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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal Year Ended December 31, 2004

Commission File Number: 000-21429

ArQule, Inc.

(Exact name of Registrant as Specified in Its Charter)

19 Presidential Way, Woburn, Massachusetts 01801

(Address of principal executive offices including zip code)

Registrant’s telephone number, including area code:

(781) 994-0300

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

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

Common Stock, $.01 Par Value

      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 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 Rule 12b-2 of the Act).     Yes þ          No o

      The aggregate market value of voting and non-voting common stock held by non-affiliates of the registrant as of June 30, 2004 was: $151,933,752.

      There were 34,872,631 shares of the registrant’s Common Stock outstanding as of March 1, 2005.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the definitive proxy statement for the Registrant’s Annual Meeting of Shareholders to be held on May 19, 2005, which will be filed with the Securities and Exchange Commission not later than 120 days after the registrant’s fiscal year end of December 31, 2004, are incorporated by reference into Part III of the Form 10-K.

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IMPORTANT FACTORS REGARDING FORWARD-LOOKING STATEMENTS

      You should carefully consider the risks described below together with all of the other information included in this Form 10-K before making an investment decision. An investment in our common stock involves a high degree of risk. We operate in a dynamic and rapidly changing industry that involves numerous uncertainties. The risks and uncertainties described below are not the only ones we face. Other risks and uncertainties, including those that we do not currently consider material, may impair our business. If any of the risks discussed below actually occur, our business, financial condition, operating results or cash flows could be materially adversely affected. This could cause the trading price of our common stock to decline, and you may lose all or part of your investment.

      This Form 10-K contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. All statements that are not descriptions of historical fact are forward-looking statements, based on estimates, assumptions and projections that are subject to risks and uncertainties. These statements can generally be identified by use of forward looking terminology such as “believes”, “expects”, “intends”, “may”, “will”, “should”, “anticipates” or similar terminology. Although we believe that the expectations reflected in such forward looking statements are reasonable as of the date thereof, such expectations are based on certain assumptions regarding the progress of product development efforts under collaborative agreements, the execution of new collaborative agreements and other factors relating to our growth. Such expectations may not materialize if product development efforts, including any necessary trials of our potential drug candidates, are delayed or suspended, if positive early results are not repeated in later studies or in humans, if planned acquisitions or negotiations with potential collaborators are delayed or unsuccessful, if we are unsuccessful at integrating acquired assets or technologies, if our planned transition to a drug discovery and development company takes longer or is more expensive than we anticipated or if other assumptions prove incorrect. The forward-looking statements contained herein represent the judgment of ArQule as of the date of this Form 10-K. ArQule disclaims any intent or obligation to update any forward-looking statement except to the extent required by law.

PART I

Business Overview

      We are a biotechnology company engaged in the research and development of cancer therapeutics. Our mission is to research, develop, and commercialize broadly effective cancer drugs with reduced toxicities compared to conventional cancer chemotherapeutics. We develop cancer therapies based on our innovative and proprietary Activated Checkpoint Therapy^sm (ACT^sm) platform and our traditional strength in small molecule chemistry.

      We also apply our expertise in the design, production and evaluation of chemical compounds in our chemistry services business. Since our incorporation in 1993, we have provided high-quality library design and compound production to pharmaceutical collaborators. We assist our collaborators with their development programs by, for example, synthesizing potential drug candidates, assessing their suitability and selecting the most promising — by means of high throughput, automated chemistry.

Cyclis Acquisition

      On September 8, 2003, we acquired Cyclis Pharmaceuticals, Inc. (“Cyclis”), an early stage cancer therapeutics company. This acquisition enabled us to continue our transition to a drug discovery and development company in accordance with our stated strategy. The Cyclis acquisition provided us with the proprietary ACT^sm platform, an oncology discovery pipeline and ARQ 501, which is now in Phase 1 clinical trials. We believe that the ACT^sm approach to anti-cancer therapies offers the potential to deliver clinical candidates with improved activity and reduced toxicity over many other molecular approaches and traditional therapies.

ArQule’s Approach to Cancer — The Activated Checkpoint Therapy^sm Platform

      The ACT^sm platform is designed to produce small molecule compounds that selectively kill cancer cells while leaving normal cells unharmed. This is a key concept in our approach to drug development.

      The cells in the human body usually grow, divide and die so that the body always has the number of each different type of cells necessary to support a healthy existence. Cell division is controlled through a series of molecular events called the cell cycle. The cell cycle ensures that cell division proceeds accurately, so that each daughter cell receives the appropriate cellular DNA and other subcellular machinery.

      The cell cycle has several built in “checkpoints,” which are components in a cell’s natural defense mechanism that ensure genomic integrity during the phases of the cellular replication cycle. For example, in a normal cell, checkpoint functions monitor for damage to the cellular DNA. If damage is detected, the cell attempts to repair the damage. If the DNA damage is too severe, the cell undergoes programmed cell death. Thus, a cellular checkpoint is a natural defense mechanism that ensures the genomic integrity of the cells in the body by eliminating damaged cells.

      Cancer cells have multiple abnormalities including genetic (DNA) damage. They are able to survive and proliferate because key checkpoints and apoptotic pathways are disabled as the cancer develops. As a result, cancer cells undergo cell division in an uncontrolled way. Conventional chemotherapy seeks to kill cancer cells by creating further damage to DNA sufficient to prevent cell replication. A well-known side effect of this approach is that normal cells are indiscriminately damaged, creating toxicity to patients and limiting the cancer cell killing activity of conventional chemotherapy.

      Our ACT^sm platform is based on the understanding that a therapeutic agent which reactivates the quality control, or checkpoint functions of a cell, has the potential to re-enable the cell to detect and respond to DNA damage. Because cancer cells contain genes relating to tumor formation (activated oncogenes) and irreparable DNA damage, we believe that restoration of their checkpoint functions will result in such cells undergoing cell death. In addition to the effect that checkpoint activation has in cancer cells, the absence of adverse effects in

normal cells is important. Normal, healthy cells have little DNA damage compared with cancer cells. Consequently, when a checkpoint is activated in a healthy cell, we do not expect to see cell death. In other words, since non-cancer cells are genetically normal, they are more likely to be spared even if exposed to the same checkpoint-activating stimulus as the cancer cell.

      We believe therapeutics based on the ACT^sm approach will be more effective and less toxic than traditional cancer therapies due to their ability to selectively cause cancer cells to undergo cell death, while leaving healthy cells unaffected. This is in contrast to conventional chemotherapy which seeks to kill cancer cells by creating further damage to DNA. A well-known side effect of this approach is that some normal cells are indiscriminately damaged, creating toxicity in patients and limiting the cancer cell killing activity of conventional chemotherapy. Furthermore, because checkpoint functions are virtually the same in different cell types, and because many cancers have checkpoint defects, we believe that therapeutics developed using the ACT^sm platform will be effective against a broad spectrum of cancers and will counteract the variable genetic makeup of cancer cells.

Clinical Trials

      ARQ 501 entered Phase 1 clinical trials in September 2003.

      Preclinical findings. ARQ 501 causes rapid and sustained elevation in the checkpoint regulatory protein E2F1. Based on preclinical findings, we believe that ARQ 501 has the potential for improved activity and reduced toxicity over other molecular approaches and traditional cancer chemotherapy. The compound has demonstrated anti-cancer activity in mice when applied as both a single agent and in combination with chemotherapeutics. In addition to its selectivity for tumor cells over normal cells, ARQ 501 is active against tumor cells with a broad range of genetic defects. We believe this is particularly advantageous for treatment of solid tumors, where individual tumor masses are comprised of highly heterogeneous cancer cells.

      Ongoing Phase 1 study in monotherapy. Our ARQ 501 Phase 1 monotherapy dose-escalation study in patients with advanced solid tumors is currently underway primarily at the Dana-Farber Cancer Institute, Beth Israel Deaconess Medical Center and Massachusetts General Hospital. The objectives of this study are to determine the safety profile (clinical tolerability) of ARQ 501 and a recommended dose to be used in Phase 2 clinical trials. Tumor response is assessed by imaging after eight weeks of therapy. As of January 31, 2005, we continue to explore dosing regimens between 390 and 550 milligrams per meter squared and have not yet identified dose limiting toxicity. Out of 25 eligible subjects, one has experienced a partial response, meaning that the evaluable tumor has shrunk by more than 30%, and five have stable disease states, meaning that their disease did not progress after treatment with ARQ 501. We anticipate completing enrollment in this study in 2005.

      Ongoing Phase 1 study in combination with Taxotere. In December 2004, we initiated a Phase 1 study of ARQ 501 in combination with Taxotere for patients with advanced solid tumors at the Mary Crowley Medical Research Center in Dallas, Texas. The objectives of this study are to determine the safety profile (clinical tolerability) of ARQ 501 in combination with Taxotere and a recommended dose to be used in Phase 2 clinical trials. This trial was initiated because of the synergistic effect of the combination of ARQ 501 and Taxol that was observed in animal studies. In these animal combination studies the tumors were completely eradicated. Taxotere is one of the most common chemotherapeutic agents and is used against a wide range of solid tumors. Our clinical trial is an open label dose escalation study being conducted at a single site in the United States. We are enrolling patients with various forms of advanced solid tumors, some of whom may have previously received Taxotere.

      Ongoing Phase 1b/2 study in combination with gemcitabine. In January 2005, we announced the enrollment of the first patient in a Phase 1b/2 study in combination with gemcitabine at the M.D. Anderson Cancer Center in Houston, Texas. The phase 1b component is an open label dose escalation study, enrolling patients with advanced cancer, some of whom may have previously received gemcitabine. ArQule anticipates

that this component will be followed by a phase 2 study exploring the use of ARQ 501 and gemcitabine in patients with advanced cancer.

Preclinical Pipeline

      Applying our platform in small molecule chemistry and intelligent drug design to our 550 series program, we are developing analogues and derivatives of ARQ 501. These new compounds also modulate E2F. We have identified several such compounds and we are currently in the process of selecting a compound that has the most advantageous set of drug-like characteristics.

      In our Cancer Survival Pathway (“CSP”) program, we are developing compounds aimed at blocking cellular survival mechanisms that cancer cells possess and, thereby, selectively triggering cell death in such cancer cells. CSPs are certain proteins, including cytosolic and nuclear proteins, that are inappropriately elevated to excessive levels in cancer cells. In an animal model of cancer, our scientists explored the feasibility of safely and effectively treating cancer by blocking the activity of cancer cell survival pathways. We have discovered a series of proprietary small molecular weight compounds which modulate cancer survival pathways. Our lead compound in this program has proved highly effective in killing a variety of human cancer cells in cell cultures and has also demonstrated potent anti-tumor activity against human cancer in mice. Work is underway to advance this series of compounds to select a clinical candidate. While the potential outcome is expected to be similar (namely selective cell death), the targets, mechanism of action and chemistry involved in the 650 series are different from those involved in the 501 and 550 programs.

      Activating B-RAF mutations have been implicated in nearly 70% of human melanomas as well as in lower percentages of other cancers. This ArQule program has identified and developed a series of novel and proprietary compounds that are highly selective when tested against a panel of over 100 human kinases, a profile distinctly different from other known B-RAF inhibitors. The ArQule compounds from this program inhibit B-RAF kinase in the nanomolar range, effectively shutting down the aberrant proliferative signaling that is exhibited by human cancer cells in models harboring clinically relevant mutant B-RAF.

Research

      p53, a protein that controls several key cell cycle checkpoints, is the most commonly mutated gene in human cancer. A potential way to restore normal function to this pathway is to activate apoptotic pathways which act downstream of p53. ArQule is currently validating targets that activate apoptosis downstream of p53.

      ArQule is using its proprietary ACT^sm based drug discovery approach to screen for compounds that activate candidate checkpoints. We have identified compounds with the unique properties of activating checkpoints without first inducing DNA damage or disrupting microtubule (cell skeleton) dynamics. These compounds are being optimized for their drug-like properties.

