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 March 31, 2006.

	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		43-0433090
(State or other jurisdiction of incorporation or organization)		(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 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 o

Accelerated filer ý

Non - accelerated filer o

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 April 28, 2006
Common Stock
$0.001 par value		27,372,767

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “estimate,” “intend,” “plan,” “project,” “will,” “may” and other similar expressions. In addition, any statements that refer to expectations, projections, plans, objectives, goals, strategies or other characterizations of future events or circumstances are forward-looking statements. These forward-looking statements speak only as of the date stated and we do not undertake any obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise, even if experience or future events make it clear that any expected results expressed or implied by these forward-looking statements will not be realized. Although we believe that the expectations reflected in these forward-looking statements are reasonable, these expectations may not prove to be correct or we may not achieve the financial results, savings or other benefits anticipated in the forward-looking statements. These forward-looking statements are necessarily estimates reflecting the best judgment of our senior management and involve a number of risks and uncertainties, some of which may be beyond our control, that could cause actual results to differ materially from those suggested by the forward-looking statements. These risks and uncertainties include, but are not necessarily limited to:

• our inability to obtain adequate funds;

• we have incurred significant losses since our inception and it is our expectation that we will incur substantial losses in the future;

• our technology not proving to be safe or effective;

• our inability to obtain regulatory approval of our technology, which is only in the clinical development stage;

• delay or failure to complete clinical studies;

• our dependence on our license agreement with Aruba International B.V.;

• our reliance on collaborations with strategic partners and consultants;

• competition in our industry, including the development of new products by others that may provide alternative or better therapies;

• failure to secure and enforce our intellectual property rights;

• risks associated with use of biological and hazardous materials;

• acceptance of our potential products by healthcare providers and patients; and

• our dependence on key personnel.

Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in “Item 1A. Risk Factors” in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 15, 2006.

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)	March 31, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	2,244		$	1,752
Short-term investments	10,389			12,836
Prepaid expenses	239			355
Other current assets	36			18
Total current assets	12,908			14,961
Property and equipment	381			419
Long-term lease deposits	19			19
Total assets	$	13,308		$	15,399
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued liabilities	$	1,488		$	1,292
Accrued related party royalties	375			250
Accrued compensation	530			390
Taxes payable	3			—
Total current liabilities	2,396			1,932
Deferred rent	11			9
Total liabilities	2,407			1,941

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; 27,372,767 and 27,359,267 shares issued and outstanding at March 31, 2006 and December 31, 2005, respectively	27			27
Additional paid-in capital	77,152			76,712
Deficit accumulated in the development stage	(66,278		)	(63,281		)
Total stockholders’ equity	10,901			13,458
Total liabilities and stockholders’ equity	$	13,308		$	15,399

See accompanying Notes to Condensed Consolidated Financial Statements

Lipid Sciences, Inc.

(A Development Stage Company)

Condensed Consolidated Statements of Operations (Unaudited)

	Three Months Ended March 31,						Period from Inception (May 21, 1999) to March 31,
(In thousands, except per share amounts)	2006			2005			2006

Grant Revenue	$	22		$	—		$	63
Operating expenses:
Research and development (including non-cash stock option compensation expense of $222 and $41 for the three months ended March 31, 2006 and March 31, 2005, respectively)	1,950			1,624			54,198
Selling, general and administrative (including non-cash stock option compensation expense of $203 and zero for the three months ended March 31, 2006 and March 31, 2005, respectively)	1,209			848			24,273
Total operating expenses	3,159			2,472			78,471
Operating loss	(3,137		)	(2,472		)	(78,408		)
Interest and other income	140			87			3,723
Loss from continuing operations	(2,997		)	(2,385		)	(74,685		)
Income tax benefit	—			—			8,004
Net loss from continuing operations	(2,997		)	(2,385		)	(66,681		)
Discontinued operations:
Income from discontinued operations	—			—			582
Income tax expense	—			—			(179		)
Income from discontinued operations - net	—			—			403
Net loss	$	(2,997	)	$	(2,385	)	$	(66,278	)

Loss per share — basic and diluted:
Net loss per share	$	(0.11	)	$	(0.10	)

Weighted average number of common shares outstanding — basic and diluted	27,361			24,912

See accompanying Notes to Condensed Consolidated Financial Statements

Lipid Sciences, Inc.

