UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

COMMISSION FILE NUMBER 0-19871

STEMCELLS, INC.

(Exact name of Registrant as specified in its charter)

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

      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 þ         No o

      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.    þ

      Indicate by check mark whether the registrant is an accelerated filer as defined in Exchange Act Rule 126(2).    Yes þ         No o

      Aggregate market value of Common Stock held by non-affiliates at June 30, 2004: $81,006,548. 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 March 8, 2005: 62,417,451 shares.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the registrant’s definitive Proxy Statement relating to the registrant’s 2005 Annual Meeting of Stockholders to be filed with the Commission pursuant to Regulation 14A are incorporated by reference in Part III of this report.

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.

Table of Contents

Overview

      We are engaged in research aimed at the development of therapies that would use stem and progenitor cells to treat, and possibly cure, human diseases and injuries such as neurodegenerative diseases (for instance, Batten’s, Parkinson’s, and Alzheimer’s diseases, and other metabolic genetic disorders), demyelinating disorders (for instance, Multiple Sclerosis), spinal cord injuries, stroke, hepatitis, chronic liver failure, and diabetes. 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. 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 use cells derived from fetal or adult tissue sources, and are not developing embryonic stem cells for therapeutic use. Neither are we involved in any activity directed toward human cloning; our programs are all directed toward the use of tissue-derived cells for treating or curing diseases and injuries.

      Many diseases, such as Alzheimer’s, Parkinson’s, lysosomal storage diseases 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 that these neural, liver and pancreatic conditions affect more than 50 million people in the United States and account for more than $300 billion annually in health care costs.(1)

      Our stem cell discovery engine relies upon our state of the art cell sorting capabilities and our library of proprietary monoclonal antibodies to human proteins. Using this library of monoclonal antibodies, we have successfully identified, purified, and characterized the human central nervous system stem cell. We have also used our proprietary monoclonal antibodies to make significant advances in our search for stem or progenitor cells of the liver and the pancreas. 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 are concentrating our efforts on the preclinical and clinical development of our neural stem cell program and research endeavors in characterizing the candidate stem/progenitor cells for the liver and pancreas programs.

      In late December 2004, we submitted our first Investigational New Drug application (IND), for a clinical trial in Batten Disease. That IND is currently on clinical hold, and discussions with the U.S. Food and Drug Administration (FDA) are continuing as the Company formulates plans to respond to the FDA’s questions and concerns.

Cell Therapy Background

      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

      (1) This estimate is based on information from the Alzheimer’s Association, the Alzheimer’s Disease Education & Referral Center (National Institute on Aging), the National Institutes of Health’s National Institute on Neurological Disorders and Stroke, the Foundation for Spinal Cord Injury Prevention, Care & Cure, the Centers for Disease Control and Prevention, the American Association of Diabetes Educators, the University of Georgia College of Pharmacy, the Wisconsin Chapter of the Huntington’s Disease Society of America, the Cincinnati Children’s Hospital Medical Center, JAIDs, the American Liver Foundation, the Northwest Parkinson’s Foundation and the Parkinson’s Action Network.

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 in some diseases, such as dopamine which is deficient in the brains of individuals with Parkinson’s disease as a result of the loss of dopamine producing neurons. 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, 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.

      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, such cells can often be obtained only through significant surgical procedures. The challenge, therefore, has been three-fold:

      We have developed techniques for discovering novel monoclonal antibodies that can be used to label markers on the cell surface to identify and isolate specific cell types, and particularly stem and progenitor cells. This methodology allows us to purify the stem cell population and eliminate other unwanted cell types. For example, we have discovered and patented the use of monoclonal antibodies to identify human central nervous system, or CNS, stem cells, as well as a candidate human liver stem-like cell and a candidate pancreatic stem/progenitor cell.

      We have also developed a process, based on a proprietary in vitro culture system in chemically defined media, that reproducibly grows normal human 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 be used to restore function by replacing specific cells that have been damaged or destroyed. In our research, we have shown that when human stem cells of the central nervous system are transplanted into animals, they are accepted, migrate, and successfully specialize to produce mature neurons and glial cells.

