGULATIONS

In addition to safety regulations enforced by the FDA, we are also subject
to regulations under the Occupational Safety and Health Act, the Environmental
Protection Act, the Toxic Substances Control Act and other present and potential
future foreign, Federal, state and local regulations.

Outside the United States, we will be subject to regulations that govern the
import of drug products from the United States or other manufacturing sites and
foreign regulatory requirements governing human clinical trials and marketing
approval for our products. The requirements governing the conduct of clinical
trials, product licensing, pricing and reimbursements vary widely from country
to country. In particular, the European Union, or EU, is revising its regulatory
approach to high tech products, and representatives from the United States,
Japan and the EU are in the process of harmonizing and making more uniform the
regulations for the registration of pharmaceutical products in these three
markets.

REIMBURSEMENT AND HEALTH CARE COST CONTROL

Reimbursement for the costs of treatments and products such as ours from
government health administration authorities, private health insurers and others
both in the United States and abroad is a key element in the success of new
health care products. Significant uncertainty often exists as to the
reimbursement status of newly approved health care products.

The revenues and profitability of some health care-related companies have
been affected by the continuing efforts of governmental and third party payers
to contain or reduce the cost of health care through various means. Payers are
increasingly attempting to limit both coverage and the level of reimbursement
for new therapeutic products approved for marketing by the FDA, and are
refusing, in some cases, to provide any coverage for uses of approved products
for disease indications for which the FDA has not granted marketing approval.
For example, in certain foreign markets, pricing or profitability of
prescription pharmaceuticals is subject to government control. In the United
States, there have been a number of Federal and state proposals to implement
government control over health care costs.

EMPLOYEES

As of December 31, 2001, we had thirty-three full-time employees, of whom
nine have Ph.D. degrees. Twenty-two full-time employees work in research and
development and laboratory support services. A number of our employees have held
positions with other biotechnology or pharmaceutical

20

companies or have worked in university research programs. No employees are
covered by collective bargaining agreements.

SCIENTIFIC ADVISORY BOARD

Members of our Scientific Advisory Board provide us with strategic guidance
in regard to our research and product development programs, as well as
assistance in recruiting employees and collaborators. Each Scientific Advisory
Board member has entered into a consulting agreement with us. These consulting
agreements specify the compensation to be paid to the consultant and require
that all information about our products and technology be kept confidential. All
of the Scientific Advisory Board members are employed by employers other than us
and may have commitments to or consulting or advising agreements with other
entities that limit their availability to us. The Scientific Advisory Board
members have generally agreed, however, for so long as they serve as consultants
to us, not to provide any services to any other entities that would conflict
with the services the member provides to us. We are entitled to terminate the
arrangement if we determine that there is such a conflict. Members of the
Scientific Advisory Board offer consultation on specific issues encountered by
us as well as general advice on the directions of appropriate scientific inquiry
for us. In addition, Scientific Advisory Board members assist us in assessing
the appropriateness of moving our projects to more advanced stages. The
following persons are members of our Scientific Advisory Board:

- Irving L. Weissman, M.D., is the Karel and Avice Beekhuis Professor of
Cancer Biology, Professor of Pathology and Professor of Developmental
Biology at Stanford University, Stanford California. Dr. Weissman was a
cofounder of SyStemix, Inc., and Chairman of its Scientific Advisory
Board. He has served on the Scientific Advisory Boards of Amgen Inc., DNAX
and T-Cell Sciences, Inc. Dr. Weissman is Chairman of the Scientific
Advisory Board of StemCells.

- David J. Anderson, Ph.D., is Professor of Biology, California Institute of
Technology, Pasadena, California and Investigator, Howard Hughes Medical
Institute.

- Fred H. Gage, Ph.D., is Professor, Laboratory of Genetics, The Salk
Institute for Biological Studies, La Jolla, California and Adjunct
Professor, Department of Neurosciences, University of California, San
Diego, California.

- Ben A. Barres, Ph.D., is Associate Professor of Neurobiology and of
Developmental Biology, Stanford University, Stanford California.

