UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the Quarterly Period Ended September 30, 2005.

	OR

o	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: 0-497

Lipid Sciences, Inc.

(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of incorporation or organization)

43-0433090
(I.R.S. Employer Identification No.)

7068 Koll Center Parkway, Suite 401, Pleasanton, California 94566
(Address of principal executive offices) (Zip Code)

(925) 249-4000
(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 (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý

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

Class		Shares outstanding at October 31, 2005
Common Stock $0.001 par value		27,359,267

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Lipid Sciences, Inc.

(A Development Stage Company)

Condensed Consolidated Balance Sheet (Unaudited)

(In thousands, except share amounts)	September 30, 2005			December 31, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	11,354		$	4,640
Short-term investments	6,925			12,414
Prepaid expenses	135			313
Restricted cash	—			105
Other current assets	11			11
Assets held for sale	—			1,167
Total current assets	18,425			18,650
Property and equipment	428			436
Long-term lease deposits	19			—
Total assets	$	18,872		$	19,086
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued liabilities	$	2,344		$	863
Accrued related party royalties	125			750
Accrued compensation	362			542
Other current liabilities	7			20
Total current liabilities	2,838			2,175
Deferred rent	6			—
Total liabilities	2,844			2,175

Commitments and contingencies (Note 7)
Stockholders’ equity:
Preferred stock, $0.001 par value; 10,000,000 shares authorized and issuable; no shares outstanding	—			—
Common stock, $0.001 par value; 75,000,000 shares authorized; 27,359,267 and 24,912,263 shares issued and outstanding at September 30, 2005 and December 31, 2004, respectively	27			25
Additional paid-in capital	76,676			69,953
Deficit accumulated in the development stage	(60,675		)	(53,067		)
Total stockholders’ equity	16,028			16,911
Total liabilities and stockholders’ equity	$	18,872		$	19,086

See accompanying Notes to Condensed Consolidated Financial Statements

Lipid Sciences, Inc.

(A Development Stage Company)

Condensed Consolidated Statements of Operations (Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,						Period from Inception (May 21, 1999) to September 30,
(In thousands, except per share amounts)	2005			2004			2005			2004			2005

Grant Revenue	$	—		$	—		$	1		$	—		$	33
Operating expenses:
Research and development	1,787			2,262			5,282			6,744			50,361
Selling, general and administrative	908			927			2,617			2,848			22,172
Total operating expenses	2,695			3,189			7,899			9,592			72,533
Operating loss	(2,695		)	(3,189		)	(7,898		)	(9,592		)	(72,500		)
Interest and other income	101			71			290			283			3,418
Loss from continuing operations	(2,594		)	(3,118		)	(7,608		)	(9,309		)	(69,082		)
Income tax benefit	—			2			—			2			8,004
Net loss from continuing operations	(2,594		)	(3,116		)	(7,608		)	(9,307		)	(61,078		)
Discontinued operations:
Income/(loss) from discontinued operations	—			(107		)	—			(121		)	582
Income tax expense	—			—			—			—			(179		)
Income/(loss) from discontinued operations - net	—			(107		)	—			(121		)	403
Net loss	$	(2,594	)	$	(3,223	)	$	(7,608	)	$	(9,428	)	$	(60,675	)
Loss per share — basic and diluted:
Net loss per share continuing operations	$	(0.10	)	$	(0.13	)	$	(0.31	)	$	(0.38	)
Net loss per share discontinued operations	$	0.00		$	0.00		$	0.00		$	0.00
Net loss per share	$	(0.10	)	$	(0.13	)	$	(0.31	)	$	(0.38	)
Weighted average number of common shares outstanding — basic and diluted	24,925			24,679			24,919			24,592

See accompanying Notes to Condensed Consolidated Financial Statements

Lipid Sciences, Inc.

(A Development Stage Company)

Condensed Consolidated Statements of Cash Flows (Unaudited)

	Nine Months Ended September 30,						Period from Inception (May 21, 1999) to September 30,
(In thousands)	2005			2004			2005
Cash flows used in operating activities:
Net loss from continuing operations	$	(7,608	)	$	(9,307	)	$	(61,078	)
Adjustments to reconcile net loss from continuing operations to net cash used in operating activities:
Depreciation and amortization	168			242			1,128
Loss on disposal of assets	2			—			205
Accretion of discount on investments	(206		)	(94		)	(488		)
Stock compensation expense for options issued to consultants and advisors	100			1,684			6,078
Issuance of warrants to consultants	—			—			1,044
Changes in operating assets and liabilities:
Prepaid expenses and other current assets	178			337			(146		)
Notes receivable	—			5,513			6,569
Other assets	(19		)	—			(19		)
Income taxes	—			(18		)	—
Accounts payable and other current liabilities	1,468			(538		)	301
Accrued related party royalties	(625		)	375			125
Accrued compensation	(180		)	(7		)	362
Deferred rent	6			(8		)	6
Net cash used in operating activities of continuing operations	(6,716		)	(1,821		)	(45,913		)

Cash flows provided by/(used in) investing activities:
Capital expenditures	(165		)	(63		)	(1,778		)
Restricted cash	105			213			—
Proceeds from disposal of assets	3			—			17
Purchases of investments	(10,305		)	(13,333		)	(78,723		)
Maturities and sales of investments	16,000			8,000			72,286
Net cash provided by/(used in) investing activities of continuing operations	5,638			(5,183		)	(8,198		)

Cash flows provided by financing activities:
Acquisition of NZ Corporation — cash acquired	—			—			20,666
Payment of acquisition costs	—			—			(1,863		)
Payment to repurchase stock	—			—			(12,513		)
Proceeds from sale of common stock, net of issuance costs	6,625			304			25,014
Proceeds from issuance of warrants	—			—			40
Net cash provided by financing activities of continuing operations	6,625			304			31,344
Net increase/(decrease) in cash and cash equivalents from continuing operations	5,547			(6,700		)	(22,767		)
Cash flows provided by discontinued operations:
Operating activities	1,167			6,392			38,192
Investing activities	—			—			10,837
Financing activities	—			—			(14,908		)
Net cash provided by discontinued operations	1,167			6,392			34,121
Cash and cash equivalents at beginning of period	4,640			4,905			—
Cash and cash equivalents at end of period	$	11,354		$	4,597		$	11,354

Lipid Sciences, Inc.

