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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002    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 ý    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. o

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ý    No o

        The aggregate market value of voting and non-voting common stock held by non-affiliates of the registrant as of June 30, 2002 was: $142,535,828.

        There were 23,325,962 shares of the registrant's Common Stock outstanding as of March 21, 2003.

DOCUMENTS INCORPORATED BY REFERENCE

        Portions of the definitive proxy statement for the Registrant's Annual Meeting of Shareholders to be held on May 21, 2003, which definitive proxy statement will be filed with the Securities and Exchange Commission not later that 120 days after the registrant's fiscal year end of December 31, 2002, are incorporated by reference into Parts II and III of the Form 10-K.

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. Actual results may differ materially from those projected in the forward-looking statements or from historical performance due to numerous risks and uncertainties that exist in ArQule's operations, development efforts and the business environment, including without limitation: the ability to transition successfully from chemistry services to drug discovery, to satisfy milestones, and to deliver compounds to corporate collaborators; the ability to predict consistently and successfully absorption, distribution, metabolic, elimination and toxicological (ADMET) properties and to design small molecules that possess drug-like characteristics; the progress of product research and development activities and projected expenditures; the ability to enter into future collaborations with pharmaceutical and biotechnology companies; and difficulties and costs associated with the integration of the acquired businesses and the risks and uncertainties described this document. 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.

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PART I

ITEM 1. BUSINESS

BUSINESS OVERVIEW

        Our company was incorporated in Delaware in 1993, and completed a public offering in 1996. Since inception, we have primarily provided fee-based services to pharmaceutical companies and biotechnology companies, using our chemistry based technology and expertise to attract collaborators.

        While we continue to provide high quality fee-based services to our collaborators, we are now using our experience to create small molecules that possess drug-like characteristics prior to pre-clinical development and thus may have greater potential to become medicines than molecules that have not been optimized but merely demonstrate activity toward biological targets. We refer to our molecules with drug-like characteristics as Optimal Chemical Entities ("OCEs"). We strive to increase the efficiency of the drug discovery process and the quality of its results compared with the current industry standard. As we make the transition to drug discovery on our own, we expect to continue to perform services for our clients, but also to keep or share rights in promising compounds that could become medicines.

        Presently we have an early-stage pre-clinical pipeline of product candidates. To accelerate our opportunities in drug discovery and development we are pursuing a strategy to obtain a clinical portfolio of therapeutic compounds. This could include in-licensing opportunities, acquisitions or internally building in-house biological or therapeutic scientific expertise in a focused area.

        In December 2002, we announced a significant restructuring of our operations. We ceased further development work on our predictive ADMET (absorption, distribution, metabolism, elimination and toxicity) modeling technology platform. As part of our strategy for furthering the development of our ADMET modeling platform we had focused on attempting to sign a significant strategic alliance centered on our predictive modeling tools. We determined in late 2002, after many months of negotiation, that we could not secure a mutually beneficial alliance with a major pharmaceutical company. The restructuring actions included closing our facilities in Redwood City, California and Cambridge, United Kingdom, along with the elimination of 128 positions, or approximately 31% of our workforce. We believe that taking these actions will allow us to rapidly minimize our technology development expenditures while preserving cash for our internal drug discovery programs and other strategic initiatives focused on accelerating our transition to a drug discovery and development company.

        We are focused on our long-term strategy of developing what we believe will be an efficient drug discovery approach using our expertise in chemistry, intelligent design and parallel processes. We use computer models to design, analyze and screen compounds for desired characteristics. We also use processing equipment that can analyze and produce large numbers of compounds quickly and sophisticated computer software to collect and analyze research data. We also have what we believe is an experienced and highly qualified scientific and management team that can apply our platform to produce quality compounds that have attributes of medicines.

        In the long term, we hope to build our platform and experience to allow us to:

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design and discover compounds with optimal drug-like characteristics;



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increase the likelihood of success during clinical development;



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ameliorate product development challenges previously thought too costly or otherwise impractical to resolve using traditional chemistry methods;



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produce significant drug development cost reductions; and

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recover earlier research and development expenses for successful drugs.

How the Drug Discovery Process Has Traditionally Been Conducted

        Drugs are typically chemical compounds that affect the biological activity associated with particular diseases to achieve a desired beneficial effect. Drug discovery and development is the process of creating and evaluating compounds for the safe and effective treatment of human disease. The drug discovery process historically has taken 12 to 15 years from original concept to market introduction of a drug at an average cost in excess of $800 million.

        In order to understand ArQule's approach to drug discovery, one must first understand the traditional drug discovery process:

        Identification and Validation of Biological Targets.    Scientists study how a disease works and identify those mechanisms, called targets, that are most integral to that disease. These targets are then "validated" by determining whether altering the function of a target is likely to have a therapeutic effect.

        Generation of Lead Compounds.    Large collections of chemical compounds are tested to determine whether they react with a biological target. The likelihood of finding a compound that reacts with a target (a "hit") is increased to the extent that the compounds in these collections are selected ahead of time for their potential to react with that particular target. From among the compounds registering a hit, scientists choose a "lead compound", i.e., a compound that exhibits a profile consistent with a clinically effective drug including potency, selectivity and efficacy suitable for additional testing as a precursor to Good Laboratory Practices ("GLP") Safety/Toxicology studies in anticipation of preclinical drug development. The compound's absorption, distribution, metabolism and elimination ("ADME") characteristics are also important factors in the selection process.

        Optimization of Leads.    Once a lead compound is identified, its drug-like characteristics must be refined ("optimized") with the goal of producing a drug candidate for animal and human testing. Traditionally, medicinal chemists analyze a lead compound's structure and use their experience to suggest changes and create variations (or analogs) of the lead compound that might produce the desired result for potency or other desirable drug characteristics. Because changes to a compound's structure that enhance one desired feature may impair other features, scientists must make and test hundreds of analogs of a lead compound to find one suitable for use in clinical testing.

        This process is long, expensive and risky because it is conducted in single sequential steps using trial and error methods. Drug candidates developed in this manner typically have a 90% failure rate through clinical testing, after significant investment of time and money.

        Laboratory, Animal and Human Testing.    Lead compounds chosen as drug candidates are tested first in the laboratory and in animals (pre-clinical) and then, if promising, in humans (clinical) for both safety and effectiveness. Data collected in these tests are ultimately submitted to government authorities in order to obtain approval to market the compound as a commercial medicine.

How Our Approach Could Improve the Drug Discovery Process and Benefit Us

        Our approach is intended to:

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Begin with well-validated, publicly available targets or proprietary targets obtained from third parties.



