PART I

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report, including the information we incorporate by reference, contains forward-looking statements that involve substantial risks and uncertainties. All statements, other than statements of historical fact, included in this report regarding our strategy, future operations, future financial position, future revenue, projected costs, prospects, plans and objectives of management are forward-looking statements. The words “anticipate,” “believe,” “estimate,” “expect,” “hope,” “intend,” “may,” “plan,” “project,” “will,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements we make. We have included in this report, particularly in the “Risk Factors” section, important factors that we believe could cause actual results or events to differ materially from the forward-looking statements that we make. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, capital raising or in-licensing transactions, joint ventures or investments we may make. We do not assume any obligation to update any forward-looking statements.

ITEM 1. BUSINESS

General

We are a clinical-stage biopharmaceutical company focused on the discovery, development and commercialization of novel, small molecule therapeutics for use in oncology and other unmet medical needs. We have built our product candidate portfolio through internal discovery and the in-licensing of novel cancer therapeutics. We are advancing our product candidates through in-house research and development efforts and strategic collaborations with leading pharmaceutical and biopharmaceutical companies. We believe the quality and breadth of our product candidate pipeline, platform technology, strategic collaborations and scientific team will enable us to become a fully integrated biopharmaceutical company with a diversified portfolio of novel therapeutics for major diseases.

We are advancing three proprietary oncology product candidates, SNS-595, SNS-032 and SNS-314, through in-house research and development efforts. Our lead product candidate, SNS-595, is a novel cell cycle inhibitor. With SNS-595, we are currently conducting one Phase 2 clinical trial in small cell lung cancer, one Phase 2 clinical trial in ovarian cancer, and one Phase 1 clinical trial in acute leukemias. In January 2007, we announced that we are terminating enrollment for our Phase 2 clinical trial in non-small cell lung cancer and progressing to the second stage in our Phase 2 clinical trial in small cell lung cancer. In 2007, we expect to initiate a Phase 1 clinical trial in acute leukemias in combination with cytarabine, and a Phase 2 clinical trial in acute myelogenous leukemia, or AML. We in-licensed SNS-595 from Dainippon Sumitomo Pharma Co., Ltd., or Dainippon, in October 2003. Our second most advanced product candidate, SNS-032, is a cyclin-dependent kinase, or CDK, inhibitor. We are currently conducting a Phase 1 clinical trial with SNS-032 in patients with advanced solid tumors. We are also conducting a Phase 1 clinical trial in patients with advanced B-cell lymphoid malignancies. We in-licensed SNS-032 from Bristol-Myers Squibb, or BMS, in April 2005. We are also developing SNS-314, an Aurora kinase inhibitor, for the treatment of cancer, and in February 2007, we filed an investigational new drug application, or IND, for this compound. We have worldwide development and commercialization rights to SNS-595, SNS-032 (for diagnostic and therapeutic applications) and SNS-314. We may in the future enter into collaborations to maximize the commercial potential of these programs.

We have developed a proprietary method of discovering drugs in pieces, or fragments. We call this fragment-based discovery approach “Tethering®.” Tethering® is a process whereby a target protein

known to be involved in a disease process is engineered to facilitate the binding of small drug fragments. Once a small fragment is identified, the fragment is built out using the target protein’s surface as a template to make a new full-size therapeutic compound. We combine Tethering® with other drug discovery tools, such as structure-based design and medicinal chemistry, to discover and develop novel therapeutics for major diseases. In addition to its use in our internal drug discovery efforts, Tethering® is the basis of our four ongoing strategic collaborations with Biogen Idec, Johnson & Johnson PRD and Merck. We believe that our strategic collaborations will enable us to leverage and expand our internal development capabilities, manage our cash expenditures and diversify risk across our pipeline.

We were incorporated in Delaware in February 1998 as Mosaic Pharmaceuticals, Inc., and we subsequently changed our name to Sunesis Pharmaceuticals, Inc. Our offices are headquartered at 341 Oyster Point Boulevard, South San Francisco, California 94080, and our telephone number is (650) 266-3500. Our website address is www.sunesis.com. Information contained in, or accessible through, our website is not a part of this report. References in this report to “we,” “us,” “our,” “our company” or “Sunesis” refer to Sunesis Pharmaceuticals, Inc.

Sunesis, Tethering® and , our logo are registered trademarks of our company. All other trademarks, trade names and service marks appearing in this report are the property of their respective owners.

Our Programs

SNS-595 Program

SNS-595 is a novel cell-cycle inhibitor that we believe represents a new class of anti-tumor drugs. The process of cell division is tightly regulated in order to control growth. In cancer, this cell regulation has been circumvented, and cancer cell proliferation is unrestrained. We believe that SNS-595 causes cancer cells to arrest during cell division and consequently, under programmed cell death or apoptosis. In preclinical studies, SNS-595 demonstrated broad anti-tumor activity.

Since 2004, we have conducted two Phase 1 clinical trials to evaluate doses and schedules of administration in patients with advanced solid tumors. In October 2005, we began a Phase 1 clinical trial in acute leukemias. In December 2005, we commenced a Phase 2 clinical trial in non-small cell lung cancer for which we recently announced that we are terminating enrollment. We also initiated a Phase 2 clinical trial in small cell lung cancer in March 2006 which we recently announced will progress to the second stage of the study. Lastly, in December 2006, we initiated a Phase 2 clinical trial in ovarian cancer. In addition, in 2007, we expect to initiate a Phase 1 clinical trial in acute leukemias in combination with cytarabine, and a Phase 2 clinical trial in AML. We obtained worldwide development and commercialization rights to SNS-595 from Dainippon through a license agreement in 2003.

SNS-032 Program

SNS-032 is a targeted inhibitor of certain cyclin-dependent kinases, including CDK2, CDK7 and CDK9. Kinases are enzymes critical in the communication and relay of signals to promote cell growth and function, and cyclin-dependent kinases relay signals in the cell cycle. SNS-032 is a novel targeted inhibitor of CDKs 2, 7 and 9, which are critical in the communication and relay of signals to promote cellular growth and function. CDK2 is involved in cellular proliferation by regulating the initiation of and progression through the DNA-synthesis phase of the cell cycle. CDK7 and CDK9 are involved in transcriptional regulation of certain proteins involved in cell survival. Inappropriate activity by these CDKs can lead to unregulated proliferation, avoidance of apoptosis and increased cell survival, all of which are hallmarks of cancer. By selectively targeting these CDKs, SNS-032 may halt both aberrant cell proliferation and induce apoptosis. In preclinical studies, SNS-032 has demonstrated broad anti-tumor activity in multiple mouse and human tumor models, including breast, ovarian, colorectal and skin cell cancers. BMS conducted three

Phase 1 dose-escalation clinical trials evaluating the safety and tolerability of SNS-032 at three different dosing regimens in approximately 135 patients with refractory solid tumors. In January 2006, we commenced a Phase 1 clinical trial with SNS-032. We designed this trial to evaluate the safety and tolerability of daily, repeated exposures to SNS-032 as a stand-alone therapy in patients with advanced solid tumors. We expect to release results of this Phase 1 clinical trial in the first half of 2007. In March 2007, we commenced a Phase 1 clinical trial with SNS-032 in B-cell lymphoid malignancies. We obtained worldwide rights to develop and commercialize SNS-032 for diagnostic and therapeutic applications from BMS through a license agreement in April 2005.

SNS-314 Program

SNS-314 is a targeted inhibitor of the Aurora A, B and C kinases. Aurora kinases are key enzymes involved in cell growth and division and play an essential role in the abnormal growth and proliferation of tumor cells. The goal of this program is to develop novel Aurora kinase inhibitors that exhibit broad activity in tumors and do not cause significant peripheral nerve cell death, known as peripheral neuropathy. We filed an IND in February 2007 and expect to commence a Phase 1 clinical trial in the second quarter of 2007. We have retained worldwide rights to commercialize SNS-314.

Other Oncology Kinase Programs

We are applying Tethering® in several programs to discover and develop novel cancer therapeutics that inhibit other kinases.

Raf Kinase Inhibitors Program. We are developing our Raf kinase inhibitors program in collaboration with Biogen Idec. We provided Raf kinase inhibitors to the collaboration and have jointly with Biogen Idec optimized these molecules to show oral antitumor activity in animal models. Raf kinase is an enzyme in the Ras pathway, a signaling pathway important to cell proliferation. The goal of this program is to develop Raf kinase inhibitors with improved pharmaceutical properties as compared to other Raf kinase inhibitors in development. We expect to select a compound for good laboratory practice, or GLP, preclinical development in late 2007.

Other Kinase Inhibitors Programs. As part of our collaboration with Biogen Idec, we are applying Tethering® to discover novel small molecule leads that inhibit up to five additional oncology and immunology kinase targets. We and Biogen Idec are working together on the identification, optimization and development of inhibitor drugs for these kinases. We have an option to co-develop and co-promote the product candidates from two of the collaboration kinase targets, including Raf, developed through this program on a worldwide basis. We are also working on the identification and optimization of kinase inhibitor drugs outside of our collaboration with Biogen Idec.

Other Programs

Cathepsin S Inhibitors Program for Inflammatory Diseases. In collaboration with Johnson & Johnson PRD, we applied Tethering® to discover small molecule inhibitors of Cathepsin S, an enzyme involved in the activation of T-cells. Inappropriate activation of T-cells may lead to some inflammatory diseases, such as asthma, rheumatoid arthritis, multiple sclerosis, psoriasis and Crohn’s disease. Although the research term of this collaboration ended in December 2005, our agreement with Johnson & Johnson PRD continues so long as a compound arising from the collaboration is the subject of an active development project or for so long as there is an obligation to pay royalties under the agreement. Several collaboration compounds continue to be evaluated in preclinical studies and are the subject of an active development project. Johnson & Johnson PRD holds worldwide rights to commercialize any drugs resulting from this program.

BACE Inhibitors for Alzheimer’s Disease. We collaborated with Merck to identify and optimize inhibitors of BACE, an important enzyme target in Alzheimer’s disease. The research term of this collaboration ended in February 2006. Merck is responsible for advancing these compounds into lead optimization, preclinical studies and clinical trials, and collaboration compounds continue to be advanced in preclinical studies. Merck holds worldwide rights to commercialize any drugs resulting from this program.

Anti-Viral Inhibitors Program. We are collaborating with Merck to identify novel small molecule inhibitors of an anti-viral target. We have licensed to Merck a series of small molecule compounds we derived from Tethering® that target a specific viral protein. Merck holds worldwide rights to commercialize any drugs resulting from this collaboration and is responsible for advancing these compounds into lead optimization, preclinical studies and clinical trials.

Anti-Cancer Program. We collaborated with Biogen Idec to identify novel small molecule inhibitors of a non-kinase cancer target. We provided Biogen Idec with a series of small molecule compounds we derived from Tethering® that target a specific protein overexpressed in certain cancers, including breast and colorectal cancers. Biogen Idec holds worldwide rights to commercialize any drugs resulting from this collaboration and is responsible for advancing these compounds into lead optimization, preclinical studies and clinical trials. This program is no longer being actively pursued by Biogen Idec.

LFA-1 Program. We internally identified a series of small-molecule antagonists to the cell adhesion molecule LFA-1, an extracellular receptor found on white blood cells that mediates both migration and adhesion of the white blood cells to sites of inflammation as a part of the body’s immune response. LFA-1 antagonists have promise as therapeutic agents for immunological and inflammatory diseases including psoriasis, chronic dry eye, and multiple sclerosis. We discontinued development of our LFA-1 antagonist program in 2004 when we focused our research and development efforts in oncology. We licensed to SARcode worldwide rights to all of our LFA-1 patents and related know-how in March 2006.

Our Fragment-Based Drug Discovery Approach

We are applying Tethering® to discover and develop novel therapeutics for major diseases. Tethering® allows us to screen drug fragments based on binding properties, which enables us to potentially identify compounds that may not be discovered through conventional methods of drug discovery. We believe that this capability allows us to efficiently design product candidates that bind to sites or regions on a specific protein not readily accessed by other discovery methods. Tethering® is applicable to most proteins, and we have used Tethering® on over 15 different protein targets to date.

Corporate Strategy

We are focused on discovering, developing and commercializing novel small molecule therapeutics for oncology and other unmet medical needs. The key elements of our strategy are as follows:

· focus on small molecules with differentiated therapeutic benefits;

· maximize the value of our pipeline of product candidates through internal development and strategic collaborations; and

· expand our portfolio of product candidates through our internal drug discovery engine and selective in-licensing.

Manufacturing and Raw Materials

We outsource the manufacture of SNS-595 to third-party contract manufacturers. The active pharmaceutical ingredient, or API, of SNS-595 is manufactured by a single-source supplier through a

13-step convergent synthesis in which two intermediates are manufactured in a parallel process and then combined and deprotected in the final two steps. The API is then formulated and vials are filled and finished by two different third party manufacturers. The API is classified as a toxic substance, which limits the number of suppliers qualified to manufacture it. We have a sufficient supply of SNS-595 API to conduct our current and planned non-pivotal Phase 1 and Phase 2 clinical trials in North America. Our current inventory of SNS-595 finished product is suitable for use through the third quarter of 2009. New lots of finished product will be manufactured and released as required to support our current and planned clinical activities.

We outsource the manufacture of SNS-032 to third-party contract manufacturers. As part of our agreement with BMS, we acquired enough of the API of SNS-032 for at least our Phase 1 clinical trial for SNS-032. Methods for preparing and testing SNS-032 API have been transferred to our API contract manufacturer, and we have released a Good Manufacturing Practice, or GMP, batch of SNS-032. Methods for preparing and testing the corresponding drug product, SNS-032 API, have also been transferred to our finished product manufacturer and we have released a clinical batch of SNS-032 API drug product which is now supporting our clinical trial. We have a sufficient supply of SNS-032 to conduct our current and planned Phase 1 and Phase 2 clinical trials. Our current inventory of SNS-032 finished product is suitable for use through at least the fourth quarter of 2007. New lots of finished product will be manufactured and released as required to support our current and planned clinical activities.

Methods for manufacturing and testing SNS-314 API have been transferred to our API contract manufacturer and we have manufactured and released a GMP batch of SNS-314. Methods for preparing and testing the corresponding drug product, SNS-314 API, have also been transferred to our finished product manufacturer and we have released a clinical batch of SNS-314 API which will be used to support our planned clinical trial.

License Agreements

Dainippon Sumitomo Pharma

In October 2003, we entered into a licensing agreement with Dainippon in which we obtained a worldwide, exclusive license, including the right to sublicense, to SNS-595 and related compounds.

In addition to upfront payments and milestone payments made as of December 31, 2006, the agreement provides to Dainippon future milestone payments of up to $8.0 million for starting Phase 3 clinical testing, and for filing new drug applications, or NDAs, and receiving regulatory approval in the United States, Europe and Japan for cancer treatment. In February 2006, we paid Dainippon a $500,000 milestone payment related to the commencement of our Phase 2 clinical trial in non-small cell lung cancer. If SNS-595 is approved for a non-cancer indication, additional milestone payments become payable to Dainippon.

The agreement also provides for royalty payments to Dainippon at rates that are based on total annual net sales. We may reduce our royalty payments to Dainippon if a third party markets a competitive product or we must pay royalties for third party intellectual property rights necessary to commercialize SNS-595. Royalty obligations under the agreement continue on a country-by-country and product-by-product basis until the later of the date on which no valid patent claims relating to a product exist or 10 years from the date of the first sale of the product.

If we discontinue seeking regulatory approval and/or sale of the product in a region, we are required to return to Dainippon its rights to the product in that region. The agreement may be terminated by either party for the other party’s uncured breach or bankruptcy.

Bristol-Myers Squibb Company

In April 2005, we entered into a license agreement with Bristol-Myers Squibb, or BMS, in which we obtained worldwide exclusive and non-exclusive diagnostic and therapeutic licenses, including rights to sublicense, to SNS-032 and any related compounds that are active against CDK-1, -2, -4, -7 and -9 and are covered by licensed intellectual property.

In April 2005, we paid BMS an $8.0 million upfront payment through the issuance of shares of our Series C-2 preferred stock which converted into 879,094 shares of common stock upon our initial public offering, or IPO, in September 2005. Under the terms of the agreement, we are obligated to make milestone payments to BMS of up to $29.0 million in cash and equity based on the successful development and approval for the first indication and formulation of SNS-032. Additional development and commercialization milestones could total up to $49.0 million in cash and equity totaling up to $78.0 million for beginning Phase 1, Phase 2 and Phase 3 clinical testing, and for filing NDAs and receiving regulatory approval in the United States, Europe and Japan as well as for achieving certain commercial milestones. Milestone payments are distributed among intravenous, or IV, and oral formulations and various cancer indications. We may, at our election, pay some of the initial milestone payments in equity or a mixture of cash and equity, rather than entirely in cash. Shares of our stock issued in connection with milestone payments will be valued at the average closing price of our common stock for a specified five-day period prior to issuance. In February 2006, as consideration for a $2.0 million milestone payment due pursuant to the license agreement for initiating a Phase 1 clinical trial, we issued an aggregate of 404,040 shares of our common stock to BMS.