(A Development Stage Company)

Condensed Consolidated Statements of Cash Flows (Unaudited) — (Continued)

	Nine Months Ended September 30,				Period from Inception (May 21, 1999) to September 30,
(In thousands)	2005		2004		2005
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest (net of amount capitalized)	$	—	$	—	$	839
Income tax paid/(recovered)	—		—		(1,473		)

SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING TRANSACTIONS
Acquisition of NZ Corporation:
Current assets (other than cash)	$	—	$	—	$	1,040
Property and equipment	—		—		30,193
Commercial real estate loans	—		—		16,335
Notes and receivables	—		—		15,166
Investments in joint ventures	—		—		2,343
Current liabilities assumed	—		—		(1,947		)
Long-term debt assumed	—		—		(14,908		)
Deferred taxes associated with the acquisition	—		—		(7,936		)
Fair value of assets acquired (other than cash)	$	—	$	—	$	40,286

SUPPLEMENTAL DISCLOSURES OF NON-CASH FINANCING TRANSACTIONS
Accrued acquisition costs	$	603	$	—	$	603

See accompanying Notes to Condensed Consolidated Financial Statements

Lipid Sciences, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

NOTE 1: ORGANIZATION AND BASIS OF PRESENTATION

On November 29, 2001, Lipid Sciences, Inc., a privately-held corporation, merged with and into NZ Corporation. NZ Corporation survived the merger and changed its name to Lipid Sciences, Inc. In this report, unless the context otherwise requires, the current company, Lipid Sciences, Inc., is referred to as “we,” “the Company” or “Lipid Sciences” with respect to periods of time from the effective date of the merger to the date of this report; the merged company, Lipid Sciences, Inc., a privately-held corporation, is referred to as “we” or “Pre-Merger Lipid” with respect to periods prior to the effective date of the merger; and NZ Corporation is referred to as “NZ,” with respect to periods prior to the effective date of the merger.

The Company is engaged in the research and development of products and processes intended to treat major medical indications such as cardiovascular disease and viral infections in which lipids, or fat components, play a key role. Our primary activities since incorporation have been conducting research and development (including pre-clinical studies); performing business, strategic and financial planning; and raising capital. Accordingly, the Company is considered to be in the development stage.

Historically, NZ engaged in various real estate and commercial real estate lending activities. On March 22, 2002, the Company formalized a plan to discontinue the operations of our real estate and real estate lending business, including commercial real estate loans, to fund the ongoing operations of Lipid Sciences’ biotechnology business. As a result, we have reclassified the results of operations and the assets and liabilities of the discontinued operations for all periods presented.

In the course of its research and development activities, the Company has sustained continued operating losses and expects those losses to continue for the foreseeable future as we continue to invest in research and development and begin to allocate significant and increasing resources to clinical testing and other activities related to seeking approval to market our products. As of September 30, 2005, we had cash and cash equivalents and short-term investments equal to approximately $18.3 million. We anticipate that these assets will provide sufficient working capital for our operations, including our current development projects, through mid-2007. We expect additional capital will be required in the future. We intend to seek capital needed to fund our operations through corporate partnerships, technology licensing, the pursuit of research and development grants or through public or private equity or debt financings.

The Condensed Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated.

The Condensed Consolidated Financial Statements presented are unaudited and in the opinion of management reflect all adjustments necessary (consisting only of normal recurring adjustments) for a fair presentation of the financial condition and results of operations as of, and for, the interim periods presented. The results for interim periods are not necessarily indicative of the results to be expected for the full year. The December 31, 2004 balance sheet, as presented, was derived from the audited Consolidated Financial Statements as of December 31, 2004. These Condensed Consolidated Financial Statements should be read in conjunction with the Company’s audited Consolidated Financial Statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 15, 2005.

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

Certain prior period amounts have been reclassified to conform to the current period’s presentation. Specifically, the Company has reclassified the presentation of Restricted Cash from an Operating Activity to an Investing Activity in the Statement of Cash flows and has reclassified the presentation of Purchases and Maturities of securities from a net presentation to a gross presentation included in the Period from Inception (May 21, 1999) to September 30, 2005 column of the Statement of Cash Flows.

NOTE 2: NET LOSS PER SHARE

The Company computes its net loss per share under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings Per Share.” Basic net loss per share is calculated by dividing net loss by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The Company had securities outstanding, which could potentially dilute basic earnings per share, but because the Company incurred a net loss for all periods presented, such securities were excluded from the computation of diluted net loss per share as their effect would have been antidilutive. The securities excluded from diluted loss per share consist of the following:

	At September 30,
	2005	2004
Stock options	6,846,377	6,221,279
Warrants to purchase common stock	2,839,565	1,036,314
	9,685,942	7,257,593

NOTE 3: STOCK COMPENSATION

The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, as interpreted by Financial Accounting Standards Board (“FASB”) Interpretation No. 44, “Accounting for Transactions Involving Stock Compensation—an Interpretation of APB Opinion No. 25” (“FIN No. 44”). The Company accounts for stock-based awards to non-employees in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” and Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”.

Had compensation expense for the Company’s employee stock option awards been determined based on the Black-Scholes fair value at the grant dates for awards under those plans consistent with the fair value method of SFAS No. 123, the Company would have recorded additional compensation expense and its net loss and loss per share (“EPS”) would have been reduced to the pro forma amounts presented in the following table:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Reported net loss	$	(2,594	)	$	(3,223	)	$	(7,608	)	$	(9,428	)
Add stock-based compensation included in net loss	(21		)	—			—			—
Compensation expense for stock options	(313		)	(249		)	(1,075		)	(1,050		)
Pro forma net loss	$	(2,928	)	$	(3,472	)	$	(8,683	)	$	(10,478	)

Net loss per share — basic and diluted:
As reported	$	(0.10	)	$	(0.13	)	$	(0.31	)	$	(0.38	)
Pro forma	$	(0.12	)	$	(0.14	)	$	(0.35	)	$	(0.43	)

Stock compensation income related to options granted to non-employees as consideration for services was $42,000 for the three-months ended September 30, 2005. Stock compensation expense related to options granted to non-employees as consideration for services was $236,000 for the three-months ended September 30, 2004. Stock compensation expense related to options granted to non-employees as consideration for services was $100,000 and $1,685,000 for the nine-months ended September 30, 2005 and 2004, respectively. The stock compensation income and decrease in stock compensation expense recognized during the three and nine month periods ended September 30, 2005 was primarily due to the absence of stock compensation charges associated with the modification of certain existing non-employee stock options to extend their expiration dates. These modifications were made in the three months ended June 30, 2004.

NOTE 4: STOCKHOLDERS’ EQUITY

On September 30, 2005, we completed the private placement of 2,430,198 shares of the Company’s common stock at a price of $2.98 per share, for an aggregate offering price of approximately $7.2 million, to institutional and accredited investors (the “Investors”). In connection with the private placement, we also issued to the Investors warrants to purchase 729,057 shares of common stock at $4.20 per share and additional investment rights (“AIRs”) in the form of warrants to purchase 1,215,096 shares of common stock at $3.73 per share. The warrants expire September 30, 2010 and the AIRs may be exercised at the option of the holders until 90 days following the effective date of a registration statement filed with the Securities and Exchange Commission registering the resale of shares of common stock issued to the Investors pursuant to the Securities Purchase Agreement, AIRs and warrants. If exercised, we have the potential to receive approximately $4,500,000 in additional gross proceeds related to the additional investment rights. Up to 607,509 additional shares of common stock are issuable as a result of potential future adjustments to the exercise price of the warrants.

As part of the transaction, we agreed to register for resale under the Securities Act all of the shares of common stock issued in the offering, as well as shares of common stock issuable upon exercise of the AIRs and warrants, within thirty calendar days following the closing date of September 30, 2005, and will use our best efforts to have it declared effective within ninety days of the closing date. We filed a Registration Statement on Form S-3 with the SEC on October 27, 2005. Under the transaction agreements, a failure to have the Registration Statement declared effective within 90 days after the closing, other than for allowed delays as defined therein, may subject us to liquidated damages equal to 1.5% of the aggregate purchase price paid (with regard to the shares of common stock issued in the offering only) for each thirty day period or part thereof, until the time that the Registration Statement is declared effective.