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Generate lead compounds by producing collections of compounds (1) tailored to react with the particular target being tested and (2) selected for favorable drug-like characteristics.

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Use computational computer models to optimize multiple characteristics of lead compounds at the same time.

        In addition we may accelerate our drug discovery and development efforts by seeking to in-license or acquire clinical compounds and build in-house expertise in a specific therapeutic area or target class.

        Many of our techniques are performed in a computer-based environment without producing a single compound, reducing the need for manual methods that are more labor, cost and time intensive.

        Using our technology and our experience, we intend to discover and develop several drug candidates from the pre-clinical testing phase through Phase I or Phase II clinical testing. We then expect to out-license or sell our drug candidates to pharmaceutical companies for completion of clinical testing and commercialization. We believe that by striking this balance at the proper time, we will be able to obtain the maximum risk-adjusted return on our investment in these potential drugs.

        We believe our overall approach to drug development presents a significant market opportunity for several reasons:

        The Market for Small Molecule Drugs is Large.    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 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. They are also more costly to manufacture than small molecules.

        The Market for Chemistry Expertise Is Expanding.    We believe that the current bottleneck in the drug discovery process for small molecule drugs is at the stages of lead generation and lead optimization of lead compounds, when expertise in chemical design, synthesis and production is most critical. While the revolution in genomics has resulted in the identification of a large number of possible biological targets of disease, finding drugs to react with these targets remains slow, expensive and risky. For these reasons, we believe that access to chemistry expertise to identify and produce small molecules is essential to any small molecule drug developer. We have designed our technology platform and business strategy to meet what we believe is the need for improved productivity and reduced risk in these chemistry stages of the drug discovery process.

        Drugs With the Best Drug-Like Characteristics Have Larger Markets.    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. An example of this is Pfizer's cholesterol-lowering drug Lipitor (Atorvastatin), which is by far the best selling drug in its category despite being introduced years after its closest competitors. Thus, if we are able to generate drug candidates that have the best possible set of drug-like characteristics, we believe we are strengthening the competitive advantage of the candidate.

        We Believe Pharmaceutical and Biotech Companies Need Our Expertise.    While chemistry might be considered a strength of the largest pharmaceutical companies, in our opinion we are witnessing a trend towards outsourcing to the best chemistry companies. We believe that pharmaceutical companies have collaborated with us because of our expertise in library design and high throughput automated chemistry as well as our concentration of chemistry talent. Other pharmaceutical companies may partner with us because they believe that due to our focus, ArQule is in a position to provide value to their early stage discovery efforts particularly in lead generation and lead optimization.

        We Believe We Have Technology and Personnel Advantages Over Our Competitors.    Although we have several competitors who focus on the chemistry aspects of drug discovery, we do not believe that any possess the particular combination of technology included in our platform. We believe our

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computer modeling and parallel testing capabilities provide a competitive advantage over the industry standard techniques. We also believe these assets will enable drug developers (including ourselves) to identify the optimal small molecule for a given target from the enormous number of molecules that could possibly be produced.

        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.

ArQule's Technology Platform

        Our drug discovery platform has three major functional components:

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Compound Analysis and Design: computer- and laboratory-based testing methods to help us analyze the drug-like characteristics of compounds and design collections of compounds with those desirable characteristics;



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Parallel Testing: computer and laboratory-based methods to test and optimize for multiple drug-like characteristics simultaneously; and



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Rapid Production: a system for the fast, automated production of large volumes of high-quality compounds.

        We apply these components to compound production lead generation and lead optimization.

        Computational Modeling.    We have developed various computer-based and laboratory based models that help us analyze the drug-like characteristics of chemical compounds before they are produced. While standard optimization methods test variations of compounds by hand in single, sequential steps, our scientists simulate and evaluate in a computer-based environment multiple drug characteristics early in the discovery process. We believe this approach will improve the efficiency and reduce the risk of current methods by allowing deficient compounds to be identified and eliminated early in the process.

        In addition, we have developed an integrated information system that enables us to gather and apply data from our lead generation activities on an ongoing basis. We use that data to increase the efficiency of the drug discovery process, and to design compounds based on a growing knowledge of the structure and activity of molecular components.

        Lead Generation.    In the "lead generation" stage of the discovery process, our scientists use ArQule's technology to analyze the structure of a given validated biological target in order to determine the attributes that a compound must have in order to have an effect on the target. Using this information, our scientists design collections of compounds that they believe are most likely to react favorably with the target. These compound collections are then tested against the target to identify which series of compounds actually have an effect. Additional assays are implemented to validate the target pathway (in animal studies) and assess the ADMET properties (both in vitro and in vivo). We believe that this method ultimately will generate more lead compounds faster and at lower cost than standard techniques that involve testing vast collections of compounds on a comparatively random basis.

        Lead Optimization.    Our scientists also use our technology for the "lead optimization" stage of the discovery process to design and select the version of a given lead compound that has the most advantageous set of drug-like characteristics possible. The chemical make-up or structure of a compound is a key determinant of its potency, specificity, dosing regimen and side effect profile when used as a medicine. Deficiencies in the drug-like characteristics of a compound (including its ADME characteristics and its toxicity in the body) account for 30-40% of failures during early drug

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development and the vast majority for warnings of adverse drug-drug interaction and dosing restrictions for marketed therapeutics.

        High Speed Production of Compounds.    To support both our lead generation and lead optimization technologies, we rely on our "automated molecular assembly plant" (which we call AMAP) system. Once we have determined the structure for a compound, we are able to produce it, purify it and verify its structural information through automated high-speed parallel production. Our system is capable of producing thousands of compounds per day, each in milligram quantities adequate for multiple tests.

Our Business Strategy for Using Our Experience and Technology in Our New Business Focus

        In addition to our commitment to our current chemistry-based services business, our goal is to apply our chemistry experience, expertise and unique technology platform to transition ArQule to a drug discovery company. Our strategy includes focusing our drug discovery and development efforts in a specific biological or therapeutic area in order to successfully apply our core chemistry on internal drug discovery programs.

        We also plan to apply our lead generation and optimization expertise and technology to internal drug discovery efforts in order to advance our own lead compounds with the aim of out-licensing or selling drug candidates upon completion of Phase I or Phase II clinical trials.

        Pursuant to existing agreements, we have a solid revenue generating chemistry service business that generates cash flow that we reinvest in our drug discovery activities, which will facilitate the execution of our business strategy. This revenue generating business focuses on the design and production of chemical compound collections. We are an established market leader in the production of diverse collections of chemical compounds using automated high throughput technology-and computational design tools.