ITEM 2. PROPERTIES

We entered into a 5-year lease, as of February 1, 2001, for a 40,000 square
foot facility, located in the Stanford Research Park in Palo Alto, California.
This facility includes space for animals as well as laboratories, offices, and a
Good Manufacturing Practices suite, signifying that the facility can be used to
manufacture materials for clinical trials. The new facility will better enable
us to achieve our goal of utilizing genetically unmodified human stem cells for
the treatment of disorders of the nervous system, liver, and pancreas. We have
space-sharing agreements for part of the animal facility not needed for our own
use with Stanford University and with Celtrans, Inc.

We continue to lease the following facilities in Lincoln, Rhode Island
obtained in connection with our former encapsulated cell technology: our former
research laboratory and corporate headquarters building which contains 65,000
square feet of wet labs, specialty research areas and administrative offices
held on a lease agreement that goes through June 2013, as well as a 21,000
square-foot pilot manufacturing facility and a 3,000 square-foot cell processing
facility financed by bonds issued by the Rhode Island Industrial Facilities
Corporation. In 2001 we subleased the 3,000 square foot facility and effective
in 2002 we have subleased the 21,000 square-foot facility. We have also
subleased

21

approximately one-third of the 65,000 square foot facility. We are actively
seeking to sublease, assign or sell our remaining interests in these properties.

ITEM 3. LEGAL PROCEEDINGS

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

22

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS

The common stock of StemCells is traded on the National Market System of
NASDAQ under the Symbol STEM (Previously traded under the Symbol CTII until
May 2000). The quarterly ranges of high and low bid prices for the last two
fiscal years as reported by NASDAQ are shown below:

No cash dividends have been declared on the Company common stock since the
Company's inception.

As of February 25th, 2001, there were approximately 362 holders of record of
the common stock.

On December 4, 2001, we issued 5,000 shares of 3% Cumulative Convertible
Preferred Stock to Riverview Group, L.L.C., a wholly owned subsidiary of
Millennium Partners, L.P. This preferred stock is convertible into shares of our
common stock at a conversion price of $2.00 per share of common stock; there is
a mandatory redemption provision under which any preferred stock outstanding on
December 4, 2003, shall be redeemed on that date. The conversion price may be
below the trading market price of the stock at the time of conversion. Also on
December 4, 2001, in connection with the preferred stock agreement, we issued to
Riverview Group a warrant to purchase 350,877 shares of our common stock at a
price of $3.42 per share. The warrant expires on December 4, 2005. Riverview
Group paid $5,000,000 for the preferred stock and warrant. We also issued to
Cantor Fitzgerald & Co., our financial advisor in connection with the
transaction, a warrant for 146,199 shares exercisable at $3.42 per share. These
transactions were exempt from registration under the Securities Act of 1933
pursuant to Regulation D thereunder.

ITEM 6. SELECTED FINANCIAL DATA

The following selected historical information has been derived from the
audited financial statements of the Company. The financial information as of
December 2001 and 2000 and for each of

23

the three years in the period ended December 31, 2001 are derived from audited
financial statements included elsewhere in this Form 10-K.

- ------------------------

(1) See footnote 3 in the consolidated financial statements

(2) See footnote 2 in the consolidated financial statements

(3) See footnote 11 in the consolidated financial statements

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion of our financial condition and results of
operations should be read in conjunction with the accompanying financial
statements and the related footnotes thereto.

This report contains forward looking statements within the meaning of
Section 27A of the Securities Act and Section 21E of the Securities Exchange Act
that involve substantial risks and

24

uncertainties. Such statements include, without limitation, all statements as to
expectation or belief and statements as to our future results of operations, the
progress of our research, product development and clinical programs, the need
for, and timing of, additional capital and capital expenditures, partnering
prospects, costs of manufacture of products, the protect of and the need for
additional intellectual property rights, effects of regulations, the need for
additional facilities and potential market opportunities. Our actual results may
vary materially from those contained in such forward-looking statements because
of risks to which we are subject, such as failure to obtain a corporate partner
or partners to support the development of our stem cell programs, our ability to
sell, assign or sublease our interest in our facilities related to our
encapsulated cell technology program, risks of delays in, or adverse results
from, our research, development and clinical testing programs, obsolescence of
our technology, lack of available funding, competition from third parties,
intellectual property rights of third parties, failure of our collaborators to
perform, regulatory constraints, litigation and other risks to which we are
subject. See "Cautionary Factors Relevant to Forward-Looking-Information" filed
herewith as Exhibit 99 and incorporated herein by reference.