(A Development Stage Company)

Condensed Consolidated Statements of Cash Flows (Unaudited)

	Three Months Ended March 31,						Period from Inception (May 21, 1999) to March 31,
(In thousands)	2006			2005			2006
Cash flows used in operating activities:
Net loss from continuing operations	$	(2,997	)	$	(2,385	)	$	(66,681	)
Adjustments to reconcile net loss from continuing operations to net cash used in operating activities:
Depreciation and amortization	53			61			1,230
Loss on disposal of assets	—			—			206
Accretion of discount on investments	(117		)	(60		)	(735		)
Stock compensation expense for options issued to consultants, employees and advisors	425			41			6,589
Issuance of warrants to consultants	—			—			1,044
Changes in operating assets and liabilities:
Prepaid expenses and other current assets	98			60			(275		)
Notes receivable	—			—			6,569
Other assets	—			—			(19		)
Taxes payable	3			4			3
Accounts payable and other current liabilities	196			198			(555		)
Accrued related party royalties	125			(375		)	375
Accrued compensation	140			9			530
Deferred rent	2			—			11
Net cash used in operating activities of continuing operations	(2,072		)	(2,447		)	(51,708		)

Cash flows provided by/(used in) investing activities:
Capital expenditures	(15		)	(11		)	(1,834		)
Proceeds from disposal of assets	—			—			17
Purchases of investments	(2,436		)	(3,448		)	(89,440		)
Maturities and sales of investments	5,000			4,000			79,786
Net cash provided by/(used in) investing activities of continuing operations	2,549			541			(11,471		)

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	15			—			24,979
Proceeds from issuance of warrants	—			—			40
Net cash provided by financing activities of continuing operations	15			—			31,309
Net increase/(decrease) in cash and cash equivalents from continuing operations	492			(1,906		)	(31,870		)
Cash flows provided by discontinued operations
Operating activities	—			1,167			38,185
Investing activities	—			—			10,837
Financing activities	—			—			(14,908		)
Net cash provided by discontinued operations	—			1,167			34,114
Cash and cash equivalents at beginning of period	1,752			4,640			—
Cash and cash equivalents at end of period	$	2,244		$	3,901		$	2,244

Lipid Sciences, Inc.

(A Development Stage Company)

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

	Three Months Ended March 31,				Period from Inception (May 21, 1999) to March 31,
(In thousands)	2006		2005		2006
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest (net of amount capitalized)	$	—	$	—	$	839
Income tax 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

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 its 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. The last remaining real estate asset was sold in February 2005.

In the course of our 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 March 31, 2006, we had cash and cash equivalents and short-term investments equal to approximately $12.6 million. We anticipate that these assets will provide sufficient working capital for our operations, including our current development projects, through the first quarter of 2007. We expect additional capital will be required in the future. We intend to seek capital needed to fund our operations through new collaborations, such as licensing or other arrangements, through pursuit of research and development grants or through public or private financings.

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

The accompanying interim unaudited Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, for interim financial information and in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission, or SEC, and do not contain all of the information and footnotes required by GAAP and the SEC for annual financial statements. The results for interim periods are not necessarily indicative of the results to be expected for the full year. The December 31, 2005 balance sheet, as presented, was derived from the audited Consolidated Financial Statements as of December 31, 2005. 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, 2006.

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.

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 net loss per share reflects the potential dilution that would 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 net 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 March 31,
	2006	2005
Stock options	7,285,837	6,362,245
Warrants to purchase common stock	1,624,469	895,412
	8,910,306	7,257,657

NOTE 3: STOCK-BASED COMPENSATION

Effective January 1, 2006, we adopted SFAS No. 123 (revised 2004), “Share-Based Payment,” “FAS 123(R),” which requires that compensation cost relating to share-based payment transactions be recognized in our financial statements. We have adopted FAS 123(R) on a modified prospective basis, which requires that compensation cost relating to all new awards and to awards modified, repurchased, or cancelled is recognized in our financial statements beginning January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that are outstanding as of January 1, 2006 will be recognized as the requisite service is rendered on or after January 1, 2006. The pro forma disclosures previously permitted under SFAS No. 123, “Accounting for Stock-Based Compensation,” (“FAS 123”) are no longer an alternative to financial statement recognition.

Stock Option Plans

Prior to the merger, we maintained stock-based compensation plans for our employees, consultants and Directors. The 2000 Stock Option Plan (the “2000 Plan”), adopted by the Board of Directors in May 2000 and approved by stockholders on March 20, 2001, allows for the granting of options for up to 3,118,040 shares of common stock. Stock options granted under the 2000 Plan may be either incentive stock options or nonstatutory stock options. Options may be granted with exercise prices not less than the fair value of the Company’s common stock at the date of grant, as determined by the Board of Directors. All options granted pursuant to the 2000 Plan are to have a term not greater than 10 years from the date of grant. Options vest as determined by the Board of Directors, generally over four years (but not less than 20% of the total number of shares granted per year).

In October 1997, the Company’s Board of Directors approved the New Mexico and Arizona Land Company 1997 Stock Incentive Plan (the “1997 Plan”). The 1997 Plan provides that the following types of awards may be granted under the 1997 Plan: stock appreciation rights, incentive stock options, non-qualified stock options, restricted stock awards, unrestricted stock awards, and performance share awards which entitle recipients to acquire shares upon the attainment of specified performance goals. Under the 1997 Plan, awards may be granted with respect to a maximum of 900,000 shares of the Company’s common stock, subject to adjustment in connection with certain events such as a stock split, merger or other recapitalization of the Company. We assumed the 1997 Plan as a result of the merger.

In November 2001, the Company’s Board of Directors approved the 2001 Performance Equity Plan (the “2001 Plan”). The stockholders approved the Plan on November 29, 2001. The 2001 Plan allows for the granting of options for up to 5,000,000 shares of common stock to employees, officers, consultants, and Directors. The number of shares authorized automatically increases on January 1, in each of the calendar years 2002, 2003, 2004, 2005 and 2006 by an amount equal to 3% of the shares of common stock outstanding on December 31 of the immediately preceding calendar year, if the 2001 Plan is then in effect, but in no event shall any annual increase exceed 500,000 shares of common stock as reflected on the stock ledger of the Company. Stock options granted under the 2001 Plan may be either incentive stock options or nonstatutory stock options. Options may be granted with exercise prices not less than the fair value of the Company’s common stock at the date of grant, as determined by the Board of Directors. All options granted pursuant to the 2001 Plan are to have a term not greater than 10 years from the date of grant. Options vest as determined by the Board of Directors, generally over four years (but not less than 20% of the total number of shares granted per year).

At March 31, 2006, options to purchase 4,814,431 common shares remain available for grant under all the plans.

All options in the 2000 Plan were adjusted to reflect the 1.55902 merger exchange ratio with the number of shares underlying each option multiplied by the ratio and the related exercise prices divided by the ratio. All the above disclosures reflect the share and per share amounts on a post merger equivalent basis. Additionally, all historical stock option information of Pre-Merger Lipid that is provided herein has been similarly restated.

Other Required FAS 123(R) Disclosures in the First Period of Adoption

The following table represents stock option activity for the three months ended March 31, 2006:

	Number of Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contract Life	Aggregate Intrinsic Value
Outstanding options at beginning of period	6,058,556		$	3.72
Granted	500,244		2.64
Exercised	(13,500	)	1.00
Forfeited	—		—
Outstanding options at end of period	6,545,300		$	3.64	6.43	$	2,456,491
Exercisable options at end of period	5,156,649		$	3.82	5.83	$	2,109,389

We use the Black-Scholes option pricing model to estimate the fair value of stock-based awards with the following weighted-average assumptions for the indicated periods:

	Three Months Ended March 31,
	2006			2005
Risk-free interest rate	4.67		%	3.71		%
Expected life of options (in years)	4.00			2.19
Expected volatility	97.0		%	65.1		%
Expected dividend yield	—			—
Weighted-average grant-date fair value	$	1.84		$	1.45

The assumptions above are based on multiple factors, including historical exercise patterns of employees and post-vesting employment termination behaviors. We use historical data to estimate the options’ expected term, which represents the period of time that options granted are expected to be outstanding. Due to the relatively low trading volume of options on our common stock, we do not use implied volatility to determine the expected volatility of our common stock. Rather, the historical volatility that is commensurate with the expected life of the option on the date that it is measured is used as our estimate of future expected volatility. Since we have never paid any dividends and do not anticipate paying any dividends at least through the expected life of our stock options outstanding, we use an expected dividend yield of zero when calculating the fair value of stock options. The risk-free interest rate for periods within the contracutal life of the option is based on the U.S. Treasury yield curve in effect at the measurement date of the option.

FAS 123(R) requires that we estimate forfeitures, or the number of shares that are expected to be cancelled prior to vesting, at the time of grant, and adjust for actual forfeitures in subsequent periods if they differ from our original estimates. Based on our historical experience of options cancelled prior to vesting, we have assumed an annualized forfeiture rate of 12% for all new option grants. In the Company’s pro-forma information required under FAS 123 for the periods prior to fiscal 2006, we accounted for forfeitures as they occurred.

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 FAS 123, the Company would have recorded additional compensation expense and its net loss and loss per share would have been reduced to the pro forma amounts presented in the following table:

	Three Months Ended March 31, 2005
Reported net loss	$	(2,385	)
Compensation expense for stock options	(248		)
Pro forma net loss	$	(2,633	)

Net loss per share — basic and diluted:
As reported	$	(0.10	)
Pro forma	$	(0.11	)

Total compensation cost for share-based payment arrangements recognized in income for the three months ended March 31, 2006 was approximately $425,000. This included approximately $392,000 and $33,000 for employee and non-employee share-based arrangements, respectively. The total compensation cost related to nonvested awards not yet recognized as of March 31, 2006 was approximately $1,853,000 and the weighted average expected remaining recognition period as of March 31, 2006 was approximately 2 years. We received $13,500 in gross proceeds as a result of 13,500 stock options exercised in the three month period ended March 31, 2006. We did not recognize any tax benefit related to these share-based arrangements as we are in a loss position and have a full valuation allowance against our tax benefits.

NOTE 4: RECENTLY ISSUED ACCOUNTING STANDARDS

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment,” which replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” 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 FAS 123 are no longer an alternative to financial statement recognition. This statement is effective beginning with our first quarter of fiscal 2006. We have adopted FAS 123(R) on a modified prospective basis and recognized $392,000 in expense related to the adoption of the new accounting standard (See Note 3).

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.

In November 2005, the FASB issued FASB Staff Position No. 115-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (“FSP 115-1”), which outlines a three-step model for identifying investment impairments in debt and equity securities within the scope of FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”), and cost-method investments. The three steps involve (1) determining whether the investment is impaired, (2) evaluating whether the impairment is other-than-temporary, and (3) if the impairment is other than temporary, recognizing an impairment loss. FSP 115-1 carries forward the disclosure requirements of Emerging Issues Task Force (“EITF”) Issue 03-1-1, “The Meaning of Other-Than-Temporary Impairment and its Applications to Certain Investments.” FSP 115-1 is effective for reporting periods beginning after December 15, 2005. We believe that the adoption of FSP 115-1 will not have a material impact on our financial position, results of operations or cash flows.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statement No. 133 and 140.” This statement clarifies the accounting for and reporting of the servicing of certain financial assets. This statement is effective for fiscal years beginning after September 15, 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.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140.” This statement clarifies the conditions that must exist to recognize a servicing asset or liability and permits an entity to choose between an amortization or fair value method for each class of separately recognized servicing assets and servicing liabilities. This statement is effective for fiscal years beginning after September 15, 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.

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, in “Item 1A. Risk Factors” in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 15, 2006. 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 Operation,” “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, 2005.

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, 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, and as of December 31, 2004, we had completed the disposition of substantially all of the real estate assets and our business is no longer organized into two segments. The remaining real estate asset at December 31, 2004 was sold in February 2005 for $1,167,000.

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 corporate partnerships, technology licensing, the pursuit of research and development grants, public or private financings, and cash on hand. We anticipate that existing cash, cash equivalents and short-term investments will provide sufficient working capital for our operations, which includes our current development projects, through the first quarter of 2007. In the longer term, we expect to additionally finance our operations through revenues from product sales and licenses, including outlicensing opportunities of our proprietary delipidation process for non-human health applications such as the field of animal health, 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.

In December 2005, the Company filed an Investigational Device Exemption (“IDE”) application with the Center for Devices and Radiological Health of the Food and Drug Administration (“FDA”) for their review. In January 2006, the FDA granted conditional approval of the IDE to allow the Company to begin a human clinical trial with the Company’s Plasma Delipidation System-2 (“PDS-2”). The Company was granted this approval subject to the condition that within 45 days it would submit a response to the questions and observations made by the FDA. The Company submitted its response on February 22, 2006, which was within 45 days of receiving conditional approval from the FDA. In addition, the FDA required the Company to obtain approval from the Institutional Review Board (“IRB”) of the MedStar Institute in Washington, D.C. to begin the trial.

On April 20, 2006, we announced that we received approval from the IRB. On April 28, 2006 that approval was submitted to the FDA as required. We are now prepared to begin our human clinical trial. The PDS-2 systems are in place at the trial site, Washington Hospital Center in Washington, D.C., and have been validated. The clinical trial support personnel are in place and have

been trained. The planned process of validating every step of the human clinical trial protocol in preparation for the recruitment of the trial subjects is nearing completion. We have begun an outreach effort to the regional medical community to identify subjects within that patient population who might be suitable for recruitment into our human clinical trial, “A Randomized Single-Blind Placebo Controlled Study to Evaluate the Safety of the Lipid Sciences PDS-2 in Subjects with Prior Acute Coronary Syndrome.” We expect to begin the process to recruit 30 patients on May 15, 2006. The subjects of the trial will be between 18 and 75 years of age with angiographic evidence of Coronary Artery Disease in the target artery as defined by at least one lesion with an occlusion between 20-50%. An intravascular ultrasound assessment will be made before inclusion into the trial and after the conclusion of 7 weekly delipidation/re-infusion treatments. The treatment subjects will receive infusions of plasma that has been delipidated by the PDS-2 system; the control subjects will receive infusions of their own untreated plasma that has not been delipidated. Including the screening, treatment and post treatment analysis, the study duration for each subject will be approximately 10 weeks. It is expected that the total study will conclude by the end of 2006.

Effective January 1, 2006, we adopted SFAS No. 123 (revised 2004), “Share-Based Payment,” which requires that compensation cost relating to share-based payment transactions be recognized in our financial statements. We have adopted FAS 123(R) on a modified prospective basis, which requires that compensation cost relating to all new awards and to awards modified, repurchased, or cancelled is recognized in our financial statements beginning January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that are outstanding as of January 1, 2006 will be recognized as the requisite service is rendered on or after January 1, 2006. The pro forma disclosures previously permitted under SFAS No. 123, “Accounting for Stock-Based Compensation,” are no longer an alternative to financial statement recognition.

Results of Continuing Operations – Three Months Ended March 31, 2006 and 2005

Revenue. We recognized $22,000 in grant revenue in the three months ended March 31, 2006. This grant revenue relates to the Small Business Technology Transfer grant awarded in the second quarter of 2004 by the National Institutes of Health, for a Virion Solvent Treatment for Severe Acute Respiratory Syndrome. The term of the grant was extended to March 31, 2007 during the three months ended March 31, 2006.

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 increased approximately $326,000, or 20%, to $1,950,000 in the three months ended March 31, 2006 from $1,624,000 for the same period in 2005. The increase was due primarily to an increase in stock compensation expense. This non-cash stock compensation expense included approximately $189,000 related to employee stock option expense. As described above, we have implemented FAS 123(R) this quarter which requires us to recognize the fair value of employee stock options in the income statement, rather than as a pro-forma disclosure, which was allowed in prior periods. Outside research and development costs also increased in preparation of our human clinical trial of our HDL Therapy platform at Washington Hospital Center in Washington D.C. This increase was partially offset by a decrease in costs related to 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.

