SECURITIES AND EXCHANGE COMMISSION

Washington, DC 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 December 31, 2004.

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 0-22987

VALENTIS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware		94-3156660
(State or Other Jurisdiction of Incorporation or Organization)		(IRS Employer Identification No.)

863A Mitten Rd., Burlingame, CA		94010
(Address of Principal Executive Offices)		(Zip Code)

650-697-1900
(Registrant’s Telephone Number Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

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

The number of outstanding shares of the registrant’s Common Stock, $0.001 par value, was 13,098,762 as of February 11, 2005.

PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

VALENTIS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)

	December 31, 2004			June 30, 2004
	(unaudited)			(Note 1)
ASSETS
Current assets:
Cash and cash equivalents	$	4,701		$	9,516
Short-term investments	9,300			10,934
Interest and other receivables	137			190
Prepaid expenses and other current assets	790			666
Total current assets	14,928			21,306
Property and equipment, net	43			79
Goodwill	409			409
Other assets	96			97
Total assets	$	15,476		$	21,891
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	18		$	207
Accrued compensation	415			1,137
Accrued clinical trial costs	1,088			1,437
Other accrued liabilities	867			1,120
Deferred revenue	—			100
Total current liabilities	2,388			4,001
Stockholders’ equity:
Common stock	13			13
Additional paid-in capital	232,850			232,137
Accumulated other comprehensive loss	(706		)	(706		)
Accumulated deficit	(219,069		)	(213,554		)
Total stockholders’ equity	13,088			17,890
Total liabilities and stockholders’ equity	$	15,476		$	21,891

See accompanying notes.

VALENTIS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

	Three Months Ended December 31,						Six Months Ended December 31,
	2004			2003			2004			2003
License and other revenue	$	124		$	395		$	1,296		$	7,104
Total revenue	124			395			1,296			7,104

Operating expenses:
Research and development	1,759			2,428			4,646			4,686
General and administrative	856			874			2,270			1,856
Total operating expenses	2,615			3,302			6,916			6,542
Income (loss) from operations	(2,491		)	(2,907		)	(5,620		)	562

Interest income	75			11			150			27
Other expenses	—			—			(45		)	(45		)
Net income (loss)	$	(2,416	)	$	(2,896	)	$	(5,515	)	$	544

Income (loss) per share
Basic	$	(0.19	)	$	(0.52	)	$	(0.43	)	$	0.10
Diluted	$	(0.19	)	$	(0.52	)	$	(0.43	)	$	0.10

Weighted-average shares used in computing income (loss) per common share
Basic	12,986			5,622			12,942			5,588
Diluted	12,986			5,622			12,942			5,708

See accompanying notes.

VALENTIS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

	Six Months Ended December 31,
	2004			2003
Cash flows from operating activities:
Net income (loss)	$	(5,515	)	$	544
Adjustments to reconcile net income (loss) to net cash provided by (used in) operations:
Depreciation	36			729
Gain on disposal of property and equipment	—			(8		)
Stock options and warrants granted to non-employees for services rendered	486			—
Changes in operating assets and liabilities:
Interest and other receivables	53			177
Prepaid expenses and other assets	(123		)	(88		)
Deferred revenue	(100		)	(75		)
Accounts payable	(189		)	(121		)
Accrued liabilities	(1,324		)	704
Foreign currency translation adjustment	—			53
Net cash provided by (used in) operating activities	(6,676		)	1,915

Cash flows from investing activities:
Purchase of property and equipment	—			(5		)
Proceeds from sale of property and equipment	—			8
Purchase of available-for-sale investments	(7,662		)	(300		)
Maturities of available-for-sale investments	9,296			300
Net cash provided by investing activities	1,634			3

Cash flows from financing activities:
Payments on long-term debt	—			(9		)
Proceeds from issuance of common stock, net of repurchases	227			4,918
Net cash provided by financing activities	227			4,909

Net increase (decrease) in cash and cash equivalents	(4,815		)	6,827
Cash and cash equivalents, beginning of period	9,516			3,290
Cash and cash equivalents, end of period	$	4,701		$	10,117

Schedule of non-cash transactions:
Stock issued for prior year accrued lease termination fees	$	—		$	433
Stock issued for prior year accrued 401(k) matching contributions	$	—		$	113

See accompanying notes.

VALENTIS, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The accompanying condensed consolidated financial statements are unaudited and have been prepared by Valentis, Inc. (“Valentis,” the “Company,” “we,” “us” or “our”) in accordance with the rules and regulations of the Securities and Exchange Commission for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in our annual consolidated financial statements as required by accounting principles generally accepted in the United States have been condensed or omitted. The interim condensed consolidated financial statements, in the opinion of management, reflect all adjustments (consisting of normal recurring accruals) necessary for a fair statement of financial position at December 31, 2004 and the results of operations for the interim periods ended December 31, 2004 and 2003. The balance sheet at June 30, 2004 is derived from the audited consolidated financial statements at that date but does not include all the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

The results of operations for the three and six months ended December 31, 2004 are not necessarily indicative of the results of operations to be expected for the fiscal year, although Valentis expects to incur a substantial loss for the year ended June 30, 2005. These interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the fiscal year ended June 30, 2004, which are contained in Valentis’ Annual Report on Form 10-K, as amended, filed with the Securities and Exchange Commission.

The accompanying condensed consolidated financial statements include the accounts of Valentis and its wholly-owned subsidiary, PolyMASC Pharmaceuticals plc. All significant intercompany balances and transactions have been eliminated.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. Our unaudited condensed consolidated financial statements have been presented on a basis that contemplates the realization of assets and satisfaction of liabilities in the normal course of business.

2. Significant Accounting Policies

Stock-Based Compensation Pro Forma Information

Valentis has elected to follow APB 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under SFAS 123, “Accounting for Stock-Based Compensation,” requires use of valuation models that were not developed for use in valuing employee stock options. Under APB 25, if the exercise price of Valentis’ employee stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recognized.

Pro forma net income (loss) and income (loss) per share information is required by SFAS 148, “Accounting for Stock-Based compensation—Transition and Disclosure an amendment of FASB Statement No. 123” which requires that the information be determined as if Valentis has accounted for its employee stock options under the fair market value method of that statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting periods. Valentis’ pro forma information follows (in thousands except for income (loss) per share information):

	Three Months Ended December 31,						Six Months Ended December 31,
	2004			2003			2004			2003
Net income (loss) – as reported	$	(2,416	)	$	(2,896	)	$	(5,515	)	$	544

Deduct:
Stock-based employee stock compensation expense determined under SFAS 123	(807		)	(354		)	(1,835		)	(689		)
Net income (loss) – Pro Forma	$	(3,223	)	$	(3,250	)	$	(7,350	)	$	(145	)

Income (loss) per share -as reported
Basic	$	(0.19	)	$	(0.52	)	$	(0.43	)	$	0.10
Diluted	$	(0.19	)	$	(0.52	)	$	(0.43	)	$	0.10

Income (loss) per share -pro forma
Basic	$	(0.25	)	$	(0.58	)	$	(0.57	)	$	(0.03	)
Diluted	$	(0.25	)	$	(0.58	)	$	(0.57	)	$	(0.03	)

All stock-based awards to non-employees are accounted for at fair value, as calculated using the Black-Scholes option-pricing model, in accordance with SFAS 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees.”

Revenue Recognition

Revenue arrangements with multiple elements are divided into separate units of accounting if certain criteria are met, including whether the delivered item has value to the customer on a stand-alone basis and whether there is objective and reliable evidence of the fair value of the undelivered items. Consideration received is allocated among the separate units of accounting based on their respective fair values, and the applicable revenue recognition criteria are considered separately for each of the separate units.

Non-refundable up-front payments received in connection with research and development collaboration agreements, including technology advancement funding that is intended for the development of the Company’s core technology, are deferred and recognized on a straight-line basis over the relevant period specified in the agreement, generally the research term.