      More generally, because the tissue-derived stem cell is the pivotal cell that produces all the functional mature cell types of the organ from which it originates, we believe these cells, if successfully identified, expanded and stored as frozen cell banks, may serve as platforms for five major areas of regenerative medicine and biotechnology:

      We intend to research, develop, and commercialize the therapeutic uses of our stem and progenitor cells alone or in partnership with third parties. We also intend to monetize non-core uses of our stem cell technology, such as diagnostics, gene discovery and use, drug discovery and drug screening, by engaging in a number of non-exclusive agreements

Stem Cell Technology

      Stem cells have two defining characteristics:

      Stem cells are known to exist for a number of systems of the human body, including the blood and immune system, the central and peripheral nervous systems (including the brain), the skin, bone, and even the hair. They are thought to exist for many others, including the liver and pancreas endocrine systems, gut, muscle, and heart. Stem cells are responsible for organ regeneration during normal cell replacement and, to greater or lesser 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, derived from human tissue, with commercial importance. We have also obtained rights to certain inventions relating to stem cells and progenitor cells from academic institutions. We expect to continue to expand our search for, and to seek to acquire rights from third parties relating to, new stem and progenitor cells, and to further develop our intellectual property positions with respect to them in-house and through research at scholarly institutions. Our portfolio of issued patents includes a method of culturing normal human central nervous system stem and progenitor cells in our proprietary chemically defined media, and our published studies show that these cultured and expanded cells give rise to all three major cell types of the central nervous system. In rodents, we have shown that these cells exhibit the unique properties of stem cells: They migrate and colonize throughout the organ from which they were derived and mature into the specialized cells, such as neurons and glial cells, that are normally found in that region of the organ. We also have patent applications pending in connection with our search for liver and pancreas stem and progenitor cells.

      Neurological disorders such as Parkinson’s disease, Alzheimer’s disease, the side effects of stroke, and the neural degeneration that accompanies genetic disorders such as Gaucher’s Disease, Tay-Sachs Disease, and Batten 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 of these diseases.

      We have published the results of a study showing 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. We own or have exclusive licenses to U.S. patents on this process, as well as issued patents and pending patent applications for compositions of matter. 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 are the exclusive licensee of a U.S. patent issued in December, 2002, covering the transplantation of central nervous system stem cells (U.S. Patent No. 6,497,872, “Neural transplantation using proliferated multipotent neural stem cells and their progeny”). We have also filed patent applications covering the growth and expansion of these purified normal human central nervous system cells.

      In 2001, we also announced the results of a new study (published in 2002) 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.

      In 2003, we announced results of three preclinical studies showing proof of principle of the human CNS-SC for a neurodegenerative disease using the mouse model for Infantile Batten Disease (a rare lysosomal storage disease), for spinal cord injury using a spinal cord crush mouse model and for myelination in the shiverer mouse model. We also demonstrated in a mouse model for the Batten disease mouse model that the Company’s human CNS-SC engraft, migrate throughout the brain and produce the enzyme that is missing in this transgenic mouse. The transplanted human cells are able to neuroprotect specific neurons, in the transgenic mouse, from death and quantitatively reduce the insoluble storage material in the brain, a characteristic hallmark of this disease. We discussed these results with the FDA, and began preparations toward the filing of an Investigational New Drug application (IND).

      At the October, 2004 Society for Neuroscience meeting in San Diego, the Company presented an update to the preclinical data demonstrating the secretion from the human neural stem cells of the enzyme that is missing in Batten disease. The secreted enzyme can be taken up by cells in culture derived from Batten’s patients, which provides additional evidence for the Company’s hypothesis that these purified and expanded human neural stem cells may provide a source of enzyme to deficient cells. The Company also presented data in the transgenic mouse model for Batten disease showing the steady rise in enzyme levels in the brains of these mice over time.