Other Portfolio Programs

      In November 2003, we commenced GLP-toxicology studies with our lead compound, ARQ 101, a p38 MAP Kinase inhibitor for rheumatoid arthritis. Throughout 2003, we had progressed several compounds through advanced lead optimization demonstrating functional oral activity in a rat model of rheumatoid arthritis. In this established animal model, the data indicated that our compounds reduced joint swelling in a dose-dependent manner and were well tolerated at all doses studied. In order to focus on our cancer programs, we have ceased internal efforts and are currently exploring opportunities to out-license this program.

Partnered Pipeline

      Wyeth currently has a Phase 1 clinical trial and a preclinical program based upon compounds discovered in collaboration with ArQule. The clinical trial is in Rheumatoid Arthritis and the preclinical program is in Alzheimer’s Disease.

      Solvay currently has a preclinical program in irritable bowel syndrome based upon a compound discovered in collaboration with ArQule.

      The partnered pipeline is derived from former collaborations in our Chemistry Technologies business, and ArQule has received milestone payments from the above companies. Should any of these compounds proceed further in the clinic, or become drugs, under the terms of the agreements, ArQule will be eligible to receive various further milestone payments and royalties.

Hoffmann-La Roche Alliance

      In April 2004, we entered into an alliance with Hoffmann-La Roche (“Roche”) to discover and develop drug candidates targeting the E2F biological pathway. The alliance includes ARQ 501 and our ARQ-550RP programs. Under the terms of the agreement, Roche obtained an option to license drugs resulting from our E2F program in the field of cancer therapy. Roche provided immediate research funding of $15 million and financial support for ongoing research and development. We are responsible for advancing drug candidates from early stage development into phase 2 trials. Roche may opt to license worldwide rights for the development and commercialization of products resulting from this collaboration by paying an option fee. Assuming the successful development and commercialization of a compound under the program, we could receive up to $276 million in predetermined payments, plus royalties based on net sales. Additionally, we have the option to co-promote products in the U.S.

BUSINESS STRATEGY

Overview

      Our business strategy aims to balance revenues from our chemistry services with our cancer drug discovery and development. Our specific goals for the near future are as follows:

Drug Discovery And Development Strategy

      Our strategy for developing compounds into commercial products has the following components:

      Focus on cancer, a market with a large unmet need. Cancer is the second most common cause of death in the western world. Estimates for 2003 suggest that approximately 1.2 million new cases of invasive cancer will be diagnosed annually in the United States. Medical therapy has evolved as an alternative to, or adjunct of, surgery including the introduction of cytotoxic chemotherapy and radiation over 50 years ago. While chemotherapies have evolved, many are still harmful to all rapidly dividing cells. More recently, a number of alternative therapies that are target specific have been introduced. We believe that our approach has the potential to be more selective for cancer cells than traditional chemotherapies and applicable to a broad spectrum of cancers.

      Take advantage of available accelerated regulatory approval strategies as appropriate. Cancer compounds have been eligible for accelerated regulatory approval. On average, three new oncology agents have been approved per year over the past 14 years. Once on the market, the agents may be approved for additional indications with supportive data. We intend to pursue clinical development of our drug candidates primarily in a manner that optimizes our chances for regulatory approval, pursuing opportunities for accelerated approval as appropriate.

      Focus on small molecule drugs. Most prescription medicines are — and we believe will continue to be — small molecules. Approximately 88% of the top 200 prescription drugs, based on worldwide sales in 2001, are compounds described as small molecules. Small molecules can usually be made into pills that can be readily swallowed. In addition, small molecule drugs have a low production cost as compared to other therapeutic agents because they are easier to make, store and ship. Other therapeutic agents, such as proteins and antibodies, are more difficult to administer — requiring, for example, injections — and are also more costly to manufacture than small molecules. We intend to leverage our expertise in small molecule chemistry to discover and develop drugs that have these advantages.

      Benefit from the resources and strengths of collaborators. On April 2, 2004, we entered into an agreement with Hoffmann-La Roche (“Roche”) in which Roche acquired the right to an option on certain compounds in our E2F program and to the E2F program in total for oncology indications. While we are responsible for development of ARQ 501 through Phase 2, we benefit from Roche’s resources and expertise in manufacturing, regulatory, clinical development, and commercialization. We intend to pursue future partnership arrangements only as appropriate and when our partner’s capabilities complement our strengths in oncology drug discovery and development.

      Acquire new technologies as necessary. As we further our transition to oncology-focused biotechnology, we may need to supplement our portfolio and resources by acquisition, in-licensing and/or developing internal expertise. Such transactions could allow us to move more quickly toward developing additional candidates for clinical trials. We may also continue to invest in technology and personnel to enhance or expand our capabilities in drug discovery.

      Continue to exploit our strength in chemistry for oncology drug discovery and development. ArQule has developed a chemistry-based drug discovery technology platform designed to create small molecules that possess drug-like characteristics. We believe that identifying drug-like characteristics prior to preclinical development increases the likelihood that small molecules reaching preclinical development will have a greater potential to become medicines. Without such a technology platform, the traditional approach is to develop small molecules that have demonstrated activity toward biological targets, with little regard to whether the molecules otherwise would make good medicines. In our view, a drug that has the best set of drug-like characteristics for its indication (i.e., one that is the most effective and has the fewest side effects) will ultimately generate the most revenue in its category, even if it is not the first to become available on the market. We are using our chemistry technology and expertise in our cancer discovery programs.

      Build on the pharmaceutical and biotechnology expertise of our management and scientific teams. Our executive team consists of leaders with experience in drug discovery and development and specific expertise in oncology. Our CEO, Dr. Stephen Hill, formerly led global drug development for F. Hoffmann-La Roche, Ltd. After the Cyclis acquisition, we retained the scientific founder of Cyclis and the inventor of the ACT^sm platform, Dr. Chiang Li as our CSO and head of ArQule Biomedical Institute to advance our research and development programs based on the ACT^sm platform. In 2004, we hired Dr. Shi-Chung Ng as Vice President of Drug Discovery Biology, and Dennis France as Vice President of Oncology Lead Discovery. Dr. Ng was formerly a Senior Group Leader and Volwiler Associate Fellow at Abbott Laboratories, and Dennis France was formerly an Executive Director at Novartis.

Chemical Technologies Strategy

      We provide chemistry services to collaborators and customers for their discovery programs. In line with our transition to drug discovery, we intend to run our chemistry technologies as a profitable, cash flow positive business.

      We are an established market leader in the production of diverse collections of chemical compounds using automated high throughput technology and computational design tools. We do not believe that any of our competitors in small molecule chemistry possess the particular combination of technology included in our chemistry technology platform and we believe our capabilities provide a competitive advantage over the industry standard techniques for designing and producing drug-like molecules. We believe it would take any competitor several years, (assuming it would be possible to work around our proprietary technology), to duplicate our technology platform and process.

      We are currently providing chemistry technology services under collaborations with Pfizer Inc and Novartis Institute for Biomedical Research, Inc. (“Novartis”). Our collaboration with Pfizer is our largest collaboration and accounted for 84% of our revenue for 2004. During 2004, we also completed the active phase of our chemistry-based collaboration with Sankyo Company, Ltd (“Sankyo”). In 2004, Novartis renewed and extended their collaboration to February 2005. We also completed activity under collaborations with Bayer AG, Solvay Duphar B.V. and Pharmacia Corporation in 2003. Under our collaboration agreements, we generally receive fees for the services we provide during the active phase of the agreement. These agreements also impose trailing obligations on our collaborators to, under specified circumstances, make milestone and royalty payments to us based on their further development of compounds we provided to them. In addition, for several of our formerly active collaborators, we have agreed to provide a limited amount of compound production services, as such collaborators seek to optimize promising compounds. Wyeth has filed two INDs based upon compounds from our Directed Array Program, one of which is currently in phase I clinical trials, while Wyeth has ceased development on the other. A third compound derived from our collaboration is progressing within Wyeth’s internal development track. We received milestone payments in connection therewith in October 2002, February 2004, December 2004 and February 2005.

      The terms of our currently active collaborations are summarized below:

      Pfizer. Since the inception of this relationship in 1999, we have produced collections of chemical compounds exclusively for Pfizer using our automated high throughput system. This agreement expires in 2008, subject to early termination as discussed below. In February 2004, the agreement was amended to

maintain compound deliveries at approximately the same level from 2004 through the end of the term, instead of increasing them as previously specified.

      As of March 1, 2005, we have received $234 million from Pfizer since inception of this relationship in 1999. If our relationship with Pfizer is successful, we could receive up to an additional $136 million over the remaining term of the contract. Pfizer has made equity investments in our company of $10 million in 2001, and $8 million in 2003, based on the achievement of certain delivery milestones. Under the amended agreement, upon notice, Pfizer may terminate the relationship beginning in December 2005 for any reason, but would not be entitled to receive any refund for amounts paid to ArQule through the date of termination.

      Novartis Institute for BioMedical Research, Inc. On September 3, 2003, we entered into a one year chemistry services collaboration with Novartis Institute for BioMedical Research, Inc. (“Novartis”), an affiliate of Novartis AG. As part of the collaboration we are applying our integrated chemistry technology platform to generate and optimize small molecule compounds for Novartis’ anti-infective drug discovery program. In September 2004, this contract was extended six months. The total amended contract value of the agreement is $1.5 million, of which we have received the entire balance as of December 31, 2004. Novartis must also make additional payments if we achieve certain developmental milestones.

PATENTS AND PROPRIETY RIGHTS

      We believe that patent and trade secret protection is crucial to our business and that our future will depend in part on our ability to obtain patents, maintain trade secret protection and operate without infringing the proprietary rights of others, both in the U.S. and other countries. As of March 1, 2005, we had 22 issued or allowed U.S. utility patents, one issued U.S. design patent, 18 granted foreign patents, and numerous patent applications in the U.S. and other countries. While many patent applications have been filed in the U.S. and other countries with respect to our cancer programs, the majority of these have not yet been issued or allowed. The patent positions of companies in the biotechnology industry and the pharmaceutical industry are highly uncertain and involve complex legal and factual questions. Therefore, we cannot predict the breadth of claims, if any, that may be allowed under any of our patent applications, or the enforceability of any of our issued patents.

      As needed, we obtain rights under patents owned by other parties through licenses. We have several exclusive and nonexclusive technology licenses from certain institutions in support of our research programs. We anticipate that we will continue to seek licenses from universities and others where applicable technology complements our research and development efforts.

      Patents extend for varying periods according to the date of patent filing or grant and the legal term of patents in the various countries where patent protection is obtained. The actual protection afforded by a patent, which can vary from country to country, depends on the type of patent, the scope of its coverage and the availability of legal remedies in the country.

      In an effort to maintain the confidentiality and ownership of our trade secrets and proprietary information, we require all of our employees and consultants to sign confidentiality agreements. Employees and consultants involved in scientific and technical endeavors also sign invention assignment agreements. We intend these confidentiality and assignment agreements to protect our proprietary information by controlling the disclosure and use of technology to which we have rights. These agreements also provide that we will own all the proprietary technology developed at ArQule or developed using our resources.

      “ArQule”, the ArQule logo, “Directed Array”, “Mapping Array” and “AMAP” are trademarks of ArQule that are registered or entitled to be registered in the U.S. Patent and Trademark Office. The terms “AMAP”, “ArQule Reactor”, “Compass Array”, “Custom Array”, “MapMaker”, “Optimal Chemical Entities”, “OCEs”, “Parallel Track”, and “PrepQule” are trademarks of ArQule. The terms “Activated Checkpoint Therapy” and “ACT” are service marks of ArQule.