Revenue related to research with the Company’s corporate collaborators is recognized as research services are performed over the related funding periods for each contract. Under these agreements, the Company is required to perform research and development activities as specified in each respective agreement. The payments received under each respective agreement are not refundable and are generally based on a contractual cost per full-time equivalent employee working on the project. Research and development expenses under the collaborative research agreements approximate or exceed the revenue recognized under such agreements over the terms of the respective agreements. Deferred revenue may result when the Company does not incur the required level of effort during a specific period in comparison to funds received under the respective contracts. Payments received relative to substantive, at-risk incentive milestones, if any, are recognized as revenue upon achievement of the incentive milestone event because the Company has no future performance obligations related to the payment. Incentive milestone payments are triggered either by results of the Company’s research efforts or by events external to the Company, such as regulatory approval to market a product.

The Company also has licensed technology to various biotechnology, pharmaceutical and contract manufacturing companies. Under these arrangements, the Company receives nonrefundable license payments in cash. These payments are recognized as revenue when received, provided the Company has no future performance or delivery obligations under these agreements. Otherwise, revenue is deferred until performance or delivery is satisfied. Certain of these license agreements also provide the licensee an option to acquire additional licenses or technology rights for a fixed period of time. Fees received for such options are deferred and recognized at the time the option is exercised or expires unexercised. Additionally, certain of these license agreements involve technology that the Company has licensed or otherwise acquired through arrangements with third parties pursuant to which the Company is required to pay a royalty equal to a fixed percentage of amounts received by the Company as a result of licensing this technology to others. Such royalty obligations are recorded as a reduction of the related revenue. Furthermore, the Company also receives royalty and profit sharing payments under a licenseing agreement with a contract manufacturing company. Royalty and profit sharing payments are recognized as revenue when received.

Critical Accounting Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Valentis believes the accrual for clinical trial expense represents its most significant estimate used in the preparation of its consolidated financial statements. Valentis’ accruals for clinical trial expenses are based in part on estimates of services received and efforts expended pursuant to agreements established with clinical research organizations and clinical trial sites. We have a history of contracting with third parties that perform various clinical trial activities on behalf of Valentis in the ongoing development of its biopharmaceutical drugs. The financial terms of these contracts are subject to negotiations and may vary from contract to contract and may result in uneven payment flows. The Company determines its estimates through discussion with internal clinical personnel and outside service providers as to progress or stage of completion of trials or services and the agreed upon fee to be paid for such services. The objective of Valentis’ clinical trial accrual policy is to reflect the appropriate trial expenses in its consolidated financial statements by matching period expenses with period services and efforts expended. In the event of early termination of a clinical trial, we accrue expenses associated with an estimate of the remaining, non-cancelable obligations associated with the winding down of the trial.

3. Income (Loss) Per Share

Basic net income (loss) per share has been computed using the weighted-average number of shares of common stock outstanding during the period, less of shares of common stock held in escrow and shares of outstanding common stock subject to our right of repurchase. Basic and diluted net loss per share amounts are the same in the three months ended December 31, 2004 and 2003, and in the six months ended December 31, 2004 as we have incurred net losses. Since we had net income in the six months ended December 31, 2003, diluted net income per share includes the impact of shares held in escrow and shares subject to repurchase.

The following table sets forth the computation for basic and diluted income (loss) per share (in thousands, except per share data).

	Three Months Ended December 31,						Six Months Ended December 31,
	2004			2003			2004			2003
Numerator:
Net income (loss)	$	(2,416	)	$	(2,896	)	$	(5,515	)	$	544

Denominator:
Weighted average shares for basic income (loss) per common share	12,986			5,622			12,942			5,588
Weighted average shares in escrow, subject to return	—			—			—			2
Weighted average shares subject to repurchase	—			—			—			118
Weighted-average shares for diluted income (loss) per common share	12,986			5,622			12,942			5,708

Income (loss) per share
Basic	$	(0.19	)	$	(0.52	)	$	(0.43	)	$	0.10
Diluted	$	(0.19	)	$	(0.52	)	$	(0.43	)	$	0.10

The following potential common shares have been excluded from the calculation of diluted income (loss) per share for the three and six months ended December 31, 2004 and 2003 because the effect of inclusion would be antidilutive:

• Options to purchase 2,349,221 shares of common stock with prices ranging from $1.97 to $465.00 and a weighted average price of $8.54 per share for the three months ended December 31, 2004 and option to purchase 1,164,513 shares of common stock with prices ranging from $3.19 to $466.88 and a weighted average price of $16.19 per share for the three months ended December 31, 2003.

• Options to purchase 2,317,128 shares of common stock with prices ranging from $1.97 to $465.00 and a weighted average price of $8.92 per share for the six months ended December 31, 2004 and option to purchase 1,078,288 shares of common stock with prices ranging from $3.19 to $466.88 and a weighted average price of $18.16 per share for the six months ended December 31, 2003.

• Warrants to purchase up to an aggregate of 1,755,107, 670,431, 100,000 and 223,478 shares of common stock at an exercise price of $3.00, $6.98, $6.30 and $5.4075 per share, respectively, at December 31, 2004.

• Warrants to purchase up to an aggregate of 42,226 and 1,060,508 shares of common stock at an exercise price of $307.50 and $3.00 per share, respectively, at December 31, 2003.

The following outstanding common shares have been included in the calculation of diluted income per share for the six months ended December 31, 2003, but excluded from the calculation of diluted loss per share for the three months ended December 31, 2004 and 2003, and for the six months ended December 31, 2004 because the effect of inclusion would be antidilutive:

• A total of 2,106 shares of common stock issued in partial consideration for a license agreement. The 2,106 shares of common stock are held in escrow and will be released when certain conditions in the license agreement are met.

• A total of 130,000 and 118,000 weighted average shares of common stock that were subject to a repurchase option of the Company as of December 31, 2004 and 2003, respectively.

The options and common stock purchase warrants will be included in the calculation of income per share at such time as the effect is no longer antidilutive, as calculated using the treasury stock method for options and warrants.

4. Comprehensive Income (Loss)

Following are the components of comprehensive income (loss) (in thousands):

	Three Months Ended December 31,								Six Months Ended December 31,
	2004				2003				2004				2003
Net income (loss)	$		(2,416	)	$		(2,896	)	$		(5,515	)	$		544
Net unrealized loss on available-for-sale securities	(5			)	—				—				—
Foreign currency translation adjustment	—				—				—				53
Comprehensive income (loss)	$	(2,421		)	$	(2,896		)	$	(5,515		)	$	597

The components of accumulated other comprehensive loss are as follows (in thousands):

	December 31, 2004			June 30, 2004
Unrealized loss on available-for-sale securities	$	(13	)	$	(13	)
Foreign currency translation adjustments	(693		)	(693		)
Accumulated other comprehensive loss	$	(706	)	$	(706	)

5. New Accounting Pronouncements

In December 2004, the FASB issued Statement No. 123 (revised 2004, or Statement 123R), “Share-Based Payment,” effective beginning after June 15, 2005. FAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and will require companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments including stock options and employee stock purchase plans. We will be required to implement FAS 123R no later than the fiscal year that begins July 1, 2005. The cumulative effect of adoption, if any, applied on a modified prospective basis, would be measured and recognized on July 1, 2005. We are currently evaluating option valuation methodologies and assumptions in light of FAS 123R, and therefore cannot estimate the impact of our adoption at this time. However, we expect that our adoption of FAS 123R will have a material adverse impact on our consolidated financial statements.

6. Other Accrued Liabilities

Other accrued liabilities consist of the following (in thousands):

	December 31, 2004		June 30, 2004
Accrued research and development expenses	$	90	$	125
Accrued rent	84		95
Accrued property and use taxes	396		441
Accrued legal expenses	70		179
Accrued accounting fees	84		112
Other	143		168
Total	$	867	$	1,120

7. Issuance of warrants

In August 2004, the Company issued warrants, exercisable at any time for a five-year period, to purchase a total of 100,000 shares of common stock to four individuals who are non-employees of Valentis. These warrants are exercisable at $6.30 per share. The Company estimated the fair value of the warrants using the Black-Scholes option-pricing model and recorded the resulting general and administrative expense of $454,000 in the quarter ended September 30, 2004.