      In late December 2004, the Company filed an IND for a Phase I clinical trial of StemCells’ proprietary neural cell therapy product (HuCNS SC)-in Batten disease. The FDA has informed the Company that it has suggestions and questions related to the proposed trial that require additional information from the Company and has placed the proposed trial on clinical hold. StemCells expects to be in active dialogue with the FDA to address the outstanding issues. We note that none of the FDA’s suggestions or questions are related to contaminated embryonic stem cells that have been the matter of media attention. StemCells, Inc. does not use embryonic stem cells, and does not use mouse feeder cells in any way in preparing its stem cells. All cells

prepared by StemCells, Inc. are grown in serum-free media and do not come into contact with cells from animals.

      The Company’s proprietary human neural stem cells have also shown promising results in preclinical results in spinal cord injury. Drs. Aileen Anderson and Brian Cummings of the Reeve-Irvine Center at the University of California presented the data from their study in mice at theTenth Annual Conference of the American Society for Neural Transplantation and Repair on May  2, 2003, showing that the Company’s stem cell technology has the potential to protect and regenerate damaged nerves and nerve fibers in patients with spinal cord injuries. In quantitative tests designed to measure functional recovery from complete hind limb paralysis to normal walking, the Company’s researchers reported that injured mice transplanted with the Company’s human neural stem cells (hCNS-SC) showed improved motor function compared to control animals. Inspection of the spinal cords from these mice showed significant levels of human neural cells derived from the transplanted stem cells. Previously, injured rats have been given stem cells from other rats or mice, but not stem cells from humans. The performance of the human cells in this rodent injury model suggests the possibility that similar results may be obtainable in humans. We believe that the significance of this study is that there is now hope in treating two aspects of spinal cord injury: nerve damage and loss of motor function.

      In November 2003, the Company presented data at the 33rd Annual Society for Neuroscience Meeting showing production of myelin, the insulator for nerve cells. In the mutant shiverer mouse, which is deficient in myelin production, transplantation of hCNS-SC into the brain resulted in widespread engraftment of human cells that matured into oligodendrocytes, the myelin producing cells. Analysis of the brain tissue of these mice shows the human cells juxtaposed to the mouse nerves where the myelin produced by the human cells now ensheath the mouse nerve, providing the proper layers of insulation. Further studies are in progress to demonstrate proper function of the newly produced myelin. Loss of myelin characterizes conditions such as spinal cord injury, multiple sclerosis, cerebral palsy and certain genetic disorders (for example, Krabbe’s disease, metachormatic leukodystrophy, Tay Sachs disease).

      We continue to advance our research programs on the candidate liver and pancreas stem and/or progenitor cells. 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. These programs are discussed below.

      In November 2004, California State Proposition 71 (Prop. 71), the California Stem Cell Research and Cures Initiative, was adopted by the electorate. It is intended to encourage stem cell research in the State of California, and to finance such research with State funds of approximately $295 million annually for 10 years beginning with 2005. It is our understanding that the California Institute for Regenerative Medicine to be created under the Initiative will provide grants, primarily but not exclusively to academic institutions, to advance both embryonic stem cell research and adult stem cell research; the latter is the current and exclusive focus at StemCells. StemCells, Inc. is eligible to receive Prop. 71 generated funds and we do intend to apply for such funding. We also remain eligible for federal government support from the National Institute of Health (NIH) due to our focus on adult stem cells. NIH grants to the Company or to its academic collaborators assist research in the use of our cells for various diseases and conditions such as Alzheimer’s disease and spinal cord injuries. Prop. 71 funds will not go to any project that receives NIH funding. The Company considers government grants to be important confirmation of the quality of its science and intellectual property, but does not rely on them as a significant source of financial support.

Expected Advantages of Our Stem Cell Technology

      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.

      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.

      Most approved therapies for the diseases being targeted by the Company are palliative in nature, primarily treating the symptoms of the disease. Stem cell therapy, by contrast, has the potential to arrest or slow down the progression of the disease or even cure the patient.