COMPETITION

      The pharmaceutical and biotechnology industries are highly competitive. We face intense competition from organizations such as large pharmaceutical companies, biotechnology companies and academic and research organizations. The major pharmaceutical organizations competing with us have greater capital resources, larger overall research and development staff and facilities and considerably more experience in drug development and commercialization. Biotechnology companies competing with us may have these advantages as well. In addition to competition for collaborators and investors, these companies and institutions also compete with us in recruiting and retaining highly qualified scientific and management personnel.

      With respect to our cancer drug discovery and development programs, other companies have potential drugs in preclinical and clinical trials that may result in effective, commercially successful treatments for the same cancers we target. In the area of small molecule anti-cancer therapeutics, we have identified a number of companies that have clinical development programs and focused research and development in small molecule approaches to cancer such as, for example, Onyx Pharmaceuticals; OSI Pharmaceuticals; Oxigene, Inc.; and Telik Inc.

      Several organizations are actively attempting to identify and optimize compounds for internal or collaborator programs and, like us, act both as chemistry service providers and as integrated drug discovery companies. These companies include Array^tm BioPharma and Exelixis. Other competitors in the chemistry technology services market are Pharmacopeia, Inc.; Albany Molecular Research, Inc.; Evotec OAI; and Discovery Partners International, Inc.

      We face competition in several areas of our business including:

      There can be no assurance that our competitors will not develop more effective or more affordable products or technology, or achieve earlier product development and commercialization than ArQule, thus rendering our technologies and/or products obsolete, uncompetitive or uneconomical.

GOVERNMENT REGULATION

      Virtually all pharmaceutical and biotechnology products that we or our collaborative partners develop will require regulatory approval by governmental agencies prior to commercialization. The nature and the extent to which these regulations apply varies depending on the nature of the products. In particular, human pharmaceutical products are subject to rigorous preclinical and clinical testing and other approval procedures by the FDA. Various federal and, in some cases, state statutes and regulations also govern or influence the manufacturing, safety, labeling, storage, record keeping and marketing of these products required by the FDA. The process of obtaining these approvals and the subsequent compliance with appropriate federal statutes and regulations are time consuming and require substantial resources and the outcome is uncertain.

      Generally, in order to gain FDA approval, a company first must conduct preclinical studies in the laboratory and in animal models to gain preliminary information on a compound’s activity and to identify potential safety problems. Preclinical studies must be conducted in accordance with FDA regulations. The results of these studies are submitted as a part of an IND that the FDA must review before human clinical

trials of an investigational drug can start. If the FDA does not respond with any questions, a drug developer can commence clinical trials thirty days after the submission of an IND.

      In order to eventually commercialize any products, we or our collaborator first will be required to sponsor and file an IND and will be responsible for initiating and overseeing the clinical studies to demonstrate the safety and efficacy that are necessary to obtain FDA marketing approval. Clinical trials are normally done in three phases and generally take several years, but may take longer to complete. Furthermore, the FDA may suspend clinical trials at any time if the FDA believes that the subjects participating in trials are being exposed to unacceptable risks or if the FDA finds deficiencies in the conduct of the trials or other problems with our product under development.

      After completion of clinical trials of a new product, FDA marketing approval must be obtained. If the product is classified as a new pharmaceutical, we or our collaborator will be required to file a New Drug Application (“NDA”), and receive approval before commercial marketing of the drug. The testing and approval processes require substantial time and effort. NDAs submitted to the FDA can take several years to obtain approval and the FDA is not obligated to grant approval at all.

      Even if FDA regulatory clearances are obtained, a marketed product is subject to continual review. If and when the FDA approves any of our or our collaborators’ products under development, the manufacture and marketing of these products will be subject to continuing regulation, including compliance with current Good Manufacturing Practices (“cGMP”), adverse event reporting requirements and prohibitions on promoting a product for unapproved uses. Later discovery of previously unknown problems or failure to comply with the applicable regulatory requirements may result in restrictions on the marketing of a product or withdrawal of the product from the market as well as possible civil or criminal sanctions. Various federal and, in some cases, state statutes and regulations also govern or influence the manufacturing, safety, labeling, storage, record keeping and marketing of pharmaceutical products.

      For marketing outside the United States, we or our partners will be subject to foreign regulatory requirements governing human clinical trials, marketing approval and post-marketing activities for pharmaceutical products and biologics. The requirements governing the conduct of clinical trials, product licensing, pricing and reimbursement vary widely from country to country.

      Our research and development processes involve the controlled use of hazardous materials and controlled substances. Although we are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of these materials and waste products, the license or sale of our chemistry services is not subject to the same degree of government regulations applicable to our drug product candidates.

EMPLOYEES

      As of March 1, 2005, we employ 270 people at two sites in Massachusetts: Woburn (headquarters, discovery and development, and chemistry technologies) and Norwood (target identification and validation). Of that total, 99 hold Ph.D.s and 25 hold Masters in the Sciences. As of March 1, 2005, 150 of our employees were engaged in operations, 72 were engaged in research and development and 48 were engaged in marketing and general administration.

CERTAIN OTHER INFORMATION

      We file annual and quarterly reports, proxy statements and other information with the SEC. You may read and copy any document we file at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room. The SEC maintains a website at http://www.sec.gov that contains reports, proxy and information statements and other information concerning filers. We also maintain a web site at http://www.ArQule.com that provides additional information, free of charge, about our company and links to documents we file with the SEC.

      Set forth below is certain information regarding our current executive officers and directors, including their respective ages, as of March 10, 2005:

Stephen A. Hill, B.M. B.Ch., M.A., F.R.C.S.

President and Chief Executive Officer. Dr. Hill has served as ArQule’s President and CEO since April 1999. Before joining ArQule, Dr. Hill was the Head of global Drug Development at F. Hoffmann-La Roche Ltd. from 1997-1999. Dr. Hill joined Roche in 1989 as Medical Adviser to Roche Products in the United Kingdom. He held several senior positions there that included Medical Director, responsible for clinical trials of compounds across a broad range of therapeutic areas, such as CNS, HIV, cardiovascular, metabolic and oncology products. Subsequently, he served as Head of International Drug Regulatory Affairs at Roche headquarters in Basel, Switzerland, where he led the regulatory submissions for seven major new chemical entities. Dr. Hill also was a member of Roche’s Portfolio Management, Research, Development and Pharmaceutical Division Executive Boards. Prior to Roche, Dr. Hill served seven years with the National Health Service in the United Kingdom in General and Orthopedic Surgery. Dr. Hill is a Fellow of the Royal College of Surgeons of England and holds his scientific and medical degrees from St. Catherine’s College at Oxford University.

Chiang J. Li, M.D.

Chief Scientific Officer and Vice President, Head of ArQule Biomedical Institute. Dr. Li joined ArQule in September 2003. Prior to joining ArQule, he had served as the scientific founder and Vice President of Research at Cyclis Pharmaceuticals, Inc., a faculty member at Harvard Medical School and an attending physician at Harvard’s Beth Israel Deaconess Medical Center. At Cyclis, Dr. Li directed research efforts that led to a cancer therapeutic portfolio, which culminated in the successful IND filing of Cyclis’ first drug candidate, CO-501. Dr. Li is the inventor of, and has directed research efforts on, the Activated Checkpoint Therapy^sm (ACT^sm) platform that underscores ArQule’s oncology portfolio. He has published a number of highly cited articles in over 30 publications in leading biomedical journals and holds 15 issued or filed patents. Dr. Li is a member of several professional societies, including a recent induction to the National Register’s Who’s Who in Executives and Professionals. Dr. Li has been a recipient of a number of honors, recognitions and research awards. Most recently his work was recognized by the editorial board of the journal, Cell Cycle, as one of the “Top Ten Most Outstanding Cell Cycle Research Papers” of the past year published in all biomedical journals. Dr. Li graduated from the Harvard-MIT Division of Health Science and Technology and received his M.D. degree Magna Cum Laude from Harvard Medical School.

Louise A. Mawhinney, C.P.A.

Vice President, Finance and Chief Financial Officer. Ms. Mawhinney joined the Company in December 2003 as Vice President, Finance and CFO. Ms. Mawhinney has more than 20 years of experience in finance covering audit, accounting, treasury, tax, SEC reporting, investor relations, corporate financing and merger

and acquisition responsibilities. For the past three years, Ms. Mawhinney has been Chief Financial Officer, Secretary and Treasurer of Cleanwise, Inc., a Massachusetts-based third-party logistics software start-up company. From 1999 to 2000, she was Chief Financial Officer, Secretary and Treasurer of Veridiem Inc., a Massachusetts-based marketing automation software start-up. From 1993 to 1999, Ms. Mawhinney served in a variety of finance functions, and in 1996 became Chief Financial Officer, Secretary and Treasurer, for The Butcher Company, a chemical process manufacturer with annual sales of $80 million. Prior to that she was with KPMG in Boston, MA. Ms. Mawhinney holds a Masters degree from St. Andrews University in Scotland and has been a C.P.A. in Massachusetts since 1989.

      Patrick J. Zenner was named Chairman of the Board in May 2004 and has been a director since 2002. A 32-year veteran of the pharmaceutical industry, Patrick Zenner retired in 2001 from the position of President and Chief Executive Officer of Hoffmann-La Roche Inc., North America. Hoffmann-La Roche Inc., based in Nutley, N.J., is the prescription drug unit of the Roche Group. Long active in industry, academic and civic affairs, Mr. Zenner is immediate past chairman of the HealthCare Institute of New Jersey and served on the Boards of Directors and Executive Committees of the Pharmaceutical Research & Manufacturers of America (PhRMA) and the Biotechnology Industry Organization (BIO). In addition, Mr. Zenner has been a member of numerous associations, including the American Foundation for Pharmaceutical Education, the Health Care Leadership Council and the National Committee for Quality Health Care. Mr. Zenner is currently on the Boards of Trustees of Creighton University and Fairleigh Dickinson University. In addition, Mr. Zenner is a member on the Boards of Directors of CuraGen Corporation, Dendrite International, Praecis Pharmaceuticals Inc., Geron Corporation, First Horizon Pharmaceutical Corporation, Xoma Ltd., West Pharmaceutical Services and Exact Sciences, Inc.

      Laura Avakian has been a director since March 2000. Since 1999, Ms. Avakian has been Vice President for Human Resources for the Massachusetts Institute of Technology, where she directs all human resource programs and oversees the Institution’s Medical Department. Prior to joining MIT, she was Senior Vice President, Human Resources, for Beth Israel Deaconess Medical Center and for its parent corporation CareGroup (1996-1999). She previously served as President of The American Society for Healthcare Human Resources Administration, and received the distinguished service award, literature award and chapter leadership award from that society. She received the 1996 Award for Professional Excellence in Human Resources Management from the Society for Human Resource Management. She has also served as editor of the Yearbook of Healthcare Management and authored numerous chapters and articles on human resources management. Ms. Avakian received her B.A. degree from the University of Missouri at Columbia and her M.A. degree from Northwestern University.

      Timothy C. Barabe has been a director since November 2001. Mr. Barabe has been employed by Regent Medical Ltd. since September, 2004 as its Chief Financial Officer, located in Manchester, England. Regent Medical is one of the world’s largest suppliers of disposable surgical gloves and associated antiseptic products. Previously Mr. Barabe was employed by Novartis AG from 1982 through August, 2004 in various capacities, lastly as the Chief Financial Officer of Sandoz GmbH, the generic pharmaceutical subsidiary of Novartis. From February 2002 until April 2003, Mr. Barabe was Group Vice President and President, Specialty Lenses of CIBA Vision. From 1993 through January 2002, Mr. Barabe was the Chief Financial Officer of CIBA Vision Corp., a contact lens and lens care subsidiary of Novartis. Mr. Barabe received his B.B.A. degree from the University of Massachusetts (Amherst) and his M.B.A. degree from the University of Chicago.