COLLABORATIONS

Pharmaceutical Collaborations

        Pfizer.    Our largest collaboration is with Pfizer, Inc. Since the inception of this relationship in 1999, we have managed and staffed a facility that produces collections of chemical compounds exclusively for Pfizer using our automated high-speed compound production system. Pfizer received a non-exclusive license to use this system in its internal production program. We expanded this contract in December 2001 to a seven-year agreement ("new agreement"). With this expansion Pfizer and ArQule scientists work more closely on idea generation and library design. Pfizer has also committed to undertake one lead optimization program with ArQule and has direct access to our library design tools on a non-exclusive basis.

        If our relationship with Pfizer is successful, we could earn up to $345 million over the term of the contract. As of March 1, 2003, we have received $132.1 million from Pfizer since inception of this relationship in 1999. As of March 1, 2003, we have received $52.6 million since we expanded this contract in December 2001. Pfizer made a $10 million equity investment in our company in December 2001 and made another $5 million equity investment based on our achieving 2002 production goals in March 2003. Pfizer may make additional investments totaling $3 million depending on the achievement of certain delivery milestones. Although Pfizer owns all rights in compounds produced pursuant to the collaboration, the activities we perform on behalf of Pfizer allow us to enhance and validate our high-throughput compound production techniques as applied to lead generation. Pfizer may terminate the new agreement after four years from its inception for any reason, but would not be entitled to receive any refund for amounts paid to ArQule through the date of termination.

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        In addition, we have collaborations with the following companies:

        Bayer.    In October 1999, we entered into a three-year collaboration with Bayer AG to produce large collections of compounds designed exclusively for Bayer in accordance with its specifications. We refer to such collections as Custom Array libraries. In December 2002, we extended the production period until September 30, 2003. Bayer will own all rights in compounds for an initial period, after which we will co-own rights in compounds that Bayer has not claimed in a patent application. We received a $3 million upfront payment and will receive up to an additional $27 million during the term of the agreement for delivery and success fees. As of March 1, 2003, we have received $26.8 million under this agreement. Bayer will pay no milestones or royalties to us on compounds that they develop and market.

        Sankyo.    In November 1997, we entered into a three-year agreement with Sankyo Company, Ltd. to discover and optimize drug candidates. Under the terms of the agreement, Sankyo received a subscription to our Mapping Array Program. The program involved a large collection of compounds provided on a non-exclusive basis to several pharmaceutical companies as a tool to discover new lead compounds. Sankyo also committed to a minimum number of Directed Array Programs during the term of the agreement. In April 2001, we extended our agreement with Sankyo through June 2004 to include access to the Compass Array libraries, which are a subset of the Mapping Arrays, in addition to continuing to use our Directed Array Program, which involves a target-focused library. The total value of the extended agreement is up to $14.8 million in committed payments of which, as of March 1, 2003, we have received $13.3 million. To date, we have not received any milestone or royalty payments under this agreement.

        Solvay.    In November 1995, we entered into a five-year agreement with Solvay Duphar B.V. Under this agreement, Solvay subscribed to our Mapping Array and Directed Array Programs and received a non-exclusive license to our AMAP Chemistry Operating System. This agreement was superseded by an amended and restated agreement with Solvay Pharmaceuticals, B.V., which became effective on January 1, 2001. The amended agreement extends the collaboration through December 31, 2003. Under the amended agreement, Solvay receives our Compass Array libraries and continues to access our Directed Array Programs. We received a total of $18.1 million under the original agreement. Solvay is committed to make additional payments totaling $2.5 million under the amended agreement. As of March 1, 2003, we have received $20.6 million under these agreements. Solvay must also make additional payments if we achieve certain development milestones and pay royalties on sales of any drugs that result from the relationship. To date, we have not received any milestone or royalty payments; however, one of our compounds is in preclinical development with Solvay. In connection with the original collaboration, signed in November 1995, an affiliate of Solvay, Physica B.V., made a $7 million equity investment in ArQule.

        GlaxoSmithKline.    In November 2000, we entered into a five-year collaboration and license agreement with SmithKline Beecham Corporation (now GlaxoSmithKline). Under the terms of the agreement, GlaxoSmithKline received access to our Compass Array libraries and Mapping Array libraries for screening primarily in the anti-infective field. GlaxoSmithKline elected to terminate the agreement in November 2002, before the end of the five-year term. As of March 1, 2003, we have received $1.5 million under this collaboration. GlaxoSmithKline has agreed to pay us development milestones and royalties on sales of products resulting from the collaboration. To date, we have not received any milestone or royalty payments.

        Pharmacia.    We entered into a five-year collaboration with Monsanto Company (now Pharmacia Corporation) in December 1996. Under this agreement, we provided Monsanto with access to our Mapping and Directed Array Programs for use in the development of agrochemicals. In January 2000, we expanded this collaboration to cover life science applications, including pharmaceutical use by Monsanto's G.D. Searle division, and extended the term until December 2002. We also agreed to

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provide Monsanto with Compass Array and Mapping Array libraries through 2001 and Compass Array libraries only through December 2002. In addition, we converted the Monsanto agrochemical Directed Array Program into a credit for pharmaceutical lead optimization services. Pharmacia has made payments totaling $12.7 million under this agreement. In addition, Monsanto has agreed to pay us development milestones and royalties from the sales of products resulting from the collaboration. In July 1998, we received a milestone payment for a Mapping Array compound selected by Monsanto for entry into field trials. On June 30, 2000, in connection with the merger between Monsanto and Pharmacia, we replaced our existing collaboration agreement with a new collaboration agreement with G.D. Searle & Co., a division of Pharmacia. The financial terms of the new agreement are substantially the same as the prior agreement. However, we expanded the scope of the agreement to enable Pharmacia and its affiliates to screen our compounds, which may result in milestone and royalty payments in the future. In March 2002, we entered into a one-year technical access agreement with Pharmacia Corporation which granted Pharmacia non-exclusive access to our proprietary ADMET simulation technology. In March 2003, we extended the technical access agreement to June 30, 2003 and gave Pharmacia an option to extend it an additional three months.

        Wyeth Pharmaceuticals.    In July 1997, we entered into a four and one half year agreement with Wyeth Pharmaceuticals ("Wyeth"). Under this agreement, Wyeth subscribed to our Mapping Array and Directed Array Programs. We discontinued our Mapping Array Program as of 2002, and as a consequence and in agreement with Wyeth, we did not renew our collaboration. Wyeth has continuing rights to screen the compounds from the Mapping and Directed Array Programs and continuing obligations to pay us development milestones and royalties from the sales of products resulting from compounds we shipped during the collaboration. Wyeth has selected a compound from the Directed Array Program for its development pipeline and, on October 8, 2002 made a milestone payment to us in connection therewith. As of March 1, 2003 we have received $26.4 million under this agreement.