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 March 31, 2006 however, 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 increased approximately $361,000, or 43%, to $1,209,000 in the three months ended March 31, 2006 from $848,000 for the same period in 2005. The increase was due primarily to an increase in stock compensation expense. This non-cash stock compensation expense included approximately $203,000 related to employee stock option expense resulting from the implementation of FAS 123(R).

Interest and Other Income. Interest and other income for the three months ended March 31, 2006 increased approximately $53,000, or 61%, to $140,000 from $87,000 for the same period in 2005. The increase was due to higher yields earned on both our cash and short-term investment assets during the three months ended March 31, 2006.

Liquidity and Capital Resources

The net cash used in operating activities was approximately $2,072,000 for the three months ended March 31, 2006, resulting primarily from operating losses incurred. The net cash used in operating activities for the three months ended March 31, 2005, was approximately $2,447,000, resulting from operating losses incurred, and a $500,000 payment of related party royalties, which reflected the minimum annual royalty due to Bill E. Cham, Ph.D., a founding stockholder of Pre-Merger Lipid and one of our former Directors.

The net cash provided by investing activities was approximately $2,549,000 and $541,000 for the three months ended March 31, 2006 and March 31, 2005, respectively. The net cash provided by investing activities for the periods were primarily attributable to the purchase and subsequent maturities of short-term investments.

The net cash provided by financing activities was approximately $15,000 for the three month periods ended March 31, 2006. The net cash provided by financing activities for the three month period ended March 31, 2006 was attributable to the proceeds received from employee stock option exercises.

Net cash provided by discontinued operations was approximately $1,167,000 for the three month periods ended March 31, 2005 and was primarily attributable to the sale of royalty credits in February 2005, representing the disposition of our last remaining real estate asset.

In September 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 accredited investors (the “Investors”). Pursuant to the terms of the 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 (“AIRs”) in the form of warrants to purchase 1,215,096 shares of common stock at $3.73 per share. The AIRs expired March 29, 2006, and the warrants will expire September 30, 2010. 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. In connection with the private placement, approximately $490,000 was paid to A.G. Edwards who acted as the placement agent for the transaction.

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 conducting our human clinical trial. The expected use of our funds related to our Viral Immunotherapy platform includes costs associated with our non-human primate study. We believe the results of this non-human primate 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 March 31, 2006 we had cash and cash equivalents and short-term investments equal to approximately $12,600,000. We anticipate that these assets will provide sufficient working capital for our operations, which include our current development projects and human clinical trial, through the first quarter of 2007. We expect additional capital will be required in the future. Our Board of Directors continues to consider third-party inquiries and explore strategic initiatives, public or private financings, and the formation of strategic development or licensing partnerships. 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)	2006		2007		2008		2009		2010		2011		Total
Operating Leases	$	206	$	211	$	217	$	223	$	56	$	—	$	913
Purchase Obligations	36		—		—		—		—		—		36
Royalty Payments*	500		500		500		500		500		500		3,000
Total	$	742	$	711	$	717	$	723	$	556	$	500	$	3,949

*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.

		Page No.
FORWARD-LOOKING STATEMENTS		i

PART I – FINANCIAL INFORMATION

Item 1.	Financial Statements	1
	Condensed Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005	1
	Condensed Consolidated Statements of Operations for the three months ended March 31, 2006 and 2005, and cumulative period from Inception (May 21, 1999) to March 31, 2006	2
	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and 2005, and cumulative period from Inception (May 21, 1999) to March 31, 2006	3
	Notes to Condensed Consolidated Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	14

Item 4.	Controls and Procedures	14


PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	15

Item 1A.	Risk Factors	15

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	15

Item 3.	Defaults upon Senior Securities	15

Item 4.	Submission of Matters to a Vote of Security Holders	15

Item 5.	Other Information	15

Item 6.	Exhibits	15


SIGNATURES		16

INDEX TO EXHIBITS FOR FORM 10-Q		17

Date: May 10, 2006	Lipid Sciences, Inc.

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

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.

10.1		Employment Agreement with S. Lewis Meyer, effective April 14, 2006.

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.

Washington, D. C. 20549

Delaware

7068 Koll Center Parkway, Suite 401, Pleasanton, California 94566

Notes to Condensed Consolidated Financial Statements