10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(MARK ONE)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM                      TO                     

Commission File Number: 0-33489

ZYMOGENETICS, INC.

(exact name of registrant as specified in its charter)

Washington	91-1144498
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

1201 Eastlake Avenue East, Seattle, Washington 98102

(Address of principal executive offices) (Zip Code)

(206) 442-6600

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes  x.    No  ¨.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨            Accelerated filer  x            Non-accelerated filer  ¨.

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes  ¨    No  x.

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common stock outstanding at July 28, 2006: 67,040,095 shares.

ZYMOGENETICS, INC.

Quarterly Report on Form 10-Q

For the quarterly period ended June 30, 2006

TABLE OF CONTENTS

		Page No.
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)
a)	Balance Sheets	3
b)	Statements of Operations	4
c)	Statements of Cash Flows	5
d)	Notes to Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	16
Item 4.	Controls and Procedures	17
PART II	OTHER INFORMATION
Item 1A.	Risk Factors	17
Item 4.	Submission of Matters to a Vote of Security Holders	17
Item 6.	Exhibits	18
SIGNATURE		19

2

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

ZYMOGENETICS, INC.

BALANCE SHEETS

(in thousands)

(unaudited)

	June 30, 2006			December 31, 2005
Assets
Current assets
Cash and cash equivalents	$	36,334		$	122,322
Short-term investments		273,945			243,989
Receivables
Related party		903			962
Trade		2,385			2,366
Interest and other receivables		1,926			1,775
Prepaid expenses		3,562			3,781
Total current assets		319,055			375,195
Property and equipment, net		71,849			71,803
Other assets		6,414			6,355
Total assets	$	397,318		$	453,353
Liabilities and Shareholders’ Equity
Current liabilities
Accounts payable	$	3,502		$	3,897
Accrued liabilities		11,179			11,911
Deferred revenue		8,550			15,928
Total current liabilities		23,231			31,736
Lease obligations		66,982			66,754
Deferred revenue		14,557			17,070
Other noncurrent liabilities		4,189			4,130
Commitments and contingencies
Shareholders’ equity
Preferred stock, no par value, 30,000 shares authorized		—			—
Common stock, no par value, 150,000 shares authorized, 67,038 and 65,935 issued and outstanding at June 30, 2006 and December 31, 2005, respectively		719,683			702,957
Non-voting common stock, no par value, 30,000 shares authorized		—			—
Accumulated deficit		(429,444	)		(367,816	)
Accumulated other comprehensive loss		(1,880	)		(1,478	)
Total shareholders’ equity		288,359			333,663
Total liabilities and shareholders’ equity	$	397,318		$	453,353

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

3

ZYMOGENETICS, INC.

STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Revenues
Royalties
Related party	$	666		$	874		$	1,421		$	2,397
Other		1,068			963			2,166			1,821
Option fees
Related party		1,889			1,875			3,764			3,750
Other		784			784			1,569			1,569
License fees and milestone payments
Related party		3,008			2,270			5,255			5,538
Other		652			1,249			1,284			4,895
Total revenues		8,067			8,015			15,459			19,970
Operating expenses
Research and development		31,375			25,888			64,325			50,419
General and administrative		8,297			5,861			16,104			11,845
Total operating expenses		39,672			31,749			80,429			62,264
Loss from operations		(31,605	)		(23,734	)		(64,970	)		(42,294	)
Other income (expense)
Investment income		3,532			1,831			7,160			3,449
Interest expense		(1,906	)		(1,895	)		(3,810	)		(3,773	)
Other, net		8			(5	)		(8	)		27
Net other income (expense)		1,634			(69	)		3,342			(297	)
Net loss	$	(29,971	)	$	(23,803	)	$	(61,628	)	$	(42,591	)
Basic and diluted net loss per share	$	(0.45	)	$	(0.41	)	$	(0.93	)	$	(0.74	)
Weighted-average number of shares used in computing net loss per share		66,832			57,855			66,564			57,764

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

4

ZYMOGENETICS, INC.

STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Six Months Ended June 30,
	2006			2005
Operating activities
Net loss	$	(61,628	)	$	(42,591	)
Adjustments to reconcile net loss to net cash used in operating activities
Depreciation and amortization		3,306			3,134
Net loss (gain) on disposition of property and equipment		1			(29	)
Noncash milestone revenue		—			(500	)
Stock-based compensation		9,401			2,200
Net realized loss on short-term investments		29			380
Net (accretion) amortization of (discount) premium on short-term investments		(174	)		778
Changes in operating assets and liabilities
Receivables		(111	)		1,548
Prepaid expenses		219			11
Other assets		(59	)		150
Accounts payable		(395	)		52
Accrued liabilities		(732	)		(1,308	)
Deferred revenue		(9,891	)		(12,092	)
Lease obligations		228			280
Other noncurrent liabilities		59			(97	)
Net cash used in operating activities		(59,747	)		(48,084	)
Investing activities
Purchases of property and equipment		(3,353	)		(2,653	)
Purchases of short-term investments		(107,745	)		(163,082	)
Proceeds from sale and maturity of short-term investments		77,532			148,603
Net cash used in investing activities		(33,566	)		(17,132	)
Financing activities
Proceeds from exercise of stock options		7,325			1,645
Net cash provided by financing activities		7,325			1,645
Net decrease in cash and cash equivalents		(85,988	)		(63,571	)
Cash and cash equivalents at beginning of period		122,322			117,308
Cash and cash equivalents at end of period	$	36,334		$	53,737

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

5

ZYMOGENETICS, INC.

NOTES TO FINANCIAL STATEMENTS

(unaudited)

1. Basis of presentation

The accompanying unaudited financial statements of ZymoGenetics, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. In the opinion of management, the financial statements reflect all normal recurring adjustments necessary to present fairly the Company’s financial position and results of operations as of and for the periods indicated. Operating results for such periods are not necessarily indicative of the results that may be expected for the full year or for any future period.

The December 31, 2005 balance sheet data was derived from the audited financial statements at that date but does not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. These unaudited interim financial statements should be read in conjunction with the audited financial statements and related footnotes included in the Company’s Annual Report filed on Form 10-K for the year ended December 31, 2005.

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and that affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

2. Net loss per share

Basic and diluted net loss per share has been computed based on net loss and the weighted-average number of common shares outstanding during the applicable period. The Company has excluded all outstanding options to purchase common stock as such shares are antidilutive for all periods presented.

3. Short-term investments

Short-term investments consisted of the following at June 30, 2006 (in thousands):

	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Estimated Fair Value
Type of security:
Commercial paper and money market	$	4,000	$	—	$	—		$	4,000
Corporate debt securities		85,986		25		(282	)		85,729
Asset-backed securities		130,555		12		(1,232	)		129,335
U.S. government and agency securities		55,284		—		(403	)		54,881
	$	275,825	$	37	$	(1,917	)	$	273,945
Maturity date:
Less than one year	$	190,539						$	189,583
Due in 1-3 years		85,286							84,362
	$	275,825						$	273,945

6

The Company’s management has concluded that unrealized losses are temporary, as the duration of the decline in the value of the investments has been relatively short; the extent of the decline, both in dollars and percentage of cost is not severe; and the Company has the ability and intent to hold the investments until at least substantially all of the cost of the investments is recovered.

4. Stock compensation

In March 2000, the Company adopted the 2000 Stock Incentive Plan (the 2000 Plan). Upon completion of the Company’s initial public offering in February 2002, the 2000 Plan was suspended and the 2001 Stock Incentive Plan (the 2001 Plan) became effective. Both Plans provide for the issuance of incentive stock options and nonqualified stock options to employees, directors, consultants and other independent contractors who provide services to the Company. The Company’s board of directors is responsible for administration of the Plans and determines the term of each option, exercise price and the vesting terms. The 2001 Plan provides for an annual increase in authorized shares effective the first day of each year equal to the least of (i) 2,700,000 shares; (ii) 5% of the outstanding common stock as of the end of the Company’s preceding fiscal year; and (iii) a lesser amount as determined by the Board of Directors. The first annual increase under the 2001 Plan occurred upon completion of the Company’s initial public offering. Any shares from the 2000 Plan that are not actually issued shall continue to be available for issuance under the 2001 Plan. The Company has reserved a total of 19,738,650 shares of common stock for issuance under the Plans, of which 3,173,369 are available for future grant at June 30, 2006. Options granted to employees under the Plans generally vest over a four-year period and expire ten years from the date of grant. Options to purchase 747,085 shares have been granted to board members, of which 144,000 options were immediately exercisable and 351,085 options vest over approximately one year.