The agreement also provides for royalty payments to BMS at rates that are based on total annual net sales. Royalty obligations under the agreement continue on a country-by-country basis until the later of (i) expiration of all patents that are owned by us or exclusively licensed to us (whether by BMS or a third party) that cover a licensed product, (ii) 10 years following the first commercial sale of a licensed product, or (iii) expiration of all applicable data exclusivity with respect to a licensed product. The U.S. composition of matter patent covering SNS-032 is due to expire on October 21, 2018, and most of its foreign counterparts are due to expire on December 7, 2020.

After completion of any Phase 2 clinical trial with SNS-032 or other licensed product under an IND, should we desire to sublicense our rights under the agreement, BMS will have the first right to negotiate with us for such sublicense. If we and BMS do not reach agreement within a designated period of time, then we are free to sublicense to any third party provided the financial terms are not less favorable than those offered to BMS. We cannot grant a sublicense to any third party before the completion of such Phase 2 clinical trial unless we receive BMS’ consent.

The agreement may be terminated by BMS for our uncured breach (other than a diligence breach) or bankruptcy. BMS may terminate this agreement on a country-by-country basis for our uncured failure to use commercially reasonable efforts to develop and/or commercialize at least one licensed compound or licensed product in a particular country or territory. Further, if such uncured failure occurs in certain countries, BMS may terminate the agreement as to entire designated territories. BMS may also terminate the agreement if we develop or market a competitive product within certain designated time periods. We may terminate this agreement with respect to a specific licensed product in a particular country without cause but with a specified notice period. We may also terminate the agreement for BMS’ uncured breach.

The University of California, San Francisco

In August 2005, and amended in April 2006, we entered into research and license agreements with the University of California, San Francisco, or UCSF, that allows UCSF a limited license to use Tethering® for academic purposes. UCSF intends to leverage Tethering® to identify novel, small molecule drug candidates. In return, we received an exclusive royalty-free license to any improvements to Tethering® or

fragment libraries that emerge from UCSF’s research. In the event that any small molecules are discovered using Tethering®, we will have a right of first negotiation to in-license the compounds. UCSF is precluded from utilizing the technology for commercial purposes and from conducting research in the kinase field or any other drug target on which our company is currently interested. The research at UCSF is being conducted by Dr. James Wells. Dr. Wells was a founder of our company and is a member of our board of directors.

SARcode, Inc.

In March 2006, and amended in December 2006, the Company entered into a license agreement with SARcode, Inc., or SARcode, a privately-held biopharmaceutical company, that provides SARcode a license to our LFA-1 inhibitor program. SARcode intends to use the license to develop small molecule drugs to treat inflammatory diseases. We had previously discontinued our LFA-1 inhibitor program, which is outside of our strategic focus on discovering and developing novel small molecule therapeutics to treat cancer.

In conjunction with the license, in January 2007 we received a $250,000 license fee and a $250,000 note convertible into preferred stock in certain circumstances. Under the terms of the license agreement, SARcode received an exclusive, worldwide license to all of our LFA-1 patents and related know-how. In addition to cash and and convertible notes already received, we may in the future receive up to $1.0 million in license fees and convertible notes, $31.0 million in development and marketing milestone payments, and royalties for the commercialization of a licensed compound.

Strategic Collaborations

As of February 28, 2007, we had four ongoing strategic collaborations, one of which involves active participation by our personnel, with three leading pharmaceutical and biopharmaceutical companies. These alliances have been designed to enable us to leverage and expand our internal development capabilities, manage our cash expenditures and diversify risk across our pipeline. Through our strategic collaborations, we are able to pursue more programs than we could fund on our own. As of December 31, 2006, we had received an aggregate of approximately $74.1 million in cash in the form of stock purchase proceeds and fees from our current and former collaboration partners, excluding Biogen Idec’s $5.0 million investment in our company through our IPO.

In forming each of our strategic collaborations, we have agreed for a certain period of time not to conduct certain research, independently or with any commercial third party, that is on the same target as that covered by the collaboration agreement. Some of our collaborations also significantly restrict our ability to utilize intellectual property derived from a collaboration for a purpose outside of the collaboration.

Biogen Idec (formerly Biogen, Inc.)—TNF Family and Oncology Research Collaboration

In December 2002, we entered into a collaboration with Biogen Idec to apply Tethering® to discover and develop small molecule modulators of up to four members of the TNF trimeric cytokine super-family plus up to two additional targets. The research phase of this collaboration ended in June 2005, and to our knowledge Biogen Idec has discontinued the development of all product candidates that were subject to this collaboration.

Pursuant to this agreement, we received a $3.0 million upfront technology access fee. In addition, Biogen Idec made a $6.0 million equity investment in our company. The agreement also provided for a maintenance fee payable to us of $357,500 per quarter, starting in April 2004 and continuing until the end of the initial research phase which ended in July 2005. Both parties agreed to dedicate resources as

provided in the research plan. To date, we have received payments totaling $10.8 million under this collaboration, net of $4.0 million in loan proceeds which were repaid in full in September 2005.

Biogen Idec—Kinase Research, Development and Commercialization Collaboration

In August 2004, we entered into a collaboration agreement with Biogen Idec to discover, develop and commercialize small molecule inhibitors of Raf kinase and up to five additional targets. The primary focus of the program is to discover small molecule inhibitors of kinases that play a role in oncology and immunology indications or in the regulation of the human immune system. During the research term, we and Biogen Idec agreed to work together exclusively to develop pharmaceutical compounds against collaboration targets with the exception that either party may collaborate with a third party on a Phase 2 clinical trial or later stage compound against a collaboration target. Our exclusivity obligation continues for an additional year after the end of the research term. We also agreed not to develop or commercialize any compound active against a collaboration target that is the subject of the agreement.

Pursuant to this agreement, we received a $7.0 million upfront technology access fee. In addition, Biogen Idec made a $14.0 million equity investment in our company. As of December 31, 2006, we had received payments totaling $33.5 million under this collaboration, including the $14.0 million equity investment. The initial research term is four years, and both parties agreed to dedicate the research personnel provided in the research plan with Biogen Idec increasing funding for research personnel in 2007. Biogen Idec has the option to extend the research term for up to two additional one-year periods upon payment of an additional technology access fee and a commitment to provide research funding. Biogen Idec agreed to bear all costs related to this program for all targets through at least the completion of Phase 1 clinical trials, after which we have the right to participate in the co-development and co-promotion of product candidates for up to two targets.

We granted Biogen Idec a worldwide non-exclusive license to our intellectual property relating to Tethering® with respect to specific collaboration targets and an exclusive license to our portion of the collaboration intellectual property for the commercialization of small molecule compounds that have a specified activity against collaboration kinases arising from the collaboration. Biogen Idec is required to pay up to $60.5 million in pre-commercialization milestones per target as well as royalty payments depending on product sales. Royalty payments may be increased if we exercise our option on co-development and co-promotion rights. Royalty rates payable to us will be reduced if Biogen Idec is required to license additional intellectual property related to Tethering® from one or more third parties in order to commercialize a collaboration product. Rights to collaboration products revert to us with a reverse royalty to Biogen Idec if Biogen Idec fails to use commercially reasonable and diligent efforts during development and commercialization of co-funded products. If we do not exercise our co-funding option for a product directed at a target selected for further collaborative work, then Biogen Idec may pursue such target on its own. We also have a non-exclusive license, with the right to obtain an exclusive license, from Biogen Idec under joint collaboration intellectual property to develop and commercialize products against other kinase targets. We will owe royalty payments to Biogen Idec for sales of any such products. Royalty obligations under the agreement continue on a country-by-country and product-by-product basis until the later of the date on which no valid patent claim relating to a product exists or 10 years from the date of first sale of the product.

Our agreement with Biogen Idec is scheduled to continue for so long as a product arising from the collaboration is the subject of an active development project or for so long as there is an obligation to pay royalties under the agreement. The agreement may be terminated earlier by Biogen Idec without cause at any time before the second anniversary of the agreement upon six months’ written notice or immediately upon written notice and payment of a termination fee. Biogen Idec may also terminate the agreement without cause upon 90 days’ written notice. Either party may also terminate the agreement for the other party’s uncured breach or bankruptcy. If Biogen Idec terminates the agreement early without cause or we

terminate due to Biogen Idec’s breach or bankruptcy, all co-funded products not approved for sale prior to termination will revert to us, and we will receive a reduction in the royalties we owe to Biogen Idec. If Biogen Idec terminates the agreement early due to our breach or bankruptcy, Biogen Idec will receive a reduction in the royalties it owes to us. Many of the parties’ other product rights are not substantially affected by early termination.

Johnson & Johnson PRD—Research, Development and Commercialization Collaboration

In May 2002, we entered into a collaboration agreement with Johnson & Johnson PRD to discover, develop and commercialize small molecule inhibitors of Cathepsin S, an enzyme that is important in regulating an inflammatory response. During the period of the research term plus two years, we and Johnson & Johnson PRD agreed to work together exclusively to develop pharmaceutical compounds against Cathepsin S. Johnson & Johnson PRD retains the sole right to determine whether a product candidate enters development. Johnson & Johnson PRD holds worldwide rights to commercialize any drugs resulting from this program.

The agreement provides for payment by Johnson & Johnson PRD to us of a technology access fee and research funding. To date, we have received payments totaling $6.3 million under this collaboration. The initial research term was two years, and Johnson & Johnson PRD had the option to extend the research term for up to two additional one-year periods with the same level of research funding. Johnson & Johnson PRD exercised its first option to extend the research term through May 2005, and in December 2004, Johnson & Johnson PRD extended the research term further to December 31, 2005. Johnson & Johnson PRD did not extend the research term beyond December 31, 2005.

We granted Johnson & Johnson PRD a worldwide non-exclusive license to our intellectual property relating to Tethering® on Cathepsin S and an exclusive license under the collaboration intellectual property for the commercialization of small molecule products arising from the collaboration. Patents and patent applications arising from the collaboration are owned by our company. Johnson & Johnson PRD is required to pay research and development milestones of up to $24.5 million well as royalty payments depending on product sales. Royalty rates payable to us may be reduced if Johnson & Johnson PRD is required to license additional intellectual property related to Tethering® from one or more third parties in order to commercialize a collaboration product. Royalty obligations under the agreement continue on a country-by-country and product-by-product basis until the later of the date on which no valid patent claim relating to a product exists or 10 years from the date of first sale of the product.

Although the research term of the collaboration ended in December 2005, our agreement with Johnson & Johnson PRD will continue for so long as a product arising from the collaboration is the subject of an active development project or for so long as there is an obligation to pay royalties under the agreement. We believe Johnson & Johnson PRD is actively pursuing compounds derived from this collaboration. Johnson & Johnson PRD may terminate the agreement earlier without cause after the end of the research term and upon six months’ written notice, and either party may terminate the agreement for the other party’s uncured breach or bankruptcy. If we terminate the agreement due to Johnson & Johnson PRD’s breach or bankruptcy, Johnson & Johnson PRD would grant us certain exclusive licenses and transfer its regulatory filings to us, and we will be obligated to pay modest royalties to Johnson & Johnson PRD in return.

Merck—BACE Research, Development and Commercialization Collaboration

In February 2003, we entered into a license and collaboration agreement with Merck to discover, develop and commercialize small molecule inhibitors of BACE, or beta secretase, an enzyme that is believed to be important for the progression of Alzheimer’s disease. During the period of the research term plus one year, we and Merck agreed to work together exclusively to develop a pharmaceutical

compound against the collaboration target, with the exception that Merck may acquire from a third party a compound that satisfies development candidate criteria specified in the agreement. Merck holds worldwide rights to commercialize any drugs resulting from this collaboration.

The agreement provides for payment by Merck to us of a technology access fee and research funding. To date, we have received payments totaling $18.0 million under this collaboration. The initial research term was three years and both parties agreed to dedicate the resource funding provided in the research plan. Merck elected not to exercise its option to extend the research term for an additional one-year period, and the research term of this collaboration ended in February 2006. In June 2006, we received a $4.25 million payment from Merck for meeting certain preclinical milestones related to BACE.

We granted Merck a worldwide, non-exclusive license to our intellectual property relating to Tethering® on BACE and an exclusive license to a composition of matter patent and future intellectual property relating to BACE. Merck is required to pay research and development milestones of up to $90.3 million as well as royalty payments depending on product sales. Royalty rates payable to us may be reduced if Merck is required to license additional intellectual property from one or more third parties in order to commercialize a collaboration product or if a third party markets a version of the collaboration product. Royalty obligations under the agreement continue on a country-by-country and product-by-product basis until the later of the date on which no valid patent claim relating to a product exists or 12 years from the date of first sale of the product. We retain the right to develop and commercialize non-pharmaceutical products containing compounds arising from the collaboration. We would owe Merck a royalty based on sales of any such products.

Our agreement with Merck is scheduled to continue for so long as a product arising from the collaboration is the subject of an active development project or for so long as there is an obligation to pay royalties under the agreement. We believe Merck is actively pursing compounds derived from this collaboration. The agreement may be terminated by either party for the other party’s uncured breach or bankruptcy. The agreement may be terminated by Merck at any time upon three months’ notice to us.

Merck—Anti-viral License and Research Collaboration

In July 2004, we entered into a license and collaborative research agreement with Merck that allows Merck to discover and develop small molecule drugs against an enzyme target for treating viral infections. During the period from the beginning of the research term until the time that Merck ceases activities against the enzyme target, we agreed not to work with any third party on compounds that inhibit the enzyme target. Merck holds worldwide rights to commercialize any drugs resulting from this collaboration.

The agreement provides for a payment by Merck to us of an upfront technology access fee and annual license fees. To date, we have received $3.1 million under this collaboration. The initial research term is three years and may be extended for one year upon mutual agreement of the parties. In July 2006, we received the annual license fee of $150,000 to cover the period from July 2006 through July 2007.

We assigned to Merck small molecule compounds related to the viral target and our interest in research program patents and to compounds that act on the target through our inhibition mode. Merck owns all intellectual property generated in the course of performing the research except for improvements related to Tethering®, which we own. Merck is required to pay pre-commercialization milestones of up to $22.1 million as well as royalty payments based on product sales. Royalty rates payable to us may be reduced if Merck is required to license additional intellectual property from one or more third parties in order to commercialize a collaboration product. Merck may also reduce its royalty payments to us if the product is not covered by a patent or if a third party markets a competitive product. Royalty obligations under the agreement continue on a country-by-country and product-by-product basis until the later of the date on which no valid patent claim relating to a product exists or 12 years from the date of first sale of the product.

Our agreement with Merck is scheduled to continue for so long as a product arising from the collaboration is the subject of an active development project or for so long as there is an obligation to pay royalties under the agreement. Either party may terminate the agreement for the other party’s uncured breach or bankruptcy. The agreement may be terminated by Merck at any time upon three months’ notice to us.

Competition

We compete primarily in the segments of the biopharmaceutical markets that address cancer and other unmet medical needs, which are highly competitive. We face significant competition from many pharmaceutical, biopharmaceutical and biotechnology companies that are researching and selling products designed to address cancer and other unmet medical needs. Many of our competitors have significantly greater financial, manufacturing, marketing and drug development resources than we do. Large pharmaceutical companies in particular have extensive experience in clinical testing and in obtaining regulatory approvals for drugs. These companies also have significantly greater research capabilities than we do. In addition, many universities and private and public research institutes are active in cancer research, some of which are in direct competition with us.

Our product candidates will compete with a number of cancer therapeutics that are currently marketed or in development that also target proliferating cells but at different points of the cell cycle or with a different mechanism of action. These drugs include irinotecan, doxorubicin, taxanes and other cell-cycle inhibitors. To compete effectively with these agents, our product candidates will need to demonstrate advantages that lead to improved clinical efficacy as either a single agent or in combination settings. We believe there are currently over 40 cell-cycle inhibitors undergoing clinical trials worldwide.

SNS-595 is a novel cell-cycle inhibitor that targets DNA repair, causing double strand DNA breaks in replication (S-phase) and inducing G2 arrest followed rapidly by apoptosis. SNS-595 is currently being tested in the clinic in acute leukemias, ovarian cancer and small cell lung cancer. Current competitors to SNS-595 include Genzyme’s clofarabine, MGI Pharma’s decitabine and Vion’s cloretazine, all of which could change the treatment paradigm of acute leukemia. Each of these compounds are further along in clinical development than is SNS-595. Additionally, Pharmion, Poniard and Vion (Cloretazine®) have compounds in the clinic in small cell lung cancer, and liposomal doxorubicin and topotecan are current standards of care in 2nd line platinum resistant ovarian cancer patients. Furthermore, Telik is testing Telcyta as an add-on to liposomal doxorubicin in a randomized Phase 3 clinical trial, and Novartis has initiated a head-to-head Phase 3 clinical trial in platinum refractory patients. comparing its compound patupilone against liposomal doxorubicin.

SNS-032 is a targeted inhibitor of certain CDKs, including CDK2, CDK7 and CDK9. We believe that several companies, including AstraZeneca, Cyclacel Pharmaceuticals, Pfizer, Roche, Schering AG and others, are conducting clinical trials with CDK inhibitors and others are developing other compounds that may compete with SNS-032. We are not aware of any CDK inhibitors that are currently being marketed.