OVERVIEW

Since our inception in 1988, we have been primarily engaged in research and
development of human therapeutic products. As a result of a restructuring in the
second half of 1999, our sole focus is now on our stem cell technology.

We have not derived any revenues from the sale of any products, and we do
not expect to receive revenues from product sales for at least several years. We
have not commercialized any product and in order to do so we must, among other
things, substantially increase our research and development expenditures as
research and product development efforts accelerate and clinical trials are
initiated. We have incurred annual operating losses since inception and expect
to incur substantial operating losses in the future. As a result, we are
dependent upon external financing from equity and debt offerings and revenues
from collaborative research arrangements with corporate sponsors to finance our
operations. There are no such collaborative research arrangements at this time
and there can be no assurance that such financing or partnering revenues will be
available when needed or on terms acceptable to us.

In 2001, we entered into two significant financing agreements: In May, we
entered into an equity line enabling us to draw up to $30,000,000 subject to
various restrictions, and we did draw down $4,000,000 in July; and in December,
we issued 3% convertible preferred stock for $5,000,000 gross. In addition,
under the terms of the financing agreement we entered into in 2000 with
Millennium Partners, LP, Millennium exercised its final option to purchase
$2,000,000 of our common stock; that agreement has now terminated. (See
"Liquidity and Capital Resources" below for further detail on each of these
transactions.)

In addition, we received two grants from the National Institutes of Health,
one for work on hepatitis to be carried out jointly by us and Stanford
University, and one focusing on the effort to identify liver stem and progenitor
cells for the treatment of liver diseases. Although the grants are relatively
small ($300,000 a year for two years and $225,000 a year for four years,
respectively, and dependent on availability of funds and satisfactory progress),
we are very pleased by this recognition of our work by the agency.

Our results of operations have varied significantly from year to year and
quarter to quarter and may vary significantly in the future due to the
occurrence of material recurring and nonrecurring events, including without
limitation the receipt and payment of recurring and nonrecurring licensing
payments, the initiation or termination of research collaborations, the on-going
expenses to lease and maintain our facilities in Rhode Island and the increasing
costs associated with our move to a larger facility in California. To expand and
provide high quality systems and support to our Research and

25

Development programs, we will need to hire more personnel, which will lead to
higher operating expenses.

The Company believes the following critical accounting policies affect its
more significant judgments and estimates used in the preparation of its
consolidated financial statements:

USE OF ESTIMATES

The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States, that requires
management to make estimates and assumptions that affect the amounts reported in
the consolidated financial statements. Actual results could differ from these
estimates.

STOCK-BASED COMPENSATION

The Company's employee stock option plan is accounted for under Accounting
Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to
Employees." The Company grants qualified stock options for a fixed number of
shares to employees with an exercise price equal to the fair market value of the
shares at the date of grant. In accordance with APB 25, the Company recognizes
no compensation expense for qualified stock option grants. The Company also
issues non-qualified stock options for a fixed number of shares to employees
with an exercise price less than the fair market value of the shares at the date
of grant. When such options vest, the Company recognizes the difference between
the exercise price and fair market value as compensation expense in accordance
with APB 25.

For certain stock options granted to non-employees, the Company accounts for
these grants in accordance with FAS No. 123--accounting for stock-based
compensation and EITF 96-18--accounting for equity instruments that are issued
to other than employees for acquiring, or in conjunction with selling, goods or
services, and accordingly, recognizes as expense the estimated fair value of
such options as calculated using the Black-Scholes valuation model, and is
remeasured during the service period. Fair value is determined using
methodologies allowable by FAS No. 123. The cost is amortized over the vesting
period of each option or the recipient's contractual arrangement, if shorter.

LONG-LIVED ASSETS

The Company routinely evaluates the carrying value of its long-lived assets.
The Company records impairment losses on long-lived assets used in operations
when events and circumstances indicate that assets may be impaired and the
undiscounted cash flows estimated to be generated by the assets are less than
the carrying amount of those assets. If an impairment exists, the charge to
operations is measured as the excess of the carrying amount over the fair value
of the assets.

RESEARCH AND DEVELOPMENT COSTS

The Company expenses all research and development costs as incurred.
Research and Development costs include costs of personnel, external services,
supplies, facilities and miscellaneous other costs.

RESULTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999

Revenues totaled $805,000, $74,000 and $5,022,000 for the years ending
December 31, 2001, 2000 and 1999, respectively. Revenues for 2001 are from
grants received from the National Institute of Health's Small Business
Innovation Research (SBIR) office for research relating to our Neural & Liver
stem cell programs ($505,000) and from the assignment to Modex
Therapeutics, Ltd., of our retained

26

rights to a portion of certain possible future revenues arising out of our sale
of our former Encapsulated Cell Technology (ECT) to Neurotech, S.A.($300,000).
Revenues for 2000 were from Neurotech, SA. in return for that sale of our ECT
intellectual property assets described above under "Research and Development
Programs" above. Revenues for 1999 were from collaborative agreements, earned
primarily from a Development, Marketing and License Agreement with AstraZeneca
Group plc, which was signed in March 1995 and which related to the ECT. The
decrease in revenues from 1999 to 2000 resulted primarily from the June 1999
termination of the agreement with AstraZeneca. The increase from 2000 to 2001
was primarily due to the receipt of money from grants. There were no receipts
from grants in 2000.

Research and development expenses totaled $8,603,000 in 2001, as compared to
$5,979,000 in 2000 and $9,984,000 in 1999. The increase of $2,624,000, or 44%,
from 2000 to 2001 was primarily attributable to the costs related to leasing a
larger facility and an increase in personnel to facilitate the expansion of our
research and initiate development. Our program in neural stem and progenitor
cells has entered the preclinical stage, as we focus increasingly on testing
human neural stem cells in small animal models of human diseases, both in-house
and through external academic collaborators. In our liver stem cell program, we
are intensifying our efforts to identify liver stem and progenitor cells. In
part, we will do this by following up studies we have done showing that purified
blood stem cells can give rise to liver tissue, to seek a possible transitional
cell transitional between the blood stem cells and the mature liver cells. Our
pancreas program is concentrated on the use of animal models, available through
a consortium of academic collaborators, to attempt to identify and test
candidate stem cells for use in the treatment of diseases such as certain types
of diabetes, and is being carried on for the present primarily through those
collaborators. The decrease of $4,005,000 or 40%, from 1999 to 2000, was
primarily attributable to the wind-down of research activities relating to our
ECT, precipitated by termination of the agreement with AstraZeneca.

General and administrative expenses were $3,788,000 in 2001, compared with
$3,361,000 in 2000 and $4,927,000 in 1999. The increase of $427,000 or 13%, from
2000 to 2001 was primarily attributable to the related costs of an increase in
personnel, which included the hiring of senior management personnel as part of
the reorganization and consolidation of our operations in California, and the
costs related to leasing a larger facility. The decrease of $1,566,000 or 32%
from 1999 to 2000 was due to the wind-down of our ECT and relocation of our
headquarters in October1999 from Rhode Island to California.

Wind-down expenses related to our ECT research, our Rhode Island operations
and the transfer of our headquarters to California totaled $0, $3,327,000 and
$6,048,000 for 2001, 2000 and 1999, respectively. 1999 expenses included
accruals of approximately $1.6 million for employee severance costs,
$1.9 million in losses and reserves for the write-down of related patents and
fixed assets, $1.2 million for our costs of settlement of a 1989 funding
agreement with the Rhode Island Industrial Recreational Building Authority,
$700,000 of estimated additional carrying costs through June 30, 2000, and other
related expenses totaling $760,000.

During 2000, we incurred approximately $290,000 of costs in excess of the
amounts accrued as of December 31, 1999 for the carrying costs, including lease
payments, property taxes and utilities, through the expected June 30, 2000
disposition of the Rhode Island facilities. During the third and fourth quarters
of 2000 we incurred additional $1.3 million in carrying costs for the Rhode
Island facilities, as we were unable to dispose of them as expected. We created
a reserve of $1,780,000 related to the carrying costs for the Rhode Island
facilities through 2001. In the year 2001 we utilized all of the reserve. We
have subleased substantial portions of the facilities and are actively seeking
to sublease, assign or sell our remaining interests in the properties. However,
there can be no assurance that we will be able to dispose of these facilities in
a reasonable time, if at all. As we cannot predict the exact disposal date of
these properties, we will record all future expenses as they incur as normal
operating expenses.