        Johnson & Johnson.    In December 1998, we entered into a three-year collaboration with R.W. Johnson Pharmaceutical Research Institute, a division of Johnson & Johnson, Inc., in which R.W. Johnson subscribed to our Mapping Array Program. We discontinued our Mapping Array Program as of 2002, and, as a consequence and in agreement with R.W. Johnson, we did not renew our collaboration. As of March 1, 2003, we have received $9.0 million under this agreement. In addition, R.W. Johnson has agreed to pay us developmental milestones and royalties from sales of any products resulting from this collaboration. To date, we have not received any milestone or royalty payments.

Biotechnology Collaborations

        Genome Therapeutics Corporation.    On October 17, 2000, we entered into a collaborative drug discovery agreement with Genome Therapeutics Corporation to discover and develop anti-infective drug candidates. Under the agreement, we screened and optimized compounds against a significant number of proprietary validated anti-infective targets which Genome Therapeutics has derived from its PathoGenome™ Database. In July 2002, Genome Therapeutics Corporation nominated two anti-infective lead compound series for optimization arising out of its collaboration with us. By screening our chemical compounds against genomic targets identified by Genome Therapeutics, the companies were able to identify several novel small molecule compound series.

        In July 2002, we decided to cease our efforts in this collaboration in order to focus on our wholly-owned drug discovery programs. As a result we and Genome Therapeutics have restructured our business relationship. The companies agreed upon a method for allocation of the intellectual property and other results of our collective efforts. Each company will take full operational and financial responsibility for advancing through optimization and clinical development the respective lead compounds it selects, if any. In addition, each of the parties will share in future milestone, royalty and up-front payments resulting from the out-licensing of clinical candidates or later stage compounds.

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        ACADIA Pharmaceuticals.    On December 18, 2000, ArQule and ACADIA Pharmaceuticals entered into a drug discovery collaboration. Under the agreement, ACADIA combined its functional genomics platform with ArQule's Parallel Track Drug Discovery Program to discover novel small-molecule drug candidates directed at individual G-protein coupled receptor (GPCR) targets. The companies shared intellectual property resulting from the collaboration. Under the agreement, the companies will share any revenues resulting from the commercialization of joint drug discovery programs. In addition to these joint drug discovery programs, each company will receive exclusive rights to certain compounds that the companies have decided not to develop in a joint drug discovery program, subject to a royalty payment to the other party. In July 2002, we decided to cease our efforts on this collaboration in order to focus on our internal drug discovery programs.

Internal Drug Discovery Programs

        In addition to our revenue generating business, we have ongoing internal drug discovery efforts. We plan to base each of our discovery programs on a well-validated target obtained from a public source or a third party. We will then proceed with lead generation and optimization using our computational modeling, parallel testing and rapid production technologies. The goal of each of our programs will be to identify the lead compound that has the best possible drug-like characteristics for use against the target, thus giving it the greatest likelihood of success through the clinical trial process. In order to capture the greatest value from any drug candidates we develop, we plan to take our candidates though Phase I or, possibly, Phase II clinical trials prior to out-licensing or selling them.

        We have existing discovery programs that use our integrated technology platform. These consist of wholly-owned programs focused on kinase and ion channel target classes. To date, these programs have served primarily as test vehicles to assist in the validation of our technology platform. We may supplement or replace these programs with other programs that would help accelerate our efforts. We may achieve this goal either by acquiring or in-licensing compounds in pre-clinical or clinical testing.

        p 38 MAP Kinase.    ArQule's Kinase Program began with the creation of a biased library against a panel of kinase targets. Kinases, or phosphokinases, are enzymes that act as a catalyst in the transfer of phosphate from adenosine triphosphate to another molecule, releasing energy used by the body. Kinases are also involved in intracellular signaling. As such, kinases are biological targets in a number of therapeutic approaches. In the first half of 2002, our effort focused on identifying inhibitors of p38 alpha and was expanded, with the support of SignalGene's chemotype-shifting technology, to pursue alternative strategies to generate leads based upon known inhibitors. In each of these tracks, ArQule used predictive ADME models, which directed synthetic efforts toward specific areas of chemical space and resulted in the identification of eight lead series. Several of these series have demonstrated cellular activity with good selectivity for p38 alpha. ArQule has selected five advanced leads, on which we plan to begin preliminary animal testing shortly.

        Ion Channels.    Like the Kinase Program, the ion channel program began with a biased library approach against nine ion channel screens. Ion channels are large membrane proteins that form pores through the plasma membranes of cells so that ions (positively or negatively charged atoms) can pass through the membrane. Ion channels are named for the ion they allow to pass through. Channels open in reaction to a number of stimuli including chemical compounds such as the ones we produce as part of our Ion Channel Program. The ions that pass through serve as an electronic intracellular signal. Consequently, like kinases, ion channels are an important biological target. ArQule is focusing on calcium N-type channel blockers for neuropathic pain. We have identified three chemical series from which we are profiling compounds in various in vitro assays. We intend to select one series for lead optimization.

        In addition to our early stage pre-clinical programs, we plan to continue our transition and fulfill our mission to be recognized as a drug discovery and development organization. We expect to

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accomplish this goal through acquisition, in-licensing or internally developing in-house expertise in a focused therapeutic area or target class.

PATENTS AND PROPRIETARY RIGHTS

        As of March 1, 2003, we had eighteen issued or allowed U.S. utility patents, one issued U.S. design patent, seven granted foreign patents, and numerous patent applications in the U.S. and other countries. As needed, we obtain rights under patents through licenses. We depend, in part, on these patents to protect our technology and products. We also rely upon our trade secrets, know-how and continuing technological advances to develop and maintain our competitive position. 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.

        The terms "ArQule", "Directed Array", and "Mapping Array" are trademarks of ArQule that are 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.

COMPETITION

        The biotechnology industry is highly competitive. Many organizations are actively attempting to identify and optimize compounds for potential pharmaceutical development both as chemistry services providers or as integrated drug discovery companies. We face competition in several areas of the drug-discovery and chemistry services businesses, including:

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obtaining well validated targets for further research purposes;



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designing and producing chemical compound collections for lead generation;



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identifying and optimizing potential lead compounds; and



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developing and protecting our proprietary technology to maintain our position as an industry leader.

        ArQule competes with the research departments of pharmaceutical companies, biotechnology companies and chemistry service companies such as Pharmcopeia, Inc., Albany Molecular Research, Inc., Evotec OAI, and Discovery Partners International, Inc. We also compete with academic and scientific institutions, governmental agencies and public and private research organizations.