We are not aware of any marketed Aurora kinase inhibitors to treat cancer. However, Merck and Vertex are co-developing an Aurora kinase inhibitor and Cyclacel Pharmaceuticals, AstraZeneca, Astex Therapeutics, Millennium Pharmaceuticals and Rigel Pharmaceuticals in conjunction with Serono/Merck, and others are also developing Aurora kinase inhibitors. Several other companies have Aurora kinase programs for which they are close to filing an IND. Other molecules that may compete with SNS-314 may include other naturally occurring cell-cycle inhibitor drugs.

We believe that our Raf kinase inhibitor would compete with Nexavar® developed jointly by Bayer AG and Onyx Pharmaceuticals, which received FDA approval in December 2005, and several compounds being developed by Pfizer. Likewise, Novartis and Plexxicon initiated a Phase 1 clinical trials with their Raf kinase inhibitors in 2006 and Exelixis has filed an IND for its Raf inhibitor and will likely start enrolling patients in clinical trials in 2007.

We also compete with other companies that may be pursuing drug discovery using other technologies, including fragment-based technologies.

We believe that our ability to successfully compete will depend on, among other things:

· our ability to develop novel compounds with attractive pharmaceutical properties free of third party patents and to secure and protect intellectual property rights based on our innovations;

· the efficacy, safety and reliability of our drug candidates;

· the speed at which we develop our drug candidates;

· our ability to design and successfully complete appropriate clinical trials;

· our ability to maintain a good relationship with regulatory authorities;

· the timing and scope of regulatory approvals;

· the success of our collaborations;

· our ability to manufacture and sell commercial quantities of future products to the market; and

· acceptance of future products by physicians and other healthcare providers.

Intellectual Property

We patent the technology, inventions and improvements that we consider important to the development of our business. As of December 31, 2006, we owned or had exclusive rights to 166 issued U.S. and foreign patents and 181 pending U.S. and foreign patent applications. These issued patents expire between June 6, 2015 and June 5, 2023. We have an exclusive license to 44 issued patents that cover SNS-595 compositions of matter. The U.S. composition of matter patent is due to expire on October 6, 2015 and most of its foreign counterparts are due to expire on June 6, 2015. We also have 28 pending applications pertaining to SNS-595 life cycle management. In addition, we have obtained from BMS exclusive rights for SNS-032 and certain other related compounds against CDK-1, -2, -4, -7 and -9. The exclusive rights for SNS-032 primarily derive from four issued U.S. patents, their foreign counterparts, and other patents and applications that claim priority to these four issued U.S. patents. The U.S. composition of matter patent covering SNS-032 is due to expire on October 21, 2018 and most of its foreign counterparts are due to expire on December 7, 2020. In addition, there are four pending Sunesis-filed applications relating to SNS-032 life-cycle management. There are three pending U.S. and two pending foreign applications in our Aurora kinase program and one pending U.S. and one pending foreign application in our Raf kinase program which relate to composition of matter, formulations, and methods of use in oncology and other kinase-mediated diseases. We intend to seek patent term restoration, orphan drug status or data exclusivity in the U.S. and their equivalents in other relevant jurisdictions to the maximum extent that the laws will permit at such time.

We have twenty-five issued patents, which will expire between 2018 and 2022, and 46 pending applications that relate to Tethering®. We also have two pending applications relating to other kinases. We also co-own with, and have exclusively licensed to, Merck 14 pending U.S. applications and 79 pending foreign applications relating to BACE inhibitor compositions of matter. The remaining patents and applications relate to other aspects of our technology or other drug discovery programs that we are no longer actively pursuing.

Our ability to build and maintain our proprietary position for our technology and drug candidates will depend on our success in obtaining effective claims and enforcing those claims once granted. The patent positions of biopharmaceutical companies like ours are generally uncertain and involve complex legal and factual questions for which important legal principles remain unresolved. No consistent policy regarding

the breadth of patent claims has emerged to date in the United States. The patent situation outside the United States is even more uncertain. We do not know whether any of our patent applications or those patent applications that we license will result in the issuance of any patents. The patents we own or license and those that may issue in the future may be challenged, invalidated or circumvented, and the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages.

We may not be able to develop patentable products or be able to obtain patents from pending patent applications. Even if patents are issued, they may not be sufficient to protect the technology and drug candidates owned by or licensed to us. These current patents and patents that may issue in the future may be challenged, invalidated, infringed or circumvented, and the rights granted in those patents may not provide proprietary protection or competitive advantage to us. Patent applications filed before November 29, 2000 in the United States are maintained in secrecy until patents issue. Later filed U.S. applications and patent applications in most foreign countries generally are not published until at least 18 months after they are filed. Scientific and patent publication often occurs long after the date of the scientific discoveries disclosed in those publications. Accordingly, we cannot be certain that we were the first to invent the subject matter covered by any patent application or that we were the first to file a patent application for any inventions.

Our commercial success depends on our ability to operate without infringing patents and proprietary rights of third parties. We cannot determine with certainty whether patents or patent applications of other parties may materially affect our ability to conduct our business. The existence of third party patent applications and patents could significantly reduce the coverage of patents owned by or licensed to us and limit our ability to obtain meaningful patent protection. If patents containing competitive or conflicting claims are issued to third parties and these claims are ultimately determined to be valid, we may be enjoined from pursuing research, development or commercialization of products, or be required to obtain licenses to these patents or to develop or obtain alternative technology.

We may need to commence litigation to enforce any patents issued to us or to determine the scope and validity of third party proprietary rights. Litigation would result in substantial costs, even if the eventual outcome is favorable to us. An adverse outcome in litigation could subject us to significant liabilities to third parties and require us to seek licenses of the disputed rights from third parties or to cease using the technology if such licenses are unavailable.

We also rely on trade secrets to protect our technology, especially where we do not believe patent protection is appropriate or obtainable. However, trade secrets are difficult to protect.

We seek to protect our proprietary information by requiring our employees, consultants, contractors and other advisers to execute nondisclosure and assignment of invention agreements upon commencement of their employment or engagement. Agreements with our employees also prevent them from bringing the proprietary rights of third parties to us. We also require confidentiality or material transfer agreements from third parties that receive our confidential data or materials. There can be no assurance that these agreements will provide meaningful protection, that these agreements will not be breached, that we will have an adequate remedy for any such breach, or that our trade secrets will not otherwise become known or independently developed by a third party.

Government Regulation

The Food and Drug Administration, or FDA, and comparable regulatory agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon the clinical development, manufacture, marketing and distribution of drugs. These agencies and other federal, state and local entities regulate research and development activities and the testing, manufacture, quality control, safety,

efficacy, labeling, storage, record keeping, approval, advertising and promotion of our drug candidates and drugs.

U.S. Government Regulation

In the United States, the FDA regulates drugs under the Federal Food, Drug, and Cosmetic Act, or FFDCA, and implementing regulations. The process required by the FDA before our drug candidates may be marketed in the United States generally involves the following:

· completion of extensive preclinical laboratory tests, preclinical animal studies and formulation studies, all performed in accordance with FDA’s good laboratory practices, or GLP, regulations;

· submission to FDA of an IND application which must become effective before clinical trials may begin;

· performance of adequate and well-controlled clinical trials to establish the safety and efficacy of the product candidate for each proposed indication;

· submission of a new drug application, or NDA, to the FDA;

· satisfactory completion of a FDA pre-approval inspection of the manufacturing facilities at which the product candidate is produced to assess compliance with current GMP, or cGMP, regulations; and

· FDA review and approval of the NDA prior to any commercial marketing, sale or shipment of the drug.

The testing and approval process requires substantial time, effort and financial resources, and we cannot be certain that any approvals for our drug candidates will be granted on a timely basis, if at all.

Preclinical tests include laboratory evaluation of product chemistry, formulation and stability, as well as studies to evaluate toxicity in animals. The results of preclinical tests, together with manufacturing information and analytical data, are submitted as part of an IND application to the FDA. The IND automatically becomes effective 30 days after receipt by the FDA, unless the FDA, within the 30-day time period, raises concerns or questions about the conduct of the clinical trial, including concerns that human research subjects will be exposed to unreasonable health risks. In such a case, the IND sponsor and the FDA must resolve any outstanding concerns before the clinical trial can begin. Our submission of an IND, or those of our collaboration partners, may not result in FDA authorization to commence a clinical trial. A separate submission to an existing IND must also be made for each successive clinical trial conducted during product development, and FDA must grant permission before each clinical trial can begin. Further, an independent institutional review board, or IRB for each medical center proposing to conduct the clinical trial, must review and approve the plan for any clinical trial before it commences at that center and it must monitor the study until completed. The FDA, the IRB or the sponsor may suspend a clinical trial at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk. Clinical testing also must satisfy extensive Good Clinical Practice, or GCP, requirements and regulations for informed consent.

Clinical Trials

For purposes of NDA submission and approval, clinical trials are typically conducted in the following three sequential phases, which may overlap:

· Phase 1 clinical trials are initially conducted in a limited population to test the drug candidate for safety, dose tolerance, absorption, metabolism, distribution and excretion in healthy humans or, on occasion, in patients, such as cancer patients. In some cases, particularly in cancer trials, a sponsor

may decide to conduct what is referred to as a “Phase 1b” evaluation, which is a second safety-focused Phase 1 clinical trial typically designed to evaluate the impact of the drug candidate in combination with currently approved drugs.

· Phase 2 clinical trials are generally conducted in a limited patient population to identify possible adverse effects and safety risks, to determine the efficacy of the drug candidate for specific targeted indications and to determine dose tolerance and optimal dosage. Multiple Phase 2 clinical trials may be conducted by the sponsor to obtain information prior to beginning larger and more expensive Phase 3 clinical trials. In some cases, a sponsor may decide to conduct what is referred to as a “Phase 2b” evaluation, which is a second, confirmatory Phase 2 clinical trial that could, if positive and accepted by the FDA, serve as a pivotal clinical trial in the approval of a drug candidate.

· Phase 3 clinical trials are commonly referred to as pivotal trials. When Phase 2 clinical trials demonstrate that a dose range of the drug candidate is effective and has an acceptable safety profile, Phase 3 clinical trials are undertaken in large patient populations to further evaluate dosage, to provide substantial evidence of clinical efficacy and to further test for safety in an expanded and diverse patient population at multiple, geographically dispersed clinical trial sites.

In some cases, the FDA may condition approval of an NDA for a drug candidate on the sponsor’s agreement to conduct additional clinical trials to further assess the drug’s safety and efficacy after NDA approval. Such post-approval trials are typically referred to as Phase 4 clinical trials.

New Drug Application

The results of drug candidate development, preclinical testing and clinical trials are submitted to the FDA as part of an NDA. The NDA also must contain extensive manufacturing information. Once the submission has been accepted for filing, by law the FDA has 180 days to review the application and respond to the applicant. The review process is often significantly extended by FDA requests for additional information or clarification. The FDA may refer the NDA to an advisory committee for review, evaluation and recommendation as to whether the application should be approved. The FDA is not bound by the recommendation of an advisory committee, but it generally follows such recommendations. The FDA may deny approval of an NDA if the applicable regulatory criteria are not satisfied, or it may require additional clinical data or an additional pivotal Phase 3 clinical trial. Even if such data are submitted, the FDA may ultimately decide that the NDA does not satisfy the criteria for approval. Data from clinical trials are not always conclusive and the FDA may interpret data differently than we or our collaboration partners interpret data. Once issued, the FDA may withdraw drug approval if ongoing regulatory requirements are not met or if safety problems occur after the drug reaches the market. In addition, the FDA may require testing, including Phase 4 clinical trials, and surveillance programs to monitor the effect of approved products that have been commercialized, and the FDA has the power to prevent or limit further marketing of a drug based on the results of these post-marketing programs. Drugs may be marketed only for the approved indications and in accordance with the provisions of the approved label. Further, if there are any modifications to the drug, including changes in indications, other labeling changes, or manufacturing processes or facilities, we may be required to submit and obtain FDA approval of a new NDA or NDA supplement, which may require us to develop additional data or conduct additional preclinical studies and clinical trials.

Fast Track Designation

FDA’s fast track program is intended to facilitate the development and to expedite the review of drugs that are intended for the treatment of a serious or life-threatening condition for which there is no effective treatment and which demonstrate the potential to address unmet medical needs for the condition. Under

the fast track program, the sponsor of a new drug candidate may request the FDA to designate the drug candidate for a specific indication as a fast track drug concurrent with or after the filing of the IND for the drug candidate. The FDA must determine if the drug candidate qualifies for fast track designation within 60 days of receipt of the sponsor’s request.

If fast track designation is obtained, the FDA may initiate review of sections of an NDA before the application is complete. This rolling review is available if the applicant provides and the FDA approves a schedule for the submission of the remaining information and the applicant pays applicable user fees. However, the time period specified in the Prescription Drug User Fees Act, which governs the time period goals the FDA has committed to reviewing an application, does not begin until the complete application is submitted. Additionally, the fast track designation may be withdrawn by the FDA if the FDA believes that the designation is no longer supported by data emerging in the clinical trial process.

In some cases, a fast track designated drug candidate may also qualify for one or more of the following programs:

· Priority Review. Under FDA policies, a drug candidate is eligible for priority review, or review within a six-month time frame from the time a complete NDA is accepted for filing, if the drug candidate provides a significant improvement compared to marketed drugs in the treatment, diagnosis or prevention of a disease. A fast track designated drug candidate would ordinarily meet the FDA’s criteria for priority review. We do not know whether any of our drug candidates will receive a priority review designation or, if a priority designation is received, whether that review or approval will be faster than conventional FDA procedures, or that the FDA will ultimately grant drug approval.

· Accelerated Approval. Under the FDA’s accelerated approval regulations, the FDA is authorized to approve drug candidates that have been studied for their safety and efficacy in treating serious or life-threatening illnesses and that provide meaningful therapeutic benefit to patients over existing treatments based upon either a surrogate endpoint that is reasonably likely to predict clinical benefit or on the basis of an effect on a clinical endpoint other than patient survival. In clinical trials, surrogate endpoints are alternative measurements of the symptoms of a disease or condition that are substituted for measurements of observable clinical symptoms. A drug candidate approved on this basis is subject to rigorous post-marketing compliance requirements, including the completion of Phase 4 or post-approval clinical trials to validate the surrogate endpoint or confirm the effect on the clinical endpoint. Failure to conduct required post-approval studies, or to validate a surrogate endpoint or confirm a clinical benefit during post-marketing studies, will allow the FDA to withdraw the drug from the market on an expedited basis. All promotional materials for drug candidates approved under accelerated regulations are subject to prior review by the FDA.

When appropriate, we and our collaboration partners intend to seek fast track designation, accelerated approval or priority review for our drug candidates. We cannot predict whether any of our drug candidates will obtain a fast track or accelerated approval designation, or the ultimate impact, if any, of the fast track or the accelerated approval process on the timing or likelihood of FDA approval of any of our drug candidates.

Satisfaction of FDA regulations and approval requirements or similar requirements of foreign regulatory agencies typically takes several years, and the actual time required may vary substantially based upon the type, complexity and novelty of the product or disease. Typically, if a drug candidate is intended to treat a chronic disease, as is the case with some of the drug candidates we are developing, safety and efficacy data must be gathered over an extended period of time. Government regulation may delay or prevent marketing of drug candidates for a considerable period of time and impose costly procedures upon our activities. The FDA or any other regulatory agency may not grant approvals for new indications for our drug candidates on a timely basis, or at all. Even if a drug candidate receives regulatory approval, the

approval may be significantly limited to specific disease states, patient populations and dosages. Further, even after regulatory approval is obtained, later discovery of previously unknown problems with a drug may result in restrictions on the drug or even complete withdrawal of the drug from the market. Delays in obtaining, or failures to obtain, regulatory approvals for any of our drug candidates would harm our business. In addition, we cannot predict what adverse governmental regulations may arise from future United States or foreign governmental action.

Other Regulatory Requirements

Any drugs manufactured or distributed by us or our collaboration partners pursuant to FDA approvals are subject to continuing regulation by the FDA, including recordkeeping requirements and reporting of adverse experiences associated with the drug. Drug manufacturers and their subcontractors are required to register with the FDA and certain state agencies, and are subject to periodic unannounced inspections by the FDA and certain state agencies for compliance with ongoing regulatory requirements, including cGMPs, which impose certain procedural and documentation requirements upon us and our third-party manufacturers. Failure to comply with the statutory and regulatory requirements can subject a manufacturer to possible legal or regulatory action, such as warning letters, suspension of manufacturing, seizure of product, injunctive action or possible civil penalties. We cannot be certain that we or our present or future third-party manufacturers or suppliers will be able to comply with the cGMP regulations and other ongoing FDA regulatory requirements. If our present or future third-party manufacturers or suppliers are not able to comply with these requirements, the FDA may halt our clinical trials, require us to recall a drug from distribution, or withdraw approval of the NDA for that drug.