Research and Development Programs

      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 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

      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 founding scientists Irving L. Weissman, M.D., of Stanford University, Fred H. Gage, Ph.D., of The Salk Institute, and David Anderson, Ph.D., of the California Institute of Technology, as well as other occasional consultants including William C. Mobley, M.D., Ph.D., Maria Millan, M.D., Ben Barres, Ph.D., and Seung Kim, M.D., Ph.D., all of Stanford University, and Stephen Back, M.D., of the Oregon Health Science University.

      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 “NeuroSpheres Ltd.” under “License Agreements” below.

      In 2000, using our proprietary markers on the surface of the cell, our researchers succeeded in identifying, isolating and purifying human CNS stem cells from brain tissue. We believe that this study, published in Proceedings of the National Academy of Science in December 2000, was the first 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.

      We have found, during the course of long-term studies using a number of our cell lines, that 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.

      The company has established a number of research collaborations in the neural field to assess the effects of transplanting the human CNS stem cells into preclinical animal models, including the spinal cord injury collaboration with Drs. Aileen Anderson and Brian Cummings of the Reeve-Irvine Center at the University of California and a collaboration with the laboratory of Dr. Gary Steinberg, Chairman of the Department of Neurosurgery of Stanford University School of Medicine and Co-director of the Stanford Stroke Center, pertaining to the evaluation of our human neural stem cells in animal models of stroke. Pilot studies have been initiated with Stephen A. Back, M.D., Ph.D., of the Oregon Health Sciences University and with Jeffery D. Kocsis, Ph.D., of the Yale University School of Medicine for understanding myelin production and repair, as well as with Jay Pasricha, M.D., of The University of Texas Medical Branch and with Martin Marsala, M.D., of the University of California, San Diego, regarding the formation of specific populations of neurons; (UCSD). In addition, we have an NIH-funded collaboration with Dr. George A. Carlson of the McLaughlin Research Institute, to understand the role of Alzheimer’s plaques in neuronal cell death in Alzheimer’s disease.

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

      StemCells Inc holds a substantial portfolio of issued and allowed patents in the neural field. See “Patents, Proprietary Rights and Licenses.”

      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: The “FAH transgenic mouse.” This mouse lacks a key enzyme (FAH, or fumaryl-acetoacetate hydrolase), which results in build-up of a toxic substance which causes liver damage. In addition, we obtained an 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.

      The Company focuses 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. The Company intends to use these advanced methods, as they become available, to establish enriched cell populations suitable for transplantation.

      StemCells has devised a culture assay that it uses in its efforts to identify liver stem and progenitor cells. In addition, the culture assay can support the growth of an early human liver bipotent progenitor cell — a cell that can develop into two kinds of mature liver cells: bile duct cells and hepatocytes. Further, since cells in this culture can be infected with human hepatitis virus, it provides a valuable system for study of the virus. This technology also could provide a unique in vitro model for the testing of drugs that act on, or are metabolized by, human liver cells.

      The Company’s scientists have identified proprietary monoclonal antibodies that permit us to purify a population of human liver-engrafting cells, including a candidate human liver stem cell (hLEC). When tested in the Company’s in vitro culture assay, these antibody-enriched cells produce human serum albumin, a measure of hepatocyte generation. Studies to date show that these hLECs can produce human serum albumin in mouse serum following transplantation into immunodeficient mice, suggesting that the human liver-engrafting cell, once transplanted, becomes a functional cell. The program will focus on demonstrating the robust engraftment and function of these hLECs in a preclinical animal model of liver degeneration for proof of principle of a therapeutic cell for liver disease. A source of defined human cells capable of engraftment and substantial liver regeneration could provide a cell-based therapeutic product available to a wider patient base than liver transplants. An in vitro culture system that can reproducibly grow human liver progenitor cells might also provide cells for genetic modification to correct inborn errors of metabolism.

