ESSENTIAL THERAPEUTICS INC - 10-Q Quarterly Report

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 whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ¨ No x

Number of shares of Common Stock, $0.001 par value per share, outstanding as of April 30, 2003: 18,939,941

Essential Therapeutics, Inc. (“Essential”, or the “Company”), is a biopharmaceutical company committed to the development of breakthrough products for the treatment of life-threatening diseases. Essential is dedicated to commercializing novel small molecule products addressing important unmet therapeutic needs.

The accompanying unaudited condensed consolidated financial statements have not been reviewed by our independent auditors. Upon filing for protection under Chapter 11 of the U.S. Bankruptcy Code as described below, our engagement of Ernst & Young LLP was suspended pending authorization of the Bankruptcy Court to re-engage Ernst & Young LLP and enable them to provide professional services to us.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete consolidated financial statements. In the opinion of management, all adjustments, which consist of normal recurring accruals, considered necessary for a fair presentation have been included. The results of operations for the interim periods shown herein are not necessarily indicative of operating results for the entire year.

This unaudited financial data should be read in conjunction with the consolidated financial statements and footnotes contained in our annual report on Form 10-K for the year ended December 31, 2002, which was filed with the Securities and Exchange Commission on March 31, 2003.

The Nasdaq National Market previously informed us that we were not in compliance with certain continued listing requirements. On February 7, 2003, we received formal notice that the Company’s request for continued listing would be considered at a hearing to be held before a panel authorized by the Nasdaq National Market. On March 20, 2003, the Company presented its appeal at the hearing. On April 10, 2003 we were informed of Nasdaq’s determination to delist the Company’s securities from The Nasdaq Stock Market effective with the opening of business on April 14, 2003. The Company is currently trading on the Over-the-Counter Bulletin Board, or OTCBB, under the symbol ETRX.OB.

As a result of delisting, the holders of Series B preferred stock had the right to cause the Company to redeem their shares of Series B preferred stock at a price of $1,000 per share in accordance with the terms of the Series B preferred stock. In April 2003, the holders of 60,000 shares of Series B preferred stock exercised their right to require the Company to redeem their preferred stock. This resulted in our having a redemption obligation to purchase this stock for $60.0 million subject to the limitations of Delaware law as to the immediate enforceability of payment in full. We do not have the funds available to redeem 60,000 shares of Series B preferred stock.

On May 1, 2003, Essential Therapeutics, Inc. and its wholly owned subsidiaries, The Althexis Company, Inc. and Maret Corporation, filed for protection under Chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware. Essential has filed a Plan of Reorganization (“the Plan”) which details its intent to make payment in full of obligations owed to certain creditors and providing for the recapitalization of the company as a privately-held entity, held solely by the former holders of Essential’s Series B preferred stock.

The Company and its subsidiaries remain in possession of their assets and properties and continue to operate their businesses each as a “debtor-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and orders of the Bankruptcy Court.

We previously announced that we began discussions with an entity to acquire a portion of our California operations, including the possible sale of our California facilities, the selection of pre-clinical infectious disease programs and the hiring of a portion of our employees in California. It was our desire to identify a buyer for our California operations by March 31, 2003 and we previously announced that we would implement our plan to gradually eliminate California operations if we did not enter into definitive documents by March 31, 2003. We were unable to negotiate mutually agreeable terms with a buyer of our California operations by March 31, 2003. Consequently, on March 31, 2003, we eliminated 44 positions. The employees remaining in California will either assist with the closure of certain California facilities or assist in the performance of the Company’s

obligations under its collaborative agreement with Fujisawa Pharmaceutical Co., Ltd, which is expected to conclude in the third quarter of 2003.

The Company considers all highly liquid investments with a maturity from date of purchase of three months or less to be cash equivalents. The Company maintains deposits with financial institutions in the United States and invests its excess cash in commercial paper and corporate debt securities which bear minimal risk.

Management determines the appropriate classification of securities at the time of purchase and reevaluates such designation as of each balance sheet date. At March 31, 2003 and December 31, 2002, respectively, all securities were designated as available-for-sale. These securities are stated at fair value based upon market quotes, with the unrealized gains and losses reported in stockholders’ equity. Amortization of premiums and discounts are included in interest income. Realized gains and losses and declines in value judged to be other than temporary, if any, are included in other income. The cost of securities sold is based on the specific identification method.

Cash and cash equivalents are primarily held at one major financial institution in the United States. Deposits with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and, therefore, bear minimal risk. Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of marketable securities. Marketable securities consist of high-grade corporate bonds, asset-backed and U.S. government agency securities. The Company’s investment policy limits the amount the Company may invest in any one type of investment, thereby reducing credit risk concentrations.

Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, which varies between one to seven years. Equipment under capital lease and leasehold improvements are amortized using the straight-line method over the estimated useful lives of the assets or the term of the lease, whichever is shorter.

Goodwill is the excess of any purchase price over the estimated fair market value of net tangible assets acquired not allocated to specific intangible assets. In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill and indefinite-lived intangible assets are no longer amortized but are reviewed annually for impairment or more frequently if impairment indicators arise. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives.

In June 2002 in conjunction with the restructuring detailed in Note 3, Essential recorded a $6.3 million impairment charge for the goodwill associated with the acquisition of Althexis. An impairment test indicated that no goodwill was present due to the decision not to pursue the research activities at Althexis. The remaining goodwill as of March 31, 2003 of $1.5 million is the goodwill associated with the acquisition of Maret. As of March 31, 2003, the value of this goodwill has not been proven to be impaired. This goodwill will continue to be reviewed annually for impairment or more frequently if impairment indicators arise and will be adjusted as necessary.

Effective January 1, 2000, the Company changed its method of accounting for revenue recognition in accordance with Staff Accounting Bulletin No. 101—Revenue Recognition in Financial Statements. Essential previously recognized nonrefundable upfront license fees as revenue when received and when all contractual obligations of the Company relating to the fees had been fulfilled. Under the new accounting method adopted retroactively to January 1, 2000, the Company recognizes revenues related to research contracts over the related funding periods for each contract. The Company is required to perform research activities as

specified in each respective agreement on a best efforts basis and the Company is reimbursed based on the costs associated with the number of full-time equivalent employees working on each specific contract, which is generally recognized on a ratable basis as the research services are performed. Deferred revenue may result when the Company receives funding prior to commencing research efforts, or when the Company has not incurred the required level of effort during a specific period in comparison to funds received under the respective contracts. Nonrefundable license payments received at the inception of a collaboration agreement are recognized over the expected research term on a ratable basis. Milestone payments that are “at risk” at the inception of a collaborative effort are recognized upon the achievement of the milestone, such as selection of candidates for drug development following a screening effort, the commencement of clinical trials or receipt of regulatory approvals. The Company reports other revenues which principally relate to the sale of molecular diversity samples to pharmaceutical or biotechnology companies for use in their drug discovery programs.

Essential’s research and development costs are expensed as incurred. Research and development expenses include, but are not limited to, payroll and personnel expenses, contract research services, lab supplies, facilities costs and outside services. The Company’s research and development expenses for the three months ended March 31, 2003 and 2002 were $4.3 million and $5.6 million, respectively.

The Company follows Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations, in accounting for its stock-based compensation plans, rather than the alternative fair value accounting method provided for under SFAS No. 123, “Accounting for Stock-Based Compensation.” Under APB 25, when the exercise price of options granted under these plans equals the market price of the underlying stock on the date of grant, no compensation expense is required. In accordance with Emerging Issues Task Force (EITF) 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” the Company records compensation expense equal to the fair value of options granted to non-employees over the vesting period, which is generally the period of service.

The following tables illustrate the assumptions used and the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to employee stock-based compensation. The Company has computed the pro forma disclosures required under SFAS No. 123 and SFAS No. 148 for all employee stock options granted using the Black-Scholes option pricing model prescribed by SFAS No. 123.

The Company’s stock option grants vest over several years and the Company intends to grant varying levels of stock options in the future periods. Therefore, the effects on 2003 and 2002 pro forma net loss and net loss per common share of expensing the estimated fair value of stock options and common shares issued pursuant to the stock option plan are not necessarily representative of the effects on reported results from operations for future years.

Deferred compensation, which relates primarily to the intrinsic value of unvested stock options and restricted stock assumed in the acquisition of Althexis, is presented as a reduction of stockholders’ equity and is being amortized over the vesting period of the applicable options or restricted stock using the straight-line method.