The FDA closely regulates the post-approval marketing and promotion of drugs, including standards and regulations for direct-to-consumer advertising, off-label promotion, industry-sponsored scientific and educational activities and promotional activities involving the Internet. A company can make only those claims relating to safety and efficacy that are approved by the FDA. Failure to comply with these requirements can result in adverse publicity, warning letters, corrective advertising and potential civil and criminal penalties. Physicians may prescribe legally available drugs for uses that are not described in the drug’s labeling and that differ from those tested by us and approved by the FDA. Such off-label uses are common across medical specialties, including cancer therapy. Physicians may believe that such off-label uses are the best treatment for many patients in varied circumstances. The FDA does not regulate the behavior of physicians in their choice of treatments. The FDA does, however, impose stringent restrictions on manufacturers’ communications regarding off-label use.

Foreign Regulation

In addition to regulations in the United States, we are subject to foreign regulations governing clinical trials and commercial sales and distribution of our future products. We are currently conducting clinical trials in Canada and plan to initiate clinical trials in Europe in the second half of 2007. Whether or not we obtain FDA approval for a product, we must obtain approval of a product by the comparable regulatory authorities of foreign countries before we can commence clinical trials or marketing of the product in those countries. The approval process varies from country to country, and the time may be longer or shorter than that required for FDA approval. The requirements governing the conduct of clinical trials, product licensing, pricing and reimbursement vary greatly from country to country.

Under the Canadian regulatory system, Health Canada is the regulatory body that governs the sale of drugs for the purposes of use in clinical trials. Accordingly, any company that wishes to conduct a clinical trial in Canada must submit a clinical trial application to Health Canada. Health Canada reviews the application and notifies the company within 30 days if the application is found to be deficient. If the application is deemed acceptable, Health Canada will issue a letter to the company within the 30-day review priod which means the company may proceed with its clinical trial(s).

Under European Union regulatory systems, marketing authorizations may be submitted either under a centralized or mutual recognition procedure. The centralized procedure provides for the grant of a single marketing authorization that is valid for all European Union member states. The mutual recognition procedure provides for mutual recognition of national approval decisions. Under this procedure, the holder of a national marketing authorization may submit an application to the remaining member states. Within 90 days of receiving the applications and assessment report, each member state must decide whether to recognize approval.

In addition to regulations in Europe, Canada and the United States, we will be subject to a variety of other foreign regulations governing clinical trials and commercial distribution of our future products. Our ability to sell drugs will also depend on the availability of reimbursement from government and private practice insurance companies.

Employees

As of December 31, 2006, our workforce consisted of 138 full-time employees, 46 of whom hold Ph.D. or M.D. degrees, and 33 of whom hold other advanced degrees. Of our total workforce, 111 are engaged in research and development and 27 are engaged in business development, finance, legal, human resources, facilities and information technology administration and general management. We have no collective bargaining agreements with our employees, and we have not experienced any work stoppages. We believe that our relations with our employees are good.

ITEM 1A. RISK FACTORS

Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below and all information contained in this report before you decide to purchase our common stock. If any of the possible adverse events described below actually occurs, we may be unable to conduct our business as currently planned and our financial condition and operating results could be harmed. In addition, the trading price of our common stock could decline due to the occurrence of any of these risks, and you may lose all or part of your investment. Please see “Special Note Regarding Forward-Looking Statements.”

Risks Related to Our Business

We have incurred losses since inception and anticipate that we will continue to incur losses for the foreseeable future. We may not ever achieve or sustain profitability.

We are a clinical-stage biopharmaceutical company with a limited operating history. We are not profitable and have incurred losses in each year since our inception in 1998. We do not currently have any products that have been approved for marketing, and we continue to incur research and development, and general and administrative expenses related to our operations. Our net loss for 2006, 2005 and 2004 was $31.2 million, $27.5 million (excluding a preferred stock dividend of $88.1 million) and $20.5 million, respectively. As of December 31, 2006, we had an accumulated deficit of $240.2 million, including an $88.1 million deemed dividend related to our IPO in September 2005. We expect to continue to incur losses for the foreseeable future, and we expect these losses to increase significantly, especially upon commencing Phase 3 clinical trials, as we continue our research activities and conduct development of, and seek regulatory approvals for, our product candidates, and commercialize any approved drugs. Our losses, among other things, have caused and will continue to cause our stockholders’ equity and working capital to decrease. To date, we have derived all of our revenue from collaboration agreements and, to a lesser extent, grants and fellowships. We do not anticipate that we will generate revenue from the sale of products for the foreseeable future. If our product candidates fail in clinical trials or do not gain regulatory approval, or if our future products do not achieve market acceptance, we may never become profitable.

Even if we achieve profitability in the future, we may not be able to sustain profitability in subsequent periods.

We will require substantial additional funding, which may not be available to us on acceptable terms, or at all.

We are advancing multiple product candidates through discovery and development. We will need to raise substantial additional capital to continue our discovery, development and commercialization activities. We plan to retain the development and commercialization rights to some of our novel cancer therapeutics at least until we have completed a Phase 2 clinical trial to maximize our economic upside, which will require substantial expenditures by us. In 2007, we intend to enter into a strategic partnership for one of our product candidates wherein we would extend the geographic reach of the product candidate while retaining significant U.S. ownership.

We will need to raise substantial additional capital to:

· fund clinical trials and seek regulatory approvals;

· pursue the development of additional product candidates;

· expand our research and development activities;

· build or access manufacturing and commercialization capabilities;

· implement additional internal systems and infrastructure;

· maintain, defend and expand the scope of our intellectual property portfolio; and

· hire additional management and scientific personnel.

Our future funding requirements will depend on many factors, including but not limited to:

· the rate of progress and cost of our clinical trials, preclinical studies and other discovery and research and development activities;

· the costs associated with establishing manufacturing and commercialization capabilities;

· the costs of acquiring or investing in businesses, product candidates and technologies;

· the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights;

· the costs and timing of seeking and obtaining FDA and other regulatory approvals;

· the effect of competing technological and market developments; and

· the economic and other terms and timing of any collaboration, licensing or other arrangements into which we may enter.

Until we can generate a sufficient amount of product revenue to finance our cash requirements, which we may never do, we expect to finance future cash needs primarily through public or private equity offerings, debt financings or strategic collaborations. We do not know whether additional funding will be available on acceptable terms, or at all. If we are not able to secure additional funding when needed, we may have to delay, reduce the scope of or eliminate one or more of our clinical trials or research and development programs. In addition, we plan to partner one or more of our product candidate programs at an earlier stage of development, which would lower the economic value of such program or programs to our company.

There is a high risk that our drug discovery and development activities could be halted significantly or delayed for various reasons.

Most of our product candidates are in the early stages of drug discovery or development and are prone to the risks of failure inherent in drug development. As of the date of this report, only two of our product candidates, SNS-595 and SNS-032, have been tested in humans. We and our collaboration partners will need to conduct significant additional preclinical studies and clinical trials before we or our collaboration partners can demonstrate that our product candidates are safe and effective to the satisfaction of the FDA and other regulatory authorities. In our industry, it is unlikely that the limited number of compounds that we have identified as potential product candidates will actually lead to successful product development efforts. Failure can occur at any stage of the process, and successful preclinical studies and early clinical trials do not ensure that later clinical trials will be successful. Product candidates in later stage trials may fail to show desired efficacy and safety traits despite having progressed through initial clinical trials. A number of companies in the pharmaceutical industry have suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier trials.

We do not know whether our ongoing Phase 1 and Phase 2 clinical trials with SNS-595, our ongoing and planned Phase 1 clinical trials with SNS-032, our planned Phase 1 clinical trial with SNS-314, or any other future clinical trials with any of our product candidates will be completed on schedule, or at all, or whether our ongoing or planned Phase 1 and Phase 2 clinical trials will begin on time. The commencement of our planned clinical trials could be substantially delayed or prevented by several factors, including:

· limited number of, and competition for, suitable patients with particular types of cancer for enrollment in clinical trials;

· delays or failures in obtaining regulatory approval to commence a clinical trial;

· delays or failures in obtaining sufficient clinical materials;

· delays or failures in reaching agreement on acceptable clinical trial agreement terms or clinical trial protocols with prospective sites; or

· delays or failures in obtaining institutional review board approval to conduct a clinical trial at a prospective site.

The completion of our clinical trials could also be substantially delayed or prevented by several factors, including:

· slower than expected rates of patient recruitment and enrollment;

· failure of patients to complete the clinical trial;

· unforeseen safety issues;

· lack of efficacy during clinical trials;

· inability or unwillingness of patients or medical investigators to follow our clinical trial protocols; and

· inability to monitor patients adequately during or after treatment.

For example, due to potential complications from treatment in our planned Phase 1 clinical trial of SNS-032 in B-cell lymphoid malignancies, we will need to provide patients enrolling in this clinical trial with in-patient hospital care. We believe that this may result in difficulty in recruiting patients and increased costs in performing the clinical trial. Additionally, our clinical trials may be suspended or terminated at any time by the FDA, other regulatory authorities, our company or, in some cases, our

collaboration partners. Any failure or significant delay in completing clinical trials for our product candidates could harm our financial results and the commercial prospects for our product candidates.

Our clinical trials for our lead product candidates, SNS-595, SNS-032 and SNS-314, may not demonstrate safety or efficacy or lead to regulatory approval.

Our lead product candidates, SNS-595, SNS-032 and SNS-314, are small-molecule therapeutics being developed for the treatment of certain types of cancer. Many cancer drugs promote cancer cell death by inhibiting cell proliferation, and commonly have a narrow dose range between efficacy and toxicity, commonly known as a “therapeutic window.” Based on the results of our Phase 1 clinical trials, we may select a dose for use in future clinical trials that may prove to be ineffective in treating cancer. If our clinical trials result in unacceptable toxicity or lack of efficacy, we may have to terminate further clinical trials for SNS-595, SNS-032 and/or SNS-314. Even if we are able to find a proper dose that balances the toxicity and efficacy of one or more of our product candidates, we will be required to conduct extensive additional clinical trials before we are able to seek the regulatory approvals needed to market them. If clinical trials of SNS-595, SNS-032 and/or SNS-314 are halted, or if they do not show that these product candidates are safe and effective, our future growth would be limited and we may not have any other product candidates to develop. Furthermore, our current development strategy for each of SNS-595, SNS-032 and SNS-314 is to test the efficacy and toxicity of each product candidate as a single agent. We may later determine that one or more of these product candidates is more efficacious and/or less toxic in combination with another approved cancer drug. Likewise, each of our product candidates may only receive FDA and foreign approvals, if at all, in combination with another cancer drug.

In addition to the risks described above, we are aware of risks that are specific to SNS-032. In previous Phase 1 clinical trials of SNS-032, significant safety risks were observed in patients who were administered SNS-032 on either a one-hour or a 24-hour infusion once every three weeks. For example, increases in certain phases of the cardiac cycle, known as the QT interval, or the corrected QT interval, or QTc, on the electrocardiograms of patients were observed in patients receiving the 24-hour infusion regimen. Increased QT intervals may be associated with increased risk for cardiac rhythm abnormalities, some of which can be serious, life-threatening events. In addition, pronounced, rapidly reversible decreases in white blood cells were observed following infusion under the one-hour infusion regimen, most likely associated with higher peak drug levels in this regimen. Further, some patients also experienced reversible liver toxicity, which limited the amount of drug that could be administered to those patients. Two of these planned clinical trials were discontinued prior to completion and prior to determination of a maximum tolerated dose. Both of these trials were discontinued by the former sponsor, BMS, because of a change in priorities within BMS’ portfolio. We will not receive regulatory approval for SNS-032 unless we are able to deliver therapeutically active doses of SNS-032 while keeping toxicities at acceptable levels. In our existing Phase 1 clinical trial, we are delivering the drug on a daily basis in a one-hour infusion for five consecutive days. There is a significant risk that this dose and regimen may not allow us to achieve efficacious exposure in the absence of dose-limiting toxicity, and thus SNS-032 may not advance as a single agent therapeutic.

In our Phase 1 clinical trial of SNS-032 in B-cell lymphoid malignancies, we are aware that SNS-032 has the potential to kill a large number of cancer cells rapidly and all at once and the contents of those cells may be released into a patient’s bloodstream. This may result in a higher risk of a severe complication called tumor lysis syndrome. If tumor lysis syndrome occurs, some chemicals in a patient’s blood, such as potassium, uric acid and phosphate levels will rise, whereas some others like calcium may decline. Tumor lysis syndrome, if severe enough, may result in kidney failure and without treatment, can be life-threatening. We are aware that this severe complication has a higher risk of occurring early in the course of treatment and we are taking measures, which may not be effective, to prevent, monitor and treat this complication should it occur.

In addition, in clinical trials to date SNS-032 has demonstrated variable pharmacokinetics, or PK, which is the measure of the concentration of drug in the bloodstream over time. The PK variability results in differences in drug exposure between patients, and in some cases in the same patient, who are administered the same dose of SNS-032. Dose levels in Phase 2 clinical trials will be selected primarily based on safety criteria. Because of the observed PK variability between and among patients, we believe that there is a risk that some patients may receive sub-therapeutic exposure, limiting the opportunity to show activity and efficacy for SNS-032. As with other product candidates in the biotechnology industry at this stage of development, even if we are able to find adequate doses and schedules from our planned Phase 2 clinical trials, we will be required to conduct extensive additional clinical trials before we are able to seek regulatory approval to market SNS-032.

If we fail to maintain our existing, or enter into new, strategic collaborations, we may have to reduce or delay our product candidate development or increase our expenditures.

Our business model is based in part upon entering into strategic collaborations for discovery and/or development of some of our product candidates. In particular, we are substantially dependent on our strategic collaboration with Biogen Idec to discover, develop and commercialize small molecule inhibitors of Raf kinase and up to five additional targets. The agreement may be terminated by Biogen Idec without cause at any time upon 90 days’ written notice. If we are not able to maintain this collaboration with Biogen Idec or our other existing collaborations, or establish and maintain additional strategic collaborations of similar scope:

· the development of our current or future product candidates may be terminated or delayed;

· our cash expenditures related to development of our current or future product candidates would increase significantly;

· we may be required to hire additional employees or otherwise develop expertise, such as sales and marketing expertise, for which we have not budgeted;

· we will bear all of the risk related to the development of each of our current and future product candidates; and

· we may be unable to meet demand for any future products that we may develop.

In that event, we would likely be required to limit the size or scope of one or more of our programs.

The results of preclinical studies and clinical trials may not satisfy the requirements of the FDA or other regulatory agencies.

Prior to receiving approval to commercialize any of our product candidates in the United States or abroad, we and our collaboration partners must demonstrate with substantial evidence from well-controlled clinical trials, and to the satisfaction of the FDA and other regulatory authorities abroad, that such product candidates are safe and effective for their intended uses. The results from preclinical studies and clinical trials can be interpreted in different ways. Even if we and our collaboration partners believe the preclinical or clinical data for our product candidates are promising, such data may not be sufficient to support approval by the FDA and other regulatory authorities. Administering any of our product candidates to humans may produce undesirable side effects, which could interrupt, delay or halt clinical trials of our product candidates and result in the FDA or other regulatory authorities denying approval of our product candidates for any or all targeted indications.

Our approach to developing cancer therapeutics by inhibiting cyclin-dependent kinases, Aurora kinases and Raf kinases has not been clinically validated and may not be successful.

We have programs to develop small molecule inhibitors of CDK, Aurora and Raf kinases for the treatment of cancer. SNS-032 is a CDK inhibitor, and SNS-314 is an Aurora kinase inhibitor. The therapeutic benefit of inhibiting CDK, Aurora or Raf kinases in the treatment of human cancer has not been established definitively. Although a competitive kinase inhibitor, Nexavar®, has recently been approved and is commencing commercial use, this compound inhibits Raf and other kinases and its non-Raf kinase activities may be responsible for its efficacy. In addition, there are conflicting scientific reports regarding the reliance or necessity of CDK2 in the cell-cycle. Although several other companies have CDK and Aurora kinase programs, we are not aware of any candidates that have demonstrated therapeutic benefit in clinical testing. If CDK, Aurora or Raf kinase inhibition is not an effective treatment of human cancer, SNS-032, SNS-314 and any other drug candidates from these programs may have little or no commercial value.

The failure to enroll patients for clinical trials may cause delays in developing our product candidates.

We may encounter delays if we or our collaboration partners are unable to enroll enough patients to complete clinical trials. Patient enrollment depends on many factors, including, the size of the patient population, the nature of the protocol, the proximity of patients to clinical sites and the eligibility criteria for the trial. Moreover, when one product candidate is evaluated in multiple clinical trials simultaneously, patient enrollment in ongoing trials can be adversely effected by negative results from completed trials. Our product candidates are focused in oncology, which can be a difficult patient population to recruit. Without exception, oncology patients have failed treatment in first and second line treatment before enrolling in a study of an investigational product candidate.

We rely on a third party to manufacture our product candidates, including SNS-595, SNS-032 and SNS-314, and depend on a single supplier for SNS-595 and SNS-032. There is a limited number of manufacturers that are capable of manufacturing the active ingredient of SNS-595.