      Werner Cautreels, Ph.D. has been a director since September 1999. He has over 20 years of experience in the healthcare industry. Since May 1998, Dr. Cautreels has been the Global Head of Research and Development of Solvay Pharmaceuticals. Prior to that time, Dr. Cautreels served as Senior Vice President of Research and Development at Nycomed Amersham Ltd., held two senior management positions at Sterling Winthrop and served as Vice President of Scientific Affairs at Sanofi Pharmaceuticals, where he conducted clinical trials in various therapeutic areas and researched licensing opportunities. Dr. Cautreels received his Ph.D. in Chemistry from University of Antwerp, Belgium.

      Tuan Ha-Ngoc has been a director since 2002. Mr. Ha-Ngoc has 28 years of worldwide experience in the healthcare industry, primarily in the biotechnology sector but also in the pharmaceutical, medical devices,

and information technology areas. He has been President and CEO of AVEO Pharmaceuticals, Inc. (f/k/a GenPath Pharmaceuticals, Inc.) since its inception in 2002. From 1999 to 2002, he was co-founder, President & CEO of deNovis, Inc., an enterprise-scale software development company for the automation of healthcare administrative functions. From 1998 to 1999, he served as Corporate Vice President, Strategic Development for American Home Products Corporation (recently renamed Wyeth) after its acquisition of Genetics Institute. From 1984 to 1998, he was at Genetics Institute, Inc. as its Executive Vice President responsible for Corporate Development, Commercial Operations, European Operations and Japanese Operations. From 1976 to 1984, he held various marketing and business positions at Baxter Healthcare, Inc. a leading medical device company. Mr. Ha-Ngoc received his MBA degree from INSEAD and his Master’s degree in Pharmacy at the University of Paris, France. He serves on the Board of several academic and non-profit organizations such as the Harvard School of Dental Medicine, the Tufts School of Medicine, the Belmont Hill School, the Boston Philharmonic Orchestra, and the International Institute of Boston.

      William G. Messenger has been a director since January, 2005. From 1994 to date he has been the owner and managing director of the Lexington Sycamore Group, consultants in the fields of business strategy, organization and leadership. Mr. Messenger serves as Director of the Mockler Center for Faith and Ethics in the Workplace at Gordon-Conwell Theological Seminary. He is also Director of the Boston Division of the Business Leadership & Spirituality Network. Mr. Messenger received a BS in Physics with highest honors from Case Western Reserve University, an MBA with high distinction from Harvard Business School and a Master of Divinity degree, summa cum laude, from Boston University School of Theology.

RISKS RELATING TO OUR BUSINESS AND STRATEGY

Development of our products is at an early stage and is uncertain and our approach and technology may never result in a commercial drug.

      The discovery and development of drugs is inherently risky and involves a high rate of failure. Discovering and developing commercial drugs is relatively new to us.

      Our proposed drug products and drug research programs are in early stages and require significant, time-consuming and costly research and development, testing and regulatory approvals. We do not expect that these product candidates will be commercially available for several years, if ever. We have never identified a drug candidate that has been developed into a commercial drug using our technology platform. It is uncertain whether our technology platform will produce a commercial drug at all, or whether it will do so competitively.

We must show the safety and efficacy of our product candidates through expensive, time consuming preclinical and clinical trials, the results of which are uncertain, governed by exacting regulations.

      Our product candidates are in early clinical or preclinical stages of development. Although several of our product candidates have demonstrated some favorable pharmacological effects in preclinical studies, they may not prove to be sufficiently effective in humans, if at all. We will need to conduct extensive further testing of all of our product candidates, expend significant additional resources and possibly partner with another company (as we have done with Roche for ARQ 501) to realize commercial value from any of our product candidates.

      Before obtaining regulatory approvals for the commercial sale of our products, we must demonstrate, through preclinical studies (animal testing) and clinical trials (human testing), that our proposed products are safe and effective for use in each target indication. This testing is expensive and time-consuming, and failure can occur at any stage. Acceptable results from initial preclinical studies and clinical trials of products under development are not necessarily indicative of results that will be obtained from subsequent or more extensive preclinical studies and clinical testing in humans. Clinical trials may not demonstrate sufficient safety and efficacy to obtain the required regulatory approvals or result in marketable products. The failure to adequately demonstrate the safety and efficacy of a product under development will delay and could prevent its 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.

      Though it is our stated strategy to pursue clinical development to take advantage of available accelerated regulatory approval processes, there is no guarantee that our product candidates will show the evidence predictive of clinical benefit necessary to qualify for regulatory treatment.

      Clinical trials for the product candidates we are developing may be delayed by many factors, including that potential appropriate patients for testing are limited in number and may be difficult to recruit. The failure of any clinical trials to meet applicable regulatory standards or the standards of relevant local Institutional Review Boards could cause such trials to be delayed or terminated, which could further delay the commercialization of any of our product candidates. Any such delays will increase our product development costs, with the possibility that we could run out of funding. Consequently, if such delays are significant they could negatively affect our financial results and the commercial prospects for our products.

We have limited capabilities in clinical development of drug candidates.

      We are dependent on third-party providers of preclinical and clinical development services, including cGMP and testing. For example, we do not have sufficient facilities for all of the preclinical testing of candidate drugs in animals which must be undertaken in order to advance to clinical testing in humans. Also, preclinical and clinical testing require the manufacture of amounts of drugs which exceeds the designed capacity of our facilities. Furthermore, our facilities do not meet the requirements of cGMP. If we choose to perform such studies ourselves or scale up our production capabilities and qualify them under cGMP, we will be required to incur significant costs and devote significant efforts to establish our own development facilities and capabilities. If we are unable to reach agreement with third-party service providers on acceptable terms, or to establish our own development facilities, ArQule’s preclinical and clinical development of products will be delayed and our financial results will be adversely affected.

We may face challenges in realizing the benefits of the Cyclis acquisition, and future acquisitions.

      Having acquired Cyclis Pharmaceuticals, Inc. on September 8, 2003, we have been operating the Cyclis business for only sixteen months. This has been a complex process of integrating the former Cyclis operations and personnel, including the ARQ 501 program, and the Cyclis molecular biology expertise into our existing operations. It is too early to be certain that the integration has been successful or that we will achieve the anticipated benefits of the merger. There may be unexpected delays or we may be unable to successfully develop the Cyclis business and technology over the long-term. As noted below, we also may make additional acquisitions, which could pose similar, or greater, risks than the Cyclis acquisition. There is also the risk that we may have greater difficulty integrating more than one acquisition at the same time.

If we choose to acquire complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions, to integrate successfully an acquired business or technology in a cost-effective and non-disruptive manner or to complete commercialization of an acquired product.

      From time to time, we may choose to acquire complementary businesses, products, or technologies instead of developing them ourselves. We do not know if we will be able to complete any particular acquisitions, or whether we will be able to successfully integrate the acquired business, operate it profitably or retain its key employees. Integrating any business, product or technology we acquire could be expensive and time-consuming, disrupt our ongoing business and distract company management. In addition, in order to finance any acquisition, we might need to raise additional funds through public or private equity or debt financings. In that event, we could be forced to obtain financing on less than favorable terms. In the case of equity financing, that may result in dilution to our stockholders. In addition, under certain circumstances, amortization of assets or charges resulting from the costs of acquisitions could harm our business and operating results.

We may not be able to find collaborators or successfully form collaborations in furtherance of our drug development efforts.

      As we did in regard to ARQ 501, we plan to seek collaborators for our drug development efforts. We would like to enter into these collaborations to obtain external financing for drug development and to obtain access to commercialization expertise. The availability of partners depends on the willingness of pharmaceutical companies to collaborate in drug discovery activities. There are only a limited number of pharmaceutical companies that would fit our requirements. The number could decline further through consolidation or the number of collaborators with interest in our drugs could decline. If the number of our potential collaborators declines further, collaborators may be able to negotiate terms unfavorable to us.

      We face significant competition in seeking collaborators, both from other biotechnology companies and from the internal capabilities and compound pipelines of the pharmaceutical companies themselves. This competition is particularly intense in the oncology field. Our ability to interest such companies in forming co-development and commercialization arrangements with us will be influenced by, among other things:

      Even if we are able to gain the interest of potential drug development partners, the negotiation, documentation and implementation of collaborative arrangements are complex and time-consuming. Collaborative opportunities may not be available on commercially acceptable terms and, if formed, may not be commercially successful or, if successful, may not realize sufficient return for us. If we are unable to form collaborations, we may not gain access to the financial resources and industry expertise necessary to develop drug products or successfully market any products we develop on our own and, therefore, be unable to generate revenue from pharmaceutical products.

Our success depends on the efforts of our collaborators, whom we do not and cannot control.

      If we are able to enter into collaborations for the development and commercialization of our drug candidates, we will depend on our partners to develop and commercialize our drug candidates. Similarly, we depend on parties to whom we have provided compounds through chemistry services collaborations to develop and commercialize those compounds. Each of our current chemistry services collaborators has, and we expect that each future collaborator will have, significant discretion in determining the efforts and resources that it will apply to the development and commercialization of compounds and drug candidates covered by its collaboration with us.

      Any of our current or future collaboration partners may fail to develop or commercialize a compound or product to which they have obtained rights from us for a variety of reasons, including that our partner:

We may not receive any further milestone, royalty or license payments under our current or any future collaborations.

      Although we have received license and milestone fees to date under our chemistry services collaborations, we may never receive any royalty payments or additional license and milestone fees under such agreements.

Likewise, even if we are able to enter into collaboration agreements relating to our drug candidates, we may never receive any milestone, royalty or license payments under such future agreements.

      Our receipt of any future milestone, royalty or license payments depends on many factors, including whether our collaborators want or are able to continue to pursue a potential drug candidate and the ultimate commercial success of the drug. Development and commercialization of potential drug candidates depends not only on the achievement of objectives by us and our collaborators, but also on each collaborator’s financial, competitive, marketing, internal R&D and strategic considerations and regulation in the United States and other countries. Pharmaceutical products our collaborators develop will require lengthy and costly testing in animals and humans and regulatory approval by governmental agencies prior to commercialization. These agencies may not approve the products for commercialization despite the substantial time and resources required to seek approvals and comply with appropriate statutes and regulations. If unforeseen complications arise in the development or commercialization of the potential drug candidates by our collaborators, we may not realize milestone, royalty or license payments.

We face fierce competition from competitors with greater resources.

      Even if we are successful in bringing a product to market, we face substantial competitive challenges in effectively marketing and distributing our products. Many other companies and research institutions are developing products within the field of oncology, including large pharmaceutical companies with much greater financial resources, and more experience in developing products, running clinical trials, obtaining FDA approval and bringing new drugs to market. We are in a rapidly evolving field of research. Consequently, our technology may be rendered non-competitive or obsolete by approaches and methodologies discovered by others, both before and after we have gone to market with our product. We also face competition from existing therapies that are currently accepted in the marketplace, and the impact of adverse events in our field that may affect regulatory approval or public perception.

We may not be able to recruit and retain the scientists and management we need to compete.

      To succeed, we must attract, retain and motivate highly skilled scientists and management. We compete intensely with pharmaceutical and biotechnology companies, including our collaborators, medicinal chemistry outsourcing companies, contract research companies, and academic and research institutions to recruit scientists and management. If we cannot hire additional qualified personnel, the workload may increase for both existing and new personnel. The shortage of personnel with experience in drug development could lead to increased recruiting, relocation and compensation costs, which may exceed our expectations and resources. These increased costs also may reduce our profit margins and make hiring new scientists impractical.

We may be exposed to potential liability related to the development, testing or manufacturing of compounds we develop.

      We develop, test and manufacture the precursors to drugs generally intended for use in humans. If our drug discovery activities result in clinical trials, or the manufacture and sale of drugs, we could be liable if persons are injured or die while using these drugs. We may have to pay substantial damages and/or incur legal costs to defend claims resulting from injury or death, and we may not receive expected royalty or milestone payments if commercialization of a drug is limited or ended as a result of such claims. We have product liability insurance that contains customary exclusions and provides coverage per occurrence at levels, in the aggregate, which we believe are customary and commercially reasonable in our industry given the stage we have achieved in drug commercialization. However, our product liability insurance does not cover every type of product liability claim that we may face or loss we may incur and may not adequately compensate us for the entire amount of covered claims or losses or for the harm to our business reputation. Also, we may be unable to maintain our current insurance policies or obtain and maintain necessary additional coverage at acceptable costs or at all.

