UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT UNDER SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005

OR

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

Commission file number: 000-31617

CIPHERGEN BIOSYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Ciphergen Biosystems, Inc.
6611 Dumbarton Circle
Fremont, CA 94555
(510) 505-2100

(Address, including zip code, of registrant’s principal executive offices
and telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: none

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001 par value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes o No x

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 ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this form 10-K. x

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 o                  Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes o No x

The aggregate market value of voting stock held by non-affiliates of the Registrant was approximately $30.0 million as of June 30, 2005, based upon the closing price on the Nasdaq National Market reported for such date. This calculation does not reflect a determination that certain persons are affiliates of the Registrant for any other purpose. The number of shares outstanding of the Registrant’s common stock on February 28, 2006 was 35,998,881 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement for its 2006 Annual Meeting of Stockholders (the “Proxy Statement”), to be filed with the Securities and Exchange Commission, are incorporated by reference into Part III of this Form 10-K Report.

CIPHERGEN BIOSYSTEMS, INC.

FORM 10-K

INDEX

Ciphergen, ProteinChip and Biomarker Discovery Center are registered trademarks of Ciphergen Biosystems, Inc. Biomek is a registered trademark of Beckman Coulter Inc. BioSepra is a registered trademark of Pall Corporation.

PART I

We have made statements under the captions “Business”, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Factors That May Affect Our Results” and in other sections of this Form 10-K that are forward-looking statements for purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. We claim the protection of such safe harbor, and disclaim any intent or obligation to update any forward-looking statement. You can identify these statements by forward-looking words such as “may”, “will”, “expect”, “intend”, “anticipate”, “believe”, “estimate”, “plan”, “could”, “should” and “continue” or similar words. These forward-looking statements may also use different phrases. We have based these forward-looking statements on our current expectations and projections about future events. Examples of forward-looking statements include statements about projections of our future revenue, gross margin, results of operations and financial condition; anticipated deployment, capabilities and uses of our products and our product development activities and product innovations; the importance of proteomics as a major focus of biology research; the ability of our products to enable proteomics research; competition and consolidation in the markets in which we compete; existing and future collaborations and partnerships; our ability to operate our Biomarker Discovery Center® laboratories and secure commercial rights to biomarkers discovered at our Biomarker Discovery Center laboratories; the utility of biomarker discoveries and the effectiveness of our Biomarker Discovery Center laboratories; our ability to leverage our Biomarker Discovery Center laboratory operations to foster further adoption of our products and technology and to generate revenue by obtaining some combination of fees and commercial rights related to biomarkers discovered in our Biomarker Discovery Center laboratories in exchange for performing research services; our belief that biomarker discoveries may have diagnostic and/or therapeutic utility; our belief that our Biomarker Discovery Center laboratories may accelerate biomarker discovery and validation in both pharmaceutical drug discovery, toxicology and clinical trials, and in clinical research laboratories; our plan to deploy the prototypes of our latest technology and protocols to maintain and extend a technological advantage in our Biomarker Discovery Center laboratories; our plans to develop and commercialize diagnostic tests through our strategic alliance with Quest Diagnostics; our ability to comply with applicable government regulations; our ability to expand and protect our intellectual property portfolio; decreasing general and administrative costs; decreasing sales and marketing costs; decreasing research and development costs; expected stock-based compensation expense after adoption of SFAS 123(R); anticipated future losses; potential expenses associated with a product retrofit; expected levels of capital expenditures; forgiveness of loan obligations to Quest Diagnostics; the rating of our convertible notes and the value of the related put options; the period of time for which our existing financial resources, debt facilities and interest income will be sufficient to enable us to maintain current and planned operations; foreign currency exchange rate fluctuations and our plans for mitigating foreign currency exchange risks; and the market risk of our investments.

These statements are subject to significant risks and uncertainties, including those identified in the section of this Form 10-K entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Our Results”, that could cause actual results to differ materially from those projected in such forward-looking statements due to various factors, including our ability to generate growth in unit sales while maintaining pricing; managing our manufacturing costs, operating expenses and cash resources consistent with our plans; our ability to conduct our ongoing new product development and product improvement activities within the budgets and time frames we have established; the ability of our ProteinChip® technology to discover protein biomarkers that have diagnostic, theranostic and/or drug development utility; the continued emergence of proteomics as a major focus of biological research and drug discovery; and our ability to protect and promote our proprietary technologies. We believe it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to accurately predict or that we do not fully control that

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could cause actual results to differ materially from those expressed or implied in our forward-looking statements.

References to “Ciphergen”, the “Company”, “we”, “us” and “our” refer to Ciphergen Biosystems, Inc. and its subsidiaries, taken as a whole.

ITEM 1.  BUSINESS

Overview

We develop, manufacture and market our ProteinChip Systems, which use patented Surface Enhanced Laser Desorption/Ionization (“SELDI”) technology. The ProteinChip Systems enable protein discovery, characterization and assay development to provide researchers with a better understanding of biological functions at the protein level. Protein characterization is the determination of the detailed identity of a protein, including its sequence as predicted by the corresponding gene and any chemical modifications introduced after the protein is produced. Assay development is the simplification and optimization of a set of procedures to develop a method for detecting and quantifying a specific protein. Our ProteinChip Systems are novel, enabling tools in the emerging field of protein-based biology research, known as proteomics. While technological advances in DNA tools have substantially changed the field of genomics, the absence of enabling protein analysis tools has limited progress in proteomics research. Proteomics provides a direct approach to understanding the role of proteins in the biology of disease, monitoring disease progression and the therapeutic effects of drugs. We believe proteomics will be a major focus of biological research by enhancing the researcher’s understanding of gene function and the molecular basis of disease. In May 1999, we commercially launched our ProteinChip Biology System and in July 2004, we launched our next-generation system, the ProteinChip System, Series 4000.

We develop, manufacture and sell our ProteinChip System family of proteomics research equipment, which includes (i) the ProteinChip System, Series 4000, a versatile system for protein analysis consisting of a ProteinChip Reader and ProteinChip Software; (ii) the ProteinChip Biomarker System, a system including Biomarker Patterns™ Software for advanced protein expression profiling; (iii) the ProteinChip AutoBiomarker System, a system including an Autoloader which automates array processing; (iv) the ProteinChip Tandem MS Interface for advanced identification work using tandem mass spectrometry; (v) automation accessories such as the Biomek® 3000 Workstation, which is manufactured by Beckman Coulter, and an Autoloader to facilitate sample handling and increase throughput; and (vi) other associated accessories. This equipment is used in conjunction with our ProteinChip Arrays, which are consumable biochips whose surface contains binding sites (i.e., chemistries that bind or capture specific proteins or classes of proteins). In addition, we provide associated SELDI technology contract research services through our Biomarker Discovery Center laboratories to foster further adoption of our products and technology as an industry standard and to generate revenue by obtaining some combination of fees and commercial rights related to biomarkers discovered in our Biomarker Discovery Center laboratories in exchange for performing research services.

In addition to generating revenue by providing technology and services to life science researchers, in the last several years we have discovered and filed patents on biomarkers and patterns of biomarkers that are associated with various diseases and other pathological states. Initial areas of focus have included a variety of cancers as well as neurological, cardiovascular and infectious diseases. The clinical questions we have been researching include early detection, treatment response, monitoring of disease progression, prognosis and others. We have established a number of collaborations to assist in these discovery and validation efforts, such as with The Johns Hopkins School of Medicine, the University of Texas M.D. Anderson Cancer Center and University College London. The goal of our efforts is to develop certain of these biomarker discoveries into assays delivered on our ProteinChip platform that could be used to improve patient care. On July 22, 2005, we entered into a strategic alliance agreement with Quest

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Diagnostics Incorporated (“Quest Diagnostics”) covering a three year period during which the parties will strive to develop and commercialize up to three diagnostic tests based on Ciphergen’s proprietary SELDI technology. Under this agreement, Quest Diagnostics will have the non-exclusive right to commercialize these tests on a worldwide basis, with exclusive commercialization rights in territories where Quest Diagnostics has a significant presence for up to five years following commercialization.

Ciphergen Biosystems, Inc. was originally incorporated in California on December 9, 1993 under the name Abiotic Systems. In March 1995, we changed our corporate name to Ciphergen Biosystems, Inc. On May 23, 2000, we reincorporated in Delaware. On September 28, 2000, we had our initial public offering. On July 31, 2001, we acquired BioSepra S.A., a wholly-owned subsidiary of Ciphergen located near Paris, France, which is principally engaged in the development, manufacture and marketing of process chromatography sorbents, which are media used to capture and purify proteins. On November 30, 2004, we sold BioSepra S.A. and related assets to Pall Corporation.

Our revenue is derived from the sales of interrelated products and services on a worldwide basis. Although discrete components that earn revenues and incur expenses exist, significant expenses such as sales and marketing and corporate administration are not incurred by nor allocated to these components but rather are employed by the entire enterprise. Additionally, the chief operating decision maker evaluates resource allocation not on a product or geographic basis, but rather on an enterprise-wide basis. Therefore, we have determined that we operate in only one reportable segment, which is the protein research tools and collaborative services business.

Industry Background

Genes are the hereditary coding system of living organisms. Genes encode proteins that are responsible for cellular functions. The study of genes and their functions has led to the discovery of new targets for drug development. The majority of drug targets are proteins, such as receptors, hormones and enzymes. Although genomics allows researchers to identify drug targets, it does not provide complete information on how these targets function within an organism. Industry sources estimate that within the human genome there are approximately 30,000 genes. The initial structure of a protein is determined by a single gene. The final structure of a protein is frequently altered by interactions with additional genes or proteins. These subsequent modifications result in hundreds of thousands of different proteins. In addition, proteins may interact with one another to form complex structures that are ultimately responsible for cellular functions.

Genomics allows researchers to establish the relationship between gene activity and disease. However, many diseases are manifested not at the genetic level, but at the protein level. The complete structure of modified proteins cannot be determined by reference to the encoding gene alone. Thus, while genomics provides some information about diseases, it does not provide a full understanding of disease processes.

The Relationship Between Proteins and Diseases

The entire genetic content of any organism, known as its genome, is encoded in strands of deoxyribonucleic acid, or DNA. Cells perform their normal biological functions through the genetic instructions encoded in their DNA, which results in the production of proteins. The process of producing proteins from DNA is known as gene expression or protein expression. Differences in living organisms result from variability in their genomes, which can affect the types of genes expressed and the levels of gene expression. Each cell of an organism expresses only approximately 10% to 20% of the genome. The type of cell determines which genes are expressed and the amount of a particular protein produced. For example, liver cells produce different proteins from those produced by cells found in the heart, lungs, skin, etc. Proteins play a crucial role in virtually all biological processes, including transportation and storage of energy, immune protection, generation and transmission of nerve impulses and control of growth.

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Diseases may be caused by a mutation of a gene that alters a protein directly or indirectly, or alters the level of protein expression. These alterations interrupt the normal balance of proteins and create disease symptoms. A protein biomarker is a protein that is present in a greater or lesser amount in a disease state versus a normal condition. By studying changes in protein biomarkers, researchers may identify diseases prior to the appearance of physical symptoms. Researchers characterize proteins by their molecular weight. In addition, researchers can utilize protein biomarkers to identify new disease pathways to be used as drug targets. Disease pathways are groups of interacting proteins that lead to disease if any one or more of the proteins is altered. Historically, researchers discovered protein biomarkers as a byproduct of basic biological disease research. This has resulted in the validation by researchers of approximately 200 protein biomarkers that are being used in commercially available clinical diagnostic products. The development of new diagnostic products has been limited by the complexity of disease states, which may be caused or characterized by several or many interacting proteins. Diagnostic products that are limited to the detection of a single protein may lack the ability to detect more complex diseases, and thus produce results that are unacceptable for practical use. The detection of patterns of multiple proteins may prove to be more useful. In recent years, the National Institutes of Health, or NIH, has recognized the importance of protein biomarkers in overcoming this problem and their usefulness in the development of new diagnostic and therapeutic products. Among other initiatives, the NIH has established a grant program (The Early Detection Research Network) to fund the discovery and clinical validation of new protein biomarkers.

Limitations of Available Technologies for Proteomics Research and Protein Purification

Efforts to understand biology and to improve the diagnosis, monitoring and treatment of diseases have been dramatically enhanced through advances in modern genomic technologies. These new technologies have formed the basis for the development of new analytical tools, which are primarily directed at DNA and genomic analysis, but are not applicable to protein research or proteomics. These new tools have accelerated the ability to sequence and analyze the human genome. Historically, researchers used gel electrophoresis as a primary tool for sequencing DNA. Gel electrophoresis measures how far a DNA fragment or other biomolecule, such as a protein, migrates through the pores of gels in response to an applied electric field over a fixed time interval. Electrophoresis is a time-consuming, manual process that requires large amounts of pure DNA to be useful. The development of polymerase chain reaction, or PCR, allowed researchers to amplify, or produce multiple copies of, a fragment of DNA. Researchers could then enhance the signal of trace amounts of DNA from an unprocessed biological sample, such as tissue or blood, to a level where measurement was possible. Successive advances in technologies have produced faster, automated sequencing machines and new, biochip-based technologies. These new technologies have dramatically improved the throughput and accuracy of DNA analysis. In addition, these new technologies have reduced costs by increasing automation and reducing necessary labor.

Although recent technological advances have benefited genomics, there have been fewer significant advances in proteomics. While DNA has been relatively simple to study because of its ease of detection and linear structure, protein analysis has been a far more difficult challenge. The goal of proteomics is to determine the structure and function of proteins. Researchers use techniques such as tagging, amplification and sequencing to analyze DNA, but researchers cannot use these techniques effectively to study proteins. These techniques can change the structure of proteins and may change their characteristics or function, which would limit researchers’ ability to identify and analyze samples. In addition, these techniques do not allow researchers to monitor or study how proteins interact, or to identify which proteins interact together, to perform biological functions.

Currently, researchers perform proteomics research using gel electrophoresis and other protein purification and analysis products. These tools require substantial, labor-intensive sample preparation processes to enable researchers to produce enough purified proteins before identification and analysis can

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occur. In addition, these tools must be operated by researchers with substantial technical expertise. As a result, proteomics research has not advanced at a rate comparable to that of genomics. New tools are needed that are specifically designed to allow researchers to analyze proteins to enable protein biomarker discovery, to fully understand biological pathways and function, and ultimately to accelerate the discovery of new drugs and clinical diagnostics.

The Ciphergen Solution

We develop, manufacture and market our ProteinChip Systems, which use patented Surface-Enhanced Laser Desorption/Ionization (“SELDI”) technology. The ProteinChip Systems enable protein biomarker discovery, characterization and assay development. Our ProteinChip Systems integrate the key steps of proteomics research on a single, miniaturized biochip. Our ProteinChip Systems incorporate SELDI technology on the surface of a consumable biochip, which allows researchers to capture and analyze proteins directly. Our ProteinChip Systems enable rapid, reproducible, on-chip protein expression and protein analysis from complex biological samples, such as whole blood, tissue or saliva, without separation, tagging and amplification processes and with minimal prior purification. SELDI enables protein detection and quantification by reducing signals from unwanted biomolecules that would otherwise obscure the measurement results.

We believe our ProteinChip Systems enable researchers to identify and quantify proteins by direct molecular weight detection and measurement. Researchers can add chemicals or enzymes at any step during the process to greatly enhance the detailed knowledge gained from a set of experiments. We believe the integration of these processes enables a researcher to rapidly discover, characterize and assay proteins directly from biological samples, providing a novel technique for protein discovery and analysis compared to currently available methods. We provide these capabilities to our customers by selling them our ProteinChip Systems and/or our Biomarker Discovery Center collaboration services. We believe our ProteinChip Systems can enable protein research in the following areas:

·       Differential Protein Expression.   Our ProteinChip Systems are designed to enable biology researchers to rapidly conduct studies in differential protein expression. Differential protein expression is the comparison of proteins expressed in different, usually related, biological samples, such as blood serum from a diseased individual and blood serum from an individual without that disease. The differences include differences in the identities of the collection of proteins present in the samples, as well as differences in the amounts of a particular protein present in both samples. Proteins that are either present in one sample and absent in the other, or present at different relative levels in both samples, are potential protein biomarkers of the disease. Further research may validate the use of potential protein biomarkers for the diagnosis of the disease or as targets for the discovery of drugs to treat the disease. In addition, the information derived from our ProteinChip Systems enables scientists to compare genetic message information derived from DNA biochips, or miniaturized biochips containing DNA, to protein information, in order to better define protein function. Differential expression studies and protein discovery that previously were impossible to conduct or took a long time may be performed on our ProteinChip Systems in a much shorter timeframe. By quickly analyzing statistically significant numbers of samples, biomarker candidates can be validated. Researchers can use quantitative assays of proteins developed from differential protein expression to diagnose and monitor disease.

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·       Protein Characterization.   Once a potential protein biomarker is identified, a usual next step is the characterization of the protein. Protein characterization is the process of determining the identity of the protein and/or characterizing aspects of its physical structure. Using our ProteinChip Systems, biology researchers can enrich and concentrate a rare protein from a crude biological sample in a shorter timeframe than typically has been experienced with traditional methods. Researchers can then proceed to determine the identity of the protein. This process can involve, for example, determining a fragment pattern for the protein (produced, for example, by treatment with enzymes) with our ProteinChip Systems, and comparing this pattern with fragment patterns of proteins identified in publicly available protein and genomic databases. Based on this comparison, the researcher may be able to identify the protein in the database that corresponds to the experimental protein. Identifying a protein can provide the researcher with information useful in understanding the biology of the sample being studied. Identifying the gene from which the protein originates can provide useful structural or processing information. Also, researchers can characterize aspects of the physical structure of a protein using our ProteinChip Systems to perform enzymatic-, chemical- or antibody-based tests or assays. Such assays may reveal, for example, whether the protein has been modified after production. Protein modification can suggest changes in protein function, which may be important to the particular disease under study.

·       Quantitative Assay of Proteins and Protein Interactions.   Once a protein biomarker has been identified and characterized, the researcher may want to develop assays based on the protein. One such assay is the routine detection of the protein and determination of its amount in a sample. This is a quantitative assay. It is useful, for example, in diagnostic assays for the severity or stage of a disease. Another assay is a test of protein interactions between the biomarker and other proteins. This assay is useful in tests of the biological function of the protein that may be important for its role in disease. This assay is also useful in drug discovery to identify drug candidates that interfere with protein interaction. Our ProteinChip Systems enable the researcher to perform quantitative and protein interaction assays by selecting a limited number of chemical or biochemical surfaces and optimizing the conditions for a particular type of assay. We believe our ProteinChip System can simplify assay development and speed functional validation of discovered biomarkers for both diagnostic and drug discovery applications.

·       Novel, High-Speed Protein Purification and Production.   Researchers seek rapid purification of proteins from either native biological sources or from “gene to protein” biologically manufactured proteins in order to conduct basic research. Drug developers need to obtain large quantities of proteins of interest for target discovery, validation and large-scale production of therapeutics. Using our ProteinChip Systems, the application of gradient wash conditions to the chromatographic surfaces of our ProteinChip Arrays, which produces a step-wise elution of retained compounds, may allow “on-chip” optimization and purification of proteins more rapidly than using existing methodologies. The “on-chip” optimization method is akin to that accomplished while utilizing columns for liquid chromatography separations but the method allows for purification using only microliters of biological sample versus milliliters of biological sample, and it is thus particularly useful as “predictive protein chromatography” in large-scale production. Our new method of purity analysis is called ProteinChip Retentate Chromatography—Mass Spectrometry (“RC-MS”).

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Our Market Opportunity

There are several types of laboratories that perform proteomics research and development. We believe our ProteinChip Systems and Biomarker Discovery Center collaboration services can enable proteomics research in the following markets:

·       Basic Biology Research.   Basic biology research laboratories focus on the study of general biological processes and the understanding of the molecular basis of disease. Most of the techniques used by researchers in basic biology research to study proteins are labor intensive or have limited analytical capabilities. We believe that the ease of use and problem-solving versatility of our ProteinChip Systems may enable biologists to perform proteomics research at their workstations in the laboratory.

·       Clinical Research.   Clinical research is focused on associating clinical disease symptoms to changes in certain proteins in the disease state versus in the normal state. In doing so, researchers seek to identify markers, many of which are proteins, or patterns of multiple markers that can be used to diagnose diseases early, assess treatment response and monitor treatment progress. We believe that our ProteinChip Systems and collaborative services may enable researchers to rapidly discover protein biomarkers and to develop these biomarkers into clinical diagnostic tests. We are actively pursuing the development of such diagnostic tests as a major part of our business strategy, and have established a strategic alliance with Quest Diagnostics as part of this effort.

·       Diagnostics.   The in vitro diagnostics industry manufactures and distributes products that are used to detect thousands of individual components present in human derived specimens. Many of these assays are used to specifically identify single protein biomarkers. Diagnostic assays that are limited to the detection of a single protein often have limitations in clinical specificity (true positives) and sensitivity (true negatives) due to the complex nature of many diseases and the inherent biological diversity among populations of people. Over the last several years, we have been pursuing the discovery of panels of biomarkers that may yield improved clinical predictivity and utility. We are actively pursuing the development of such diagnostic tests as a major part of our business strategy, and have established a strategic alliance with Quest Diagnostics as part of this effort.

·       Pharmaceutical Drug Research and Development.   A current bottleneck in drug research is secondary screening, during which drug lead candidates are validated by researchers using complex biological assays in which markers are used to assess biological responses to varying compounds, dose levels and conditions. Current assay systems often have poor specificity, are usually labor intensive and require substantial development time. In addition, it is estimated that approximately 25% of drug development failures occur in toxicology, or the study of the negative or harmful effects of a drug, in which the availability of useful data is hampered by similar issues. We believe a lack of protein biomarkers currently limits the ability of researchers to adequately evaluate drug target function, cell pathway analysis and toxicological and therapeutic effects throughout the drug development process. We believe our ProteinChip Systems and collaborative services can substantially improve preclinical development and clinical trial effectiveness by greatly expanding the use of protein biomarkers.

·       Pharmaceutical Production Process.   Another current bottleneck appears in drug development and production. The most popular current method for preparative separation of proteins is liquid chromatography (“LC”). In LC, solid sorbents, which have complementary physicochemical properties to proteins of interest, are employed for selective adsorption. To design an LC protein separation process is a relatively long and systematic task built essentially on a trial and error approach. The application of our ProteinChip System—the RC-MS method—is a rapid alternative

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method that consumes minimal sample yet predicts optimal separation conditions for large-scale LC purification of proteins from complex biological matrices.

Business Strategy

We intend to establish our ProteinChip Systems as an enabling technology platform for protein biomarker discovery and proteomics research in the basic biological research, clinical research, and pharmaceutical drug discovery and development process markets, and as an assay platform in the in vitro diagnostics market. Key elements of our strategy are to:

·       Enter the Diagnostics Market with Proprietary Assays.   In the last several years, we have discovered and filed patents on biomarkers and patterns of biomarkers that are associated with various diseases and other pathological states. Initial areas of focus have included a variety of cancers as well as neurological, cardiovascular and infectious diseases. The clinical questions we have been researching include early detection, treatment response, monitoring of disease progression, prognosis and others. We have established a number of collaborations to assist in these discovery and validation efforts, such as with The Johns Hopkins School of Medicine, the University of Texas M.D. Anderson Cancer Center and University College London. The goal of our efforts is to develop certain of these biomarker discoveries into assays delivered on our ProteinChip platform that could be used to improve patient care. On July 22, 2005, we entered into a strategic alliance agreement with Quest Diagnostics covering a three year period during which the parties will strive to develop and commercialize up to three diagnostic tests based on Ciphergen’s proprietary SELDI technology. Under this agreement, Quest Diagnostics will have the non-exclusive right to commercialize these tests on a worldwide basis, with exclusive commercialization rights in territories where Quest Diagnostics has a significant presence for up to five years following commercialization.

·       Accelerate Awareness and Acceptance of Our ProteinChip Systems.   We intend to focus on expanding the installed base of our ProteinChip Systems with leading academic, government, pharmaceutical and clinical research laboratories to promote awareness and acceptance of our technology. In addition, we will support the use of our ProteinChip Systems through customer education and training as well as customer collaborations, such as those with Bayer and sanofi-aventis, to increase the applications and use of our ProteinChip Arrays. Further, we intend to pursue commercialization of our products through our own sales and marketing organization in North America, Western Europe and Japan, and through distributors or sales representatives in selected other parts of the world, including Australia, China, Malaysia, Singapore, South Korea, Taiwan and Turkey.

·       Expand Product Development and Innovation.   We intend to expand the scope of our product portfolio by continuously developing new products and applications based on our ProteinChip technology. We believe that by expanding the applications of our technology and products and increasing their functionality, we will promote the use and acceptance of our ProteinChip Systems by biology researchers. Current proteomic challenges involve how to simplify the biological sample sufficiently for analysis, without losing the ability to detect the low-abundance and potentially the most important candidate proteins for disease detection in the earliest stages. In 2005, we introduced the Protein Equalizer™ bead technologies and services that allow detection of these lower-abundance proteins in complex samples.

·       Leverage Our Biomarker Discovery Center Laboratory Operations.   Both directly and through partnerships, we operate several Biomarker Discovery Center laboratories which provide SELDI technology-based research services. By performing contract research projects and engaging in research collaborations, we intend not only to foster further adoption of our products and technology, but also to generate revenue by obtaining some combination of fees and commercial rights related to biomarkers discovered in our Biomarker Discovery Center laboratories in

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exchange for performing research services. We believe that these biomarker discoveries may have diagnostic and/or therapeutic utility. We also believe that our Biomarker Discovery Center laboratories may accelerate biomarker discovery and validation in both pharmaceutical drug discovery, toxicology and clinical trials, and in clinical research laboratories. We plan to deploy the prototypes of our latest technology and protocols to maintain and extend a technological advantage in our Biomarker Discovery Center laboratories. Examples of research collaborations being conducted through our Biomarker Discovery Center laboratories include working with The Johns Hopkins School of Medicine on ovarian and other cancers, the University of Texas M.D. Anderson Cancer Center on ovarian cancer, and University College London on ovarian and breast cancers.

·       Expand Our Intellectual Property Portfolio.   We include many issued, allowed and pending patents on the SELDI technology and ProteinChip Systems, Arrays and Software in our current patent portfolio, and intend to expand this portfolio in several areas of technology related to our business, including applications of SELDI technology and biomarker discoveries. We intend to continue to license and acquire technologies from others that complement our core capabilities and to protect our proprietary technologies with patents and trade secrets.

Our ProteinChip Technology

Our ProteinChip technology is based on SELDI, which combines laser-based molecular weight detection with the use of a chemically or biochemically active biochip array surface constructed from proprietary-treated metal. Our ProteinChip technology enables researchers to apply a crude biological sample, such as whole blood or tissue, directly to the surface of a ProteinChip Array. These ProteinChip Arrays are designed to select desired proteins from the sample through affinity capture, which employs chemical processes or biochemical targets such as receptors, antibodies or DNA probes. Researchers then wash away the remainder of the sample with a variety of solutions with varying stringency conditions, depending on the type of test performed. This enhances the signal of the proteins of interest on the biochip by reducing signals from unwanted biomolecules that would otherwise obscure the measurement results. The purified sample proteins remain evenly distributed on the surface of the ProteinChip Array. This even distribution allows the researcher to accurately measure and quantify the proteins.

The researcher then places the ProteinChip Array in a specially developed laser-based, molecular weight detection analyzer, or ProteinChip Reader. The ProteinChip Reader uses a laser beam to release the retained proteins from the ProteinChip Array surface. The ProteinChip Reader accelerates the retained proteins and guides them through a flight tube under vacuum to a detector. The time of this flight is directly related to the exact molecular weight of each protein. This process allows the molecular weight of a sample protein to be determined by the researcher.

The researcher generates protein expression profiles by examining the samples collected with different affinity-based ProteinChip Arrays or different stringency washes, and collecting the information under the different conditions. Using our ProteinChip Systems, researchers can compare protein expression profiles from different samples, such as disease versus normal states, and display differences in the proteins expressed. Proteins that are differentially expressed in the disease versus normal state may be new, potentially relevant protein biomarkers. Researchers can then process proteins of interest on-chip to:

·       obtain sequence identification;

·       detect secondary modifications of proteins;

·       identify protein interactions;

·       quantitatively measure protein concentrations; and

·       perform assays.

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Our ProteinChip Systems and Related Products

Our ProteinChip Systems are fully integrated platforms consisting of a ProteinChip Reader to read ProteinChip Arrays and our proprietary ProteinChip Software to analyze and manage protein-based information.

The ProteinChip Reader is a laser-based, molecular weight detection system designed for use with consumable ProteinChip Arrays, which are biochips containing chemical or biochemical surfaces that capture or bind specific proteins or classes of proteins. We designed our ProteinChip Reader to be used in the laboratory by basic biology researchers. Our ProteinChip Reader consists of a nitrogen laser, high-speed digital electronics, a vacuum system and a standard personal computer with our proprietary ProteinChip Software for system control and data analysis.

Our ProteinChip Software is designed to facilitate system operation by biology researchers with no experience in molecular detection systems and minimal experience in protein analysis. The software allows fully automated operation of the ProteinChip Systems with graphic data presentation and analysis readouts in familiar formats for the biologist, such as those displayed by gel electrophoresis systems. Our ProteinChip Software enables differential protein expression analysis by automatically comparing protein profiles and highlighting differences in protein expression. Our ProteinChip Software provides researchers with Internet access for rapid database searches, which facilitates protein identification. Furthermore, our ProteinChip Software allows researchers to perform quantitative protein interaction assays.

In May 1999, we commercially launched the ProteinChip System, Series PBS II, which we now refer to as the ProteinChip Biology System. In December 2001, we announced the introduction of the ProteinChip Biomarker System which extends the capability of a ProteinChip Biology System by incorporating Biomarker Patterns™ Software and ready-to-use profiling kits. The system is designed for advanced protein expression profiling and serves as a versatile clinical proteomics platform for scientists in clinical disease and toxicological research, as well as pharmaceutical research and development. In October 2002, we introduced the ProteinChip AutoBiomarker System, which consists of a ProteinChip Biomarker System, a ProteinChip Autoloader and a Biomek 2000 Workstation, to increase sample throughput and automate the reading of arrays. In July 2004, we introduced our next generation ProteinChip System, the Series 4000. The Series 4000 features the Pattern Track™ biomarker discovery-to-assay process, which integrates our proprietary ProteinChip Arrays, SELDI-TOF-MS detection and Biomarker Patterns Software. The Series 4000 was specifically designed to offer a complete solution for translating biomarker discoveries into predictive and quantitative assays on a single platform. We believe the Series 4000 and our Pattern Track process is the first proteomics tool that allows researchers to rapidly achieve biomarker discovery and development of biomarker assays on a single platform and enable SELDI-based assays for biological function discovery, disease diagnosis, prognosis or prediction of drug response.

Our ProteinChip Arrays are typically used by researchers for protein expression profiling, characterization and quantitative protein interaction applications. Our ProteinChip Arrays consist of a metal surface with multiple sample spots. We treat these spots with our proprietary coatings that are designed to capture certain families of proteins. We offer two standard types of ProteinChip Arrays. One type has ready-to-use chemical surfaces. This type is particularly useful in performing differential protein expression. The other type has pre-activated surfaces that customers use to make their own customized biochemical surfaces. This type is particularly useful in protein interaction studies. We are not required to customize our ProteinChip Arrays to meet client specifications. Researchers use both types of ProteinChip Arrays to perform protein identification and characterization.

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Our Biomarker Patterns Software is designed to automate pattern recognition-based statistical analysis methods to correlate protein expression patterns from clinical samples with disease phenotypes. This multivariate data analysis software solution addresses a key component of the biomarker discovery process. A major benefit of the ProteinChip platform is in the discovery and correlation of multiple biomarkers in a population of samples to rapidly validate clinical, toxicological and cell pathway pathology. As was the case in the development of DNA array technology, the flood of data produced by the instrument makes informatics tools critical to interpreting the results. This software package combined with an updated “Biomarker Wizard” module in the core ProteinChip Software package automatically identifies multiple protein peaks that correlate with phenotype differences between samples.

CiphergenExpress™ DataManager is a software offering that provides a client-server, relational database system for management and analysis of ProteinChip System data. High throughput collection and analysis of multi-dimensional SELDI data requires managing data related to samples, ProteinChip Arrays, reagents and spectra. To meet this need, CiphergenExpress DataManager provides advanced data handling, data mining and analysis capabilities to allow rapid, automated analysis of multiple experiments over multiple conditions to identify potential biomarkers.

Our ProteinChip Tandem MS Interface was introduced in May 2001. The ProteinChip Tandem MS Interface can be affixed to certain tandem mass spectrometers and thereby allow a researcher to gather data regarding a biological sample using both ProteinChip Arrays and tandem mass spectrometry. The ProteinChip Tandem MS Interface allows for biochip-based identification studies, epitope and phosphorylation mapping, and protein interaction analyses with a tandem mass spectrometer.

A customized version of Beckman Coulter’s Biomek 2000 Workstation™ was first sold by us in late 2001, which was later superseded by the Biomek 3000 Workstation™. Available exclusively through Ciphergen, the customized Biomek 3000 is a device that automates liquid handling when used in combination with Ciphergen’s 96-well ProteinChip Array processor. Sample throughput can be increased five-fold or more while improving reproducibility using this robotic accessory. In addition, the Biomek 3000 can be used to perform sample fractionation procedures prior to chip binding, thus increasing the number of proteins detected from each sample.

In addition, we offer a number of related accessories, such as bioprocessors, reagents, spin columns and assorted kits designed for proteomics research.

ProteinChip Systems and related products contributed approximately 82%, 78% and 67% of revenue in 2003, 2004 and 2005, respectively, after reclassifying sales of process chromatography sorbents and related process proteomics services to discontinued operations for all periods presented due to the sale of that business in November 2004. The remainder of our revenue came from research services performed by our Biomarker Discovery Center laboratories, as well as from consulting, training, maintenance contracts and other services we provided.

We generally include a 12-month warranty on our instruments and accessories in the form of a maintenance contract upon initial sale. We also sell separately priced maintenance (extended warranty) contracts, which are generally for 12 or 24 months, upon expiration of the initial warranty.

Diagnostics

One major element of Ciphergen’s business strategy is the discovery of protein biomarkers and panels of biomarkers, and their development into protein molecular diagnostic tests that improve patient care. We source biomarkers with potential diagnostic utility by two means. The first is through specifically sponsored programs with selected academic collaborators, such as The Johns Hopkins School of Medicine, the University of Texas M. D. Anderson Cancer Center and University College London. The second is by

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monitoring the publications and activities of a substantial number of academic ProteinChip customers with a view toward in-licensing discoveries that we deem to have diagnostic potential.

We believe that biomarkers and their use in diagnostics are generally patentable by their discoverer, and therefore we and our collaborators file patents broadly upon discoveries that we believe may have commercial value. While many of our initial diagnostic research efforts have focused on various cancers, we also have active discovery programs underway for neurological, cardiovascular, infectious, and other diseases. These programs are designed to address a variety of clinical questions including early detection, disease treatment response, monitoring, classification and prognosis.

Our most advanced research project is in the field of oncology. During 2003, we and our collaborators at The Johns Hopkins University School of Medicine completed a multi-site study employing over 500 patient serum samples, in which a multi-marker panel was identified that may have utility in the detection of ovarian cancer, particularly with respect to early stage cancer where early detection has been shown to dramatically improve patient survivability. This study, published in Cancer Research in August 2004, has been followed by several multi-institutional studies encompassing over 1,500 patient samples. These studies have been aimed at (1) validating biomarkers described in the August 2004 Cancer Research paper, (2) identifying biomarkers that could distinguish between benign and malignant pelvic masses, and (3) identifying biomarkers that could predict patient outcome. To accomplish this, Ciphergen employed its Deep Proteome™ tools and developed quantitative SELDI-based assays to specifically measure the three biomarkers identified in the Cancer Research paper. The results of these studies were consistent with prior studies in terms of changes to the biomarkers in the panel, and the Company discovered new potential biomarkers that may have additional diagnostic value.

If we are successful at discovering biomarkers and panels of biomarkers that have diagnostic utility, our commercialization strategy includes partnering with other parties to assist in the development and commercialization of our initial tests. On July 22, 2005, we entered into a strategic alliance agreement with Quest Diagnostics covering a three year period during which the parties will strive to develop and commercialize up to three diagnostic tests based on Ciphergen’s proprietary SELDI technology. Under this agreement, Quest Diagnostics will have the non-exclusive right to commercialize these tests on a worldwide basis, with exclusive commercialization rights in territories where Quest Diagnostics has a significant presence for up to five years following commercialization. In addition to working through Quest Diagnostics, Ciphergen may seek to partner for commercialization purposes with traditional in vitro diagnostic companies and/or with clinical reference labs in territories where Quest Diagnostics does not have exclusive rights.

Biomarker Discovery Center Laboratories

We believe our Biomarker Discovery Center laboratories, which provide SELDI technology-based research services, and which we are operating directly and through partnerships and client relationships, can foster further adoption of our products and technology by showcasing the products and demonstrating practical applications of the technology. We also seek to obtain intellectual property and commercialization rights related to biomarkers discovered in our Biomarker Discovery Center laboratories; although we have derived no revenues to date from such rights, our goal is to generate future revenue from these commercialization rights by developing our biomarker discoveries into diagnostic tests that improve patient care. We intend to discover and characterize new protein biomarkers and patterns of biomarkers from biological samples provided by our current and future collaborators. We believe that our Biomarker Discovery Center laboratories may accelerate biomarker and biomarker pattern discovery and validation in pharmaceutical drug discovery, toxicology and clinical trials, and clinical research laboratories. We intend to deploy the prototypes of each next-generation ProteinChip System and other specialized equipment, software and protocols to maintain and extend a technological advantage in our Biomarker Discovery Center laboratories.

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Our Biomarker Discovery Center laboratories have established project contracts with The Johns Hopkins University School of Medicine, the University of Texas M.D. Anderson Cancer Center, University College London and other academic and government institutions, commercial biotechnology companies and pharmaceutical companies, including Bayer and sanofi-aventis. These project contracts specify the types of samples that will be analyzed, outline the work to be done, and specify a fee and/or license rights for discoveries arising from the projects. We have commercialization rights to certain potential discoveries under many of these collaborations based on our contractual agreements. For example, in some cases we have the right to commercialize diagnostic tests based on biomarkers discovered through these collaborations. To date, we have not commercialized any such discoveries.

Our Biomarker Discovery Center laboratories perform agreed-upon analyses of customer samples in order to either discover biomarkers and biomarker patterns for a variety of differential classification and predictive purposes, or sequence particular proteins to obtain a probability of match between known and unknown proteins, or a determination that the protein has not been previously identified. The terms of a project contract include a fee payable to us for a specified analysis plan on a defined sample set and we generally seek to include a license to us for medical uses of biomarkers discovered in such projects. We cannot currently estimate the commercial significance of rights to biomarkers that we may acquire. In 2003, 2004 and 2005, approximately 6%, 4% and 8% of our revenue from continuing operations, respectively, came from performing such project work. Projects for the largest single customer accounted for less than 3% of total revenue from continuing operations in each of 2003, 2004 and 2005.

While most of our Biomarker Discovery Center contracts are fee-for-services arrangements, we entered into an agreement with the Israel-U.S. Binational Industrial Research and Development Foundation (“BIRD”), which provided funding for research we were undertaking with Mindsense Biosystems, Ltd., using our SELDI technology to discover potential biomarkers for the diagnosis and monitoring of major depression. Our funding from BIRD ended in 2003. Revenue from the BIRD grant totaled $128,000 in 2001, $129,000 in 2002 and $106,000 in 2003.

We sponsor research at various institutions, including The Johns Hopkins University, the University of Texas M.D. Anderson Cancer Center and University College London. We spent approximately $1.2 million in 2003, $1.7 million in 2004, and $1.6 million in 2005 in the form of cash, equipment and consumables on such sponsored research.

We lease facilities and have hired managerial and scientific staff for our Biomarker Discovery Center laboratories in Copenhagen, Denmark, in Malvern, Pennsylvania, in Yokohama, Japan and as part of our headquarters facility in Fremont, California. We also provide financial and technical support for a Biomarker Discovery Center laboratory at The Johns Hopkins University School of Medicine.

Sales and Marketing

We utilize a direct sales force in North America, Western Europe and Japan. Our sales process involves on-site applications problem-solving, scientific publications, product demonstrations, seminars, exhibits, conventions and meetings, word of mouth, direct mail, advertising and the Internet. We have designed our sales process to increase market awareness of our ProteinChip Systems and Biomarker Discovery Center services, and promote acceptance of our products and services.

Our sales force includes program managers and field research scientists, most of whom have Ph.D. degrees in biology or biochemistry. The primary responsibility of the program manager is to manage sales efforts. The primary responsibility of the field research scientist is to provide solutions to biological problems for our customers and sales prospects through applications development, scientific seminars, joint scientific publications with customers and product demonstrations. In some territories, the field research scientists serve as our primary field representatives for after-sales customer service and technical support. Our sales and marketing organization as of February 28, 2006 consisted of 72 employees, 25 of

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whom have Ph.D. or M.D. degrees. As of February 28, 2006, we had 15 program managers and 14 field research scientists.

We formed Ciphergen Biosystems KK in Japan in 1999 as a joint venture with Sumitomo Corporation to distribute our products in Japan and signed a distribution and marketing agreement granting Ciphergen Biosystems KK the exclusive right to distribute our products in Japan for ten years. In March 2004, we paid $1.0 million in cash to purchase Sumitomo’s remaining interest in Ciphergen Biosystems KK, bringing our ownership interest to 100%. We have also established relationships with distributors who cover Australia, China, Malaysia, Singapore, South Korea, Taiwan, Turkey and other territories.

Customers

We have a broad and diversified global life science customer base. This customer base is composed primarily of end-users and includes pharmaceutical and biotechnology companies, as well as academic users such as university laboratories, medical schools and other not-for profit research institutes and government laboratories. Our customers generally do not have a need to buy multiple systems at one time, and historically we have not depended on any single customer in the sale of our systems. No single customer accounted for 10% or more of our revenue in any of the last three fiscal years.

Backlog

Ciphergen typically receives a substantial portion of its product orders in the last month of the quarter. We endeavor to maintain sufficient inventory on hand to ship all products immediately upon receipt of an order. As a result, we generally have little or no backlog except for support and service revenue. Management does not believe that backlog orders at any given point in time are a meaningful indicator of our company’s future business prospects.

Geographic Information

Information about the geographies in which we operate can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements at note 21, “Segment Information and Geographic Data.”

Competition

We encounter intense competition from a number of companies that offer competing products using alternative technologies. Current competition comes primarily from companies providing products that incorporate established technologies, such as gel electrophoresis, liquid chromatography and mass spectrometry.

In order to compete effectively, we need to demonstrate the advantages of our ProteinChip Systems over alternative technologies and products. We also must demonstrate the potential economic value of our ProteinChip products relative to these alternative technologies and products. Some of the companies that provide these products include the Applied Biosystems division of Applera, the Micromass division of Waters Corporation, Amersham Biosciences, Bruker Biosciences, Perkin-Elmer, Thermo Electron Corporation and several smaller reagent and equipment companies. Our future success will depend in large part on our ability to establish and maintain a competitive position with respect to these and future technologies.

In offering proteomic research services through our Biomarker Discovery Center laboratories, we may compete with other companies offering proteomic services. We expect an increasing number of companies to provide such services in the future. If we are able to develop diagnostic assays which have clinical utility, we will enter the highly competitive in vitro diagnostics market. There are many large, established

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competitors in this industry including the clinical reference laboratories, such as Quest Diagnostics and Laboratory Corporation of America, and the major in vitro diagnostic companies such as Roche Diagnostics, Abbott Laboratories, Johnson & Johnson, Bayer Diagnostics, Dade Behring, Beckman Coulter and others. In addition, we may compete with smaller diagnostic companies depending on the nature of the particular test. Our future success will depend heavily on the accuracy and predictive power of our potential tests, the cost of such tests, reimbursement, and the marketing and distribution arrangements which we can put in place.

In many instances, our competitors have or will have substantially greater financial, technical, research and other resources and larger, more established marketing, sales, distribution and service organizations than we do. Moreover, competitors may have greater name recognition than we do, and may offer discounts as a competitive tactic. Our competitors may succeed in developing or marketing technologies or products that are more effective or commercially attractive than our products, or that would render our technologies and products obsolete. Also, we may not have the financial resources, technical expertise or marketing, distribution or support capabilities to compete successfully in the future.

Research and Development

A major area of our research and development activities centers around efforts to discover and validate biomarkers and patterns of biomarkers that can be developed into diagnostic assays. We do this both through in-house programs and through collaborations we have established with The Johns Hopkins School of Medicine, the University of Texas M.D. Anderson Cancer Center and University College London, among others.

Our ProteinChip System is a single technology platform we believe can be used in many markets for a wide variety of scientific applications. We have ongoing technology development programs for our ProteinChip Arrays and reagents, sample pre-treatment tools and methods, novel surface chemistries, instrumentation improvement, software and manufacturing processes.

In applied research, we are developing new applications and reagents for quantitative differential protein expression analysis, protein interaction assays and protein characterization. Our efforts are now particularly focused on discovery and quantitative analysis of low-abundance proteins present in complex samples such as plasma, serum and urine. We have demonstrated that the surface chemistries immobilized on ProteinChip Arrays have similar protein selectivity to those chemistries immobilized on higher capacity bead formats, facilitating the transition from discovery on arrays to small prep purification on beads as well as orthogonal purification. Using these approaches, we seek to improve the speed and efficiency of designing protein separation strategies at any scale based on the predictive information obtained using our ProteinChip Systems. We believe these methods will accelerate the identification of discovered biomarkers.

Instrumentation research and development efforts include high-sensitivity mass detection and quantitation, improvement in system resolution and mass accuracy, internal normalization, and calibration algorithms that standardize instrument performance from one to another and thus allows comparative determinations across multiple sites. We also have ongoing software development projects to further improve the functionality, expand the applications, and strengthen the data management and analysis capabilities of our ProteinChip System.

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Intellectual Property

Our intellectual property includes a portfolio of owned, co-owned or licensed patents and patent applications. As of December 31, 2005, our patent portfolio included 30 issued U.S. patents, 101 pending U.S. patent applications and numerous pending patent applications and issued patents outside the U.S. These patents and patent applications are directed to several areas of technology important to our business, including our core SELDI technology and its applications, protein biochips, instrumentation, software and biomarkers. The issued patents covering the SELDI and RC-MS technologies expire at various times from 2013 to 2019.

We derive our rights to the core SELDI technology through royalty-bearing sublicenses from Molecular Analytical Systems, Inc. (“MAS”). MAS holds an exclusive license to patents directed to the SELDI technology from the owner, Baylor College of Medicine. MAS granted certain rights under these patents to our wholly owned subsidiaries, IllumeSys Pacific, Inc. and Ciphergen Technologies, Inc. in 1997. We obtained further rights under the patents in 2003 through sublicenses and assignments executed as part of the settlement of a lawsuit between Ciphergen, MAS, LumiCyte and T. William Hutchens. Together, the sublicenses and assignments provide us with all rights to develop, make and have made, use, sell, import, market and otherwise exploit products and services covered by the patents throughout the world in all fields and applications, both commercial and non-commercial. We are obligated to pay MAS a royalty equal to 2% of SELDI-related revenues recognized between February 21, 2003 and the earlier of (i) May 28, 2014, or (ii) the date on which the cumulative payments to MAS have reached $10,000,000. Through December 31, 2005, we had paid or accrued a total of approximately $2.2 million in such royalties.

We hold licenses or options to license biomarkers developed using SELDI technology, and related intellectual property. Approximately 38 of our patent applications are directed to biomarker inventions. These include applications in the areas of cancer, cardiovascular disease, infectious disease, neurodegenerative disease and women’s health. We hold an exclusive license from the Johns Hopkins School of Medicine to patent applications directed to biomarkers for ovarian cancer that we intend to commercialize as an ovarian cancer diagnostic test.  Other institutions and companies from which we hold such licenses or options to license include University College London (England), University of Texas M.D. Anderson Cancer Center, University of Kentucky, McGill University (Canada), Eastern Virginia Medical School, Aaron Diamond AIDS Research Center, University of Texas Medical Branch, Göteborg University (Sweden), University of Kuopio (Finland) and the Netherlands Cancer Institute (Netherlands).

Our intellectual property portfolio also includes copyrights on our ProteinChip Software, as well as registered U.S. trademarks for, among other things, the names “Ciphergen” and “Biomarker Discovery Center”, our dragonfly logo and the ProteinChip mark.

Manufacturing

We design, manufacture and distribute ProteinChip Systems and Arrays, including related instrumentation, consumables, accessories and software, at our Fremont, California facility, which is registered under ISO 9001:2000. During 2005 Ciphergen enhanced its quality system in order to comply with U.S. Food and Drug Administration (“FDA”) regulations, which has been reviewed through an independent audit. Ciphergen believes it is prepared to begin manufacturing in compliance with the FDA’s Quality System Regulations (“QSRs”) in 2006. We rely upon outside suppliers for many components of our ProteinChip Systems. Final assembly and quality control of our ProteinChip Readers are performed by us in our Fremont facility. We purchase customized extruded aluminum for our ProteinChip Arrays from a third-party supplier. External vendors etch and base coat our ProteinChip Arrays. We apply all chemistries to the ProteinChip Arrays and perform in-process and final quality control at our facility. We develop software for our ProteinChip Systems in-house, and provide multivariate data analysis software through an

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OEM arrangement with Salford Systems. We supply a robotic accessory for sample processing through an OEM arrangement with Beckman Coulter.

Generally, we acquire components, accessories and manufacturing services on an individual purchase order basis. However, from time to time we have entered into contracts with a limited number of third parties in the ordinary course of business to manufacture products to our specifications, supply components, supply accessories, provide software and provide manufacturing services. Currently we have approximately seven such active contracts. We intend to continue and may expand the subcontracting portions of our manufacturing processes when we believe it leverages the suppliers’ manufacturing expertise, reduces costs or improves our ability to meet customer demand. The raw materials and component parts required in our manufacturing operations generally are readily available. However, we use single-source suppliers for some key components and manufacturing services, and finding alternate vendors for these items could be difficult. We endeavor to maintain a sufficient stock of critical parts to enable us to continue production for at least three to six months in the event we lose a single-source supplier, during which time we believe we would be able to secure an alternate source. However, in one case, loss of a critical contract manufacturing service for more than six months could adversely affect virtually all of our revenue from ProteinChip Arrays, and the unavailability of our consumable products eventually could result in decreased sales of our ProteinChip Systems as well.

Environmental Matters and Laser Regulations

International, federal, state and local requirements relating to the discharge of substances into the environment, the disposal of hazardous wastes, and the sale and use of lasers as part of our ProteinChip Readers may have an impact on our manufacturing operations and sales. We believe that we are in material compliance with applicable environmental and laser and radiological health laws and regulations. To date, compliance with regulatory requirements concerning environmental matters and lasers has been accomplished without material effect on our liquidity or capital resources. To date, we have not made material capital expenditures to comply with environmental and laser and radiological health laws and regulations.

Government Regulation

General

Our future activities related to diagnostics products are, or have the potential to be, subject to regulatory oversight by the FDA under provisions of the Federal Food, Drug and Cosmetic Act and regulations thereunder, including regulations governing the development, marketing, labeling, promotion, manufacturing and export of our products. Failure to comply with applicable requirements can lead to sanctions, including withdrawal of products from the market, recalls, refusal to authorize government contracts, product seizures, civil money penalties, injunctions and criminal prosecution.

Generally, certain categories of medical devices, a category that may be deemed to include potential future products based upon our ProteinChip platform, require FDA pre-market approval or clearance before they may be marketed and placed into commercial distribution. Although the FDA believes it has jurisdiction to regulate in-house laboratory tests, or “home brews,” that have been developed and validated by the laboratory providing the tests, the FDA has not, to date, actively regulated those tests. “Active ingredients” (known as “analyte specific reagents” or “ASRs”) that are sold to laboratories for use in tests developed in-house by clinical laboratories generally do not require FDA approval or clearance. ASRs generally do not require FDA pre-market approval or clearance if they are (i) sold to clinical laboratories certified by the government to perform high complexity testing, (ii) manufactured in compliance with the FDA’s QSRs, and (iii) labeled in accordance with FDA requirements, including a statement that their analytical and performance characteristics have not been established. A similar statement would also be

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required on all advertising and promotional materials relating to ASRs, such as those used in certain of our proposed future tests. We believe that clinical laboratory testing based upon our ProteinChip platform, and any ASRs that we intend to sell to clinical reference laboratories, currently would not require FDA approval or clearance. The FDA has publicly stated it is reevaluating its ASR policy, and we expect that revisions to FDA policies may be implemented in the future that may have the effect of increasing the regulatory burden on manufacturers of these devices. The commercialization of our products and services could be impacted by being delayed, halted or prevented. We cannot be sure that tests based upon our ProteinChip platform, or a combination of reagents, will not require pre-market approval or clearance.

Regardless of whether a medical device requires FDA approval or clearance, a number of other FDA requirements apply to its manufacturer and to those who distribute it. Device manufacturers must be registered and their products listed with the FDA, and certain adverse events, corrections and removals must be reported to the FDA. The FDA also regulates the product labeling, promotion and, in some cases, advertising of medical devices. Manufacturers must comply with the FDA’s QSRs, which establish extensive requirements for design, quality control, validation and manufacturing. Thus, manufacturers and distributors must continue to spend time, money and effort to maintain compliance, and failure to comply can lead to enforcement action. The FDA periodically inspects facilities to ascertain compliance with these and other requirements.

Diagnostic Kits

The Food, Drug and Cosmetic Act requires that medical devices introduced to the U.S. market, unless exempted by regulation, be the subject of either a premarket notification clearance, known as a 510(k), or a premarket approval, known as a PMA. Some of our potential future clinical products may require a PMA, others may require a 510(k). Other products, like ASRs, may be exempt from regulatory clearance or approval.

With respect to devices reviewed through the 510(k) process, we may not market a device until an order is issued by the FDA finding our product to be substantially equivalent to a legally marketed device known as a predicate device. A 510(k) submission may involve the presentation of a substantial volume of data, including clinical data. The FDA may agree that the product is substantially equivalent to a predicate device and allow the product to be marketed in the U.S. The FDA, however, may determine that the device is not substantially equivalent and require a PMA, or require further information, such as additional test data, including data from clinical studies, before it is able to make a determination regarding substantial equivalence. By requesting additional information, the FDA can further delay market introduction of our products.

If the FDA indicates that a PMA is required for any of our potential future clinical products, the application will require extensive clinical studies, manufacturing information and likely review by a panel of experts outside the FDA. Clinical studies to support either a 510(k) submission or a PMA application would need to be conducted in accordance with FDA requirements. Failure to comply with FDA requirements could result in the FDA’s refusal to accept the data or the imposition of regulatory sanctions. There can be no assurance that we will be able to meet the FDA’s requirements or receive any necessary approval or clearance.

Once granted, a 510(k) clearance or PMA approval may place substantial restrictions on how our device is marketed or to whom it may be sold. Even in the case of devices like ASRs, many of which are exempt from 510(k) clearance or PMA approval requirements, the FDA may impose restrictions on marketing. Our potential future ASR products may be sold only to clinical laboratories certified under Clinical Laboratory Improvement Amendments of 1988 (“CLIA”) to perform high complexity testing. In addition to requiring approval or clearance for new products, the FDA may require approval or clearance prior to marketing products that are modifications of existing products or the intended uses of these

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products. We cannot assure that any necessary 510(k) clearance or PMA approval will be granted on a timely basis, or at all. Delays in receipt of or failure to receive any necessary 510(k) clearance or PMA approval, or the imposition of stringent restrictions on the labeling and sales of our products, could have a material adverse effect on us. As a medical device manufacturer, we are also required to register and list our products with the FDA. In addition, we are required to comply with the FDA’s QSRs, which require that our devices be manufactured and records be maintained in a prescribed manner with respect to manufacturing, testing and control activities. Further, we are required to comply with FDA requirements for labeling and promotion. For example, the FDA prohibits cleared or approved devices from being promoted for uncleared or unapproved uses. In addition, the medical device reporting regulation requires that we provide information to the FDA whenever there is evidence to reasonably suggest that one of our devices may have caused or contributed to a death or serious injury, or that there has occurred a malfunction that would be likely to cause or contribute to a death or serious injury if the malfunction were to recur.

Our manufacturing facilities are subject to periodic and unannounced inspections by the FDA and state agencies for compliance with QSRs. Additionally, the FDA will generally conduct a preapproval inspection for PMA devices. Although we believe we will be able to operate in compliance with the FDA’s QSRs for ASRs, we have never been inspected by the FDA and cannot assure that we will be able to maintain compliance in the future. If the FDA believes that we are not in compliance with applicable laws or regulations, it can issue a warning letter, detain or seize our products, issue a recall notice, enjoin future violations and assess civil and criminal penalties against us. In addition, approvals or clearances could be withdrawn under certain circumstances. Failure to comply with regulatory requirements or any adverse regulatory action could have a material adverse effect on us.

Any customers using our products for clinical use in the U.S. may be regulated under CLIA. CLIA is intended to ensure the quality and reliability of clinical laboratories in the U.S. by mandating specific standards in the areas of personnel qualifications, administration, participation in proficiency testing, patient test management, quality control, quality assurance and inspections. The regulations promulgated under CLIA establish three levels of diagnostic tests, namely, waived, moderately complex and highly complex, and the standards applicable to a clinical laboratory depend on the level of the tests it performs. We cannot assure you that the CLIA regulations and future administrative interpretations of CLIA will not have a material adverse impact on us by limiting the potential market for our potential future products.

Medical device laws and regulations are also in effect in many of the countries in which we may do business outside the U.S. These range from comprehensive device approval requirements for some or all of our potential future medical device products, to requests for product data or certifications. The number and scope of these requirements are increasing. Medical device laws and regulations are also in effect in some states in which we do business. There can be no assurance that we will obtain regulatory approvals in such countries or that we will not incur significant costs in obtaining or maintaining foreign regulatory approvals. In addition, export of certain of our products which have not yet been cleared or approved for domestic commercial distribution may be subject to FDA export restrictions.

Employees

As of December 31, 2005, we had 158 full-time employees worldwide, including 72 in sales and marketing, 36 in research and development, 27 in manufacturing and 23 in administration. 48 of our employees on December 31, 2005 had M.D. degrees or Ph.D. degrees in chemistry, biology or biochemistry, and many are experts in software and engineering. We also had an additional 12 individuals engaged as independent contractors. None of our U.S. employees are covered by a collective bargaining agreement, though many of our European employees are covered under national labor agreements. We believe that our relations with our employees are good. Ciphergen’s success will depend in large part on our ability to attract and retain skilled and experienced employees.

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Available Information

We routinely file reports and other information with the Securities and Exchange Commission (“SEC”), including Forms 8-K, 10-K and 10-Q. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of that site is http://www.sec.gov.

We maintain an Internet website which includes a link to a site where copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act may be obtained free of charge as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC. These materials may be accessed by accessing the website at http://www.ciphergen.com and selecting “Investors.” Paper copies of these documents may also be obtained free of charge by writing to us at Ciphergen Biosystems, Inc., Investor Relations, 6611 Dumbarton Circle, Fremont, CA 94555.

The transfer agent for our common stock is:

Wells Fargo Shareowner Services
161 N. Concord Exchange
South St. Paul, MN 55075
Tel:  800-468-9716
www.wellsfargo.com/com/shareowner_services

Code of Ethics for Executive Officers

We have adopted a Code of Ethics for Executive Officers. We publicize the Code of Ethics for Executive Officers by posting the policy on our website, http://www.ciphergen.com. We will disclose on our website any waivers of, or amendments to, our Code of Ethics.

ITEM 1A.        RISK FACTORS

The reader should carefully consider each of the risks and uncertainties we describe below, as well as all of the other information in this report. The risks and uncertainties we describe below are not the only ones we face. Additional risks and uncertainties which we are currently unaware of or that we currently believe to be immaterial could also adversely affect our business.

We expect to continue to incur net losses in 2006 and 2007. If we are unable to significantly increase our revenues or significantly decrease our expenses, we may never achieve profitability.

From our inception in December 1993 through December 31, 2005, we have generated cumulative revenue from continuing operations of approximately $175.1 million and have incurred net losses of approximately $195.8 million. We have experienced significant operating losses each year since our inception and expect these losses to continue for at least the next several quarters. For example, we experienced net losses of approximately $25.8 million in 2001, $29.1 million in 2002, $36.7 million in 2003, $19.8 million in 2004, and $35.4 million in 2005. Our losses have resulted principally from costs incurred in research and development, sales and marketing, litigation, and general and administrative costs associated with our operations. These costs have exceeded our gross profit which, to date, has been generated principally from product sales. We expect to incur additional operating losses and these losses may be substantial. We may never achieve profitability. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis.

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If we are unable to further establish the utility of our products, our products and services may not achieve market acceptance.

The commercial success of our ProteinChip Systems and Arrays depends upon validating their utility for important biological applications and increasing their market acceptance by researchers in pharmaceutical and biotechnology companies, academic and government research centers and clinical reference laboratories. If our products are not demonstrated to be more effective in providing commercially useful protein information than other existing technologies, it could seriously undermine market acceptance of our products and reduce the likelihood that we will ever achieve profitability.

If we fail to successfully market the Series 4000, expand sales of our ProteinChip Systems, and develop new and improved applications for our products, our revenue will not increase and we will not achieve profitability.

Our success depends on our ability to continue to expand commercial sales of our ProteinChip Systems and Arrays, and develop new and improved applications for this platform. In particular, our success will depend on our success in marketing and growing sales of our ProteinChip System, Series 4000. If this system does not perform in accordance with market expectations, it is unlikely that we will be able to expand our sales. We may encounter difficulties in developing new, higher performance products or producing our current proteomic systems on a timely basis, we may not be able to produce them economically, we may fail to achieve expected performance levels, or we may fail to gain industry acceptance of such products.

We may experience increased manufacturing costs or failure rates for our ProteinChip Systems and Arrays that are higher than we anticipated, particularly for new products that are introduced.

Our products and the components used in our products are based on complex technologies and we are currently in the process of developing new versions of certain products. We may not be able to cost effectively manufacture such new products. In addition, it is difficult to predict the failure rate of new products. If our manufacturing costs are higher than anticipated or if the failure rates for our products are higher than anticipated, resulting in increased warranty claims and increased costs associated with servicing those claims, our gross profit will decrease. We may also incur additional costs associated with a product retrofit initiated by one of our suppliers for a pump used in older model ProteinChip Systems.

We may not succeed in developing diagnostic products and even if we do succeed in developing diagnostic products, they may never achieve significant commercial market acceptance.

There is considerable risk in developing diagnostic products based on our biomarker discovery efforts as potential tests may fail to validate results in larger clinical studies and may not achieve acceptable levels of clinical sensitivity and specificity. If we do succeed in developing diagnostic tests with acceptable performance characteristics, we may not succeed in achieving significant commercial market acceptance for those tests. Our ability to successfully commercialize diagnostic products that we may develop, such as tests, kits and devices, will depend on several factors, including:

·       our ability to convince the medical community of the safety and clinical efficacy of our products and their advantages over existing diagnostic products;

·       our ability to further establish business relationships with other diagnostic companies that can assist in the commercialization of these products; and

·       the agreement by Medicare and third-party payers to provide full or partial reimbursement coverage for our products, the scope and extent of which will affect patients’ willingness to pay for our products and will likely heavily influence physicians’ decisions to recommend our products.

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These factors present obstacles to significant commercial acceptance of our potential diagnostic products, which we will have to spend substantial time and money to overcome, if we can do so at all. Our inability to successfully do so would prevent us from generating additional revenue from diagnostic products and we could be unable to develop a profitable business.

Our ability to commercialize our potential diagnostic tests is heavily dependent on our strategic alliance with Quest Diagnostics.

On July 22, 2005, Ciphergen and Quest Diagnostics entered into a strategic alliance which will focus on commercializing up to three assays chosen from Ciphergen’s pipeline over the next three years. If this strategic alliance does not continue for its full term or if Quest Diagnostics fails to proceed to diligently perform its obligations as part of the strategic alliance, such as independently developing, validating and commercializing potential diagnostics tests, our ability to commercialize our potential diagnostic tests would be seriously harmed. If we elect to increase our expenditures to fund diagnostic development programs or research programs on our own, we will need to obtain additional capital, which may not be available on acceptable terms, or at all.

If we are unable to attract additional clients for our Biomarker Discovery Center services and satisfy these clients, we may not be successful in furthering adoption of our products and technology or generating additional revenue through commercial rights related to biomarker discoveries.

One element of our business strategy is to operate Biomarker Discovery Center laboratories in part through partnerships with pharmaceutical and biotechnology companies as well as academic and government research centers in order to increase adoption of our products and technology. Although we are currently in negotiation with additional potential partners and clients, to date we have entered into only a few such arrangements. Failure to enter into additional arrangements or expand existing relationships could limit adoption of our products and prevent us from generating additional revenue through commercialization of biomarker discoveries.

New product introductions can result in disruptions to our revenue patterns and increased sales and marketing costs, and may involve manufacturing challenges that can negatively impact our gross margin.

We have introduced, and we may introduce in the future, new versions of our ProteinChip Systems, Arrays and Software. New product introductions entail training and educating our customers and prospective customers about the new features, protocols and technology encompassed by the new products. This could disrupt our revenue patterns or temporarily lengthen our sales cycles to a greater extent than it would at larger companies with broader product offerings. New product introductions may temporarily increase our sales and marketing costs. Manufacturing new products inherently runs the risk that initial costs may be high as new production processes are introduced, and it is possible that new products may involve quality issues that negatively impact our gross margins. In addition, the introduction of new products makes the continuing sales of previous product versions difficult and may require significant price discounts on such products.

If we fail to continue to develop the technologies we base our products on, we may not be able to successfully foster further adoption of our products and services as an industry standard or develop new product offerings.

The technologies we use for our ProteinChip Systems and related product offerings are new and complex technologies, which are subject to change as new discoveries are made. New discoveries and further progress in our field are essential if we are to maintain and expand the adoption of our product offerings. Development of these technologies remains a substantial risk to us due to various factors including the scientific challenges involved, our ability to find and collaborate with others working in our field, and competing technologies, which may prove more successful than ours. In addition, we have

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reduced our research and development headcount and expenditures, which may adversely affect our ability to further develop our technology.

If we are unable to provide our customers with software that enables the integration and analysis of large volumes of data, the acceptance and use of our products may be limited.

The successful commercial research application of our products requires that they enable researchers to process and analyze large volumes of data and to integrate the results into other phases of their research. The nature of our software enables a level of integration and analysis that is adequate for many projects. However, if we do not continue to develop and improve the capabilities of our ProteinChip Software to perform more complex analyses of customer samples and to meet increasing customer expectations, market acceptance of our products may not increase and we could lose our current customers, which might adversely impact our revenues and we could be unable to develop a profitable business.

Our quarterly operating results may fluctuate significantly due to a number of causes outside our control.

Because the timing of our product orders can vary, we may not be able to reliably predict quarterly revenue and profitability. Our operating results can also vary substantially in any period depending on the mix of products sold. Our quarterly sales and operating results are highly dependent on the volume and timing of orders received during the quarter, as well as the seasonal and cyclical nature of our markets. Historically, a relatively large percentage of our sales have arrived in the last month of each quarter, and often towards the end of such month. Accordingly, a short delay in receiving an order, shipping product, or recognizing revenue from such order may result in substantial quarterly fluctuations in revenue and earnings.

A significant portion of our operating expenses is relatively fixed in nature due to our significant sales, research and development, administration and manufacturing costs. If we cannot adjust spending quickly enough to compensate for a revenue shortfall, this may magnify the adverse impact of such revenue shortfall on our results of operations. As a result, our quarterly operating results could fluctuate, and such fluctuation could cause the market price of our common stock and convertible senior notes to decline. Results from one quarter should not be used as an indication of future performance.

If we are unable to reduce our lengthy sales cycle, our ability to become profitable will be harmed.

Our ability to obtain customers for our products depends in significant part upon the perception that our products and services can help enable protein biomarker discovery, characterization and assay development. From the time we make initial contact with a potential customer until we receive a binding purchase order typically takes between a few weeks to a year or more. Our sales effort requires the effective demonstration of the benefits of our products and may require significant training, sometimes of many different departments within a potential customer. These departments might include research and development personnel and key management. In addition, we may be required to negotiate agreements containing terms unique to each customer. We may expend substantial funds and management effort and may not be able to successfully sell our products or services in a short enough time to achieve profitability.

We will need to raise additional capital in the future, and if we are unable to secure adequate funds on terms acceptable to us, we may be unable to execute our business plan.

We currently believe that current cash resources together with existing debt facilities will be sufficient to meet our anticipated needs for the next 12 months. However, we may need to raise additional capital sooner in order to develop new or enhanced products or services, increase our efforts to discover biomarkers and develop them into diagnostic products, or acquire complementary products, businesses or technologies. If we are unable to obtain financing, or to obtain it on acceptable terms, we may be unable to successfully execute our business plan.

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Future changes in financial accounting standards or practices may cause adverse unexpected fluctuations and affect our reported results of operations.

Future changes in financial accounting standards will affect our reported results of operations. For example, the mandated change effective for us on January 1, 2006 requiring that we record compensation expense in the statement of operations for employee stock options using the fair value method or changes in existing taxation rules related to stock options will have a negative effect on our reported results. The Financial Accounting Standards Board allows a choice of valuation models to estimate the fair value of employee stock options. These models, including the Black-Scholes option-pricing model, use varying methods and inputs and may yield significantly different results. Under the new standard, our estimate of compensation expense will require a number of complex and subjective assumptions including our stock price volatility, employee exercise patterns (expected life of the options), future forfeitures and related tax effects.

Because our business is highly dependent on key executives, scientists, engineers and sales people, our inability to recruit and retain these people could hinder our business expansion plans.

We are highly dependent on our executive officers, senior scientists, engineers and sales people. In certain countries, a few key individuals are important to our local success. Our product development and marketing efforts could be delayed or curtailed if we lose the services of any of these people. To expand our research, product development and sales efforts, we need people skilled in areas such as bioinformatics, biochemistry, information services, manufacturing, sales, marketing and technical support. Competition for qualified employees is intense. We will not be able to expand our business if we are unable to hire, train and retain a sufficient number of qualified employees. During 2004 and 2005, we took steps to reduce our headcount and our voluntary employee turnover has increased from historic levels. In addition, the adoption of Statement of Financial Accounting Standards No. 123 (Revised), “Share-Based Payment”, on January 1, 2006, which will require us to expense all stock-based compensation, may require us to change the manner in which we compensate our employees, which could considerably impact our ability to recruit and retain qualified employees.

If we are unable to successfully expand our limited manufacturing capacity for ProteinChip readers and arrays, we may encounter manufacturing and quality control problems as we increase our efforts to meet demand.

We currently have only one manufacturing facility at which we produce limited quantities of our ProteinChip Arrays and ProteinChip Readers. Some aspects of our manufacturing processes may not be easily scalable to allow for production in larger volumes, resulting in higher than anticipated material, labor and overhead costs per unit. As a result, manufacturing and quality control problems may arise as we increase our level of production. We may not be able to increase our manufacturing capacity in a timely and cost-effective manner and we may experience delays in manufacturing new products. If we are unable to consistently manufacture our products on a timely basis because of these or other factors, we will not be able to meet anticipated demand. As a result, we may lose sales and fail to generate increased revenue and become profitable.

We face intense competition in our current and potential markets and if our competitors develop new technologies or products, our products may not achieve market acceptance and may fail to capture market share.

Competition in our existing and potential markets is intense and we expect it to increase. Currently, our principal competition comes from other technologies that are used to perform many of the same functions for which we market our ProteinChip System. The major technologies that compete with our ProteinChip System are liquid chromatography-mass spectrometry and 2D-gel electrophoresis-mass spectrometry. In the life science research market, competitive protein research tools and services are currently provided by a number of companies, including several which are larger than Ciphergen. In the

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diagnostics market, there are several larger direct competitors. In many instances, our competitors may have substantially greater financial, technical, research and other resources and larger, more established marketing, sales, distribution and service organizations. Additionally, our potential customers may internally develop competing technologies. If we fail to compete effectively with these technologies and products, or if competitors develop significant improvements in protein detection systems, develop systems that are easier to use, or introduce comparable products that are less expensive, our products may not achieve market acceptance and our sales may decrease.

Shareholder litigation may have a negative financial impact on us and require management time and attention.

Ciphergen and certain of its current and former officers have been named as defendants in a securities class action complaint filed on December 5, 2005, in the United States District Court, Northern District of California. The complaint has been brought on behalf of all persons who purchased Ciphergen’s common stock from August 8, 2005, when we issued a press release announcing unaudited financial results for the second quarter of 2005, through November 16, 2005, when we announced our intention to restate those financial results. Dealing with this matter may require considerable management time and attention, and may result in a negative financial impact on us.

If we are unable to maintain our licensed rights to the SELDI technology, we may lose the right to produce ProteinChip Systems and products based on the SELDI technology and the right to provide services and information related thereto.

Our commercial success depends on our ability to maintain our sublicenses to the SELDI technology. All of our revenue from continuing operations was derived from SELDI-based products within the scope of the Baylor SELDI patents. Pursuant to the settlement of the litigation between Ciphergen, Molecular Analytical Systems (“MAS”), LumiCyte and T. William Hutchens, MAS cannot terminate Ciphergen’s rights under the sublicenses. However, Baylor College of Medicine has the right to terminate its license with MAS in case of material breach by MAS. If the agreements between Baylor College of Medicine and MAS were terminated and we were unable to obtain a license to these rights from Baylor College of Medicine, we would be precluded from selling any SELDI-based products within the scope of the Baylor SELDI patents, we would no longer generate revenue from the sale of these products and we would have to revise our business direction and strategy.

If the government grants a license to the SELDI technology to others, it may harm our business.

Some of the inventions covered by our sublicense agreements with MAS were developed under a grant from an agency of the U.S. government and therefore, pursuant to the Bayh-Dole Act and regulations promulgated thereunder, the government has a paid-up, nonexclusive nontransferable license to those inventions and will be able in limited circumstances to grant a license to others on reasonable terms. We are not aware of any basis for the government to exercise such rights, but if circumstances change and the government exercises such rights, our business could be harmed.

If we fail to maintain our rights to utilize intellectual property directed to diagnostic biomarkers, we may not be able to offer diagnostic tests using those biomarkers.

One aspect of our business plan is to develop diagnostic tests based on certain biomarkers which we have the right to utilize through licenses with our academic collaborators, such as The Johns Hopkins School of Medicine and University College London. In some cases, our collaborators own the entire right to the biomarkers. In other cases we co-own the biomarkers with our collaborator. If, for some reason, we lose our license to biomarkers owned entirely by our collaborators, we may not be able to use those biomarkers in diagnostic tests. If we lose our exclusive license to biomarkers co-owned by us and our collaborators, our collaborators may license their share of the intellectual property to a third party that may compete with us in offering the diagnostic test.

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We have drawn funds from the $10 million secured line of credit provided by Quest Diagnostics. If we fail to achieve the loan forgiveness milestones set forth therein, we will be responsible for full repayment of the loan.

In connection with the strategic alliance with Quest Diagnostics, Quest Diagnostics agreed to provide us with a $10 million secured line of credit, from which we had drawn a total of $2.5 million as of December 31, 2005. Borrowings may be made in monthly increments of up to approximately $417,000 over a two year period, with accrued interest to be paid monthly. Funds from this collateralized line of credit may only be used to pay certain costs and expenses directly related to the strategic alliance, with forgiveness of the repayment obligations based upon our achievement of milestones related to the development, regulatory approval and commercialization of laboratory tests. Should we fail to achieve these milestones, we would be responsible for the repayment of the outstanding principal amount of any such loans on or before July 22, 2010.

If a competitor infringes our proprietary rights, we may lose any competitive advantage we may have as a result of diversion of management time, enforcement costs and the loss of the exclusivity of our proprietary rights.

Our commercial success depends in part on our ability to maintain and enforce our proprietary rights. We rely on a combination of patents, trademarks, copyrights and trade secrets to protect our technology and brand. In addition to our licensed SELDI technology, we also have submitted patent applications directed to subsequent technological improvements and application of the SELDI technology, including patent applications covering biomarkers that may have diagnostic or therapeutic utility. Our patent applications may not result in additional patents being issued.

If competitors engage in activities that infringe our proprietary rights, our management’s focus will be diverted and we may incur significant costs in asserting our rights. We may not be successful in asserting our proprietary rights, which could result in our patents being held invalid or a court holding that the competitor is not infringing, either of which would harm our competitive position. We cannot be sure that competitors will not design around our patented technology.

We also rely upon the skills, knowledge and experience of our technical personnel. To help protect our rights, we require all employees and consultants to enter into confidentiality agreements that prohibit the disclosure of confidential information. These agreements may not provide adequate protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use or disclosure.

If others successfully assert their proprietary rights against us, we may be precluded from making and selling our products or we may be required to obtain licenses to use their technology.

Our success also depends on avoiding infringing on the proprietary technologies of others. If a third party were to assert claims that we are violating their patents, we might incur substantial costs defending ourselves in lawsuits against charges of patent infringement or other unlawful use of another’s proprietary technology. Any such lawsuit may not be decided in our favor, and if we are found liable, we may be subject to monetary damages or injunction against using their technology. We may also be required to obtain licenses under their patents and such licenses may not be available on commercially reasonable terms, if at all.

We rely on single-source suppliers for many components of our ProteinChip Systems as well as processing services for our ProteinChip Arrays, and if we are unable to obtain these components and processing services, we would be harmed and our operating results would suffer.

We depend on many single-source suppliers for the necessary raw materials and components required to manufacture our products. We also rely on some single-source subcontractors for certain outsourced manufacturing services. Some of these suppliers are small companies without extensive financial resources.

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Because of the limited quantities of products we currently manufacture, it is not economically feasible to qualify and maintain alternate vendors for most components of our ProteinChip Readers and processing services for our ProteinChip Arrays. We have occasionally experienced delays in receiving raw materials, components and services, resulting in manufacturing delays. If we are unable to procure the necessary raw materials, components or services from our current vendors, we will have to arrange new sources of supply and our raw materials and components shipments could be delayed, harming our ability to manufacture our products, and our ability to sustain or increase revenue could be harmed. As a result, our costs could increase and our profitability could be harmed.

We may incur additional costs due to recalls made by our suppliers of parts integrated into some of our products.

In July 2005, we were notified by a supplier about a potential safety hazard in certain pumps used in some older model ProteinChip Systems. This product recall does not affect our current Series 4000 line. To remedy the potential safety hazard, the supplier is recommending that a capacitor in the pumps it supplied be replaced, and is making the requisite parts available to us at no cost. While we believe this component part retrofit can be easily performed by our customers, or that Ciphergen personnel can perform the work during regularly scheduled service calls, unexpected difficulties with this product retrofit or possibly other unanticipated product recalls in the future by our suppliers could result in additional costs and decrease our gross profit. Additionally, such events could cause disruptions to our customers and harm Ciphergen’s reputation.

If we fail to maintain certain distribution and patent license agreements, we may have to stop selling certain products and this may harm our revenue.

We sell certain products under either OEM or distribution or patent license agreements. These include arrangements with Beckman Coulter with respect to selling a customized version of the Biomek 3000 Workstation, with Salford Systems with respect to selling Biomarker Patterns software, and with Applied Biosystems / MDS Sciex with respect to selling our ProteinChip Tandem MS Interfaces. If we fail to maintain or extend after their expiration the underlying agreements with these companies, we would have to stop selling these particular products and may have to seek alternate products to sell, as a result of which our sales may be harmed.

If there are reductions in research funding, the ability of our existing and prospective customers to purchase our products could be seriously harmed.

A significant portion of our products are sold to universities, government research laboratories, private foundations and other institutions where funding is dependent upon grants from government agencies, such as the National Institutes of Health. Government funding for research and development has fluctuated significantly in the past due to changes in congressional appropriations. Research funding by the U.S. government or the governments of other countries may be significantly reduced in the future. Any such reductions may seriously harm the ability of our existing and prospective research customers to purchase our products or may reduce the number of ProteinChip Arrays used. Limitations in funding for commercial, biotechnology and pharmaceutical companies and academic institutions that are the potential customers for our ProteinChip Systems and Arrays, and general cost containment pressures for biomedical research may limit our ability to sell our products and services.

If we or our future potential partners fail to comply with FDA requirements, we may not be able to market our products and services and may be subject to stringent penalties; further improvements to our manufacturing operations may be required that would entail additional costs.

Currently, the FDA does not actively regulate clinical laboratory tests, or “home brews”, that have been developed and used by the laboratory to conduct in-house testing. “Active ingredients” (known as “analyte specific reagents” or “ASRs”) that are sold to laboratories for use in tests developed in-house by

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clinical laboratories are generally exempt from the FDA’s pre-market review requirements. We believe that ASRs that we may provide will fall within those exemptions. However, the FDA has publicly stated it is reevaluating its ASR policy and we expect that revisions to FDA policies may be implemented in the future that may have the effect of increasing the regulatory burden on manufacturers of these devices. The commercialization of our products could be impacted by being delayed, halted or prevented. If the FDA were to view any of our actions as non-compliant, it could initiate enforcement action such as a warning letter and possible imposition of penalties. Finally, ASRs that we may provide will be subject to a number of FDA requirements, including compliance with the FDA’s QSRs, which establish extensive regulations for quality assurance and control as well as manufacturing procedures. Failure to comply with these regulations could result in enforcement action for us or our potential partners. Adverse FDA action in any of these areas could significantly increase our expenses and limit our revenue and profitability. Although we are ISO 9001:2000 certified in our ProteinChip manufacturing processes, we will need to undertake additional steps to maintain our operations in line with FDA QSR requirements. Our manufacturing facilities will be subject to periodic regulatory inspections by the FDA and other federal and state regulatory agencies. We have not yet been subject to an FDA inspection. We may not satisfy such regulatory requirements, and any such failure to do so would have an adverse effect on our diagnostics efforts.

Our diagnostic efforts may cause us to have significant product liability exposure.

The testing, manufacturing and marketing of medical diagnostics entails an inherent risk of product liability claims. Potential product liability claims may exceed the amount of our insurance coverage or may be excluded from coverage under the terms of the policy. Our existing insurance will have to be increased in the future if we are successful at introducing diagnostic products and this will increase our costs. In the event that we are held liable for a claim against which we are not indemnified or for damages exceeding the limits of our insurance coverage, our liabilities could exceed our total assets.

Business interruptions could limit our ability to operate our business.

Our operations as well as those of the collaborators on which we depend are vulnerable to damage or interruption from fire, natural disasters, computer viruses, human error, power shortages, telecommunication failures, international acts of terror and similar events. Our only production facility is located in Fremont, California, where we also have laboratories. Although we have certain business continuity plans in place, we have not established a formal comprehensive disaster recovery plan, and our back-up operations and our business interruption insurance may not be adequate to compensate us for losses we may suffer. A significant business interruption could result in losses or damages incurred by us and require us to cease or curtail our operations.

Legislative actions resulting in higher compliance costs are likely to adversely impact our future financial position, cash flows and results of operations.

Compliance with changing regulation of corporate governance and public disclosure will result in additional expenses. Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq National Market listing requirements, are resulting in increased compliance costs. Specifically, we undertook significant efforts and incurred great expense to comply with Section 404 of the Sarbanes-Oxley Act of 2002. Compliance with these evolving standards will result in increased general and administrative expenses and may cause a diversion of management time and attention from revenue-generating activities to compliance activities.

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Our business is subject to risks from international operations.

We conduct business globally. Accordingly, our future results could be materially adversely affected by a variety of uncontrollable and changing factors including, among others, foreign currency exchange rates; regulatory, political, or economic conditions in a specific country or region; trade protection measures and other regulatory requirements; and natural disasters. Any or all of these factors could have a material adverse impact on our future international business. In certain countries, a few key individuals are important to our local success. In addition, China does not currently have a comprehensive and highly developed legal system, particularly with respect to the protection of intellectual property rights. As a result, enforcement of existing and future laws and contracts is uncertain, and the implementation and interpretation of such laws may be inconsistent. Such inconsistency could lead to piracy and degradation of our intellectual property protection.

We are exposed to fluctuations in the exchange rates of foreign currency.

As a global concern, we face exposure to adverse movements in foreign currency exchange rates. With our ownership of Ciphergen Biosystems KK, a significant percentage of our net sales are exposed to foreign currency risk. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results.

Consolidation in the pharmaceutical and biotechnology industries may reduce the size of our target market and cause a decrease in our revenue.

Consolidation in the pharmaceutical and biotechnology industries is generally expected to occur. Planned or future consolidation among our current and potential customers could decrease or slow sales of our technology and reduce the markets our products target. Any such consolidation could limit the market for our products and seriously harm our ability to achieve or sustain profitability.

We may not successfully resolve problems encountered in connection with any future acquisitions or strategic investments.

In July 2001, we acquired the BioSepra process chromatography business from Invitrogen Corporation, which we subsequently sold in November 2004. In August 2002, we increased our ownership interest in Ciphergen Biosystems KK, the Japanese joint venture we formed with Sumitomo Corporation in 1999, from 30% to 70%, and in March 2004, we further increased our ownership to 100%. In the event of any future acquisitions, joint ventures and other strategic investments, we could:

·       issue stock that would dilute ownership of our then-existing stockholders;

·       incur charges for the impairment of the value of investments or acquired assets; or

·       incur amortization expense related to intangible assets.

If we fail to achieve the financial and strategic benefits of past and future acquisitions or strategic investments, our operating results will suffer. Acquisitions and strategic investments involve numerous other risks, including:

·       difficulties integrating the acquired operations, technologies or products with ours;

·       failure to achieve targeted synergies;

·       unanticipated costs and liabilities;

·       potential impairment of goodwill;

·       diversion of management’s attention from our core business;

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·       adverse effects on our existing business relationships with suppliers and customers or those of the acquired organization; and

·       potential loss of key employees, particularly those of the acquired organization.

We are subject to environmental laws and potential exposure to environmental liabilities.

We are subject to various international, federal, state and local environmental laws and regulations that govern our operations, including the handling and disposal of nonhazardous and hazardous wastes, the recycling and treatment of electrical and electronic equipment, and emissions and discharges into the environment. Failure to comply with such laws and regulations could result in costs for corrective action, penalties or the imposition of other liabilities. We also are subject to laws and regulations that impose liability and clean-up responsibility for releases of hazardous substances into the environment. Under certain of these laws and regulations, a current or previous owner or operator of property may be liable for the costs of remediating hazardous substances or petroleum products on or from its property, without regard to whether the owner or operator knew of, or caused, the contamination, as well as incur liability to third parties impacted by such contamination. The presence of, or failure to remediate properly, such substances could adversely affect the value and the ability to transfer or encumber such property. Based on currently available information, although there can be no assurance, we believe that such costs and liabilities have not had and will not have a material adverse impact on our financial results.

Anti-takeover provisions in our charter, bylaws and Stockholder Rights Plan and under Delaware law could make a third party acquisition of us difficult.

Our certificate of incorporation, bylaws and Stockholder Rights Plan contain provisions that could make it more difficult for a third party to acquire us, even if doing so might be deemed beneficial by our stockholders. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. We are also subject to certain provisions of Delaware law that could delay, deter or prevent a change in control of us.

The rights issued pursuant to our Stockholder Rights Plan will become exercisable the tenth day after a person or group announces acquisition of 15% or more of our common stock or announces commencement of a tender or exchange offer the consummation of which would result in ownership by the person or group of 15% or more of our common stock. If the rights become exercisable, the holders of the rights (other than the person acquiring 15% or more of our common stock) will be entitled to acquire, in exchange for the rights’ exercise price, shares of our common stock or shares of any company in which we are merged, with a value equal to twice the rights’ exercise price.

Because we do not intend to pay dividends, our stockholders will benefit from an investment in our common stock only if it appreciates in value.

We have never declared or paid any cash dividends on our common stock. We currently intend to retain our future earnings, if any, to finance the expansion of our business and do not expect to pay any cash dividends in the foreseeable future. As a result, the success of an investment in our common stock will depend entirely upon any future appreciation. There is no guarantee that our common stock will appreciate in value or even maintain the price at which our investor purchased his shares.

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Risks Related to Our Convertible Senior Notes and Common Stock

Substantial leverage and debt service obligations may adversely affect our cash flows.

In connection with the sale of the convertible senior notes (the “notes”), we incurred $30 million of indebtedness. As a result of this indebtedness, our principal and interest payment obligations increased substantially. The degree to which we are leveraged could, among other things:

·       make it difficult for us to make payments on the notes;

·       make it difficult for us to obtain financing for working capital, acquisitions or other purposes on favorable terms, if at all;

·       make us more vulnerable to industry downturns and competitive pressures; and

·       limit our flexibility in planning for, or reacting to changes in, our business.

Our ability to meet our debt service obligations will depend upon our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control.

The notes are unsecured, and future indebtedness could effectively rank senior to the notes.

The notes are unsecured and will rank equal in right of payment with our existing and future unsecured and unsubordinated indebtedness. The notes will be effectively subordinated to any secured debt to the extent of the value of the assets that secure the indebtedness. The notes will also be “structurally subordinated” to all indebtedness and other liabilities, including trade payables and lease obligations, of our existing and future subsidiaries. In the event of our bankruptcy, liquidation or reorganization or upon acceleration of the notes, payment on the notes could be less, ratably, than on any secured indebtedness. We may not have sufficient assets remaining to pay amounts due on any or all of the notes then outstanding.

The indenture governing the notes does not prohibit or limit us or our subsidiaries from incurring additional indebtedness and other liabilities, or from pledging assets to secure such indebtedness and liabilities. The incurrence of additional indebtedness and, in particular, the granting of a security interest to secure the indebtedness, could adversely affect our ability to pay our obligations on the notes. We anticipate that we may incur additional indebtedness from time to time in the future.

The notes are not protected by restrictive covenants, including financial covenants.

Neither we nor our subsidiaries are restricted from incurring additional debt, including senior debt, or liabilities under the indenture. In addition, the indenture does not restrict us or any of our subsidiaries from paying dividends or issuing or repurchasing securities. If we or our subsidiaries were to incur additional debt or liabilities, our ability to pay our obligations on the notes could be adversely affected.

We may be unable to repay, repurchase or redeem the notes.

At maturity, the entire outstanding principal amount of the notes will become due and payable by us. Upon a change in control, as defined in the indenture, note holders may require us to repurchase all or a portion of their notes. We may not have enough funds or be able to arrange for additional financing to pay the principal at maturity or to repurchase the notes on a change in control. Future credit agreements or other agreements relating to our indebtedness may restrict the redemption or repurchase of the notes and provide that a change in control constitutes an event of default. If the maturity date or a change in control occurs at a time when we are prohibited from repaying or repurchasing the notes, we could seek the consent of our lenders to purchase the notes or we could attempt to refinance this debt. If we do not obtain the necessary consents or cannot refinance the debt on favorable terms, or at all, we will be unable to repay or repurchase the notes. Our failure to repay the notes at maturity or repurchase tendered notes would

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constitute an event of default under the indenture, which might constitute a default under the terms of our other debt. Our obligation to offer to purchase the notes upon a change in control would not necessarily afford note holders protection in the event of a highly leveraged transaction, reorganization, merger or similar transaction involving us.

There may not be an active, liquid market for our common stock or the notes.

There is no guarantee that an active trading market for our common stock will be maintained on the Nasdaq Stock Market’s National Market. Investors may not be able to sell their shares quickly or at the latest market price if trading in our stock is not active. An active trading market for the notes may not be maintained. If an active market for the notes is not sustained, the trading price of the notes could decline significantly. The notes are eligible for trading on the PORTAL Market. We do not intend to apply for listing of the notes on any securities exchange.

The notes and the common stock issuable upon conversion of the notes may be subject to restrictions on resale.

We entered into a registration rights agreement with the initial purchasers of the notes, pursuant to which we filed a shelf registration statement covering the resale of the notes and the common stock issuable upon conversion of the notes. If the effectiveness of the registration statement is not maintained, the liquidity and price of the notes and common stock issuable upon conversion of the notes would be adversely affected and note holders could lose all or part of their investment.

At various times during 2003, 2004 and 2005, the price at which our common stock could be purchased on the Nasdaq National Market was lower than the conversion price of the notes, and our stock price may be lower than the conversion price in the future.

Prior to electing to convert notes, the note holder should compare the price at which our common stock is trading in the market to the conversion price of the notes. Our common stock trades on the Nasdaq National Market under the symbol CIPH. The initial conversion price of the notes is approximately $9.19 per share. The market prices of our securities are subject to significant fluctuations. Such fluctuations, as well as economic conditions generally, may adversely affect the market price of our securities, including our common stock and the notes.

The notes may not be rated or may receive a lower rating than anticipated.

We believe it is unlikely that the notes will be rated. However, if one or more rating agencies rates the notes and assigns the notes a rating lower than the rating expected by investors, reduces their rating in the future or indicates that it will have their ratings on the notes under surveillance or review with possible negative implications, the market price of the notes and our common stock would be harmed. In addition, a ratings downgrade could adversely affect our ability to access capital.

Our stock price has been highly volatile, and an investment in our stock could suffer a decline in value, adversely affecting the value of the notes or the shares into which those notes may be converted.

The trading price of our common stock has been highly volatile and could continue to be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including:

·       actual or anticipated period-to-period fluctuations in financial results;

·       failure to achieve, or changes in, financial estimates by securities analysts;

·       announcements of new products or services or technological innovations by us or our competitors;

·       developments regarding actual or potential discoveries of biomarkers by us or others;

·       comments or opinions by securities analysts or major stockholders;

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·       conditions or trends in the pharmaceutical, biotechnology and life science industries;

·       announcements by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments;

·       developments regarding our patents or other intellectual property or that of our competitors;

·       litigation or threat of litigation;

·       additions or departures of key personnel;

·       sales of our common stock;

·       limited daily trading volume; and

·       economic and other external factors or disasters or crises.

In addition, the stock market in general, and the Nasdaq National Market and the market for technology companies in particular, have experienced significant price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Further, there has been significant volatility in the market prices of securities of life science companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted. A securities class action suit against us could result in substantial costs, potential liabilities and the diversion of management’s attention and resources.

Future sales of our common stock in the public market could adversely affect the trading price of our common stock, the value of the notes and our ability to raise funds in new stock offerings.

Future sales of substantial amounts of our common stock in the public market, or the perception that such sales are likely to occur, could affect prevailing trading prices of our common stock and the value of the notes. As of December 31, 2005, we had:

·       35,998,881 shares of common stock outstanding;

·       6,333,504 shares of common stock reserved for issuance upon exercise of options outstanding under our stock option plans with a weighted average exercise price of $4.46 per share;

·       in addition to the shares reserved for issuance upon the exercise of options referred to in the preceding bullet point, 425,797 shares reserved for future issuance under our stock option and employee stock purchase plans;

·       a warrant outstanding for 2,200,000 shares of common stock at a purchase price of $3.50 per share; and

·       25,000 shares of common stock potentially issuable to Gail Page, President and Chief Executive Officer of Ciphergen, contingent upon the achievement of a specific diagnostic milestone.

Because the notes are convertible into common stock only at a specific conversion price, a decline in our common stock price may cause the value of the notes to decline.

ITEM 1B.       UNRESOLVED STAFF COMMENTS

None.

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ITEM 2.                PROPERTIES

Our principal facility is located in Fremont, California. The following chart indicates the facilities that we lease, the location and size of each facility and its designated use.

We are actively reviewing all of our space needs with a view to reducing our overall facilities expenses. Actions we may take include not renewing certain leases upon their expiration as well as seeking to sublease space to others.

ITEM 3.                LEGAL PROCEEDINGS

Ciphergen and certain of its current and former officers have been named as defendants in a securities class action complaint filed on December 5, 2005, in the United States District Court, Northern District of California (Docket No. C 05 4997 MHP). The complaint has been brought on behalf of all persons who purchased Ciphergen’s common stock from August 8, 2005, when we issued a press release announcing unaudited financial results for the second quarter of 2005, through November 16, 2005, when we announced our intention to restate those financial results. The Plaintiffs do not demand any particular amount in damages. We have not yet responded to this complaint. Given the early stage of this action, Ciphergen cannot predict the ultimate outcome of this matter at this time.

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

There were no matters submitted to a vote of security holders during the fourth quarter of 2005.

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PART II

ITEM 5.                MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock has been quoted on the Nasdaq National Market under the symbols “CIPH” and “CIPHE” since the effective date of our initial public offering on September 28, 2000. Prior to that time, there was no public market for our stock. The closing price for our common stock on February 28, 2006 was $1.75 per share. The following table sets forth the high and low sales prices per share of our common stock as reported on the Nasdaq National Market for the periods indicated.

We currently expect to retain future earnings, if any, for use in the operation and expansion of our business. We have not paid any cash dividends, nor do we anticipate paying any cash dividends in the foreseeable future. As of February 28, 2006, there were 35,998,881 shares of our common stock issued and outstanding and held by approximately 144 holders of record. There are approximately 4,000 beneficial owners of our common stock.

Sale of Convertible Senior Notes

On August 22, 2003, we closed the sale of $30.0 million of convertible senior notes due September 1, 2008, underwritten by SG Cowen. Offering costs were approximately $1.9 million. Interest on the notes is 4.5% per annum on the principal amount, payable semiannually on March 1 and September 1, beginning March 1, 2004. The effective interest rate is 5.85% per annum. The notes are convertible, at the option of the holder, at any time on or prior to maturity of the notes into shares of our common stock initially at a conversion rate of 108.8329 shares per $1,000 principal amount of the notes, which is equal to a conversion price of approximately $9.19 per share. The conversion price, and hence the conversion rate, is subject to adjustment upon the occurrence of certain events, such as stock splits, stock dividends and other distributions or recapitalizations. Because the market value of the stock rose above the conversion price between the day the notes were priced and the closing date, we recorded a discount of $2,677,000 related to the intrinsic value of the beneficial conversion feature resulting from this price change and the fact that the initial purchaser of the notes was not required to purchase the notes until the closing date. Immediately after the closing, Ciphergen common stock had a market price of $10.01 per share, or $0.82 per share higher than the conversion price. The value of the beneficial conversion feature was determined by multiplying this difference in the per share price of Ciphergen’s common stock by the 3,264,987 underlying shares. This amount will be amortized to interest expense using the effective interest method over the five-year term of the notes, or a shorter period in the event of conversion of the notes.

The notes are our senior unsecured obligations and rank on parity in right of payment with all of our existing and future senior unsecured debt and rank senior to our existing and future debt that expressly provides that it is subordinated to the notes. The notes are also effectively subordinated in right of

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payment to our existing and future secured debt, to the extent of such security, and to our subsidiaries’ liabilities. The indenture does not limit the incurrence by Ciphergen or its subsidiaries of other indebtedness.

Ciphergen may redeem the notes at its option, in whole or in part, at any time on or after September 1, 2006 at specified redemption prices plus accrued and unpaid interest, provided that the notes will be redeemable only if the closing price of the stock equals or exceeds 150% of the conversion price then in effect for at least 20 trading days within a period of 30 consecutive trading days ending on the trading day before the date of the notice of the redemption. The 3,264,987 shares that could be issued if all convertible senior notes were converted into common stock have not been included in the calculation of loss per share, as these potential common shares are antidilutive. Upon a change of control, each holder of the notes may require us to repurchase some or all of the notes at specified redemption prices, plus accrued and unpaid interest. The debenture contains a put option that entitles the holder to require us to redeem the debenture at a price equal to 105.0% of the principal balance upon a change in control of Ciphergen. We do not anticipate that the put option will have significant value because no change of control is currently contemplated.

The notes and underlying shares were registered with the SEC on Form S-3 on October 8, 2003.

Issuance of Common Stock to LumiCyte

On May 28, 2003, we settled our litigation with Molecular Analytical Systems, Inc., LumiCyte, Inc. and T. William Hutchens. As part of this settlement, we issued to LumiCyte 1,250,000 shares of Ciphergen common stock, which were valued at $7.8 million. These shares were registered with the SEC on Form S-3 on June 24, 2003.

Recent Sales of Other Unregistered Securities

On July 22, 2005, pursuant to a stock purchase agreement, Ciphergen sold Quest Diagnostics Incorporated (“Quest Diagnostics”) 6,225,000 shares of Ciphergen’s common stock, or approximately 17.4% of shares outstanding after the transaction, for an aggregate purchase price of $15,000,000 and issued Quest Diagnostics a warrant to purchase up to 2,200,000 shares of Ciphergen’s common stock at an exercise price of $3.50 per share, subject to certain adjustments. While the warrant issued to Quest Diagnostics is exercisable at any time, Ciphergen and Quest Diagnostics later clarified that the total number of shares of common stock purchased pursuant to such transaction and issuable upon exercise of the warrant would at no time exceed 19.9% of the total number of outstanding shares of Ciphergen common stock (provided that Quest Diagnostics may, prior to or concurrently with the exercise of their warrant, sell such number of shares of Ciphergen common stock that, after the exercise of the warrant and such sale of shares, Quest Diagnostics would not own more than 19.9% of Ciphergen’s common stock). This warrant is exercisable at any time prior to July 22, 2010. The proceeds received by Ciphergen from the sale of the common stock or upon any exercise of the warrant will be used for working capital and general corporate purposes. The securities offered, issued and sold pursuant to this financing will not be registered under the Securities Act of 1933, as amended, by reason of an exemption from the registration requirements under Section 4(2) and/or Rule 506 of Regulation D of the Securities Act, and may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements. Pursuant to the terms of the stock purchase agreement, we were able to rely upon the representations and warranties provided by Quest Diagnostics contained therein in connection with the issuance of the shares of common stock and the warrants without registration. Pursuant to the stock purchase agreement, we also provided certain registration rights to Quest Diagnostics whereby they may demand that we subsequently register their shares under the Securities Act or, if we file another registration statement under the Securities Act, Quest Diagnostics may elect to include their shares in that

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registration, subject to various conditions. This stock sale and the issuance of the warrant were not subject to stockholder approval.

Securities Authorized for Issuance Under Equity Compensation Plans

We currently maintain three equity-based compensation plans that have been approved by our stockholders—the 1993 Stock Option Plan, which was approved by the stockholders in 1993 and is referred to as the “1993 Plan,” the 2000 Stock Plan, which was approved by the stockholders in 2000 and is referred to as the “2000 Plan,” and the 2000 Employee Stock Purchase Plan, which was approved by the stockholders in 2000 and is referred to as the “ESPP”.

·                     1993 Plan.   Certain stock option grants remain outstanding to our officers, employees, directors and a consultant under this plan. However, the authority to grant new awards under this plan terminated in 2001. The Board of Directors continues to administer this plan with respect to the options that remain outstanding.

·                     2000 Plan.   Stock option awards may be granted under the 2000 Plan. The 2000 Plan is administered by, and each award grant must be approved by, the Board or a committee of the Board. Persons eligible to receive awards under the 2000 Plan include our officers, employees, directors and consultants. Ciphergen’s non-employee directors are also eligible for certain automatic stock option grants under the 2000 plan. The Board or a committee of the Board will determine the purchase price for any shares of our common stock subject to an award under the 2000 Plan, the vesting schedule (if any) applicable to each award, the term of each award, and the other terms and conditions of each award, in each case subject to the limitations of the 2000 Plan.

·                     ESPP.   Subject to limits, all of our officers and employees in the U.S. are eligible to participate in the ESPP. The ESPP operates in successive 6-month offering and purchase periods. Participants in the ESPP may purchase common stock at the end of each purchase period at a purchase price equal to 85% of the lower of the fair market value of the stock at the beginning of the offering period or the end of the purchase period. The administrator of the ESPP may allow participants to contribute up to 15% of their eligible compensation to purchase stock under the plan. The ESPP is administered by the Board or a committee of the Board.

Summary Table.   The following table sets forth, for each of Ciphergen’s equity-based compensation plans, the number of shares of Ciphergen common stock subject to outstanding options and rights, the weighted-average exercise price of outstanding options, and the number of shares available for future award grants as of December 31, 2005.

Equity Compensation Plan Table

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(1)          Includes outstanding stock options for 812,035 shares under the 1993 Plan and 5,521,469 shares under the 2000 Plan. Also includes 41,479 shares after giving effect to estimated purchases under the ESPP for the purchase period that will end on May 1, 2006 based on participant contributions through December 31, 2005.

(2)          Includes 259,299 shares for the 2000 Plan. On January 1 of each year during the term of the 2000 Plan, the total number of shares available for award purposes under the 2000 Plan will increase by the lesser of (i) 2,150,000 shares, (ii) 5% of the outstanding shares of common stock on the last day of the immediately preceding fiscal year, or (iii) an amount determined by the Board. The aggregate number of shares available for issuance under the 2000 Plan increased by 1,300,000 shares on January 1, 2006. The data presented in this table was calculated as of December 31, 2005 and does not reflect the January 1, 2006 increase. Also includes 166,498 shares for the ESPP. On January 1 of each year during the term of the ESPP, the total number of shares available for sale under the ESPP will increase by the lesser of (i) 430,000 shares, (ii) 1% of the outstanding shares of common stock on the last day of the immediately preceding fiscal year, or (iii) an amount determined by the Board. The aggregate number of shares available for sale under the ESPP increased by 170,000 shares on January 1, 2006 and is not included in the table above.

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ITEM 6.               SELECTED FINANCIAL DATA

The following tables reflect selected summary consolidated financial data for each of the last five fiscal years. This data should be read in conjunction with the consolidated financial statements and notes thereto, and with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-K. Historical results are not necessarily indicative of the results to be expected in the future. On November 30, 2004 we completed the sale of our BioSepra business. Accordingly, the information set forth in the table below has been restated to reflect the BioSepra business as a discontinued operation.

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ITEM 7.               MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

We develop, manufacture and sell our ProteinChip® Systems, which use patented Surface Enhanced Laser Desorption/Ionization (“SELDI”) technology. These systems consist of a ProteinChip Reader, ProteinChip Software and related accessories which are used in conjunction with our consumable ProteinChip Arrays and ProteinChip Kits. We market and sell our products primarily to research biologists in pharmaceutical and biotechnology companies, and academic and government research laboratories. In 1997, we acquired IllumeSys Pacific, Inc., which holds specific rights to the SELDI technology for the life science research market. Our first designed and manufactured system, the ProteinChip System, Series PBS I, was available for shipment in the third quarter of 1997. In 1997, we also established a subsidiary in the U.K. and began direct selling in Europe. During 1999, we initiated an expanded marketing program and in May began shipping the ProteinChip System, Series PBS II, the latest version of which is now referred to as the ProteinChip Biology System. In 1999, we also established a joint venture with Sumitomo Corporation to distribute our products in Japan. During 2000, we began offering research services and established Biomarker Discovery Center laboratories in Fremont, California; Copenhagen, Denmark; and Malvern, Pennsylvania.

In 2001, we introduced the ProteinChip Biomarker System, which utilizes sophisticated third-party software to automate pattern recognition-based statistical analysis methods and correlate protein expression patterns from clinical samples with disease phenotypes. We also began selling the Biomek® 2000 Workstation, a robotic accessory which is manufactured by Beckman Coulter and which has been optimized for use with our ProteinChip Biomarker System to increase sample throughput and reproducibility. In addition, we expanded our product offering with a SELDI ProteinChip interface to high-end tandem mass spectrometers, which we developed and which is manufactured for us by a third party manufacturing company. On July 31, 2001, Ciphergen acquired the BioSepra® process chromatography business from Invitrogen Corporation; this business was subsequently sold to Pall Corporation on November 30, 2004.

On August 31, 2002, we increased our ownership interest in Ciphergen Biosystems KK, the Japanese joint venture we formed with Sumitomo Corporation in 1999, from 30% to 70%. Shortly thereafter, we opened a Biomarker Discovery Center laboratory at the Yokohama facility of Ciphergen Biosystems KK. In October 2002, we launched the ProteinChip AutoBiomarker System, an automated version of our ProteinChip Biomarker System, which incorporates an autoloader and a Biomek robot to increase sample throughput and automate the reading of ProteinChip Arrays. On March 23, 2004, we purchased the remaining 30% ownership interest in Ciphergen Biosystems KK. In July 2004, we launched the ProteinChip System, Series 4000, our next generation ProteinChip System.

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We have used our resources primarily to develop and expand our proprietary ProteinChip Systems and related consumables and to establish a marketing and sales organization for commercialization of our products. We also used our funds to establish a joint venture to distribute our products in Japan and to increase our ownership in the joint venture to 100%. In addition, we acquired the BioSepra process chromatography business in 2001, which we sold for a gain in 2004. We have also used our resources to establish Biomarker Discovery Center laboratories to provide research services to our clients, to foster further adoption of our products and technology, and to discover biomarkers that we seek to patent for diagnostic and other purposes. In early 2004, we increased our efforts to discover and commercialize protein biomarkers and panels of biomarkers that can be developed into protein molecular diagnostic tests that improve patient care. Since our inception we have incurred significant losses and as of December 31, 2005, we had an accumulated deficit of $195.8 million.

Our sales are currently driven by the need for new and better tools to perform protein discovery, characterization, purification, identification and assay development. Many of the ProteinChip Systems sold to our customers also generate a recurring revenue stream from the sale of consumables and maintenance contracts. In addition, some of our customers later enhance their ProteinChip Systems by adding our automation accessories and advanced software.

Our expenses have consisted primarily of materials, contracted manufacturing services, labor and overhead costs to manufacture our ProteinChip Systems and ProteinChip Arrays and to provide customer services; marketing and sales activities; research and development programs; litigation; and general and administrative costs associated with our operations.

We expect to incur losses at least for the next year. Our current level of revenue is insufficient for us to become profitable. To become profitable, we will need to increase unit sales of our ProteinChip Systems and Arrays as well as begin achieving revenue from our diagnostics efforts. We have a limited history of operations and we anticipate that our quarterly results of operations will fluctuate for the foreseeable future due to several factors, including market acceptance of current and new products, the length of the sales cycle and timing of significant orders, the timing and results of our research and development efforts, the introduction of new products by our competitors and possible patent or license issues. Our limited operating history makes accurate prediction of future results of operations difficult or impossible.

Recent Developments

On July 22, 2005, we entered into a strategic alliance agreement with Quest Diagnostics covering a three year period during which the parties will strive to develop and commercialize up to three diagnostic tests based on Ciphergen’s proprietary SELDI ProteinChip technology. Pursuant to the agreement, Quest Diagnostics will have the non-exclusive right to commercialize these tests on a worldwide basis, with exclusive commercialization rights in territories where Quest Diagnostics has a significant presence for up to five years following commercialization. As part of the strategic alliance, there is a royalty arrangement under which Quest Diagnostics will pay royalties to Ciphergen based on fees earned by Quest Diagnostics for applicable diagnostics services, and Ciphergen will pay royalties to Quest Diagnostics based on Ciphergen’s revenue from applicable diagnostics products. To date, no such royalties have been earned by either party. Quest Diagnostics and Ciphergen have also entered into a supply agreement under which Ciphergen will sell instruments and consumable supplies to Quest Diagnostics to be used for performing diagnostics services. In addition, for an aggregate purchase price of $15 million, Quest Diagnostics has purchased 6,225,000 shares of Ciphergen’s common stock, or approximately 17.4% of shares outstanding after the transaction, and a warrant having a term of five years to purchase up to an additional 2,200,000 shares for $3.50 per share. The warrant was valued at approximately $2.2 million based on the fair value as determined by a Black-Scholes model using the following assumptions: risk-free interest rate, 4.04%; expected life, 5 years; expected volatility 69%. Quest Diagnostics has also agreed to loan Ciphergen up to $10 million with interest accrued at the prime rate plus 0.5% and paid monthly, solely to fund certain

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development activities related to the strategic alliance. Borrowings may be made by Ciphergen in monthly increments of up to approximately $417,000 on the last day of each month during the first two years of the strategic alliance, and at December 31, 2005, such borrowings amounted to $2.5 million. This loan, collateralized by certain intellectual property of Ciphergen, will be forgiven based on Ciphergen’s achievement of certain milestones related to development, regulatory approval and commercialization of certain diagnostic tests. Should the Company fail to achieve these milestones, the outstanding principal amount of any such loans will become due and payable on July 22, 2010. From the inception of the strategic alliance through December 31, 2005, we have spent approximately $2.2 million of the loan proceeds on in-house research and development, as well as collaborations with others, directed towards achieving the milestones. Spending for this purpose is expected to continue and to increase, partly as a result of the additional expenses associated with the collaboration with University College London et al. described below.

On October 3, 2005, we entered into a two year research and license agreement with University College London and UCL BioMedica Plc. (together, “UCL”) to utilize Ciphergen’s suite of proteomic solutions (Deep Proteome™, Pattern Track™ Process and ProteinChip® System) to further UCL’s ongoing research in ovarian cancer and breast cancer. Under the terms of the agreement, Ciphergen has exclusive rights to license intellectual property resulting from discoveries made during the course of this collaboration for use in developing, manufacturing and selling products and services utilizing the intellectual property. Additionally, Ciphergen will contribute approximately $2.1 million in cash and $652,000 in the form of Ciphergen equipment, software, arrays and consumable supplies as requested by UCL, valued at Ciphergen’s list selling price, to cover part of the costs incurred by UCL specifically for this research program. $1.1 million of the cash obligation is to be paid in the first year of the agreement and is non-cancelable. The remainder is to be paid in the second year of the agreement and is cancelable with three months advance notice. As of December 31, 2005, we had expensed $306,000, of which $33,000 represented our cost for the arrays and consumables we had provided, and the remaining $273,000 was recorded as an accrued liability.

On December 20, 2005, Ciphergen’s Board of Directors approved the accelerated vesting of all unvested and “out-of-the-money” stock options held by employees with an exercise price per share of $4.00 or higher. The accelerated vesting caused options previously awarded for the purchase of approximately 1,035,000 shares of Ciphergen’s common stock, representing approximately 16% of total options outstanding, to vest and become exercisable immediately, subject to continued restrictions on sale. Of the 224 option grants subject to accelerated vesting, 27 are held by executive officers. Under APB No. 25 and FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation” , the acceleration of the vesting of these options did not result in a compensation charge because the exercise prices of the affected options was greater than the closing price of our common stock on December 20, 2005. The decision to accelerate the vesting of these options was made primarily to reduce non-cash compensation expense that would have been recorded in Ciphergen’s income statement in future periods upon the adoption of SFAS 123(R) beginning in January 2006. As a result of this acceleration, we expect to reduce the stock option expense we would otherwise be required to record by approximately $2.2 million, which is included in the pro forma calculation of net income under SFAS 123 included in note 1 of the Notes to Consolidated Financial Statements. Approximately $0.9 million of the $2.2 million would have related to 2006. The Board of Directors believes the accelerated vesting of these options to be in the best interest of our shareholders and employees.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires

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us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. (See note 1 of the Notes to Consolidated Financial Statements.)

Revenue Recognition

We derive our revenue from primarily two sources: (i) products revenue, which includes systems, accessories, software licenses and consumables, and (ii) services and support revenue, which includes Biomarker Discovery Center services, maintenance, training and consulting revenue. As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period.

We recognize revenue from the sales of systems, accessories, separately priced software products and consumables when realized or realizable and earned, which is when the following criteria are met:

·       persuasive evidence of an agreement exists,

·       the price is fixed or determinable,

·       the product has been delivered,

·       no significant obligations remain, and

·       collection of the receivable is reasonably assured.

For all sales, except for small amounts of consumables, we use a binding purchase order, contract or signed sales quotation as evidence of an arrangement. Sales through our distributors are evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction-by-transaction basis.

At the time of the transaction, we assess whether the price is fixed and determinable and whether or not collection is reasonably assured. We assess whether the price is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of the payment is due after our normal payment terms, which are 30 to 90 days from invoice date in most countries, we generally treat the price as not being fixed and determinable. In these cases, we recognize revenue for the extended portions of the payment as they become due. We assess collectibility based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. We do not request collateral from our customers. If we determine that collection of a payment is not reasonably assured, we defer the revenue until the time collection becomes reasonably assured, which is generally upon receipt of cash.

Delivery generally occurs when the product is delivered to a common carrier or when the customer receives the product, depending on the nature of the arrangement. Revenue from shipping and handling is generally recognized upon product shipment, based on the amount billed to customers for shipping and handling. The related cost of shipping and handling is included in cost of revenue upon product shipment.

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We generally include a standard 12-month warranty on our instruments and accessories in the form of a maintenance contract upon initial sale. We also sell separately priced maintenance (extended warranty) contracts, which are generally for 12 or 24 months, upon expiration of the initial warranty. We make no distinction between a standard warranty and a maintenance (extended warranty) contract, as coverage under both the standard and extended maintenance contracts is identical. Because we do not offer traditional warranties but enhance them such that they are identical to our separately priced maintenance contracts, we believe it is appropriate to account for them the same way. Revenue for both the standard and extended maintenance contracts is deferred and recognized ratably over the maintenance contract term. Related costs are expensed as incurred. If we were to experience an increase in warranty claims or if costs of servicing these maintenance contracts were greater than the expectations upon which the maintenance contract deferrals had been based, our gross margins could be adversely affected.

For revenue from Biomarker Discovery Center contracts and other consulting contracts, if elements are specifically tied to a separate earnings process, then revenue related to an element is recognized when the specific performance obligation associated with that element is completed. When revenues for an element are not specifically tied to a separate earnings process, they are recognized ratably over the term of the agreement. Revenue from Biomarker Discovery Center services and other consulting contracts is recognized at the completion of key stages in the performance of the service as described in our agreement with the customer. Often there is only a single element, namely delivery of a scientific report upon completion of our analysis of customer samples, in which case we recognize all the revenue upon the conclusion of the project when all deliverables have been provided to the customer. Revenue is deferred for fees received before earned. Our training is billed based on published course fees and we generally recognize revenue as the training is provided to the customer.

For revenue arrangements with multiple elements that are delivered at different points in time (for example, where we have delivered the hardware and software but are also obligated to provide services, maintenance and/or training), we evaluate whether the delivered elements have standalone value to the customer, whether the fair value of the undelivered elements is reliably determinable, and whether the delivery of the remaining elements is probable and within our control. When all these conditions are met, we recognize revenue on the delivered elements. If any one of these conditions is not met, we defer the recognition of revenue until all these conditions are met or all elements have been delivered. Fair values for ongoing maintenance are based upon separate sales of renewals to other customers. Fair values for services, such as training or consulting, are based upon separate sales by us of those services to other customers.

Allowance for Doubtful Accounts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. These reserves are determined by (1) analyzing specific customer accounts that have known or potential collection issues, and (2) reviewing the length of time receivables are outstanding and applying historical loss rates to the aging of the accounts receivable balances. If the financial condition of Ciphergen’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances would be required.

Inventory Reserves

We write down our inventory for estimated excess and obsolete inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand, market conditions and the release of new products that will supersede older ones. Such estimates are difficult to make under current volatile economic conditions. Reviews for excess inventory are done on a quarterly basis and required reserve levels are calculated with reference to our projected ultimate usage of that inventory. In order to determine the ultimate usage, we take into account recent sales forecasts,

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historical experience, projected obsolescence and our current inventory levels. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Depreciation and Amortization

Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization is computed for financial reporting purposes principally using the straight-line method over the following estimated useful lives: machinery and equipment, 3-5 years; demonstration equipment, 2 years; computer equipment and software, 3 years; furniture and fixtures, 5 years; buildings and leasehold improvements, lesser of their economic life or the term of the underlying lease. If assets are determined to have useful lives shorter than originally estimated, the net book value of the assets is depreciated over the newly determined remaining useful lives.

Valuation of Long-Lived Assets Including Acquired Intangible Assets

We review long-lived assets, which include property, plant and equipment and acquired identifiable intangibles, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment evaluations involve management estimates of the useful lives of the assets and the future cash flows they are expected to generate. An impairment loss is recognized when estimated undiscounted future cash flows expected to result from the use of the asset plus net proceeds expected from disposition of the asset (if any) are less than the carrying value of the asset. This approach also uses our estimates of future market growth, forecasted revenue and costs and appropriate discount rates. Actual useful lives, cash flows and other factors could be different from those estimated by management and this could have a material effect on our operating results and financial position. When impairment is identified, the carrying amount of the asset is reduced to its estimated fair value. Deterioration of our business for a significant product or in a particular geographic region in the future could also lead to impairment adjustments as such issues are identified.

Goodwill Impairment

We recorded goodwill principally as a result of our acquisitions of IllumeSys Pacific, Inc. in 1997, Ciphergen Technologies, Inc. in 1998 and BioSepra S.A. in 2001, and the increases in our ownership of Ciphergen Biosystems KK in 2002 and 2004. The goodwill related to BioSepra was written off against the gain on the sale of the BioSepra business in 2004. We perform goodwill impairment tests on an annual basis and more frequently when events and circumstances occur that indicate a possible impairment of goodwill. In determining whether there is an impairment of goodwill, we calculate the estimated fair value of the reporting unit in which the goodwill is recorded using a discounted future cash flow method. We then compare the resulting fair value to the net book value of the reporting unit, including goodwill. If the net book value of a reporting unit exceeds its fair value, we measure the amount of the impairment loss by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. To the extent that the carrying amount of a reporting unit’s goodwill exceeds its implied fair value, we recognize a goodwill impairment loss. We performed annual impairment tests through 2004 and determined that no impairment had occurred. We performed an annual impairment test in 2005 and determined that goodwill of $2.5 million associated with our Japanese subsidiary had been impaired. (See note 6, “Purchase of Additional Ownership Interest in Ciphergen Biosystems KK”, and note 8, “Goodwill and Other Intangible Assets”, in the Notes to Consolidated Financial Statements.) The discounted future cash flow method used in the first step of our impairment test involves significant estimates including future cash inflows from estimated revenues, future cash outflows from estimated project costs and general and administrative costs, timing of collection and payment of various items, working capital levels, future growth rates and profit margins, as well as discount rate and terminal value

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assumptions. Although we believe the estimates and assumptions that we used in testing for impairment are reasonable, changes in any one of these assumptions could produce a significantly different result.

Stock-Based Compensation

We have various stock option, stock purchase and incentive plans to reward employees and key executive officers of our company. We account for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”, and apply the disclosure provisions of Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation”, as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure”. Under APB 25, unearned stock-based compensation is measured as the difference, if any, on the date of grant, between the fair value of our common stock and the exercise price. Under SFAS 123, stock-based compensation is based on the fair value of the stock award measured using option valuation models. All deferred stock-based compensation is amortized and expensed in accordance with Financial Accounting Standards Board Interpretation No. 28, an accelerated vesting model.

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised), “Share-Based Payment.” This new standard requires the expensing of all stock-based compensation. Under the new standard, our estimate of compensation expense will require a number of complex and subjective assumptions including our stock price volatility, employee exercise patterns (expected life of the options), future forfeitures and related tax effects. SFAS No. 123(R) will be effective for us beginning in the first quarter of fiscal 2006. Management expects that we will use the modified prospective application method and that we will recognize stock-based compensation expense on a straight-line basis over the vesting periods of the awards. The amount of stock-based compensation we record will depend on a number of factors, including the amount of awards granted and the fair value of those awards at the time of grant.

Contingencies

We have been, and may in the future become, subject to legal proceedings related to intellectual property licensing matters. Based on the information available at the balance sheet dates and through consultation with our legal counsel, we assess the likelihood of any adverse judgments or outcomes for these matters, as well as potential ranges of probable loss. If losses are probable and reasonably estimable, we will record a reserve in accordance with Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies”. Currently we have no such reserves recorded. Any reserves recorded in the future may change due to new developments in each matter.

Deferred Taxes

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that Ciphergen would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that Ciphergen would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

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Results of Operations

Comparison of Years Ended December 31, 2005, 2004 and 2003

In the following discussion of our results of operations, results related to the BioSepra business have been reclassified as discontinued operations for all periods discussed.

Revenue

Product revenue was $18.4 million in 2005, $31.4 million in 2004, and $35.9 million in 2003. The $13.0 million or 42% decrease in product revenue from 2004 to 2005 was largely the result of a 54% decrease in revenue from sales of our ProteinChip Systems, accessories and software, as well as a 14% decrease in revenue from our arrays and consumables. The decrease in systems and related revenue was due to a 41% decrease in unit sales of ProteinChip Systems and a 22% decrease in average revenue per system sold due to increased discounting and incentives we offered to expedite orders, discounts offered to customers on trade ins of their older model ProteinChip Systems for a new Series 4000, and the competitive environment. The decrease in array and consumable sales was largely driven by lower unit sales due in part to fewer new instrument placements, which typically include a significant initial purchase of consumables. In Japan, we price our products in Japanese yen, and the strengthening of the U.S. dollar against the Japanese yen resulted in a decrease in product revenue of approximately $370,000.

In the third quarter of 2005, we sold nine ProteinChip Systems to one customer for $601,000. We also entered into a product development agreement with this same customer, whereby the customer will develop for us a specific new product and we may pay the customer up to $500,000 based on the customer’s attainment of specified development milestones. Under this agreement, Ciphergen paid this customer $300,000 of development fees during 2005. This was recorded, following EITF 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)”, as a reduction to revenue, resulting in net revenue from this customer of approximately $301,000 in 2005. This constituted approximately 2% of products revenue and 1% of total revenue for 2005. In future periods, if this third party achieves a development milestone, Ciphergen will record its payment obligation as a reduction to revenue in the period in which that development milestone is met.

The $4.5 million or 13% decrease in product revenue from 2003 to 2004 was primarily the result of a 22% decrease in revenue from sales of our ProteinChip Systems, accessories and software. This was largely due to a 13% decline in unit sales of ProteinChip Systems, reflecting a more competitive selling environment. In addition, we experienced a 10% decrease in average revenue per system sold due to lower list prices for the Series 4000 as compared to its predecessor model, as well as increased discounting as a result of the competitive environment and slightly lower accessory sales when comparing the two periods. This was partially offset by a 20% increase in array and other consumables sales driven by greater unit sales to a larger installed base of customers.

Service revenue was $8.9 million in 2005, $8.8 million in 2004, and $7.8 million in 2003. The $93,000 or 1% increase in service revenue from 2004 to 2005 was primarily due to a $313,000 increase in revenue from collaboration services handled through our Biomarker Discovery Center laboratories due to the completion of several large contracts in 2005, and from a $97,000 increase in revenue from maintenance contracts, driven by growth in our installed base. However, revenue from training and consulting services decreased $317,000 primarily due to fewer new instrument placements, which typically include an initial registration for one or more training classes.

The $1.0 million or 13% increase in service revenue from 2003 to 2004 was primarily due to $1.8 million higher revenue from maintenance contracts, training and consulting services driven by growth in our installed base. This was partially offset by a decline of $776,000 in revenue from Biomarker Discovery Center services; we redirected much of our selling effort towards ProteinChip System sales and

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away from service projects during this period, in part due to our desire to focus more of our Biomarker Discovery Center resources on research for our own account.

We expect that future revenues for our business will be affected by, among other things, our ability to develop and commercialize diagnostic tests based on the ProteinChip platform, demand for our ProteinChip Systems and Arrays, the degree of acceptance by the market of our Series 4000 platform, the level of continuing purchases of arrays by existing customers, new product and application introductions, customer budgets, competitive conditions and government funding for research in our field.

Cost of Revenue

Cost of product revenue was $9.4 million in 2005, $11.2 million in 2004, and $11.9 million in 2003. The $1.8 million or 16% decrease in cost of product revenue from 2004 to 2005 resulted from a decrease in unit sales of our ProteinChip Systems, accessories, software, arrays and other consumables, as well as a $1.1 million decrease in the provision for excess and obsolete inventories in 2005 compared to 2004. We introduced our current Series 4000 platform in 2004 and concurrently increased inventory reserves for older products. These decreases were partially offset by higher costs of materials recorded in 2005, compared to 2004 when a portion of sales included instruments with components previously charged to research and development. The gross margin for product revenue decreased from 64% in 2004 to 49% in 2005. The decrease in gross margin for product revenue was largely due to lower gross margins for arrays and consumables resulting from lower production volumes in 2005 compared to 2004, thus spreading our fixed manufacturing overhead costs over fewer units produced and eroding gross margin on products revenue by approximately 12% of products revenue. The decrease in gross margin from 2004 to 2005 was also due to lower gross margins for ProteinChip Systems as a result of increased discounting.

The $712,000 or 6% decrease in cost of product revenue from 2003 to 2004 resulted primarily from a decrease in unit sales of our ProteinChip Systems. The gross margin for product revenue decreased from 67% in 2003 to 64% in 2004. This decrease was largely due to a decrease in the average selling price of our systems. In the third quarter, we offered special, introductory pricing for one quarter for our newly introduced ProteinChip System, Series 4000; we also discounted our remaining stock of older model ProteinChip Systems. In the six months of 2004 after launching the Series 4000, this new product accounted for 81% of our unit sales, while older model ProteinChip Systems and Tandem MS Interfaces accounted for 14% and 5%, respectively. Cost of product revenue in 2004 also included an increase in the provision for excess and obsolete inventory of $1.2 million. This reduced the gross margin for product revenue by 4% of product revenue. The increase in the provision for excess and obsolete inventory was largely to provide an appropriate reserve for our older ProteinChip Systems in light of the introduction of the new Series 4000 model. This was offset by sales of the ProteinChip System, Series 4000, that were built with $1.3 million of components previously charged to research and development expense prior to the product achieving technological feasibility, thus favorably impacting the gross margin by 4% of product revenue.

Deferred stock-based compensation for options granted to employees is the difference between the fair value of our common stock on the date such options were granted and their exercise price. Stock-based compensation for options granted to consultants is periodically remeasured as the underlying options vest. Stock-based compensation expense in cost of product revenue was $0 in 2005, $45,000 in 2004, and $81,000 in 2003.

Cost of service revenue was $4.3 million in 2005, $3.9 million in 2004, and $3.4 million in 2003. From 2004 to 2005, cost of service revenue increased $445,000 or 11% primarily due to increased costs associated with paid projects performed by our Biomarker Discovery Center laboratories and customer training. The gross margin for service revenue decreased from 56% in 2004 to 51% in 2005 mainly due to lower gross margins realized on Biomarker Discovery Center contracts, which have costs that typically vary based on

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the complexity and difficulty of the work being undertaken, and lower gross margins on our training services.

From 2003 to 2004, cost of service revenue increased $450,000 or 13% due to increased field service costs to provide service for a greater number of maintenance contracts, partially offset by decreased collaboration expenses associated with revenue-generating contracts at our Biomarker Discovery Center laboratories. The gross margin for service revenue remained at 56% for 2003 and 2004.

We believe that gross profit as a percentage of revenue in future periods will be affected by, among other things, sales volumes, competitive conditions, discounts offered, inventory reserve levels and the amount of scrap and rework we incur in our manufacturing processes.

Litigation Settlement

On May 28, 2003, we settled our litigation with Molecular Analytical Systems, Inc. (“MAS”), LumiCyte, Inc. (“LumiCyte”), and T. Williams Hutchens whereby we acquired the undisputed exclusive rights granted to MAS under patents licensed from Baylor College of Medicine and the parties released all claims against each other. These patent rights refer to technology known as SELDI-TOF-MS, and provide us with an exclusive worldwide license and right to sublicense the technology and to commercialize any and all products, information and services derived from the technology without limitation. Furthermore, LumiCyte assigned all rights granted to it from MAS and related to the Baylor College of Medicine patents to us without restriction. As part of the settlement:

·       Ciphergen paid LumiCyte $3.0 million in cash;

·       Ciphergen issued to LumiCyte 1,250,000 shares of Ciphergen common stock which was valued at $7.8 million; and

·       Ciphergen agreed to pay license fees to MAS based on the revenues Ciphergen and its affiliates derive from the SELDI technology and recognize between February 21, 2003 and May 28, 2014, provided that such license fees will not exceed $1.0 million during the calendar year 2003 or $10.0 million in the aggregate. Although $10.0 million is the maximum amount that could be payable, we feel it is likely that in the remaining approximately nine years until May 2014, we will achieve cumulative sales sufficient to reach this upper limit. Through December 31, 2005, we paid or accrued a total of $2.2 million in such license fees.

The total cost of the litigation settlement, including future license fees, is expected to be $20.8 million. We cannot predict the amount of future revenue we will earn over the remaining life of the technology. Therefore we do not relate the license fees to revenue. Rather, we view our license rights as an intangible asset we purchased which we amortize over a 17-year useful life on a straight line basis. The 17-year useful life started in April 1997, when we originally acquired our license rights (subsequently the subject of a litigation settlement), and expires in the second calendar quarter of 2014. We believe that researchers will have a need to do advanced protein analysis for far longer than the remaining approximately nine years and, because of the complexity of that task, multiple technologies will be employed. Largely due to the complexity of analyzing proteins, we do not believe that an as-yet-undeveloped technology will be developed by others that would obsolete the use of ProteinChip technology, although undoubtedly alternate approaches will be introduced in the future at the same time as we continue to evolve and improve the performance of our technology. Nor do we foresee ourselves introducing a new technology that would supplant the SELDI technology. As an analogy, polymerase chain reaction (PCR) technology was invented in 1983 and continues to be a key method used in genetic research today. On the other hand, once the fundamental patents protecting the ProteinChip technology expire, we believe that multiple parties will want to enter the market using the technology. Hence, we have concluded that a 17-year useful life is appropriate.

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Of the total anticipated settlement costs of $20.8 million, $7.3 million was attributed to periods prior to April 1, 2003 and expensed as a non-recurring item in the second quarter of 2003. $906,000 was amortized to cost of revenue for the remainder of 2003, $1.2 million was amortized to cost of revenue in both 2004 and 2005, and the remaining $10.2 million will be amortized to cost of revenue in future periods through the second quarter of 2014. The cost is being prorated between cost of products revenue and cost of services revenue each month based on the ratio of SELDI-based products revenue to SELDI-based services revenue.

Operating Expenses

Research and Development

Research and development expenses were $13.2 million in 2005, $19.3 million in 2004, and $23.6 million in 2003. From 2004 to 2005, research and development expenses decreased $6.1 million or 32% primarily due to a decrease of $2.2 million in salaries, payroll taxes and employee benefits due to a 39% decline in research and development staff. Materials and supplies used in the development of new products also decreased by $1.9 million and consulting fees decreased by $1.0 million, consistent with the scaling back of research programs related to our instrument platform. Spending on diagnostics research under the strategic alliance with Quest Diagnostics was approximately $2.2 million in 2005 during the first five months of the alliance.

From 2003 to 2004, research and development expenses decreased $4.4 million or 18% primarily due to a decrease of $2.5 million in salaries, payroll taxes and employee benefits, excluding our Biomarker Discovery Center laboratories, due to a decline in research and development staff resulting primarily from the completion of our Series 4000 development program as well as the cancellation or scaling back of various early-stage research and development projects in line with our cost reduction efforts. These actions also resulted in a decrease of approximately $1.6 million for engineering parts and other project materials, excluding our Biomarker Discovery Center laboratories. These were partially offset by an increase of approximately $907,000 in Biomarker Discovery Center activities related to projects targeting the discovery and development of biomarkers that could potentially be developed into diagnostic products. In addition, stock-based compensation expense declined $150,000.

Stock-based compensation expense in research and development expenses was $0 in 2005, $37,000 in 2004, and $187,000 in 2003.

We expect research and development expenses to decline in 2006 relative to 2005 due to having fewer research and development employees in 2006 as well as slowing or canceling selected early-stage research and development programs related to new instrumentation platforms as part of our efforts to control expenses, partially offset by an increase in our research and development activities associated with developing and commercializing diagnostic tests as part of our strategic alliance with Quest Diagnostics, and discovering biomarkers that could potentially be developed into additional diagnostic products.

Sales and Marketing

Sales and marketing expenses were $18.0 million in 2005, $26.0 million in 2004, and $21.3 million in 2003. From 2004 to 2005, sales and marketing expenses decreased $8.0 million or 31%, largely due to lower payroll-related costs as a result of a 40% decrease in the sales and marketing staff thereby decreasing payroll and related costs approximately $4.1 million. The reduction in our sales force also resulted in a $1.6 million decrease in travel expenses and a $559,000 decrease in ProteinChip Arrays and lab supplies used for customer demonstrations. The cost of advertising, trade shows and other promotional activities declined by approximately $1.2 million; such expenses were unusually high in 2004 due to the launch of our Series 4000 ProteinChip System that year.

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From 2003 to 2004, sales and marketing expenses increased $4.8 million or 22%, largely due to a $1.6 million increase in salaries, payroll taxes and employee benefits in line with a higher average number of sales and marketing employees in 2004 compared to 2003, as well as an $816,000 increase in travel costs due to the higher average headcount in 2004 and increased travel related to the introduction of our new ProteinChip System, Series 4000, in July 2004 and the new diagnostics efforts which began in early 2004. Largely due to the new product introduction, the cost of advertising, trade shows and other promotional activities increased approximately $772,000; equipment costs, consisting primarily of depreciation of demonstration ProteinChip Systems, increased approximately $413,000; and ProteinChip Arrays and lab supplies used for customer demonstrations increased approximately $326,000. These increases were partially offset by a decline of $181,000 in stock-based compensation expense.

Stock-based compensation expense in sales and marketing expenses was $0 in 2005, $93,000 in 2004, and $274,000 in 2003.

We expect sales and marketing expenses to decrease in 2006 relative to 2005 as a result of a smaller sales force and reduced associated selling expenses.

General and Administrative

General and administrative expenses were $14.4 million in 2005, $14.1 million in 2004, and $14.8 million in 2003. From 2004 to 2005, general and administrative expenses increased $268,000 or 2%, largely driven by $679,000 in severance costs for two former executives, partly offset by a $142,000 reduction in payroll and related costs resulting from a 32% reduction in administrative staff which occurred in the second half of 2005. Outside professional fees increased approximately $429,000 as a result of work done to assist us with our restatement of our second quarter 2005 financial statements. Other audit and accounting fees increased $321,000, largely the result of efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002. These increases were partially offset by decreases of $427,000 in stock-based compensation expense, $249,000 in costs of temporary help, $165,000 in travel expenses and $124,000 in the provision for bad debts.

From 2003 to 2004, general and administrative expenses decreased $679,000 or 5%, largely driven by a $2.3 million reduction in legal fees which resulted primarily from the settlement of our litigation in 2003 and more selective patent activities in 2004, and a decrease of $449,000 in stock-based compensation expense, partially offset by increases of $549,000 in payroll and related expenses and $331,000 in travel costs, both largely related to the new diagnostics efforts which begin in early 2004, a $636,000 increase in accounting and audit fees almost entirely due to compliance with the Sarbanes-Oxley Act of 2002, and a $417,000 increase in the portion of occupancy costs allocated to administrative departments largely due to the shift in employee mix following reductions in research and development headcount.

Stock-based compensation expense in general and administrative expenses was $0 in 2005, $427,000 in 2004, and $876,000 in 2003.

We expect general and administrative expenses to decrease in 2006 relative to 2005 due to lower headcount in administrative functions and because certain large expenses incurred in 2005, such as severance payments to former executives and outside professional fees related to the restatement of our financial results for the second quarter of 2005, are not expected to recur. In addition, we expect our costs related to compliance with Section 404 of the Sarbanes-Oxley Act of 2002 to decrease significantly as we are now deemed a non-accelerated filer no longer required to comply with Section 404. However, these reductions are expected to be partly offset by normal salary increases and additional legal fees related to the securities class action complaint. (See Item 3—Legal Proceedings.)

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Goodwill Impairment

We recorded goodwill principally as a result of our acquisition of BioSepra in 2001, the increases in our ownership of Ciphergen Biosystems KK in 2002 and 2004, and the acquisitions of Ciphergen Technologies, Inc. and IllumeSys Pacific, Inc. in 1997 and 1998. We performed annual impairment tests from 2002 through 2004 and determined that no impairment had occurred. The goodwill related to BioSepra was written off against the sale of the BioSepra business in 2004. Due to Ciphergen Biosystems KK’s lower than expected operating results and cash flows throughout 2005 and based on revised forecasted results, a goodwill impairment loss of $2.5 million was recognized in the fourth quarter of 2005. The fair value of Ciphergen Biosystems KK was estimated using expected discounted cash flows. (See note 6, “Purchase of Additional Ownership Interest in Ciphergen Biosystems KK”, and note 8, “Goodwill and Other Intangible Assets”, of the Notes to Consolidated Financial Statements.)

Interest and Other Income (Expense), Net

Interest income was $839,000 in 2005, $505,000 in 2004, and $702,000 in 2003. The increase of $334,000 from 2004 to 2005 was largely due to higher interest rates. The decrease of $197,000 from 2003 to 2004 was primarily due to lower average investment balances.

Interest expense was $2.0 million in both 2005 and 2004, and $763,000 in 2003. Interest expense related to our convertible senior notes was approximately $1.4 million, of which $535,000 was a non-cash expense for amortizing the beneficial conversion feature associated with the notes. The increase of $1.2 million from 2003 to 2004 was primarily due to an increase of $1.2 million in interest expense related to the $30.0 million convertible senior notes issued in August 2003, of which $344,000 was an increase in amortization expense for the beneficial conversion feature associated with the notes.

Other income (expense) was $717,000 of expense in 2005, $649,000 of expense in 2004, and $150,000 of expense in 2003. In 2005, other expense consisted primarily of $373,000 of expense for the amortization of issuance costs for the convertible senior notes and foreign exchange losses of approximately $232,000, largely due to the impact on the translation of the financial statements of our U.K. subsidiary from the strengthening of the U.S. dollar against the British pound and transaction losses at our Japanese subsidiary resulting from the strengthening of the U.S. dollar against the Japanese yen. In 2004, other expense consisted mainly of $373,000 in expense associated with the amortization of issuance costs for the convertible senior notes. Subsequent to our acquisition of majority control of Ciphergen Biosystems KK on August 31, 2002 and prior to our acquisition of 100% control of Ciphergen Biosystems KK at the end of the first quarter of 2004, we attributed a share of this joint venture’s income or losses to SC BioSciences’ (a subsidiary of Sumitomo Corporation) minority interest. For 2004, we attributed $0 of loss to minority interest, as cumulative losses attributable to the minority shareholder exceeded previous income. For 2003, we attributed $133,000 of the joint venture’s income to minority interest.

Income Taxes

Our provision for income taxes was due to current foreign income taxes, which were $7,000, $172,000, and $1.4 million for the years ended December 31, 2005, 2004 and 2003, respectively, including discontinued operations. Excluding discontinued operations, current foreign income taxes were an expense of $7,000, an expense of $109,000, and a benefit of $47,000 for the years ended December 31, 2005, 2004 and 2003, respectively.

We have incurred net losses since inception and consequently are not subject to corporate income taxes in the U.S. to the extent of our tax loss carryforwards. At December 31, 2005 we had net operating loss carryforwards of approximately $135.7 million for federal and $45.3 million for state tax purposes. If not utilized, these carryforwards will begin to expire beginning in 2009 for federal purposes and 2006 for state purposes. We also have research credit carryforwards of approximately $4.9 million and $4.5 million

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for federal and state tax purposes, respectively. If not utilized, the federal research credit carryforwards will expire in various amounts beginning in 2011. The California research credit can be carried forward indefinitely. The utilization of net operating loss carryforwards to reduce future income taxes will depend on our ability to generate sufficient taxable income prior to the expiration of the net operating loss carryforwards. In addition, the maximum annual use of the net operating loss carryforwards may be limited in situations where changes occur in our stock ownership.

We have incurred income tax liabilities primarily in France and Japan, as well as in most of the other countries outside the U.S. in which we operate. We have used net operating loss carryforwards to reduce our income tax liabilities in Japan and the United Kingdom. We fully utilized our Japanese net operating loss carryforwards in 2004, resulting in higher 2004 Japanese income tax liability, although this was followed in 2005 by a net loss. The 2005 net loss can be carried forward for seven years. We expect to fully utilize our U.K. net operating loss carryforwards in 2006.

Income (Loss) From Discontinued Operations, Net of Tax

Discontinued operations includes all revenue, cost of revenue, operating expenses, interest expense, other income (expense) and tax provisions related to our BioSepra business, which was sold to Pall Corporation on November 30, 2004. Income (loss) from discontinued operations was $0 in 2005, $1.8 million of loss in 2004, and $2.1 million of income in 2003.

The operating results of the BioSepra business are presented in the following table (in thousands):

The decrease in income from discontinued operations, net of tax, of $3.9 million in 2004 relative to 2003 resulted primarily from a revenue decrease of $5.2 million or 38% through the date of sale compared to the same eleven month period in 2003, as well as the shorter comparative period in 2004. BioSepra’s business is characterized by a relatively low number of orders for large quantities of customer-specific products, often $250,000 to $1.5 million or more per order, that are utilized and consumed by pharmaceutical customers to manufacture biological therapeutics. Filling these large orders entails a lengthy and highly controlled manufacturing process at BioSepra, and customers cannot tolerate batch-to-batch variability, so customers typically order several years of supply to be manufactured at one time and provided to them in a few large deliveries for storage in environmentally-controlled facilities. Orders from an individual customer may not recur from year to year or may vary significantly in volume from year to year due to the customer’s rate of consumption. The majority of the decrease in BioSepra’s revenue from 2003 to 2004 was due to the decreased level of such orders occurring in 2003 that did not occur in 2004. BioSepra generally prices its products in euros. Revenue and operating income benefited in 2004 relative to 2003 by approximately $1.3 million and $936,000, respectively, due to the weakening of the U.S. dollar against the euro in 2004.

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Gain From Sale of BioSepra Business, Net of Tax

The $18.5 million gain we recognized in 2004 on the sale of our BioSepra business is summarized as follows (in thousands):

In addition, $1.0 million was placed in an interest-bearing escrow account for one year, after which that amount plus $21,000 of accrued interest was paid to Ciphergen and treated as an additional gain of $1,021,000 on the sale in 2005. This was partly offset by a $67,000 reduction of the gain on the sale of the BioSepra business for a post-closing adjustment in 2005, in accordance with the Asset Purchase Agreement, resulting in a net gain of $954,000 in 2005.

Liquidity and Capital Resources

From our inception through December 31, 2005, we have financed our operations principally with $211.0 million from the sales of products and services to customers and net proceeds from equity financings totaling approximately $160.8 million. This includes net proceeds of $92.4 million from our initial public offering in September 2000, net proceeds of $26.9 million from our Series E Preferred Stock financing in March 2000, and net proceeds of $15.0 million from the sale of 6,225,000 shares of our common stock and a warrant for 2,200,000 shares of our common stock to Quest Diagnostics on July 22, 2005. We received $28.1 million of net proceeds from the sale of 4.5% convertible senior notes on August 22, 2003. These notes are due September 1, 2008. In addition, in July 2005, Quest Diagnostics agreed to loan us up to $10 million with interest accrued at the prime rate plus 0.5% and paid monthly, solely to fund certain development activities related to our strategic alliance, against which we had borrowed approximately $2.5 million as of December 31, 2005. We also received net proceeds of $27.0 million from the sale of our BioSepra business in November 2004. An additional $1.0 million plus accrued interest which was in an interest-bearing escrow account for one year after the sale of our BioSepra business was paid to us on December 1, 2005. Cash, cash equivalents and short-term investments at December 31, 2005 were $28.0 million, compared to $37.6 million at December 31, 2004. Working capital at December 31, 2005 was $27.1 million, compared to $39.9 million at December 31, 2004. The decrease in working capital was principally due to a net $27.1 million decrease in cash and investments to fund our operating losses, partly offset by a $17.5 million cash increase resulting from the sale of our

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common stock to, and loans from, Quest Diagnostics. In addition, there was a $5.0 million decrease in accounts receivable, reflecting the decline in revenue from continuing operations in 2005 compared to 2004, and a $1.3 million decrease in inventory which resulted from our reducing and delaying raw materials purchases. These decreases were partially offset by a $1.2 million decrease in accrued liabilities due to our cost-cutting measures and reduced inventory purchases, and a $1.4 million decrease in current deferred revenue consistent with our lower revenues. Long-term debt and capital lease balances at December 31, 2005 totaled $31.5 million, compared to $29.4 million at December 31, 2004, largely due to a loan draw down of $2.5 million from the line of credit provided by Quest Diagnostics.

Net cash used in operating activities was $22.9 million in 2005 compared to $32.5 million in 2004. Less cash was collected from customers in 2005 as compared to 2004 due to lower sales in 2005. Cash used in operating activities was mainly to fund payroll, inventory purchases and operating expenses. The decrease in cash collected was offset by an increase in interest income received in 2005 as compared to 2004 as a result of higher interest rates. Net cash used in operating activities was $32.5 million in 2004 compared to $20.6 million in 2003. Including discontinued operations, revenue decreased by $9.8 million in 2004 compared to 2003, resulting in less cash collected in 2004. Cash used in operating activities was mainly to fund inventory purchases, payroll and operating expenses. Also, more cash was used in 2004 to pay interest, as the first two interest payments on our convertible senior notes fell due in 2004.

Net cash used in investing activities was $3.5 million in 2005 compared to net cash provided by investing activities of $34.0 million in 2004. Net cash used in investing activities in 2005 included property and equipment purchases of $2.8 million and payments of $587,000 for a technology license related to our litigation which was settled in 2003. We also paid $1.1 million to Pall Corporation for post-closing adjustments related to the sale of our BioSepra business, based on the final financial statements as of the closing date, as specified in the Asset Purchase Agreement, and we received $1.0 million plus $21,000 of accrued interest from an escrow account related to the sale of our BioSepra business. Net cash provided by investing activities was $34.0 million in 2004 compared to net cash used in investing activities of $4.1 million in 2003. Net cash provided by investing activities in 2004 consisted primarily of $28.1 million received from the sale of our BioSepra business, net of transaction costs related to the sale, and maturities and sales of investment securities of $12.1 million, partly offset by purchases of property and equipment of $4.6 million, payments totaling approximately $1.0 million for a technology license related to our litigation which was settled in 2003, and a payment of $1.0 million for the remaining 30% ownership interest in our Japanese subsidiary. We anticipate capital expenditures of approximately $2-3 million in 2006.

Net cash provided by financing activities was $17.2 million in 2005 compared to $792,000 in 2004. The increase resulted primarily from $15.0 million in net proceeds from the sale of our common stock to Quest Diagnostics and the receipt of $2.5 million in loans from Quest Diagnostics. There was also a repayment of one stockholder loan in the aggregate principal amount of $349,000, and the issuance of common stock under our stock option and employee stock purchase plans of $349,000, offset by repayments of an equipment financing loan of $925,000 and the repayment of capital lease obligations of $24,000. Net cash provided by financing activities was $792,000 in 2004 compared to $31.0 million in 2003. Net cash provided by financing activities in 2004 was derived primarily from issuances of common stock under our stock plans of $1.2 million and the repayment of stockholder loans in the aggregate principal amount of $744,000. These were partly offset by $1.2 million of debt repayments.

We currently believe that current cash resources together with existing debt facilities will be sufficient to maintain our operations for the next 12 months. Subsequently, we currently expect to fund our liquidity needs as well as expenditures for our obligations related to the strategic alliance with Quest Diagnostics and for capital requirements from a combination of available cash and short-term investments, proceeds from the alliance with Quest Diagnostics including borrowings from Quest Diagnostics, and potential sales of additional equity and/or debt securities. We will be required to raise additional capital at some point in the future, which might be achieved through a variety of sources, including the public equity market,

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private financings, sales of assets, collaborative arrangements and debt. If additional capital is raised through the issuance of equity or securities convertible into equity, our stockholders may experience dilution, and such securities may have rights, preferences or privileges senior to those of the holders of our common stock or the notes. If we obtain additional funds through arrangements with collaborators or strategic partners, we may be required to relinquish our rights to certain technologies or products that we might otherwise seek to retain. Additional financing may not be available to us on favorable terms, if at all. If we are unable to obtain financing on acceptable terms, we may be unable to execute our business plan and we could be required to delay, reduce the scope of, or eliminate our operations and we may not be able to pay off the convertible senior notes or the loans from Quest Diagnostics if and when they come due.

The following summarizes Ciphergen’s contractual obligations at December 31, 2005, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands).

(1)          Principal amounts, not including interest.

(2)          Based on outstanding principal balance and interest rate as of December 31, 2005.

(3)          Excludes the beneficial conversion feature amounting to $2,677, less related amortization of $1,263.

(4)          We have extended our commitment to fund a Biomarker Discovery Center laboratory at The Johns Hopkins University School of Medicine, which totals $305,000 for the period December 2005 to March 2006, after which we expect to negotiate a further extension. None of this amount had been paid at December 31, 2005. This $305,000 commitment is non-cancelable.

(5)          On October 3, 2005, the Company entered into a two year research and license agreement with University College London and UCL BioMedica Plc. (together, “UCL”) to utilize Ciphergen’s suite of proteomic solutions (Deep Proteome™, Pattern Track™ Process and ProteinChip® System) to further UCL’s ongoing research in ovarian cancer and breast cancer. Under the terms of the agreement, Ciphergen will have exclusive rights to license intellectual property resulting from discoveries made during the course of this collaboration for use in developing, manufacturing and selling products and services utilizing the intellectual property. Ciphergen is obligated to make contributions of approximately $2.1 million in cash and $652,000 in the form of Ciphergen equipment, software, arrays and consumable supplies as requested by UCL, valued at Ciphergen’s list selling price, to cover part of the costs incurred by UCL specifically for this research program. $1.1 million of the cash obligation is to be paid in the first year of the agreement and is non-cancelable. The

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remainder is to be paid in the second year of the agreement and is cancelable with three months advance notice. As of December 31, 2005, Ciphergen had expensed $306,000, of which $33,000 represented our cost for the arrays and consumables we had provided, and the remaining $273,000 was recorded as an accrued liability.

(6)          Purchase obligations include agreements to purchase inventory that are enforceable and legally binding on Ciphergen and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty.

On November 29, 2005, we were notified by the holder of a portion of our convertible senior notes that Ciphergen was in default under the indenture related to the convertible senior notes due to the delinquency in our SEC filing, and that we had 60 days from the date of the notice of default to cure the default. We cured this deficiency by filing our Quarterly Report on Form 10-Q covering the third quarter of 2005 on December 21, 2005. Ciphergen believes it has complied with all other requirements set forth in its credit agreements.

Off-Balance Sheet Arrangements

As of December 31, 2005, we had no off-balance sheet arrangements that are reasonably likely to have a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.

Recent Accounting Pronouncements

See note 1 of the Notes to Consolidated Financial Statements for a full description of recent accounting pronouncements, including the respective dates of adoption and effects on our consolidated financial condition, results of operations and cash flows.

ITEM 7A.        QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

We have classified our marketable securities as available-for-sale, and have, accordingly, recorded such securities on the balance sheet at fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income (loss). These securities are not leveraged and are held for purposes other than trading.

The following discussion about our market risk involves forward-looking statements. We are exposed to market risk related mainly to changes in interest rates. We do not invest in derivative financial instruments.

Interest Rate Sensitivity

As of December 31, 2005, our only investment was a fixed rate annuity with a fair value of $2.2 million which was liquidated in February 2006. We believe that, in the near-term, we will maintain our available funds in money market accounts, or invest in short-term, highly liquid securities with original maturities of 90 days or less.

The primary objective of our investment activities is to preserve principal, maintain proper liquidity to meet operating needs and maximize yields. Our investment policy, which has been approved by our Board of Directors, specifies credit quality standards for our investments and limits the amount of credit exposure to any single issue, issuer or type of investment. We may maintain our portfolio of cash equivalents, short-term investments and long-term investments in a variety of securities, including commercial paper, money market funds, and government and non-government debt securities, subject to our investment policy.

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Our exposure to market risk for changes in interest rates relates primarily to the increase or decrease in the amount of interest income we can earn on our available funds for investment. Our long-term debt and capital lease agreements are at fixed interest rates. We do not plan to use derivative financial instruments in our investment portfolio.

Foreign Currency Exchange Risk

Most of our revenue is realized in U.S. dollars. However, all our revenue in Japan is realized in Japanese yen. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Because most of our revenue is currently denominated in U.S. dollars, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in foreign markets.

The functional currency of Ciphergen Biosystems KK is the Japanese yen. Accordingly, the accounts of this operation were translated from the local currency to the U.S. dollar using the current exchange rate in effect at the balance sheet date for the balance sheet accounts, and using the average exchange rate during the period for revenue and expense accounts. The effects of translation are recorded as a separate component of stockholders’ equity. The net tangible assets of our non-U.S. operations, excluding intercompany debt, were $4.2 million at December 31, 2005.

The accounts of all other non-U.S. operations are remeasured to the U.S. dollar, which is the functional currency. Accordingly, all monetary assets and liabilities of these foreign operations are translated into U.S. dollars at current period-end exchange rates, and non-monetary assets and related elements of expense are translated using historical rates of exchange. Income and expense elements are translated to U.S. dollars using average exchange rates in effect during the period. Gains and losses from the foreign currency transactions of these subsidiaries are recorded as other income (expense), net in the statement of operations.

In 2003 and 2004, we entered into foreign currency contracts to manage the volatility of currency fluctuations as a result of an intercompany loan of approximately $1.0 million, denominated in yen, to our subsidiary in Japan. The effect of exchange rate changes on the forward exchange contracts largely offset the effect of exchange rate changes on the intercompany loan. As of December 31, 2004, there were no forward contracts outstanding and none were entered into during 2005. Net realized foreign currency gains and losses related to foreign currency forward contracts were not material for the year ended December 31, 2004, and there were no such gains or losses in the year ended December 31, 2005. Although we will continue to monitor our exposure to currency fluctuations, we cannot provide assurance that exchange rate fluctuations will not harm our business in the future.

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ITEM 8.                FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a) (1), present fairly, in all material respects, the financial position of Ciphergen Biosystems, Inc. and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a) (2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP

San Jose, California

March 17, 2006

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CIPHERGEN BIOSYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)

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

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CIPHERGEN BIOSYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)