      The Company’s scientists have again used StemCells’ monoclonal antibody-based search engine to identify a rare subset of human pancreatic cells that may be candidate pancreatic stem/progenitor cells. The Company has filed a patent application on the monoclonal antibodies used. In 2002, the Company established a collaboration with Dr. Seung Kim of Stanford University to pursue other avenues to identify an insulin-producing cell. Dr. Kim’s laboratory is studying the developmental biology and controlling events of generating insulin-producing cells. We believe that these approaches 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. The Company has developed what we believe to be an appropriate animal model to test the biological activity of the purified candidate pancreatic stem cells.

Subsidiary

      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. StemCells California remains our wholly-owned subsidiary, and the owner or licensee of most of our intellectual property. The members of its Board of Directors are Irving L. Weissman, M.D., David J. Anderson, Ph.D., and Fred H. Gage, Ph.D., who were the founders of StemCells California, as well as John J. Schwartz, Ph.D. and Martin McGlynn. Drs. Weissman and Schwartz and Mr. McGlynn are also members of the Board of the parent company; Mr. McGlynn is President of StemCells California as well as President and CEO of StemCells, Inc. References in this annual report to “the Company,” “we,” “us,” and similar words include this subsidiary.

License Agreements

      We have entered into a number of research-plus-license agreements with academic organizations including The Scripps Research Institute (Scripps), the California Institute of Technology (Cal Tech), the Oregon Health Sciences University (OHSU), and the University of Texas Medical Branch (UTMB). The research components of the UTMB agreement is in progress, but those with the other institutions mentioned have been concluded and have resulted in a number of license agreements for resultant technology. Under the license agreements, we are typically subject to obligations of due diligence and the requirement to pay royalties on products that use patented technology licensed under such agreements. The license agreements with these institutions 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. Generally speaking, these license agreements will terminate upon expiration, revocation or invalidation of the patents licensed to us, unless governmental regulations require a shorter term. They 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.

      In the case of Scripps, we must pay $50,000 upon the initiation of the Phase II trial for our first product using Scripps licensed technology, 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.

      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 and $5,000 on the first 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. In August 2002 we acquired an additional license from Cal Tech to different technology, pursuant to which we issued 27,535 shares of our common stock with a market value of approximately $35,000; we have also issued 9,535 shares of our common stock with a market value of approximately $15,000 to Cal Tech on the issuance of two patents covered under this additional license.

      Pursuant to the terms of the license agreement with OHSU 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 for which shares were issued on March 31, 2002; the remaining option was terminated and we issued 4,000 shares of our common stock, with a market value of approximately $3,900, to OHSU in January 2003, pursuant to an amendment to the license agreement.

      In 2002, we issued a license to BioWhittaker, Inc., for the exclusive right to make, sell and distribute one of our proprietary cells for the research market only. In 2003 and 2004 respectively, we issued non-exclusive licenses to StemCell Technologies, Inc. to make, use and sell certain proprietary mouse and rat neural stem cells and culture media for all mammalian neural stem cells, and to R&D Systems to make, use and sell certain stem cell expansion kits, also for the research market. These licenses are not expected to generate material revenues.

      In December 1997, we entered into two sublicense agreements with Signal Pharmaceuticals (Signal), Inc. under which each party sublicensed to the other certain patent rights and biological materials for use in defined fields. Signal has now been acquired by Celgene, which in 2004 relinquished its license to the University of California, which then terminated the sublicense to StemCells for lack of diligence. The remaining sublicense with Signal will terminate no later than at the expiration of all patents licensed under it, but StemCells can terminate it earlier if Celgene breaches its obligations under the agreement or declares bankruptcy; Celgene can terminate the agreement at any time upon notice to StemCells.

      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, payable at various stages in the development of potential products, would total $500,000 for each product that is approved for market. The first milestone for a potential product is $50,000, became due in 2004 when the product candidate for Batten disease entered pre-clinical development in a non-rodent model. The next milestone for that product candidate will be $75,000, due upon acceptance of our Investigational New Drug (IND) application with the U.S. Food and Drug Administration (FDA) and the commencement of clinical trials in human patients. In addition, we made our first annual payment of $50,000 in 2004; the annual payments are due by the last day of the year and are fully creditable against royalties due to NeuroSpheres. 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 have a security interest in the licensed technology.