        In addition, our competitors include other chemistry based drug discovery companies such as Array BioPharma, Vertex Pharmaceuticals and Sepracor Inc. Some of these competitors have greater financial and human resources and more experience in research and development than ArQule. Smaller companies may also prove to be significant competitors, particularly through arrangements with large corporate collaborators. In addition to competition for customers, these companies and institutions also compete with ArQule in recruiting and retaining highly qualified scientific and management personnel.

        Historically, pharmaceutical companies have maintained close control over their research activities, including the synthesis, screening and optimization of chemical compounds. Many of these companies are developing in-house combinatorial chemistry and other methodologies to improve productivity, including major investments in robotics technology to permit the automated parallel synthesis of compounds and computational chemistry skills, which represent a significant potential market for our products and services.

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        These companies may already have large collections of compounds previously synthesized or ordered from chemical supply catalogs or other sources against which they may screen new targets. Other sources of compounds include extracts from natural products such as plants and microorganisms and compounds created using rational design. Academic institutions, governmental agencies and other research organizations are also conducting research in areas in which we are working either on their own or through collaborative efforts.

        ArQule anticipates that it will face increased competition in the future as new companies enter the market and advanced technologies become available. Our processes may be rendered obsolete or uneconomical by technological advances or entirely different approaches developed by one or more of our competitors. The existing approaches of ArQule's competitors or new approaches or technology developed by our competitors may be more effective than those developed by ArQule.

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

GOVERNMENT REGULATION

        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 products is not subject to significant government regulation. Our future profitability, however, depends on our collaborators selling pharmaceuticals and other products developed from our compounds that may be subject to government regulation.

        Virtually all pharmaceutical and biotechnology products developed by our collaborative partners will require regulatory approval by governmental agencies prior to commercialization. The nature and the extent to which these regulations apply to our collaborative partners vary depending on the nature of their products. In particular, human pharmaceutical products and biologics are subject to rigorous preclinical and clinical testing requirements and other prerequisites to approval by the FDA (for products sold in the United States) and by foreign regulatory authorities (for products sold outside the United States). Various federal and, in some cases, state statutes and regulations also govern or influence the manufacturing, labeling, storage, distribution, record keeping and promotion of these products. The process of obtaining these approvals and the subsequent compliance with appropriate federal, state and foreign statutes and regulations is time consuming and requires substantial resources.

        Generally, in order to gain FDA approval, a company first must conduct pre-clinical studies in the laboratory and in animals to gain preliminary information on a compound's efficacy and to identify any toxicity and safety problems. The results of these studies are submitted as a part of an Application for an Investigational New Drug ("IND") that the FDA must review before human clinical trials of an investigational drug can start. The FDA may require compliance with GLPs in support of the IND. The FDA may refuse to permit human clinical trials to begin or may put a "hold" on ongoing human clinical trials at later stages. The FDA also requires compliance with current Good Manufacturing Practices ("GMPs"), in producing the investigational new drug for use in such clinical trials.

        In order to commercialize any products, we or our collaborators will be required to sponsor and file an IND and will be responsible for initiating and overseeing all regulated development studies (both preclinical and clinical) to demonstrate the safety and efficacy that are necessary to obtain FDA approval. In the United States, clinical trials are normally done in three phases and generally have a duration of several years, but may take longer to complete. 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, or NDA, and

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receive FDA approval before commercial marketing of the drug. The testing and approval processes require substantial time and effort. Approval of NDAs submitted to the FDA can take several years.

        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 GMP compliance, adverse event reporting requirements and prohibitions on promoting a product for unapproved uses. Later discovery of previously unknown safety or effectiveness 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.

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

EMPLOYEES

        As of March 1, 2003, we employed 298 people, 279 in Woburn and Medford, Massachusetts and 19 in Cambridge, United Kingdom. As of March 31, 2003, the Cambridge U.K. facility will be closed, and we will no longer have any United Kingdom based employees. Of the remaining 279 employees, 71 have Ph.D. degrees. As of March 1, 2003, 202 of our employees were engaged in operations, 69 were engaged in research and development, and 27 were engaged in marketing and general administration. None of our employees are covered by collective bargaining agreements. We believe that we have good relations with our employees.

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ITEM 1A. EXECUTIVE OFFICERS AND DIRECTORS OF THE REGISTRANT

        Set forth below is certain information regarding our current executive officers and directors, including their respective ages, as of March 1, 2003:

        STEPHEN A. HILL, M.D.    Stephen A. Hill, B.M., B.Ch., M.A., F.R.C.S. has served as our President, CEO and as a director since April 1999. Prior to his employment with us, from 1997, Dr. Hill was the Head of Global Drug Development at F. Hoffmann-La Roche Ltd. He joined Roche in 1989 as Medical Adviser to Roche Products in the United Kingdom. He held several senior positions there, including that of Medical Director, with responsibility for clinical trials of compounds across a broad range of therapeutic areas, including those of CNS, HIV, cardiovascular, metabolic, and oncology products. Dr. Hill also served as Head of International Drug Regulatory Affairs at Roche headquarters in Basel, Switzerland, where he led the global regulatory submissions for seven major new chemical entities. He also was a member of Roche's Portfolio Management, Research, Development and Pharmaceutical Division Executive Boards. Prior to joining Roche, Dr. Hill served for seven years with the National Health Service in the United Kingdom, in General and Orthopedic Surgery. Dr. Hill serves on the Board of Directors of Akceli Corporation. 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.

        ANDREW C.G. UPRICHARD, M.D., F.A.C.P., F.R.C.P.    Andrew C. G. Uprichard, M.D., F.A.C.P., F.R.C.P., joined ArQule as Vice President and Chief Operating Officer in July 2002. Dr. Uprichard has an extensive background in discovery research and development in the biopharmaceutical industry. Prior to joining ArQule, Dr. Uprichard served for two years as Chief Operating Officer at Curis, Inc. For the preceding 11 years, Dr. Uprichard held numerous management positions at Parke-Davis/Warner-Lambert (now part of Pfizer) in pharmaceutical research, where his experience—spanning drug discovery, preclinical and clinical development—included the oversight of a number of IND filings, which resulted in several commercial drugs. From 1997 to 2000, he was Vice President, Drug Development, from 1994 to 1997 he was Senior Director, Cardiovascular Pharmacology, and from 1989 to 1994, he held various oversight positions in Cardiovascular Clinical Development. In the late 1980s, Dr. Uprichard was a Cardiology and Postdoctoral Fellow at the University of Michigan Medical School. Educated at the University of Edinburgh, Dr. Uprichard is a Member of the Faculty of Pharmaceutical Medicine, a Fellow of the American College of Physicians and a Fellow of the Royal College of Physicians of Edinburgh.