NOTE 5: RECENTLY ISSUED ACCOUNTING STANDARDS

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), which replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”) and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” This statement requires that compensation cost relating to share-based payment transactions be recognized in financial statements. The pro forma disclosures previously permitted under SFAS No. 123 will no longer be an alternative to financial statement recognition. This statement is effective beginning with our first quarter of fiscal 2006. We are currently evaluating the requirements of SFAS No. 123(R) and expect that the adoption of SFAS No. 123(R) may have a material impact on our consolidated results of operations and net loss per share.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3.” This statement changes the requirement for the accounting for and reporting of a change in accounting principle by requiring retroactive application of a voluntary change in accounting principle to prior period financial statements unless it is impracticable. This statement is effective beginning with our first quarter of fiscal 2006. We believe that the adoption of this statement will not have a material impact on our financial position, results of operations or cash flows.

NOTE 6: PROPERTY AND EQUIPMENT

Property and equipment are carried at cost less accumulated depreciation and amortization. Property and equipment are depreciated using the straight-line method over the estimated useful lives, generally three to five years. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful life of the asset or the remaining term of the lease. Property and equipment consist of the following (in thousands):

	September 30, 2005			December 31, 2004
Equipment	$	1,256		$	1,100
Leasehold improvements	255			255
	1,511			1,355
Less accumulated depreciation and amortization	(1,083		)	(919		)
Total property and equipment, net	$	428		$	436

NOTE 7: RELATED PARTY TRANSACTIONS

In December 1999, we entered into an Intellectual Property License Agreement to obtain the exclusive worldwide rights to certain patents, trademarks, and technology with Aruba International Pty. Ltd. (“Aruba”), an Australian company, controlled by Bill E. Cham, Ph.D., a founding stockholder of Pre-Merger Lipid and one of our former Directors. As consideration for the license, we issued Aruba 4,677,060 shares of our common stock valued at $250,000. Under this agreement, we are obligated to pay Aruba a continuing royalty on revenue in future years, subject to a minimum annual royalty amount of $500,000, 10% of any External Research Funding initiated by Dr. Cham and received by us to further this technology, as defined in the agreement, and $250,000 upon commencement of our initial human clinical trial utilizing the technology under the patents. The $250,000 related to the commencement of our initial human clinical trial was paid to Aruba in July 2002. For the three month periods ended September 30, 2005 and September 30, 2004 we have expensed $125,000 and $125,000, respectively, and for the nine month periods ended September 30, 2005 and September 30, 2004 we have expensed $375,000 and $375,000, respectively, related to this agreement. Amounts for 2005 and 2004 were charged to research and development expense. In November 2004, all rights, title, interest and obligations covered under the Intellectual Property License Agreement were assigned to Aruba International B.V., a Netherlands company controlled by Dr. Cham.

On May 16, 2005 we entered into a consulting agreement with H. Bryan Brewer, Jr., M.D., a Director of the Company, and Washington Cardiovascular Associates, LLC (“WCA”), an entity beneficially owned by Dr. Brewer, pursuant to which WCA will provide the services of Dr. Brewer as the Company’s Chief Scientific Director. Dr. Brewer was also appointed Vice Chairman of the Company’s Board of Directors on May 16, 2005, and serves as Chairman of the Company’s Scientific Advisory Board. The consulting agreement is for a three year term. As consideration for Dr. Brewer’s services as Chief Scientific Director, we are required to pay WCA annual fees of $395,000. For the three and nine months ended September 30, 2005, approximately $99,000 and $149,000, respectively, was charged to selling, general and administrative expense for fees related to the consulting agreement. In addition to the annual fee, we have granted Dr. Brewer an option award of 100,000 shares of our common stock to vest in three equal annual installments on the first, second and third anniversaries of the consulting agreement. For the three months and nine months ended September 30, 2005, approximately $25,000 and $57,000, respectively, was recorded as non-cash compensation charges related to the stock option awarded to Dr. Brewer under the consulting agreement.

During the three month period ended June 30, 2005, the Company cancelled and re-granted 411,927 options which had been issued to Dr. Brewer in his capacity as a member of the Company’s Board of Directors and as a member of the Company’s Scientific Advisory Board. As a result of this transaction, the Company recognized $21,000 in compensation expense for the three month period ended June 30, 2005 and $21,000 in compensation income for the three month period ended September 30, 2005. Both amounts were charged to selling, general and administrative expense.

NOTE 8: DISCONTINUED OPERATIONS

As a result of the merger between Pre-Merger Lipid and NZ on November 29, 2001, certain real estate assets, including commercial real estate loans, were acquired. As part of the merger, we announced our intent to conduct an orderly disposition of those assets to fund the ongoing operations of our biotechnology business. On March 22, 2002, we formalized a plan to discontinue the operations of our real estate business, including commercial real estate loans. All of those assets were included in the Real Estate segment. The plan identified the major assets to be disposed of, the method of disposal, and the period required for completion of the disposal. As a result, we have reclassified the results of operations and the assets and liabilities of the discontinued operations for all periods presented. The carrying amounts of the major classes of assets and liabilities included as part of the disposal group as of September 30, 2005 and December 31, 2004, are as follows:

(In thousands)	September 30, 2005		December 31, 2004
Current assets	$	—	$		2
Royalty credits	—		1,165
Total assets held for sale	—		1,167
Net assets held for disposal	$	—	$	1,167

In October 2004, the United States Department of the Interior, Minerals Management Service, issued the Company royalty credits in exchange for our remaining mineral rights in New Mexico. Royalty credits are used by the United States Department of the Interior for payment of royalties due under oil and gas leases located on the outer continental shelf. Based on a valuation performed at the time of the merger with NZ, zero value was recorded for these mineral rights and therefore prior to the exchange they had no carrying value. As a result of this exchange the Company recognized a gain of $1,165,000 in 2004, representing the estimated fair value of the royalty credits less the costs to sell the credits. As of December 31, 2004 the fair value of the credits was recorded in assets held for sale. In February 2005, the Company sold the royalty credits and received cash of $1,165,000. The sale of the royalty credits in February 2005 represented the final disposition of the Company’s real estate related assets.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Form 10-Q contains forward-looking statements concerning plans, objectives, goals, strategies, future events or performance as well as all other statements which are not statements of historical fact. These statements contain words such as, but not limited to, “believes,” “anticipates,” “expects,” “estimates,” “projects,” “will,” “may” and “might.” The forward-looking statements contained in this Form 10-Q reflect our current beliefs and expectations on the date of this Form 10-Q. Actual results, performance or outcomes may differ materially from what is expressed in the forward-looking statements. We have discussed the important factors, which we believe could cause actual results, performance or outcomes to differ materially from what is expressed in the forward-looking statements, under the caption “Factors That May Affect Future Results and Financial Condition.” We are not obligated to publicly announce any revisions to these forward-looking statements to reflect a change in facts or circumstances.

You should read the discussion below in conjunction with Part I, Item 1, “Financial Statements,” of this Form 10-Q and Part II, Items 7, 7A and 8, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Quantitative and Qualitative Disclosures About Market Risk” and “Financial Statements and Supplementary Data,” respectively, of our Annual Report on Form 10-K for the year ended December 31, 2004.