27

Interest income for the years ended December 31, 2001, 2000 and 1999 totaled
$201,000, $304,000 and $564,000, respectively. The average cash and cash
equivalents were $9,034,000, $5,668,000 and $10,663,000 in 2001, 2000 and 1999,
respectively. The decrease in interest income from 2000 to 2001 was attributable
to the lower interest rate on overnight and money market funds. The decrease in
interest income from 1999 to 2000 to 2001 was attributable to lower average
balances.

In 2001, interest expense was $246,000, compared to $273,000 in 2000 and
$335,000 in 1999. Interest expense for year 2001 was charged against the
wind-down reserve, as the expense was part of the bond payments related to the
Rhode Island facilities. The decrease from 1999 to 2000 to 2001 was attributable
to lower outstanding debt and capital lease balances.

Gain on sale of short-term investments relates to the sale of Modex shares.
On January 9, 2001, we sold 22,616 Modex shares for a net price of 182.00 Swiss
francs per share, which converted to $112.76 per share, for total proceeds and a
realized gain of $2,550,230. On April 30, 2001, we sold our remaining shares in
Modex for a net price of 87.30 Swiss Francs per share, which converted to
approximately $50.51 for total proceeds and a realized gain of $5,232,000, net
of commissions and fees. We no longer hold any shares of Modex.

The net loss in 2001, 2000 and 1999 was $3,446,000, $11,125,000, and
$15,709,000, respectively. The loss per share was $0.19, $.57 and $.84 in 2001,
2000 and 1999, respectively. The decrease from 2000 to 2001 is primarily
attributable to a realized gain of $7,782,000 from our sale of Modex shares in
2001, offset by an increase in operating expenses attributable to an increase in
personnel and our move to a larger facility. The decrease from 1999 to 2000 was
primarily attributable to the wind-down of our encapsulated cell technology
research and our Rhode Island operations and offset by the elimination of
revenue from the Astra Agreement.

DEEMED DIVIDENDS RELATED TO CONVERTIBLE PREFERRED STOCK.

In 2001, we recorded a deemed dividend of $743,667 related to the 3%
Cumulative Convertible Preferred Stock (see note 11 to the financial statements)
which includes the accretion of common stock warrants, the accretion of the
beneficial conversion feature and the accretion of related issuance costs. The
aggregate accretion value associated with the warrants, beneficial conversion
feature and issuance costs were included in the calculation of net loss
applicable to common stockholders.

In 2000 we recorded a deemed dividend aggregating $481,000 related to the 6%
Cumulative Convertible Preferred Stock (see note 11 to the financial
statements). The dividend reflects the value of warrants issued and the
beneficial conversion feature. In November 2000, the FASB issued Emerging Issues
Task Force Issue No. 00-27, "Application of EITF Issue No. 98-5, Accounting for
Convertible Securities with Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios, to Certain Convertible Instruments" ("EITF
00-27"). Prior to adoption of EITF 00-27, we recognized $216,000 of deemed
dividend on preferred stock. Upon adoption of the new accounting principle, we
have presented an additional deemed dividend of $265,000 as a cumulative effect
of a change in accounting principle as allowed for in EITF 00-27

LIQUIDITY AND CAPITAL RESOURCES

Since our inception, we have financed our operations through the sale of
common and preferred stock, the issuance of long-term debt and capitalized lease
obligations, revenues from collaborative agreements, research grants and
interest income.

We had cash and cash equivalents totaling $13,697,000 at December 31, 2001.
Cash equivalents are invested in US Treasuries with maturities of less than
90 days. We used $10.5 million, $6.3 million, and $11.9 million of cash, in
2001, 2000 and 1999 respectively, in our operating activities. The increase in
cash used in 2001 is the result of increased research and development spending
in 2001 over 2000.

28

Our liquidity and capital resources were, in the past, significantly
affected by our relationships with corporate partners, which were related to our
former ECT. These relationships are now terminated, and we have not yet
established corporate partnerships with respect to our stem cell technology. Our
liquidity and capital resources have, in the past, also been affected by our
holdings of Modex, all of which holdings have now been sold, resulting in
proceeds to us of $7,782,000 in 2001.