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

The discussion in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements include, without limitation, statements containing the words “believes,” “anticipates,” “expects,” “intends,” “projects,” and other words of similar import or the negative of those terms or expressions. Forward-looking statements in this section include, but are not limited to, expectations of future levels of research and development spending, general and administrative spending, levels of capital expenditures and operating results, results of preclinical studies, plans for and the timing of additional clinical trials, sufficiency of our capital resources and our intention to seek revenue from the licensing of our proprietary manufacturing technologies. Forward-looking statements subject to certain known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Factors that could affect our actual results include the early stage of development of our products, uncertainties related to the timing of completing clinical trials, the need for additional capital and whether clinical trial results will validate and support the safety and efficacy of our products. Further, there can be no assurance that the necessary regulatory approvals will be obtained, that we will be able to develop commercially viable gene-based products or that any of our programs will be partnered with pharmaceutical partners. Actual results may differ materially from those projected in such forward-looking statements as a result of the “Additional Factors That May Affect Future Results” described below and other risks detailed in our reports filed with the Securities and Exchange Commission. We undertake no obligation to revise or update any such forward-looking statements.

OVERVIEW

VLTS 934 PRODUCT FOR THE TREATMENT OF PERIPHERAL ARTERIAL DISEASE		In September 2004, we reported the results of our Deltavasc™ Phase IIa clinical trial in peripheral arterial disease. Briefly, both the Deltavasc™ and the VLTS 934 groups demonstrated statistically significant improvements in exercise tolerance (Peak Walk Time, PWT) and ankle brachial index (ABI) compared to baseline with no significant differences between treatment groups. The unforeseen results observed in both groups led to additional intellectual property filings in anticipation of our next phase of product development. We anticipate that we will begin a follow-on Phase IIb clinical trial using our VLTS 934 product compared to a saline placebo in the quarter ending June 30, 2005.

		VLTS 934 is an investigational product that is a non-ionic polyoxyethylene-polyoxypropylene block copolymer, which has the chemical characteristics of components of cell membranes. We are currently investigating the poloxamer’s possible mechanism of action. The poloxamer may improve microvascular blood flow by increasing local adenosine (a nucleoside that is present in all living cells) levels. We are conducting further preclinical studies to better understand possible effects the poloxamer may have on vasodilation, particularly in light of possible sustained effects resulting from intramuscular administration. These studies may help us better understand potential effects at the arteriolar and capillary level and how the poloxamer may exert a pharmacologic effect over a prolonged period. These hypotheses would be consistent with the concomitant improvement in ankle brachial index observed in our Phase IIa trial.

TECHNOLOGIES		Valentis’ synthetic gene delivery systems provide efficient delivery after intramuscular, intravenous or intratumoral administration. These delivery systems are designed to enhance cellular distribution and uptake of genes in vivo and to permit the achievement of therapeutic levels of proteins.

		Valentis’ PINC™ polymers are designed to provide efficient delivery to a variety of tissues, including muscle and solid tumors.

		Valentis’ GeneSwitch® gene regulation technology permits therapeutic protein production that is controlled via an orally administered drug. Products incorporating our GeneSwitch® gene regulation technology are delivered with a polymer delivery system and electroporation. This results in controlled production of therapeutic proteins from muscle tissue for prolonged periods. In research applications, and particularly with transgenics, the GeneSwitch® system is widely appreciated for its ability to permit the study of otherwise lethal mutations.

		Valentis’ expertise can assist in the selection of appropriate PINC™ polymers or other synthetic delivery technologies depending on the indication. Licensing of these technologies is available.

GMP MANUFACTURING		We have devoted substantial resources for the development of scaleable, proprietary GMP manufacturing for plasmid DNA-based therapeutics. We have demonstrated that we can successfully manufacture plasmid DNA containing therapeutic genes from lab scale to commercial scale. Our methods are distinctive because they are scaleable such that we believe the same process can be used at all scales. In addition to being of direct benefit to us in our development of products, we intend to seek revenue from the licensing of our proprietary manufacturing technologies.

RESULTS OF OPERATIONS

Overview

For the quarter ended December 31, 2004, we incurred significant losses primarily due to the advancement of our research and development programs and because we generated limited revenue. This is generally consistent with our performance since inception. We expect that operating results will fluctuate from quarter to quarter and that such fluctuations may be substantial. At December 31, 2004, our accumulated deficit was approximately $219.1 million. We expect to incur substantial losses for the foreseeable future and do not expect to generate revenue from the sale of products in the foreseeable future, if at all.

There have been no significant changes in our critical accounting policies during the six months ended December 31, 2004 as compared to what was previously disclosed in our Annual Report on Form 10-K for the year ended June 30, 2004 filed with the SEC on September 15, 2004.

Revenue

Revenue recognized in the three and six months ended December 31, 2004 and 2003 is as follows (in thousands):

	Three Months Ended December 31,				Six Months Ended December 31,
	2004		2003		2004		2003
License and other revenue
PEGylation	$	—	$	—	$	—	$	6,500
GeneSwitch® gene regulation	110		1		687		210
PINC^TM gene delivery	—		250		550		250
Manufacturing technology	14		144		59		144
Total revenue	$	124	$	395	$	1,296	$	7,104

Changes in revenue for the three and six months ended December 31, 2004 and 2003 are explained below:

• In July 2003, PolyMASC Pharmaceuticals, our wholly owed subsidiary, entered into a license and settlement agreement with ALZA Corporation, a unit of Johnson & Johnson. Under the agreement, PolyMASC settled its patent infringement litigation against ALZA and granted a worldwide, irrevocable and non-exclusive license to ALZA under its PEG-liposome patents. Non-recurring license revenue of $6.5 million was recognized from this agreement in the quarter ended September 30, 2003. No additional revenue is expected to be recognized under this agreement.

• The GeneSwitch® gene regulation revenue recognized in the three and six months ended December 31, 2004 and 2003 resulted primarly from license and annual license maintenance fees received under several agreements for ourGeneSwitch® gene regulation technology. GeneSwitch® revenue recognized in the six months ended December 31, 2004 included approximately $550,000 of license fee, received under an agreement with Schering AG in August 2004.

• The PINC^TM gene delivery revenue recognized in the six months ended December 31, 2004 primarly reflects license fees received under an agreement with Schering AG. The PINC^TM gene delivery revenue recognized in the three and six months ended December 31, 2003 resulted from the licensing of our PINC^TMpolymer based gene delivery system to Genencor International Inc. for the development of DNA vaccines against the hepatitis B virus (HBV) and the human papilloma virus (HPV).

• Manufacturing technology revenue consists of profit sharing and royalty revenue recognized under an agreement related to Valentis’ plasmid DNA manufacturing technology.

Revenue derived from corporate collaborations and licenses helps us fund our operations and may increase in the future if we are successful in establishing new collaborations and additional licensing of our technology. We expect revenues for fiscal year 2005 to be less than revenues for fiscal year 2004 due to the recognition of the non-recourring license revenue from ALZA in fiscal 2004. If we are unsuccessful in establishing new collaborations or additional licensing of our technology, our revenues will decline and we may be required to limit our research and development, clinical trial, manufacturing and marketing efforts.

Research and Development Expenses

Research and development expenses dereased approximately $600,000 to approximately $1.8 million for the three months ended December 31, 2004, compared to approximately $2.4 million for the corresponding period in 2003. For the six months ended December 31, 2004, research and development expenses decreased approximately $100,000 to approximately $4.6 million, compared to approximately $4.7 million for the corresponding period in 2003. The decreases were primarily attributable to decreased expenses for the Deltavasc™ PAD Phase II clinical trial , which completed the dosing of patients in June 2004 and resulted in a fall off in clinical trial expesnes. We expect research and development spending in the future to increase from the current levels reflecting higher expenses associated with the commencement of the VLTS 934 Phase IIb clinical trial currently planned to begin in the quarter ending June 30, 2005.