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        DAVID C. HASTINGS    David C. Hastings has served as our Vice President, Chief Financial Officer, and Treasurer since February 2000. Prior to his employment with us, Mr. Hastings was Vice President and Corporate Controller at Genzyme, Inc. where he was responsible for the management of the finance department. Prior to his employment with Genzyme, Mr. Hastings was the Director of Finance at Sepracor, Inc. where he was primarily responsible for Sepracor's internal and external reporting. Mr. Hastings is a Certified Public Accountant and received his BA in Economics at the University of Vermont.

        J. DAVID JACOBS, J.D.    J. David Jacobs, J.D. joined ArQule in June 2001 as Vice President, Legal and General Counsel. In July, 2001 he was named Secretary of ArQule. Previously, Mr. Jacobs held the position of Senior Counsel in the Biomedical Services division of the American Red Cross in Washington, D.C. where he was responsible for all matters involving new products, revenue generation, licensing, intellectual property, and mergers and acquisitions. Prior to joining the Red Cross, Mr. Jacobs practiced in the fields of tax and international commercial transactions at the law firms of Kramer, Levin, Nessen & Frankel in New York City and Shimron, Molcho & Persky in Jerusalem. Mr. Jacobs received his J.D. with honors from Columbia Law School, an M.A. with distinction from the Jewish Theological Seminary and a B.A. from Columbia College.

        LAURA AVAKIAN    Laura Avakian has been a director since March 2000. Ms. Avakian is currently and since 1999 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 BA degree from the University of Missouri at Columbia and her MA degree from Northwestern University.

        TIMOTHY C. BARABE    Timothy C. Barabe has been a director since November 2001. Mr. Barabe has been employed by Novartis AG, one of the world's largest pharmaceutical companies, since April 1982 in various capacities. From 1993 through January 2002 Mr. Barabe was the Chief Financial Officer of CIBA Vision Corp., a subsidiary of Novartis. Since February 2002, Mr. Barabe has been Group Vice President and President, Specialty Lenses of CIBA Vision. Commencing in May 2003, Mr. Barabe will be the Chief Financial Officer of Biochemie GmbH, the generic pharmaceutical subsidiary of Novartis. Since June 1998, Mr. Barabe served as a director of BioCure, Inc., a majority-owned subsidiary of Novartis. Mr. Barabe is a Trustee and Treasurer of Fernbank Natural History Museum. 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.    Werner Cautreels, Ph.D. has been a director since September 1999. Since May 1998, Dr. Cautreels has been the Global Head of Research and Development of Solvay Pharmaceuticals. Prior to that, Dr. Cautreels was employed by Nycomed Amersham Ltd., Sterling Winthrop, and Sanofi in a variety of positions in Research and Development. Dr. Cautreels received his Ph.D. in Chemistry from University of Antwerp, Belgium.

        ARIEL ELIA    Ariel Elia has been a director since September 2000, and was named Chairman of the Board in March 2001. Currently, and since 1999, Mr. Elia serves as Chairman of the European Advisory Board of E.Med Securities, a private, U.S.-based company providing investment banking services to emerging growth companies in the life science industry. Mr. Elia is and since 1995 has been a director of Altamir S.A., a French venture capital company, and is and since 1999 has been a director

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of Yissum, the research and development company of the Hebrew University of Jerusalem in Israel. Mr. Elia also serves as a Governor of both the Ben Gurion University (since 1992) and the Hebrew University of Jerusalem (since 1998), in Israel. Prior to his current positions, Mr. Elia was the Chief Executive Officer of Jouveinal Laboratories, a privately held, French pharmaceutical company. Mr. Elia also spent 17 years with Merck & Co., serving both in Europe and in the U.S., most recently as Senior Vice President, International Division. Before joining Merck & Co., Mr. Elia spent 12 years with American Home Products Corp., serving as President of the International Household Products Division prior to his departure. He graduated from Victoria College in Alexandria, Egypt with an Oxford and Cambridge degree as a Bachelor of Arts. His honors include Knight of the Order of the Crown in Belgium, and Doctor of Philosophy Honoris Causa of Ben Gurion University, Israel.

        TUAN HA-NGOC    Tuan Ha-Ngoc is the President and CEO of GenPath Pharmaceuticals, Inc., a biopharmaceutical company. He has 26 years of worldwide experience in the healthcare industry, primarily in the biotechnology sector but also in the pharmaceutical, medical devices, and Information Technology areas. From 1999 to 2002, he was co-founder, President and 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. From 1984 to 1998, he was at Genetics Institute, Inc., as its Executive Vice President responsible for Corporate Development, Commercial Operations, European and Japanese Operations. From 1976 to 1984, he was in various marketing and business positions at Baxter Healthcare, Inc. 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 Fellows, Harvard School of Dental Medicine, and on the Boards of Directors of Phylos, Inc. and the International Institute of Boston.

        MICHAEL ROSENBLATT, M.D.    Michael Rosenblatt, M.D. has been a director since April 1998. From 1992-1998, Dr. Rosenblatt served as the Robert H. Ebert Professor of Molecular Medicine at the Harvard Medical School, Chief of the Division of Bone and Mineral Metabolism at Beth Israel Hospital, and the director of the Harvard-MIT Division of Health Sciences and Technology. From 1996-1999, he was the executive director of the Carl J. Shapiro Institute for Education and Research at Harvard Medical School and Beth Israel Deaconess Medical Center. From 1996-1999, he was Harvard faculty dean for academic programs at the Beth Israel Deaconess Medical Center. From 1999 - 2001, he was President of Beth Israel Deaconess Medical Center. He currently serves as the George R. Minot Professor of Medicine at Harvard Medical School. Prior to 1992, Dr. Rosenblatt was the Senior Vice President for Research at Merck Research Laboratories, a pharmaceutical company. Dr. Rosenblatt serves as a director of certain privately held companies.

        PATRICK J. ZENNER    Patrick J. Zenner joined ArQule's Board in 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., (Roche), based in Nutley, N.J., is the prescription drug unit of the Roche Group, a leading research-based health care enterprise that ranks among the world's leaders in pharmaceuticals, diagnostics and vitamins. 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. Currently, Mr. Zenner serves on the Boards of Trustees of Creighton University and Fairleigh Dickinson University. In addition, Mr. Zenner has recently been elected to the Boards of Directors of CuraGen Corporation, Dendrite International, Praecis Pharmaceuticals Inc., Geron Corporation, Genta Inc., First Horizon Pharmaceutical

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Corporation, Xoma Ltd., West Pharmaceutical Services, Exact Sciences, Inc. and Gryphon Therapeutics.