Manufacturing

      We believe that our facility in Palo Alto has the capacity to be used for cell processing under FDA-determined Good Manufacturing Practices-like 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 marketing 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 to compositions of matter, methods of obtaining such cells, and methods for preparing, transplanting and utilizing such cells. Currently, our U.S. patent portfolio includes forty-three issued U.S. patents, three of which issued in 2004. More than thirty additional patent applications are pending, two of which have been allowed. In addition, we have foreign counterparts to many of the U.S. applications and patents; counterparts to fourteen of our U.S. patents or applications have issued in various countries, making a total of about 130 individual non-U.S. patents from those fourteen cases. In 2003, one party filed an opposition to two of our issued European patent cases. While we are confident that we will overcome the opposition, there is no guarantee that we will prevail. If we are unsuccessful in our defense of the opposed patents, all claimed rights in the opposed patents will be lost in Europe. U.S. counterparts to these patents are part of our issued patent portfolio; they are not subject to opposition, since that procedure does not exist under U.S. patent law, although other types of proceedings may be available to third parties to contest our U.S. patents.

      In December 1998, the U.S. 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. U.S. 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 U.S. Patent No. 6,103,530, covering our media for culturing human CNS stem cells, was granted in 2000.

      In 2002, the U.S. Patent Office issued a key strategic patent to us: U.S. Patent Number 6,468,794, entitled “Enriched central nervous system stem cell and progenitor cell populations, and methods for identifying, isolating and enriching for such populations.” The patent issued on October 22, 2002 and covers the identification and purification of the human CNS stem cell. In 2001, we were granted U.S. Patent No. 6,238,922 (“Use of collagenase in the preparation of neural stem cell cultures”) which described methods to advance the in vivo culture and passage of human CNS stem cells that result in a 100-fold increase in CNS stem and progenitor cell production after 6 passages. We believe the methodologies of these two patents together will augment our leadership position in the stem cell field by providing a reproducible proprietary method for obtaining and expanding stem cells for therapeutic uses.

      Another significant patent in the neural field, of which we are the exclusive licensees, was also issued in 2002, and, we believe, may prove even more important: We believe that U.S. Patent Number 6,497,872, entitled “Neural transplantation using proliferated multipotent neural stem cells and their progeny,” covers transplanting any neural stem cells or their differentiated progeny, whether the cells have been cultured in suspension or as adherent cells, for the treatment of any disease. The patent gives us the right to exclude others from practicing the claimed invention.

      In 2003, two neurogenin-related patents were issued (U.S. Patents Numbers 6,555,337 and 6,566,496) as well as U.S. Patent Number 6,638,501, covering the use of multipotent neural stem cell progeny to augment non-neural tissues and U.S. Patent Number 6,541,251, covering a novel pancreatic progenitor gene and its uses.

      In 2004, U.S. Patent Number 6,777,233, covering a cell culture composition of multipotent human neural stem cells regardless of the source of tissue from which the cells are derived, was issued to the Company. In

addition, U.S. Patent Number 6,824,774, covering antibodies that specifically bind to a neuron-restrictive silencer factor protein, and U.S. Patent Number 6,753,153, covering markers for identification and isolation of certain pancreatic islet progenitors, were issued; these patents are exclusively licensed to the Company.

      These new patents, together with U.S. Patent Number 6,294,346 (“Use of multipotent neural stem cells and their progeny for the screening of drugs and other biological agents”), which issued September 25, 2001, have strengthened our already extensive patent portfolio and, we believe, give StemCells the dominant intellectual property position in the field, covering methods for identification, isolation, expansion, and transplantation of neural stem cells as well as drug discovery and testing.

      The following table lists our issued U.S. patents and published international patent applications: