UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

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

For the Quarterly Period Ended September 30, 2006.

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 x 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 x

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 x

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, 2006
Common Stock
$0.001 par value		32,366,548

LIPID SCIENCES, INC.

FORM 10-Q

For the Period Ended September 30, 2006

Table of Contents

		Page No.
PART I – FINANCIAL INFORMATION

Item 1.	Financial Statements	1
	Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005	1
	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005, and cumulative period from Inception (May 21, 1999) to September 30, 2006	2
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005, and cumulative period from Inception (May 21, 1999) to September 30, 2006	3
	Notes to Condensed Consolidated Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	16

Item 4.	Controls and Procedures	16

PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	17

Item 1A.	Risk Factors	17

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	17

Item 3.	Defaults upon Senior Securities	17

Item 4.	Submission of Matters to a Vote of Security Holders	17

Item 5.	Other Information	17

Item 6.	Exhibits	17

SIGNATURES		18

INDEX TO EXHIBITS FOR FORM 10-Q		19

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Lipid Sciences, Inc.

(A Development Stage Company)

Condensed Consolidated Balance Sheets (Unaudited)
(In thousands, except share amounts)

	September 30, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	11,149		$	1,752
Short-term investments	1,992			12,836
Prepaid expenses	169			355
Other current assets	54			18
Total current assets	13,364			14,961
Property and equipment	389			419
Long-term lease deposits	19			19
Total assets	$	13,772		$	15,399

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued liabilities	$	1,537		$	1,292
Accrued related party royalties	125			250
Accrued compensation	411			390
Total current liabilities	2,073			1,932
Deferred rent	14			9
Total liabilities	2,087			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; 32,366,548 and 27,359,267 shares issued and outstanding at September 30, 2006 and December 31, 2005, respectively	32			27
Additional paid-in capital	83,427			76,712
Deficit accumulated in the development stage	(71,774		)	(63,281		)
Total stockholders’ equity	11,685			13,458
Total liabilities and stockholders’ equity	$	13,772		$	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 September 30,						Nine Months Ended September 30,						Period from Inception (May 21, 1999) to September 30,
(In thousands, except per share amounts)	2006			2005			2006			2005			2006
Grant revenue	$	10		$	—		$	37		$	1		$	79
Operating expenses:
Research and development(1)	2,033			1,787			5,733			5,282			57,980
Selling, general and administrative(2)	1,038			908			3,211			2,617			26,276
Total operating expenses	3,071			2,695			8,944			7,899			84,256
Operating loss	(3,061		)	(2,695		)	(8,907		)	(7,898		)	(84,177		)
Interest and other income	149			101			414			290			3,996
Loss from continuing operations	(2,912		)	(2,594		)	(8,493		)	(7,608		)	(80,181		)
Income tax benefit	—			—			—			—			8,004
Net loss from continuing operations	(2,912		)	(2,594		)	(8,493		)	(7,608		)	(72,177		)
Discontinued operations:
Income from discontinued operations	—			—			—			—			582
Income tax expense	—			—			—			—			(179		)
Income from discontinued operations - net	—			—			—			—			403

Net loss	$	(2,912	)	$	(2,594	)	$	(8,493	)	$	(7,608	)	$	(71,774	)

Loss per share – basic and diluted:
Net loss per share	$	(0.10	)	$	(0.10	)	$	(0.30	)	$	(0.31	)

Weighted average number of common shares outstanding – basic and diluted	30,250			24,925			28,328			24,919

Non-cash stock option compensation expense/(income) included in operating expenses:
(1) Research and development	77	(41	)	278	100
(2) Selling, general and administrative	112	(21	)	451	—

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)	2006			2005			2006
Cash flows used in operating activities:
Net loss from continuing operations	$	(8,493	)	$	(7,608	)	$	(72,177	)
Adjustments to reconcile net loss from continuing operations to net cash used in operating activities:
Depreciation and amortization	162			168			1,340
Loss on disposal of assets	—			2			206
Accretion of discount on investments	(265		)	(206		)	(883		)
Stock compensation expense for options issued to consultants, employees and advisors	729			100			6,893
Issuance of warrants to consultants	—			—			1,044
Changes in operating assets and liabilities:
Prepaid expenses and other current assets	150			178			(224		)
Notes receivable	—			—			6,569
Other assets	—			(19		)	(19		)
Accounts payable and other current liabilities	157			1,468			(593		)
Accrued related party royalties	(125		)	(625		)	125
Accrued compensation	21			(180		)	411
Deferred rent	5			6			14
Net cash used in operating activities of continuing operations	(7,659		)	(6,716		)	(57,294		)

Cash flows provided by/(used in) investing activities:
Capital expenditures	(132		)	(165		)	(1,952		)
Proceeds from disposal of assets	—			3			17
Restricted cash	—			105			—
Purchases of investments	(4,391		)	(10,305		)	(91,395		)
Maturities and sales of investments	15,500			16,000			90,286
Net cash provided by/(used in) investing activities of continuing operations	10,977			5,638			(3,044		)

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	6,079			6,625			31,043
Proceeds from issuance of warrants	—			—			40
Net cash provided by financing activities of continuing operations	6,079			6,625			37,373
Net increase/(decrease) in cash and cash equivalents from continuing operations	9,397			5,547			(22,965		)
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	$	11,149		$	11,354		$	11,149

	Nine Months Ended September 30,				Period from Inception (May 21, 1999) to September 30,
(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
SUPPLEMENTAL DISCLOSURES OF NON-CASH FINANCING TRANSACTIONS
Accrued financing costs	$	88	$	603	$	88

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, clinical and 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 September 30, 2006, we had cash and cash equivalents and short-term investments equal to approximately $13.1 million. We anticipate that these assets will provide sufficient working capital for our operations, including our current development projects, through the fourth quarter of 2007. We expect additional capital will be required in the future. We intend to seek capital needed to fund our operations through public or private financings, new collaborations, such as licensing or other arrangements or through research and development grants. 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.

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 September 30,
	2006	2005
Stock options	6,859,128	6,846,377
Warrants to purchase common stock	3,076,552	2,839,565
	9,935,680	9,685,942

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, but generally over four years (but not less than 20% of the total number of shares granted per year).

In October 1997, NZ’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, but generally over four years (but not less than 20% of the total number of shares granted per year).

At September 30, 2006, options to purchase an aggregate of 5,241,140 shares of common stock 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

The following table represents stock option activity for the three months ended September 30, 2006:

	Number of Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contract Life	Aggregate Intrinsic Value
Outstanding options at beginning of period	6,637,800		$	3.61
Granted	21,000		1.62
Exercised	—		—
Forfeited	(10,209	)	3.60
Expired	(530,000	)	3.28
Outstanding options at end of period	6,118,591		$	3.63	5.94	$	1,312,252
Exercisable options at end of period	5,093,754		$	3.74	5.38	$	1,296,019

The following table represents stock option activity for the nine months ended September 30, 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	613,744		2.45
Exercised	(13,500	)	1.00
Forfeited	(10,209	)	3.60
Expired	(530,000	)	3.28
Outstanding options at end of period	6,118,591		$	3.63	5.94	$	1,312,252
Exercisable options at end of period	5,093,754		$	3.74	5.38	$	1,296,019

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 September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Risk-free interest rate	4.56		%	4.06		%	4.72		%	3.66		%
Expected life of options (in years)	5.00			5.00			3.92			3.04
Expected volatility	94.75		%	87.30		%	95.20		%	81.40		%
Expected dividend yield	—			—			—			—
Weighted-average grant-date fair value	$	1.20		$	2.72		$	1.68		$	2.09

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 in prior quarters, and the withdrawal of options on our common stock in the current quarter, 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 that have been 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			Nine Months Ended
	September 30, 2005			September 30, 2005
Reported net loss	$	(2,594	)	$	(7,608	)
Add stock-based compensation included in net loss	(21		)	—
Compensation expense for stock options	(313		)	(1,075		)
Pro forma net loss	$	(2,928	)	$	(8,683	)

Net loss per share – basic and diluted:
As reported	$	(0.10	)	$	(0.31	)
Pro forma	$	(0.12	)	$	(0.35	)

Total compensation cost for share-based payment arrangements recognized in income for the three and nine month periods ended September 30, 2006 was approximately $189,000 and $729,000, respectively. The compensation cost for share-based payment arrangements for the three month period ended September 30, 2006 was comprised of approximately $145,000 and $44,000 in employee related and non-employee related compensation expense, respectively. The compensation cost for share-based payment arrangements for the nine month period ended September 30, 2006 was comprised of approximately $712,000 and $17,000 in employee related and non-employee related compensation expense, respectively. The total compensation cost related to nonvested awards not yet recognized as of September 30, 2006 was approximately $1,504,000 and the weighted average expected remaining recognition period as of September 30, 2006 was approximately 2 years. We received $13,500 in gross proceeds as a result of the 13,500 stock options that were exercised in the nine month period ended September 30, 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 approximately $189,000 and $729,000 in compensation cost for our share-based payment arrangements, for the three and nine month periods ended September 30, 2006, respectively (See Note 3).