RISKS RELATED TO OUR FINANCIAL CONDITION

We may not achieve profitability.

      From our inception in 1993 through December 31, 2004, we have incurred cumulative losses of approximately $189 million. These losses have resulted principally from the costs of our research activities and enhancements to our technology. We have derived our revenue primarily from:

      To date, these revenues have generated profits only in 1997 and 2000. We have not realized any revenue from royalties from the sale by any of our collaboration partners of a commercial product developed using our technology. We might never become profitable on a sustained basis.

Our revenue from chemistry technologies collaborations is uncertain and not diversified.

      Our ability to generate revenue from chemistry services collaborations typically involves significant technical evaluation and/or commitment of capital by our collaborators and is subject to a number of significant risks, including collaborators’ budgetary constraints and internal acceptance reviews.

      To maintain our current relationships with chemistry services collaborators and to meet the performance and delivery requirements in our contracts, we must provide drug discovery capabilities and chemistry technology products and services at appropriate levels, with acceptable quality and at acceptable cost. Our ability to deliver the drug discovery capabilities, products and services we want to offer to our collaborators is limited by many factors, including the difficulty of the chemistry, the lack of predictability in the scientific process and the shortage of qualified scientific personnel. In particular, a large portion of our revenue depends on producing collections of high-quality chemical compounds, at a high rate of production. If we are unable to maintain the rate of compound synthesis necessary to meet our existing or future contractual commitments, it may result in delayed or lost revenue, loss of collaborations and/or failure to expand our existing relationships. In addition, competition from providers in India, Eastern Europe and other lower cost jurisdictions puts and will likely increasingly put pressure on pricing and on our ability to achieve an acceptable margin from this business.

      Also, at present we depend largely on chemistry services collaboration arrangements for our revenue and cannot be sure whether our collaborations will succeed or whether we will realize much of the potential revenue from our collaborations. In addition, 84% of our revenue in 2004 was generated from our Pfizer collaboration which Pfizer may terminate beginning in December 2005 for any reason. Significant portions of the revenue from milestones and royalties that we may receive under these collaborations will depend upon our ability and/or our partners’ ability to successfully develop, license, introduce, market and sell new drugs developed using our chemical compounds and/or proprietary technology. We have little control over the efforts of our partners. We may not be able to achieve these milestones and may not be able to develop commercial drugs or other products on which royalties will be payable.

      Products developed in collaborations will result in commercialized drugs generating royalties only after, among other things:

Our operating results will continue to fluctuate significantly.

      Our chemistry services collaborators can influence when we deliver products and perform services under their contracts with us. This could cause our operating results to fluctuate significantly. In addition, we expect to continue to experience significant fluctuations in operating results due to factors such as general and industry specific economic conditions that may affect the research and development expenditures of pharmaceutical and biotechnology companies, as well as the timing of compound shipments to our collaborators.

      Revenue is recognized in accordance with generally accepted accounting principles (“GAAP”), which require us to expense certain costs as incurred and defer the related revenue over the life of the contract. This makes gross margin fluctuate up and down as revenue is not matched with the associated costs. See Significant Accounting Policies in Note 2 to the Consolidated Financial Statements contained in Item 8 of this Annual Report on Form 10K.

      We thus believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. Our operating results in some periods may not meet the expectations of stock market analysts and investors, causing our stock price to decline.

We may not be able to fund our operations.

      Although we believe that we have sufficient funding in the near term, we may at some point need to obtain additional financing. Such financing could come from the proceeds of public or private debt or equity financings or corporate partnerships. We may not be able to obtain adequate funds for our operations from these sources when needed or on acceptable terms. If we raise additional capital through the sale of equity, or securities convertible into equity, each shareholder’s proportionate ownership in ArQule may be diluted.

      If we cannot obtain additional financing, we could be forced to delay or scale back our research and development programs. If adequate funds are not available, we may be required to curtail operations significantly or to obtain funds by entering into arrangements with collaboration partners or others that may require that we relinquish rights to certain technologies, product candidates, products or potential markets.

      In particular, our plans for clinical development of drug candidates will cause us to incur significant costs. If we are successful in our drug development efforts, we may be involved in multiple clinical trials with cumulative costs escalating greatly over time.

      We believe that our cash, cash equivalents and short-term investment securities balances as of December 31, 2004, combined with the $28.5 million raised in a registered direct stock offering on January 28, 2005, will be sufficient to meet our operating and capital requirements for the next three years. We have based this estimate on assumptions and estimates that may prove to be wrong. Even if our estimates are correct, we may need or choose to obtain additional financing during that time.

RISKS RELATED TO INTELLECTUAL PROPERTY

Our patents and other proprietary rights may fail to protect our business.

      To be successful and compete, we must obtain and protect patents on our products and technology and protect our trade secrets. Where appropriate, we seek patent protection for certain aspects of our technology, but patent protection may not be available for some of the compounds and drugs, and their use, synthesis, formulations and technologies we are developing. The patent position of biotechnology firms is highly uncertain, involves complex legal and factual questions, and has recently been the subject of much litigation. No consistent policy has emerged from the U.S. Patent and Trademark Office or the courts regarding the breadth of claims allowed or the degree of protection afforded under many biotechnology patents. In addition, there is a substantial backlog of biotechnology patent applications at the U.S. Patent and Trademark Office, and the approval or rejection of patent applications may take several years.

      We do not know whether our patent applications will result in issued patents. For example, we may not have developed a method for treating a disease before others have developed similar methods. In addition, the receipt of a patent might not provide much practical protection. If we receive a patent with a narrow scope, then it will be easier for competitors to design products that do not infringe on our patent. We cannot be certain that we will receive any additional patents, that the claims of our patents will offer significant protection of our technology, or that our patents will not be challenged, narrowed, invalidated or circumvented.

      Competitors may interfere with our patent protection in a variety of ways. Competitors may claim that they invented the claimed invention prior to us. Competitors may also claim that we are infringing on their patents and that therefore we cannot practice our technology as claimed under our patents. Competitors may also contest our patents by showing the patent examiner that the invention was not original, was not novel or was obvious. In litigation, a competitor could claim that our issued patents are not valid for a number of reasons. If a court agrees, we would lose that patent. As a company, we have no meaningful experience with competitors interfering with our patents or patent applications.

      To protect or enforce our patent rights, we may initiate patent litigation against third parties, such as infringement lawsuits or interference proceedings. Such litigation can be expensive, take significant time and divert management’s attention from other business concerns, which could increase our research and development expense and delay our product programs. Litigation that we initiate may provoke third parties to assert claims against us.

      It is also unclear whether our trade secrets will prove to be adequately protected. To protect our trade secrets, we require our employees, consultants and advisors to execute confidentiality agreements. We cannot guarantee, however, that these agreements will provide us with adequate protection against improper use or disclosure of confidential information. Our employees, consultants or advisors may unintentionally or willfully disclose our information to competitors. In addition, in some situations, these agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants or advisors had or have previous employment or consulting relationships. Like patent litigation, enforcing a claim that a third party illegally obtained and is using our trade secrets is expensive and time-consuming, and the outcome is unpredictable. In addition, courts outside the United States are sometimes less willing than our federal and state courts to protect trade secrets. Furthermore, others may independently develop substantially equivalent knowledge, methods and know-how.

      If we must spend significant additional time and money protecting our patents and trade secrets, we will have fewer resources to devote to the development of our technologies, and our business and financial prospects may be harmed.

Our success will depend partly on our ability to operate without infringing on or misappropriating the proprietary rights of others.

      There are many patents in our field of technology and we cannot guarantee that we do not infringe on those patents or that we will not infringe on patents granted in the future. If a patent holder believes a product of ours infringes on its patent, the patent holder may sue us even if we have received patent protection for our technology. Intellectual property litigation is costly and, even if we prevail, the cost of such litigation could adversely affect our business, financial condition and results of operations. In addition, litigation is time-consuming and could divert management attention and resources away from our business. If we do not prevail in litigation, we may have to pay substantial damages for past infringement.

      Also, if we lose, the court may prohibit us from selling or licensing the product that infringes the patent unless the patent holder licenses the patent to us. The patent holder is not required to grant us a license. If a license is available, it may not be available on acceptable terms. For example, we might have to pay substantial royalties or grant cross-licenses to its patents. In addition, some licenses may be nonexclusive and, accordingly, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license, we could encounter delays in product development while we attempt to design around other patents or we could even be prohibited from developing, manufacturing or selling products requiring these

licenses. If we are unable to cost-effectively redesign our products so they do not infringe a patent, we may be unable to sell some of our products. Any of these occurrences will result in lost revenues and profits for us.

Our collaborators may restrict our use of scientific information.

      We may not be able to acquire any rights to technology or products derived from our collaborations. There is also a risk that disputes may arise as to the rights to technology or products developed in collaboration with other parties.

      The success of our strategy depends, in part, on our ability to apply a growing base of knowledge, technology and data across all of our internal projects and our collaborations. Some of this data has been and will continue to be generated from our work with collaborators. Although we believe that certain of this information is not proprietary to our collaborators, our collaborators may disagree and may succeed in preventing us from using some or all of this information and/or technology ourselves or with others. Without the ability to use this information freely, we may be limited in our ability to improve the efficiency of our drug discovery and development process.

RISKS RELATED TO REGULATION

We may not obtain regulatory approval for the sale and manufacture of drug products.

      The development and commercialization of drug candidates in the United States, including those drug candidates we develop alone or in collaboration with our partners, are subject to regulation by U.S. regulatory authorities. Pharmaceutical products require lengthy and costly testing in animals and humans and regulatory approval by the appropriate governmental agencies prior to commercialization. Regulatory authorities may suspend clinical trials at any time if they believe that the subjects participating in the trials are being exposed to unacceptable risks or if an agency finds deficiencies in the conduct of the trials or other problems with our product under development. Approval of a drug candidate as safe and effective for use in humans is never certain and these agencies may delay or deny approval of the products for commercialization. Changes in regulatory policy during the period of regulatory review may result in unforeseen delays or denial of approval. Similar regulations, delays, denials and other risks may be encountered in foreign countries.

      As a company, ArQule has never obtained regulatory approval to manufacture and sell a drug. If we and/or our collaborators develop a drug candidate and cannot obtain this approval, we may not realize milestone or royalty payments based on commercialization goals for such drug candidate. Even if regulatory approval is obtained, regulatory authorities may require additional clinical studies after sales of a drug have begun. In addition, the identification of certain side effects after a drug is on the market may result in the subsequent withdrawal of approval, reformulation of the drug, additional preclinical and clinical trials, changes in labeling, recalls, warnings to physicians or the public, and negative publicity.

      Any of these events could delay or prevent us from generating revenue from the commercialization of any drug candidates we develop or help to develop.

We have only limited experience in regulatory affairs, and some of our products may be based on new technologies; these factors may affect our ability or the time we require to obtain necessary regulatory approvals.

      As we have only recently initiated clinical trials for our first product candidate, we have only limited experience in filing and prosecuting the applications necessary to gain regulatory approvals. Moreover, certain of the products that are likely to result from our research and development programs may be based on new technologies and new therapeutic approaches that have not been extensively tested in humans. The regulatory requirements governing these types of products may be more rigorous than for conventional products. As a result, we may experience a longer regulatory process in connection with any products that we develop based on these new technologies or new therapeutic approaches.

RISKS RELATING TO PRODUCT MANUFACTURING

If our use of chemical and hazardous materials violates applicable laws or causes personal injury, we may be liable for damages.