We do not currently own or operate manufacturing facilities and lack the capability to manufacture any of our product candidates on a clinical or commercial scale. As a result, we rely on third parties to manufacture both the active pharmaceutical ingredients, or API, and drug products for SNS-595, SNS-032 and SNS-314. The APIs are classified as toxic substances, limiting the available manufacturers. We believe that there are at least five contract manufacturers in North America with suitable capabilities for API manufacture, and at least four that can manufacture our drug products. If our third-party manufacturers are unable or unwilling to produce API, we will need to establish contracts with other suppliers. However, establishing a relationship with an alternative supplier would likely delay our ability to produce API for six to nine months, during which time we will rely on current inventory to supply our drug product manufacturing activities. We expect to continue to depend on third-party contract manufacturers for the foreseeable future.

Our product candidates require precise, high quality manufacturing. A contract manufacturer is subject to ongoing periodic unannounced inspection by the FDA and corresponding state agencies to ensure strict compliance with current Good Manufacturing Practice, or cGMP, and other applicable government regulations and corresponding foreign standards. Our contract manufacturer’s failure to achieve and maintain high manufacturing standards in compliance with cGMP regulations could result in manufacturing errors resulting in patient injury or death, product recalls or withdrawals, delays or interruptions of production or failures in product testing or delivery, delay or prevention of filing or approval of marketing applications for our products, cost overruns or other problems that could seriously harm our business.

To date, our product candidates have been manufactured in small quantities for preclinical studies and clinical trials. Prior to one of our product candidates being approved for commercial sale, we will need to manufacture that product in larger quantities. Significant scale-up of manufacturing will be accompanied by significant validation studies, which will be reviewed by the FDA prior to approval. If we are unable to successfully increase the manufacturing capacity for a product candidate, the regulatory approval or commercial launch may be delayed or there may be a shortage in commercial supply.

Any performance failure on the part of a contract manufacturer could delay clinical development or regulatory approval of our product candidates or commercialization of our future products, depriving us of potential product revenue and resulting in additional losses. In addition, our dependence on a third parties for manufacturing may adversely affect our future profit margins. Our ability to replace an existing manufacturer may be difficult because the number of potential manufacturers is limited and the FDA must approve any replacement manufacturer before it can begin manufacturing our product candidates for commercial sale. Such approval would require new testing and compliance inspections. It may be difficult or impossible for us to identify and engage a replacement manufacturer on acceptable terms in a timely manner, or at all.

We expect to significantly expand our clinical research and development and marketing capabilities, and any difficulties retaining key personnel or managing this growth could disrupt our operations.

We are highly dependent on the principal members of our management and technical staff. We expect to significantly expand our clinical research and development and marketing capabilities by increasing expenditures in these areas, hiring additional employees and expanding the scope of our current operations. Future growth will require us to continue to implement and improve our managerial, operational and financial systems, expand our facilities and continue to retain, recruit and train additional qualified personnel, which may impose a strain on our administrative and operational infrastructure. The competition for qualified personnel in the biopharmaceutical field is intense. We are highly dependent on our continued ability to attract, retain and motivate highly-qualified management, clinical and scientific personnel. Due to our limited resources, we may not be able to effectively manage the expansion of our operations or recruit and train additional qualified personnel. If we are unable to retain key personnel or manage our growth effectively, we may not be able to implement our business plan.

If we are sued for infringing intellectual property rights of third parties, litigation will be costly and time consuming and could prevent us from developing or commercializing our future products.

Our commercial success depends on not infringing the patents and proprietary rights of other parties and not breaching any collaboration or other agreements we have entered into with regard to our technologies and product candidates. Numerous third-party U.S. and foreign issued patents and pending applications exist in the area of kinases, including CDK, Aurora and Raf kinases for which we have research programs. Because patent applications can take several years to issue, there may be pending applications that may result in issued patents that cover our technologies or product candidates. For example, some pending patent applications contain broad claims that could represent freedom to operate limitations for some of our kinase programs should they be issued unchanged. If we wish to use the technology or compound claimed in issued and unexpired patents owned by others, we will need to obtain a license from the owner, enter into litigation to challenge the validity of the patents or incur the risk of litigation in the event that the owner asserts that we infringe its patents.

If a third party asserts that we infringe its patents or other proprietary rights, we could face a number of issues that could seriously harm our competitive position, including:

· infringement and other intellectual property claims, which would be costly and time consuming to litigate, whether or not the claims have merit, and which could delay the regulatory approval process and divert management’s attention from our business;

· substantial damages for past infringement, which we may have to pay if a court determines that our product candidates or technologies infringe a competitor’s patent or other proprietary rights;

· a court prohibiting us from selling or licensing our technologies or future drugs unless the holder licenses the patent or other proprietary rights to us, which it is not required to do; and

· if a license is available from a third party, we may have to pay substantial royalties or grant cross licenses to our patents or other proprietary rights.

If our competitors develop and market products that are more effective, safer or less expensive than our future products, our commercial opportunities will be negatively impacted.

The life sciences industry is highly competitive, and we face significant competition from many pharmaceutical, biopharmaceutical and biotechnology companies that are researching and marketing products designed to address cancer and other unmet medical needs. We are developing small molecule therapeutics that will compete with other drugs and therapies that currently exist or are being developed. Many of our competitors have significantly greater financial, manufacturing, marketing and drug development resources than we do. Large pharmaceutical companies in particular have extensive experience in clinical testing and in obtaining regulatory approvals for drugs. These companies also have significantly greater research capabilities than we do. In addition, many universities and private and public research institutes are active in cancer, Alzheimer’s and inflammation research, some of which are in direct competition with us.

Our product candidates will compete with a number of drugs that are currently marketed or in development that also target proliferating cells. These drugs include marketed products, such as irinotecan, doxorubicin and taxanes, which are generic and widely available, and many other cell-cycle inhibitors that have been shown to be effective anti-cancer agents. To compete effectively with these agents, our product candidates will need to demonstrate advantages that lead to improved clinical efficacy compared to these competitive products. We also compete with other companies that may be pursuing drug discovery using other technologies, including fragment-based technologies.

We believe that our ability to successfully compete will depend on, among other things:

· our ability to develop novel compounds with attractive pharmaceutical properties and to secure and protect intellectual property rights based on our innovations;

· the efficacy, safety and reliability of our product candidates;

· the speed at which we develop our product candidates;

· our ability to design and successfully execute appropriate clinical trials;

· our ability to maintain a good relationship with regulatory authorities;

· the timing and scope of regulatory approvals;

· our ability to manufacture and sell commercial quantities of future products to the market; and

· acceptance of future products by physicians and other healthcare providers.

If our competitors market products that are more effective, safer or less expensive than our future products, if any, or that reach the market sooner than our future products, if any, we may not achieve commercial success. In addition, the biopharmaceutical industry is characterized by rapid technological change. Because our research approach integrates many technologies, it may be difficult for us to stay abreast of the rapid changes in each technology. If we fail to stay at the forefront of technological change, we may be unable to compete effectively. Technological advances or products developed by our competitors may render our technologies or product candidates obsolete.

Our proprietary Tethering® drug discovery approach is experimental and may not discover any therapeutic compounds of commercial value.

We have developed a proprietary drug discovery approach called “Tethering®.” Tethering® is a process whereby a target protein known to be involved in a disease process is engineered to facilitate the binding of small drug fragments. Once a small fragment is identified, the fragment is built out using the target protein’s surface as a template to make a new full-size therapeutic compound. Tethering® is unproven as a drug discovery approach. We have only conducted preclinical studies of product candidates discovered through Tethering®. Our Tethering® drug discovery approach may not identify any therapeutic compounds of commercial value.

We rely on third parties to conduct our clinical trials for SNS-595 and SNS-032 and plan to rely on third parties to conduct our clinical trials for SNS-314. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may be unable to obtain regulatory approval for or commercialize SNS-595, SNS-032, SNS-314 or any of our other product candidates.

We do not have the ability to independently conduct clinical trials for SNS-595, SNS-032, SNS-314 or any other product candidate. We rely on third parties, such as contract research organizations, medical institutions, clinical investigators and contract laboratories, to conduct our planned and existing clinical trials in the United States, Canada and Europe of our product candidates for which we do not have a collaboration. If the third parties conducting our clinical trials do not perform their contractual duties or obligations, do not meet expected deadlines or need to be replaced, or if the quality or accuracy of the clinical data they obtain is compromised due to the failure to adhere to our clinical trial protocols or for any other reason, we may need to enter into new arrangements with alternative third parties and our clinical trials may be extended, delayed or terminated or may need to be repeated, and we may not be able to obtain regulatory approval for or commercialize the product candidate being tested in such trials.

The commercial success of our collaborations depends in part on the development and marketing efforts of our collaboration partners, over which we have limited control. If our collaborations are unsuccessful, our potential to develop and commercialize products through our collaborations, and to generate future revenue from the sale of these products, would be significantly reduced.

Our dependence on collaboration arrangements subjects our company to a number of risks. Our ability to develop and commercialize drugs that we develop with our collaboration partners depends on our collaboration partners’ ability to establish the safety and efficacy of our product candidates, obtain and maintain regulatory approvals and achieve market acceptance of a product once commercialized. Our collaboration partners may elect to delay or terminate development of one or more product candidates, independently develop products that compete with ours, or fail to commit sufficient resources to the marketing and distribution of products developed through their collaborations with us. In the event that one or more of our collaboration partners fails to diligently develop or commercialize a product candidate covered by one of our collaboration agreements, we may have the right to terminate our partner’s rights to such product candidate but we will not receive any future revenue from that product candidate unless we are able to find another partner or commercialize the product candidate on our own, which is likely to

result in significant additional expense. Business combinations, significant changes in business strategy, litigation and/or financial difficulties may also adversely affect the willingness or ability of one or more of our collaboration partners to complete their obligations under our collaboration agreements. If our collaboration partners fail to perform in the manner we expect, our potential to develop and commercialize products through our collaborations, and to generate future revenue from the sale of these products, would be significantly reduced.

If conflicts of interest arise between our collaboration partners and us, any of them may act in their self-interest, which may be adverse to our interests.

If a conflict of interest arises between us and one or more of our collaboration partners, they may act in their own self-interest and not in the interest of our company or our stockholders. Some of our collaboration partners are conducting, and any of our future collaboration partners may conduct, multiple product development efforts within the disease area that is the subject of collaboration with our company. In some of our collaborations, we have agreed not to conduct, independently or with any third party, any research that is competitive with the research conducted under our collaborations. Our collaboration partners, however, may develop, either alone or with others, products in related fields that are competitive with the product candidates that are the subject of these collaborations. Competing products, either developed by our collaboration partners or to which our collaboration partners have rights, may result in their withdrawal of support for our product candidates.

If one or more of our collaboration partners were to breach or terminate their collaboration agreements with us or otherwise fail to perform their obligations thereunder in a timely manner, the preclinical or clinical development or commercialization of the affected product candidates or research programs could be delayed or terminated. We do not know whether our current or any future collaboration partners will pursue alternative technologies or develop alternative product candidates, either on their own or in collaboration with others, including our competitors, as a means for developing treatments for the diseases targeted by collaboration agreements with our company.

Our proprietary rights may not adequately protect our technologies and product candidates.

Our commercial success will depend on our ability to obtain patents and maintain adequate protection for our technologies and product candidates in the United States and other countries. As of December 31, 2006, we owned or had exclusive rights to 166 issued U.S. and foreign patents and 181 pending U.S. and foreign patent applications. We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary technologies and future products are covered by valid and enforceable patents or are effectively maintained as trade secrets.

We apply for patents covering both our technologies and product candidates, as we deem appropriate. However, we may fail to apply for patents on important technologies or product candidates in a timely fashion, or at all. Our existing patents and any future patents we obtain may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products and technologies. In addition, we generally do not control the patent prosecution of subject matter that we license to and from others. Accordingly, we are unable to exercise the same degree of control over this intellectual property as we would over our own. Moreover, the patent positions of biopharmaceutical companies are highly uncertain and involve complex legal and factual questions for which important legal principles remain unresolved. As a result, the validity and enforceability of patents cannot be predicted with certainty. In addition, we do not know whether:

· we or our licensors were the first to make the inventions covered by each of our issued patents and pending patent applications;

· we or our licensors were the first to file patent applications for these inventions;

· others will independently develop similar or alternative technologies or duplicate any of our technologies;

· any of our or our licensors’ pending patent applications will result in issued patents;

· any of our or our licensors’ patents will be valid or enforceable;

· any patents issued to us or our licensors and collaboration partners will provide us with any competitive advantages, or will be challenged by third parties;

· we will develop additional proprietary technologies that are patentable; or

· the patents of others will have an adverse effect on our business.

We also rely on trade secrets to protect some of our technology, especially where we do not believe patent protection is appropriate or obtainable. However, trade secrets are difficult to maintain. While we use reasonable efforts to protect our trade secrets, our or our collaboration partners’ employees, consultants, contractors or scientific and other advisors may unintentionally or willfully disclose our proprietary information to competitors. Enforcement of claims that a third party has illegally obtained and is using trade secrets is expensive, time consuming and uncertain. In addition, foreign courts are sometimes less willing than U.S. courts to protect trade secrets. If our competitors independently develop equivalent knowledge, methods and know-how, we would not be able to assert our trade secrets against them and our business could be harmed.

The composition of matter patents covering SNS-595 are due to expire in 2015. Even if SNS-595 is approved by the FDA, we may not be able to recover our development costs prior to the expiration of these patents.

The composition of our lead product candidate, SNS-595, is covered by U.S. patent 5,817,669 and its counterpart patents and patent applications in 43 foreign jurisdictions. U.S. patent 5,817,669 is due to expire on October 6, 2015, and most of its foreign counterparts are due to expire on June 6, 2015. We do not know whether patent term extensions and data exclusivity periods will be available in the future. SNS-595 must undergo extensive clinical trials before it can be approved by the FDA. We do not know when, if ever, SNS-595 will be approved by the FDA. Even if SNS-595 is approved by the FDA in the future, we may not have sufficient time to commercialize SNS-595 to enable us to recover our development costs prior to the expiration of the U.S. and foreign patents covering SNS-595. Our obligation to pay royalties to Dainippon, the company from which we licensed SNS-595, may extend beyond the patent expiration, which will further erode the profitability of this product.

The composition of matter patents covering SNS-032 are due to expire in 2018 in the U.S. Even if SNS-032 is approved by the FDA, we may not be able to recover our development costs prior to the expiration of these patents.

The composition of our product candidate SNS-032 is covered by U.S. patent 6,515,004 and its counterpart patents and patent applications in 33 foreign jurisdictions. U.S. patent 6,515,004 is due to expire on October 21, 2018, and most of its foreign counterparts are due to expire on May 9, 2021. We do not know whether patent term extensions and data exclusivity periods will be available in the future. SNS-032 must undergo extensive clinical trials before it can be approved by the FDA. We do not know when, if ever, SNS-032 will be approved by the FDA. Even if SNS-032 is approved by the FDA in the future, we may not have sufficient time to commercialize SNS-032 to enable us to recover our development costs prior to the expiration of the U.S. and foreign patents covering SNS-032. Our obligation to pay royalties to BMS, the company from which we licensed SNS-032, may extend beyond the patent expiration, which will further erode the profitability of this product.

We may be subject to damages resulting from claims that we or our employees have wrongfully used or disclosed alleged trade secrets of our employees’ former employers.

Many of our employees were previously employed at universities or biotechnology or pharmaceutical companies, including our competitors or potential competitors. We may be subject to claims that these employees or we have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel. A loss of key research personnel or their work product could hamper or prevent our ability to commercialize our product candidates, which could severely harm our business. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management.

We currently have limited marketing staff and no sales or distribution organization. If we are unable to develop a sales and marketing and distribution capability on our own or through collaborations with marketing partners, we will not be successful in commercializing our future products.

We currently have no sales or distribution capabilities and limited marketing staff. We intend to establish our own sales and marketing organization with technical expertise and supporting distribution capabilities to commercialize some future products, which will be expensive and time consuming. Any failure or delay in the development of our internal sales, marketing and distribution capabilities would adversely impact the commercialization of these products. With respect to other future products, we plan to collaborate with third parties that have direct sales forces and established distribution systems. To the extent that we enter into co-promotion or other licensing arrangements, our product revenue is likely to be lower than if we directly marketed or sold our products. In addition, any revenue we receive will depend upon the efforts of third parties, which may not be successful and are only partially within our control. If we are unable to enter into such arrangements on acceptable terms or at all, we may not be able to successfully commercialize these future products. If we are not successful in commercializing our future products, either on our own or through collaborations with one or more third parties, our future product revenue will suffer and we may incur significant additional losses.

We depend on various scientific consultants and advisors for the success and continuation of our research and development efforts.

We work extensively with various scientific consultants and advisors. The potential success of our drug discovery and development programs depends, in part, on continued collaborations with certain of these consultants and advisors. We rely on certain of these consultants and advisors for expertise in our research, regulatory and clinical efforts. Our scientific advisors are not our employees and may have commitments and obligations to other entities that may limit their availability to us. We do not know if we will be able to maintain such consulting agreements or that such scientific advisors will not enter into other arrangements with competitors, any of which could have a detrimental impact on our research objectives and could have a material adverse effect on our business.

Our facilities are located near known earthquake fault zones, and the occurrence of an earthquake or other catastrophic disaster could cause damage to our facilities and equipment, which could require us to cease or curtail operations.

