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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.

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