      Our drug discovery activities, including the analysis and synthesis of chemical compounds, involve the controlled use of chemicals, including flammable, combustible, toxic and radioactive materials that are potentially hazardous if misused. Federal, state and local laws and regulations govern our use, storage, handling and disposal of these materials. These laws and regulations include the Resource Conservation and Recovery Act, the Occupational Safety and Health Act and local fire and building codes, and regulations promulgated by the Department of Transportation, the Drug Enforcement Agency, the Department of Energy, the Department of Health and Human Services, and the laws of Massachusetts, where we conduct our operations. We may incur significant costs to comply with these laws and regulations in the future. Notwithstanding our extensive safety procedures for handling and disposing of such materials, the risk of accidental contamination or injury from these materials cannot be completely eliminated. In the event of an accident, our business could be disrupted and we could be liable for damages, and any such liability could exceed our resources, and have a negative impact on our financial condition and results of operations.

      Because we have limited manufacturing capabilities, if we decide to outsource the manufacturing of chemical compounds, or initiate a drug manufacturing strategy, we will be dependent on third-party manufacturers or will be required to incur significant costs and devote significant efforts to establish our own manufacturing facilities and capabilities.

      There are a limited number of manufacturers that operate under the FDA’s good manufacturing practices regulations capable of manufacturing our products. As a result, we may experience difficulty finding manufacturers for our products with adequate capacity for future needs. If we are unable to arrange for outsourced manufacturing of our products, or to do so on commercially reasonable terms, we may not be able to complete development of our products or market them.

      Reliance on an outsourced manufacturer entails risks to which we would not be subject if we manufactured products ourselves, including reliance on the manufacturer for regulatory compliance and quality assurance, the possibility of breach of the manufacturing agreement because of factors beyond our control and the possibility of termination or nonrenewal of the agreement by the manufacturer, based on the manufacturer’s own business priorities, at a time that is costly or inconvenient for us.

      We may in the future elect to manufacture certain of our products in our own manufacturing facilities. We would need to invest substantial additional funds and recruit qualified personnel in order to build or lease and operate any such manufacturing facilities.

      In November 1999, we moved our main operations to a new facility in Woburn, Massachusetts, which includes approximately 128,000 square feet of laboratory and office space. This facility was designed to our specific requirements. In March 2001, we purchased this building and the land on which it sits and a developable adjacent parcel of land for $18.2 million and $2.3 million, respectively, in an arms-length transaction with the original developer.

      We lease approximately 56,000 square feet of laboratory and office space in Medford, Massachusetts from Cummings Properties, LLC (“Cummings”) under two lease agreements, one of which expires on July 30, 2005 and the other on July 30, 2006. The Company subleases portions of these facilities pursuant to a sublease agreement. See LEGAL PROCEEDINGS below for a discussion of a dispute between ArQule and Cummings concerning an increase in rental rates on the lease that expires on July 30, 2006.

      In March 2002, we entered into an eight year lease with Pacific Shores Development LLC for approximately 34,000 square feet of laboratory and office space in Redwood City, California. We took occupancy in September 2002. Each base lease payment, the first of which was due and paid in September 2002, is $75,823 per month, subject to annual escalation provisions. In the third quarter of 2004, we entered

into a sublease for the California facility. See Note 11, “Restructuring Actions” in the Notes to Consolidated Financial Statements appearing in Item 8 in this Annual Report on Form 10-K.

      In December 2002, we announced a major restructuring of our operations which included closing our facilities in Redwood City, California as of December 31, 2002 and Cambridge, United Kingdom as of March 31, 2003. In October 2003, we completed an agreement with InPharmatica Ltd. to sell certain assets of our former operations in the United Kingdom and to assign our facility lease obligation.

      On August 1, 2001, Cummings significantly raised ArQule’s rent on the lease that expires July 30, 2006. We believe this increase to be in excess of that which is permissible under the lease agreement. Accordingly, on January 16, 2002, we brought a complaint in the Superior Court of Middlesex County in the Commonwealth of Massachusetts for declaratory relief and damages against Cummings arising, in part, out of Cummings’ attempts to increase the lease rates. Nevertheless, during the pendency of this dispute, we are paying the rental rates proposed by Cummings. The Company seeks recovery of the funds that it has already paid, and is paying, under protest. We do not believe that the outcome of this lawsuit will have a material adverse effect on the Company, its business, prospects, financial condition or operating results.

      No matters were submitted to stockholders for a vote during the fourth quarter of 2004.

PART II

      ArQule’s common stock is traded on the NASDAQ National Market under the symbol “ARQL”.

      The following table sets forth, for the periods indicated, the range of the high and low closing sale prices for ArQule’s common stock:

      As of March 1, 2005, there were approximately 181 holders of record and approximately 6,347 beneficial shareholders of our common stock.

Dividend Policy

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

Securities Authorized for Issuance under Equity Compensation Plans

      The following table provides information as of December 31, 2004 regarding compensation plans (including individual compensation arrangements) under which our equity securities are authorized for issuance.

      The following data, insofar as it relates to the years 2000, 2001, 2002, 2003 and 2004 have been derived from ArQule’s audited consolidated financial statements, including the consolidated balance sheet as of December 31, 2003 and 2004 and the related consolidated statements of operations and of cash flows for the three years ended December 31, 2004 and notes thereto appearing in Item 8 of this Annual Report on Form 10-K. This data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Financial Statements and the Notes thereto appearing in Items 7 and 8, respectively of this Annual Report on Form 10-K. The historical results are not necessarily indicative of the results of operations to be expected in the future. This data is in thousands, except per share data.

Overview

      We are a biotechnology company engaged in the research and development of small molecule cancer therapeutics. We also provide fee-based chemistry services to pharmaceutical and biotechnology companies to produce novel chemical compounds with drug-like characteristics.

      We have incurred a cumulative net loss of $189 million from inception through December 31, 2004. Our expenses prior to September 2003 related to development activities associated with our chemistry services, the associated administrative costs required to support those efforts, and the cost of acquisitions. We expect research and development costs to increase in 2005 as we pursue development of our cancer programs. We do not expect to make additional investments in chemistry services during 2005 as we continue to reinvest our positive cash flow from chemistry services into research and development. Although we have generated positive cash flow from operations for the last six years, we have recorded a net loss for each of those years. We expect to record a loss for 2005. Based on our cash position at the end of 2004 we will be able to dedicate approximately $25 million per year over the next three years to our ACT^sm research and development program. This estimate is based upon the assumption that we will continue to operate our chemistry services on a cash flow positive basis, and to invest in cancer related research and development.

      Our revenue is derived from chemistry services performed for customers and research and development funding from our alliance with Roche. Revenue, expenses and gross margin fluctuate from quarter to quarter based upon a number of factors, notably: the timing and extent of our cancer related research and development activities together with the length and outcome of our clinical trials; and our chemistry services contractual deliverables and the timing of the recognition of revenue under our revenue recognition policy (see the discussion of this under “Critical Accounting Policies” below). While our focus will be on cancer related

research and development, we will continue to pursue revenue opportunities from customers for our chemistry services.

      In February 2004, we amended our contract with Pfizer. Under the amended terms of the contract ArQule will continue to work with Pfizer’s scientists to match more closely its compound deliveries to those libraries which Pfizer believes represent the greatest developmental opportunities. Under this new agreement, ArQule will maintain compound deliveries at approximately the same level to be supplied in 2004 instead of increasing compound deliveries as specified in the previous agreement. If our amended relationship with Pfizer is successful, we could earn up to $291 million over the term of the contract (2001-2008).

      On April 2, 2004 we announced an alliance with Roche to discover and develop drug candidates targeting the E2F biological pathway. The alliance includes a compound that is currently in phase 1 clinical development. Under the terms of the agreement, Roche obtained an option to license our E2F program in the field of cancer therapy. Roche provided immediate research funding of $15 million, and will provide financial support for ongoing research and development. We are responsible for advancing drug candidates ranging from early stage development to phase 2 trials. Roche may opt to license worldwide rights for the development and commercialization of products resulting from this collaboration by paying an option fee.

      Assuming the successful development and commercialization of a compound under the program, we could receive up to $276 million in pre-determined payments, plus royalties based on net sales. Additionally, we have the option to co-promote products in the U.S.

      On January 28, 2005, we completed a stock offering in which we sold 5.79 million shares of common stock at $5.25 per share for net proceeds of approximately $28.5 million after commissions and offering expenses.

Liquidity and Capital Resources

      Cash flow from operating activities. The uses of our cash flow from operating activities have primarily consisted of salaries and wages for our employees, facility and facility-related costs for our offices and laboratories, fees paid in connection with preclinical and clinical studies, laboratory supplies and materials, and professional fees. The sources of our cash flow from operating activities have consisted of payments from our collaborators for services performed or upfront payments for future services. For 2004, the net source of funds of $5.5 million was primarily due to the upfront research funding from Roche of $15 million, an operating profit (excluding non-cash charges) of $2.7 million and $0.4 from reductions in accounts receivable based on the timing of customer payments, partially offset by $2.8 million related to payments of severance and facility related restructuring costs and the current year restructuring credit, $1.1 million of reductions on accounts payable and accruals resulting from the timing of vendor payments at year end, $0.4 million related to an increase in prepaid expense due to the timing of payments for service contracts and $8.1 million related to the recognition of deferred revenues.

      Cash and cash equivalents used in investing activities. The total use was $11.1 million in 2004, compared to $1.0 million in 2003. The 2004 use was comprised of capital expenditures of $4.4 million and net purchases of marketable securities of $6.7 million. The composition and mix of cash, cash equivalents and

marketable securities may change frequently as a result of the Company’s constant evaluation of conditions in financial markets, the maturity of specific investments, and the Company’s near term need for liquidity.

      Cash and cash equivalents used in financing activities. The total use was $6.0 million in 2004 compared to $1.4 million in 2003. The 2004 use was comprised of debt principal repayments of $6.9 million, primarily associated with the Company’s paydown of all term debt with Bank of America (former Fleet National Bank), partially offset by $1.0 million of proceeds from the exercise of stock options.

      We have been cash flow positive from operations for six consecutive years, although we do not expect to be cash flow positive from operations in 2005. We expect that our available cash and marketable securities, totaling approximately $100 million after the January 2005 stock offering, together with operating results and investment income, will be sufficient to finance our working capital and capital requirements for the next three years.

      Our cash requirements may vary materially from those now planned depending upon the results of our drug discovery and development strategies, our ability to enter into any additional corporate collaborations in the future and the terms of such collaborations, results of research and development, the need for currently unanticipated capital expenditures, competitive and technological advances, acquisitions and other factors. We cannot guarantee that we will be able to obtain additional customers for our chemistry services, or that such services will produce revenues adequate to fund our operating expenses. We cannot guarantee that we will be able to develop any of our drug candidates into a commercial product. If we experience increased losses, we may have to seek additional financing from public and private sale of our securities, including equity securities. There can be no assurance that additional funding will be available when needed or on acceptable terms.

      Our contractual obligations were comprised of the following as of December 31, 2004 (in thousands):

      Included in the total minimum payments for operating leases is approximately $5.7 million related to unoccupied real estate in California which was accrued as a liability, net of contractual sublease income, as a part of the Company’s restructuring charge in 2002 and subsequently adjusted in 2003 and 2004 (see Note 11 to the Consolidated Financial Statements in Item 8 of this Form 10K). Purchase obligations are comprised primarily of outsourced preclinical and clinical trial expenses and payments to license certain intellectual property to support the Company’s research efforts.

Critical Accounting Policies and Estimates

      A “critical accounting policy” is one which is both important to the portrayal of the Company’s financial condition and results and requires management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management believes the following are critical accounting policies. For additional information, please see the discussion of our significant accounting policies in Note 2 to the Consolidated Financial Statements included in Item 8 of this Form 10-K.