Our facilities are located in the San Francisco Bay Area near known earthquake fault zones and are vulnerable to significant damage from earthquakes. We are also vulnerable to damage from other types of disasters, including fires, floods, power loss, communications failures and similar events. We are in the process of designing and implementing a disaster relief plan. However, even if such a plan were in place, if any disaster were to occur, our ability to operate our business at our facilities may be seriously or

completely impaired and our research could be lost or destroyed. In addition, the unique nature of our research activities and of much of our equipment could make it difficult for us to recover from a disaster.

Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses.

Changing laws, regulations and standards relating to corporate governance and public disclosure may create uncertainty regarding compliance matters. New or changed laws, regulations and standards are subject to varying interpretations in many cases. As a result, their application in practice may evolve over time. We are committed to maintaining high standards of corporate governance and public disclosure. Complying with evolving interpretations of new or changed legal requirements may cause us to incur higher costs as we revise current practices, policies and procedures, and may divert management time and attention from revenue generating to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, our reputation may also be harmed. In addition, it has become more expensive for us to obtain director and officer liability insurance. Further, our board members, chief executive officer and chief financial officer could face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficulty attracting and retaining qualified board members and executive officers, which could harm our business.

Risks Related to Our Industry

The regulatory approval process is expensive, time consuming and uncertain and may prevent us or our collaboration partners from obtaining approvals for the commercialization of some or all of our product candidates.

The research, testing, manufacturing, selling and marketing of drug candidates are subject to extensive regulation by the FDA and other regulatory authorities in the United States and other countries, which regulations differ from country to country. Neither we nor our collaboration partners are permitted to market our product candidates in the United States until we receive approval of an NDA from the FDA. Neither we nor our collaboration partners have received marketing approval for any of our product candidates. Obtaining approval of an NDA can be a lengthy, expensive and uncertain process. In addition, failure to comply with FDA and other applicable U.S. and foreign regulatory requirements may subject our company to administrative or judicially imposed sanctions, including warning letters, civil and criminal penalties, injunctions, product seizure or detention, product recalls, total or partial suspension of production, and refusal to approve pending NDAs or supplements to approved NDAs.

Regulatory approval of an NDA or NDA supplement is not guaranteed, and the approval process is expensive and may take several years. Furthermore, the development process for oncology products may take longer than other therapeutic areas. The FDA also has substantial discretion in the drug approval process. Despite the time and expense exerted, failure can occur at any stage, and we could encounter problems that cause us to abandon clinical trials or to repeat or perform additional preclinical studies and clinical trials. The number of preclinical studies and clinical trials that will be required for FDA approval varies depending on the drug candidate, the disease or condition that the drug candidate is designed to address, and the regulations applicable to any particular drug candidate. The FDA can delay, limit or deny approval of a drug candidate for many reasons, including:

· a drug candidate may not be deemed safe or effective;

· FDA officials may not find the data from preclinical studies and clinical trials sufficient;

· the FDA might not approve our or our third-party manufacturer’s processes or facilities; or

· the FDA may change its approval policies or adopt new regulations.

Even if we receive regulatory approval to market our product candidates, the market may not be receptive to our products.

Even if our product candidates obtain regulatory approval, resulting products, if any, may not gain market acceptance among physicians, patients, healthcare payors and/or the medical community. We believe that the degree of market acceptance will depend on a number of factors, including:

· timing of market introduction of competitive products;

· efficacy of our product;

· prevalence and severity of any side effects;

· potential advantages or disadvantages over alternative treatments;

· strength of marketing and distribution support;

· price of our future products, both in absolute terms and relative to alternative treatments; and

· availability of reimbursement from health maintenance organizations and other third-party payors.

The potential toxicity of single and repeated doses of SNS-595 has been explored in a number of animal studies that suggest the mechanism-based dose-limiting toxicities in humans receiving SNS-595 may be similar to some of those observed in approved cytotoxic agents, including temporary toxicity to bone marrow cells, the gastrointestinal system and other systems with rapidly dividing cells. In our Phase 1 and Phase 2 clinical trials, we have witnessed the following side effects, irrespective of severity, ranging from mild to more severe: lowered white blood cell count that may lead to a serious or possibly life-threatening infection, hair loss, fatigue, nausea with or without vomiting, lowered platelet count, which may lead to an increase in bruising or bleeding, lowered red blood cell count (anemia), weakness, tiredness, shortness of breath and diarrhea.

In previous clinical trials conducted by BMS, SNS-032 has been administered by IV infusion on a once-a-week and once-every-three-weeks basis. We believe that SNS-032 will need to be administered on a more frequent basis to show efficacy. Our current Phase 1 clinical trial design for SNS-032 includes administration of SNS-032 by a one-hour IV infusion once a day for five consecutive days, followed by 16 days without the drug. This IV regimen is inconvenient for patients, and commercial success may depend on developing an effective oral formulation of SNS-032. Should the development of an oral formulation be necessary, it could be costly and result in delays for the advancement of the program, and we cannot be certain that we will be able to develop an effective oral formulation for SNS-032. In our Phase 1 clinical trial, we have witnessed the following side effects, irrespective of severity, ranging from mild to more severe: fatigue, nausea with or without vomiting, diarrhea, anorexia, injection site reaction and inflammation of the pharynx and the mucous lining of the mouth.

If our future products fail to achieve market acceptance, we may not be able to generate significant revenue to achieve or sustain profitability.

Even if we receive regulatory approval for a product candidate, we will be subject to ongoing FDA obligations and continued regulatory review, which may result in significant additional expense and limit our ability to commercialize our future products.

Any regulatory approvals that we or our collaboration partners receive for our product candidates may also be subject to limitations on the indicated uses for which the product may be marketed or contain requirements for potentially costly post-marketing follow-up studies. In addition, if the FDA approves any of our product candidates, the labeling, packaging, adverse event reporting, storage, advertising, promotion and recordkeeping for the product will be subject to extensive and ongoing regulatory requirements. The subsequent discovery of previously unknown problems with the product, including

adverse events of unanticipated severity or frequency, may result in restrictions on the marketing of the product, and could include withdrawal of the product from the market.

The FDA’s policies may change and additional government regulations may be enacted that could prevent or delay regulatory approval of our product candidates. We cannot predict the likelihood, nature or extent of government regulation that may arise from future legislation or administrative action, either in the United States or abroad. If we are not able to maintain regulatory compliance, we might not be permitted to market our future products and we may not achieve or sustain profitability.

The coverage and reimbursement status of newly approved drugs is uncertain, and failure to obtain adequate coverage and reimbursement could limit our ability to market any future products we may develop and decrease our ability to generate revenue.

There is significant uncertainty related to the third party coverage and reimbursement of newly approved drugs both nationally and internationally. The commercial success of our future products in both domestic and international markets depends on whether third-party coverage and reimbursement is available for the ordering of our future products by the medical profession for use by their patients. Medicare, Medicaid, health maintenance organizations and other third-party payors are increasingly attempting to manage healthcare costs by limiting both coverage and the level of reimbursement of new drugs and, as a result, they may not cover or provide adequate payment for our future products. These payors may not view our future products as cost-effective, and reimbursement may not be available to consumers or may not be sufficient to allow our future products to be marketed on a competitive basis. Likewise, legislative or regulatory efforts to control or reduce healthcare costs or reform government healthcare programs could result in lower prices or rejection of our future products. Changes in coverage and reimbursement policies or healthcare cost containment initiatives that limit or restrict reimbursement for our future products may reduce any future product revenue.

Failure to obtain regulatory approval in foreign jurisdictions will prevent us from marketing our products abroad.

We intend to market our future products in international markets. In order to market our future products in Canada, the European Union and many other foreign jurisdictions, we must obtain separate regulatory approvals. We have had limited interactions with foreign regulatory authorities, and the approval procedures vary among countries and can involve additional testing at significant cost, and the time required to obtain approval may differ from that required to obtain FDA approval. Approval by the FDA does not ensure approval by regulatory authorities in other countries, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other foreign countries or by the FDA. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not obtain foreign regulatory approvals on a timely basis, if at all. We may not be able to file for regulatory approvals and may not receive necessary approvals to commercialize our products in any market.

We may incur significant costs complying with environmental laws and regulations, and failure to comply with these laws and regulations could expose us to significant liabilities.

We use hazardous chemicals and radioactive and biological materials in our business and are subject to a variety of federal, state and regional local laws and regulations governing the use, generation, manufacture, storage, handling and disposal of these materials. Although we believe our safety procedures for handling and disposing of these materials and waste products comply with these laws and regulations, we cannot eliminate the risk of accidental injury or contamination from the use, storage, handling or disposal of hazardous materials. In the event of contamination or injury, we could be held liable for any

resulting damages, and any liability could significantly exceed our insurance coverage, which is limited to $100,000 for pollution cleanup, and we are uninsured for third-party contamination injury.

We may be subject to costly claims related to our clinical trials and may not be able to obtain adequate insurance.

Because we conduct clinical trials in humans, we face the risk that the use of our product candidates will result in adverse side effects. We cannot predict the possible harms or side effects that may result from our clinical trials. Although we have clinical trial liability insurance for up to $10.0 million, our insurance may be insufficient to cover any such events. We do not know whether we will be able to continue to obtain clinical trial coverage on acceptable terms, or at all. We may not have sufficient resources to pay for any liabilities resulting from a claim excluded from, or beyond the limit of, our insurance coverage. There is also a risk that third parties that we have agreed to indemnify could incur liability. Any litigation arising from our clinical trials, even if we were ultimately successful, would consume substantial amounts of our financial and managerial resources and may create adverse publicity.

Foreign governments often impose strict price controls, which may adversely affect our future profitability.

We intend to seek approval to market our future products in both the United States and foreign jurisdictions. If we obtain approval in one or more foreign jurisdictions, we will be subject to rules and regulations in those jurisdictions relating to our product. In some foreign countries, particularly in the European Union, prescription drug pricing is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take considerable time after the receipt of marketing approval for a drug candidate. To obtain reimbursement or pricing approval in some countries, we may be required to conduct a clinical trial that compares the cost-effectiveness of our future product to other available therapies. If reimbursement of our future products is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, we may be unable to achieve or sustain profitability.

Risks Related to Our Common Stock

The price of our common stock may continue to be volatile, and the value of an investment in our common stock may decline.

We sold shares of common stock in our IPO in September 2005 at a price of $7.00 per share, and our stock has subsequently traded as low as $4.03 per share. An active and liquid trading market for our common stock may not develop or be sustained. Factors that could cause volatility in the market price of our common stock include, but are not limited to:

· results from, and any delays in or discontinuance of, our clinical trial programs, including our ongoing and planned clinical trials for SNS-595, SNS-032 and SNS-314;

· announcements of FDA non-approval of our product candidates, including SNS-595, SNS-032 or SNS-314, delays in filing regulatory documents with the FDA or other regulatory agencies, or delays in the review process by the FDA or other foreign regulatory agencies;

· failure or discontinuation of any of our research programs;

· announcements relating to future collaborations or our existing collaborations with Biogen Idec, Johnson & Johnson PRD and Merck;

· delays in the commercialization of our future products;

· market conditions in the pharmaceutical, biopharmaceutical and biotechnology sectors and issuance of new or changed securities analysts’ reports or recommendations;

· actual and anticipated fluctuations in our quarterly operating results;

· developments or disputes concerning our intellectual property or other proprietary rights;

· introduction of technological innovations or new products by us or our competitors;

· issues in manufacturing our product candidates or future products;

· market acceptance of our future products;

· deviations in our operating results from the estimates of analysts;

· third-party healthcare reimbursement policies;

· FDA or other U.S. or foreign regulatory actions affecting us or our industry;

· litigation or public concern about the safety of our product candidates or future drugs;

· sales of our common stock by our officers, directors or significant stockholders; and

· additions or departures of key personnel.

In addition, the stock markets in general, and the markets for pharmaceutical, biopharmaceutical and biotechnology stocks in particular, have experienced extreme volatility that have been often unrelated to the operating performance of the issuer. These broad market fluctuations may adversely affect the trading price or liquidity of our common stock. In the past, when the market price of a stock has been volatile, holders of that stock have sometimes instituted securities class action litigation against the issuer. If any of our stockholders were to bring such a lawsuit against us, we could incur substantial costs defending the lawsuit and the attention of our management would be diverted from the operation of our business.

The ownership of our common stock is highly concentrated, and your interests may conflict with the interests of our existing stockholders.

Our executive officers and directors and their affiliates, together with our current significant stockholders, beneficially owned approximately 60.6% of our outstanding common stock as of February 9, 2007. Accordingly, these stockholders, acting as a group, have significant influence over the outcome of corporate actions requiring stockholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transaction. These stockholders could delay or prevent a change of control of our company, even if such a change of control would benefit our other stockholders. The significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors’ perception that conflicts of interest may exist or arise.

If we sell shares of our common stock in future financings, common stockholders may experience immediate dilution and, as a result, our stock price may go down.

We may from time to time issue additional shares of common stock at a discount from the current trading price of our common stock. As a result, our common stockholders would experience immediate dilution upon the purchase of any shares of our common stock sold at such discount.

In addition, as opportunities present themselves, we may enter into financing or similar arrangements in the future, including the issuance of debt securities, preferred stock or common stock. In March 2006, we issued common stock and warrants in a private placement resulting in gross proceeds of approximately $45.3 million. In November 2006, we filed a $75 million universal shelf registration statement on Form S-3 with the Securities and Exchange Commission, or SEC. The registration statement which was declared effective on December 8, 2006, will enable the Company to issue registered securities from time to time. If we issue common stock or securities convertible into common stock, our common stockholders could experience dilution.

Provisions of our charter documents or Delaware law could delay or prevent an acquisition of our company, even if the acquisition would be beneficial to our stockholders, and could make it more difficult to change management.

Provisions of our amended and restated certificate of incorporation and amended and restated bylaws may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which stockholders might otherwise receive a premium for their shares. In addition, these provisions may frustrate or prevent any attempt by our stockholders to replace or remove our current management by making it more difficult to replace or remove our board of directors. These provisions include:

· a classified board of directors so that not all directors are elected at one time;

· a prohibition on stockholder action through written consent;

· limitations on our stockholders’ ability to call special meetings of stockholders;

· an advance notice requirement for stockholder proposals and nominations; and

· the authority of our board of directors to issue preferred stock with such terms as our board of directors may determine.

In addition, Delaware law prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person who, together with its affiliates, owns or within the last three years has owned 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Delaware law may discourage, delay or prevent a change in control of our company.

Provisions in our charter and other provisions of Delaware law could limit the price that investors are willing to pay in the future for shares of our common stock.

We have never paid dividends on our capital stock and we do not anticipate paying any cash dividends in the foreseeable future.

We have never declared or paid cash dividends on our capital stock. We do not anticipate paying any cash dividends on our capital stock in the foreseeable future. We currently intend to retain all available funds and any future earnings to fund the development and growth of our business. As a result, capital appreciation, if any, of our common stock will be our stockholders’ sole source of gain for the foreseeable future.

Changes in financial accounting standards related to share-based payments are expected to continue to have a significant effect on our reported results.

On January 1, 2006, we adopted Statement of Financial Accounting Standards No. FAS 123 (revised 2004) (FAS 123R), “Share-Based Payment,” which requires that we record compensation expense in the statement of operations for share-based payments, such as employee stock options, using the fair value method. The adoption of this new standard is expected to continue to have a significant effect on our reported results of operations, although it will not affect our cash flows, and could adversely impact our ability to provide accurate guidance on our future reported financial results due to the variability of the factors used to estimate the values of share-based payments. If factors change and we employ different assumptions or different valuation methods in the application of FAS 123R in future periods, the compensation expense that we record under FAS 123R may differ significantly from what we have recorded in the current period, which could negatively affect our stock price and our stock price volatility.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

We lease approximately 54,000 square feet of office and laboratory space in South San Francisco, California. Our lease expires in June 2013, subject to our option to extend the lease through June 2018.

In December 2006, we leased approximately 15,000 square feet of additional office space in a building near to our main office in South San Francisco, California beginning March 1, 2007. This lease expires in April 2013, subject to our option to extend the lease through February 2014. We believe that our current facilities will be sufficient to meet our needs through the first half of 2009.

ITEM 3. LEGAL PROCEEDINGS

From time to time, we may be involved in litigation relating to claims arising out of our operations. We are not currently involved in any material legal proceedings.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

PART II

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock, par value $0.0001 per share, has been traded on the Nasdaq National Market and subsequently, the Nasdaq Global Market, since September 27, 2005 under the symbol SNSS.

Prior to such time, there was no public market for our common stock. The following table sets forth the range of the high and low sales prices by quarter as reported by the Nasdaq Global Market.

Fiscal 2005	High		Low
Third Quarter (commencing September 27, 2005)	$	7.09	$	6.25
Fourth Quarter	$	7.01	$	4.25

Fiscal 2006	High		Low
First Quarter	$	7.40	$	4.47
Second Quarter	$	7.25	$	5.79
Third Quarter	$	6.20	$	4.14
Fourth Quarter	$	5.75	$	4.03

As of March 1, 2007, there were approximately 245 holders of record of our common stock. This number does not include the number of persons whose shares are in nominee or in “street name” accounts through brokers. On March 1, 2007, the last sale price reported on the Nasdaq Global Market for our common stock was $4.36 per share.