A summary of stock option activity under the Plans for the six months ended June 30, 2006 is presented below (shares and aggregate intrinsic value in thousands):

	Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value
Balance, January 1, 2006	11,470		$	10.88
Granted	1,565			20.60
Exercised	(629	)		6.35
Forfeited	(90	)		16.42
Expired	(3	)		15.92
Balance, March 31, 2006	12,313		$	12.30	7.2	$	114,725
Granted	646			18.65
Exercised	(473	)		7.06
Forfeited	(265	)		17.95
Expired	—			—
Balance, June 30, 2006	12,221		$	12.72	7.0	$	82,180
Exercisable, June 30, 2006	7,110		$	8.52	5.6	$	75,307

7

A summary of stock option value under the Plans is presented below (in thousands, except per stock option share data):

	Three Months Ended June 30,				Six Months Ended June 30,
	2006		2005		2006		2005
Weighted average grant-date fair value per stock option share granted	$	9.00	$	10.88	$	10.66	$	11.60
Total intrinsic value of stock options exercised		5,920		2,114		15,369		4,810
Total fair value of stock options vested		4,511		3,999		11,227		9,738

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R) (SFAS 123(R)), Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires instead that such transactions be accounted for using a fair-value-based method. The Company has adopted the modified prospective transition method and determines fair value using the Black-Scholes valuation method. Accordingly, prior periods have not been restated to reflect stock-based compensation under SFAS 123(R). The Company recorded the following amounts of stock-based compensation expense for the periods presented (in thousands):

	Three Months Ended June 30, 2006		Six Months Ended June 30, 2006
Research and development expense	$	3,133	$	6,032
General and administrative expense		1,718		3,337
Total	$	4,851	$	9,369

The Company has capitalized $32,000 of stock-based compensation cost to its internal software development project in the three and six months ended June 30, 2006. No income tax benefit has been recorded as the Company has a full valuation allowance and management has concluded it is more likely than not that the net deferred tax asset will not be realized. As of June 30, 2006, there was $49.2 million of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of approximately three years.

Estimated fair values of stock options granted have been determined using the Black-Scholes option pricing model with the following assumptions:

	Three Months Ended June 30, 2006		Six Months Ended June 30, 2006
Expected stock price volatility	56	%	56	%
Risk-free interest rate	4.95	%	4.56	%
Expected life of options	6.1 years		6.1 years
Expected dividend yield	0	%	0	%

The Company does not have historical trading information for its common stock for a long enough period to calculate historical volatility solely based on the trading of its common stock. Furthermore, the market for options on the Company’s common stock is illiquid and cannot be relied upon as a source of implied volatility. Accordingly, the Company has estimated the volatility of its common stock by augmenting its historical volatility with that of other similar companies, and blending it with the implied volatility of market traded options of similar companies. The risk-free interest rate used in the option

8

valuation model is based on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term of the options. The Company has estimated the expected life of its stock options using the simplified method for determining the expected term as prescribed by the Securities and Exchange Commission’s Staff Accounting Bulletin 107, Share-based Payment. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore an expected dividend yield of zero is used in the option valuation model. Forfeitures are estimated at the time of grant and revised in subsequent periods if actual forfeitures differ from those estimates. Accordingly, stock-based compensation expense is recorded only for those awards that vest. All stock-based payment awards are amortized on a straight-line basis over the requisite service periods of the awards, which are generally the vesting periods.

The following table illustrates the effect on net loss and loss per share for the periods presented as if the fair value based method prescribed by SFAS 123 had been applied to all outstanding and unvested awards (in thousands, except per share data):

	Three Months Ended June 30, 2005			Six Months Ended June 30, 2005
Net loss, as reported	$	(23,803	)	$	(42,591	)
Add:       employee stock-based compensation under APB 25 included in reported net loss		954			2,200
Deduct:  employee stock-based compensation expense determined under the fair value method		(4,778	)		(9,540	)
Net loss, pro forma	$	(27,627	)	$	(49,931	)
Basic and diluted net loss per share, as reported	$	(0.41	)	$	(0.74	)
Basic and diluted net loss per share, pro forma	$	(0.48	)	$	(0.86	)

5. Comprehensive loss

For the three and six months ended June 30, 2006, total comprehensive loss was $30.0 million and $62.0 million, respectively. For the three and six months ended June 30, 2005, total comprehensive loss was $23.1 million and $42.2 million, respectively. Comprehensive loss is composed of net loss and unrealized gains and losses on short-term investments. The net change in accumulated other comprehensive loss for the six months ended June 30, 2006 was $402,000, reflecting an increase in net unrealized losses on short-term investments due to increasing interest rates.

6. Recent accounting pronouncements

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return, including a decision whether to file or not to file a return in a particular jurisdiction. Under FIN 48, the financial statements will reflect expected future tax consequences of such positions presuming the taxing authorities’ full knowledge of the position and all relevant facts, but without considering time values. The new accounting model for uncertain tax positions in FIN 48 is effective for annual periods beginning after December 15, 2006. The Company is currently assessing the impact of FIN 48 on its results of operations, cash flows and financial condition.

9

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

The following discussion and analysis should be read in conjunction with the financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q. This report contains, in addition to historical information, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. This Act provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about themselves so long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. Factors that could cause or contribute to such differences include, but are not limited to, risks associated with our unproven discovery strategy, preclinical and clinical development, regulatory oversight, intellectual property claims and litigation and other risks detailed in our public filings with the Securities and Exchange Commission, including those risks described in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2005. All statements other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. When used in this document, the words “believes,” “expects,” “anticipates,” “intends,” “plans” and similar expressions, are intended to identify certain of these forward-looking statements. However, these words are not the exclusive means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The cautionary statements made in this document should be read as being applicable to all related forward-looking statements wherever they appear in this document. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may subsequently arise. Readers are urged to carefully review and consider the various disclosures made in this report and in our other reports filed with the Securities and Exchange Commission that attempt to advise interested parties of the risks and other factors that may affect our business, prospects and results of operations.

Business Overview

We are a biopharmaceutical company focused on discovering, developing and commercializing therapeutic protein-based products for the treatment of human diseases. The process for taking one of our discoveries to the marketplace is long, complex and very costly. It is difficult to predict the time it will take to commercialize any given product candidate, but it is not unusual for such commercialization to span ten years or more and cost hundreds of millions of dollars. It is also a business of attrition; it is expected that, for the industry as a whole, less than 20% of the drug candidates entering human clinical trials will actually make it to the marketplace. For the products that do make it, particularly for those that address previously unmet medical needs, the markets can be significant, with a number of successful products selling in excess of $1 billion per year.

An important element of our strategy is that we intend to maintain all or a significant share of the commercial rights to a number of our product candidates in North American markets. As a result, we will be required to pay a significant portion of the development costs for these product candidates. A second important element of our strategy is that we are developing a broad portfolio of product candidates to give our company more opportunities to be successful. We currently have three product candidates in clinical development and expect to add additional proteins to this portfolio in the future. Thus, we are paying a significant portion of development costs for several potential products. Assuming these product candidates progress through clinical development successfully, the costs of clinical trials are expected to increase significantly.

Our most significant financial challenges are to obtain adequate funding to cover the cost of product development, and to control spending and direct it toward product candidates that will create the most value for our shareholders over the long term. It can be a complex and highly subjective process to establish the

10

appropriate balance between cash conservation and value generation. There are a number of important factors that we consider in addressing these challenges, including the following:

• the nature, timing and magnitude of financing transactions, which would typically involve issuance of equity or equity-based securities;

• the nature and timing of product development collaborations, which would typically provide for funding of a portion of the respective product development costs, as well as bring in near-term potential revenues in the form of upfront fees and milestone payments;

• the breadth of product development programs, i.e. the number of potential disease indications for which a product candidate is tested in clinical trials;

• the number of products in our development portfolio and the decision to move new product candidates into clinical development; and

• periodic assessments of the relative capital requirements, risk and value of each of our product candidates.

We expect that it will be several years or more before we can generate enough product-related revenues to reach net income or cash flow breakeven. For example, we have estimated that our net loss will be within the range of $135-150 million in 2006, and that we will use net cash of $125-140 million. Revenues from existing relationships help to defray our expenses, but additional funding will be required, the amount of which could be significant. We may decide to enter into additional product development collaborations, which would reduce our funding requirements. We may also generate funding through licensing of patents that are not relevant to our product development programs.

It is likely that we will continue to look for opportunities to raise equity capital as a primary means of funding our company over the next several years. The equity markets for biotechnology stocks have tended to experience long cycles during which the sale of equity securities has been extremely difficult. It is not possible to predict the timing or length of these cycles. As a result, many biotechnology companies, including ours, have adopted an opportunistic strategy of raising equity capital when it is available. We believe this strategy is important to minimizing the financial risks to our company and our shareholders. Consistent with our strategy, in August 2005, we issued 7.5 million shares of common stock raising net proceeds of $126.4 million.

Results of Operations

Revenues

Royalties. We earn royalties on sales of certain products subject to license agreements with Novo Nordisk, our former parent and current owner of approximately 31% of our outstanding common stock, and several other companies. Royalties have decreased for both the three and six-month periods ended June 30, 2006 compared to the corresponding periods in 2005, primarily due to insulin and glucagon patent expiration in certain countries. Insulin and glucagon royalties declined to 38% and 40% of our total royalty for the three and six-month periods ended June 30, 2006, respectively, from 48% and 57% for the corresponding periods in 2005. This downward trend is expected to continue and, in 2007, royalties for both insulin and glucagon in the remaining major markets will end. Royalties earned on sales of GEM 21S, a product of BioMimetic Therapeutics, Inc., have partially offset this decrease.

Option fees. In the three and six-month periods ended June 30, 2006 and 2005, we recognized option fee revenue of $1.9 million and $3.8 million, respectively, under an Option and License Agreement with Novo Nordisk, pursuant to which we have granted an option to license certain rights to proteins that we discover. The initial term of this agreement expired in November 2004; however, Novo Nordisk exercised its right to extend the agreement to November 2006 and has paid us $7.5 million per year for those two additional years. We received the final payment from Novo Nordisk in November 2005, of which $2.7 million was recorded as deferred revenue at June 30, 2006 and will be recognized as option fee revenue evenly through November 2006.

11

In September 2004, we signed a five-year strategic alliance agreement with Serono under which Serono may acquire rights and licenses to certain leads and targets from our research and development pipeline. In the three and six-month periods ended June 30, 2006 and 2005, we recognized revenue of $784,000 and $1.6 million, respectively, from this agreement. At June 30, 2006, $10.3 million was recorded as deferred revenue which will be recognized at a rate of $3.1 million per year.

License fees and milestone payments. Revenues from license fees and other up-front payments are recognized over the period we are contractually required to provide other rights or services that represent continuing obligations. From period to period, license fees and milestone payments can fluctuate substantially based on the completion of new licensing or collaborative agreements and the achievement of development-related milestones. In the three months ended June 30, 2006, we earned a $1.5 million IL-20 milestone payment from Novo Nordisk. The decrease of $3.9 million for the six-month period ended June 30, 2006, as compared to the corresponding period in 2005, resulted from certain amounts earned in the six-month period ended June 30, 2005 for which no comparable amounts were earned in 2006. Specifically, these were a one-time, lump sum license fee from Eli Lilly and a milestone payment from BioMimetic Therapeutics, Inc.

In October 2004 we entered into a license agreement with Novo Nordisk with respect to recombinant Factor XIII. The upfront fee of $15.0 million was deferred and recognized over a period of 20 months. Recognition of this revenue, amounting to $750,000 per month, ended in May 2006. A resulting decline in license fee revenue is expected in future periods.

Operating expenses

Research and development. Research and development expense has been our most significant expense to date, consisting primarily of salaries and benefit expenses, costs of consumables and contracted services. Our research and development activities have expanded in the past year, particularly related to our clinical-stage product candidates, rhThrombin, TACI-Ig and IL-21. In addition, the impact of recognizing stock-based compensation cost in 2006 in accordance with SFAS 123(R) has increased research and development expenses. Research and development expense in both periods was slightly offset by cost reimbursements from Novo Nordisk for work performed on rFactor XIII. The work supporting the rFactor XIII clinical development program began in late 2004 and is expected to end in 2006. These trends for the three and six-month periods ended June 30 are shown in the following table (in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Salaries and benefits	$	12,901		$	11,102		$	26,009		$	21,876
Consumables		3,045			3,028			5,886			7,101
Facility costs		1,899			1,495			3,699			3,112
Contracted services		9,798			9,133			21,980			15,935
Depreciation and amortization		1,335			1,279			2,711			2,568
Stock-based compensation		3,133			812			6,032			1,748
Subtotal		32,111			26,849			66,317			52,340
Cost reimbursement from collaborators		(736	)		(961	)		(1,992	)		(1,921	)
Net research and development expense	$	31,375		$	25,888		$	64,325		$	50,419

Salaries and benefits, consumables and facility, as shown in the table above, have tended to track fairly consistently with increases in our employee base from year to year. Between June 30, 2005 and June 30, 2006, we added approximately 42 full-time equivalent employees who are involved in product development activities. Contrary to this trend, in the six months ended June 30, 2006, we experienced a reduction in consumable costs related to manufacturing IL-29 product in 2005 for use in toxicology studies and clinical trials, for which there were no comparable costs during the same period in 2006.

12

Contracted services include the cost of items such as contract manufacturing, clinical trials, non-clinical studies and payments to collaborators. These costs relate primarily to clinical development programs and can fluctuate substantially from period-to-period depending on the stage of our various programs. Generally, these external costs increase as a program advances toward commercialization, but there can be periods between major clinical trials during which costs decline. Our clinical trial costs increased in the three and six-month periods ended June 30, 2006, as compared to the corresponding periods in 2005, reflecting the costs of rhThrombin Phase 3 clinical trials and greater IL-21 clinical trial activity. Also, contract manufacturing costs tend to be incurred irregularly over the course of a development program, with relatively short manufacturing campaigns that may provide enough product to supply multiple years of clinical trial activity. Our contract manufacturing costs increased for the three and six-month periods ended June 30, 2006 as compared to the same periods in 2005, reflecting on-going process development and manufacturing campaigns for rhThrombin to support the anticipated filing of a license application with the FDA in late 2006. The cost increase for both periods was partially offset by the impact of out-licensing rFactor XIII to Novo Nordisk in October 2004.

To date, our business needs have not required us to fully allocate all research and development costs among our various programs. However, we track direct labor, contracted services and certain consumable costs by program, which we monitor to ensure appropriate utilization of company resources. We also incur indirect costs that are not allocated to specific programs. These costs include indirect labor, certain consumable costs, facility costs, and depreciation and amortization, all of which benefit all of our research and development programs.

The following table presents our research and development costs allocated to clinical development, pre-development and discovery research programs, together with the unallocated costs that benefit all programs for the three and six-month periods ended June 30 (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2006		2005		2006		2005
Clinical development programs:
Hemostasis	$	10,131	$	6,328	$	22,334	$	10,149
Autoimmunity and oncology		4,506		4,809		8,617		9,477
Antiviral		1,100		—		2,738		—
Pre-development programs		2,286		2,842		3,294		6,331
Discovery research programs		2,117		2,090		4,889		4,582
Unallocated indirect costs		11,235		9,819		22,453		19,880
Total	$	31,375	$	25,888	$	64,325	$	50,419

The following summarizes the reasons for significant changes in research and development program costs for the periods presented in the table:

• Hemostasis clinical development program costs increased substantially from 2005 to 2006 for both the three and six-month periods ended June 30 reflecting the production of rhThrombin bulk drug validation lots and Phase 3 clinical trial costs in 2006.

• Autoimmunity and oncology clinical development program (TACI-Ig and IL-21) costs decreased from 2005 to 2006 for both the three and six-month periods ended June 30 primarily due to completion of the TACI-Ig rheumatoid arthritis clinical trial in late 2005.

• Antiviral clinical development program costs in 2006 reflect activities associated with preparing for clinical testing of IL-29.

• Pre-development program costs declined primarily due to the transition of IL-29 to development in mid-2005.

13

• Unallocated indirect costs increased from 2005 to 2006 for both the three and six-month periods ended June 30 primarily due to the impact of recording stock-based compensation expense pursuant to SFAS 123R.

General and administrative. General and administrative expense, which consists primarily of salaries and benefit expenses, professional fees and other corporate costs, increased 42% and 36% for the three and six-month periods ended June 30, 2006, respectively, as compared to the corresponding periods in 2005. The increase was primarily due to the impact of recording stock-based compensation expense in accordance with SFAS 123(R). Higher personnel and patent costs also contributed to the increase.

Stock-based compensation. Effective January 2006, we adopted Statement of Financial Accounting Standards No. 123(R) (SFAS 123(R)), Share-Based Payment. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, and generally requires instead that such transactions be accounted for using a fair-value-based method. We have adopted the modified prospective transition method and determine fair value using the Black-Scholes valuation method. Accordingly, we recorded stock-based compensation expense of $4.9 million and $9.4 million for the three and six-month periods ended June 30, 2006, respectively. Stock-based compensation of $954,000 and $2.2 million for the respective periods in 2005 was recorded pursuant to APB 25. We are estimating that the financial impact for the full year 2006 will be to increase our operating expenses by approximately $19-21 million.

Other income (expense)

Investment income. Investment income is generated primarily from investment of our cash reserves in investment grade, fixed-income securities. There are three primary factors affecting the amount of investment income that we report: amount of cash reserves invested, the effective interest rate, and the amount of gains or losses recognized. Investment income increased significantly for the three and six-month periods ended June 30, 2006 as compared to the corresponding periods in 2005, largely due to increases in the effective interest rate realized and higher average amounts of cash reserves invested. The following table shows how each of these factors affected investment income for the three and six months ended June 30 (in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Weighted average amount of cash reserves	$	318,389		$	282,785		$	332,330		$	295,624
Effective interest rate		1.12	%		0.70	%		2.16	%		1.30	%
Investment income before gains and losses		3,561			1,988			7,190			3,829
Net losses on sales of investments		(29	)		(157	)		(30	)		(380	)
Investment income, as reported	$	3,532		$	1,831		$	7,160		$	3,449

Interest expense. We have accounted for a sale-leaseback transaction completed in October 2002 as a financing transaction. Under this method of accounting, an amount equal to the net proceeds of the sale is considered a long-term interest bearing liability. Rent payments under the leases are considered to be payments toward the liability and are allocated to principal and interest. Interest expense was $1.9 and $3.8 million for the three and six-month periods, respectively, for both 2006 and 2005.

Liquidity and Capital Resources

As of June 30, 2006, we had cash, cash equivalents and short-term investments of $310.3 million, which we intend to use to fund our operations and capital expenditures over the next several years. These cash reserves are held in a variety of investment-grade, fixed-income securities, including corporate bonds, commercial paper and money market instruments. We believe that our existing cash resources should provide sufficient funding for the next two to three years. If we complete additional collaborative development transactions, which could generate both revenues and cost reductions, these cash resources could extend the period of time over which these funds would cover our operating costs.

14

Cash flows from operating activities. The amount of cash used to fund our operating activities generally tracks our net losses, with the following exceptions:

• noncash expenses, such as depreciation and amortization, gain or loss on sale or disposal of assets, and stock-based compensation, which do not result in uses of cash;

• net realized gains and losses and accretion and amortization of discounts and premiums on short-term investments, which are reflected as sources of cash from investing activities upon maturity or sale of the respective investments;

• changes in receivables, which generally represent temporary timing differences between the recognition of certain revenues and the subsequent receipt of cash payments;

• changes in deferred revenue, which reflect the difference in timing between the receipt of cash from option fees, license fees and other upfront payments and the subsequent recognition of these amounts as revenue over the period we are contractually required to provide other rights or services that represent continuing obligations; and

• changes in other assets and liabilities, which generally represent temporary timing differences between the recognition of certain expenses and their payment.

Generally, with the exception of changes in deferred revenue, we do not expect these items to generate material year-to-year fluctuations in the relationship between our net loss and the amount of net cash used in operating activities. Substantial license or upfront fees may be received upon the date we enter into new licensing or collaborative agreements and be recorded as deferred revenue. For example, in 2004 upon the execution of a strategic alliance agreement with Serono and a license agreement with Novo Nordisk, we recorded $36.2 million of deferred revenue, which is being recognized as revenue over approximately five years. For the six-month periods ended June 30, 2006 and 2005, we recognized $9.9 million and $12.1 million, respectively, of previously deferred revenue from these and other transactions. The timing of additional deferred revenue transactions is expected to be irregular and, thus, has the potential to create fluctuations in the relationship between our net loss and the amount of cash used in operating activities.

Cash flows from investing activities. Our most significant use of cash in investing activities is for capital expenditures. We expend a certain amount each year on routine items to maintain the effectiveness of our business, e.g., to adopt newly developed technologies, expand into new functional areas, adapt our facilities to changing needs and/or replace obsolete assets. In addition, at various times we have used cash to purchase land and expand facilities. Cash flows from investing activities also reflect large amounts of cash used to purchase short-term investments and received from the sale and maturity of short-term investments. These amounts primarily relate to shifts between cash and cash equivalents and short-term investments. Because we manage our cash usage with respect to our total cash, cash equivalents and short-term investments, we do not consider these cash flows to be important to an understanding of our liquidity and capital resources.

Cash flows from financing activities. We received $7.3 million and $1.6 million of proceeds from the exercise of stock options for the six-month periods ended June 30, 2006 and 2005, respectively.

We expect to incur substantial additional costs as we continue to advance and expand our product development programs. We expect these expenditures to increase over the next several years, particularly if the outcomes of clinical trials are successful and our product candidates continue to advance. Our plans include the internal development of selected product candidates and the co-development of product candidates with collaborators where we would assume a percentage of the overall product development costs. If, at any time, our prospects for financing these programs decline, we may decide to reduce our ongoing investment in our development programs. We could reduce our investment by discontinuing our funding under existing co-development arrangements, establishing new co-development arrangements for other product candidates to provide additional funding sources or out-licensing product candidates that we might otherwise develop internally. Additionally, we could consider delaying or discontinuing development of product candidates to reduce the level of our related expenditures.

15

Our long-term capital requirements and the adequacy of our available funds will depend on several factors, many of which may not be in our control, including:

• results of research and development programs;

• cash flows under existing and potential future arrangements with licensees, collaborators and other parties;

• costs involved in filing, prosecuting, enforcing and defending patent claims; and

• costs associated with the expansion of our facilities.

Over the next several years we expect to seek additional funding through public or private financings, including equity financings, and through other arrangements, including collaborative arrangements. Poor financial results, unanticipated expenses or unanticipated opportunities that require financial commitments could give rise to additional financing requirements sooner than we expect. However, financing may be unavailable when we need it or may not be available on acceptable terms. If we raise additional funds by issuing equity or equity-based securities, the percentage ownership of our existing shareholders would be reduced, and these securities could have rights superior to those of our common stock. If we are unable to raise additional funds when we need them, we could be required to delay, scale back or eliminate expenditures for some of our development programs or expansion plans, or grant rights to third parties to develop and market product candidates that we would prefer to develop and market internally, with license terms that are not favorable to us.

Contractual Obligations

At June 30, 2006 we are contractually obligated to make payments as follows (in thousands):

	Payments Due by Period
	Total		Less than 1 Year		1-3 Years		3-5 Years		More than 5 Years
Building lease obligations	$	119,437	$	7,480	$	15,755	$	16,878	$	79,324
Operating leases		9,495		1,585		3,336		3,523		1,051
Development contracts		3,568		3,305		263		—		—
Total	$	132,500	$	12,370	$	19,354	$	20,401	$	80,375

The building lease obligations, which resulted from our sale-leaseback financing transaction, reflect the lease term through May 2019. Operating lease terms range from one to seven years and generally relate to leased office space nearby our corporate headquarter buildings. We have certain renewal provisions at our option, which are not reflected in the above table, for the building leases and the operating leases. The development contracts include the production of process validation lots of rhThrombin, which may also be used partly for commercial purposes.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market risk is primarily limited to interest income sensitivity, which is affected by changes in the general level of United States interest rates, particularly because the majority of our investments are in short-term debt securities. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive without significantly increasing risk. To minimize risk, we maintain our portfolio of cash, cash equivalents and short-term investments in a variety of interest-bearing instruments, including United States government and agency securities, high-grade United States corporate bonds, asset-backed securities, commercial paper and money market funds. Due to the nature of our short-term investments, all of which mature within three years, we believe that we are not subject to any material market risk exposure. We have no material foreign currency exposure, nor do we hold derivative financial instruments.

16

Item 4. Controls and Procedures

Our principal executive officer and principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report, have concluded that as of such date our disclosure controls and procedures were effective. No change in our internal control over financial reporting occurred during the quarter ended June 30, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II OTHER INFORMATION

Item 1A. Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

Item 4. Submission of Matters to a Vote of Security Holders

We held our annual meeting of shareholders on June 15, 2006. Of the 66,600,525 shares of common stock outstanding as of the record date of the annual meeting, 61,128,795 shares, or 91.8% of the total shares eligible to vote at the annual meeting, were represented in person or by proxy. Three proposals were submitted to our shareholders and approved at the annual meeting, as follows:

1. Election of Directors. Judith A. Hemberger, Ph.D. was elected to serve as a member of the board of directors for a term expiring in 2008. David I. Hirsh, Ph.D., David H. MacCallum and Kurt Anker Nielsen were elected to serve as members of the board of directors with terms expiring in 2009. The number of votes cast for or withheld from each nominee, both in person and by proxy, was as follows:

Name	Votes For	Votes Withheld
Judith A. Hemberger, Ph.D.	60,721,113	407,682
David I. Hirsh, Ph.D.	60,696,477	432,318
David H. MacCallum	58,928,418	2,200,377
Kurt Anker Nielsen	60,650,540	478,255

2. Approval of material terms for our 2001 Stock Incentive Plan.

For	48,807,084
Against	3,562,608
Abstain	25,049

3. Ratify the appointment of PricewaterhouseCoopers LLP as independent registered public accountants, to act as the independent auditors for the fiscal year ending December 31, 2006.

For	60,920,634
Against	191,009
Abstain	17,152

17

Item 6. Exhibits

Exhibit Number
10.1	Employment Agreement, dated April 25, 2006 between ZymoGenetics, Inc. and Vaughn B. Himes.
10.2	Employment Agreement, dated May 1, 2006 between ZymoGenetics, Inc. and Michael J. Dwyer.
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

18

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	ZYMOGENETICS, INC.
Date: August 3, 2006	By:	/s/ James A. Johnson
		James A. Johnson Senior Vice President and Chief Financial Officer (Principal Financial Officer and Authorized Officer)

19

EX-10.1

Exhibit 10.1

EMPLOYMENT AGREEMENT

This AGREEMENT, dated April 25, 2006, is between ZymoGenetics, Inc., a Washington corporation (“Company”) and Vaughn B. Himes (“Executive”).

1. Employment. Company will employ Executive and Executive will accept employment as Senior Vice President, Technical Operations, of the Company. Executive accepts employment upon the terms and conditions contained in this Agreement and for the period (hereinafter called the “Term of Employment”) specified in Section 3 below.

2. Duties. Executive shall, during the Term of Employment, serve the Company under the direction of the President of the Company. Executive shall perform the duties of his position faithfully, diligently and competently and to the best of his ability, and shall devote his full business time to his employment. Executive shall perform such other duties as are assigned to him by the President or the Board of Directors of the Company. Executive may devote reasonable periods of time to (a) engaging in personal investment activities, (b) serving on the Board of Directors of other corporations with the consent of the Compensation Committee of the Board, if such service would not otherwise be prohibited by Section 7 hereof, and (c) engaging in charitable or community service activities, so long as none of the foregoing additional activities materially interfere with Executive’s duties under this Agreement.

3. Term of Employment; Termination.

Executive’s Term of Employment shall be two years from the date of this Agreement, unless extended or earlier terminated as provided below.

(a) Termination or Extension of Term of Employment By Company

The Company shall employ Executive, for a period commencing on the date hereof and terminating as follows:

(i) Two years from the date hereof, if at least thirty (30) days prior to such date either the Company or Executive has, at its election, notified the other in writing that this Agreement shall terminate on such date. If notice of termination is not given, this Agreement shall be deemed to extend from year to year. It can then be terminated by written notice at least thirty (30) days prior to the annual renewal date.

(ii) With or without “Cause” (as defined below), Company may terminate the employment of Executive at any time upon giving “Notice of Termination” (as defined below).

(b) By Executive

Executive may terminate his employment at any time, for any reason, upon giving Notice of Termination.

(c) Automatic Termination

This Agreement and Executive’s employment hereunder shall terminate automatically upon the death or total disability of Executive. The term “total disability” as used herein shall mean Executive’s inability to perform the duties set forth in paragraph 1 hereof for a period or periods aggregating ninety (90) calendar days in any 12-month period as a result of physical or mental illness, loss of legal capacity or any other cause beyond Executive’s control, unless Executive is granted a leave of absence by the Board of Directors of Company. Executive and Company hereby acknowledge that Executive’s ability to perform the duties specified in paragraph 2 hereof is of the essence of this Agreement. Termination hereunder shall be deemed to be effective (a) at the end of the calendar month in which Executive’s death occurs or (b) immediately upon a determination by the Board of Directors of Company of Executive’s total disability, as defined herein.

(d) Notice

The term “Notice of Termination” shall mean at least thirty (30) days’ written notice of termination, by either party, of Executive’s employment, during which period Executive’s employment and performance of services will continue; provided, however, that Company may, upon notice to Executive and without reducing Executive’s compensation during such period, excuse Executive from any or all of his duties during such period. Such a reduction in duties shall not constitute “good reason” for voluntary termination so as to trigger termination payments in accordance with subparagraph 4.2. The effective date of the termination (the “Termination Date”) of Executive’s employment hereunder shall be the date on which such 30-day period expires.

4. Termination Payments

In the event of termination of the employment of Executive, all compensation and benefits set forth in this Agreement shall terminate except as specifically provided in this paragraph 4:

4.1 Termination by Company

(a) Upon termination by Company, Company shall pay Executive any unpaid annual base salary which has accrued for services already performed as of the Termination Date.

-2-

(b) If Company terminates Executive’s employment without Cause, as defined below, Executive shall be entitled to receive termination payments equal to twelve (12) months annual base salary. The termination payments shall be calculated according to Executive’s base salary as of the date of Notice of Termination and the termination payments will be paid semi-monthly in equal parts in accordance with the same time schedule that Company or a “Successor Company” (as defined in the Stock Option Agreement and incorporated by reference herein) makes its customary payroll. Company or a Successor Company may deduct customary withholdings including social security, federal and state income taxes, and state disability insurance from these severance payments; however, any and all such obligations shall be Executive’s responsibility. Company will issue and file appropriate Form 1099 or similar tax documents in connection with any termination payments. The termination payments described in this paragraph are expressly contingent upon Executive’s full compliance with the terms of his Employee Inventions and Proprietary Information Agreement with Company (the “Inventions Agreement”), a copy of which is attached hereto. In the event Executive were to materially breach this Inventions Agreement, his right to any termination payments under this paragraph shall be extinguished, Company (and any Successor Company) shall cease payments, and Executive shall immediately return to Company or to any Successor Company any severance payments already made. If Executive is terminated by either Company or any Successor Company for Cause, Executive shall not be entitled to receive any of the foregoing benefits, other than those set forth in clause (a) above.

4.2 Termination by Executive

In the case of the termination of Executive’s employment by Executive for “good reason,” as defined below, Executive shall be entitled to the termination payments as set forth in clauses 4.1(a) and (b). In the case of termination of Executive’s employment by Executive for any other reason, Executive shall not be entitled to any termination payments or accelerated vesting benefit, other than as set forth in clause 4.1(a), above.

4.3 Termination as a Result of Death or Total Disability

In the event of termination of Executive’s employment pursuant to subparagraph 3(c), Executive or his estate shall be paid the compensation set forth in clause 4.1(a) and shall not be entitled to any of the benefits under clauses 4.1(b).

4.4 “Good Reason”

“Good reason” shall mean the occurrence of any of the following events, without the consent of the Executive:

a) a demotion or other material reduction in the nature or status of Executive’s responsibilities; provided, however, that a change in the person or office to

-3-

which Executive reports, without a corresponding reduction in duties, status and responsibilities, shall not constitute “good reason;”

b) a non-voluntary reduction in the Executive’s annual base salary;

c) requirement by a Successor Company that the Executive relocate his principal place of employment to a location that is more than 50 miles from the principal place of employment where Executive was employed; or

d) the failure of Company to obtain a satisfactory agreement from any Successor Company to assume and perform the obligations under this Agreement within thirty (30) calendar days after the consummation of a merger, consolidation, sale or similar transaction;

e) following a Change in Control (as defined in subsection 4.6 hereof), the Executive ceases to hold the position of Senior Vice President, Technical Operations of the parent or combined entity resulting from such Change in Control; or

f) even if there is no Change in Control, but the Company enters into a merger, partnership or similar transaction, which results in a person other than the Executive becoming Senior Vice President, Technical Operations of the new combined entity.

4.5 Cause

Wherever reference is made in this Agreement to termination being with or without Cause, “Cause” shall include, without limitation, the occurrence of one or more of the following events:

a) willful misconduct, insubordination, or dishonesty in the performance of Executive’s duties or other knowing and material violation of Company’s or a Successor Company’s policies and procedures in effect from time to time which results in a material adverse effect on Company or a Successor Company;

b) willful actions (or intentional failures to act) in bad faith by Executive with respect to Company or a Successor Company that materially impair Company’s or a Successor Company’s business, goodwill or reputation;

c) conviction of Executive of a felony involving an act of dishonesty, moral turpitude, deceit or fraud, or the commission of acts that could reasonably be expected to result in such a conviction; or

d) any material violation by Executive of Executive’s Inventions Agreement with Company.

-4-

4.6 Change in Control

As used herein, a “Change in Control” shall mean:

a) The acquisition by any individual, entity or group (within the meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) (a “Person”), other than any one or more Series B Investor (as defined in the ZymoGenetics Series B Preferred Stock Purchase Agreement October 20, 2000), either directly or indirectly through one or more affiliated entities (collectively “Series B Purchasers”), of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 50% or more of either (x) the then outstanding shares of common stock of the Company (the “Outstanding Company Common Stock”) or (y) the combined voting power of the then outstanding voting securities of the Company entitled to vote generally in the election of directors (the “Outstanding Company Voting Securities”); provided, however, that for purposes of this subsection 4.6(a), the following acquisitions shall not constitute a Change in Control: (A) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Company or (B) any acquisition by any corporation pursuant to a transaction which complies with clauses (A), (B), and (C) of subsection 4.6(b); or

b) Consummation of a reorganization, merger or consolidation or sale or other disposition of all or substantially all of the assets of the Company (a “Business Combination”), in each case, unless, following such Business Combination: (A) all or substantially all of the individuals and entities who were the beneficial owners, respectively, of the Outstanding Company Common Stock and Outstanding Company Voting Securities immediately prior to such Business Combination beneficially own, directly or indirectly, more than 50% of, respectively, the then outstanding shares of common stock and the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Company or all or substantially all of the Company’s assets either directly or through one or more subsidiaries), (B) no Person (excluding (1) any one or more Series B Purchasers, (2) any corporation resulting from such Business Combination, or (3) any employee benefit plan (or related trust) of the Company or such corporation resulting from such Business Combination) beneficially owns, directly or indirectly, 50% or more of, respectively, the then outstanding shares of common stock of the corporation resulting from such Business Combination or the combined voting power of the then outstanding voting securities of such corporation except to the extent that such ownership existed prior to the Business Combination and (C) at least a majority of the members of the board of directors of the corporation resulting from such

-5-

Business Combination were members of the incumbent board of the Company at the time of the execution of the initial agreement, or of the action of the Board, providing for such Business Combination; or

c) Approval by the shareholders of the Company of a complete liquidation or dissolution of the Company.

5. Compensation and Fringe Benefits.

(a) The Company shall, during the Term of Employment, pay to the Executive as compensation for the performance of his duties and obligations a salary of $270,000 per annum. This compensation is subject to annual review and adjustment, as appropriate in the judgment of the Company. The compensation payable pursuant to this Section 5(a) shall be payable in equal semi-monthly installments on the last day of each such pay period.

(b) The Executive shall be enrolled and participate in any retirement, group insurance and other fringe benefit plans and arrangements which are applicable to the similarly situated personnel of the Company and in effect from time to time, if the Executive is eligible therefor, in each case in accordance with and subject to the provisions thereof.

(c) Stock Options

(i) Executive has been granted a ten-year stock option under the Company’s 2001 Stock Incentive Plan which allows Executive to purchase 100,000 shares of the Company’s common stock.