      Historically, ArQule has entered into various collaborative agreements with pharmaceutical and biotechnology companies under which ArQule produces and delivers compound arrays and provides research and development services. Revenue elements from collaborative agreements include non-refundable technology transfer fees, funding of compound development work, payments based upon delivery of specialized compounds meeting collaborators’ specific criteria and certain milestones and royalties on product sales. In each instance, the Company analyzes each distinct revenue element of the contract to determine the basis for revenue recognition. Revenue for each element is generally recognized over the period compounds are delivered and/or services are performed, provided there is a contractual obligation on behalf of the customer to pay ArQule and payment is reasonably assured. The nature of each distinct revenue element, the facts surrounding the services provided, and ArQule’s ongoing obligations to provide those services dictate how revenue is recognized for each revenue element. This accounting conforms to Generally Accepted Accounting Principles in the United States, in particular Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements, and is disclosed more fully in Note 2 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

      In May 2003, the Financial Accounting Standards Board reached a consensus on Emerging Issues Task Force No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). EITF 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying the guidance, revenue arrangements with multiple deliverables can only be considered as separate units of accounting if: a) the delivered item has value to the customer on a standalone basis, b) there is objective and reliable evidence of the fair value of the undelivered items and c) if the right of return exists, delivery of the undelivered items is considered probable and substantially in the control of the vendor. If these criteria are not met, the revenue elements must be considered a single unit of accounting for purposes of revenue recognition. EITF 00-21 became effective for new revenue arrangements entered into in fiscal periods beginning after June 15, 2003.

      In February 2004, the Company entered into an amended contract with Pfizer. The amendment modified the quantity and composition of compounds to be produced and delivered by ArQule, with a corresponding adjustment to the remaining contractual billings for undelivered elements under the contract. We concluded that the modification was substantial enough to require evaluation of the contract to determine if EITF 00-21 applied. We concluded that because the contract does contain multiple deliverables (license to technology, research services and compound deliveries) EITF 00-21 did apply. We determined that there was not sufficient evidence of fair value of the undelivered elements (compounds), and therefore the amended contract represented a single unit of accounting for revenue recognition purposes. As a result, in Q1 2004 ArQule began treating the amended Pfizer agreement as a single unit of accounting and recognizing revenue based on the delivery of compounds against the contractual compound delivery schedule.

      We follow these guidelines to measure revenue; however, certain judgments affect the application of these policies. For example, in connection with our Pfizer collaboration we have recorded current and long term deferred revenue based on our best estimate of when such revenue will be recognized. The estimate of deferred revenue reflects our estimate of the timing and extent of services that we will provide to Pfizer. Our services to Pfizer, and the timing of those services, are difficult to estimate and are impacted by factors outside of our control. For example, the timing and quantity of compounds we provide is largely dependent on Pfizer’s internal needs. Changes to estimates could impact the timing and amount of revenue we recognize in the future.

      Compound development revenue was derived from the following contractual elements in 2002, 2003 and 2004 (in thousands):

      Before 2004, ArQule recognized revenue from Pfizer based on the individual contractual elements of the collaborative agreement. As noted above, in 2004 as a result of the amended Pfizer agreement and the adoption of EITF 00-21, the Company began to account for Pfizer revenue as a single unit of accounting. In 2004, Pfizer revenue in above table is fully included in “Payments based on delivery of specialized compounds.”

      Under the terms of the Roche agreement, Roche obtained an option to license ArQule’s E2F program in the field of cancer therapy. Roche provided immediate research funding of $15 million, and financial support for ongoing research and development. ArQule is responsible for advancing drug candidates from early stage development into phase 2 trials. Roche may opt to license worldwide rights for the development and commercialization of products resulting from this collaboration by paying an option fee. Assuming the successful development and commercialization of a compound under the program, ArQule could receive up to $276 million in pre-determined milestone payments, plus royalties based on net sales. ArQule considers the development portion of the arrangement to be a single unit of accounting under EITF 00-21 for purposes of revenue recognition, and will recognize the initial and ongoing development payments as research and development revenue over the maximum estimated development period. We estimate the maximum development period could extend until December 2009, although this period may ultimately be shorter depending upon the outcome of the development work, which would result in accelerated recognition of the development revenue. Milestone and royalty payments will be recognized as revenue when earned. The cost associated with satisfying the Roche contract is included in research and development expense in the Consolidated Statement of Operations.

      Upon consummation of the Cyclis acquisition, we immediately charged to income $30.4 million representing purchased in-process research and development (“IPR&D”) that had not yet reached technical feasibility and had no alternative future use. Approximately $14 million of the charge represents the fair value of the IPR&D; the remaining $16.4 million of the charge represents the allocation to IPR&D of a portion of the excess of purchase price over the fair value of assets acquired.

      We believe that this charge represents a reasonably reliable estimate of the future benefits attributed to purchased IPR&D. The value assigned IPR&D (before the step-up adjustment) was the projected value of three Cyclis preclinical drug development projects based on various mechanisms of actions associated with the ACT^sm technology. The valuation was determined using the income approach. Potential revenue and drug development expenses were projected through 2020 based on information obtained from management and from published third-party industry statistics for similar drug development businesses. Specifically, we estimated that the development of our current cancer programs through clinical trials to commercial viability will take approximately nine years and cost in excess of $500 million. The discounted cash flow method was applied to the projected cash flows, adjusted for the probability of success, using a discount rate of 30%. The discount rate takes into consideration the uncertainty surrounding successful development and commercialization of the IPR&D. Since the acquisition, nothing has occurred that would lead us to believe that the original

estimates of the cost to develop these compounds, or their revenue potential, is materially different from the estimates used at the time of the acquisition for purposes of purchase accounting.

      Accruals for abandoned facilities under lease requires significant management judgment and the use of estimates, including assumptions concerning the ability of a sublessee to fulfill its contractual sublease obligations. In the third quarter of 2004, we entered into a sublease for the Company’s abandoned facility in Redwood City, California. The term of the sublease extends through 2010, the remaining term of the Company’s primary lease. As a result of signing the sublease, we adjusted our accrual for abandoned facilities to reflect the full amount of the anticipated sublease income to be received. This assumption about the subleasee’s ability to fulfill its contractual obligation is based on an analysis of their financial position and ability to generate future working capital. If the subleasee is unable to meet its obligations, and the Company is unable to enter into another sublease for the facility, ArQule may be required to adjust its restructuring accrual and record additional restructuring expense of up to $4.5 million.

      At December 31, 2003, we performed an assessment of the fair value of our investment in a privately held proteomics company. This assessment included analysis of that company’s current financial condition, its prospects for generating additional cash flow from operating activities, the current market conditions for raising capital funding for companies in this industry and the likelihood that any funding raised would significantly dilute our ownership percentage. As a result of this analysis it was our judgment that an impairment had occurred and that the fair value of our investment was $0.25 million, resulting in a non-cash loss on investment of $4.75 million. The was no indication of further impairment in 2004. If this entity is unsuccessful in its efforts to secure additional financing it may cease operations, rendering our investment worthless and necessitating a further write down. If the value of this investment recovers, we will not write-up the investment until it is sold.

Results of Operations

      Years ended December 31, 2002, 2003 and 2004:

      2004 as compared to 2003: Compound development revenue in 2004 decreased by $16.1 million, or 25%, from 2003. Revenue from our chemistry-based collaboration with Pfizer was $45.8 million, a decrease of $9.4 million, or 17%, from 2003. Although the number of compounds delivered to Pfizer in 2004 were approximately the same as in 2003, in the fourth quarter of 2003 ArQule received a contractual milestone payment on an accelerated basis which increased 2003 revenue. Beginning in 2004, as a result of the amended Pfizer agreement and the application of EITF 00-21, ArQule began recognizing revenue from Pfizer based solely on the number of compounds produced and shipped (i.e. all obligations were treated as a single unit of accounting) rather than based on individual contractual elements. See “Revenue Recognition” under “Critical Accounting Policies and Estimates” contained herein for more information. Compound development revenue was also lower in 2004 due to a reduction in revenue from Bayer of $6.8 million, Sankyo of $1.3 million, Pharmacia of $0.8 million and Johnson & Johnson of $0.4 million, all the result of contracts which ended at various times in 2003 and 2004. Partially offsetting the decrease was a) $2.0 million of milestone revenue from Wyeth related to the advancement by Wyeth of three compounds, the discovery of which were facilitated by a collaboration with ArQule and b) an increase in revenue from Novartis of $0.7 million related to a compound development contract entered into in the latter half of 2003 that was in effect for all of 2004. Research and development revenue is comprised of revenue from Roche in connection with the alliance agreement signed in April 2004.

      2003 as compared to 2002: Compound development revenue increased by $2.7 million, or 4%. Revenue from our chemistry collaboration with Pfizer increased by $8.5 million due to an increase in the number of compounds developed under the terms of the contract and our receipt of certain contractual milestone payments on an accelerated basis because we met delivery requirements in 2003 ahead of schedule. This increase was offset by reductions in revenue from Bayer of $2.1 million, Solvay of $1.1 million, and Pharmacia of $0.5 million as the Company completed its final contractual obligations with these companies in 2003, and from reductions in revenue from Searle of $1.0 million, Wyeth of $0.7 million and Glaxo-Smith-Kline of $0.6 million as a result of contract completions in 2002.

      2004 as compared to 2003: Cost of revenue — compound development decreased in absolute dollars primarily due to: reduced material and supply costs necessary to satisfy the Bayer, Sankyo, Pharmacia and Johnson and Johnson contracts which ended at various times in 2003 and 2004; lower depreciation charges resulting from reduced capital spending in new equipment and a lower depreciable basis in existing capital equipment; and a reduction in personnel dedicated to compound development as a result of the amended Pfizer collaborative agreement and the corporate restructuring in the first quarter of 2004 (see Restructuring Actions below). Compound development gross margin percentage was lower in 2004 due partially to a) a higher gross margin percentage in 2003 as a result of the recognition of deferred revenue from Bayer at the end of that contract in 2003 for which the associated costs were incurred in prior years and the recognition of a contracted milestone from Pfizer on an accelerated basis which increased 2003 revenue with no associated cost, and b) partially to a lower gross margin percentage in 2004 resulting from the lower overall level of revenue available to offset fixed overhead and facility-related expenses.

      2003 as compared to 2002: Cost of revenue — compound development increased due to increased cost of personnel, materials and facility related expenses, including depreciation, necessary to satisfy the increase in activity under the Pfizer contract during 2003, partially offset by a reduction in material costs associated with the completion of the Bayer contract during the third quarter of 2003. Gross margin as a percentage of revenue increased primarily as a result of the one-time increase in Pfizer revenue due to our receipt of certain contractual milestone payments on an accelerated basis because we met delivery requirements in 2003 ahead

of schedule and to the recognition of previously deferred revenue from Bayer as a result of our completing our contractual obligations, the associated costs for which were incurred in earlier years.

      ArQule’s research and development expense consists primarily of salaries and related expenses for personnel, costs of contract manufacturing services, costs of facilities and equipment, fees paid to professional service providers in conjunction with independently monitoring our clinical trials and acquiring and evaluating data in conjunction with our clinical trials, fees paid to research organizations in conjunction with preclinical animal studies, costs of materials used in research and development, consulting, license, and sponsored research fees paid to third parties and depreciation of capital resources used to develop our products. These costs include those incurred in conjunction with research and development revenue. We expect our research and development expense to increase as we continue to develop our portfolio of oncology programs.