Comprehensive income (loss) is comprised of net loss and other comprehensive income (loss). Other comprehensive income (loss) includes some changes in equity that are excluded from net loss. Specifically, unrealized holding gains and losses on our available-for-sale securities, which were reported separately in stockholders’ equity, are included in accumulated other comprehensive income (loss).

During the first quarter of 2003, the Company incurred a restructuring charge of $4.4 million. The charge was in connection with the Company’s previously announced decision to phase-out the Mountain View, California operations beginning in March 2003. Specific actions taken included the reduction of the Company’s workforce by 44 employees, the disposition of excess equipment and the consolidation of facilities.

In the second quarter of 2002, the Company had recorded a restructuring charge of approximately $10.7 million when it reduced the Company’s workforce by 73 employees, disposed of excess equipment and consolidated facilities in both Waltham, Massachusetts and in Mountain View, California. In the fourth quarter of 2002, the Company recorded an additional restructuring charge of $0.6 million related to the write-down of additional leasehold improvements on excess facilities in Mountain View, California. The following table summarizes the activity during the first quarter of 2003 related to the restructurings:

As of March 31, 2003, the majority of the remaining balance of the restructuring charges included severance and costs associated with exiting certain leases and other facility exit costs which will not have future benefits and which will be paid over the respective remaining lease terms. Of the total restructuring charges unpaid as of March 31, 2003, $0.6 million has been classified as a long-term liability in the accompanying consolidated balance sheets, as these charges are related to lease commitments that extend past a year.

During the first quarter of 2003 in conjunction with the restructuring plan detailed in Note 5, the Company committed to sell certain scientific equipment with a carrying value of approximately $0.9 million. The carrying value of the scientific equipment was adjusted to its fair value less costs to sell, amounting to approximately $0.6 million, which was determined based on quoted market prices of similar assets. The resulting $0.3 million non-recurring impairment loss was recorded as part of the restructuring charge in the first quarter 2003 condensed consolidated statements of operations. The carrying value of the scientific equipment is separately presented in the “Assets Held for Sale” caption in the condensed consolidated balance sheets as of March 31, 2003.

During the second quarter of 2002 in conjunction with the restructuring plan detailed in Note 5, the Company committed to sell certain scientific equipment with a carrying value of approximately $1.4 million. The carrying value of the scientific equipment was adjusted to its fair value less costs to sell, amounting to $0.7 million, which was determined based on quoted market prices of similar assets. The resulting $0.8 million non-recurring impairment loss was recorded as part of the restructuring charge in the second quarter 2002 condensed consolidated statements of operations. The carrying value of the scientific

equipment is separately presented in the “Assets Held for Sale” caption in the condensed consolidated balance sheets and as of March 31, 2003, $0.2 million is still classified as “Assets Held for Sale”.

The Company believes that all items classified as held for sale will be sold no later than the end of the year.

In management’s opinion, the restructuring detailed in Note 5 represented an indication of impairment of recorded goodwill. In accordance with SFAS No. 142, an interim test of goodwill impairment was performed as of June 30, 2002. In assessing the recoverability of the goodwill associated with the acquisition of Althexis, we made assumptions regarding estimated future cash flows associated with the technologies that were under development by Althexis and other factors to determine the fair value of the intangible assets acquired. The results of the impairment test indicated that no goodwill was present due to the decision not to pursue the research activities at Althexis and accordingly, we recognized a one-time goodwill impairment charge of $6.3 million in the second quarter of 2002, which was included in the restructuring charge.

The remaining goodwill as of March 31, 2003 of $1.5 million is the goodwill associated with the acquisition of Maret. As of March 31, 2003, the value of the goodwill has not been proven to be impaired. This goodwill will continue to be reviewed annually for impairment or more frequently if impairment indicators arise and will be adjusted as necessary.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated With Exit or Disposal Activities.” SFAS No. 146 nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring).” SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Therefore, SFAS No. 146 eliminates the definition and requirements for recognition of exit costs in EITF No. 94-3. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. In conjunction with the planned phase out of the California operations in March 2003, we expect to incur severance charges of $3.5 million, charges for the reduction in the value of leasehold improvements and the carrying value of equipment of $1.4 million, as well as charges of approximately $0.5 million for facility exit costs will be accounted for in accordance with SFAS No. 146.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation–Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition to the fair value method of accounting for stock-based employee compensation. SFAS No. 148 also requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. The disclosure requirements for interim financial statements containing condensed consolidated financial statements are effective for interim periods beginning after December 15, 2002. The Company adopted SFAS No. 148 in the fourth quarter of 2002, and the adoption did not have a material impact on its results of operations or financial position.

On April 30, 2003, the Company repaid the $1,875,000 balance due on its term loan with Fleet National Bank. In addition, on April 30, 2003, the Company entered into lease termination agreements with certain landlords that allow the Company to cease future rental payments for its California facilities upon vacating these facilities in exchange for payments aggregating approximately $1.3 million. The Company expects to vacate its California locations in the third quarter of this year.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Essential is a biopharmaceutical company committed to the development of breakthrough products. Essential is dedicated to commercializing novel small molecule products addressing important unmet therapeutic needs. Essential has wound healing and antibiotic programs.

As a result of delisting, the holders of Series B preferred stock had the right to cause the Company to redeem their shares of Series B preferred stock at a price of $1,000 per share in accordance with the terms of the Series B preferred stock. In April 2003, the holders of 60,000 shares of Series B preferred stock exercised their right to require the Company to redeem their preferred stock. This resulted in the Company having a redemption obligation to purchase this stock for $60.0 million subject to the limitations of Delaware law as to the immediate enforceability of payment in full. We do not have the funds available to redeem 60,000 shares of Series B preferred stock.

We previously announced that we began discussions with an entity to acquire a portion of our California operations, including the possible sale of our California facilities, and a selection of pre-clinical infectious disease programs along with the hiring of a portion of our employees in California. It was our desire to identify a buyer for our California operations by March 31, 2003 and we previously announced that we would implement our plan to phase out our California operations if we did not enter into definitive documents by March 31, 2003. We were unable to date to negotiate mutually agreeable terms with a buyer of our California operations. Consequently, on March 31, 2003, we eliminated 44 positions. The employees remaining in California will either assist with the closure of certain California facilities or assist in the performance of the Company’s obligations under its collaborative agreement with Fujisawa Pharmaceutical Co., Ltd, which is expected to conclude in the third quarter of 2003. In connection with the phase-out of the California operations, we incurred restructuring charges of approximately $4.4 million, consisting of $2.5 million in severance, $1.4 million for the write-down of the value of lease hold improvements and equipment and $0.5 million in facility exit costs.

On March 11, 2002, we completed the acquisition of Maret, as a result of which Maret became a wholly owned subsidiary of Essential.

On October 24, 2001, we completed the acquisition of The Althexis Company, Inc., as a result of which Althexis became a wholly owned subsidiary of Essential.

The acquisitions were accounted for under the purchase method of accounting. The condensed consolidated financial statements discussed herein reflect the inclusion of the results of Maret from the date of acquisition. All material intercompany accounts and transactions have been eliminated in consolidation.

We have entered into collaboration agreements with major pharmaceutical and biotechnology companies relating to a range of therapeutic products and services. These agreements provide us with the opportunity to receive license fees and research funding, and may provide certain additional payments contingent upon our achievement of research and regulatory milestones and

royalties and/or share profits if our collaborations are successful in developing and commercializing products. The collaborations which we consider material to our business are:

In December 2001, the SEC requested that all registrants discuss their most “critical accounting policies” in management’s discussion and analysis of financial condition and results of operations. The guidance defines a critical accounting policy as one that is both important to the portrayal of the company’s financial condition and results and one that requires management’s most subjective judgment, as most often it requires the need to make estimates about the effect of matters that are highly uncertain. On an on-going basis, we evaluate our estimates, including those related to accruals and revenue recognition. We base our estimates on historical experience and facts and circumstances that exist at each balance sheet date. While our significant accounting policies are described in these financial statements, we believe the following accounting policies to be critical:

Goodwill—Goodwill is the excess of any purchase price over the estimated fair market value of net tangible assets acquired not allocated to specific intangible assets. In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill and indefinite-lived intangible assets are no longer amortized but are reviewed annually for impairment or more frequently if impairment indicators arise. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives.