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109.” This interpretation prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 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 September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement defines fair value, established a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. 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 5: 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. 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. For the three month periods ended September 30, 2006 and 2005, we have expensed $125,000 and $125,000, respectively, and for the nine month periods ended September 30, 2006 and 2005 we have expensed $375,000 and $375,000, respectively, related to this agreement. Amounts for 2006 and 2005 were charged to research and development expense. Accrued related party royalties under this agreement were $125,000 and $250,000 at September 30, 2006 and December 31, 2005, respectively.

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 months periods ended September 30, 2006 and 2005, approximately $99,000 and $99,000 was charged to selling, general and administrative expense for fees related to the consulting agreement. For the nine month periods ended September 30, 2006 and 2005, approximately $296,000 and $149,000 was charged to selling, general and administrative expense for fee 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 and nine month periods ended September 30, 2006, approximately $30,000 and $22,000, respectively, was recorded as non-cash compensation expense related to the stock option awarded to Dr. Brewer under the consulting agreement. For the three and nine month periods ended September 30, 2005, approximately $25,000 and $57,000, respectively, was recorded as non-cash compensation expense related to the stock option awarded to Dr. Brewer under the consulting agreement.

In connection with the Company’s August 8, 2006 private placement, the Company sold 2,714,817 shares of common stock and warrants exercisable for an additional 814,445 shares to Sterling Pacific Assets, Inc. in exchange for an investment of approximately $3,421,000. The shares and warrants held by Sterling Pacific Assets, Inc. are deemed beneficially owned by Mr. William Pope, an existing substantial shareholder of the Company and former Director of the Company. The shares of common stock and warrants were issued to Sterling Pacific Assets, Inc. on the same terms as those offered to the other participating investors.

In addition, in the private placement the Company sold 257,933 shares of common stock for an aggregate investment of approximately $325,000 and warrants exercisable for an additional 77,376 shares to five members of our Board of Directors: Frank M. Placenti, Bosko Djordjevic, Gary S. Roubin, M.D., Ph.D., S. Lewis Meyer, Ph.D., and H. Bryan Brewer, Jr., M.D. The individual investments made by each Director are listed in the table below. The shares of common stock and warrants were issued on the same terms as those offered to the other participating investors.

Investor	Investment		Common Stock Issued	Warrants Issued
Directorship Services, Inc. Profit Sharing Trust(1)	$	14,999	11,904	3,571
Placenti Revocable Trust(2)	9,999		7,936	2,380
Bosko Djordjevic	100,000		79,365	23,809
Gary S. Roubin, M.D., Ph.D.	74,999		59,523	17,856
The Meyer Family Revocable Trust(3)	49,999		39,682	11,904
Washington Cardiovascular Associates, LLC(4)	74,999		59,523	17,856
	$	324,995	257,933	77,376

(1)	Frank M. Placenti serves as a Director pursuant to an arrangement between the Company and Directorship Services, Inc. (“DSI”). Directorship Services, Inc. Profit Sharing Trust was established by DSI as a retirement planning vehicle for DSI’s employees. Mr. Placenti is the sole trustee of the trust and, in such capacity, has sole beneficial ownership of all Company shares owned by the Trust.
(2)	The Placenti Revocable Trust is an estate planning trust of which Mr. Placenti is a trustee. In his capacity as a trustee of such trust, Mr. Placenti is deemed to have beneficial ownership of all Company shares held by the Placenti Revocable Trust.
(3)	The Meyer Family Revocable Trust is an estate planning trust of which S. Lewis Meyer, Ph.D. is a trustee. In his capacity as a trustee of such trust, Mr. Meyer is deemed to have beneficial ownership of all Company shares held by The Meyer Family Revocable Trust.
(4)	H. Bryan Brewer, Jr., M.D. serves as a Director pursuant to an arrangement between the Company and Washington Cardiovascular Associates, LLC, an entity owned by Dr. Brewer. Dr. Brewer is deemed a 100% beneficial owner of Washington Cardiovascular Associates, LLC.