      We have not accumulated and tracked our internal historical research and development costs or our personnel and personnel-related costs on a program-by-program basis. In addition, we use our employee and infrastructure resources across several projects, and many of our costs are not attributable to an individually named project; rather they are directed to broadly applicable research endeavors. As a result, we cannot state the costs incurred for each of our oncology programs on a program-by-program basis. While we cannot state the internal costs incurred for each of our oncology programs on a program-by-program basis, we estimate that payments made by us to third-parties for preclinical and clinical trials in 2004 and since inception of each program were as follows (in thousands):

      We expect that a large percentage of our research and development expenses in the future will be incurred in support of our current and future oncology programs. These expenditures are subject to numerous uncertainties in timing and cost to completion. We test potential products in numerous preclinical studies for safety, toxicology, and efficacy. We then may conduct multiple clinical trials for each product. As we obtain results from trials, we may elect to discontinue or delay clinical trials for certain products in order to focus our resources on more promising products. Completion of clinical trials may take several years or more, but the length of time generally varies substantially according to the type, complexity, novelty, and intended use of a product. It is not unusual for the preclinical and clinical development of these types of products to each take nine years or more, and for total development costs to exceed $500 million for each product.

      We estimate that clinical trials of the type generally needed to secure new drug approval are typically completed over the following timelines:

The duration and the cost of clinical trials may vary significantly over the life of a project as a result of differences arising during clinical development, including, among others, the following:

      An element of our business strategy is to pursue the research and development of a broad pipeline of products. This is intended to allow us to diversify the risks associated with our research and development expenditures. As a result, we believe our future capital requirements and future financial success are not substantially dependent on any one product. To the extent we are unable to maintain a broad pipeline of products, our dependence on the success of one or a few products increases.

      Our strategy includes the option of entering in alliance arrangements with third parties to participate in the development and commercialization of our products, such as our collaboration agreement with Roche. In the event that third parties have control over the clinical trial process for a product, the estimated completion date would largely be under control of that third party rather than under our control. We cannot forecast with any degree of certainty whether our products will be subject to future collaborative arrangements or how such arrangements would affect our development plans or capital requirements.

      As a result of the uncertainties discussed above, we are unable to determine the duration and completion costs of our oncology programs or when and to what extent we will receive cash inflows from the commercialization and sale of a product. Our inability to complete our oncology programs in a timely manner or our failure to enter into collaborative agreements, when appropriate, could significantly increase our capital requirements and could adversely impact our liquidity. These uncertainties could force us to seek additional, external sources of financing from time-to-time in order to continue with our strategy. Our inability to raise additional capital, or to do so on terms reasonably acceptable to us, would jeopardize the future success of our business.

      2004 as compared to 2003: The increase in research and development expense in 2004 primarily consists of an increase in personnel-related cost of $1.2 million related to the hiring of additional scientists and $1.1 million related to the cost of pre-clinical and clinical trials to advance further the E2F program. The cost increases were partially offset by $0.7 million of costs incurred in 2003 related to the recruitment of a key employee and severance paid certain senior managers which were not incurred in 2004. At December 31, 2004, we had 65 employees dedicated to our research and development program, up from 47 at December 31, 2003. We expect research and development expenses to continue to increase in 2005 as we expand our oncology discovery pipeline and begin preclinical and clinical trials as part of the development process.

      2003 as compared to 2002: The $12.5 million decrease in research and development primarily reflects the cost savings associated with our decision in December 2002 to cease further development of the Camitro predictive modeling technology, to close the related facilities in Redwood City, California (effective December 31, 2002) and Cambridge, United Kingdom (effective March 31, 2003), and to realign our workforce in order to expedite its transition to a drug discovery and development company. These cost savings were partially offset by the increased cost associated with the acquisition of Cyclis in September 2003, notably the addition of approximately 14 scientists, increased laboratory supply and facility expenses and the cost of preclinical and clinical studies to develop the ACT^SM platform and ARQ 501.

      2004 as compared to 2003: Marketing, general and administrative expenses decreased slightly in 2004. In February 2004, we eliminated 16 administrative positions as part of our restructuring actions to reallocate resources to our oncology and drug discovery efforts causing a reduction in personnel and infrastructure expenses of $0.9 million. The cost saving associated with these personnel reductions were partially offset by increases in legal expenses of $0.4 million related to the negotiation of the alliance agreement with Roche in the first quarter of 2004 and increased costs associated with protecting our intellectual property.

      2003 as compared to 2002: The decrease in marketing, general and administrative expense is primarily due to the cost savings associated with the severance of 31 marketing, general and administrative employees as part of the Company’s restructuring actions in December 2002, and the closing of the Redwood City and Cambridge facilities. The decrease consists primarily of reductions in employee related expenses of $1.8 million, professional fees of $0.6 million and facility related expense of $0.6 million.

      2003. Acquisition related charges in 2003 relate to the September 8, 2003 acquisition of Cyclis. Upon consummation of the Cyclis acquisition, we immediately charged to income $30.4 million representing purchased in-process research and development (“IPR&D”) that had not yet reached technical feasibility and had no alternative future use. Approximately $14 million of the charge represents the fair value of the IPR&D. The remaining $16.4 million of the charge represents a step-up adjustment resulting from the excess of the purchase price over the identifiable tangible and intangible assets acquired and liabilities assumed which was allocated on a pro rata basis to the carrying value of acquired long-lived assets. See “Critical Accounting Policies and Estimates” above for a discussion of our accounting policies and significant estimates.

      2002. Acquisition related charges in 2002 all relate to the January 2001 acquisition of Camitro. Upon consummation of the acquisition in January 2001, we immediately charged to income $18.0 million representing the estimated fair value of purchased in-process technology that had not yet reached technological feasibility and had no alternative future use (see Note 4 of Notes to Consolidated Financial Statements included in Item 8 of this 10-K).

      In 2002, we continued to recognize stock-based compensation charges based on the amortization of deferred compensation arising from the issuance of stock options issued below market value and restricted stock to former employees of Camitro, in addition to amortizing core technology. We implemented Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”) in January 2002, and accordingly ceased recording periodic goodwill amortization charges in lieu of performing annual assessments for impairment. At December 31, 2002, we assessed the recoverability of the carrying value of our core technology and goodwill balances and, based on the applicable accounting standards, recorded impairment charges of $17.1 million and $25.9 million, respectively, representing the entire remaining balances of

these assets. See “Critical Accounting Policies and Estimates” above for a discussion of our accounting policies and significant estimates.

      In December 2002, we announced a restructuring of our operations whereby we ceased further development and commercialization of the Camitro predictive modeling technology and realigned our workforce to expedite the transition towards becoming a drug discovery company. The restructuring actions included closing our facilities in Redwood City, California and Cambridge, United Kingdom, along with the termination of employees in these facilities and our Massachusetts facilities. The Company recorded a restructuring charge of approximately $12.7 million, the components of which are as follows (in thousands):

      Termination benefits relate to severance and benefit costs associated with the elimination of 128 managerial and staff positions worldwide, comprising approximately 31% of the workforce. Facility-related costs relate to the remaining lease payment obligations associated with the abandonment of our facilities in Redwood City, California and Cambridge and the non-cash write-off of leasehold improvements and equipment no longer expected to provide future economic benefit at the abandoned facilities, less assumed proceeds from sale. Other charges include a $0.5 million non-cash stock compensation charge, contractual obligations which provided no future value to the Company, and other miscellaneous costs associated with closing the California and United Kingdom operations. See Item 11 in the Notes to the Consolidated Financial Statements in Item 2 of this 10K. We believe that these actions resulted in savings of approximately $12 million per year in personnel and facility-related expenses.

      In October 2003, ArQule completed an agreement with InPharmatica Ltd. to sell certain assets of its former operations in the United Kingdom. As a result, ArQule reversed $0.3 million of restructuring accrual to reflect a change in its original estimate of the remaining lease obligations and assumed sublease income in the United Kingdom. Throughout the latter half of 2003, ArQule was in negotiations with a third-party to sublease its facility in California on favorable terms. Those negotiations were terminated in January 2004. As a result, the adequacy of the accrual relative to the lease obligation and assumed sublease income for the California facility was reassessed, and based on continued deterioration in the local real estate market, an additional provision of $1.5 million was recorded in the fourth quarter of 2003.

      In the first quarter of 2004, we implemented a restructuring to shift resources from our chemical technologies business to our internal cancer therapy research. The restructuring included the termination of 53 staff and managerial employees, or approximately 18% of the workforce, in the following areas: 30 in chemistry production positions; 7 in chemistry-based research and development positions; and 16 in administrative positions. The Company anticipates annualized saving of approximately $4.4 million associated with the terminations. In connection with these actions we recorded a restructuring charge of $1.1 million in the first quarter of 2004 for termination benefits.

      In the third quarter of 2004, we entered into a sublease for the California facility. The term of the sublease extends through 2010, the remaining term of the Company’s primary lease obligation. As a result of signing the sublease, we reassessed the remaining restructuring accrual and, since the sublease was on terms more favorable than previously estimated, we recorded a $1.5 million restructuring credit in the third quarter of 2004.

      Activities against the restructuring accrual (which is included in accrued liabilities in the Consolidated Balance Sheet) in 2003 and 2004 were as follows (in thousands):

      As of December 31, 2004, all employee termination benefits have been paid. The facility- related accrual, which is primarily comprised of the difference between the Company’s lease obligation for its California facility and the amount of sublease payments it will receive under its sublease agreement, will be paid out through 2010.

      Interest income is derived from our portfolio of cash and short-term investments. Interest income increased modestly in 2004 due to the $15 million upfront payment from Roche in April 2004, which increased the average portfolio balance for the year and to generally higher interest rates. Interest income decreased in 2003 from 2002 due to a lower average principal balances and lower interest rates. Interest expense decreased in each of the last three years due to lower average debt balances and generally lower interest rates.

      The loss on investment in 2003 relates to an impairment charge taken to write down the Company’s investment in a privately-held proteomics Company to its estimated fair value. See “Critical Accounting Policies and Estimates” above for a discussion of our accounting policies and significant estimates.

Recent Accounting Pronouncements

      In December 2004, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 123R, Accounting for Stock-Based Compensation (“SFAS No. 123R”). SFAS No. 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in

share-based payment transactions. SFAS No. 123R requires that the fair value of such equity instruments be recognized as an expense in the historical financial statements as services are performed. Prior to SFAS No. 123R, only certain pro forma disclosures of fair value were required. The provisions of this Statement are effective for ArQule in the first interim period beginning after June 15, 2005. Accordingly, we will adopt SFAS No. 123R commencing with the quarter ending September 30, 2005. If we had included the fair value of employee stock options in our financial statements for the years ended December 31, 2002, 2003 and 2004, our net loss would have been as disclosed in Note 2 to the Consolidated Financial Statement included in Item 8 of this Form 10K. The Company is currently studying various adoption alternatives, but expects the adoption of SFAS No. 123R to have a material effect on our financial statements.

      We own financial instruments that are sensitive to market risk as part of our investment portfolio. Our investment portfolio is used to preserve our capital until it is used to fund operations, including our research and development activities. None of these market — risk sensitive instruments are held for trading purposes. We invest our cash primarily in money market mutual funds and U.S. Government and other investment grade debt securities. These investments are evaluated quarterly to determine the fair value of the portfolio. Our investment portfolio includes only marketable securities with active secondary or resale markets to help insure liquidity. We have implemented policies regarding the amount and credit ratings of investments. Due to the conservative nature of these policies, we do not believe we have material exposure due to market risk.

      See Notes 2 and 12 to the Consolidated Financial Statements for a description of our use of derivatives and other financial instruments. The Company had no derivatives outstanding at December 31, 2004.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

      Schedules are not included because they are not applicable or the information is included in the Notes to Consolidated Financial Statements.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of ArQule, Inc.:

      We have completed an integrated audit of ArQule Inc.’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements

      In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of ArQule, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Internal control over financial reporting

      Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

      A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized

acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

      Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Boston, Massachusetts

March 16, 2005

ARQULE, INC.

CONSOLIDATED BALANCE SHEET

The accompanying notes are an integral part of these consolidated financial statements.

ARQULE, INC.

CONSOLIDATED STATEMENT OF OPERATIONS

The accompanying notes are an integral part of these consolidated financial statements.

ARQULE, INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS

The accompanying notes are an integral part of these consolidated financial statements.

ARQULE, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS