Re:

Isis Pharmaceuticals, Inc.

Form 10-K for the fiscal year ended December 31, 2006

File No. 000-19125

/s/ B. Lynne Parshall

B. Lynne Parshall

Executive Vice President and Chief Financial Officer

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ATTACHMENT A

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Critical Accounting Policies

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We prepare our consolidated financial statements in conformity with accounting

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principles generally accepted in the United States of America. As such, we are required to

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make certain estimates, judgments and assumptions that we believe are reasonable, based

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upon the information available to us. These judgments involve making estimates about

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the effect of matters that are inherently uncertain and may significantly impact our

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quarterly or annual results of operations and financial condition. Each quarter, our senior

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management discusses the development, selection and disclosure of such estimates with

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the audit committee of our Board of Directors. There are specific risks associated with

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these critical accounting policies that we describe in the following paragraphs. For all of

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these policies, we caution that future events rarely develop exactly as expected, and that

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best estimates routinely require adjustment.  Historically, our estimates have been

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accurate as we have not experienced any material differences between our estimates

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and our actual results.  The significant accounting policies, which we believe are the

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most critical to aid in fully understanding and evaluating our reported financial results,

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require the following:

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·  Assessment of propriety of revenue recognition and associated deferred revenue;

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·  Determination of proper valuation of investments in marketable securities and

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other equity investments;

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·  Estimations to assess the recoverability of long-lived assets, including property and

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equipment, intellectual property and licensed technology;

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·  Determination of proper valuation of inventory;

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·  Determination of appropriate cost estimates for unbilled preclinical studies and

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clinical development activities;

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·  Estimation of our net deferred income tax asset valuation allowance;

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·  Determination of the appropriateness of judgments and estimates used in allocating

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revenue and expenses to operating segments; and

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·  Estimations to determine the fair value of stock-based compensation, including the

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expected life of the option, the expected stock price volatility over the term of the

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expected life and estimated forfeitures.

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Descriptions of these critical accounting policies follow.

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Revenue Recognition

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We follow the provisions as set forth by current accounting rules, which primarily

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include Staff Accounting Bulletin No. 101, or SAB 101, “Revenue Recognition in

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Financial Statements,” SAB 104, “Revenue Recognition,” and Financial Accounting

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Standards Board Emerging Issues Task Force No. 00-21, or EITF 00-21, “Accounting for

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Revenue Arrangements with Multiple Deliverables.”

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We generally recognize revenue when we have satisfied all contractual

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obligations and we are reasonably assured of collecting the resulting receivable. We are

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often entitled to bill our customers and receive payment from our customers in advance

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of recognizing the revenue under current accounting rules. In those instances where we

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have billed our customers or received payment from our customers in advance of

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recognizing revenue, we include the amounts in deferred revenue on the balance sheet.

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We often enter into collaborations where we receive non-refundable upfront

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payments for prior or future expenditures. We recognize revenue related to upfront

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payments ratably over the period of the contractual arrangements as we satisfy our

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performance obligations. Occasionally, we are required to estimate the period of a

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contractual arrangement or our performance obligations when the agreements we enter

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into do not clearly define such information. Should different estimates prevail, revenue

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recognized could be materially different. To date our estimates have not required

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material adjustments.  We have made estimates of our continuing obligations on several

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agreements, including our collaborations with Antisense Therapeutics Ltd., Lilly,

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OncoGenex and Pfizer.  Our collaborative agreements typically include a research

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and/or development project plan that includes activities to be performed in the

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collaboration and the party responsible for performing them.  We estimate the

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period of time over which we will complete the activities for which we are

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responsible and use that period of time as our period of performance for purposes of

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revenue recognition and amortize revenue over such period.  When our

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collaborators have asked us to continue performing work in a collaboration beyond

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the initial period of performance, we have extended our amortization period to

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correspond to the new extended period of performance.  In no case have

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adjustments to performance periods and related adjustments to revenue

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amortization periods had a material impact on our revenue.

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Our collaborations often include contractual milestones. When we achieve these

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milestones, we are entitled to payment, as defined by the underlying agreements. We

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generally recognize revenue related to milestone payments upon completion of the

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milestone’s performance requirement, as long as we are reasonably assured of collecting

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the resulting receivable and we are not obligated for future performance related to the

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achievement of the milestone. To date, we have earned milestone payments totaling $1.2

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million under our Pfizer collaboration. Additionally, in January 2006, Lilly initiated

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clinical trials of LY2275796 for which we received a $750,000 milestone payment and

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Merck initiated clinical trials of a drug for HCV for which we earned a $1 million

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milestone payment.

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We generally recognize revenue related to the sale of our drug inventory as we

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ship or deliver drugs to our partners. In several instances, we completed the

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manufacturing of drugs, but our partners asked us to deliver the drug on a later date.

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Under these circumstances, we ensured that our obligation was complete under the terms

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of the manufacturing agreement in place and title had transferred to the customer before

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we recognized the related revenue.

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We often enter into agreements to license our proprietary patent rights on an

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exclusive or non-exclusive basis in exchange for license fees and/or royalties. We

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generally recognize as revenue immediately those licensing fees and royalties for which

1

we have no future performance obligations and are reasonably assured of collecting the

2

resulting receivable. In the third quarter of 2006, we earned licensing revenue of

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$750,000 from Alnylam as a result of Alnylam’s alliance with a pharmaceutical company

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for the development of RNA interference therapeutics. In addition, in October 2006, in

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accordance with contractually determined timing, we received an $8 million payment

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from Drug Royalty USA, Inc. as partial payment for the monetization of our royalty

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rights in Macugen.

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We often enter into revenue arrangements that contain multiple deliverables. In

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these cases, we recognize revenue from each element of the arrangement as long as we

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are able to determine a separate value for each element, we have completed our

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obligation to deliver or perform on that element and we are reasonably assured of

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collecting the resulting receivable.

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In the fourth quarter of 2006, we sold our first commercial Ibis T5000 Biosensor

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System. The sale of an Ibis T5000 Biosensor System contains multiple elements. Since

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we have no previous experience of commercially selling the Ibis T5000 Biosensor

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System, we have no basis to determine the fair values of the various elements included in

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the system; therefore, we must account for the entire system as one deliverable and

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recognize revenue over the entire period of performance. For a one-year period following

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the sale, we have ongoing support obligations for the Ibis T5000 Biosensor System,

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therefore we are amortizing the revenue for the entire system over a one-year period.

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Once we obtain a sufficient number of sales to enable us to identify each element’s fair

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value, we will be able to recognize revenue separately for each element.

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As part of our Lilly alliance, in 2001 Lilly provided us a $100.0 million interest

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free loan to fund the companies’ research collaboration. We took quarterly draw downs

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against this loan and discounted the amounts to their net present value by imputing

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interest on the amount at 20%, which represented market conditions in place at the time

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we entered into the loan. We accreted the loan up to its face value over its term by

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recording interest expense. The difference between the cash received and the present

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value of the loan represented value Lilly gave to us to help fund the research

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collaboration. We accounted for this difference as deferred revenue and recognized it as

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revenue over the period of contractual performance. In August 2005, we converted the

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loan into 2.5 million shares of our common stock. Concurrent with the conversion, we

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extended the research collaboration.

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Valuation of Investments in Marketable Securities

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We account for our investments in marketable securities in accordance with

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current accounting rules as set forth by SFAS 115, “Accounting for Certain Investments

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in Debt and Equity Securities.” We carry these investments at fair market value based

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upon market prices quoted on the last day of the fiscal quarter. We record unrealized

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gains and losses as a separate component of stockholders’ equity, and include gross

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realized gains and losses in investment income.

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In addition to our investments in marketable securities, we have equity

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investments in privately- and publicly-held biotechnology companies. We hold

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ownership interests of less than 20% in each of the respective entities. In determining if

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and when a decrease in market value below our cost in our equity positions is other-than-

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temporary, we examine historical trends in the stock price, the financial condition of the

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issuer, near term prospects of the issuer, and our current need for cash. When we

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determine that a decline in value is other-than-temporary, we recognize an impairment

4

loss in the period in which the other-than-temporary decline occurs.  During the second

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quarter of 2006, we recorded a net gain on investments. This net gain on investments

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represented a gain of $2.7 million realized on the sale of a portion of the equity securities

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of Alnylam that we own, partially offset by a non-cash loss on investment of $465,000

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related to the impairment of our equity investment in ATL, which we believe was

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primarily a result of the financial market conditions related to biotechnology companies

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at that time. In the second half of 2006, we recorded a net unrealized gain of $390,000

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related to our equity investment in ATL as a separate component of stockholders’ equity.

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This reflected the increase in the market value of the investment since the impairment in

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the second quarter of 2006. We did not record an impairment loss on our investments in

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2005. During 2004, we recorded a non-cash loss on investments of $5.1 million,

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principally related to the impairment of our equity investment in Alnylam.

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Valuation of Long-Lived Assets

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We assess the value of our long-lived assets, which include property and

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equipment, patent costs, and licenses acquired from third parties, under the provisions set

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forth by SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, or

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SFAS 144. We evaluate our long-lived assets for impairment on at least a quarterly basis.

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During this process, we review our property and equipment listings, pending domestic

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and international patent applications, domestic and international issued patents, and

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licenses we have acquired from other parties to determine if any impairment is present.

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We consider the following factors:

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·  Evidence of decreases in market value;

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·  Changes in the extent or manner in which we use an asset;

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·  Adverse changes in legal factors or in the business climate that would affect the

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value of an asset;

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·  An adverse action or assessment by a regulator;

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·  An accumulation of costs significantly in excess of amounts originally expected

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to acquire or construct an asset;

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·  Current period operating or cash flow loss combined with a history of operating

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or cash flow losses associated with an asset used for the purpose of producing

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revenue; and

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·  Challenges or potential challenges to our existing patents, the likelihood of

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applications being issued and the scope of our issued patents.

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In December 2004, we made a strategic decision to focus our resources on our

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key programs. As a result, during the fourth quarter of 2004 we recorded charges of

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approximately $11.5 million related to the write-down of tangible and intangible assets,

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including equipment and patent costs that were non-essential to our current focus. We

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had additional write-downs of $15.6 million in 2005 associated with our restructuring

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activities, which were primarily related to the sale of three of our buildings. In 2006, we

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incurred charges of $2.4 million primarily related to the write-down of equipment and

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patent costs that were non-essential to our current focus.

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Valuation of Inventory

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In accordance with SFAS 2, Accounting for Research and Development

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Costs, we capitalize the costs of raw materials that we purchase for use in producing

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our drugs because, until we use these raw materials, they have alternative future

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uses.  We include in inventory raw material costs and related manufacturing costs for

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drugs that we manufacture for our partners under contractual terms and that we use

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primarily in our clinical development activities and drug products.  Each of our raw

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materials can be used in multiple products and, as a result, have future economic

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value independent of the development status of any single drug.  For example, if one

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of our drugs failed, the raw materials allocated for that drug have economic value

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for other drugs that we manufacture.  We expense these costs when we deliver our

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drugs to partners, or as we use these drugs in our own clinical trials. Also included in

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inventory, as of December 31, 2006, are material costs and related manufacturing costs

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associated with our Ibis T5000 Biosensor System. We reflect our inventory on the

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balance sheet at the lower of cost or market value under the first-in, first-out method. We

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review inventory periodically and reduce our carrying value of items considered to be

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slow moving or obsolete to their estimated net realizable value. We consider several

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factors in estimating the net realizable value, including shelf lives of raw materials,

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alternative uses for our drugs and clinical trial materials and historical write-offs. In the

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fourth quarter of 2004, we recorded a charge of approximately $21.0 million for the

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write-down of inventory to its net realizable value related to our decision to focus our

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resources on key programs.

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Estimated Liability for Clinical Development Costs

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We record accrued liabilities related to unbilled expenses for which service

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providers have not yet billed us related to products or services that we have received,

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specifically related to ongoing preclinical studies and clinical trials. These costs primarily

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relate to third-party clinical management costs, laboratory and analysis costs, toxicology

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studies and investigator grants. We have multiple drugs in concurrent preclinical studies

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and clinical trials at several clinical sites throughout the world. In order to ensure that we

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have adequately provided for ongoing preclinical and clinical development costs during

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the period in which we incur such costs, we maintain an accrual to cover these expenses.

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We update our estimate for this accrual on at least a quarterly basis. The assessment of

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these costs is a subjective process that requires judgment. Upon settlement, these costs

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may differ materially from the amounts accrued in our consolidated financial statements. 

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Our historical accrual estimates have not been materially different from our actual

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amounts.

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Valuation Allowance for Net Deferred Tax Assets

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We record a valuation allowance to offset our net deferred tax assets because we

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are uncertain that we will realize these net tax assets. We have had net operating losses

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since inception, and as a result, we have established a 100% valuation allowance for our

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net deferred tax asset. When and if circumstances warrant, we will assess the likelihood

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that our net deferred tax assets will more likely than not be recovered from future taxable

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income and record an appropriate reversal to the valuation allowance.

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Segment Information

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We provide segment financial information and results for our Drug Discovery and

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Development segment and our Ibis Biosciences, Inc. subsidiary based on the segregation

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of revenues and expenses used for management’s assessment of operating performance

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and operating decisions. Expenses shared by the segments require the use of judgments

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and estimates in determining the allocation of expenses to the two segments.  We have

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not made material changes to our allocation methodologies since we began reporting

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segment financial information and results.  Different assumptions or allocation

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methods could result in materially different results by segment.

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Stock-Based Compensation

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On January 1, 2006, we adopted SFAS 123R, Share-Based Payment, which

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requires the measurement and recognition of compensation expense for all stock-based

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payment awards made to employees and directors including employee stock options and

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employee stock purchases related to our Employee Stock Purchase Plan based on

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estimated fair values. SFAS 123R supersedes our previous accounting under APB 25,

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Accounting for Stock Issued to Employees and SFAS 123, Accounting for Stock-Based

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Compensation, beginning January 1, 2006. In March 2005, the SEC issued SAB 107

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relating to SFAS 123R. We have applied the provisions of SAB 107 in our adoption of

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SFAS 123R.

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We adopted SFAS 123R using the modified prospective transition method, which

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requires the application of the accounting standard as of January 1, 2006, the first day of

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our fiscal year 2006. Our Consolidated Statements of Operations for the year ended

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December 31, 2006 reflect the impact of SFAS 123R. In accordance with the modified

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prospective transition method, our Consolidated Statements of Operations for prior

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periods have not been restated to reflect, and do not include, the impact of SFAS 123R.

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As of December 31, 2006, there was $6.3 million of total unrecognized compensation

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cost related to non-vested stock-based compensation plans. Total unrecognized

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compensation cost will be adjusted for future changes in estimated forfeitures. We expect

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to recognize that cost over a weighted average period of 1.2 years.

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We utilize the Black-Scholes model and assumptions discussed in Note 4 for

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estimating the fair value of the stock-based awards we granted. Compensation expense

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for all stock-based payment awards is recognized using the accelerated multiple-option

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approach. Under the accelerated multiple-option approach (also known as the graded-

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vesting method), an entity recognizes compensation expense over the requisite service

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period for each separately vesting tranche of the award as though the award were in

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substance multiple awards, which results in the expense being front-loaded over the

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vesting period. Our risk-free interest rate assumption is based upon observed interest

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rates appropriate for the term of our employee stock options and our ESPP. The dividend

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yield assumption is based on our history and expectation of dividend payouts. We have

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not paid dividends in the past and do not expect to in the future. We use a weighted

1

average of the historical stock price volatility of our stock to calculate the expected

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volatility assumption required for the Black-Scholes model consistent with SFAS 123R.

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The expected term of stock options granted represents the period of time that they are

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expected to be outstanding. For our 2002 Non-Employee Directors’ Stock Option Plan,

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we estimate the expected term of options granted based on historical exercise patterns.

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For our employee stock option plans, the estimated expected term is a derived output of

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the simplified method, as allowed under SAB 107. We estimated forfeitures based on

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historical experience. There were no material changes to our estimated forfeitures in

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fiscal 2006.  For the periods prior to fiscal 2006, we accounted for forfeitures as they

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occurred in our pro forma information as required under SFAS 123.

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ATTACHMENT B

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3

Collaborative Arrangements and Licensing Agreements

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Antisense Drug Discovery Collaborations

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Pfizer, Inc.

6

In May 2005, Isis entered into a multi-year drug discovery collaboration with Pfizer

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to identify second generation antisense drugs for the treatment of ophthalmic disease.

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Under the terms of the agreement, Isis received an upfront technology access fee of

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$1.0 million and amortized this amount over the one year period of Isis’

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performance based on the research plan included in the agreement, which ended in

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April 2006.  There were no changes in Isis’ period of performance.  The amount of

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deferred revenue was $0 and $333,000 at December 31, 2006 and 2005, respectively. 

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To date, Isis has earned milestone payments totaling $1.2 million under the collaboration.

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Pfizer will also pay Isis additional milestone payments if key research, clinical,

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regulatory and sales milestones are achieved, and provide research funding. Assuming

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that Pfizer successfully develops and commercializes the first drug for the first indication,

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Isis will earn milestone payments totaling up to $26.1 million. In addition, Isis will

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receive royalties on the sale of drugs resulting from the collaboration.  For the years

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ended December 31, 2006, 2005 and 2004, Isis recognized revenue of $408,000, $2.2

20

million and $0, respectively, related to this collaboration.

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Eli Lilly and Company

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In August 2001, Isis entered into a broad strategic relationship with Lilly, which

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included a joint antisense research collaboration in the areas of cancer, metabolic and

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imflammatory diseases and a $100 million loan that Lilly provided to Isis to fund its

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obligations under the research collaboration.

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In August 2005, Isis extended the research collaboration with Lilly for approximately

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24 months to focus on a select number of targets. During the extension, Isis and Lilly will

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continue to advance antisense drugs identified during the initial collaboration, and

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continue their efforts to develop and refine antisense technologies. During the extension,

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Isis is using collaboration funds to support its scientists and Lilly is supporting Lilly

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scientists. The extended collaboration provides Lilly access to Isis’ patents to support

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Lilly’s internal antisense drug discovery and development program for a limited number

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of targets. As part of the extension, Isis and Lilly will continue to characterize and

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develop RNase H, siRNA, and splicing modulating inhibitors for the treatment of cancer

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using advanced generation chemistries. In connection with the extension, Isis converted

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the $100 million loan that Lilly previously provided to it into 2.5 million shares of Isis

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common stock.

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As part of the collaboration, Lilly licensed LY2181308, Isis’ antisense inhibitor of

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survivin and LY2275796, an antisense inhibitor of eIF-4E. To date, Isis has earned $4.1

40

million and $1.5 million in license fees and milestone payments related to the continued

41

development of LY2181308 and LY2275796, respectively.  Isis amortized the $1.1

42

million license fee related to LY2181308 over a two-year period, which ended in

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June 2004.  The two-year period corresponded to Isis’ period of performance for

1

LY2181308 and there were no changes to the period of performance.  In September

2

2004, Isis recognized $750,000 associated with the license fee it received for

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LY2275796.  Lilly is responsible for the preclinical and clinical development of

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LY2275796 and Isis has no performance obligations for this drug.  Isis will receive

5

additional milestone payments aggregating up to $25.0 million and $19.5 million if

6

LY2181308 and LY2275796, respectively, achieve specified regulatory and commercial

7

milestones, and royalties on future product sales of these drugs.

8

As part of the collaboration extension, Isis is exploring with Lilly antisense drugs

9

targeting Signal Transducer and Activator of Transcription 3 (STAT-3), a protein that

10

regulates cell division and growth, and prevents cell death. Isis is working closely with

11

Lilly to advance an improved STAT-3 candidate into development.

12

Isis’ relationship with Lilly historically provided several revenue sources, including

13

research funding related to the $100 million research loan and development milestones

14

similar to the milestones for LY2181308 and LY2275796. During 2006, 2005, and 2004,

15

Isis generated revenue from its relationship with Lilly totaling $1.2 million, $10.8

16

million, and $15.7 million, respectively, which comprised 5%, 27%, and 37%,

17

respectively, of Isis’ total revenue during those same periods.

18

Satellite Company Drug Discovery and Development Collaborations

19

Antisense Therapeutics Limited

20

In December 2001, Isis licensed ATL1102 to ATL, an Australian company

21

publicly-traded on the Australian Stock Exchange. Isis was responsible for completing

22

the required preclinical studies for ATL1102 and for manufacturing the drug for human

23

clinical trials at ATL’s expense. ATL agreed to undertake the future clinical development

24

and commercialization of the drug.

25

In addition to ATL1102, ATL is currently developing ATL1103 for growth and site

26

disorders. ATL1103 is a product of Isis’ joint antisense drug discovery and development

27

collaboration, which Isis recently extended for an additional two years. ATL pays Isis for

28

access to its antisense expertise and for research and manufacturing services Isis may

29

provide to ATL during the collaboration. Additionally, ATL will pay Isis royalties on any

30

antisense drugs discovered and developed within the partnership.

31

In connection with this collaboration, Isis received 30.0 million shares of ATL

32

common stock upon completion of ATL’s initial public offering (“IPO”), representing an

33

initial ownership percentage of approximately 14%, and options to purchase an additional

34

20.0 million shares of ATL common stock, which expired in 2006. The initial ATL

35

common stock Isis received had a value of $2.8 million, and Isis recognized this

36

amount into revenue ratably over the five-year period of performance under the

37

collaboration, which ended in November 2006.  There were no changes in Isis’

38

period of performance. The amount of deferred revenue was $0 and $506,000 at

39

December 31, 2006 and 2005, respectively.  For the years ended December 31, 2006,

40

2005, and 2004, Isis recorded revenue of $652,000, $698,000, and $1.4 million,

41

respectively, related to this collaboration. As of December 31, 2006, Isis’ ownership

42

percentage in ATL, including 10.3 million shares Isis purchased subsequent to shares it

43

acquired in the IPO, was less than 10%. Isis’ balance sheets at December 31, 2006 and

1

2005 included a short-term investment at fair market value of $1.3 million and $1.2

2

million, respectively, related to this equity investment.

3

OncoGenex Technologies Inc.

4

In November 2001, Isis established a drug development collaboration with

5

OncoGenex, a biotechnology company committed to the development of cancer

6

therapeutics for patients with drug resistant and metastatic cancers, to co-develop and

7

commercialize OGX-011, an anti-cancer antisense drug. Isis funds 35% of the costs of

8

developing OGX-011. In exchange, Isis receives 35% of any revenue generated by

9

OncoGenex for OGX-011. OGX-011 combines OncoGenex’s proprietary antisense

10

position in inhibitors to the target clusterin, with Isis’ proprietary second generation

11

antisense chemistry. Isis conducted preclinical toxicology and pharmacokinetic studies of

12

OGX-011 during 2002. Isis also manufactured OGX-011 for preclinical and Phase 1/2

13

studies. OncoGenex’s Phase 1 clinical trials to assess the safety of OGX-011 in

14

combination with hormone ablation therapy in men with localized prostate cancer and in

15

combination with standard chemotherapy in patients with solid tumors known to express

16

clusterin formed the basis for OncoGenex’s broad Phase 2 program for OGX-011.

17

OncoGenex currently has five ongoing Phase 2 studies of OGX-011 for the treatment of

18

prostate, non-small cell lung and breast cancers.

19

In September 2003, the companies expanded their antisense drug development

20

partnership to include the development of the second generation antisense anti-cancer

21

drug, OGX-225. OncoGenex is responsible for the preclinical and clinical development

22

of the drug and Isis has no performance obligations. OncoGenex issued to Isis

23

$750,000 of OncoGenex securities as payment for an upfront fee. In addition,

24

OncoGenex will pay Isis milestone payments totaling up to $3.5 million for the

25

achievement of clinical and regulatory milestones, and pay Isis royalties on product sales.

26

As of December 31, 2006, OncoGenex had not triggered any of these milestone payments

27

related to OGX-225.

28

In January 2005, Isis further broadened its antisense drug development partnership

29

with OncoGenex to allow for the development of two additional second generation

30

antisense anti-cancer drugs. Under the terms of the agreement, OncoGenex is responsible

31

for the preclinical and clinical development of the drugs and Isis has no performance

32

obligations. In April 2005, OncoGenex selected its first drug under this expansion,

33

OGX-427. OGX-427 targets heat shock protein 27, or Hsp27, which is over-expressed in

34

numerous tumor types and is associated with treatment resistance through its ability to

35

help cancer cells survive stress-induced injury. OncoGenex paid Isis an upfront fee of

36

$750,000 with a convertible note, which, in August 2005, converted into 244,300 shares

37

of OncoGenex’s preferred stock. OncoGenex will also pay Isis milestone payments

38

totaling up to $5 million for the achievement of key clinical and regulatory milestones,

39

and royalties on future product sales of these drugs.  As of December 31, 2006,

40

OncoGenex had not met any of the milestones that would result in payments related

41

to OGX-427.

42

For the years ended December 31, 2006, 2005 and 2004, Isis earned revenue of $1.2

43

million, $2.7 million and $669,000, respectively, related to its collaboration with

44

OncoGenex. Isis’ balance sheets at December 31, 2006 and 2005 include a long-term

1

investment of $1.5 million related to Isis’ equity investment in OncoGenex. While there

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is no readily determinable market value for these securities, there has been no indication

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that Isis’ investment in OncoGenex has been impaired; accordingly, Isis believes that the

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carrying value of this investment is equal to or below its current fair market value.

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ATTACHMENT C

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In April 2006, Isis granted the members of Symphony GenIsis Holdings LLC warrants to

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purchase 4.25 million shares of common stock at an exercise price of $8.93 per share.

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These warrants expire on April 7, 2011 and can be settled with unregistered shares

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of Isis’ common stock.  At December 31, 2006, all of these warrants remained issued

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and outstanding. If Isis enters into a merger or acquisition in which the surviving or

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resulting “parent” entity is an entity other than Isis, then the holders of these warrants

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may exchange the warrants for a new warrant exercisable in return for shares of common

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stock of the surviving entity as follows:

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·      if the terms of such merger or acquisition provide for consideration that

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consists solely of stock of the surviving entity, and the surviving entity has a

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class of common stock traded on a major national exchange or foreign

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exchange (“Public Common Shares”), then any replacement warrants issued

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to the holders will be solely for such publicly traded common shares, at an

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exchange ratio reflecting the stock consideration paid at the time of such

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change in control; or

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·      if the terms of such merger or acquisition shall provide for consideration that

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consists of cash or a combination of cash and Public Common Shares of the

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surviving entity, then any replacement warrants issued to the holders will be

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solely for Public Common Shares of the surviving entity, at an exchange ratio

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reflecting the total consideration paid by the surviving entity at the time of

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such change in control, as if the total consideration (including cash) for each

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share of Isis’ common stock was instead paid only in Public Common Shares

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of the surviving entity at the time of such change of control; or

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·      if the surviving entity is a private corporation, closely held company or other

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entity that does not have a class of Public Common Shares, then the holders of

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the warrants may elect to surrender all outstanding warrants to Isis in

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consideration of a cash payment for each share of its common stock subject to

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purchase under the warrants in an amount equal to 40% of the per share cash

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consideration to be received by a holder of one share of its common stock to

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be tendered in the merger or acquisition, subject to an aggregate limit of

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$22,000,000.

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In connection with the issuance of the warrants, Isis entered into a registration

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rights agreement with Symphony GenIsis Holdings LLC.  Pursuant to the

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registration rights agreement, Isis filed a registration statement with the SEC

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covering the shares of common stock issuable upon exercise of the warrants.  Isis is

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required to use commercially reasonable efforts to maintain the effectiveness of the

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registration statement over the term of the warrant.

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Isis evaluated the provisions of the registration rights agreement and the warrant

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purchase agreement under EITF 00-19, Accounting for Derivative Financial

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Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, and

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determined that the criteria for equity classification were met; therefore, the

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warrants were accounted for as part of stockholders’ equity.