RISKS RELATING TO OUR BUSINESS AND STRATEGY

We may not be able to augment successfully our services-based business with a product-based business.

        Historically we have derived most of our revenues from providing chemistry-based services on a fee-for-service basis. We now seek to use our expertise and technology additionally to discover chemical compounds and develop them into drugs, on our own and in collaboration with partners while continuing to generate service revenue. There are a variety of risks in seeking to do so, including:

•

success in developing drugs is highly uncertain;



•

revenues, if any, from product sales are years away;



•

regulatory and other risks can delay or block product development;

        To shift direction, our management team must work together successfully in areas new to us. Our management team has experience at other companies in drug discovery and development comparable to what we are undertaking, but it has not worked together to do this.

        While we concentrate on expanding our business strategy, there is a risk that we will pay less attention to our original, ongoing business. Furthermore, customers, potential collaborators and others may be unable to recognize and accept our shift in strategy. Also, we may not implement the shift effectively, which may undermine our results even if the strategy, technology and management team work together effectively.

We will not be able to become a successful product company if our integrated technology platform does not enable us to make the drug discovery process more efficient.

        To successfully transition from a services company to a product company, we will use our integrated technology platform in both our internal and collaborative programs. We expect, as advances occur in the technology underlying our integrated platform, that we will need to integrate those advances into our platform to reach our goal of reducing the cost and time incurred by the pharmaceutical industry for developing drug candidates.

        The drug discovery process continuously evolves. To accelerate its pace, as we hope to do, it will be necessary to keep abreast, or ahead, of improvements in discovery technology. In all likelihood, we will gain access to some of these improvements from third parties. For example, we must acquire and integrate considerable additional biology expertise, which has not been a part of our historical chemistry-services business.

        One of the ways we can accelerate the drug discovery process is by identifying potential drug candidates at the earliest stages of the candidate selection process. We have never identified a drug candidate that has been developed into a commercial drug. It is uncertain whether we will be able to make the drug discovery process more efficient to make higher quality drug candidates. Our ability to accelerate the drug discovery process depends on many factors, including the performance and decision-making capabilities of our scientists. Our information-driven technology platform, which we believe enables our scientists to make better decisions, may not enable our scientists to make correct decisions or develop viable drug candidates

        As a general matter, we may not be able to obtain access to all the technology and expertise necessary to implement our strategy. To the extent we decide or are required to obtain technology from

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third parties, we may not be able to identify appropriate technologies for acquisition, and such technology may not be available on reasonable terms, or at all.

        If we seek to obtain access to potential products or new technologies by acquiring other companies, we may not be able to integrate successfully or profitably manage acquired businesses.

        Our potential products may not become commercial successes and our technologies may not be the optimal ones. In addition, the combination of our business with these businesses may not achieve revenues, net income or loss levels, efficiencies or synergies that justify the acquisitions. The combined company may experience slower rates of growth as compared to our historical rates of growth and of these businesses independently.

        If we cannot acquire and/or effectively integrate necessary technology, our inability to use such technology will delay and could frustrate implementation of our strategy. Additionally, our programs could be delayed and our operating and research and development expenditures could increase beyond anticipated levels.

Our approach and our technology may never result in a commercial drug.

        The discovery and development of drugs is inherently risky and involves a high rate of failure. We spend a significant amount of time and money on internal research and development programs, but we may never create or help create a commercial drug product.

        Our approach to drug discovery and development is to use our current technology (developing and obtaining new technology as necessary) to make the drug discovery process more efficient and less risky. We have not yet created a commercially successful drug using this approach, nor have we proven that our technology and expertise are capable of making any stage of the drug discovery process more efficient or less risky. For example, we have not proven that we can use our computer modeling technology to increase the probability that a chemical compound we discover and develop will become a drug candidate or a commercial drug. If we cannot demonstrate that our approach and technology can result in successful drug products, we may not be able to maintain our existing collaborations, attract additional collaborators or obtain additional funding.

We may not be able to continue collaborations, find new collaborators or successfully form collaborations.

        We must maintain our collaborations and enter into new ones to earn revenue and obtain access to commercialization expertise. The availability of collaborators depends on the willingness of pharmaceutical and biotechnology companies to outsource drug discovery activities. There are only a limited number of large pharmaceutical companies and these companies represent a significant portion of the market for our capabilities. The number could decline further through consolidation. If the number of our potential collaborators declines further, they may be able to negotiate price discounts or other 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 pharmaceutical companies. Our ability to interest such companies in forming research collaborations and co-development and commercialization arrangements with us will be influenced by, among other things:

•

the compatibility of our technologies;



•

the potential partner's acceptance of our approach to drug discovery;



•

the quality and commercial potential of any drug candidate we may succeed in developing; and

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•

our ability, and collaborators' perceptions of our ability, to achieve intended results in a timely fashion, with acceptable quality and cost.

        Even if we are able to gain the interest of potential 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. If we are unable to form collaborations, we may be unable to develop drug products or successfully market any products we develop, and therefore be unable to generate product revenue.

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

        We depend on our partners to develop and commercialize compounds and drug candidates after Phase I, or possibly Phase II, clinical trials, if not before. Each of our current 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.

We may not successfully enter into additional collaborations that allow us to participate in the future success of our proprietary drug candidates through milestone, royalty and/or license payments, and we may never receive any milestone, royalty, and/or license payments under our current or any future collaborations.

        One of our business strategies is to create our own proprietary drug candidates and to then enter into collaborations for the development of these drug candidates that will allow us to earn milestone, royalty and/or license payments. Our proprietary drug discovery program is in its early stage of development and is unproven. Although we have expended, and continue to expend, time and money on internal research and development programs, we may be unsuccessful in creating valuable proprietary drug candidates that would enable us to form additional collaborations and receive milestone, royalty and/or license payments.

        Our collaborations and internal programs may not result in the discovery of potential drug candidates that will be safe and effective. Although we have received milestone payments to date, we may never receive any royalty payments, license fees, or additional milestone payments under our current or any future collaborations. Our receipt of any future milestone, royalty or license payments depends on many factors, including whether our collaborators want to continue to pursue a potential drug candidate and the ultimate commercial success of the drug. Development and commercialization of potential drug candidates depend not only on the achievement of research objectives by us and our collaborators, but also on each collaborator's financial, competitive, marketing 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 obtain 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 as expected.

        Any of our 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:

•

decides not to devote the necessary resources because of internal constraints or other priorities;



•

decides to pursue a competitive potential drug or compound developed outside of our collaborations;

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•

cannot obtain necessary regulatory approvals; or



•

exercises a right to terminate our collaboration.

Our operations could be interrupted by damage to or loss of our facilities.