Revenue Recognition—As part of our strategy to enhance our research and development capabilities and to fund, in part, our capital requirements, we have entered into collaboration agreements with several major pharmaceutical companies. Pursuant to our collaboration agreements, we received license fees, milestone payments and research support payments, and may potentially receive additional research support payments, milestone payments and royalty payments in the future. License payments are

typically non-refundable up-front payments for licenses to develop, manufacture and market any products that are developed as a result of collaboration. These payments are recognized over the expected research term on a ratable basis. A change in the term of a collaborative research agreement may result in a change of the period over which an up-front, non-refundable license payment is recognized. Such a change would be treated prospectively at the time of the extension. Research support payments are typically contractually obligated payments to fund research and development over the term of collaboration. Deferred revenue may result when we receive funding prior to commencing research efforts, or when we have not incurred the required level of effort during a specific period in comparison to funds received under the respective contracts. Milestone payments are contingent payments that are made only upon the achievement of specified milestones, such as selection of candidates for drug development, the commencement of clinical trials or receipt of regulatory approvals. Milestone payments that are “at risk” at the inception of a collaborative effort are recognized upon the achievement of the milestone. If drugs are successfully developed and commercialized as a result of our collaboration agreements, we will receive royalty payments based upon the net sales of those drugs developed in accordance with the terms of the collaboration agreements. In addition, we have derived other revenues principally through the sale of molecular diversity to other pharmaceutical and biotechnology companies for use in their research programs, and through short-term contract research.

Revenues. Total revenues for the first quarter of 2003 were $2.7 million compared to $3.1 million in the first quarter of 2002 and were derived primarily from the major collaboration agreements with SPAH and Fujisawa. The decrease in revenues during the periods was due primarily to decreased research funding as a result of the conclusion of funded research with J&J and Pfizer. The decrease in the research funding was slightly offset by increased licensing and other revenue.

Research and Development Expenses. Research and development expenses for the first quarter decreased from $5.6 million in 2002 to $4.3 million in 2003, due primarily to the restructurings in June 2002 and March 2003 which effectively concluded all research activity in both the Waltham, Massachusetts and in the Mountain View, California facilities.

Research and development expenses consist of salary and related fringe benefit expenses as well as laboratory supplies and chemicals, outside contract services and facility costs. Members of our research and development team typically work on a number of development projects concurrently. We have not historically tracked separately the costs associated with our various projects so as to enable accurate disclosure of the actual costs incurred to date on a project by project basis. Due to the risks inherent in the drug development process we are unable to estimate with any certainty the costs we will incur in advancing our projects toward commercialization. We do expect our research and development costs to increase as we continue to advance our existing wound healing project through pre-clinical and clinical phases and as we potentially in-license new compounds and advance these compounds through development.

General and Administrative Expenses. General and administrative expenses for the first quarter increased from $2.2 million in 2002 to $2.8 million in 2003, due primarily to higher expenses for legal services, consulting, payroll, rent and other outside services. We expect general and administrative expenses to decrease in 2003 as a result of our restructurings in 2002 and the phase out of the California operations in 2003.

In-Process Research and Development Expenses. In connection with the acquisition of Maret, we recorded a non-recurring non-cash charge of $7.7 million for purchased in-process research and development in the first quarter of 2002. The purchased in-process research and development, which represents the fair value attributable to the technology acquired, was expensed on the acquisition date since the technology had not yet reached technological and commercial feasibility and had no future alternative uses. The income approach was utilized in valuing the in-process research and development. The fair value assigned to the in-process research and development was determined by discounting, to present value, the cash flows expected to result from each in-process research and development project once it has reached commercial feasibility. The discount rates used to discount projected cash flows ranged from 60% to 70%, depending on the risk related with each program and its estimated stage of completion at the time of the merger. The major risk associated with the timely completion and commercialization of products resulting from the purchased in-process research and development is the ability to confirm the safety and efficacy of the technology based on the data of both pre-clinical testing and long-term clinical trials. If these projects are not successfully developed, our future results of operations may be adversely affected.

Restructuring Expenses. Restructuring charges of $4.4 million were recorded in the first quarter of 2003 in connection with the phase-out of our California operations. The restructuring expenses consist of non-cash charges of $1.6 million and cash charges of $2.8 million. The $1.6 million in non-cash charges consist primarily of reductions in the carrying value of leasehold improvements, furniture and fixtures and computer and scientific equipment. The cash charges consist primarily of $2.5 million in severance and related costs and $0.3 million in costs to decontaminate and exit the facilities in California.

Interest Income, net. Interest income for the first quarter decreased from $280,000 in 2002 to $243,000 in 2003, due primarily to a decrease in average invested cash balances. Interest expense for the first quarter increased from $26,000 in 2002 to $30,000 in 2003, due primarily to the higher balances of existing debt.

As a result of delisting, the holders of Series B preferred stock had the right to cause the Company to redeem their shares of Series B preferred stock at a price of $1,000 per share in accordance with the terms of the Series B preferred stock. In April 2003, the holders of 60,000 shares of Series B preferred stock exercised their right to require the Company to redeem their preferred stock. This resulted in the Company having a redemption obligation to purchase this stock for $60.0 million, subject to the limitations of Delaware law as to the immediate enforceability of payment in full. We do not have the funds available to redeem 60,000 shares of Series B preferred stock.

Our Independent Auditor’s report to our audited financial statements for the period ended December 31, 2002 indicated that there was substantial doubt about our ability to continue as a going concern. It is difficult to assess the adequacy of our current cash position or project the funds needed to fund future operations as this is ultimately dependent on the results of the bankruptcy proceedings.

We have financed our operations since inception primarily through the sale of equity securities, through funds provided under collaboration agreements, through other revenues principally consisting of sales of molecular diversity and through equipment financing arrangements. As of March 31, 2003, we had received $126.8 million from the sale of common and preferred stock and $74.2 million from license fees, research support and milestone payments under collaboration agreements.

Cash, cash equivalents and marketable securities at March 31, 2003 were $24.6 million compared to $33.5 million at December 31, 2002. Trade and other receivables at March 31, 2003 were $1.0 million compared to $1.6 million at December 31, 2002. The decrease in cash during the first quarter of 2003 was primarily due to cash used by operations of $7.3 million, $416,000 in capital expenditures, $1.2 million in restricted cash and $199,000 in principal payments under our debt obligations. This decrease was partially offset by $242,000 in proceeds from debt financing and $39,000 in net proceeds from sales of fixed assets.

We invested $416,000 in capital expenditures in the first quarter of 2003 compared to $491,000 in the first quarter of 2002. We spent $401,000 in the first quarter of 2003 on building improvements related to our Waltham, Massachusetts building lease entered into in January 2002. We are financing these improvement expenditures with a bank term loan. We made principal payments under our debt obligations of $199,000 in the first quarter of 2003 compared to $275,000 in the first quarter of 2002. At March 31, 2003, the remaining balance on our debt obligations was $2.7 million.

During the first quarter of 2003, we restructured our California operations after we were unable to negotiate mutually agreeable terms with a potential buyer of our California operations. As of March 31, 2003, we eliminated 44 positions and we intend to ultimately cease operations in California. The employees remaining in California will either assist with the closure of certain California facilities or assist in the performance of the Company’s obligations under its collaborative agreement with Fujisawa Pharmaceutical Co., Ltd, which is expected to conclude in the third quarter of 2003. In connection with the phase out of the California operations, we recorded a restructuring charge of $4.4 million in the first quarter of 2003, which included cash charges of $2.8 million. The cash charges consist primarily of $2.5 million in severance and related costs and $0.3 million in costs

to decontaminate and exit the facilities in California. While the restructuring resulted in lower salaries and payroll related expenses, we expect to funnel these savings into the advancement of development programs.

The following table sets forth our contractual obligations as of March 31, 2003 and thus does not reflect the repayment of the Fleet term loan or the termination of the leases in California:

In October 2001, we completed an equity financing by way of a private placement of an aggregate of 60,000 shares of our Series B convertible redeemable preferred stock for a total purchase price of $60.0 million that by its terms is required to be redeemed in October 2006, or, upon the occurrence of specified adverse events, may be required to be redeemed sooner. Under the terms of our Series B convertible redeemable preferred stock agreements, we are required to obtain the approval of the preferred stockholders prior to incurring indebtedness above specified amounts. The excess of the fair value of the common stock issued to the Series B preferred stockholders over the fair value of the securities issuable pursuant to the original conversion terms is considered to be a deemed dividend to the Series B preferred stockholders. Accordingly, such dividend has been reflected as an increase in the net loss applicable to common stockholders for purposes of computing net loss per common share.

Following the failure of the holders of a majority of the outstanding shares of our common stock to approve the conversion of Essential’s Series B preferred stock into common stock, we received a Nasdaq Staff determination letter indicating that our securities would be delisted from the Nasdaq National Market due to our failure to comply with the Nasdaq National Market System listing criteria. On March 20, 2003, the Company presented its appeal at the hearing. On April 10, 2003 we were informed of Nasdaq’s determination to delist the Company’s securities from The Nasdaq Stock Market effective with the opening of business on April 14, 2003. The Company is currently trading on the Over-the-Counter Bulletin Board or OTCBB under the symbol ETRX.OB.

As a result of delisting, the holders of Series B preferred stock had the right to cause the Company to redeem their shares of Series B preferred stock at a price of $1,000 per share in accordance with the terms of the Series B preferred stock. In April 2003, the holders of 60,000 shares of Series B preferred stock exercised their right to require the Company to redeem their preferred stock. This resulted in the Company having a redemption obligation to purchase this stock for $60.0 million, subject to the limitations of Delaware law as to the immediate enforceability of payment in full. We do not have the funds available to redeem 60,000 shares of Series B preferred stock.

On May 1, 2003, Essential Therapeutics, Inc. and its wholly owned subsidiaries, The Althexis Company, Inc. and Maret Corporation filed for protection under Chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware. Essential has filed a Plan of Reorganization (“the Plan”) which details its intent to make payment in full of obligations owed to certain creditors and providing for the recapitalization of the company as a privately-held entity, held solely by the former holders of Essential’s Series B preferred stock.

We pledged $0.4 and $1.1 million for standby letters of credit of the same amounts, related to our Waltham, Massachusetts building lease entered into in January 2002. The terms of the standby letters of credit expire in 2009 and 2012, respectively. Additionally, we have pledged $0.1 million for a credit card line to finance operating expenses which expires in May 2003 and which will be automatically renewed.

We have approximately $0.7 million outstanding on a lease line for capital purchases. The lease line will be repaid in 48 equal monthly installments commencing in January 2003 at an interest rate of 9.94%.

In September 2002, we negotiated a $2.0 million term loan with Fleet National Bank to finance the build-out of our new corporate headquarters in Waltham, Massachusetts. The Company paid the loan in full on April 30, 2003.

On February 9, 2001, we filed a registration statement on Form S-3 for a “shelf” registration, which was amended on March 21, 2001. Pursuant to the registration statement, we may offer up to $35.0 million of newly issued common stock. The registration statement became effective in March 2001. While we have no current plans to do so, we may in the future offer additional shares of common stock under our “shelf” registration statement in order to finance our operations. If we do, we cannot assure you that additional funds will be available on favorable terms, or at all, or that any funds, if raised, would be sufficient to permit us to continue to conduct our operations. If adequate funds are not available, we may be required to curtail significantly or eliminate one or more of our research programs.

OUR COMMON STOCK HAS BEEN DELISTED, OUR SERIES B PREFERRED STOCKHOLDERS FILED NOTICES OF REDEMPTION AND WE FILED FOR BANKRUPTCY UNDER CHAPTER 11 OF THE US BANKRUPTCY CODE.

On April 14, 2003, our common stock was delisted from the Nasdaq National Market System. It now trades on the OTCBB under the symbol “ETRX.OB.”A delisting of our common stock from the Nasdaq National Market constituted a holder optional repurchase event under the terms of our outstanding Series B preferred stock, giving our Series B preferred stockholders the right to cause Essential to redeem the shares of preferred stock. In April 2003, holders of approximately 60,000 shares of preferred stock exercised their right to require us to redeem their shares. We do not have the funds to redeem these shares of Series B preferred stock. Consequently, on May 1, 2003 we filed for protection under Chapter 11 of the United States Bankruptcy Code. For a description of the holder optional repurchase event and the rights of the Series B preferred stockholders associated therewith, please see Note 10 to our consolidated financial statements filed with our Form 10-K for the year ended December 31, 2002. There can be no assurances that we can satisfactorily restructure our obligations or continue our operations. If we are forced to liquidate, the proceeds resulting from such liquidation will not be sufficient to satisfy all of our debts and obligations and we will not have proceeds available for distribution to our common stockholders.

The commencement of the Chapter 11 proceedings could adversely affect our relationships with our collaborative partners, suppliers or employees. If these relationships are adversely affected, our operations could be materially affected. Weakened operating results could adversely affect our ability to obtain confirmation of the Plan or to avoid financial difficulties after consummation of the Plan.

Even if the requisite acceptances are received, there can be no assurance that the Bankruptcy Court will confirm the Plan. A Claim or an Interest holder might challenge the adequacy of the disclosure or the balloting procedures and results as not being in compliance with the Bankruptcy Code. Even if the Bankruptcy Court were to determine that the disclosure and the balloting procedures and results were appropriate, the Bankruptcy Court could still decline to confirm the Plan if it were to find that any statutory conditions to confirmation had not been met. Section 1129 of the Bankruptcy Code sets forth the requirements for

confirmation and requires, among other things, a finding by the Bankruptcy Court that the confirmation of the Plan is not likely to be followed by a liquidation or a need for further financial reorganization and that the value of distributions to non-accepting Classes of Claims and Interest Holders will not be less than the value of distributions such creditors and interest holders would receive if the Debtors were liquidated under Chapter 7 of the Bankruptcy Code. There can be no assurance that the Bankruptcy Court will conclude that these requirements have been met, but we believe that the Bankruptcy Court should be able to find that the Plan will not be followed by a need for further financial reorganization and that non-accepting classes of claims and interest holders will receive distributions at least as great as would be received following a liquidation pursuant to Chapter 7 of the Bankruptcy Code.

Additionally, even if the required acceptances of each of the impaired voting classes under the Plan are received, the Bankruptcy Court might find that the solicitation of votes or the Plan did not comply with the solicitation requirements made applicable by section 1125 of the Bankruptcy Code. In such an event, we may seek to resolicit acceptances, but confirmation of the Plan could be substantially delayed and possibly jeopardized. We believe that our solicitation of acceptances of the Plan complies with the requirements of section 1125 of the Bankruptcy Code, that duly executed Ballots will be in compliance with applicable provisions of the Bankruptcy Code and the Bankruptcy Rules, and that, if sufficient acceptances are received, the Plan should be confirmed by the Bankruptcy Court.

Should the Bankruptcy Court fail to confirm the Plan, we would then consider all financial alternatives available to us at the time, which may include an effort to sell in the Chapter 11 Cases all or part of our business or an equity interest in the company and the negotiation and filing of an alternative reorganization plan. Pursuit of any such alternative could result in a protracted and non-orderly reorganization with all the attendant risk of adverse consequences to our company and our businesses, operations, employees, partners and supplier relations and our ultimate ability to function effectively and competitively. And, alternatively, under such circumstances a party-in-interest could elect to file a motion to convert the Chapter 11 cases to liquidation proceedings under Chapter 7 of the Bankruptcy Code.

Even if the Plan is confirmed by the Bankruptcy Court, there can be no assurance that we would not thereafter suffer a disruption in our business operations as the result of filing the Chapter 11 cases.

If the Plan, or a plan determined by the Bankruptcy Court not to require resolicitation of acceptances by classes, were not to be confirmed, it is unclear whether a reorganization could be implemented and what holders of claims and interests would ultimately receive with respect to their claims and interests. If an alternative reorganization could not be agreed to, it is possible that we would have to liquidate assets, in which case holders of claims and interests could receive less than they would have received pursuant to the Plan.

Absent the consent of the holders of at least $45 million face amount of the unredeemed Old Series B Preferred Stock, the Plan cannot be confirmed more than 120 days after May 1, 2003.

Our Independent Auditor’s report to our audited financial statements for the period ended December 31, 2002 indicates that there is substantial doubt about our ability to continue as a going concern. We have been notified by the Nasdaq National Market that our common stock has been delisted. As a result of being delisted, holders of all of our Series B convertible redeemable preferred stock have a right to require the redemption of their shares of preferred stock and the holders have exercised this right. This has resulted in our having a redemption obligation to purchase this stock for $60.0 million, subject to the limitations of Delaware law as to the immediate enforceability of payment in full. We do not have the funds to cause redemption of the Series B preferred stock. Consequently, on May 1, 2003 we filed for protection under Chapter 11 of the United States Bankruptcy Code.

IF OUR RESEARCH AND DEVELOPMENT EFFORTS DO NOT RESULT IN POTENTIAL DRUG CANDIDATES AND/OR WE CANNOT ADVANCE POTENTIAL PRODUCTS THROUGH CLINICAL TRIALS, WE MAY FAIL TO DEVELOP PHARMACEUTICAL PRODUCTS.

In July 2002, J&J initiated Phase I clinical trials with RWJ-442831, an Essential-developed prodrug form of the collaboration’s lead parenteral cephalosporin product, known as RWJ-54428. We have been informed that J&J has stayed further conduct of the Phase I trial pending review of the project. There can be no assurance that J&J will move forward with the Phase I clinical trials for this cephalosporin compound, or that even if such trials are reinstated, they will be completed. We have one other cephalosporin compound in the J&J collaboration that is in pre-clinical development. Our other potential products are in the pre-clinical or research stage. All of our potential products will require significant additional research and development efforts before

we can sell them. These efforts include extensive pre-clinical and clinical testing prior to submission to the Food and Drug Administration, or FDA, or other regulatory authority. Pre-clinical and clinical testing will likely take several years. After submission, these potential products will be subject to lengthy regulatory review. We cannot predict with accuracy the time required to commercialize new pharmaceutical products. The development of new pharmaceutical products is highly uncertain and subject to a number of significant risks. We do not expect any of our potential products to be commercially available for a number of years, if at all. Pharmaceutical products that appear to be promising at early stages of development may not reach the market for a number of reasons including the following:

IF WE ARE UNABLE TO ENTER INTO NEW COLLABORATIONS, DEVELOPMENT OF POTENTIAL PRODUCTS COULD BE DELAYED.

Our strategy for building a pipeline of potential products is to in-license and develop clinical stage drug candidates that target large pharmaceutical niche markets. We are actively seeking in-licensing opportunities, but are not yet engaged in negotiations with any potential licensors. We cannot be sure that we will be successful in identifying potential candidates to in-license, or that we will be successful in negotiating agreements with the owners of such technology. The failure to do so could have a material adverse effect on our ability to enhance our development pipeline.

We have entered into collaboration agreements with J&J, Daiichi and Fujisawa. Under these agreements, our partners are responsible for:

We cannot control the timing of these actions or the amount of resources devoted to these activities by our partners. In addition, these agreements are subject to cancellation or the election not to extend by our partners. As a result, our receipt of revenue, whether in the form of product development milestone payments, or royalties on sales, depends upon the decisions made and the actions taken by our partners. Our partners are free to pursue their own existing or alternative technologies to develop products in preference to our potential products. We cannot be certain that our interests will continue to coincide with those of our partners, or that disagreements concerning our rights, technology, or other proprietary interests will not arise with our partners.

Substantially all of our revenues to date have resulted from our collaborations. We intend to continue to rely on our collaborations to fund a substantial portion of our research and development activities over the next several years. If we are unable to enter into new collaborations, the development and commercialization of our potential products may be delayed. In addition, we may be forced to seek alternative sources of financing for product development and commercialization activities.

WE HAVE INCURRED SUBSTANTIAL LOSSES IN THE PAST, EXPECT TO CONTINUE TO INCUR LOSSES FOR THE NEXT SEVERAL YEARS AND MAY NEVER ACHIEVE PROFITABILITY.

We have incurred substantial net losses in every year since our inception in December 1992. We had net losses allocable to common stockholders of $13.9 million in 2000, $28.2 million in 2001 and $42.9 million in 2002. We had an accumulated deficit of $130.8 million through March 31, 2003. We expect to continue to incur operating losses over the next several years.

IF WE FAIL TO SATISFY SAFETY AND EFFICACY REQUIREMENTS OR MEET REGULATORY REQUIREMENTS IN OUR CLINICAL TRIALS, WE WILL NOT BE ABLE TO COMMERCIALIZE OUR DRUG CANDIDATES.

Either we or our collaborators must show through pre-clinical studies and clinical trials that each of our pharmaceutical products is safe and effective in humans for each indication before obtaining regulatory clearance from the FDA for the commercial sale of that pharmaceutical product. If we fail to adequately show the safety and effectiveness of a pharmaceutical product, regulatory approval could be delayed or denied. The results from pre-clinical studies and early clinical trials are often different than the results that are obtained in large-scale testing. We cannot be certain that we will show sufficient safety and effectiveness in our clinical trials that would allow us to obtain regulatory approval. A number of companies in the pharmaceutical industry, including biotechnology companies, have suffered significant setbacks in advanced clinical trials, even after promising results in earlier trials.

Any drug is likely to produce some level of toxicity or undesirable side effects in animals and in humans when administered at sufficiently high doses and/or for a long period of time. Unacceptable toxicities or side effects may occur in the course of toxicity studies or clinical trials. If we observe unacceptable toxicities or other side effects, we, our partner or regulatory authorities may interrupt, limit, delay or halt the development of the drug. In addition, unacceptable toxicities or side effects could prevent approval by the FDA or foreign regulatory authorities for any or all indications.

We must obtain regulatory approval before marketing or selling our future drug products. In the United States, we must obtain FDA approval for each drug that we intend to commercialize. The FDA approval process is lengthy and expensive, and approval is never certain. Products distributed abroad are also subject to foreign government regulation. The process of obtaining FDA and other required regulatory approvals could vary a great deal based upon the type, complexity and novelty of the products involved. Delays or rejections may be caused by additional government regulation from future legislation or administrative action or changes in FDA policy during the period of clinical trials and FDA regulatory review. Similar delays also may be experienced in foreign countries.

None of our drug candidates has received regulatory approval. If we fail to obtain this approval, we will be unable to manufacture and sell our drug products commercially.

IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, WE MAY LOSE THE COMPETITIVE ADVANTAGE INHERENT IN OUR PROPRIETARY TECHNOLOGIES.

Our success depends in part on our ability to establish, protect and enforce our proprietary rights relating to our wound healing compound and other proprietary technology. We have received rights from USC to numerous patent applications in the United States, in addition to applications filed in other countries, in order to protect this small molecule and its wound healing application. In addition, we have numerous patents and applications covering our cephalosporin program licensed to J&J. We cannot be certain that patents will be granted with respect to any of our patent applications currently pending in the United States or in other countries, or with respect to applications filed in the future. Our failure to obtain patents pursuant to our current or future applications could have a material adverse effect on our business. Furthermore, we cannot be certain that any patents issued to us will not be infringed, challenged, invalidated or circumvented by others, or that the rights granted there under will provide competitive advantages to us. Litigation to establish the validity of patents, to defend against copatent infringement claims and to assert infringement claims against others can be expensive and time-consuming, even if the outcome is favorable to us. If the outcome of patent prosecution or litigation is not favorable to us, our business could be materially adversely affected.

Our commercial success also depends on our ability to operate without infringing patents and proprietary rights of third parties. We cannot assure you that our products will not infringe on the patents or proprietary rights of others. While we are not currently aware of any patents encumbering our ability to practice the technologies we have discovered or licensed from USC, it is possible that a patent of this nature may issue in the future. We may be required to obtain licenses to patents or other proprietary rights of others. Any licenses may not be available on terms acceptable to us, if at all. The failure to obtain these licenses could delay or prevent our partners’ activities, including the development, manufacture or sale of drugs requiring such licenses.

In addition to patent protection, we rely on trade secrets, proprietary know-how and technological advances that we seek to protect, in part, by confidentiality agreements with our partners, employees and consultants. We cannot assure you that these agreements will not be breached, that we would have adequate remedies for any breach that might occur, or that our trade secrets, proprietary know-how and technological advances will not otherwise become known or be independently discovered by others.

IF OTHER COMPANIES DEVELOP BETTER PRODUCTS THAN OURS OR MARKET SIMILAR PRODUCTS SOONER, OUR PRODUCTS MAY BE RENDERED OBSOLETE OR NONCOMPETITIVE.

We operate in a field in which new developments are occurring at an increasing pace. Competition from biotechnology and pharmaceutical companies, joint ventures, academic and other research institutions and others is intense and is expected to increase. Many of our competitors have substantially greater financial, technical and personnel resources than we have. There are other companies that have recently described cephalosporins in early stages of development that are designed for treatment of resistant gram-positive infections in hospitals, the same objective as our lead cephalosporin compound.

Competing technologies may be developed that would render our technologies obsolete or noncompetitive. We cannot assure you that our competitors will not develop competing drugs that are more effective than those developed by us and our partners or obtain regulatory approvals of their drugs more rapidly than we and our partners, thereby rendering our and our partners’ drugs obsolete or noncompetitive. Moreover, we cannot assure you that our competitors will not obtain patent protection or other intellectual property rights that would limit our and our partners’ ability to use our technology or commercialize our or their drugs.

WE HAVE NO MANUFACTURING, MARKETING OR SALES EXPERIENCE, AND IF WE ARE UNABLE TO ENTER INTO MANUFACTURING AGREEMENTS OR MAINTAIN COLLABORATIONS WITH MARKETING PARTNERS OR IF WE ARE UNABLE TO DEVELOP OUR OWN MANUFACTURING, SALES AND MARKETING CAPABILITY, WE MAY NOT BE SUCCESSFUL IN COMMERCIALIZING OUR PRODUCTS.

We do not have any experience in the manufacture of commercial quantities of drugs, and our current facilities and staff are inadequate for the commercial production or distribution of drugs. We intend to rely on our partners for the manufacturing, marketing and sales of any products that result from these collaborations. Manufacturers often encounter difficulties in scaling up to manufacture commercial quantities of pharmaceutical products. We cannot be certain that our current or any other manufacturer will not encounter similar delays in the scale-up to manufacture this or any other compound in commercial quantities in the future.

We will be required to contract with third parties for the manufacture of our products or to acquire or build production facilities before we can manufacture any of our products. We cannot assure you that we will be able to enter into contractual manufacturing arrangements with third parties on acceptable terms, if at all, or acquire or build production facilities ourselves.

To date we have no experience with sales, marketing or distribution. In order to market any of our products, we will be required to develop marketing and sales capabilities, either on our own or in conjunction with others. We cannot assure you that we will be able to develop any of these capabilities.

IF OUR PRODUCTS HARM PEOPLE, WE MAY EXPERIENCE PRODUCT LIABILITY CLAIMS THAT MAY NOT BE COVERED BY INSURANCE.

We face an inherent business risk of exposure to potential product liability claims in the event that drugs, if any, developed through the use of our technology are alleged to have caused adverse effects on patients. This risk exists for products being tested in human clinical trials, as well as products that receive regulatory approval for commercial sale. We will, if appropriate, seek to obtain product liability insurance with respect to drugs developed by us and our partners. We may not, however, be able to obtain insurance. Even if insurance is obtainable, it may not be available at a reasonable cost or in a sufficient amount to protect us against liability. Any successful product liability claims may exceed our financial resources. Further, costs of defending against product liability claims, even if we were to prevail ultimately, may have a material adverse effect on our business and results of operations.

IF WE CANNOT ATTRACT AND RETAIN MANAGEMENT AND SCIENTIFIC STAFF, WE MAY NOT BE ABLE TO PROCEED WITH OUR DRUG DISCOVERY AND DEVELOPMENT PROGRAMS.

We are highly dependent on management and scientific staff, including Mark Skaletsky, our President and Chief Executive Officer, Tim Noyes, our Chief Operating Officer and on our other officers. Considering the time necessary to recruit replacements, if we lose the services of any of the named individuals or other senior management and key scientific staff, we may incur delays in our product development and commercialization efforts or experience difficulties in raising additional funds. We may also lose a significant amount of revenues without the senior staff necessary to adequately maintain existing corporate collaborations or to enter into new collaborations. We do not carry key-man life insurance on any of our executives. We believe that our future success will depend, in part, on our ability to attract and retain highly talented managerial and scientific personnel and consultants. In recent years, because of great demand for qualified personnel and the numerous opportunities available to them in the biotechnology and pharmaceutical industries, we have experienced intense competition attracting and retaining employees from the limited number of qualified personnel available. Many of the other biotechnology and pharmaceutical companies with whom we compete for qualified personnel have qualities such as greater financial and other resources, different risk profiles and a longer history in the industry, or provide different opportunities, such as greater career advancement, that may be more appealing to, and helpful in attracting and retaining, qualified personnel. We cannot assure you that we will be able to attract and retain the personnel we require on acceptable terms, or at all. In the event we are unable to do so, the rate at which we can develop and commercialize drugs will be limited.

OUR OPERATIONS INVOLVE HAZARDOUS MATERIALS, WHICH COULD SUBJECT US TO SIGNIFICANT LIABILITY.

As with many biotechnology and pharmaceutical companies, our activities involve the use of radioactive compounds and hazardous materials. As a consequence, we are subject to numerous environmental and safety laws and regulations. We are subject to periodic inspections for possible violations of any environmental or safety law or regulation. Any violation of, and the cost of compliance with, these regulations could materially adversely affect our operations.

ANTI-TAKEOVER PROVISIONS IN OUR CHARTER AND BY-LAWS AND DELAWARE LAW, TOGETHER WITH OUR STOCKHOLDER RIGHTS PLAN, COULD MAKE THE ACQUISITION OF OUR COMPANY BY ANOTHER COMPANY MORE DIFFICULT.

Some provisions of our certificate of incorporation and by-laws may have the effect of making it more difficult for a third party to acquire, or discouraging a third party from attempting to acquire, control of Essential. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions allow us to issue preferred stock without a vote or further action by our stockholders, provide for staggered elections of our Board of Directors and specify procedures for director nominations by stockholders and submission of other proposals for consideration at stockholder meetings. None of these provisions provides for cumulative voting in the election of directors. Some provisions of Delaware law applicable to us could also delay or make more difficult a merger, tender offer or proxy contest involving us, including Section 203 of the

Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any stockholder owning 15% or more of our outstanding voting stock for a period of three years from the date the person became a 15% stockholder unless specified conditions are met.

We adopted a stockholder rights plan, dated as of February 2, 1999, pursuant to which our Board of Directors declared a dividend of one right for each share of the common stock outstanding, which right entitles the holder to purchase for $30.00 a fraction of a share of our Series A preferred stock with economic terms similar to that of one share of the common stock. In the event that an acquiror obtains 20% or more of our outstanding common stock, each right, other than rights owned by the acquiror or its affiliates, will thereafter entitle the holder thereof to purchase, for the exercise price, a number of shares of the common stock having a then current market value equal to twice the exercise price. If, after an acquiring person obtains 20% or more of our outstanding common stock, we merge into another entity, an acquiring entity merges into our company, or we sell more than 50% of our assets or earning power, then each right, other than rights owned by the acquiring person or its affiliates, will entitle the holder thereof to purchase for the exercise price, a number of shares of common stock of the person engaging in the transaction having a then current market value equal to twice the exercise price.

The possible issuance of Series A preferred stock, the procedures required for director nominations and stockholder proposals and Delaware law could have the effect of delaying, deferring or preventing a change in control of Essential, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock.

The foregoing discussion is subject to the outcome of, and processes associated with, the pending reorganization of Essential under Chapter 11 of the Bankruptcy Code, which reorganization is discussed in the Management’s Discussion and Analysis of Financial Condition and Results of Operations.

IF WE CANNOT OBTAIN ADDITIONAL FUNDING FOR FUTURE OPERATIONS, WE MAY NOT BE ABLE TO PROCEED WITH OUR DEVELOPMENT PROGRAMS.

The development of our potential pharmaceutical products will require substantially more money than we currently have. We will need additional funding from sources including other partners and through public or private financings involving the sale of equity or debt securities. We cannot assure you that any financings will be available when needed, or if available will be on acceptable terms. Funding from partners could limit our ability to control the research, development and commercialization of potential products, and could limit our revenues and profits from such products, if any. Collaboration agreements may also require us to give up rights to products or technologies that we would otherwise seek to develop or commercialize ourselves. Any additional equity financing will result in dilution to our current stockholders. If we fail to secure sufficient additional funding we will have to delay or terminate some or all of our development programs.

WE EXPECT TO RETAIN ALL FUTURE EARNINGS AND HAVE NO INTENTION TO PAY DIVIDENDS.

We have never paid any cash dividends on our common stock. We currently intend to retain all future earnings, if any, for use in our business and do not expect to pay any dividends in the foreseeable future.

WE MAY NOT REALIZE ANY OF THE ANTICIPATED BENEFITS FROM OUR ACQUISITION OF MARET.

On March 11, 2002, we concluded our acquisition of Maret. We consummated this transaction with the expectation that it would result in a substantial addition to our existing product development pipeline. Achieving this benefit will depend in part on our success in moving the acquired compounds through pre-clinical and clinical development. We cannot assure you that, following this acquisition, we will achieve revenues, specific net income or loss levels, that justify the acquisition or that the acquisition will result in increased earnings, or reduced losses, for the combined company in any future period. In January 2003, we announced that one of the potential products acquired in the Maret acquisition, ETRX 101, did not show signs of sufficient efficacy to support the continuation of development of ETRX 101 as a single agent and the Company decided not to continue its development. The Company is currently developing a wound healing compound in connection with the USC agreement.

In June 2002, we restructured our business. In March 2003, we announced that we began discussions with an entity to acquire a portion of our California operations, including the possible sale of our California facilities, and a selection of pre-clinical infectious disease programs along with the hiring of a portion of our employees in California. It was our desire to identify a buyer for our California operations by March 31, 2003 and we previously announced that we would implement our plan to phase out our California operations if we did not enter into definitive documents by March 31, 2003. We were unable to negotiate mutually agreeable terms with a buyer of our California operations. Consequently, on March 31, 2003, we began to phase out our California operations. We initiated these transactions with the expectation that it will result in a refocused company that will concentrate its resources on advancing the development of our wound healing compound or compounds that we will potentially in-license. Achieving the benefit of this restructuring will depend in part on the focusing of our technology, operations and personnel in a timely and efficient manner so as to minimize the risk that the restructuring will result in the loss of market opportunity or key employees or the diversion of the attention of management. We cannot assure you that, following this transaction, our businesses will achieve revenues, specific net income or loss levels, efficiencies or synergies that justify the restructuring or that the restructuring will result in increased earnings, or reduced losses, for the company in any future period.

We are subject to the information and reporting requirements of the Securities Exchange Act, under which we file periodic reports, proxy and information statements and other information with the SEC. Copies of the reports, proxy statements and other information may be examined without charge at the Public Reference Section of the SEC, 450 Fifth Street, N.W. Washington, D.C. 20549, or on the Internet at http:// www.sec.gov. Copies of all or a portion of such materials can be obtained from the Public Reference Section of the SEC upon payment of prescribed fees. Please call the SEC at 1-800-SEC-0330 for further information about the Public Reference Room. These reports, proxy and information statements and other information may also be inspected at the offices of the Nasdaq National Market, 1735 K Street, N.W., Washington, D.C. 20006.

This document contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In some cases, these statements can be identified by the use of forward-looking terminology such as “may,” “will,” “could,” “should,” “would,” “expect,” “anticipate,” “continue” or other similar words. These statements discuss future expectations, contain projections of results of operations or of financial condition or state trends and known uncertainties or other forward-looking information. Furthermore, these statements are based on current expectations that involve a number of uncertainties including those set forth in the risk factors above. When considering forward-looking statements, you should keep in mind that the risk factors noted above and other factors noted throughout this document or

incorporated by reference could cause our actual results to differ significantly from those contained in any forward-looking statement.

Forward-looking statements include information concerning possible or assumed future results of our operations, including statements regarding:

Many factors could affect our actual financial results, and could cause these actual results to differ materially from those in these forward-looking statements. These factors include the following:

We maintain an investment portfolio in accordance with our Investment Policy. The primary objectives of our Investment Policy are to preserve principal, maintain proper liquidity to meet operating needs and maximize yields. Although our investments are subject to credit risk, our Investment Policy specifies credit quality standards for our investments and limits the amount of credit exposure from any single issue, issuer or type of investment. Our investments are also subject to interest rate risk and will decrease in value if market interest rates increase. However, due to the conservative nature of our investments and relatively short duration, interest rate risk is mitigated. We do not own derivative financial instruments in our investment portfolio. Accordingly, we do not believe that there is any material market risk exposure with respect to derivative or other financial instruments which would require disclosure under this item.

The interest rates on our capital lease obligations are fixed and therefore not subject to interest rate risk.

At this time, we do not participate in any foreign currency exchange activities; therefore, we are not subject to risk of gains or losses for changes in foreign exchange rates.

Essential maintains disclosure controls and procedures designed to ensure that it is able to collect the information it is required to disclose in the reports it files with the SEC and to process, summarize and disclose this information within the time periods specified in the rules of the SEC. Based on their evaluation of Essential’s disclosure controls and procedures which took place as of a date within 90 days of the filing date of this report, the Chief Executive and Chief Financial Officers believe that these controls and procedures are effective to ensure that Essential is able to collect, process and disclose the information it is required to disclose in the reports it files with the SEC within the required time periods.

Essential also maintains a system of internal controls designed to provide reasonable assurance that transactions are executed in accordance with management’s general or specific authorization; transactions are recorded as necessary (1) to permit preparation of financial statements in conformity with generally accepted accounting principles, and (2) to maintain accountability for assets; access to assets is permitted only in accordance with management’s general or specific authorization; and the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.

Since the date of the most recent evaluation of our internal controls by the Chief Executive and Chief Financial Officers, there have been no significant changes in such controls or in other factors that could have significantly affected those controls, including any corrective actions with regard to significant deficiencies and material weaknesses.

On May 1, 2003, Essential Therapeutics, Inc. and its wholly owned subsidiaries, The Althexis Company, Inc. and Maret Corporation, filed for protection under Chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware (Case Nos. 03-11317(MFW), 03-11318(MFW) and 03-11319(MFW)). Essential has filed a Plan of Reorganization which details its intent to make payment in full of obligations owed to certain creditors and providing for recapitalization of the company as a privately-held entity, held solely by the former holders of Essential’s Series B preferred stock.

Essential was notified in August 2002 that Fresenius Medical Care Holdings, Inc. (“FMCH”) notified Maret of its exercise of appraisal rights. FMCH, a former common stockholder of Maret, claims to exercise these rights under Section 262 of Delaware General Corporation Law in relation to a merger between Maret, Essential and MC Merger Corp. FMCH filed a Petition For Appraisal of Stock in the Delaware Court of Chancery and delivered notice of such action to Essential’s counsel. At the present time this litigation has been stayed under Section 362 of the Bankruptcy Code.

In March 2003, we notified the Maret stockholder representative of our indemnification claim against all of the escrow property pursuant to the acquisition agreements entered into in connection with the Company’s acquisition of Maret. Essential is seeking indemnification for losses that may be incurred in connection with the FMCH claim for appraisal rights described above and for possible breach of certain representations and warranties. The escrow estate contains 200,000 shares of the common stock of Essential.

In October 2002, Essential received a letter from an attorney retained by a common stockholder indicating that his client was considering filing a claim against the Company, its directors and officers and holders of Series B preferred stock for alleged violations of Section 10(b) of the Securities and Exchange Act of 1934 and Related Rule 10b-5 as well as possible other claims. The shareholder has not filed suit and no proceeding is pending. Essential believes that these threatened claims do not have merit. Essential intends to vigorously defend itself against any claims ultimately brought against the Company and its directors and officers. No provision for any loss in connection with these possible claims has been provided for in the accompanying financial statements.

In February 2003, Essential received a summons and a complaint from the plaintiffs, Delta Opportunity Fund, Ltd., and Delta Opportunity Fund (Institutional), LLC, which was filed in the Court of Chancery in the State of Delaware, New Castle County. Plaintiffs are holders of Essential’s Series B preferred stock and they allege that a holder optional repurchase right has occurred and, as a result, that Essential is required to redeem the shares of Series B preferred stock held by the Plaintiffs. No provision for any loss in connection with these possible claims has been provided for in the accompanying financial statements. At the present time this litigation has been stayed under Section 362 of the Bankruptcy Code.

By May 1, 2003, the holders of 60,000 shares of Series B preferred stock exercised their right to require Essential to redeem their preferred stock. This resulted in the Company having a redemption obligation to purchase this stock for $60.0 million, subject to the limitations of Delaware law as to the immediate enforceability of payment in full. We do not have the funds available to redeem 60,000 shares of Series B preferred stock and have not made such payment within the specified time period. Consequently, on May 1, 2003, Essential Therapeutics, Inc. and its wholly owned subsidiaries, The Althexis Company, Inc. and Maret Corporation filed for protection under Chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware.

The matters voted upon, and the results of voting at, a Special Meeting of Stockholders held on January 23, 2003 were reported in Part 1, Item 4. of Essential’s Form 10-K for the year ended December 31, 2002, previously filed with the SEC, and are incorporated herein by reference.

On January 24, 2003, Essential Therapeutics, Inc., filed a current report on Form 8-K with the Securities and Exchange Commission. The purpose of the filing was to disclose the results of its Special Meeting of Stockholders convened to approve the conversion of its Series B Preferred Stock into common stock, increase the authorized capital stock of the Company and approve an amendment to its Restated Certificate of Incorporation to effect any of certain specified reverse stock splits.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

ESSENTIAL THERAPEUTICS, INC.
(Debtor and Debtor-In-Possession) (Registrant)

By:		/s/ MARK SKALETSKY

		Mark Skaletsky
		President and Chief Executive Officer
		(principal executive officer)

By:		/s/ PAUL MELLETT

		Paul Mellett
		Senior Vice President and Chief Financial Officer
		(principal financial officer)

Delaware		94-3186021
(State or other jurisdiction of incorporation of organization)		(I.R.S. Employer Identification Number)

78 Fourth Avenue, Waltham, Massachusetts (Address of principal executive offices)		02451 (ZIP Code)

		Page Number

PART I FINANCIAL INFORMATION

Item 1.	Unaudited Condensed Consolidated Financial Statements

	Unaudited Condensed Consolidated Balance Sheets as of March 31, 2003 and December 31, 2002	3

	Unaudited Condensed Consolidated Statements of Operations for the three months ended March 31, 2003 and March 31, 2002	4

	Unaudited Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2003 and March 31, 2002	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10

	Risk Factors That May Affect Results	16

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	24

Item 4.	Controls and Procedures	25

PART II OTHER INFORMATION

Item 1.	Legal Proceedings	25

Item 3.	Defaults Upon Senior Securities	26

Item 4.	Submission of Matters to a Vote of Security Holders	26

Item 6.	Exhibits and Reports on Form 8-K	26

Signatures		27

Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		28

	March 31,			December 31,
	2003			2002
ASSETS
Current assets:
Cash and cash equivalents	$	2,898		$	3,541
Marketable securities		21,702			29,957
Trade and other receivables		1,010			1,624
Prepaid expenses and other current assets		407			641
Assets held for sale		761			272

Total current assets		26,778			36,035
Restricted cash		3,447			2,230
Property and equipment, net		3,800			5,384
Goodwill		1,526			1,526
Other assets		1,210			1,142

Total assets	$	36,761		$	46,317

LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current liabilities:
Accounts payable	$	1,401		$	2,561
Accrued compensation		432			739
Current portion of notes payable		724			677
Accrued merger and financing costs		2			6
Deferred revenue		333			1,084
Accrued restructuring		3,168			1,400
Accrued legal services		312			1,086
Other accrued liabilities		837			787

Total current liabilities		7,209			8,340
Long-term portion of notes payable		1,957			1,961
Long-term portion of accrued restructuring		563			664
Accrued rent		646			631
Series B convertible redeemable preferred stock, par value $0.001; 60,000 shares authorized, issued and outstanding: liquidation value $60,000 (net of deemed dividend and issuance costs) at March 31, 2003 and December 31, 2002		53,902			53,477
Commitments and contingencies		—			—
Stockholders’ deficit:
Preferred stock, par value $0.001; 5,000,000 shares authorized; 60,000 Series B shares issued and outstanding at March 31, 2003 and December 31, 2002		—			—
Common stock, par value $0.001; 50,000,000 shares authorized; 18,939,941 shares issued and outstanding at March 31, 2003 and December 31, 2002		19			19
Additional paid-in capital		104,286			104,725
Deferred compensation		(1,209	)		(1,388	)
Notes receivable from officers		(160	)		(175	)
Accumulated deficit		(130,817	)		(122,315	)
Accumulated other comprehensive income		365			378

Total stockholders’ deficit		(27,516	)		(18,756	)

Total liabilities and stockholders’ deficit	$	36,761		$	46,317

	Three Months Ended March 31,
	2003			2002
Revenues:
Research revenues	$	1,503		$	2,038
Milestone, licensing and other revenues		1,151			1,067

Total revenues		2,654			3,105
Operating expenses:
Research and development		4,260			5,560
General and administrative		2,774			2,183
Purchased in-process research and development		—			7,702
Restructuring charges		4,368			—

Total operating expenses		11,402			15,445

Loss from operations		(8,748	)		(12,340	)
Interest and other income, net		246			254

Net loss		(8,502	)		(12,086	)
Accretion of deemed dividend to Series B preferred stockholders		(425	)		(425	)

Net loss allocable to common stockholders	$	(8,927	)	$	(12,511	)

Basic and diluted net loss per common share	$	(0.48	)	$	(0.75	)

Weighted-average shares used in computing basic and diluted net loss per common share		18,638			16,573

	Three Months Ended March 31,
	2003			2002
Cash flows from operating activities:
Net loss	$	(8,502	)	$	(12,086	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization		362			554
Stock compensation expense		165			234
Forgiveness of notes receivable from officers		15			—
Purchased in-process research and development		—			7,702
Accrued rent		35			(70	)
Gain on fixed assets disposal		(31	)		—
Charges for impairment of assets		1,437			—
Changes in assets and liabilities:
Trade and other receivables		614			3,607
Prepaid expenses and other current assets		234			(687	)
Other assets		(68	)		(371	)
Accounts payable		(1,160	)		(691	)
Accrued compensation		(307	)		(800	)
Accrued restructuring		1,371			—
Other accrued liabilities		(744	)		(449	)
Deferred revenue		(751	)		(1,625	)

Net cash used in operating activities		(7,330	)		(4,682	)

Cash flows from investing activities:
Short-term loan to Maret prior to acquisition		—			(275	)
Direct costs of Althexis acquisition		—			(521	)
Direct costs of Maret acquisition		(4	)		(40	)
Purchase of short-term investments		(2,689	)		(23,667	)
Sales and maturities of short-term investments		10,931			—
Change in restricted cash		(1,217	)		(372	)
Net proceeds from sales of fixed assets		39			—
Capital expenditures		(416	)		(491	)

Net cash provided by (used in) investing activities		6,644			(25,366	)

Cash flows from financing activities:
Principal payments on notes payable		(199	)		(275	)
Proceeds from debt financing		242			—
Net proceeds from issuance of common stock		—			5

Net cash provided by (used in) financing activities		43			(270	)

Net decrease in cash and cash equivalents		(643	)		(30,318	)
Cash and cash equivalents at beginning of period		3,541			57,469

Cash and cash equivalents at end of period	$	2,898		$	27,151

Supplemental disclosure of cash flow information:
Interest paid	$	30		$	26

Supplemental disclosure of Maret acquisition:
Tangible assets acquired				$	82
Liabilities assumed					2,033
Goodwill acquired					1,526
Acquisition costs incurred					497
Purchased in-process research and development					7,702
Common stock issued					6,780

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	Q1 2003			Q1 2002
Risk-free interest rates		2.84	%		4.32	%
Expected dividend yield		—			—
Expected lives		1.56 years			4.06 years
Expected volatility		1.04			0.88
Weighted average grant-date fair value of options granted during the period		—		$	2.20

	Q1 2003			Q1 2002
Net loss allocable to common stockholders as reported	$	(8,927,116	)	$	(12,510,800	)
Add: Stock-based employee compensation cost, included in the determination of net loss as reported		28,406			96,399
Add/(Less): Total stock-based compensation credit/(expense) determined under fair value based method for all employee awards		255,523			(576,575	)

Pro forma net loss	$	(8,643,187	)	$	(12,990,976	)

Basic and diluted net loss per common share:
Net loss per share as reported	$	(0.48	)	$	(0.75	)
Pro forma net loss per share	$	(0.46	)	$	(0.78	)

	Three months ended
	March 31, 2003			March 31, 2002
	(in thousands)
Net loss	$	(8,502	)	$	(12,086	)
Change in unrealized gain (loss) on available-for-sale securities		(13	)		(176	)

Comprehensive loss	$	(8,515	)	$	(12,262	)

(in millions)	Balance at December 31, 2002		Cash Payments		Net Non-Cash Charges		Additional Restructuring Charges		Balance at March 31, 2003
Severance and benefits	$	—	$	1.2	$	—	$	2.5	$	1.3
Excess facility costs		1.8		0.2		1.3		1.4		1.7
Other restructuring-related costs		0.3		—		0.1		0.5		0.7

	$	2.1	$	1.4	$	1.4	$	4.4	$	3.7

			Payment due by period
	Total		<1 year		1-3 years		4-5 years		>5 years
	(in thousands)
Long-term debt	$	3,866	$	1,079	$	2,120	$	667	$	—
Capital lease obligations		203		58		116		29		—
Operating leases		13,929		2,940		4,941		1,596		4,452
Series B convertible redeemable preferred stock		60,000		60,000		—		—		—
Research collaborations		263		263		—		—		—
Clinical trials		69		69		—		—		—

Total contractual cash obligations	$	78,330	$	64,409	$	7,177	$	2,292	$	4,452


2.1		Joint Plan of Reorganization, filed with the United States Bankruptcy Court for the District of Delaware on May 2, 2003 (incorporated by reference to Exhibit 2.1 to Essential’s Current Report on Form 8-K filed May 2, 2003 with the Securities and Exchange Commission).

99.1		Certification pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2		Certification pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.