Our research and development expenses currently include costs for scientific personnel, animal studies, supplies, equipment, consultants, patent filings, overhead allocation, human trials and sponsored research at academic and research institutions. In general, biopharmaceutical development involves a series of steps—beginning with identification of a potential target and including, among others, proof of concept in animal studies and Phase I, II, and III clinical studies in humans—each of which is typically more expensive than the previous step.

General and Administrative Expenses

General and administrative expenses remained at the same level of approximately $900,000 for the three months ended December 31, 2004 as compared to the corresponding period in 2003. For the six months ended December 31, 2004, general and administrative expenses increased approximately $400,000 to approximately $2.3 million, compared to approximately $1.9 million for the corresponding period in 2003. The increase was attributable primarily to expenses recorded in the quarter ended September 30, 2004 for the issuance of warrants to four individuals who are non-employees of the Company. We expect general and administrative spending in the future to decrease from the current level because warrant expenses recorded in the quarter ended September 30, 2004 were non-recurring.

Interest Income and Other Expenses, net

Interest income and other expenses, net, increased by approximately $64,000 to approximately $75,000 for the three months ended December 31, 2004, compared to approximately $11,000 in the corresponding period of 2003. For the six months ended December 31, 2004, interest income and other expenses, net, increased by approximately $123,000 to a net interest income of approximately $105,000, compared to a net other expenses of approximately $18,000 in the corresponding period of 2003.The increases in interest income and other expenses, net, for the three and six month periods ended December 31, 2004 primarily reflected the increased interest income earned due to higher investment balances in the three and six months ended December 31, 2004 following the completion of the June 2004 private placement of our common stock and warrants.

LIQUIDITY AND CAPITAL RESOURCES

As discussed in our Form 10-K filed with the Securities and Exchange Commission for the year ended June 30, 2004, we have received a report from our independent registered public accounting firm regarding the consolidated financial statements for the fiscal year ended June 30, 2004 that includes an explanatory paragraph stating that the financial statements have been prepared assuming we will continue as a going concern. The explanatory paragraph states the following conditions which raise substantial doubt about our ability to continue as a going concern: (i) we have incurred recurring operating losses since inception, including a net loss of $6.5 million for the fiscal year ended June 30, 2004, and our accumulated deficit was $213.6 million at June 30, 2004 and (ii) we anticipate requiring additional financial resources to enable us to fund our operations at least through June 30, 2005. Management’s plans as to these matters are described below.

Except for the quarter ended September 30, 2003, in which we reported net income of approximately $3.4 million resulting principally from $6.5 million non-recurring license revenue recognized under a license and settlement agreement with ALZA Corporation, we have experienced net losses since our inception through December 31, 2004, and reported a net loss of $2.4 million for the quarter ended December 31, 2004. Our accumulated deficit was $219.1 million at December 31, 2004. We expect such losses to continue into the foreseeable future as we proceed with the research, development and commercialization of our technologies.

As of December 31, 2004, we had $14.0 million in cash, cash equivalents and investments compared to $20.5 million at June 30, 2004. The decrease of $6.5 million in cash, cash equivalents and investments balances primarily reflects the funding of ongoing operations. Our capital expenditures were zero and $5,000 for the six months ended December 31, 2004 and 2003, respectively. We expect our capital expenditures to remain at or near current spending levels.

Since our inception, we have financed our operations principally through public and private issuances of our common and preferred stock and funding from collaborative arrangements. We have used the net proceeds from the sale of the common and preferred stock for general corporate purposes, which may include funding research, development and product manufacturing, increasing our working capital, reducing indebtedness, acquisitions or investments in businesses, products or technologies that are complementary to our own, and capital expenditures. We expect that proceeds received from any future issuance of stock will be used for similar purposes.

In January 2004, we completed a private placement of 4,878,047 shares of common stock at $2.05 per share along with warrants, exercisable for a five-year period, to purchase 1,951,220 shares of common stock at $3.00 per share, resulting in net proceeds of approximately $9.4 million (“January 2004 Private Placement”).

In June 2004, we completed a private placement, in which we issued and sold 2,234,779 shares of common stock and warrants, exercisable for a five-year period, to purchase 670,431 shares of common stock at $5.4075 per unit, resulting in net proceeds of approximately $11.2 million. (“June 2004 Private Placement”).

We entered into registration rights agreements with the purchasers in the January 2004 Private Placement and the June 2004 Private Placement. Pursuant to the registration rights agreements, we filed with the Securities and Exchange Commission registration statements related to the shares issued to the purchasers and shares issuable upon the exercise of the warrants under the private placements. In the event we must suspend use of the registration statements for greater than 20 consecutive days or a total of 40 days in the aggregate during the time we are required to keep the registration statement effective under the registration rights agreements, then we must pay to each purchaser in cash 1.0% of the purchaser’s aggregate purchase price of the shares for the first month, as well as an additional 1.5% of the purchaser’s aggregate purchase price for each additional month thereafter, while the use of the registration statements has been suspended. We currently expect to be required to maintain availability of the registration statement for at least two years following the applicable closing.

Net cash used in operating activities in the six months ended December 31, 2004 was approximately $6.7 million, which consisted primarily of the net loss of $5.5 million, reduced by non-cash expenses of $486,000 related to the issuance of warrants to non-employees, a net increase of 70,000 in receivables and prepaid expenses and a decrease of accounts payable and other accrued liabilities totaling $1.6 million. Net cash provided by operating activities in the six months ended December 31, 2003 was approximately $1.9 million, which consisted primarily of the net income of $544,000, increased by non-cash depreciation expenses of $729,000, a net decrease of $89,000 in receivables and prepaid expenses, and a net increase of $508,000 in accounts payable and other accrued liabilities.

Net cash provided by investing activities in the six months ended December 31, 2004 was $1.6 million, which resulted primarily from maturities of available-for-sale investments. In the six months ended December 31, 2003, net cash provided by investing activities was approximately $3,000, which consisted primarily of proceeds from sale of equipment.

Net cash provided by financing activities in the six months ended December 31, 2004 was approximately $277,000, which was primarily attributable to proceeds received from the issuance of common stock upon exercise of warrants. In the six months ended December 31, 2003, net cash provided by financing activities was approximately $4.9 million, which resulted primarily from proceeds received from our January 2004 private placement.

We lease our facilities under operating leases. These leases expire between November 2006 and October 2007 with renewal options at the end of these lease terms.

Minimal annual rental commitments under the operating leases, excluding amounts to be received under subleases at December 31, 2004, are as follows (in thousands):

Year ending June 30,	Operating Leases
2005 (Remaining term)	$	578
2006	1,177
2007	650
2008	65
	$	2,470

We will be required to seek additional sources of funding to continue development and commercialization of our products. Based upon our current operating plan, we anticipate that our cash, cash equivalents and investments as of December 31, 2004 will enable us to maintain our current and planned operations at least through December 31, 2005, in the absence of additional financial resources. We may need to raise additional funds to continue our operations beyond December 31, 2005. In an effort to seek additional sources of financing, we may have to relinquish greater or all rights to products at an earlier stage of development or on less favorable terms than we would otherwise seek to obtain.

We are currently seeking additional collaborative agreements and licenses with corporate partners and may seek additional funding through public or private equity or debt financing or merger of our business. We may not be able to enter into any such agreements, however, or if entered into, any such agreements may not reduce or eliminate our need to seek additional funding. Additional financing to meet our funding requirements may not be available on acceptable terms or at all. If we raise additional funds by issuing equity securities, substantial dilution to existing stockholders may result.

The accompanying consolidated financial statements have been prepared assuming that we will continue as a going concern. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the accounts and classification of liabilities that may result from the matters discussed above.