        We depend upon highly specialized laboratories and equipment in Woburn and Medford, Massachusetts. Catastrophic events, including fires or explosions caused by our chemical synthesis and other drug discovery activities, could damage our laboratories, equipment or inventories of chemical compounds and may materially interrupt our business. We employ safety precautions in our laboratory activities in order to reduce the likelihood of the occurrence of these catastrophic events. However, we cannot altogether eliminate the chance that such an event will occur. In addition, our relationship with our landlord in Medford could sour such that our continued occupancy could be put at risk. The availability of laboratory space in Woburn and Medford is extremely limited and rebuilding our facilities would be time consuming and result in substantial delays in fulfilling our agreements with collaborators. We maintain business interruption insurance to cover lost revenue caused by such occurrences. However, this insurance would not compensate us for the loss of opportunity and potential harm to customer relations that our inability to meet our collaborators' needs in a timely manner could create.

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. If we cannot hire additional qualified personnel, the workload may increase for both existing and new personnel. The shortage of experienced scientists 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 impracticable.

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

        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 acquisitions, or whether we will be able to successfully integrate any acquired businesses, operate them profitably or retain their 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 and, in the case of equity financing, that may result in dilution to our stockholders. If we are unable to integrate any acquired entities, products or technologies effectively, our business will suffer. In addition, under certain circumstances, amortization of assets or charges resulting from the costs of acquisitions could harm our business and operating results.

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RISKS RELATED TO OUR FINANCIAL CONDITION

We may not achieve profitability.

        From our inception in 1993 through 2002, we incurred cumulative losses of approximately $150 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:

•

license and technology transfer fees for access to our chemical synthesis and production platforms such as transfer of our AMAP technology to Pfizer;



•

payments for product deliveries;



•

research and development funding paid under our agreements with our collaboration partners; and



•

to a limited extent, milestone payments.

        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 collaborations is uncertain and not diversified.

        To maintain our current relationships with collaborators and to meet the performance and delivery requirements in our contracts, we must provide drug discovery capabilities at appropriate levels, with acceptable quality and at acceptable cost. Our ability to deliver the drug discovery capabilities 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, which requires a high rate of production. Some of our collaborators can influence when we provide our drug discovery capabilities under their contracts, which could increase our current contractual commitments to provide chemical compounds even further. If we are unable to increase or maintain our current rate of compound synthesis 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.

        Also, at present we depend largely on 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, a significant portion of our revenue is generated from our Pfizer collaboration. If this collaboration were to cease it would have a materially adverse effect on our financial condition. 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.

        Our collaboration agreements require us to reach significant developmental stages in the drug discovery process in order to receive milestone payments. If we do not achieve these milestones as expected, our revenue will be delayed and/or reduced. For planning purposes, we estimate the timing of the accomplishment of various scientific, clinical, regulatory and other milestones such as the commencement or completion of scientific studies and clinical trials and the submission of regulatory filings. These estimates are based on a variety of assumptions. The actual timing of these milestones can vary dramatically compared to our estimates, in many cases for reasons beyond our control.

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

•

significant preclinical and clinical development efforts, or the completion of preliminary field trials;



•

regulatory approvals;



•

development of manufacturing capabilities; and



•

successful marketing.

Our operating results likely will continue to fluctuate significantly.

        Our ability to generate revenue from 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. In addition, some of our 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.

        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.

        If our operations do not become profitable on a sustainable basis before we exhaust existing resources, we will 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, your 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.

        Moreover, our fixed expenses such as rent, license payments and other contractual commitments are substantial and will increase in the future. These fixed expenses will increase from:

•

construction or lease expense for new facilities and capital equipment to the extent that our collaborators do not reimburse us for them;



•

obtaining additional licenses and collaborative agreements;



•

contracts for consulting, maintenance and administrative services; and



•

contracts for product manufacturing.

        We believe that our cash, cash equivalents and short-term investment securities balances as of December 31, 2002 will be sufficient to meet our operating and capital requirements for the next

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several years. We have based this estimate on assumptions and estimates that may prove to be wrong. As a result, we may need or choose to obtain additional financing during that time.

Our indebtedness and debt service obligations may adversely affect our cash flow.

        As of March 1, 2003, we had approximately $14.2 million of outstanding debt. During each of the next four years, we will be required to make principal and interest payments on our outstanding debt totaling approximately $14.9 million. If we are unable to generate sufficient cash to meet these obligations and have to use existing cash or investments, we may have to delay or curtail our research and development programs, placing us at a possible competitive disadvantage to less leveraged competitors and competitors that have better access to capital resources.

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 maintain patents on our 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 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 therefore 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

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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 or litigating 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 our product infringes on his 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 our patents. In addition, some licenses may be non-exclusive 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 exclusive 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. Though we believe that 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 freely this information, 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

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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. 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 delays and denials may be encountered in foreign countries. As a company, we have 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, 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.

        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.

We have limited capabilities in preclinical and clinical development of drug candidates.

        If we proceed with preclinical and clinical development of products, we will be dependent on third-party providers of preclinical and clinical development services, including GLP synthesis and testing, or 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 such third-party service providers on acceptable terms, or to establish our own development facilities, our preclinical and clinical development of products will be delayed and our financial results will be adversely affected.

RISKS RELATING TO PRODUCT MANUFACTURING

Our development, testing and manufacture of potential drug candidates may expose us to potential liability.

        We develop, test and manufacture the precursors to drugs generally intended for use in humans. If our drug discovery activities result in 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, and in the aggregate, at levels which we believe are customary and commercially reasonable in our industry. 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

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to maintain our current insurance policies or obtain and maintain necessary additional coverage at acceptable costs or at all.

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 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. In addition, we cannot eliminate the risk of accidental contamination or injury from these materials. In the event of an accident, we could be liable for damages, and any such liability could exceed our resources and disrupt our business.

Because we have limited manufacturing capabilities, if we decide to manufacture product candidates 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.

        We have limited experience with the FDA's good manufacturing practices and no commercial scale manufacturing capabilities. In order to continue to develop products and services, apply for regulatory approvals and commercialize products and services, we will need to develop, contract for or otherwise arrange for the necessary manufacturing 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 third party 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 third party manufacturers entails risks to which we would not be subject if we manufactured products ourselves, including reliance on the third party for regulatory compliance and quality assurance, the possibility of breach of the manufacturing agreement by the third party because of factors beyond our control and the possibility of termination or non-renewal of the agreement by the third party, based on its own business priorities, at a time that is costly or inconvenient for us.

        We may in the future elect to manufacture certain of our product candidates in our own manufacturing facilities. We would then need to invest substantial additional funds and to recruit qualified personnel in order to build or l