(ii) Executive shall be eligible to receive future grants of stock options pursuant to the Company’s stock-based bonus program;

(iii) Executive shall be eligible to receive future periodic (i.e., non bonus-related) grants under the Company’s stock incentive programs; and

(iv) If Executive’s employment is terminated on or after a Change in Control (as defined in subsection 4.6 above), Executive’s stock options, restricted stock and performance shares shall fully vest on the date of termination.

(d) Executive will also receive the following executive perquisites for the duration of this contract:

(i) Company-paid term life insurance policy in the amount of $200,000; and

(ii) Company-paid use of either a laptop computer or personal computer, to be upgraded biennially at the time this contract is renewed; and

-6-

(iii) Company-paid annual executive health physical, to be administered by a physician selected by the Company; and

(iv) Company-paid expenses for a residential phone and cellular phone.

6. Expenses. All travel and other reasonable expenses incident to the rendering of service by the Executive hereunder will be paid by the Company. If such expenses are paid in the first instance by the Executive, the Company will reimburse him upon presentation of proper expense accounts. Reimbursement requests, along with supporting documentation, should be submitted within sixty (60) days of incurring the expense.

7. Non-competition.

(a) Upon termination of Executive’s employment with the Company for any reason, and for a period of twelve (12) consecutive months after leaving his employment with the Company, Executive will not directly or indirectly work or otherwise engage in research, manufacture, sale or distribution of any product, method or matter:

(i) For any business, whose commercial efforts are in competition with the products manufactured or marketed by the Company during Executive’s employment with the Company or under research or development by the Company during Executive’s employment with the Company (and on which the Company has expended at least $500,000); or

(ii) For any research institution whose research efforts pertain to the same products manufactured or marketed by the Company during Executive’s employment with the Company or under research or development by the Company during Executive’s employment with the Company (and on which the Company has expended at least $500,000), unless the Executive is not involved in any manner in the design, conduct or supervision of such research efforts, or unless such research is being conducted solely for scientific and not for commercial purposes. The executive shall be deemed to be connected with a business if such business is carried on by partnership in which he is a general or limited partner, consultant or employee, or a corporation or association of which he is a shareholder, officer, director, employee, member, consultant or agent; provided, that nothing herein shall prevent the purchase or ownership by the Executive of shares of less than 1% of the outstanding shares in a publicly or privately held corporation.

Said twelve (12) months’ period shall commence on the day on which the Executive actually leaves his employment with the Company, even if this date is prior to the expiration of any given notice of termination.

-7-

(b) The Company’s Board of Directors may, at its own discretion, by express or written consent, release the Executive from the restriction in paragraph 6(a).

(c) For a period of one (1) year after the employment of the Executive is terminated for any reason, Executive will not directly or indirectly, either for Executive’s account or as representative or agent for any other person, firm, corporation or entity, solicit the services of, or entice away, any Executive of the Company, or the Executive of any company affiliated with the Company.

(d) In the event that Executive during said period described in paragraph 6(a) violates any of the Executive’s obligations towards the Company, including but not limited to the Executive accepting a position with a competing enterprise or Executive violating terms of paragraph 6(c), payment of Severance or Salary Continuation shall cease automatically without notice, regardless of whether the Company takes legal action or otherwise tries to enforce its rights. The Company reserves all rights it may have under contract or law to relief or damages in addition to termination of the above-described payments.

8. Binding Effect. This Agreement shall be binding upon and inure to the benefit of the Company and the Executive and their respective heirs, legal or personal representatives, successors and assigns.

9. Rights of Assignment or Delegation. This Agreement is personal to the Executive and shall not be assignable. Company may assign its rights hereunder to (a) any corporation resulting from any merger, consolidation, or other reorganization to which Company is a party or (b) any corporation, partnership, association, or other person to which Company may transfer all or substantially all of the assets in business of Company existing at such time. All the terms and provisions of this Agreement shall be binding upon and shall inure to the benefit and be enforceable by the parties hereto and their respective successors and permitted assigns.

10. Waiver. No delay or failure by any party in exercising, protecting or enforcing any of its rights, titles, interests, or remedies hereunder and no course of dealing or performance with respect thereto, shall constitute a waiver. The express waiver by a party of any right, title, interest, or remedy in a particular instance or circumstance shall not constitute a waiver in any other instance or circumstance. All rights and remedies shall be cumulative and not exclusive or any rights or remedies.

11. Arbitration. Any controversies or claims arising out of or relating to this Agreement shall be finally and fully settled by arbitration of the City of Seattle, Washington in accordance with the Employment Arbitration Rules of the American Arbitration Association then in effect (the “AAA Rules”), conducted by one arbitrator, mutually agreed upon by Company and Executive or chosen in accordance with the AAA Rules, except the parties thereto shall have any right to discovery would be

-8-

permitted by the Federal Rules of Civil Procedure for a period of 90 days following the commencement of such arbitration and the arbitrator shall resolve any dispute which arises in connection with such discovery. The prevailing parties shall be entitled to costs, expenses, reasonable attorneys’ fees, and judgment upon the award rendered by the arbitrator. The award may be entered in any court having jurisdiction.

12. Amendments in Writing. No amendment, modification, waiver, termination or discharge of any provision of this Agreement, nor consent to any departure by either party, shall in any event be effective unless the same shall be in writing, specifically identifying this Agreement and the provision intended to be amended, modified, waived, terminated, or discharged and assigned by Company and Executive. Each such amendment, modification, waiver, termination, or discharge shall be effective only in the specific instance and for the specific purpose for which given. No provision of this Agreement shall be varied, contradicted, or explained by any oral agreement, course of dealing or performance or any other matter not set forth in agreement in writing and signed by Company and Executive.

13. Notices. Any notice required or desired to be given hereunder shall be in writing and shall be deemed sufficiently given when delivered or when mailed by first class certified or registered mail, postage prepaid, to the party for whom intended at the following address:

To the Company:

Dr. Bruce L. A. Carter

President and CEO

ZymoGenetics, Inc.

1201 Eastlake Avenue East

Seattle, WA 98102

-9-

To the Executive:

Vaughn B. Himes

Senior Vice President, Technical Operations

650 Mt. Olympus Drive SW

Issaquah, WA 98027

or to such other address, as to either party, as such party shall from time to time designate by like notice to the other.

14. Entire Agreement. This Agreement will, upon the commencement of the Term of Employment, supersede all prior agreements between the Executive and the Company, except the Employee Inventions and Proprietary Information Agreement dated October 15, 2005, and any such prior agreements and the terms and conditions thereof shall hereafter be null, void and of no effect.

15. Governing Law. This Agreement is made under and shall be governed by and construed in accordance with the internal laws of the State of Washington.

16. Severability. If any provision of this Agreement shall be held invalid, illegal or unenforceable in any jurisdiction, for any reason, including without limitation, the duration of such provision, its geographical scope or the extent of the activities prohibited or required by it, then, to the full extent permitted by law (a) all other provisions hereof shall remain in full force and effect and such jurisdiction shall be liberally construed in order to carry out the intent of the parties as nearly as may be possible, (b) such invalidity, illegality, or unenforcability shall not effect the validity, legality or enforceability of any other provision, and (c) any court or arbitrator having jurisdiction there over shall have the power to reform such provision to the extent necessary for such provision to be enforceable under applicable law.

17. Multiple Copies. This Agreement may be executed in two or more counterparts of like tenor and effect, each of which shall be deemed an original but all of which together shall constitute one and the same instrument.

-10-

ZYMOGENETICS, INC.
By:	/s/ Bruce L.A. Carter
Dr. Bruce L. A. Carter, President, CEO and Chairman

EXECUTIVE:

/s/ Vaughn B. Himes

Vaughn B. Himes

-11-

EX-10.2

Exhibit 10.2

EMPLOYMENT AGREEMENT

This AGREEMENT, dated May 1, 2006, is between ZymoGenetics, Inc., a Washington corporation (“Company”) and Michael J. Dwyer (“Executive”).

1. Employment. Company will employ Executive and Executive will accept employment as Senior Vice President, Marketing & Sales, of the Company. Executive accepts employment upon the terms and conditions contained in this Agreement and for the period (hereinafter called the “Term of Employment”) specified in Section 3 below.

2. Duties. Executive shall, during the Term of Employment, serve the Company under the direction of the President of the Company. Executive shall perform the duties of his position faithfully, diligently and competently and to the best of his ability, and shall devote his full business time to his employment. Executive shall perform such other duties as are assigned to him by the President or the Board of Directors of the Company. Executive may devote reasonable periods of time to (a) engaging in personal investment activities, (b) serving on the Board of Directors of other corporations with the consent of the Compensation Committee of the Board, if such service would not otherwise be prohibited by Section 7 hereof, and (c) engaging in charitable or community service activities, so long as none of the foregoing additional activities materially interfere with Executive’s duties under this Agreement.

3. Term of Employment; Termination.

Executive’s Term of Employment shall be two years from the date of this Agreement, unless extended or earlier terminated as provided below.

(a) Termination or Extension of Term of Employment By Company

The Company shall employ Executive, for a period commencing on the date hereof and terminating as follows:

(i) Two years from the date hereof, if at least thirty (30) days prior to such date either the Company or Executive has, at its election, notified the other in writing that this Agreement shall terminate on such date. If notice of termination is not given, this Agreement shall be deemed to extend from year to year. It can then be terminated by written notice at least thirty (30) days prior to the annual renewal date.

(ii) With or without “Cause” (as defined below), Company may terminate the employment of Executive at any time upon giving “Notice of Termination” (as defined below).

(b) By Executive

Executive may terminate his employment at any time, for any reason, upon giving Notice of Termination.

(c) Automatic Termination

This Agreement and Executive’s employment hereunder shall terminate automatically upon the death or total disability of Executive. The term “total disability” as used herein shall mean Executive’s inability to perform the duties set forth in paragraph 1 hereof for a period or periods aggregating ninety (90) calendar days in any 12-month period as a result of physical or mental illness, loss of legal capacity or any other cause beyond Executive’s control, unless Executive is granted a leave of absence by the Board of Directors of Company. Executive and Company hereby acknowledge that Executive’s ability to perform the duties specified in paragraph 2 hereof is of the essence of this Agreement. Termination hereunder shall be deemed to be effective (a) at the end of the calendar month in which Executive’s death occurs or (b) immediately upon a determination by the Board of Directors of Company of Executive’s total disability, as defined herein.

(d) Notice

The term “Notice of Termination” shall mean at least thirty (30) days’ written notice of termination, by either party, of Executive’s employment, during which period Executive’s employment and performance of services will continue; provided, however, that Company may, upon notice to Executive and without reducing Executive’s compensation during such period, excuse Executive from any or all of his duties during such period. Such a reduction in duties shall not constitute “good reason” for voluntary termination so as to trigger termination payments in accordance with subparagraph 4.2. The effective date of the termination (the “Termination Date”) of Executive’s employment hereunder shall be the date on which such 30-day period expires.

4. Termination Payments

In the event of termination of the employment of Executive, all compensation and benefits set forth in this Agreement shall terminate except as specifically provided in this paragraph 4:

4.1 Termination by Company

(a) Upon termination by Company, Company shall pay Executive any unpaid annual base salary which has accrued for services already performed as of the Termination Date.

-2-

(b) If Company terminates Executive’s employment without Cause, as defined below, Executive shall be entitled to receive termination payments equal to twelve (12) months annual base salary. The termination payments shall be calculated according to Executive’s base salary as of the date of Notice of Termination and the termination payments will be paid semi-monthly in equal parts in accordance with the same time schedule that Company or a “Successor Company” (as defined in the Stock Option Agreement and incorporated by reference herein) makes its customary payroll. Company or a Successor Company may deduct customary withholdings including social security, federal and state income taxes, and state disability insurance from these severance payments; however, any and all such obligations shall be Executive’s responsibility. Company will issue and file appropriate Form 1099 or similar tax documents in connection with any termination payments. The termination payments described in this paragraph are expressly contingent upon Executive’s full compliance with the terms of his Employee Inventions and Proprietary Information Agreement with Company (the “Inventions Agreement”), a copy of which is attached hereto. In the event Executive were to materially breach this Inventions Agreement, his right to any termination payments under this paragraph shall be extinguished, Company (and any Successor Company) shall cease payments, and Executive shall immediately return to Company or to any Successor Company any severance payments already made. If Executive is terminated by either Company or any Successor Company for Cause, Executive shall not be entitled to receive any of the foregoing benefits, other than those set forth in clause (a) above.

4.2 Termination by Executive

In the case of the termination of Executive’s employment by Executive for “good reason,” as defined below, Executive shall be entitled to the termination payments as set forth in clauses 4.1(a) and (b). In the case of termination of Executive’s employment by Executive for any other reason, Executive shall not be entitled to any termination payments or accelerated vesting benefit, other than as set forth in clause 4.1(a), above.

4.3 Termination as a Result of Death or Total Disability

In the event of termination of Executive’s employment pursuant to subparagraph 3(c), Executive or his estate shall be paid the compensation set forth in clause 4.1(a) and shall not be entitled to any of the benefits under clauses 4.1(b).

4.4 “Good Reason”

“Good reason” shall mean the occurrence of any of the following events, without the consent of the Executive:

a) a demotion or other material reduction in the nature or status of Executive’s responsibilities; provided, however, that a change in the person or office to

-3-

which Executive reports, without a corresponding reduction in duties, status and responsibilities, shall not constitute “good reason;”

b) a non-voluntary reduction in the Executive’s annual base salary;

c) requirement by a Successor Company that the Executive relocate his principal place of employment to a location that is more than 50 miles from the principal place of employment where Executive was employed; or

d) the failure of Company to obtain a satisfactory agreement from any Successor Company to assume and perform the obligations under this Agreement within thirty (30) calendar days after the consummation of a merger, consolidation, sale or similar transaction;

e) following a Change in Control (as defined in subsection 4.6 hereof), the Executive ceases to hold the position of Senior Vice President, Marketing & Sales of the parent or combined entity resulting from such Change in Control; or

f) even if there is no Change in Control, but the Company enters into a merger, partnership or similar transaction, which results in a person other than the Executive becoming Senior Vice President, Marketing & Sales of the new combined entity.

4.5 Cause

Wherever reference is made in this Agreement to termination being with or without Cause, “Cause” shall include, without limitation, the occurrence of one or more of the following events:

a) willful misconduct, insubordination, or dishonesty in the performance of Executive’s duties or other knowing and material violation of Company’s or a Successor Company’s policies and procedures in effect from time to time which results in a material adverse effect on Company or a Successor Company;

b) willful actions (or intentional failures to act) in bad faith by Executive with respect to Company or a Successor Company that materially impair Company’s or a Successor Company’s business, goodwill or reputation;

c) conviction of Executive of a felony involving an act of dishonesty, moral turpitude, deceit or fraud, or the commission of acts that could reasonably be expected to result in such a conviction; or

d) any material violation by Executive of Executive’s Inventions Agreement with Company.

-4-

4.6 Change in Control

As used herein, a “Change in Control” shall mean:

a) The acquisition by any individual, entity or group (within the meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) (a “Person”), other than any one or more Series B Investor (as defined in the ZymoGenetics Series B Preferred Stock Purchase Agreement October 20, 2000), either directly or indirectly through one or more affiliated entities (collectively “Series B Purchasers”), of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 50% or more of either (x) the then outstanding shares of common stock of the Company (the “Outstanding Company Common Stock”) or (y) the combined voting power of the then outstanding voting securities of the Company entitled to vote generally in the election of directors (the “Outstanding Company Voting Securities”); provided, however, that for purposes of this subsection 4.6(a), the following acquisitions shall not constitute a Change in Control: (A) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Company or (B) any acquisition by any corporation pursuant to a transaction which complies with clauses (A), (B), and (C) of subsection 4.6(b); or

b) Consummation of a reorganization, merger or consolidation or sale or other disposition of all or substantially all of the assets of the Company (a “Business Combination”), in each case, unless, following such Business Combination: (A) all or substantially all of the individuals and entities who were the beneficial owners, respectively, of the Outstanding Company Common Stock and Outstanding Company Voting Securities immediately prior to such Business Combination beneficially own, directly or indirectly, more than 50% of, respectively, the then outstanding shares of common stock and the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Company or all or substantially all of the Company’s assets either directly or through one or more subsidiaries), (B) no Person (excluding (1) any one or more Series B Purchasers, (2) any corporation resulting from such Business Combination, or (3) any employee benefit plan (or related trust) of the Company or such corporation resulting from such Business Combination) beneficially owns, directly or indirectly, 50% or more of, respectively, the then outstanding shares of common stock of the corporation resulting from such Business Combination or the combined voting power of the then outstanding voting securities of such corporation except to the extent that such ownership existed prior to the Business Combination and (C) at least a majority of the members of the board of directors of the corporation resulting from such

-5-

Business Combination were members of the incumbent board of the Company at the time of the execution of the initial agreement, or of the action of the Board, providing for such Business Combination; or

c) Approval by the shareholders of the Company of a complete liquidation or dissolution of the Company.

5. Compensation and Fringe Benefits.

(a) The Company shall, during the Term of Employment, pay to the Executive as compensation for the performance of his duties and obligations a salary of $275,000 per annum. This compensation is subject to annual review and adjustment, as appropriate in the judgment of the Company. The compensation payable pursuant to this Section 5(a) shall be payable in equal semi-monthly installments on the last day of each such pay period.

(b) The Executive shall be enrolled and participate in any retirement, group insurance and other fringe benefit plans and arrangements which are applicable to the similarly situated personnel of the Company and in effect from time to time, if the Executive is eligible therefor, in each case in accordance with and subject to the provisions thereof.

(c) Stock Options

(i) Executive has been granted a ten-year stock option under the Company’s 2001 Stock Incentive Plan which allows Executive to purchase 200,000 shares of the Company’s common stock.

(ii) Executive shall be eligible to receive future grants of stock options pursuant to the Company’s stock-based bonus program;

(iii) Executive shall be eligible to receive future periodic (i.e., non bonus-related) grants under the Company’s stock incentive programs; and

(iv) If Executive’s employment is terminated on or after a Change in Control (as defined in subsection 4.6 above), Executive’s stock options, restricted stock and performance shares shall fully vest on the date of termination.