RECENT ACCOUNTING PRONOUNCEMENTS

ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS

The following risk factors outline certain risks and uncertainties concerning future results and should be read in conjunction with the information contained in this Quarterly Report on Form 10-Q. Any of these risk factors could materially and adversely affect our business, operating results and financial condition. Additional risks and uncertainties not presently known to us, or those we currently deem immaterial, may also materially harm our business, operating results and financial condition.

We have a history of losses and may never be profitable.

We have engaged in research and development activities since our inception. We incurred losses from operations of approximately $6.5 million, $15.7 million and $34.5 million, for our fiscal years ended June 30, 2004, 2003 and 2002, respectively. For the six months ended December 31, 2004, we incurred a net loss of $5.5 million. As of December 31, 2004, we had an accumulated deficit totaling approximately $219.1 million. The development and sale of our products will require completion of additional clinical trials and significant research and development activities. We expect to incur net losses for the foreseeable future as we continue with the research, development and commercialization of our products. Our ability to achieve profitability depends on the successful completion of our clinical trials, our additional research and development efforts, our ability to successfully commercially introduce our products, market acceptance of our products, the competitive position of our products and the other risk factors set forth in this report. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis.

Our ability to achieve profitability depends upon our research and development efforts and whether we can successfully develop and commercially introduce new products.

Our future success is dependent upon, among other factors, our ability to develop working products and our ability to successfully complete clinical trials. All of our potential products currently are in research, preclinical development or the early stages of clinical testing, and commercialization of those products will not occur for at least the next several years, if at all. The development of new drugs is a highly risky undertaking and there can be no assurance that our research and development efforts will be successful. Our VLTS 934 product and our cardiovascular therapies are new and may not lead to commercially viable pharmaceutical products. All of our products will require extensive additional research and development prior to any commercial introduction. There can be no assurance that any of our research and development and clinical trial efforts will result in viable new products. If our product and development efforts are unsuccessful, we will not achieve profitability and our business and results of operations would be adversely affected.

Our products are subject to extensive regulatory approval by the FDA and others, including with regard to completion of our clinical trials, which is expensive, time consuming and uncertain, and failure to obtain regulatory approval or successfully complete clinical trials may cause us to delay or withdraw the introduction of our products and could materially adversely affect our business and prospects.

We are subject to significant regulatory requirements, including the successful completion of clinical trials, prior to the commercialization of our products. Under the Federal Food, Drug and Cosmetic Act, the Public Health Services Act, and related regulations, the Food and Drug Administration, or FDA, regulates the development, clinical testing, manufacture, labeling, sale, distribution and promotion of drugs and biologics in the United States. Prior to market introduction in the United States, a potential drug or biological product must undergo rigorous clinical trials that meet the requirements of the FDA in order to demonstrate safety and efficacy in humans. Depending upon the type, novelty and effects of the drug and the nature of the disease or disorder to be treated, the FDA approval process can take several years, require extensive clinical testing and result in significant expenditures.

Clinical trials and the FDA approval process are long, expensive and uncertain processes, which require substantial time effort and financial and human resources. We have limited experience in conducting clinical trials, and we may encounter problems or fail to demonstrate the efficacy or safety that cause us to delay, suspend or terminate the development of our products. We anticipate that we will begin a follow-on Phase IIb clinical trial using our VLTS 934 prodcut compared to a

saline placebo in the quarter ending June 30, 2005. VLTS 934 may require significant additional clinical testing. This process may take a number of years. We cannot assure you that our clinical testing will commence or be completed within any specific time period, if at all. There can be no assurance that any FDA approval will be granted on a timely basis, if at all, or that any of our products will prove safe and effective in all required clinical trials or will meet all applicable regulatory requirements necessary to receive marketing approval from the FDA.

Even if we successfully obtain FDA approval, we may not be able to obtain the regulatory approvals necessary to market our products outside the United States since the commercialization of our products outside the United States will be subject to separate regulations imposed by foreign government agencies. The approval procedures for marketing outside the United States vary among countries and can involve additional testing. Accordingly, we cannot predict with any certainty how long it will take or how much it will cost to obtain regulatory approvals for manufacturing and marketing our products within and outside the United States or whether we will be able to obtain those regulatory approvals at all. Our failure to successfully complete our clinical trials, obtain FDA and any applicable foreign government approvals or any delays in receipt of such approvals could have a material effect on our business, results of operations and financial condition.

We are dependent on the successful outcomes of clinical trials of our products, and we cannot assure you that any clinical testing will demonstrate the safety and efficacy of our products.

In order to introduce and market our products, we must be able to, among other things, demonstrate safety and efficacy with substantial evidence from well-controlled clinical trials. In September 2004, we announced that Deltavasc™ did not meet the primary endpoint in a Phase II clinical trial in patients with intermittent claudication form of peripheral arterial disease. This had been our most advanced clinical program and represented the substantial portion of our clinical development activities. VLTS 934 is an investigational product that is a non-ionic polyoxyethylene-polyoxypropylene block copolymer, which has the chemical characteristics of components of cell membranes. Although, we are currently investigating the poloxamer’s possible mechanism of action in preclinical study, there can be no assurance that VLTS 934 improves microvascular blood flow, results in a pharmacologic effect or will demonstrate efficiacy. We anticipate that we will begin a follow-on Phase IIb clinical trial using our VLTS 934 prodcut compared to a saline placebo in the quarter ending June 30, 2005. Should future clinical trials, including our follow-on Phase IIb clinical trial of our VLTS 934 prodcut, fail to demonstrate a statistically significant drug effect and show safety for the targeted patient population, our business and prospects could be harmed and the market price of our common stock could fall. If the future results of clinical trials regarding our products fail to validate the safety and effectiveness of treatments using our products, our ability to generate revenues from those products would also be adversely affected, delayed or prevented entirely and our business could be harmed.

The results of early Phase I and Phase II clinical trials are based on a small number of patients over a short period of time, and our success may not be indicative of results in a large number of patients or long-term efficacy.

The results in early phases of clinical testing are based upon limited numbers of patients and a limited follow-up period. Typically, our Phase I clinical trials for indications of safety enroll less than 50 patients. Our Phase II clinical trials for efficacy typically enroll approximately 100 patients. Actual results with more data points may not confirm favorable results from our earlier stage trials. A number of companies in the pharmaceutical and biotechnology industries have suffered significant setbacks in late stage clinical trials even after achieving promising results in earlier stage clinical trials. In addition, we do not yet know if early results will have a lasting effect. If a larger population of patients does not experience positive results, or if these results do not have a lasting effect, our products may not receive approval from the FDA. Failure to demonstrate the safety and effectiveness of our products in larger patient populations could have a material adverse effect on our business that would cause our stock price to decline significantly.

We have received a “going concern” opinion from our independent auditors, which may negatively impact our business.

We have received a report from our independent registered public accounting firm regarding the consolidated financial statements for the fiscal year ended June 30, 2004 that included an explanatory paragraph which stated that the financial statements have been prepared assuming we will continue as a going concern. The explanatory paragraph stated that our recurring operating losses and need for additional financing have raised substantial doubt about our ability to continue as a going concern. Any failure to dispel any continuing doubts about our ability to continue as a going concern could adversely affect our ability to enter into collaborative relationships with business partners and our ability to sell our products and could have a material adverse effect on our business, financial condition and results of operations.

Our stock price has been and may continue to be volatile and an investment in our common stock could suffer a decline in value.

The trading price of the shares of our common stock has been and may continue to be highly volatile. We receive only limited attention by securities analysts and may experience an imbalance between supply and demand for our common stock resulting from low trading volumes. The market price of our common stock may fluctuate significantly in response to a variety of factors, most of which are beyond our control, including the following:

• results of our clinical trials and preclinical studies, or those of our competitors;

• our ability to attract and retain corporate partners;

• negative regulatory action or regulatory approval with respect to our products or our competitors’ products;

• developments related to our patents or other proprietary rights or those of our competitors;

• announcements by us or our competitors of new products, technological innovations, contracts, acquisitions, corporate partnerships or joint ventures;

• changes in our eligibility for continued listing of our common stock on The Nasdaq SmallCap Market; and

• market conditions for biopharmaceutical or biotechnology stocks in general.