On April 13, 2000, we sold 1,500 shares of our 6% cumulative convertible
preferred stock plus warrants for a total of 75,000 shares of our common stock
to two members of our Board of Directors for $1,500,000, on terms more favorable
to us than we were able to obtain from outside investors. The face value of the
shares of preferred stock is convertible at the option of the holders into
common stock at a current conversion price of $3.77 per share. The holders of
the preferred stock have liquidation rights equal to their original investments
plus accrued but unpaid dividends. Any unconverted preferred stock will be
converted, at the applicable conversion price, on April 13, 2002. The warrants
expire on April 13, 2005. The preferred stock is redeemable in the event of
liquidation or change of control of the Company. A purchaser could acquire a
majority of the voting power of the outstanding stock, without Company approval,
thereby triggering a redemption. Accordingly, the Company has reclassified the
6% cumulative convertible preferred stock out of permanent equity for all
periods presented, in accordance with the transition guidance of EITF D-98.

On August 3, 2000, we completed a $4 million common stock financing
transaction with Millennium Partners, LP at $4.33 per share. In the purchase
agreement, we granted Millennium an option to purchase up to an additional
$3 million of our common stock. Millennium exercised its option to purchase
$1 million of our common stock on Aug 23, 2000 at $5.53 per share. On June 8,
2001, Millennium exercised its remaining option to purchase $2 million of our
common stock at $4.3692 per share. As a result of the financing agreement,
Millennium received five year warrants to purchase 101,587 shares of common
stock at $4.725 per share, 19,900 shares of common stock at $6.03 per share, and
50,352 shares at $4.7664 per share. We may call the warrants at any time at
$7.875, $10.05 and $7.944 per underlying share respectively. In addition to the
afore-mentioned warrants, Millennium was issued adjustable warrants in
connection with the original $4 million purchase, each of which entitled
Millennium to receive additional shares on eight dates beginning six months from
the respective closing dates and every three months thereafter. The exercisable
price per share under the adjustable warrant was $0.01. Millennium exercised the
first of the adjustable warrants to purchase 463,369, 622,469, and 25,804 shares
on March 30, 2001, July 26, 2001 and August 15, 2001 respectively at $0.01 per
share. On December 4, 2001, we entered into an agreement with Millennium under
which we issued 176,101 shares of our common stock as a final cashless exercise
of all outstanding adjustable warrants that Millennium was entitled to or would
be entitled to. Immediately following delivery of these shares, any further
right to acquire common stock under these adjustable warrants were cancelled by
the agreement.

On May 10, 2001, we entered into a common stock purchase agreement with
Sativum Investments Limited for the potential future issuance and sale of up to
$30,000,000 of our common stock, subject to restrictions and other obligations.
We, at our sole discretion, may draw down on this facility, sometimes termed an
equity line, from time to time, and Sativum is obligated to purchase shares of
our common stock at a 6% discount to a volume weighted average market price over
the 20 trading days following the draw-down notice. We are limited with respect
to how often we can exercise a draw down and the amount of each draw down. We
delivered a draw down notice to Sativum Investments Limited, dated as of
July 11, 2001, exercising our right to draw down up to $5,000,000 at a
market-based share price not less than $5.00 per share beginning July 12, 2001.
Sativum purchased a total of 707,947 shares of our common stock at an average
purchase price of $5.65 per share, net of Sativum's discount of six percent.
Because the market based price of our common stock was less than $5.00 for 4
trading days during the draw down period, pursuant to the terms of our with
Sativum agreement, our $5,000,000 request was reduced to $4,000,000. Our
placement agents, Pacific Crest Securities, Inc. and Granite

29

Financial Group, Inc., received $80,000 and $40,000, respectively, as placement
fees in connection with this draw down, resulting in net proceeds to us of
$3,603,407, after paying escrow fees and other associated costs. In connection
with our execution of the common stock purchase agreement with Sativum, we
issued three three-year warrants to purchase an aggregate of 350,000 shares of
our common stock at $2.38 per share to Sativum (250,000 shares), Pacific Crest
Securities Inc. (75,000 shares) and Granite Financial Group, Inc. (25,000
shares). Our placement agents have exercised their warrants in full, and we have
received payment of $238,050 for the shares issued to them.

On December 4, 2001, we issued 5,000 shares of 3% Cumulative Convertible
Preferred Stock to Riverview Group, L.L.C., a wholly owned subsidiary of
Millennium Partners. We received total proceeds of $4,727,515 net of the fee to
Cantor Fitzgerald and other associated costs. This preferred stock is
convertible into shares of our common stock at a current conversion price of
$2.00 per share of common stock. There is a mandatory redemption provision in
the preferred stock under which any preferred stock remaining on December 4,
2003, is redeemed on that date. The conversion price may be below the trading
market price of the stock at the time of conversion. In connection with the
preferred stock agreement, we issued to Riverview Group a warrant to purchase
350,877 shares of our common stock at a price of $3.42 per share. The warrant
expires on December 4, 2005. We paid Cantor Fitzgerald & Co., our financial
advisor in connection with the transaction, a fee of $200,000 and issued them a
warrant for 146,199 shares exercisable at $3.42 per share.

We continue to have outstanding obligations in regard to our former
facilities in Lincoln, Rhode Island, including lease payments and operating
costs of approximately $1,000,000 for 2002, net of subtenant income. We have
subleased a portion of these facilities and are actively seeking to sublease,
assign or sell our remaining interests in these facilities. Failure to do so
within a reasonable period of time will have a material adverse effect on our
liquidity and capital resources. Our total operating lease payments for the
years 2002 to 2013 amounts to $25,141,000, and our total capital lease payments
for the years 2002 to 2014 amounts to $4,107,000.

We have limited liquidity and capital resources and must obtain significant
additional capital resources in the future in order to sustain our product
development efforts, for acquisition of technologies and intellectual property
rights, for preclinical and clinical testing of our anticipated products,
pursuit of regulatory approvals, acquisition of capital equipment, laboratory
and office facilities, establishment of production capabilities and for general
and administrative expenses. Our ability to obtain additional capital will be
substantially dependent on our ability to obtain partnering support for our stem
cell technology and, in the near term, on our ability to realize proceeds from
the sale, assignment or sublease of our facilities in Rhode Island. Failure to
do so will have a material effect on our liquidity and capital resources. Until
our operations generate significant revenues from product sales, we must rely on
cash reserves and proceeds from equity and debt offerings, proceeds from the
transfer or sale of our intellectual property rights, equipment, facilities or
investments, and government grants and funding from collaborative arrangements,
if obtainable, to fund our operations.

We intend to pursue opportunities to obtain additional financing in the
future through equity and debt financings, grants and collaborative research
arrangements. The source, timing and availability of any future financing will
depend principally upon market conditions, interest rates and, more
specifically, on our progress in our exploratory, preclinical and future
clinical development programs. Funding may not be available when needed--at all,
or on terms acceptable to us. While our cash requirements may vary, we currently
expect that our existing capital resources will be sufficient to fund our
operations through December of 2002. Lack of necessary funds may require us to
delay, scale back or eliminate some or all of our research and product
development programs and/or our capital expenditures or to license our potential
products or technologies to third parties.

With the exception of operating leases for facilities, we have not entered
into any off balance sheet financial arrangements and have not established any
special purpose entities. We have not guaranteed

30

any debts or commitments of other entities or entered into any options on
non-financial assets. During 2001, we were party to a space-sharing agreement
entered into between us and Celtrans, LLC. Dr. Irving Weissman, a member of our
Board of Directors and Chairman of our Scientific Advisory Board, was interim
Chief Executive Officer and is a member of the Board of Managers of Celtrans, a
privately-owned biotechnology company that is also a tenant in the building in
which the Company is located. Under the agreement, which was effective as of
September 1, 2001, Celtrans or, with our approval, a subtenant of Celtrans, may
use certain animal space in our facility, which we do not currently require for
our own use. Celtrans pays the Company $16,122 per month under the space-
sharing agreement, at the same rate per square foot as we receive from Stanford
University, with which we also have an agreement for sharing the animal
facility. In addition, Dr. Weissman remains a consultant to us under an
agreement entered in 1997.

RECENT ACCOUNTING PRONOUNCEMENTS

In July 2001, the FASB issued Statement of Financial Accounting Standards
No. 141, "Business Combinations" (Statement 141). This Statement addresses
financial accounting and reporting for business combinations. Statement 141
supersedes APB Opinion No. 16, Business Combinations, and amends or supersedes a
number of interpretations of that Opinion. Statement 141 requires that (1) all
business combinations be accounted for by a single method--the purchase method,
(2) all intangible assets acquired in a business combination are to be
recognized as assets apart from goodwill if they meet one of two criteria--the
contractual-legal criterion or the separability criterion and (3) in addition to
the disclosure requirements in Opi