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, clinical and 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 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, including our current development projects, through the fourth quarter of 2007. In addition, we may also finance our future operations through collaborations with a range of potential corporate partners and outlicensing of our proprietary delipidation technology for specific application opportunities in both animal and human health. 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 Research 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. On June 1, 2006, we announced that the first patient procedure had been completed in the Company’s 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.” Thirty subjects between the ages of 18 and 85 with angiographic evidence of Coronary Artery Disease in the target artery, as defined by at least one lesion with an occlusion between 20-50%, are being recruited for the trial. Each potential participant undergoes an initial screening, which includes a blood panel and intravascular ultrasound (“IVUS”) assessment to

determine eligibility for enrollment and randomization into the study. The trial consists of a total of seven weekly delipidation/re-infusion procedures. The treatment subjects receive infusions of plasma that has been delipidated by the PDS-2 system; the control subjects receive infusions of their own untreated plasma that has not been delipidated. An IVUS assessment of the participants will also be made at the conclusion of the trial. The study duration for each participant is approximately ten weeks. We expect to present a qualitative assessment about the primary endpoint of the trial, which is safety, by the end of the first quarter of 2007.

On November 8, 2006, we announced that we entered into a collaborative research and license agreement with Elanco Animal Health (“Elanco”), a division of Eli Lilly and Company, to develop one or more immunological products for animal health applications beginning with a vaccine directed against certain lipid-enveloped organisms. Under the agreement, the Company granted to Elanco a worldwide exclusive license to research, develop, manufacture, and sell certain immunological products for animal health, which will be developed using its delipidation immunological technology. Pursuant to the terms of the agreement, Elanco will pay for all the associated research and development expenses for each targeted product. In exchange for the license, subject to completion of Elanco’s due diligence and sales of products meeting various thresholds, we may receive a technology access fee, milestone payments and royalties.

Effective January 1, 2006, we adopted Statement 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 September 30, 2006 and 2005

Revenue. We recognized $10,000 in grant revenue in the three months ended September 30, 2006. 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: 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 $246,000, or 14%, to $2,033,000 in the three months ended September 30, 2006 from $1,787,000 for the same period in 2005. The increase was due primarily to an increase in stock compensation expense, an increase in costs associated with our non-human primate study being conducted at the Yerkes National Primate Research Center at Emory University, legal fees associated with securing and expanding our patent portfolio and employee related costs. This non-cash stock compensation expense includes approximately $33,000 and $44,000 in employee and non-employee stock option expense, respectively. As described above, we have implemented FAS 123(R) in the first quarter of 2006 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. Offsetting this increase was a decrease in costs related to the human clinical trial of our HDL Therapy platform at the Washington Hospital Center in Washington, D.C. The decrease was attributed to the fact that the human clinical trial start-up costs incurred in the three months ended September 30, 2005 exceeded the recruitment and implementation costs incurred in the three months ended September 30, 2006.

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. However, for the three months ended September 30, 2006, 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 $130,000, or 14%, to $1,038,000 in the three months ended September 30, 2006 from $908,000 for the same period in 2005. The increase was due primarily to an increase in stock compensation expense, legal fees and employee related expenses. This non-cash stock compensation expense includes approximately $112,000 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 September 30, 2006 increased approximately $48,000 or 48%, to $149,000 from $101,000 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 September 30, 2006.

Results of Continuing Operations – Nine Months Ended September 30, 2006 and 2005

Revenue. We recognized $37,000 in grant revenue in the nine months ended September 30, 2006. This grant revenue relates to the STTR grant awarded in the second quarter of 2004 by the NIH, for a Virion Solvent Treatment for Severe Acute Respiratory Syndrome. The term of the grant expires March 31, 2007.

Research and Development Expenses. Research and development expenses include applied and scientific research, regulatory and business development expenses. Research and development expenses increased approximately $451,000, or 9%, to $5,733,000 in the nine months ended September 30, 2006 from $5,282,000 for the same period in 2005. The increase was due primarily to an increase in costs related to the preparation and commencement of the ongoing human clinical trial of our HDL Therapy platform at the Washington Hospital Center in Washington, D.C., legal fees associated with securing and expanding our patent portfolio and employee related costs. Contributing to the increase was an increase in stock compensation expense. This non-cash stock compensation expense includes approximately $261,000 and $17,000 related to employee and non-employee stock option expense, respectively. As described above, we have implemented FAS 123(R) in the first quarter of 2006 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. This increase was partially offset by a decrease in outside research and development 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. Research and development expense accounted for approximately 64% of total operating expenses for the nine months ended September 30, 2006.

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. However, for the nine months ended September 30, 2006, 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 $594,000, or 23%, to $3,211,000 in the nine months ended September 30, 2006 from $2,617,000 for the same period in 2005. The increase was due primarily to an increase in stock compensation expense, employee related expenses, legal fees and consulting expenses related to a consulting agreement entered into on May 16, 2005. The non-cash stock compensation expense includes approximately $451,000 related to employee stock option expense resulting from the implementation of FAS 123(R). Partially offsetting this increase were decreases in Board of Directors related costs and expenses associated with our ongoing compliance with Section 404 of the Sarbanes-Oxley Act of 2002.

Interest and Other Income. Interest and other income for the nine months ended September 30, 2006 increased approximately $124,000, or 43%, to $414,000 from $290,000 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 nine months ended September 30, 2006.

Liquidity and Capital Resources

The net cash used in operating activities was approximately $7,659,000 for the nine months ended September 30, 2006, resulting primarily from operating losses incurred as adjusted for non-cash compensation charges. The net cash used in operating activities for the nine months ended September 30, 2005, was approximately $6,716,000 resulting primarily from operating losses incurred as adjusted for non-cash compensation charges and partially offset by an increase in accounts payable primarily related to accrued costs and invoices received for various pre-clinical studies.

The net cash provided by investing activities was approximately $10,977,000 and $5,638,000 for the nine months ended September 30, 2006 and September 30, 2005, respectively. The net cash provided 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 $6,079,000 and $6,625,000 for the nine month periods ended September 30, 2006 and September 30, 2005, respectively. The net cash provided by financing activities for these periods was primarily attributable to the proceeds, net of issuance costs paid, received from the private placement of our common stock on August 8, 2006 and September 30, 2005.

Net cash provided by discontinued operations was approximately $1,167,000 for the nine month period ended September 30, 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 gross proceeds 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. As a result of the private placement completed on August 8, 2006, we issued an additional 109,858 warrant shares to the September 2005 Investors and adjusted the price of the total 838,915 warrant shares to $3.65 per share. A maximum of 497,651 additional warrant shares 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.

On August 8, 2006, we completed the sale of 4,993,781 shares of common stock at $1.26 per share and warrants to purchase an additional 1,498,127 shares of common stock at $1.51 per share in a private placement to institutional and accredited investors, which included several directors of the Company, for gross proceeds of approximately $6,300,000. The purchase price for the shares was equal to the average of the volume weighted closing prices of the Company’s common stock over the ten trading days preceding the closing of the transaction. The warrants are exercisable for a period of five years commencing on February 9, 2007 and terminating on February 9, 2012. The exercise price of the warrants was equal to 120% of the average of the volume weighted closing prices of the Company’s common stock over the ten trading days preceding the closing of the transaction. A maximum of 387,016 warrant shares are issuable as a result of potential future adjustments to the exercise price of the warrants. However, the exercise price may never adjust to less than $1.20 per share. The issuance of the shares of common stock and warrants was exempt from the registration requirements of the Securities Act of 1933, as amended, pursuant to Section 4(2) thereof, since the issuance constituted a sale not involving a public offering. Following the offering, we filed a Registration Statement on Form S-3 with the SEC on August 23, 2006 to register for resale by the investors the shares of common stock issued in the offering and issuable upon exercise of the warrants. The registration statement became effective on September 8, 2006. No placement agent was used in 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. 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, 2006 we had cash and cash equivalents and short-term investments equal to approximately $13,141,000. We anticipate that these assets will provide sufficient working capital for our operations, including our current development projects, through the fourth quarter of 2007. We expect additional capital will be required in the future. The Company continues to consider public or private financings, the formation of strategic development or licensing partnerships, and explore strategic initiatives. 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.

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. Except for the following accounting policy which changed during the nine month period ended September 30, 2006, our critical accounting policies as described in our annual report on our most recent form 10-K remain unchanged:

Stock-Based Compensation

The Company accounts for all stock options in accordance with the provisions 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. The Company accounts for stock-based awards to non-employees in accordance with FAS 123(R) and 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 recorded pursuant to the provisions of FAS 123(R). The fair value of each option granted to an employee 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 therefore are subject to management’s judgment.

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, 2005, which appear in the Company’s Annual Report on Form 10-K filed with the SEC on March 15, 2006.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk associated with changes in interest rates relates to our investment portfolio. We maintain an investment portfolio consisting of government issued securities. These investments are classified as held-to-maturity and are accounted for at their amortized cost.

As of September 30, 2006, the amortized cost of our investment portfolio, which equaled approximately $1,992,000 was exceeded by the market value of the investments contained in the portfolio by approximately $300. We have both the ability and intent to hold the securities contained in the investment portfolio until their respective maturity dates. Additionally, all securities contained in the investment portfolio have maturity dates of less than one year. No individual security is in an unrealized loss position; therefore we have no unrealized losses that are considered “other than temporary”, as defined by FASB Staff Position No. 115-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments”. Due to the short duration of our investment portfolio, an immediate 10% change in market interest rates would not have a material impact on the value of our investment portfolio.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures. Our President and Chief Executive Officer and our Chief Financial Officer have performed an evaluation, required pursuant to Rule 13a-15(b) or 15d-15(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in alerting them, on a timely basis, to material information relating to the Company (including its consolidated subsidiaries) required to be included in our periodic filings under the Exchange Act.

(b) Changes in Internal Controls Over Financial Reporting. There have not been any significant changes in our internal controls over financial reporting (as such item is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

Our management, including our President and Chief Executive Officer and Chief Financial Officer, do not expect that our disclosure controls or our internal controls over financial reporting will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met due to numerous factors, ranging from errors to conscious acts of an individual, or individuals acting together. In addition, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in a cost-effective control system, misstatements due to error and/or fraud may occur and not be detected.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We are from time to time, a party to legal proceedings. Any legal proceeding we may be currently involved in is ordinary and routine. Outcomes of the legal proceedings are uncertain until they are completed. We believe that the results of any current proceedings will not have a material adverse effect on our business or financial condition or results of operations.

Please refer to our Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2006, which discloses legal proceedings involving the Company.

ITEM 1A. RISK FACTORS

Our 2005 Form 10-K, filed on March 15, 2006, includes a detailed discussion of our risk factors. The information presented below updates, and should be read in conjunction with, the risk factors and information disclosed in that Form 10-K.

Our business exposes us to product liability claims.

Our design, testing, development, manufacture and marketing of products involve an inherent risk of exposure to product liability claims and related adverse publicity. Insurance coverage is expensive and difficult to obtain, and we may be unable to obtain coverage in the future on acceptable terms, if at all. Although we currently maintain product liability insurance for our products in the amounts we believe to be commercially reasonable, we cannot be certain that the coverage limits of our insurance policies or those of our strategic partners will be adequate. If we are unable to obtain sufficient insurance at an acceptable cost or if a successful product liability claim is made against us, whether fully covered by insurance or not, our business could be harmed.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

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

None

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

(a) Exhibits - See Exhibit Index, which is incorporated by reference.

SIGNATURES

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

Date: November 8, 2006	Lipid Sciences, Inc.

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

*Signing on behalf of the Registrant as a duly authorized officer and as the Principal Financial Officer of the Registrant

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 and incorporated herein by reference.

3.2		Bylaws, as amended. Previously filed as Exhibit 3.2 to Registrant’s Quarterly Report on Form 10-Q filed with the Commission on August 10, 2005 and incorporated herein by reference.

4.1		Form of Warrant issued by Registrant to various investors. Previously filed as Exhibit 4.1 to Registrant’s Current Report on Form 8-K filed with the Commission on August 10, 2006 and incorporated herein by reference.

4.2		Registration Rights Agreement dated as of August 8, 2006, by and among Registrant and various investors. Previously filed as Exhibit 4.2 to Registrant’s Current Report on Form 8-K filed with the Commission on August 10, 2006 and incorporated herein by reference.

10.1		Securities Purchase Agreement dated as of August 8, 2006, by and among Registrant and various investors. Previously filed as Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed with the Commission on August 10, 2006 and incorporated herein by reference.

10.2		Representation Letter dated as of August 7, 2006. Previously filed as Exhibit 10.2 to Registrant’s Current Report on Form 8-K filed with the Commission on August 10, 2006 and incorporated herein by reference.

10.3		Collaborative Research and License Agreement with Elanco Animal Health dated November 7, 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.

*Confidential Treatment Requested