Dividend Policy

We have never paid cash dividends on our common stock. We do not anticipate paying any cash dividends on our capital stock in the foreseeable future. While subject to periodic review, the current policy of our Board of Directors is to retain cash and investments primarily to provide funds for our future growth.

Securities Authorized For Issuance Under Equity Compensation Plans as of December 31, 2006:

	(A)			(B)			(C)
Plan Category	Number of Securities to be Issued upon Exercise of Outstanding Options and Rights			Weighted Average Exercise Price of Outstanding Options and Rights			Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column A)
Equity Compensation Plans Approved by Stockholders(1)		3,822,435	(2)		$	3.53		561,581	(3)
Equity Compensation Plans Not Approved by Stockholders(4)		120,000			$	5.71		80,000
Total		3,942,435			$	3.57		641,581

(1) Includes our 1998 Stock Plan, or 1998 Plan, 2001 Stock Plan, or 2001 Plan, 2005 Equity Incentive Award Plan, or 2005 Plan, and Employee Stock Purchase Plan, or ESPP.

(2) Includes (i) 1,310,370 shares of common stock issuable upon the exercise of options granted under our 1998 Plan, all of which were exercisable as of December 31, 2006, (ii) 229,969 shares of common stock issuable upon the exercise of options granted under our 2001 Plan, all of which were exercisable as of December 31, 2006, and (iii) 2,282,096 shares of common stock issuable upon the exercise of options granted under our 2005 Plan, 403,282 of which were exercisable as of December 31, 2006. Excludes purchase rights currently accruing under the ESPP. Offering periods under the ESPP are 12-month periods, which are comprised of two six-month purchase periods. Eligible employees may purchase shares of common stock at a price equal to 85% of the lower of the fair market value of the common stock at the beginning of each offering period or the end of each semi-annual purchase period. Participation is limited to 20% of an employee’s eligible compensation, subject to limitations under the Code.

(3) Includes (i) 396,716 shares of common stock available for issuance under our 2005 Plan and (ii) 164,865 shares of common stock available for issuance under our Employee Stock Purchase Plan, or ESPP. 202,941 shares of our common stock were initially reserved for issuance under our ESPP. The number of shares of common stock reserved under our ESPP will automatically increase on the first trading day each year, beginning in 2006, by an amount equal to the least of: (i) 0.5% of our outstanding shares of common stock outstanding on such date, (ii) 135,294 shares or (iii) a lesser amount determined by our Board of Directors. The maximum aggregate number of shares which may be issued over the term of the ESPP is 1,352,941 shares.

(4) Our 2006 Employment Commencement Incentive Plan, or 2006 Plan, became effective on January 1, 2006. Effective January 1, 2007, our Board of Directors increased the 2006 Plan by an additional 200,000 shares such that the aggregate number of shares of our common stock reserved for issuance under our 2006 Plan, which did not require stockholder approval pursuant to Nasdaq Marketplace Rule 4350(i)(1)(A)(iv), is 400,000 shares.

The additional information required by this Item 5 concerning our equity compensation plans is discussed in Note 11 to the financial statements contained in Part II Item 8 of this report.

Unregistered Sales of Equity Securities

In March 2006, we issued an aggregate of 7,246,377 shares of common stock and warrants to purchase up to an additional 2,173,914 shares of common stock to funds managed by Alta Partners, Deerfield

Management, Baker Brothers Investments, Warburg Pincus LLC and several other institutional investors, each of whom represented that it was an accredited investor, for an aggregate purchase price of $45,300,000 in a private placement transaction.

We claimed exemption from registration under the Securities Act for the sale and issuance of securities in the transactions described above by virtue of Section 4(2) of the Securities Act of 1933, as amended, and/or Regulation D promulgated thereunder as transactions not involving any public offering. All of the purchasers of unregistered securities for which we relied on Section 4(2) and/or Regulation D represented that they were accredited investors as defined under the Securities Act. We claimed such exemption on the basis that (a) the purchasers in each case represented that they intended to acquire the securities for investment only and not with a view to the distribution thereof and that they either received adequate information about us or had access, through employment or other relationships, to such information and (b) appropriate legends were affixed to the stock certificates issued in such transactions.

Use of Proceeds From Registered Securities

The initial public offering of 6,051,126 shares of our common stock was effected through a Registration Statement on Form S-1 (Reg. No. 333-121646) which was declared effective by the Securities and Exchange Commission on September 27, 2005. We issued 6,000,000 shares on September 30, 2005 for gross proceeds of $42,000,000. We issued 51,126 shares on November 1, 2005 for gross proceeds of $358,000. We paid the underwriters a commission of $2,965,000 and incurred additional offering expenses of approximately $2,225,000. After deducting the underwriters’ commission and the offering expenses, we received net proceeds of approximately $37,168,000.

No payments for such expenses were made directly or indirectly to (i) any of our directors, officers or their associates, (ii) any person(s) owning 10% or more of any class of our equity securities or (iii) any of our affiliates.

The net proceeds have been invested into short-term investment grade securities and money market accounts. We have begun, and intend to continue to use, our net proceeds to fund clinical and preclinical development of our product candidates, to discover additional product candidates, to repay outstanding indebtedness and for general corporate purposes, including capital expenditures and working capital. We also used a portion of our net proceeds from our initial public offering to repay Biogen Idec $4.0 million with interest that we owed pursuant to a promissory note executed in favor of Biogen Idec in December 2002. We may use a portion of our net proceeds to in-license product candidates or to invest in businesses or technologies that we believe are complementary to our own.

Issuer Purchases of Equity Securities

Period	Total Number of Shares Purchases			Average Price Paid per Share			Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		Maximum Number of Shares that May Yet be Purchased under the Plans or Programs
2006		710	(1)		$	2.55		—		—

(1) This repurchase was not made through a publicly announced plan. We repurchased 710 shares of common stock from an employee whom had early exercised the options and then was subsequently terminated.

Performance Graph

The following graph compares our cumulative total stockholder return since September 27, 2005 with the NASDAQ Composite Index and the NASDAQ Biotechnology Index composed of other companies with similar business models. The graph assumes that the value of the investment in our common stock and each index was $100.00 on September 27, 2005.

COMPARISON OF 15 MONTH CUMULATIVE TOTAL RETURN*
Among Sunesis Pharmaceuticals Inc, The NASDAQ Composite Index
And The NASDAQ Biotechnology Index

* $100 invested on 9/27/05 in stock or on 8/31/05 in index-including reinvestment of dividends.
Fiscal year ending December 31.

ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and notes to those statements included elsewhere in this report.

	Year Ended December 31,
	2006			2005			2004			2003			2002
	(In thousands, except per share amounts)
Statement of Operations Data:
Revenues:
Collaboration revenue	$	6,353		$	7,395		$	5,938		$	6,842		$	3,170
Collaboration revenue from related party	7,318			9,018			4,201			857			32
Grant and fellowship revenue	38			109			166			561			1,474
Total revenues	13,709			16,522			10,305			8,260			4,676
Operating expenses:
Research and development	35,615			36,166			23,616			21,326			18,441
General and administrative	12,255			8,283			7,352			6,136			6,179
Total operating expenses	47,870			44,449			30,968			27,462			24,620
Loss from operations	(34,161		)	(27,927		)	(20,663		)	(19,202		)	(19,944		)
Interest income	3,395			1,092			518			713			1,360
Interest expense	(478		)	(674		)	(387		)	(521		)	(594		)
Other income (expense), net	7			10			2			5			(4		)
Net loss	(31,237		)	(27,499		)	(20,530		)	(19,005		)	(19,182		)
Convertible preferred stock deemed dividend	—			(88,092		)	—			—			—
Loss applicable to common stockholders	$	(31,237	)	$	(115,591	)	$	(20,530	)	$	(19,005	)	$	(19,182	)
Basic and diluted loss per share applicable to common stockholders	$	(1.13	)	$	(17.41	)	$	(15.77	)	$	(16.16	)	$	(18.73	)
Shares used in computing basic and diluted loss per share applicable to common stockholders	27,758,348			6,637,935			1,302,096			1,175,766			1,024,024

	As of December 31,
Balance Sheet Data:	2006			2005			2004			2003			2002
	(In thousands)
Cash, cash equivalents and marketable securities	$	63,105		$	48,333		$	36,812		$	33,843		$	47,155
Working capital	55,279			40,156			27,707			27,208			42,219
Total assets	69,276			54,708			43,026			40,306			54,346
Long-term debt	956			1,306			4,438			3,249			2,593
Convertible preferred stock	—			—			108,813			94,821			94,821
Common stock and additional paid-in capital	298,077			249,692			6,494			2,723			2,637
Accumulated deficit	(240,245		)	(209,008		)	(93,417		)	(72,886		)	(53,881		)
Total stockholders’ equity (deficit)	56,804			38,466			(90,044		)	(70,376		)	(51,428		)

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with our financial statements and related notes included elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those set forth under “Risk Factors” and elsewhere in this report. All forward-looking statements included in this report are based on information available to us on the date of this report, and we assume no obligation to update any forward-looking statements contained in this report.

Overview

We are a clinical-stage biopharmaceutical company focused on the discovery, development and commercialization of novel small molecule therapeutics for oncology and other unmet medical needs. We have developed a proprietary fragment-based drug discovery approach, called “Tethering®,” that we combine with other drug discovery tools, such as structure-based design and medicinal chemistry, to discover and develop novel therapeutics. We have built our product candidate portfolio through internal discovery and the in-licensing of novel cancer therapeutics. We are advancing our product candidates through in-house research and development efforts and strategic collaborations with leading pharmaceutical and biopharmaceutical companies.

From our incorporation in 1998 through 2001, our operations consisted primarily of developing and refining our drug discovery technologies. Since 2002, we have focused on developing novel small molecule drugs mainly to treat cancer and other unmet medical needs.

As of February 28, 2007, we had four ongoing strategic collaborations, one of which involves active participation by our personnel, with three leading pharmaceutical and biopharmaceutical companies. As of December 31, 2006, we had received an aggregate of approximately $74.1 million in cash from our current and former collaboration partners in the form of stock purchase proceeds and fees from our current and former collaboration partners.

Since our inception, we have generated significant losses. As of December 31, 2006, we had an accumulated deficit of $240.2 million, including a deemed dividend of $88.1 million recorded in conjunction with our IPO in September 2005. We expect our net losses to increase primarily due to our anticipated clinical trial activities.

Financial Operations Overview

Revenue

We have not generated any revenue from sales of commercial products and do not expect to generate any product revenue for the foreseeable future. To date, our revenue has consisted of collaboration revenue and grant and fellowship revenue.

Collaboration Revenue. We generate revenue primarily through our collaborations. As of February 28, 2007, we had four ongoing research-based collaborations, one of which involves the participation of our personnel. Each of these collaborations included a technology access fee, research funding, milestone payments and royalties upon sales of future products that may result from the collaborations. The table below sets forth our revenue since January 1, 2004 from each of our current collaborators.

	Year Ended December 31,
	2006		2005		2004
	(In thousands)
Biogen Idec (a related party)	$	7,318	$	9,018	$	4,201
Johnson & Johnson PRD	—		1,418		1,334
Merck	6,353		5,977		4,604
Total	$	13,671	$	16,413	$	10,139

In May 2002, we entered into our collaboration with Johnson & Johnson PRD, the research phase of which was completed in December 2005. In December 2002, we entered into our initial collaboration with Biogen Idec, the research phase of which was completed in June 2005. In February 2003, we entered into our initial collaboration with Merck, the research phase of which was completed in February 2006. In July 2004, we entered into a second collaboration with Merck. In August 2004, we entered into a second collaboration with Biogen Idec.

In 2007 and 2008, we expect to receive additional research funding from our collaborators totaling at least $9.2 million. This funding is discretionary, but is not dependent upon the achievement of milestones. In addition, we may receive milestone payments if one or more of our research collaboration programs reach a milestone for which a payment is due. In 2006, milestone payments earned totaled $4.8 million. In the absence of any new collaborations, we expect our collaboration revenue to be lower in future years than in 2006.

Grant and Fellowship Revenue. Grant and fellowship revenue is recognized as we perform services under the applicable grant. As of December 31, 2006, we had been awarded an aggregate of $5.4 million, and had recognized as revenue $2.5 million, in federal grants under the Small Business Innovation Research, or SBIR, program. In addition, we have recognized revenue from other grants and fellowships. Grant and fellowship revenues recognized were $38,000, $109,000 and $166,000 for the periods ended December 31, 2006, 2005, and 2004, respectively. We do not plan to perform any work under additional SBIR grants in the foreseeable future.

Research and Development Expense

Most of our operating expenses to date have been for research and development activities. Research and development expense represents costs incurred to discover and develop novel small molecule therapeutics, including Phase 1 and Phase 2 clinical trial costs for SNS-595 and Phase 1 clinical trial costs for SNS-032, to develop our proprietary fragment-based Tethering® drug discovery approach, to develop in-house research and preclinical study capabilities, to discover and advance product candidates toward clinical trials, including our SNS-314 Aurora kinase program, and in connection with in-licensing activities. We expense all research and development costs as they are incurred. The table below sets forth our research and development expense since January 1, 2004 for our product candidate programs.

	Year Ended December 31,
	2006		2005		2004
	(In thousands)
SNS-595	$	8,420	$	7,230	$	4,587
SNS-032	5,446		9,665		—
SNS-314	5,238		7,102		3,688
RAF kinase inhibitors	1,482		1,552		2,967
Other kinase inhibitors	10,728		5,473		879
Cathepsin S inhibitors	7		796		967
BACE inhibitors for Alzheimer’s disease	316		1,674		2,266
Anti-viral inhibitors	—		37		32
TNF family and oncology research	3		951		2,526
Other programs	3,976		1,686		5,704
Total	$	35,616	$	36,166	$	23,616

We in-licensed SNS-032 from Bristol-Myers Squibb Company, or BMS, in April 2005 and issued BMS shares of our Series C-2 preferred stock, with an initial value of $8.0 million. These shares were converted into 879,094 shares of common stock in conjunction with our IPO in September 2005. The $8.0 million up-front payment was included in research and development expense for the period ended December 31, 2005 due to uncertainties surrounding the remaining efforts for completion of the research and development activities. In February 2006, as consideration for a milestone payment due pursuant to the license agreement for initiating a Phase 1 clinical trial, we issued an aggregate of 404,040 shares of our common stock to BMS and recorded a non-cash research and development expense of $2.0 million.

We incur research and development expense associated with both partnered and unpartnered research activities, as well as the development and expansion of our drug discovery technologies. Research and development expense relating to our collaborations with Biogen Idec and Merck consist primarily of costs related to Tethering®, lead optimization, preclinical studies and other activities related to the identification and optimization of compounds for development of kinase inhibitors for the treatment of cancer, cytokine and enzyme inhibitors for the treatment of inflammatory diseases, antiviral inhibitors for the treatment of viral disease as well as protease inhibitors for the treatment of Alzheimer’s disease. Under our Biogen Idec agreement, we have an option on a target-by-target basis to co-fund post-Phase 1 development costs for up to two oncology kinase targets, which may include Raf kinase. If we exercise one or both of our options, our research and development expense will increase significantly. Research and development expense related to co-development activities that we elect to co-fund would consist primarily of manufacturing costs for the product candidate, clinical trial-related costs, costs for consultants and contract research employee compensation and facilities costs and depreciation of equipment.

We expect to incur research and development expense to conduct clinical trials on SNS-595, SNS-032 and SNS-314. Clinical trials are costly, and as we continue to advance our product candidates through preclinical and clinical development, we expect our research and development expense to increase. For

example, we expect to spend at least $18 million (1) to advance our SNS-595 program to completion of Phase 2 clinical trials in small cell lung cancer and ovarian cancer and ongoing and planned Phase 1 and Phase 2 clinical trials in acute leukemias, (2) to advance our SNS-032 program to completion of our ongoing and planned Phase 1 clinical trials, and (3) to complete a Phase 1 clinical trial for SNS-314. As of the date of this report, due to the risks inherent in the clinical trial process and given the early state of development of our programs, we are unable to estimate the costs we will incur in the continued development of our product candidates for potential commercialization.

Due to these same factors, we are unable to determine the anticipated completion dates for our current research and development programs. Clinical development timelines, probability of success and development costs vary widely. While we are currently focused on advancing SNS-595, SNS-032 and SNS-314 through clinical development, we anticipate that we will make determinations as to which programs to pursue and how much funding to direct to each program on an ongoing basis in response to the scientific and clinical success of each product candidate, as well as an ongoing assessment as to the product candidate’s commercial potential. In addition, we cannot forecast which product candidates will be subject to future collaborative or licensing arrangements, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements. As a result, we do not know when and to what extent we will receive cash inflows from our product candidates.

General and Administrative Expense

Our general and administrative expense consists primarily of salaries and other related costs for personnel in finance, human resources, facilities management, legal, including intellectual property management, general administration and non-cash stock compensation. Other significant costs include facilities costs and fees paid to outside legal advisors and auditors.

Critical Accounting Policies and the Use of Estimates

This discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as revenue and expenses during the reporting periods. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on historical experience and on various other factors we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could therefore differ materially from those estimates under different assumptions or conditions.

Our significant accounting policies are more fully described in Note 1 to our financial statements included elsewhere in this report. We believe the following critical accounting policies reflect our more significant estimates and assumptions used in the preparation of our financial statements.

Revenue Recognition

In accordance with Emerging Issues Task Force, or EITF, 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, which we adopted effective July 1, 2003, revenue arrangements with multiple deliverable items are divided into separate units of accounting based on whether certain criteria are met, including whether the delivered item has stand-alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. We allocate the consideration we receive among the separate units of accounting based on their respective fair value, and we apply the applicable revenue recognition criteria to each of the separate units. Where an item in a revenue arrangement with

multiple deliverables does not constitute a separate unit of accounting and for which delivery has not occurred, we defer revenue until the delivery of the item is completed.

We record upfront, non-refundable license fees and other fees received in connection with research and development collaborations as deferred revenue and recognize these amounts ratably over the relevant period specified in the agreements, generally the research term.

We recognize research funding related to collaborative research with our collaboration partners as the related research services are performed. This funding is normally based on a specified amount per full-time equivalent employee per year.

We recognize revenue from milestone payments, which are substantially at risk at the time the collaboration agreement is entered into, upon completion of the applicable milestone events. We intend to recognize any future royalty revenue based on reported product sales by third-party licensees.

We recognize grant revenue from government agencies and private research foundations as the related qualified research and development costs are incurred, up to the limit of the prior approval funding amounts.

Clinical Trial Accounting

We record accruals for estimated clinical trial costs, comprising payments for work performed by contract research organizations and participating clinical trial sites. These costs may be a significant component of future research and development expense. We accrue costs for clinical trials performed by contract research organizations based on estimates of work performed under the contracts. Costs of setting up clinical trial sites for participation in trials are expensed immediately. Costs related to patient enrollment are accrued as patients are entered in the trial reduced by an initial payment made to the hospital when the first patient is enrolled. These cost estimates may or may not match the actual costs incurred for services performed by the organizations as determined by patient enrollment levels and related activities. If we have incomplete or inaccurate information, we may underestimate costs associated with various trials at a given point in time. Although our experience in estimating these costs is limited, the difference between accrued expenses based on our estimates and actual expenses have not been material to date.

Stock-Based Payments

The Company grant options to purchase common stock to its employees, directors and consultants under its stock option plans. Eligible employees can also purchase shares of common stock at 85% of the lower of the fair market value of the common stock at the beginning of an offering period or at the purchase date.

The Company account for stock compensation arrangements to non-employees in accordance with EITF No. 96-18, Accounting for Equity Instruments That Are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, using a fair value approach. The compensation costs of these arrangements are subject to remeasurement over the vesting terms as earned.

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“FAS 123R”), which supersedes the previous accounting under APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under FAS 123R, share-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as expense over the employee’s requisite service period. The Company has no awards with market or performance conditions. The Company adopted the provisions of FAS 123R using the modified prospective transition method for awards granted on or after December 23, 2004, the date on which the Company filed its initial registration statement on Form S-1 with the Securities and Exchange Commission

(“SEC”) in connection with its IPO. The prospective transition method has been applied to options granted prior to December 23, 2004. Under the modified prospective transition method, compensation cost recognized during the year ended December 31, 2006, includes: (a) compensation cost for all share-based payments granted subsequent to the initial filing of the Company’s Form S-1 on December 23, 2004, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 (as defined below) and amortized on a straight-line basis over the options’ vesting period; and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS 123R amortized on a straight-line basis over the options’ vesting period. Under the prospective transition method, options granted prior to the initial filing of the Company’s Form S-1 will continue to be accounted for in accordance with APB 25 and Financial Accounting Standards Board (“FASB”) Interpretation No. 44 (“FIN 44”), Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB No. 25, which were the accounting principles originally applied to those awards.

The valuation provisions of FAS 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified or cancelled. Estimated compensation expense for awards outstanding at the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under FASB Statement No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). As stock-based compensation expense recognized in the Statement of Operations for fiscal 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. FAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company reviewed its forfeiture estimates on a quarterly basis during 2006. In the Company’s pro forma information required under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred. The Company’s Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of FAS 123R.

Upon adoption of FAS 123R, the Company retained its method of valuation for share-based awards granted beginning in fiscal 2006 with the use of the Black-Scholes option-pricing model (“Black-Scholes model”) which was previously used for the Company’s pro forma information required under SFAS 123. The Company’s determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.

FAS 123R requires the cash flows resulting from the tax benefits related to tax deductions in excess of the compensation costs recognized for these options (excess tax benefits) to be classified as financing cash flows.

On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of share-based compensation pursuant to FAS 123R. The alternative transition method includes a simplified method to establish the beginning balance of the additional paid-in capital pool related to the tax effects of employee share-based compensation, which is available to absorb tax deficiencies recognized subsequent to the adoption of FAS 123R.

Results of Operations

Years Ended December 31, 2006 and 2005

Revenue. Revenue decreased from $16.5 million in 2005 to $13.7 million in 2006. Collaboration revenue decreased from $16.4 million in 2005 to $13.7 million in 2006, primarily due to a $1.7 million decrease in collaboration revenue from Biogen Idec and a $1.4 million decrease in collaboration revenue from Johnson & Johnson PRD. The decrease in collaboration revenue from Biogen Idec and Johnson & Johnson PRD resulted from the completion of the research phase of collaborations with these companies in 2005. Grant and fellowship revenue decreased from $109,000 in 2005 to $38,000 in 2006, primarily due to our decision in 2003 to only perform limited additional work under SBIR grants for the foreseeable future.

Research and development expense. Research and development expense decreased from $36.2 million in 2005 to $35.6 million in 2006, primarily due to a $8.0 million expense related to the in-license of SNS-032 in April 2005 versus a $2.0 million milestone payment paid for SNS-032 in 2006. Without these non-cash licensing and milestone-related expenses for SNS-032, research and development expenses increased from $28.2 million in 2005 to $33.6 million in 2006 primarily due to (i) a $1.2 million increase in expenses related to the development of SNS-595, (ii) a $1.8 million increase in expense related to the development of SNS-032, adjusted for licensing fees and milestone payments, (iii) a $5.2 million increase in expense associated with other kinase programs, and (iv) $2.3 million increase in expense related to other programs, partially offset by a $1.9 million decrease in expenses associated with our SNS-314 Aurora kinase programs and a $1.4 million decrease in expense related to our BACE inhibitor research collaboration with Merck.

Research and development expense associated with SNS-595 increased from $7.2 million in 2005 to $8.4 million in 2006 due to increased clinical trial activity. Research and development expense associated with SNS-032, our CDK inhibitor program, increased from $1.7 million in 2005, adjusted for licensing fees, to $3.4 million in 2006, adjusted for a $2.0 million milestone payment, due to increased clinical trial activity. Research and development expense associated with SNS-314, our Aurora kinase inhibitors program, decreased from $7.1 million in 2005 to $5.2 million in 2006 due to a reduced number of research employees working on this program partially offset by increased outside services expense related to toxicology studies. Research and development expense for all other programs increased from $12.2 million in 2005 to $16.5 million in 2006 due to an increase in expense related to other kinase inhibitor programs. Research and development expense in 2006 included a $0.9 million non-cash stock-based compensation expense due to the adoption of FAS 123R.

General and administrative expense. General and administrative expense increased from $8.3 million in 2005 to $12.3 million in 2006, including a $1.2 million expense related to the adoption of FAS 123R in 2006. The increase is primarily due to (i) a $780,000 increase in employee related expenses, and a $859,000 increase in non-cash stock-based compensation expense, (ii) a $1.5 million increase in professional services expenses including expenses related to managing our intellectual property portfolio and management’s testing of internal control for financial reporting, and (iii) a $798,000 increase in other expenses, including costs for directors and officers’ liability insurance and facilities costs.

Interest income and expense. Interest income increased from $1.1 million in 2005 to $3.4 million in 2006, primarily due to higher interest rates and higher average balances of cash, cash equivalents and marketable securities. Interest expense decreased from $674,000 in 2005 to $478,000 in 2006, primarily due to a reduction in average debt outstanding in 2006 compared to 2005, partially offset by higher average interest rate on outstanding debt obligations in 2006 than in 2005.

Years Ended December 31, 2005 and 2004

Revenue. Revenue increased from $10.3 million in 2004 to $16.5 million in 2005. Collaboration revenue increased from $10.1 million in 2004 to $16.4 million in 2005, primarily due to a $4.8 million increase in collaboration revenue from Biogen Idec and a $1.4 million increase in collaboration revenue from Merck. The increase in collaboration revenue from Biogen Idec and Merck resulted from new collaborations in 2004. Grant and fellowship revenue decreased from $166,000 in 2004 to $109,000 in 2005, primarily due to our decision in 2003 to only perform limited additional work under SBIR grants for the foreseeable future.

Research and development expense. Research and development expense increased from $23.6 million in 2004 to $36.2 million in 2005, primarily due to (i) a $9.7 million expense related to the in-license of SNS-032 in April 2005 and the subsequent development activities for this product candidate, (ii) a $2.6 million increase in expenses related to our clinical trials of SNS-595, (iii) a $3.4 million increase in expenses associated with our SNS-314 Aurora kinase program, and (iv) a $4.6 million increase in expense associated with other kinase programs, partially offset by a $4.0 million reduction in expense related to other programs.

Research and development expense associated with SNS-595 increased from $4.6 million in 2004 to $7.2 million in 2005. Research and development expense associated with SNS-032, our CDK inhibitor program, was $9.7 million in 2005, including an $8.0 million licensing fee. There were no expenses associated with this program in 2004. Research and development expense associated with SNS-314, our Aurora kinase inhibitors program, increased from $3.7 million in 2004 to $7.1 million in 2005. Research and development expense for all other programs decreased from $15.3 million in 2004 to $12.2 million in 2005.

General and administrative expense. General and administrative expense increased from $7.4 million in 2004 to $8.3 million in 2005, primarily due to a $425,000 increase in non-cash stock compensation expense and a $360,000 increase in salary and related expenses.

Interest income and expense. Interest income increased from $518,000 in 2004 to $1.1 million in 2005, primarily due to higher interest rates and higher average balances of cash, cash equivalents and marketable securities. Interest expense increased from $387,000 in 2004 to $674,000 in 2005, primarily due to a higher average interest rate on outstanding debt obligations and an increase in average debt outstanding in 2005 compared to 2004.

Income Taxes

Since inception, we have incurred operating losses and, accordingly, have not recorded a provision for income taxes for any of the periods presented. As of December 31, 2006, we had net operating loss carryforwards for federal and state income tax purposes of $128.4 million and $60.0 million, respectively. We also had federal research and development tax credit carryforwards of $1.7 million. If not utilized, the federal net operating loss and tax credit carryforwards will expire beginning in 2018. Utilization of the net operating loss and tax credits carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986, as amended, that are applicable if the Company experiences an “ownership change,” which may occur, for example, as a result of the Company’s initial public offering and other sales of the Company’s stock, and similar state provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization.

Liquidity and Capital Resources

Sources of Liquidity

As of December 31, 2006, we had cash, cash equivalents and marketable securities of $63.1 million and outstanding equipment financing and debt obligations of $1.8 million. In connection with our IPO, we issued 6,000,000 shares of common stock in September 2005 for gross proceeds of $42.0 million and 51,126 shares of common stock in November 2005 for gross proceeds of $357,882. After deducting the underwriters’ commission and the offering expenses, we received net proceeds of approximately $37.2 million. In March 2006, we issued common stock and warrants in a private placement resulting in gross proceeds of approximately $45.3 million. After deducting the underwriters’ commission and the offering expenses, we received net proceeds of approximately $43.7 million. In 2006, we also received net proceeds of approximately $653,000 from sale of equity to employees through our 2005 Employee Stock Purchase Plan and approximately $318,000 from sale of equity under our stock option plans. Since our inception, we have funded our operations primarily through the issuance of common and preferred stock, research funding and technology access fees from our collaboration partners, research grants, loans from Biogen Idec and other debt financings.

Cash Flow

Net cash used in operating activities increased from $10.4 million in 2004 to $20.9 million in 2005 and to $27.1 million in 2006. Net cash used in operating activities for these periods primarily reflects the loss for these periods, partially offset by (i) depreciation, amortization, and non-cash stock compensation expense, (ii) a $8.0 million milestone payment related to the in-license of SNS-032 in 2005 and a $2.0 million milestone payment related to SNS-032 in 2006. In addition, changes in deferred revenue increased cash used in operations in both 2005 and 2006 and offset cash used in operations in 2004.

Net cash used in investing activities was $28.7 million, $3.0 million, and $7.1 million in the years ended December 31, 2006, 2005, and 2004, respectively. Net cash used in investing activities for 2006 primarily reflects net purchases of marketable securities of $26.4 million and capital expenditure of $2.3 million. Net cash used in investing activities for 2005 primarily reflects net purchases of marketable securities of $1.4 million and capital expenditure of $1.7 million. Net cash used in investing activities for 2004 primarily reflects net purchases of marketable securities of $5.9 million and capital expenditure of $1.2 million.

Net cash provided by financing activities was $44.1 million in 2006, as compared to $34.1 million in 2005. The net cash provided by financing activities in 2006 primarily resulted from net proceeds of $43.7 million from the private placement of common stock and warrants completed in March 2006 and the $971,000 in net proceeds from the sale of common stock to employees, offset by the net payments of $533,000 on equipment loans. The net cash provided by financing activities in 2005 primarily resulted from net proceeds of $37.4 million from the public offering of common stock completed in September 2005, offset by the payments of $5.4 million on note payable and equipment loans. Net cash provided by financing activities was $14.6 million in 2004, which primarily resulted from the issuance of preferred stock and indebtedness incurred under our collaboration with Biogen Idec.

Credit and Loan Arrangements

In June 2000, we entered into an equipment financing agreement with General Electric Capital Corporation, which has been amended from time to time. The credit facility was available through May 2005. As of June 30, 2005, we had outstanding $2.3 million to finance equipment purchases and leasehold improvements. In August 2005, we entered into a new $2.5 million credit facility with General Electric Capital Corporation and this credit facility was available through February 4, 2007. The equipment loans are secured by the equipment financed. Outstanding borrowings bear interest at annual rates ranging from 7.4% to 10.61%, and are payable over 36 to 48 months. In connection with the original credit facility,

we issued in June 2003 a warrant to purchase shares of Series C-1 preferred stock, which was converted into a warrant to purchase 1,582 shares of common stock at an exercise price per share of $9.10 upon our IPO, and in June 2004, a warrant to purchase shares of Series C preferred stock, which was converted to a warrant to purchase 757 shares of common stock at an exercise price per share of $9.10 upon our IPO. The warrants expire in June 2013 and June 2014, respectively. In connection with the credit facility in August 2005, we issued a warrant to purchase 1,046 shares of common stock at an exercise price per share of $9.10. As of December 31, 2006, the outstanding balance under this debt facility was $1.8 million.

In December 2002, we executed a promissory note in favor of Biogen Idec for an aggregate principal amount of up to $4.0 million. Under the promissory note, we had a drawdown period of ten calendar quarters beginning on April 1, 2003 and ending on June 30, 2005. The principal and accrued interest of each draw were due five years from the date of advance of each draw and bear interest at 3.0% above LIBOR to be paid quarterly. As of June 30, 2005, we had drawn $4.0 million and the facility was fully drawn. We used a portion of our net proceeds from our initial public offering to repay our outstanding indebtedness to Biogen Idec in full.

In August 2005, we entered into a Venture Loan and Security Agreement with Oxford Finance Corporation and Horizon Technology Funding Company LLC, pursuant to which we may borrow up to $15.0 million. The full $15.0 million loan commitment was available until October 15, 2005; $10.0 million was available until January 31, 2006, and the remaining $5.0 million was available until May 31, 2006. We had not borrowed any monies under this loan facility and this facility has expired. In conjunction with this transaction, we issued warrants to the lenders to purchase 164,830 shares of common stock at a price of $9.10 per share, half of which are currently exercisable. None of the remaining warrants will vest or become exercisable. We also granted the lenders registration rights under our Eighth Amended and Restated Investor Rights Agreement.

Operating Capital and Capital Expenditure Requirements

We expect to continue to incur substantial operating losses in the future. We will not receive any product revenue until a product candidate has been approved by the FDA or similar regulatory agencies in other countries and successfully commercialized. We currently anticipate that our cash, cash equivalents, marketable securities and available credit facilities, together with revenue generated from our collaborations, will be sufficient to fund our operations at least through the middle of 2008. However, we will need to raise substantial additional funds to continue our operations and bring future products to market. We cannot be certain that any of our programs will be successful or that we will be able to raise sufficient funds to complete the development and commercialize any of our product candidates currently in development, should they succeed. Additionally, we plan to continue to evaluate in-licensing and acquisition opportunities to gain access to new drugs or drug targets that would fit with our strategy. Any such transaction would likely increase our funding needs in the future.