(d) Executive will also receive the following executive perquisites for the duration of this contract:

(i) Company-paid term life insurance policy in the amount of $200,000; and

(ii) Company-paid use of either a laptop computer or personal computer, to be upgraded biennially at the time this contract is renewed; and

-6-

(iii) Company-paid annual executive health physical, to be administered by a physician selected by the Company; and

(iv) Company-paid expenses for a residential phone and cellular phone.

6. Expenses. All travel and other reasonable expenses incident to the rendering of service by the Executive hereunder will be paid by the Company. If such expenses are paid in the first instance by the Executive, the Company will reimburse him upon presentation of proper expense accounts. Reimbursement requests, along with supporting documentation, should be submitted within sixty (60) days of incurring the expense.

7. Non-competition.

(a) Upon termination of Executive’s employment with the Company for any reason, and for a period of twelve (12) consecutive months after leaving his employment with the Company, Executive will not directly or indirectly work or otherwise engage in research, manufacture, sale or distribution of any product, method or matter:

(i) For any business, whose commercial efforts are in competition with the products manufactured or marketed by the Company during Executive’s employment with the Company or under research or development by the Company during Executive’s employment with the Company (and on which the Company has expended at least $500,000); or

(ii) For any research institution whose research efforts pertain to the same products manufactured or marketed by the Company during Executive’s employment with the Company or under research or development by the Company during Executive’s employment with the Company (and on which the Company has expended at least $500,000), unless the Executive is not involved in any manner in the design, conduct or supervision of such research efforts, or unless such research is being conducted solely for scientific and not for commercial purposes. The executive shall be deemed to be connected with a business if such business is carried on by partnership in which he is a general or limited partner, consultant or employee, or a corporation or association of which he is a shareholder, officer, director, employee, member, consultant or agent; provided, that nothing herein shall prevent the purchase or ownership by the Executive of shares of less than 1% of the outstanding shares in a publicly or privately held corporation.

Said twelve (12) months’ period shall commence on the day on which the Executive actually leaves his employment with the Company, even if this date is prior to the expiration of any given notice of termination.

-7-

(b) The Company’s Board of Directors may, at its own discretion, by express or written consent, release the Executive from the restriction in paragraph 6(a).

(c) For a period of one (1) year after the employment of the Executive is terminated for any reason, Executive will not directly or indirectly, either for Executive’s account or as representative or agent for any other person, firm, corporation or entity, solicit the services of, or entice away, any Executive of the Company, or the Executive of any company affiliated with the Company.

(d) In the event that Executive during said period described in paragraph 6(a) violates any of the Executive’s obligations towards the Company, including but not limited to the Executive accepting a position with a competing enterprise or Executive violating terms of paragraph 6(c), payment of Severance or Salary Continuation shall cease automatically without notice, regardless of whether the Company takes legal action or otherwise tries to enforce its rights. The Company reserves all rights it may have under contract or law to relief or damages in addition to termination of the above-described payments.

8. Binding Effect. This Agreement shall be binding upon and inure to the benefit of the Company and the Executive and their respective heirs, legal or personal representatives, successors and assigns.

9. Rights of Assignment or Delegation. This Agreement is personal to the Executive and shall not be assignable. Company may assign its rights hereunder to (a) any corporation resulting from any merger, consolidation, or other reorganization to which Company is a party or (b) any corporation, partnership, association, or other person to which Company may transfer all or substantially all of the assets in business of Company existing at such time. All the terms and provisions of this Agreement shall be binding upon and shall inure to the benefit and be enforceable by the parties hereto and their respective successors and permitted assigns.

10. Waiver. No delay or failure by any party in exercising, protecting or enforcing any of its rights, titles, interests, or remedies hereunder and no course of dealing or performance with respect thereto, shall constitute a waiver. The express waiver by a party of any right, title, interest, or remedy in a particular instance or circumstance shall not constitute a waiver in any other instance or circumstance. All rights and remedies shall be cumulative and not exclusive or any rights or remedies.

11. Arbitration. Any controversies or claims arising out of or relating to this Agreement shall be finally and fully settled by arbitration of the City of Seattle, Washington in accordance with the Employment Arbitration Rules of the American Arbitration Association then in effect (the “AAA Rules”), conducted by one arbitrator, mutually agreed upon by Company and Executive or chosen in accordance with the AAA Rules, except the parties thereto shall have any right to discovery would be

-8-

permitted by the Federal Rules of Civil Procedure for a period of 90 days following the commencement of such arbitration and the arbitrator shall resolve any dispute which arises in connection with such discovery. The prevailing parties shall be entitled to costs, expenses, reasonable attorneys’ fees, and judgment upon the award rendered by the arbitrator. The award may be entered in any court having jurisdiction.

12. Amendments in Writing. No amendment, modification, waiver, termination or discharge of any provision of this Agreement, nor consent to any departure by either party, shall in any event be effective unless the same shall be in writing, specifically identifying this Agreement and the provision intended to be amended, modified, waived, terminated, or discharged and assigned by Company and Executive. Each such amendment, modification, waiver, termination, or discharge shall be effective only in the specific instance and for the specific purpose for which given. No provision of this Agreement shall be varied, contradicted, or explained by any oral agreement, course of dealing or performance or any other matter not set forth in agreement in writing and signed by Company and Executive.

13. Notices. Any notice required or desired to be given hereunder shall be in writing and shall be deemed sufficiently given when delivered or when mailed by first class certified or registered mail, postage prepaid, to the party for whom intended at the following address:

To the Company:

Dr. Bruce L. A. Carter

President and CEO

ZymoGenetics, Inc.

1201 Eastlake Avenue East

Seattle, WA 98102

-9-

To the Executive:

Michael J. Dwyer

Senior Vice President, Marketing & Sales

82 Oxford Place

Hillsborough, NJ 08844

or to such other address, as to either party, as such party shall from time to time designate by like notice to the other.

14. Entire Agreement. This Agreement will, upon the commencement of the Term of Employment, supersede all prior agreements between the Executive and the Company, except the Employee Inventions and Proprietary Information Agreement dated May 2, 2006, and any such prior agreements and the terms and conditions thereof shall hereafter be null, void and of no effect.

15. Governing Law. This Agreement is made under and shall be governed by and construed in accordance with the internal laws of the State of Washington.

16. Severability. If any provision of this Agreement shall be held invalid, illegal or unenforceable in any jurisdiction, for any reason, including without limitation, the duration of such provision, its geographical scope or the extent of the activities prohibited or required by it, then, to the full extent permitted by law (a) all other provisions hereof shall remain in full force and effect and such jurisdiction shall be liberally construed in order to carry out the intent of the parties as nearly as may be possible, (b) such invalidity, illegality, or unenforceability shall not effect the validity, legality or enforceability of any other provision, and (c) any court or arbitrator having jurisdiction there over shall have the power to reform such provision to the extent necessary for such provision to be enforceable under applicable law.

17. Multiple Copies. This Agreement may be executed in two or more counterparts of like tenor and effect, each of which shall be deemed an original but all of which together shall constitute one and the same instrument.

-10-

ZYMOGENETICS, INC.
By:	/s/ Bruce L.A. Carter
	Dr. Bruce L.A. Carter, President, CEO and Chairman

EXECUTIVE:

/s/ Michael J. Dwyer

Michael J. Dwyer

-11-

EX-31.1

Exhibit 31.1

CERTIFICATIONS

I, Bruce L.A. Carter, certify that:

1. I have reviewed this report on Form 10-Q of ZymoGenetics, Inc. (the “Company”);

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this report;

4. The Company’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Company and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the Company’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter (the Company’s fourth fiscal quarter in the case of the annual report) that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting; and

5. The Company’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Company’s auditors and the audit committee of the Company’s board of directors (or persons performing the equivalent function):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Company’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Company’s internal control over financial reporting.

Date: August 3, 2006

/s/ BRUCE L.A. CARTER

President and CEO

EX-31.2

Exhibit 31.2

CERTIFICATIONS

I, James A. Johnson, certify that:

1. I have reviewed this report on Form 10-Q of ZymoGenetics, Inc. (the “Company”);

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this report;

4. The Company’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Company and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the Company’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter (the Company’s fourth fiscal quarter in the case of the annual report) that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting; and

5. The Company’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Company’s auditors and the audit committee of the Company’s board of directors (or persons performing the equivalent function):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Company’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Company’s internal control over financial reporting.

Date: August 3, 2006

/s/ JAMES A. JOHNSON

Senior Vice President and Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO SECTION 906

OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Report of ZymoGenetics, Inc. (the “Company”) on Form 10-Q for the period ended June 30, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Form 10-Q”), I, Bruce L.A. Carter, Chief Executive Officer and James A. Johnson, Chief Financial Officer, of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Form 10-Q fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C 78m or 78o(d)); and

(2) The information contained in the Form 10-Q fairly presents, in all material respects, the financial condition and results of operations of the Company.

Dated: August 3, 2006

/s/ Bruce L.A. Carter

Bruce L.A. Carter

Chief Executive Officer

/s/ James A. Johnson

James A. Johnson

Chief Financial Officer