Overview

We are a development-stage biotechnology company engaged in research and development of products and processes intended to treat major medical indications such as cardiovascular disease and viral infections in which lipids, or fat components, play a key role. Our primary activities since incorporation have been conducting research and development (including pre-clinical studies); performing business, strategic and financial planning; and raising capital, including, from the date of the merger between NZ and Pre-Merger Lipid, disposing of Company real estate assets. Accordingly, the Company is considered to be in the development stage.

On November 29, 2001, the merger between NZ and Pre-Merger Lipid was completed. The merger with NZ was accounted for under the purchase method of accounting and was treated as a reverse acquisition because the stockholders of Pre-Merger Lipid owned the majority of the Company’s common stock immediately after the merger. Pre-Merger Lipid was considered the acquiror for accounting and financial reporting purposes. Accordingly, all financial information prior to November 29, 2001 included in this report reflects Pre-Merger Lipid results. As a result of the merger, certain real estate assets were acquired, and thus our business was organized into two segments: Biotechnology and Real Estate. On March 22, 2002, we formalized a plan to discontinue the operations of our Real Estate segment. In the first quarter of 2005, we completed the disposition of these real estate assets.

In the course of our research and development activities, we have incurred significant operating losses and we expect these losses to continue for the foreseeable future as we continue to invest in research and development and begin to allocate significant and increasing resources to clinical testing and other activities related to seeking approval to market our products.

We intend to finance our operations through public or private equity or debt financings, the pursuit of research and development grants, and cash on hand. We anticipate that existing cash, cash equivalents and short-term investments will provide sufficient working capital for our operations, including our current development projects, through mid-2007. In the longer term, we expect to additionally finance our operations through revenues from product sales and licenses, upon receiving all relevant approvals. If adequate funds are not available to satisfy our requirements we may have to substantially reduce, or eliminate, certain areas of our product development activities, significantly limit our operations, or otherwise modify our business strategy.

On July 13, 2005, we announced the completion of the data analysis phase of our HDL Therapy non-human primate study. The data showed the HDL Therapy process to be safe and well-tolerated within the study population of 12 African green monkeys. The study animals were monitored before, during and after each of 12 weekly infusions of plasma delipidated using our proprietary process and device. The data included over 3,000 assays of blood chemistry and physiological variables, such as blood pressure, heart rate, temperature, and respiration rate, collected throughout the study. No significant changes in any of the monitored variables were noted during the course of the study. The study was conducted at the Wake Forest University Baptist Medical Center in Winston-Salem, North Carolina in collaboration with Dr. Lawrence L. Rudel, Professor of Pathology, Section of Comparative Medicine (Department of Pathology) and Professor of Biochemistry at Wake Forest University. The animals were evaluated with intravascular ultrasound (“IVUS”) to establish a baseline of atheroma volume (plaque buildup) at the beginning of this study. A second IVUS was conducted at the conclusion of the sequence of 12 weekly infusions of delipidated plasma. The data was then analyzed at the Cleveland Clinic Foundation under the direction of Dr. Steven Nissen and his colleagues. Although statistical significance was not achieved for measurement of effectiveness of the therapy, the primary objective of demonstrating the safety of our product and process was achieved. The safety data gathered from this study will be a critical component of our Investigational Device Exemption (“IDE”) submission to the FDA for review and approval, prior to the planned initiation of a human clinical trial of our HDL Therapy platform. We anticipate that the submission of our IDE to the FDA, the approval of the IDE submission and the initiation of a planned human clinical trial of our HDL Therapy platform should occur during the fourth quarter of 2005 and the first quarter of 2006.

On August 8, 2005 we announced the passing of our Chairman of the Board, Richard G. Babbitt. Mr. Babbitt died unexpectedly on August 6, 2005 at the age of 79. Vice Chairman H. Bryan Brewer, Jr., M.D., and S. Lewis Meyer, Ph.D., our President and Chief Executive Officer, will perform the duties of the Chairman. Mr. Babbitt was elected to our Board of Directors and served as our Chairman since September 2002.

On September 9, 2005 we announced the completion of our exploratory investigation of the therapeutic effect of delipidated autologous virus in chronically SIV-infected rhesus macaques. Simian Immunodeficiency Virus (SIV) is a widely-accepted primate model for viral diseases like HIV. The results of this study, conducted at the Yerkes National Primate Research Center at Emory University, demonstrated that the administration of “autologous” SIV viral antigen delipidated by our proprietary delipidation process to chronically SIV-infected non-human primates led to the recognition of new epitopes of the virus by the animals’ immune system which was coincident with an improvement in the general indicators of overall health in these study animals. Statistical significance was reached both in the long-term survival of these animals as compared to a retrospective, SIV-infected, non-immunized control group, as well as a viral load reduction of approximately 90%, that was achieved for the nine months’ duration of the study follow-up period. We expect to launch a pre-clinical non-human primate study related to our Viral Immunotherapy platform by year-end 2005.

On October 3, 2005, we announced the closing of a private placement of common stock and warrants on September 30, 2005. In the transaction we issued 2,430,198 shares of common stock at $2.98 per share for gross proceeds of approximately $7,200,000. In connection with this private placement, we issued to the investors warrants to purchase 729,057 shares of common stock at $4.20 per share and additional investment rights in the form of warrants to purchase 1,215,096 shares of common stock at $3.73 per share. The additional investment rights expire ninety days after the date a registration statement is deemed effective by the Securities Exchange Commission relating to these shares of common stock, warrants and additional investment rights. On October 27, 2005 we filed a registration statement on Form S-3 covering the common stock issued pursuant to the Securities Purchase Agreement and issuable upon exercise of the warrants. See Note 4 of our Condensed Consolidated Financial Statements for further discussion of our private placement.

Results of Continuing Operations — Three Months Ended September 30, 2005 and 2004

Revenue. We have had no product revenues since our Inception (May 21, 1999). Future product revenues will depend on our ability to develop and commercialize our two primary platforms: HDL Therapy and Viral Immunotherapy.

Research and Development Expenses. Research and development expenses include applied and scientific research, regulatory and business development expenses. Research and development expenses decreased approximately $475,000, or 21%, to $1,787,000 in the three months ended September 30, 2005 from $2,262,000 for the same period in 2004. The decrease was due primarily to decreases in stock compensation expense, process development costs and costs associated with our non-human primate study at Wake Forest University Baptist Medical Center in Winston-Salem, North Carolina, which concluded in the second quarter of 2005. This decrease was partially offset by an increase in costs related to the preparation of a human clinical trial of our HDL Therapy platform, including costs associated with the selection of key development partners for device and disposable manufacture, regulatory compliance and clinical trial support.

While we allocate and track resources when required pursuant to the terms of development arrangements, our research team typically works on different platforms concurrently, and our equipment and intellectual property resources often are deployed over a range of products with a view to maximize the benefit of our investment. Accordingly, we have not, and do not intend to, separately track the costs for each of our research projects on a product-by-product basis. For the three months ended September 30, 2005, we estimate that the majority of our research and development expense was associated with our two primary platforms, HDL Therapy and Viral Immunotherapy.