The stock market has, from time to time, experienced extreme price and volume fluctuations, which have particularly affected the market prices for emerging biotechnology and biopharmaceutical companies and which have often been unrelated to their operating performance. These broad market fluctuations may adversely affect the market price of our common stock. In addition, sales of substantial amounts of our common stock in the public market could lower the market price of our common stock.

Our stock price could be adversely affected by dispositions of our shares pursuant to registration statements currently in effect.

Some of our current stockholders hold a substantial number of shares, which they are currently able to sell in the public market under certain registration statements currently in effect, or otherwise. Sales of a substantial number of our shares or the perception that these sales may occur, could cause the trading price of our common stock to fall and could impair our ability to raise capital through the sale of additional equity securities.

As of February 11, 2005, we had issued and outstanding 13,098,762 shares of our common stock. This amount does not include, as of February 11, 2005:

• approximately 2.3 million shares of our common stock issuable upon the exercise of all of our outstanding options; and

• approximately 2.7 million shares of our common stock issuable upon the exercise of all of our outstanding warrants.

These shares of common stock, if and when issued, may be sold in the public market assuming the applicable registration statements continue to remain effective and subject in any case to trading restrictions to which our insiders holding such shares may be subject from time to time. If these options or warrants are exercised and sold, our stockholders may experience additional dilution and the market price of our common stock could fall.

We must be able to continue to secure additional financing in order to continue our operations, which might not be available or which, if available, may be on terms that are not favorable to us.

The continued development and clinical testing of our potential products will require substantial additional financial resources. Our future funding requirements will depend on many factors, including:

• scientific progress in our research and development programs;

• size and complexity of such programs;

• scope and results of preclinical studies and clinical trials;

• time and costs involved in obtaining FDA and other regulatory approvals;

• ability to establish and maintain corporate collaborations;

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

• competing technological and market developments; and

• the cost of manufacturing material for preclinical, clinical and commercial purposes.

We may have insufficient working capital to fund our cash needs unless we are able to raise additional capital in the future. We have financed our operations to date primarily through the sale of equity securities and through corporate collaborations. We do not anticipate generating revenues for the foreseeable future and may be required to fund our operations through additional third party financing. If we raise additional funds by issuing equity securities, substantial dilution to existing stockholders may result. We may not be able to obtain additional financing on acceptable terms, or at all. Any failure to obtain an adequate and timely amount of additional capital on commercially reasonable terms will have a material adverse effect on our business, financial condition, including our viability as an enterprise. As a result of these concerns, management may pursue strategic alternatives, which may include the sale or merger of the business, the sale of certain assets or other actions.

We may also take actions to conserve our cash resources through reductions in our personnel, delaying or scaling back our development programs or relinquishing greater or all rights to products at an earlier stage of development or on less favorable terms than we otherwise would. Any or all of these actions could have a material adverse affect on our business.

The future success of our business depends on our ability to attract and retain corporate partners to develop, introduce and market our gene therapy and other products.

Our business strategy is to attract business partners to fund or conduct research and development, clinical trials, manufacturing, marketing and sales of our gene therapy and other products. We face intense competition from many other companies in the pharmaceutical and biotechnology industry for corporate collaborations, as well as for establishing relationships with academic and research institutions and for obtaining licenses to proprietary technology. If we are unable to attract and retain corporate partners to develop, introduce and market our products, our business may be materially and adversely affected.

Our strategy and any reliance on corporate partners, if we are able to establish such collaborative relationships, are subject to additional risks. Our partners may not devote sufficient resources to the development, introduction and marketing of our products or may not pursue further development and commercialization of products resulting from collaborations with us. If a corporate partner elects to terminate its relationship with us, our ability to develop, introduce and market our products may be significantly impaired and we may be forced to discontinue the product altogether. We may not be able to negotiate alternative corporate partnership agreements on acceptable terms, if at all. The failure of any future collaboration efforts could have a material adverse effect on our ability to develop, introduce and market our products and, consequently, could have a material adverse effect on our business, results of operations and financial condition.

We face strong competition in our market and competition from alternative treatments in the biopharmaceuticals market.

The pharmaceutical and biotechnology industries are highly competitive. We are aware of several pharmaceutical and biotechnology companies that are pursuing gene-based therapeutics. For example, we are aware that AnGes MG, Aventis Pharma SA, Avigen, Inc., Cell Genesys, Inc., Corautus Genetics, Daiichi Pharmaceutical Corporation, Gencell SAS, GenVec, Inc., Introgen Therapeutics, Inc., Schering AG, Targeted Genetics Corp., and Vical Inc. are also engaged in developing cardiovascular and gene-based therapies. Many of these companies are addressing diseases that have been targeted by us directly or indirectly. Our competitive position depends on a number of factors, including safety, efficacy, reliability, marketing and sales efforts, the existence of competing products and treatments and general economic conditions. Some competitors have substantially greater financial, research, product development, manufacturing, marketing and technical resources than we do. Some companies also have greater name recognition than us and long-standing collaborative relationships. In addition, gene therapy is a new and rapidly evolving field and is expected to continue to undergo significant and rapid technological change, which could render our products obsolete.

We also face competition from biotechnology and pharmaceutical companies using more traditional approaches to treating human diseases. Our competitors, academic and research institutions or others may develop safer, more effective or less costly biologic delivery systems, gene-based therapeutics or chemical-based therapies. In addition, competitors may achieve superior patent protection or obtain regulatory approval or product commercialization earlier than we do. Any such developments could seriously harm our business, financial condition and results of operations.

Adverse events in the field of gene therapy may negatively impact regulatory approval or public perception of our potential products.

The death in 2000 of a patient undergoing a physician-sponsored, viral-based gene therapy trial has been widely publicized. Following this death and publicity surrounding the field of gene therapy, the FDA appears to have become more restrictive regarding the conduct of gene therapy clinical trials. This approach by

the FDA can lead to delays in the timelines for regulatory review, as well as potential delays in the conduct of our gene therapy clinical trials. In addition, the negative publicity around the field of gene therapy appears to have affected patients’ willingness to participate in some gene therapy clinical trials. If fewer patients are willing to participate in our clinical trials, the timelines for recruiting patients and conducting the trials will be delayed. The commercial success of our potential products will depend in part on public acceptance of the use of gene therapy for the prevention or treatment of human diseases. Negative public reaction to gene therapy in general could result in stricter labeling requirements of gene therapy products, including any of our products, and could cause a decrease in the demand for products we may develop.

If we are unable to obtain rights to required technologies including poloxamer, proprietary genes, proteins or other technologies, we will be unable to operate our business.

Our cardiovascular therapies involve multiple component technologies, many of which may be patented by others. For example, our products use gene sequences, some of which have been, or may be, patented by others. As a result, we may be required to obtain licenses or acquire rights to those gene sequences, proteins or other technologies. We may not be able to obtain a license or acquire rights to those technologies on reasonable terms, if at all. As a consequence, we might be prohibited from developing potential products or we might have to make cumulative royalty payments to several companies. These cumulative royalties would reduce amounts paid to us or could make our products too expensive to develop or market. From time to time, we may engage in preliminary discussions with third parties concerning potential acquisitions of technologies or products. Even if we are successful in acquiring technologies or products, we may experience difficulties in and costs associated with the assimilation of technologies, products, operations and personnel acquired, diversion of management’s attention from other business concerns, inability to maintain uniform standards, controls, procedures and policies and the subsequent loss of key personnel. If we are unable to acquire or obtain rights to technologies or products necessary for our business, our business would be harmed.

We rely on patents and other proprietary rights to protect our intellectual property and any inability to protect our intellectual property rights would adversely impact our business.

We rely on a combination of patents, trade secrets, trademarks, proprietary know-how, nondisclosure and other contractual agreements and technical measures to protect our intellectual property rights. We file patent applications to protect processes, practices and techniques related to our gene-therapy products that are significant to the development of our business. We have been issued 58 United States patents and 73 foreign patents on the technologies related to our products and processes. We have approximately 19 pending patent applications in the United States and 71 foreign pending patent applications. Our patent applications may not be approved. Any patents granted now or in the future may offer only limited protection against potential infringement and development by our competitors of competing products. Moreover, our competitors, many of which have substantial resources and have made substantial investments in competing technologies, may seek to apply for and obtain patents that will prevent, limit or interfere with our ability to make, use or sell our products either in the United States or in international markets.

In addition to patents, we rely on trade secrets and proprietary know-how, which we seek to protect, in part, through proprietary information agreements with employees, consultants and other parties. Our proprietary information agreements with our employees and consultants contain industry standard provisions requiring such individuals to assign to us, without additional consideration, any intellectual property conceived or reduced to practice by them while employed or retained by us, subject to customary exceptions. Proprietary information agreements with employees, consultants and others may be breached, and we may not have adequate remedies for any breach. Also, our trade secrets may become known to, or independently developed by, competitors. Any failure to protect our intellectual property would significantly impair our competitive position and adversely affect our results of operations and business.

We could become subject to litigation regarding our intellectual property rights, which could seriously harm our business.

In previous years, there has been significant litigation in the United States involving patents and other intellectual property rights. Competitors in the biotechnology industry may use intellectual property litigation against us to gain advantage. In the future, we may be a party to litigation to protect our intellectual property or as a result of an alleged infringement of others’ intellectual property. These claims and any resulting lawsuit, if successful, could subject us to significant liability for damages and invalidation of our proprietary rights. Any potential intellectual property litigation, if successful, also could force us to stop selling, incorporating or using our products that use the challenged intellectual property; obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology, which license may not be available on reasonable terms, or at all; or redesign our products that use the technology. We may also be required in the future to initiate claims or litigation against third parties for infringement of our intellectual property rights to protect these rights or determine the scope or validity of our intellectual property or the rights of our competitors. The pursuit of these claims could result in significant expenditures and the diversion of our technical and management personnel. If we are forced to take any of these actions, our business may be seriously harmed.

Any claims, with or without merit, and regardless of whether we prevail in the dispute, would be time-consuming, could result in costly litigation and the diversion of technical and management personnel and could require us to develop non-infringing technology or to enter into royalty or licensing agreements. An adverse determination in a judicial or administrative proceeding and failure to obtain necessary licenses or develop alternate technologies could prevent us from developing and selling our products, which would have a material adverse effect on our business, results of operations and financial condition.

We must rely on our partners to demonstrate large-scale manufacturing capabilities in order to be successful.

Our limited cGMP manufacturing experience makes our ability to successfully introduce our potential products more difficult than it would be otherwise. Although we had a license agreement for manufacturing and supplying plasmid DNA to us and the gene therapy industry, no third party has successfully manufactured plasmid DNA on a sustained large-scale commercial basis. We will depend on our contract manufacturing organization (CMO), Cangene Corporation (Cangene), other CMO’s or a future corporate partner for commercial-scale manufacturing of our products. Cangene and/or our corporate partners may be unable to develop adequate manufacturing capabilities for commercial-scale quantities of gene products. If Cangene or third parties are unable to establish and maintain large scale manufacturing capabilities, we will be unable to introduce sufficient products to sustain our business.

We may experience delays in the commercial introduction, manufacture or regulatory approval of our products as a result of failures by our contract manufacturers to comply with FDA manufacturing practices and requirements.

Drug-manufacturing facilities regulated by the FDA must comply with the FDA’s good manufacturing practice regulations, which include quality control and quality assurance requirements, as well as maintenance of records and documentation. Manufacturers of biologics also must comply with the FDA’s general biological product standards and may be subject to state regulation as well. Such manufacturing facilities are subject to ongoing periodic inspections by the FDA and corresponding state agencies, including unannounced inspections, and must be licensed as part of the product approval process before being utilized for commercial manufacturing. Noncompliance with the applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, withdrawal of marketing approvals, and criminal prosecution. Any of these actions by the FDA would materially and adversely affect our ability to continue clinical trials and adversely affect our business. We cannot assure you that our contract manufacturers will attain or maintain compliance with current or future good manufacturing practice requirements and the FDA could suspend or further delay our clinical trials, the commercial introduction and manufacture of our products or place restrictions on our ability to conduct clinical trials or commercialize our products, including the mandatory withdrawal of the product from the clinical trials.

Our research and development processes involve the controlled use of hazardous materials, chemicals and radioactive materials and produce waste products that could subject us to unanticipated environmental liability and would adversely affect our results of operations.

Our research and development processes involve the controlled use of hazardous materials, chemicals and radioactive materials and produce waste products. We are subject to federal, state and local environmental laws and regulations governing the use, manufacture, storage, handling and disposal of such materials and waste products. Although we believe that our safety procedures for handling and disposing of such materials comply with the standards prescribed by such laws and regulations, the risk of accidental contamination or injury from these materials cannot be eliminated completely. In the event of such an accident, we could be held liable for any damages that result, and any such liability could exceed our resources. Although we believe that we are in compliance in all material respects with applicable environmental laws and regulations, there can be no assurance that we will not be required to incur significant costs to comply with environmental laws and regulations in the future or that any of our operations, business or assets will not be materially adversely affected by current or future environmental laws or regulations.

We depend on key personnel to develop our products and, if we are unable to hire additional personnel due to the intense competition in the Bay Area and other obstacles in recruiting qualified personnel for key management, scientific and technical positions, our business may suffer.

Our ability to attract and retain management, scientific and technical staff to develop our potential products and formulate our research and development strategy is a critical factor in determining whether we will be successful in the future. The San Francisco Bay Area, where our corporate headquarters and clinical development center is located, is home to a large number of biotechnology and pharmaceutical companies, and there is a limited number of qualified individuals to fill key scientific and technical positions. Competition for highly skilled personnel is intense and we may not be successful in attracting and hiring qualified personnel to fulfill our current or future needs.

Although we have programs in place to retain personnel, including programs to create a positive work environment and competitive compensation packages, none of our officers or key employees are bound by an employment agreement for any specific term and these individuals may terminate their employment at any time. Our future success depends upon the continued services of our executive officers and other key scientific, marketing, manufacturing and support personnel. As of February 11, 2004, we had a total of 22 full-time employees, including 15 employees supporting our research and development efforts. We do not have “key person” life insurance policies covering any of our employees and the loss of services of any of our key employees would adversely affect our business. Additionally, after the corporate reorganization announced in January 2002 that resulted in the termination of 47 positions and the subsequent corporate reorganization announced in October 2002 that resulted in the termination of 34 positions, it may be more difficult for us to recruit personnel in the future. If we do not attract and retain qualified personnel, our research and development programs could be delayed, which could materially and adversely affect the development of our products and our business.

There are no assurances that we can maintain our listing on The Nasdaq SmallCap Market and the failure to maintain listing could adversely affect the liquidity and price of our common stock.

On January 31, 2003, our common stock began trading on The Nasdaq SmallCap Market pursuant to an exception from delisting. Nasdaq has notified us that in the event we fail to demonstrate compliance, as well as an ability to sustain compliance, with all requirements for continued listing on The Nasdaq SmallCap Market, including Nasdaq’s corporate governance criteria, our securities will be delisted from The Nasdaq Stock Market. If our securities are delisted from The Nasdaq Stock Market, the trading of our common stock is likely to be conducted on the OTC Bulletin Board. The delisting of our common stock from The Nasdaq SmallCap Market will result in decreased liquidity of our outstanding shares of common stock and a resulting inability of our stockholders to sell our common stock or obtain accurate quotations as to their market value, which would reduce the price at which our shares trade. The delisting of our common stock could also deter broker-dealers from making a market in or otherwise generating interest in our common stock and would adversely affect our ability to attract investors in our common stock. Furthermore, our ability to raise additional capital would be severely impaired. As a result of these factors, the value of the common stock would decline significantly, and our stockholders could lose some or all of their investment.