Selling, General and Administrative Expenses. General and administrative expenses include costs associated with our business operations, inclusive of management, legal and finance, and accounting expenses. General and administrative expenses decreased approximately $19,000, or 2%, to $908,000 in the three months ended September 30, 2005 from $927,000 for the same period in 2004. The decrease was due primarily to a reduction in stock compensation expense as a result of the full amortization in 2004 of stock options issued to certain consultants. This decrease was partially offset by an increase in expenses related to our ongoing efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002.

Interest and Other Income. Interest and other income for the three months ended September 30, 2005 increased approximately $30,000, or 42%, to $101,000 from $71,000 for the same period in 2004. The increase was due to higher yields earned on both our cash and short-term investment assets during the three months ended September 30, 2005.

Results of Continuing Operations — Nine Months Ended September 30, 2005 and 2004

Revenue. We recognized $1,000 in grant revenue in the nine months ended September 30, 2005. This grant revenue relates to the Small Business Technology Transfer (“STTR”) grant awarded in the second quarter of 2004 by the National Institutes of Health (“NIH”), for a Virion Solvent Treatment for Severe Acute Respiratory Syndrome.

We have had no product revenues since our Inception (May 21, 1999). Future product revenues will depend on our ability to develop and commercialize our two primary platforms for the treatment of cardiovascular disease (HDL Therapy) and viral infections (Viral Immunotherapy).

Research and Development Expenses. Research and development expenses decreased approximately $1,462,000, or 22%, to $5,282,000 for the nine month period ended September 30, 2005 from $6,744,000 for the same period in 2004. The decrease was due primarily to a $1,188,000 decrease in stock compensation expense and a decrease in process development costs and costs associated with our non-human primate study at Wake Forest University Baptist Medical Center in Winston-Salem, North Carolina, which concluded in the second quarter of 2005. This decrease was partially offset by an increase in costs associated with our Viral Immunotherapy platform and an increase in costs related to the preparation of a human clinical trial of our HDL Therapy platform, including costs associated with the selection of key development partners for device and disposable manufacture, regulatory compliance and clinical trial support. During the nine months ended September 30, 2004, $855,000 was charged to research and development as a result of the modification of our Scientific Advisory Board members’ option agreements in 2004. Research and development expenses accounted for approximately 67% of total operating expenses for the nine months ended September 30, 2005.

Selling, General and Administrative Expenses. General and administrative expenses decreased approximately $231,000, or 8%, to $2,617,000 for the nine month period ended September 30, 2005 from $2,848,000 for the same period in 2004. The decrease was due primarily to a reduction in stock compensation expense as a result of the full amortization in 2004 of stock options issued to certain consultants and reduced facility related expenses as a result of the renegotiation and extension of our facility lease in Pleasanton, CA. This decrease was partially offset by an increase in expenses related to our ongoing efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002.

Interest and Other Income. Interest and other income for the nine month period ended September 30, 2005 increased approximately $7,000, or 2%, to $290,000 from $283,000 for the same period in 2004. The increase was due primarily to higher yields earned on both our cash and short-term investment assets during the nine months ended September 30, 2005. This increase was partially offset by the absence of interest income generated from two notes receivable, which were paid off in May 2004.

Results of Discontinued Operations — Three and Nine Months Ended September 30, 2005 and 2004

During the three and nine months ended September 30, 2005, the Company recorded no income or loss from discontinued operations. This compares with a loss of $107,000 and $121,000 recorded in the three and nine month periods ended September 30, 2004, respectively. As of December 31, 2004, all real estate assets acquired in the merger between NZ and Pre-Merger Lipid had been disposed of, and therefore we did not have any income or loss to report for discontinued operations for the three or nine month periods ended September 30, 2005.

Liquidity and Capital Resources

The net cash used in operating activities was approximately $6,716,000 for the nine months ended September 30, 2005, resulting primarily from operating losses incurred as adjusted for non-cash compensation charges. Partially offsetting the operating loss was a net increase in accounts payable, primarily related to accrued costs and invoices received for various pre-clinical studies and offering costs related to the closing of our private placement of common stock and warrants on September 30, 2005. The net cash used in operating activities for the nine months ended September 30, 2004, was approximately $1,821,000, resulting from operating losses incurred, as adjusted for non-cash stock compensation charges, and offset by the early payoff of two notes receivable.

The net cash provided by investing activities was approximately $5,638,000 for the nine months ended September 30, 2005 and the net cash used in investing activities was approximately $5,183,000 for the nine months ended September 30, 2004. The net cash provided and used by investing activities for these periods was primarily attributable to the purchase and subsequent maturities of short-term investments.

The net cash provided by financing activities was approximately $6,625,000 and $304,000 for the nine month periods ended September 30, 2005 and September 30, 2004, respectively. The net cash provided by financing activities for the nine month period ended September 30, 2005 was attributable to the proceeds, net of issuance costs, received from the private placement of common stock on September 30, 2005 and the proceeds received from the exercise of options of our common stock. The net cash provided by financing activities for the nine month period ended September 30, 2004 was attributable to the proceeds received from the exercise of options and warrants of our common stock.

Net cash provided by discontinued operations was approximately $1,167,000 and $6,392,000 for the nine month periods ended September 30, 2005 and September 30, 2004, respectively. The net cash provided by discontinued operations in the nine month period ended September 30, 2005 was primarily attributable to the sale of royalty credits in February 2005, representing the disposition of our last remaining real estate assets. The net cash provided by discontinued operations in the nine month period ended September 30, 2004 was primarily due to the sale of real estate assets and collection of principal payments on notes receivable.

In December 1999, we entered into an Intellectual Property License Agreement to obtain the exclusive worldwide rights to certain patents, trademarks, and technology with Aruba International Pty. Ltd., an Australian company, controlled by Bill E. Cham, Ph.D., a founding stockholder of Pre-Merger Lipid and one of our former Directors. As consideration for the license, we issued Aruba 4,677,060 shares of our common stock valued at $250,000. Under this agreement, we are obligated to pay Aruba a continuing royalty on revenue in future years, subject to a minimum annual royalty amount of $500,000, 10% of any External Research Funding initiated by Dr. Cham and received by us to further this technology, as defined in the agreement, and $250,000 upon commencement of our initial human clinical trial utilizing the technology under the patents. The $250,000 related to the commencement of our initial human clinical trial was paid to Aruba in July 2002. In November 2004, all rights, title, interest and obligations covered under the Intellectual Property License Agreement were assigned to Aruba International B.V., a Netherlands company, controlled by Dr. Cham.

In May 2000, we sold a total of 4,925,300 shares of our common stock at $2.25 per share in a private placement to accredited investors. Net cash proceeds, after expenses of the placement, were approximately $11,000,000.

In March 2001, we closed a private placement of 1,375,282 shares of common stock at $4.49 per share for gross proceeds of $6,175,000. In connection with the private placement, we paid a commission to MDB Capital Group, LLC of approximately 7% of the gross proceeds, payable in shares of common stock, for services rendered in the private placement. Accordingly, 95,491 shares of common stock at $4.49 per share were issued as commission for the transaction.

On November 29, 2001, we merged with and into NZ Corporation. NZ Corporation survived the merger and changed its name to Lipid Sciences, Inc. The merger with NZ resulted in the acquisition of net assets of approximately $45,000,000, net of repurchase of stock and acquisition costs.

In September 2005, we closed a private placement of 2,430,198 shares of common stock at $2.98 per share in a private placement to institutional and accredited investors for gross proceeds of approximately $7,200,000. In connection with this private placement, we issued to the investors warrants to purchase 729,057 shares of common stock at $4.20 per share and additional investment rights in the form of warrants to purchase 1,215,096 shares of common stock at $3.73 per share. Up to 607,509 additional shares of common stock are issuable as a result of potential future adjustments to the exercise price of the warrants. The additional investment rights expire ninety days after the date a registration statement is deemed effective by the Securities Exchange Commission relating to these shares of common stock, warrants and additional investment rights. If exercised, we have the potential to receive approximately $4,500,000 in additional gross proceeds related to the additional investment rights. As of September 30, 2005, we have accrued approximately $600,000 in offering costs related to the private placement.

Our principal uses of funds are expected to be the payment of operating expenses and continued research and development funding to support our HDL Therapy and Viral Immunotherapy platforms. The expected use of funds related to our HDL Therapy platform includes costs associated with the preparation and initiation of a human clinical trial. The expected use of funds related to our Viral Immunotherapy platform includes costs associated with the launch of a pre-clinical non-human primate study by year-end 2005. The results of this study could lead to the initiation of a human clinical trial for the treatment of HIV-infected patients, with approval from the FDA, or to an offshore human study in collaboration with a partner. We expect our principal sources of funds to be cash on hand. As of September 30, 2005, we had cash and cash equivalents and short-term investments equal to approximately $18,279,000. We anticipate that these assets will provide sufficient working capital for our operations, including our current development projects, through mid-2007. We expect additional capital will be needed in the future. Our Board of Directors continues to consider third-party inquiries and explore strategic initiatives, public or private equity or debt financings, the formation of strategic development or licensing partnerships, and strategic business combinations. However, there can be no assurance that funds secured from any of these efforts, if obtained, will be sufficient to meet the Company’s future cash requirements.

Contractual Obligations

Future estimated contractual obligations are:

(In thousands)	2005		2006		2007		2008		2009		2010		Total
Long-Term Debt Obligations	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Capital Lease Obligations	—		—		—		—		—		—		—
Operating Leases*	156		206		211		217		223		56		1,069
Purchase Obligations**	—		—		—		—		—		—		—
Royalty Payments***	500		500		500		500		500		500		3,000
Other Long-Term Liabilities Reflected on the Company’s Consolidated Balance Sheet	—		—		—		—		—		—		—
Total	$	656	$	706	$	711	$	717	$	723	$	556	$	4,069

*We extended our operating lease effective April 2005. The lease will terminate in March 2010.

**While the Company does have various consulting agreements, these agreements are cancelable without penalty, generally with thirty days prior written notice.

***We have agreed to pay annual royalties in the amount of $500,000 to Aruba International B.V. in exchange for the exclusive worldwide rights to certain patents, trademarks, and technology. Under certain circumstances, additional payments related to this agreement could be required in the future. The amounts presented in the above table reflect the minimum annual royalty amount payable through the next six years.

Off-Balance Sheet Arrangements

As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities of financial partnerships, such as entities often referred to as structured finance or Special Purpose Entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Critical Accounting Policies

In December 2001, the Securities and Exchange Commission (“SEC”), required that all registrants disclose and describe their “critical accounting policies” in Management’s Discussion and Analysis of Financial Condition and Results of Operations. The SEC indicated that a “critical accounting policy” is one which is both important to the portrayal of the Company’s financial condition and results of operations and requires management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. In applying those policies, our management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical experience, terms of existing contracts, our observance of trends in the industry and information available from other outside sources, as appropriate. We believe that our following accounting policies fit this definition:

Stock Compensation

The Company accounts for stock options granted to employees using the intrinsic value method in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and, thus, recognizes no compensation expense for those options granted with exercise prices equal to the fair market value of the Company’s common stock on the date of grant. As permitted, the Company has elected to adopt only the disclosure provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). The Company accounts for stock-based awards to non-employees in accordance with SFAS No. 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Significant judgment is required on the part of management in determining the proper assumptions to use in the computation of the amounts to be disclosed or recorded pursuant to the provisions of SFAS No. 123. The fair value of each option granted is estimated on the date of grant using the Black-Scholes option valuation model. The assumptions used in the Black-Scholes option valuation model include the risk free interest rate, expected life, volatility and dividend yield of the option. Management bases its assumptions on historical data where available. However, these assumptions consist of estimates of future market conditions, which are inherently uncertain, and are therefore subject to management’s judgment.

Income Taxes

The Company follows SFAS No.109, “Accounting for Income Taxes.” Under the asset and liability method of SFAS No.109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

In assessing the realizability of deferred tax assets to determine the need for any valuation allowance, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment.

The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. Our significant accounting policies are more fully described in our audited Consolidated Financial Statements and notes thereto for the year ended December 31, 2004, which appear in the Company’s Annual Report on Form 10-K filed with the SEC on March 15, 2005.

Factors That May Affect Future Results and Financial Condition

If we are unable to obtain adequate funds, we may not be able to develop and market our potential products.

For the nine months ended September 30, 2005, we incurred a net loss of approximately $7,608,000 and since Inception through September 30, 2005, we have accumulated a deficit of approximately $60,675,000. We expect to continue to incur losses for the foreseeable future as we continue funding for clinical testing and other activities related to seeking approval to market our products. Conducting clinical trials necessary to apply for regulatory approval to sell our products will take a number of years and will require significant amounts of capital.

In the near future, we will require additional capital in amounts that cannot be quantified, but are expected to be significant. We intend to seek capital needed to fund our operations through corporate partnerships, technology licensing, the pursuit of research and development grants, or public or private equity or debt financings. Additional financing may not be available on terms favorable to us, or at all. If we are unable to obtain financing on acceptable terms or at all, our ability to continue our business as planned will be significantly impaired and we may be forced to cease operations.

Our technology is only in the clinical development stage, may not prove to be safe or effective, and may never receive regulatory approval or achieve widespread use, which would significantly harm our business prospects.

Before obtaining required regulatory approvals for the commercial sale of any of our potential products, we must demonstrate, through pre-clinical studies and clinical trials, that our technology is safe and effective for use in at least one medical indication. These studies and clinical trials are expected to take a number of years and may fail to show that our technology is sufficiently safe and effective, in which case our technology will not receive regulatory approval, and we will not be able to develop and commercialize our products.

Our technology, and hence, our business, at present is limited to addressing two medical applications: cardiovascular disease, using our HDL Therapy platform (selective HDL delipidation and HDL mimetic peptides), and viral infections, using our Viral Immunotherapy platform. HDL Therapy is aimed at developing treatments for the reversal of atherosclerosis, while the Viral Immunotherapy platform is focused on treatments for people suffering from conditions associated with infection from lipid-enveloped viruses such as HIV, Hepatitis B and C, SARS coronavirus, West Nile and influenza. If our technology does not prove to be safe or effective, if we otherwise fail to receive regulatory approval for our potential product indications, or if we fail to successfully commercialize any product that may receive regulatory approval, our business prospects would be significantly harmed and we may even be forced to cease operations.

Our future clinical studies may be delayed or unsuccessful.

Our future success depends in large part upon the results of clinical trials designed to assess the safety and effectiveness of our potential product indications. The ultimate results of clinical studies cannot be predicted with accuracy and can be impacted by many variables. We cannot be sure whether planned clinical trials will begin on time or will be completed on schedule or at all. Delay or failure to complete clinical studies may delay or prevent us from bringing products to market, which would materially harm our business. For example, any of our future clinical studies might be delayed in their initiation or performance, or even halted after initiation because:

• extensive pre-clinical animal studies are required by the regulatory authorities to demonstrate the safety of the process technology;

• the data generated by the pre-clinical animal studies does not indicate to the regulatory authorities that there is a sufficient margin of safety;

• the potential clinical benefit from the delipidation process cannot be effectively demonstrated through the pre-clinical animal studies;

• the relevant regulatory requirements for initiating and maintaining an application for a clinical study cannot be met;

• the product or process is not effective, or physicians perceive that the product is not effective;

• patients experience severe side effects during treatment or possibly even death as a result of the treatment;

• patients die during a clinical study because their disease is too advanced or because they experience medical problems that are not related to the product being studied;

• patients do not enroll in the studies at the rate we expect; or

• the discovery by us, during the course of the study, of deficiencies in the way the study is being conducted by the study investigators that raise questions as to whether the study is being conducted in conformity with the relevant regulatory authorities’ regulations or Good Clinical Practice.

We depend on our license agreement with Aruba International B.V. that may, if terminated, significantly harm our business.

We have entered into an agreement for an exclusive license to patents, know-how and other intellectual property relating to our foundation technology for removal of lipids from proteins and our continued operations at present are dependent upon such intellectual property. The licensor is Aruba International B.V., a company controlled by Dr. Bill E. Cham, a founding stockholder of Pre-Merger Lipid and one of our former Directors. Dr. Cham also controls KAI International, LLC, our largest stockholder. The technology licensed from Aruba International B.V. currently represents an important part of the technology owned or licensed by us. Aruba International B.V. may terminate the license agreement if we fail to perform and fail to remedy, following written notice, any default with respect to our material obligations under the agreement, including our obligations to make royalty payments, or if we cease, without intention to resume, all efforts to commercialize the subject matter of the licensed intellectual property. If our license with Aruba International B.V. terminates, our business would be significantly harmed and may cause us to cease operations.

We intend to rely on collaborations in order to further develop our products and processes. If these collaborations are unsuccessful, the development of our products could be adversely affected and we may incur significant unexpected costs.

We intend to enter into collaborations with strategic partners, licensors, licensees and others. We may be unable to maintain or expand our existing collaborations on favorable terms, or at all, or establish additional collaborations or licensing arrangements necessary to develop our technology on favorable terms, or at all. Any current or future collaborations or licensing arrangements may not be successful. In addition, parties we collaborate with may develop products or processes that compete with ours, and we cannot be certain that they will perform their contractual obligations or that any revenues will be derived from such arrangements. If one or more of these parties fails to achieve product development objectives, this failure could harm our ability to fund related programs and develop or commercialize products.

Our industry is intensely competitive.

The biotechnology and medical device industries are intensely competitive and we may not be able to develop, perfect or acquire rights to new products with commercial potential. We compete with biotechnology, medical device and pharmaceutical companies that have been established longer than we have, have more experience in commercializing their technology, have a greater number of products on the market, have greater financial and other resources and have other technological or competitive advantages. We also have competition in the development of technologies and processes and in acquiring personnel and technology from academic institutions, governmental agencies, and other private and public research organizations. We cannot be certain that one or more of our competitors will not receive patent protection that dominates, blocks or adversely affects our clinical studies, product development or business; will not benefit from significantly greater sales and marketing capabilities; or will not develop products that are more clinically effective, cost-effective, or that are otherwise accepted more widely than ours.

If we fail to secure and then enforce patents and other intellectual property rights underlying our technologies, or if the use of our technology is determined to infringe on the intellectual property rights of others, our business could be harmed.

Our future success will depend in part on our ability to obtain patent protection, enforce patents once obtained, maintain trade secrets and operate without infringing upon the patents and proprietary rights of others, and if needed, obtain appropriate licenses to patents or proprietary rights held by third parties with respect to their technology, both in the United States and in foreign countries. We currently have an exclusive license from Aruba International B.V. with respect to three issued U.S. patents, three issued Australian counterpart patents, one issued Japanese counterpart patent, one issued European counterpart patent and counterpart applications as well as independent pending patent applications. The issued U.S. patents will expire in January 2008, January 2016 and June 2017. There are additional pending applications assigned to us and we are constantly strengthening our intellectual property portfolio in accordance with our technological advancements. Each of the patents and pending applications relates to different aspects of our technology platforms. However, these patent applications may not be approved and, even if approved, our patent rights may not be upheld in a court of law or may be narrowed if challenged. The patent positions of biotechnology, medical device and pharmaceutical companies can be highly uncertain and involve complex legal and factual questions. Our patent rights may not provide competitive advantages for our products and may be challenged, infringed upon or circumvented by our competitors.

In addition to patents, we rely on trade secrets, know-how, continuing technological innovations, and licensing opportunities to develop and maintain our competitive position. It is our policy to require our employees, certain contractors, consultants, members of our Scientific and Viral Advisory Boards and parties to collaborative agreements to execute confidentiality agreements upon the commencement of a business relationship with us. We cannot assure you that these agreements will not be breached, that these agreements will provide meaningful protection of our trade secrets or know-how or adequate remedies if there is unauthorized use or disclosure of this information, or that our trade secrets or know-how will not otherwise become known or be independently discovered by our competitors.

If it were ultimately determined that our intellectual property rights are unenforceable, or that our use of our technology infringes on the intellectual property rights of others, we may be required or may desire to obtain licenses to patents and other intellectual property held by third parties to develop, manufacture and market products using our technology. We may not be able to obtain these licenses on commercially reasonable terms, if at all, and any licensed patents or intellectual property that we may obtain may not be valid or enforceable. In addition, the scope of intellectual property protection is subject to scrutiny and challenge by courts and other governmental bodies. Litigation and other proceedings concerning patents and proprietary technologies can be protracted, expensive and distracting to management and companies may sue competitors as a way of delaying the introduction of competitors’ products. Any litigation, including any interference proceedings to determine priority of inventions, oppositions to patents or litigation against our partners, may be costly and time-consuming and could significantly harm our business.

Because of the large number of patent filings in the biopharmaceutical field, our competitors may have filed applications or been issued patents and may obtain additional patents and proprietary intellectual property rights relating to products or processes competitive with or similar to ours. We cannot be certain that U.S. or foreign patents do not exist or will not be issued that would preempt or otherwise harm our ability to commercialize our products and product candidates.

If we use biological and hazardous materials in a manner that causes injury, we may be liable for damages.

Our research and development activities involve the controlled use of potentially harmful biological materials, such as blood products, organic solvents and other hazardous materials. We cannot completely eliminate the risk of accidental contamination or injury from the use, storage, handling or disposal of these materials. In the event of contamination or injury, we could be held liable for damages that result, and any liability could be significant. We are subject to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. The cost of compliance with these laws and regulations could be significant.

Because most of our products are based on technologies that are unfamiliar to the healthcare community, they may not be accepted by healthcare providers and patients, which could harm our business.

We may experience difficulties in launching new products, many of which are novel and based on technologies that are unfamiliar to the healthcare community. We have no assurance that healthcare providers and patients will accept such products, if developed. In addition, government agencies, as well as private organizations involved in healthcare, from time to time publish guidelines or recommendations to healthcare providers and patients. Such guidelines or recommendations can be very influential and may adversely affect the usage of any products we may develop directly (for example, by recommending a decreased dosage of a product in conjunction with a concomitant therapy or a government entity withdrawing its recommendation to screen blood donations for certain viruses) or indirectly (for example, by recommending a competitive product over our product).

We depend on key personnel and will need to hire additional key personnel in the future.

Our ability to operate successfully depends in significant part upon the experience, abilities and continued service of certain key scientific, technical and managerial personnel. If we lose the services of any of these personnel and we are unable to hire qualified replacements, our business could be harmed. Our future success also depends upon our ability to attract and retain additional highly qualified personnel in these areas and our ability to develop and maintain relationships with qualified clinical researchers. There can be no assurance that we can retain such personnel or that we can attract or retain other highly qualified scientific, technical and managerial personnel or develop and maintain relationships with clinical researchers in the future.

Our stock price may be volatile and there may not be an active trading market for our common stock.

There can be no assurance that there will be an active trading market for our common stock or that the market price of the common stock will not decline below its present market price. The market prices for securities of biotechnology companies have been, and are likely to continue to be, highly volatile. Factors that have had, and are expected to continue to have, a significant impact on the market price of our common stock include:

• material public announcements;

• actual or potential clinical results with respect to our products under development or those of our competitors;

• the announcement and timing of any new product introductions by us or others;

• technical innovations or product development by us or our competitors;

• regulatory approvals or regulatory issues;

• developments relating to patents and proprietary rights;

• political developments or proposed legislation in the biotechnology, medical device or healthcare industries;

• economic and other external factors, disaster or crisis;

• changes to our management;

• period-to-period fluctuations in our financial results or results which do not meet or exceed analyst expectations;

• our financing activities; and

• market trends relating to or affecting stock prices throughout our industry, whether or not related to results or news regarding us or our competitors.

In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We may, in the future, be the target of similar litigation. Regardless of its outcome, securities litigation may result in substantial costs and divert management’s attention and resources, which could harm our business and results of operations.

Existing stockholders may experience future dilution.

As of September 30, 2005, 6,846,377 stock options and 2,839,565 warrants to purchase common stock were outstanding, which if exercised, would result in the issuance of our common stock. Moreover, in the near future, we anticipate the need for additional capital to fund our operations. Such capital could be obtained be selling additional common stock or other equity instruments. Any future issuance of our common stock will have the effect of diluting ownership of existing stockholders.

We have adopted several anti-takeover measures.

We have taken a number of actions that could discourage a takeover attempt that might be beneficial to stockholders who wish to receive a premium for their shares from a potential bidder. For example:

• our Board of Directors has the authority to issue, without vote or action of stockholders, up to 10,000,000 shares of preferred stock and to fix the price, rights, preferences and privileges of those shares. Any series of preferred stock could contain dividend rights, conversion rights, voting rights, terms of redemption, redemption prices, liquidation preferences or other rights superior to the rights of holders of common stock;

• our Directors are elected to staggered terms, which prevents the entire Board from being replaced in any single year;

• our Certificate of Incorporation and Bylaws require the affirmative vote of the holders of sixty-six and two-thirds percent (66 2/3%) of the voting power of all of the then outstanding shares entitled to vote generally in the election of Directors, voting together as a single class, to make, alter, amend or repeal our Bylaws;

• our Certificate of Incorporation does not permit stockholders to take an action by written consent;

• our Certificate of Incorporation and the Bylaws provide that special meetings of the stockholders may be called only by the Chairman of the Board, the President, or the Board of Directors by a resolution approved by a majority of the total number of Directors we would have if there were no vacancies; and

• under our Bylaws, notice regarding stockholder proposals and Director nominations must have been delivered not less than 45 days nor more than 75 days prior to the first anniversary of the date on which we first mailed our proxy materials for the preceding year’s annual meeting.

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

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and the Nasdaq National Market rules, are creating uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, we might be subject to sanctions or investigations by regulatory authorities, such as the SEC or the Nasdaq National Market, and our reputation may be harmed. Any such action could adversely affect our financial results and the market price of our common stock.

While we believe that we currently have adequate internal control procedures in place, we are still exposed to potential risks from recent legislation requiring companies to evaluate controls under Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”). We are evaluating our internal controls systems in order to allow management to report on, and our independent registered public accountants to attest to, our internal controls, as required by Section 404. We are performing the system and process evaluation and testing required in an effort to comply with the management certification and auditor attestation requirements of Section 404. As a result, we are incurring additional expenses and a diversion of management’s time. While we anticipate being able to fully implement the requirements relating to internal controls and all other aspects of Section 404 by December 31, 2005, our fiscal year-end, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of the same on our operations since there is currently only limited precedent available by which to measure compliance adequacy. If we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, we might be subject to sanctions or investigation by regulatory authorities, such as the SEC or the Nasdaq National Market. Any such action could adversely affect our financial results and the market price of our common stock.

EXHIBIT INDEX

Exhibit Number		Description
3.1		Certificate of Incorporation. Previously filed as Exhibit 3.1 to Registrant’s Quarterly Report on Form 10-Q filed with the Commission on August 13, 2002.

4.1		Form of Series A Warrant, issued by Lipid Sciences, Inc. to the Investors. Previously filed as Exhibit 4.1 to the Registrant’s Current Report on Form 8-K filed with the Commission on September 30, 2005.

4.2		Form of Series B Warrant, issued by Lipid Sciences, Inc. to the Investors. Previously filed as Exhibit 4.2 to the Registrant’s Current Report on Form 8-K filed with the Commission on September 30, 2005.

4.3		Form of Registration Rights Agreement, dated as of September 28, 2005, by and among Lipid Sciences, Inc. and the Investors named therein. Previously filed as Exhibit 4.3 to the Registrant’s Current Report on Form 8-K filed with the Commission on September 30, 2005.

10.1		Form of Securities Purchase Agreement, dated as of September 28, 2005, by and among Lipid Sciences, Inc. and the Investors named therein. Previously filed as Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the Commission on September 30, 2005.

31.1		Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

		Page No.
PART I – FINANCIAL INFORMATION

Item 1.	Financial Statements	1

	Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004	1
	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and 2004, and cumulative period from Inception (May 21, 1999) to September 30, 2005	2
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004, and cumulative period from Inception (May 21, 1999) to September 30, 2005	3
	Notes to Condensed Consolidated Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	9

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	19

Item 4.	Controls and Procedures	19


PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	20

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	20

Item 3.	Defaults Upon Senior Securities	20

Item 4.	Submission of Matters to a Vote of Security Holders	20

Item 5.	Other Information	20

Item 6.	Exhibits	20


SIGNATURES		21

INDEX TO EXHIBITS FOR FORM 10-Q		22

Date: November 8, 2005	Lipid Sciences, Inc.

	By:	/s/ Sandra Gardiner
	Sandra Gardiner
	Chief Financial Officer*