If we are unable to complete our assessment as to the adequacy of our internal control over financial reporting within the required time periods as required by Section 404 of the Sarbanes-Oxley Act of 2002, or in the course of such assessments identify and report material weaknesses in our controls, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our common stock.

As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted rules requiring public companies to include a report of management on the company’s internal controls over financial reporting in their Annual Reports on Form 10-K. This report is required to contain an assessment by management of the effectiveness of a company’s internal controls over financial reporting. In addition, the independent registered public accounting firm auditing a public company’s financial statements must attest to and report on management’s assessment of the effectiveness of the company’s internal controls over financial reporting. We are required to be in compliance with the Section 404 requirements beginning with the fiscal year that ends June 30, 2006. Although we intend to diligently and vigorously review our internal controls over financial reporting in order to ensure compliance with the Section 404 requirements, if Ernst & Young LLP, our independent registered public accounting firm, is not satisfied with our internal controls over financial reporting or the level at which these controls are documented, designed, operated or reviewed, or if our independent registered public accounting firm interprets the requirements, rules or regulations differently from us, then they may decline to attest to management’s assessment or may issue a report that is qualified. We anticipate expending significant resources in developing the necessary documentation and testing procedures required by Section 404, however, there is a risk that we will not comply with all of the requirements imposed by Section 404. In addition, the very limited size of our organization could lead to conditions that could be considered material weaknesses, such as those related to segregation of duties that is possible in larger organizations but significantly more difficult in smaller organizations. Also, controls related to our general information technology infrastructure may not be as comprehensive as in the case of a larger organization with more sophisticated capabilities and more extensive resources. It is not clear how such circumstances should be interpreted in the context of an assessment of internal controls over financial reporting. If we fail to implement required new or improved controls, we may be unable to comply with the requirements of Section 404 in a timely manner. This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could cause the market price of our common stock to decline.

The concentration of ownership among our executive officers, directors and their affiliates may delay or prevent a change in our corporate control.

Our executive officers, directors and their affiliates beneficially own or control in excess of approximately 17% of outstanding common shares, warrants or options to purchase common stock, with approximately 14% of outstanding common shares, warrants and options to purchase common stock held by Perseus-Soros BioPharmaceutical Fund, L.P. As a result, this stockholder will be able to exercise significant control over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, which could delay or prevent an outside party from acquiring or merging with us, which could in turn reduce our stock price.

If we fail to manage growth effectively, our business could be disrupted, which could harm our operating results.

If any of our products successfully complete clinical trials and receive FDA approval, we may experience growth in our business. We must be prepared to expand our workforce and to train, motivate and manage additional employees as the need for additional personnel arises. Failure to attract and retain sufficient numbers of additional employees could impede our growth. In addition, our ability to manage our growth effectively could require us to make significant investments and expenditures to enhance our operational, management and financial infrastructure, information systems and procedures. Any failure to effectively manage future growth could have a material adverse effect on our business, results of operations and financial condition.

If our facilities were to experience an earthquake or other catastrophic loss, our operations would be seriously harmed.

Our facilities could be subject to a catastrophic loss such as fire, flood or earthquake. All of our research and development activities, our corporate headquarters and other critical business operations are located near major earthquake faults in Burlingame, California. Any such loss at any of our facilities could disrupt our operations, delay development of our products and result in large expense to repair and replace our facilities. We currently do not maintain insurance policies protecting against catastrophic loss, except for fire insurance with coverage amounts normally obtained in our industry.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We maintain a strict investment policy that ensures the safety and preservation of our invested funds by limiting default risk, market risk and reinvestment risk. Our cash and cash equivalents consist of cash and money market accounts. Our investments consist primarily of commercial paper, medium term notes, U.S. Treasury notes and obligations of U.S. Government agencies and corporate bonds. The table below presents notional amounts and related weighted-average interest rates by year of maturity for our investment portfolio (in thousands, except percentages). All of our market risk sensitive instruments mature in 2005.

	2005
Cash equivalents
Fixed rate	$	4,119
Average rate	2.06		%
Short-term investments
Fixed rate	9,300
Average rate	2.22		%
Total cash equivalents and investment securities at December 31, 2004	$	13,419

Average rate	2.17		%

ITEM 4. CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Quarterly Report on Form 10-Q is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal finance and accounting officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Our management has evaluated, with the participation of our Chief Executive Officer, who is our principal executive officer, and our Vice President of Finance and Administration , who is our principal financial officer, the effectiveness of our “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15(d)-15(e) of the Securities and Exchange Act of 1934, as amended) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our Chief Executive Officer and our Vice President of Finance and Administration concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities and Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities Exchange Commission rules and forms at the reasonable assurance level.

There have been no significant changes in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

PART II: OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Not applicable.

ITEM 2. UNREGISTERED SALES AND USE OF PROCEEDS

Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS

Our Annual Meeting of Stockholders was held on December 2, 2004 in Burlingame, California. Of the 13,098,762 shares outstanding as of the record date, 10,690,166 were present or represented by proxy at the meeting. The results of the voting on the matters submitted to the stockholders are as follows:

1. To elect three (3) directors to serve for the ensuing year or until their successors are duly elected and qualified.

Name	Votes For	Votes Withheld
Benjamin F. McGraw, III, Pharm.D.	9,297,263	1,392,903
Dennis J. Purcell	10,156,636	533,530
John S. Schroeder, M.D.	10,156,623	533,543

2. To approve an amendment to the Amended and Restated 1997 Equity Incentive Plan to increase the number of shares of common stock reserved for issuance thereunder by 2,000,000 shares from 1,700,000 shares to 3,700,000 shares.

Votes for:		3,216,023
Votes against		1,313,562
Votes abstaining:		3,461

3. To approve an amendment to the Amended and Restated 1998 Non-Employee Directors’ Stock Option Plan to increase the number of shares of common stock reserved for issuance thereunder by 200,000 shares from 375,000 shares to 575,000 shares.

Votes for:		3,913,401
Votes against		614,293
Votes abstaining:		5,352

4. To ratify the appointment of Ernst & Young LLP as independent accountants of the Company for the fiscal year ending June 30, 2005.

Votes for:		10,296,500
Votes against		391,241
Votes abstaining:		2,425

ITEM 5. OTHER INFORMATION

Not applicable.

ITEM 6. EXHIBITS

a.	Exhibits

	31.1	Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act.
	31.2	Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act.
	32.1	Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act.
	32.2	Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act.

PART I: FINANCIAL INFORMATION
ITEM 1:	FINANCIAL STATEMENTS (Unaudited)
	Condensed Consolidated Balance Sheets
	Condensed Consolidated Statements of Operations
	Condensed Consolidated Statements of Cash Flows
	Notes to the Condensed Consolidated Financial Statements
ITEM 2:	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	Overview
	Results of Operations
	Liquidity and Capital Resources
	Recnt Accounting Pronouncements
	Additional Factors That May Affect Future Results
ITEM 3:	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4:	CONTROLS AND PROCEDURES
PART II: OTHER INFORMATION
ITEM 1:	LEGAL PROCEEDINGS
ITEM 2:	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
ITEM 3:	DEFAULTS UPON SENIOR SECURITIES
ITEM 4:	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5:	OTHER INFORMATION
ITEM 6:	EXHIBITS
SIGNATURES

			VALENTIS, INC.


Date: February 14, 2005			/s/ BENJAMIN F. MCGRAW III
			Benjamin F. McGraw III Chairman of the Board of Directors, President and Chief Executive Officer (Principal Executive Officer)

Date: February 14, 2005			/s/ JOSEPH A. MARKEY
			Joseph A. Markey Vice President of Finance and Administration (Principal Financial and Accounting Officer)