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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2004

OR

For the Transition Period From              to             

Commission file No. 000-30369

VIROLOGIC, INC.

(Exact name of registrant as specified in its charter)

Registrant’s Telephone Number, Including Area Code: (650) 635-1100

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

(Title of class)

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 (Section 229.405 of this chapter) 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 an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  x    No  ¨

The aggregate market value of the voting stock held by non-affiliates of the Registrant as of June 30, 2004 was $86,801,043.*

The number of shares outstanding of the Registrant’s Common Stock was 117,351,121 as of March 11, 2005.

DOCUMENTS INCORPORATED BY REFERENCE

The registrant’s Definitive Proxy Statement, to be filed with the Securities and Exchange Commission (the “Commission”) pursuant to Regulation 14A in connection with the 2005 Annual Meeting of Stockholders (the “2005 Annual Meeting”), is incorporated by reference into Part III of this Report.

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This Annual Report on Form 10-K contains certain forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 including, without limitation, statements regarding development and commercialization of our proposed products and services, our anticipated rate of capital usage and the possible growth of our business into new markets. These statements, which sometimes include words such as “expect,” “goal,” “may,” “anticipate,” “should,” “continue,” or “will,” reflect our expectations and assumptions as of the date of this Annual Report based on currently available operating, financial and competitive information. Actual results could differ materially from those in the forward-looking statements as a result of a number of factors, including our ability to successfully complete the development and clinical validation of eTag assays and commercialize these assays for guiding treatment of cancer patients, the market acceptance of our products, the effectiveness of competitive products, new products and technological approaches, the ability to successfully integrate ACLARA’s operations into ours, the potential impact of the Contingent Value Rights on our financial position, the risks associated with our dependence on patents and proprietary rights, the possible infringement of the intellectual property rights of others, and our ability to raise additional capital if needed. These factors and others are more fully described in “Risk Factors Related to Our Business” and elsewhere in this Form 10-K. We assume no obligation to update any forward-looking statements.

PART I

Item 1. Business

Overview

We are a life sciences company committed to advancing personalized medicine and improving patient outcomes through the development of innovative products that guide and target the most appropriate treatments. Through a comprehensive understanding of the genetics, biology and pathology of particular diseases, we have pioneered and are developing molecular diagnostics and laboratory services that will:

We are a leader in developing and commercializing innovative products that help guide and improve the treatment of infectious diseases, cancer and other serious diseases. Our goal with personalized medicine is to enable the management of diseases at the individual patient level through the use of sophisticated diagnostics that permit the targeting of therapeutics to those patients most likely to respond to or benefit from them, thereby offering the right treatment to the right patient at the right time.

ViroLogic’s PhenoSense^™ and GeneSeq^™ products provide a practical method for measuring the impact of genetic mutations on human immunodeficiency virus, or HIV, drug resistance. This information is used to optimize various treatment options for the individual patient. We currently market several products directed at patients with HIV infection and have a number of additional assays that are in use by pharmaceutical companies in their clinical trials of new drugs that could, in time and as these new drugs are approved for use, provide additional valuable information to physicians in aiding the management of their patients’ disease progression.

Over the last several years, we have built a business based on the personalized medicine approach in HIV drug resistance testing. With our merger with ACLARA BioSciences, Inc., or ACLARA, completed in December 2004, we intend to leverage the experience and infrastructure we have built in the HIV market to the potentially larger market opportunity of cancer utilizing our proprietary eTag^™ technology, acquired through our merger with ACLARA. In the future, we plan to seek opportunities to address an even broader range of serious diseases.

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New targeted drug therapies are being introduced for the treatment of cancer. Our proprietary eTag technology provides an assay platform for analyzing very small amounts of tumor samples recovered and prepared in a variety of methods, including formalin fixation, the current standard technique in hospital pathology laboratories. This analytical platform is expected to be particularly well suited for the next generation of targeted cancer therapeutics. We believe the likelihood of a patient’s cancer responding to a given therapy can be predicted with a high degree of accuracy utilizing eTag assays, facilitating the selection of more precise and effective therapeutic options. We are developing Epidermal Growth Factor Receptor, or EGFR/Her, eTag assays that we believe will enable physicians to identify the appropriate course of treatment for cancers that have a particular molecular profile. While our initial focus is on drugs that target the EGFR/Her receptor family, we intend to develop eTag assays that target other protein drug targets and signaling pathways that are key drivers of proliferation or survival in cancer cells.

We were incorporated in the state of Delaware in November 1995 and commenced commercial operations in 1999. Our principal executive offices are located at 345 Oyster Point Blvd., South San Francisco, CA 94080. Further information can be found on our website: www.virologic.com. Information found on our website is not incorporated by reference into this report.

Background

Personalized Medicine

There is growing evidence that while many serious diseases, such as HIV and cancer, can be characterized at the molecular level, many drugs simply do not work optimally for an entire population of patients in these broad disease categories. The biopharmaceutical industry is witnessing two mutually dependent innovations:

Based on these innovations, a new approach to disease management is emerging—Personalized Medicine— in which the most effective treatment options for the individual patient can be identified using specific diagnostic tests. The ideal of personalized medicine is to move from the so-called “one size fits all” method of drug treatment, to providing “the right treatment to the right patient at the right time.”

Infectious Diseases

Viruses are microorganisms that must infect living cells to reproduce or replicate. These viruses infect human cells and replicate, making new viruses that can infect other cells. There are many different types of viruses, but all viruses share structural and functional characteristics associated with their ability to replicate. During the replication cycle, all types of virus often change slightly, or mutate. This is particularly true of viruses such as HIV and HCV. For example, in an untreated HIV-infected patient, HIV generates virus variants with genetic mutations at every possible nucleotide position, causing billions of new viruses to be produced each day. At any given time there can be many different variants of the virus present within the infected patient’s body, each with a slightly different genetic sequence. This large number of virus variants allows HIV to adapt very rapidly and develop resistance to drugs. As a consequence of drug resistance, HIV continues to cause a large number of infections and deaths despite the availability and introduction of new and effective treatments.

Viral drug resistance refers to a reduction in the ability of a particular drug or combination of drugs to block replication of the virus. Drug resistance typically occurs as a result of mutations that accumulate in the viral genome as it replicates. As the virus replicates and creates a multitude of mutations, the drug resistant mutations become more prominent. For people infected with HIV, drug resistance can render drugs less effective or even completely ineffective, thus significantly reducing treatment options. The emergence and spread of strains of virus with drug resistance means that the ability to treat infections and save lives has become increasingly difficult.

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There are approximately 40,000 new diagnoses of HIV infection in the United States each year. In time most of these progress to AIDS, which is one of the leading causes of death worldwide. It is estimated that approximately one million individuals in the United States are currently living with this disease. While once considered a fatal disease, with the advent of 20 FDA-approved anti-viral drugs for treatment of HIV and over 50 more in development, HIV infection increasingly can be treated as a chronic disease.

The Viral Drug Resistance Crisis

While more effective combination treatment regimens have been introduced for HIV, e.g. HAART (highly active antiretroviral therapy), over time the virus often develops resistance to the administered drugs, requiring a change in the combination of anti-viral agents prescribed. Selecting the right combination of drugs for optimal treatment of HIV patients is often difficult when physicians have limited information about the susceptibility of the patient’s HIV to specific anti-viral drugs. Each treatment failure increases the risk that the next drug combination will not work or work for a shorter period of time leaving the patient with fewer effective future treatment options. Physicians are faced with the challenge of tailoring therapy to individual patients numerous times over the course of the disease.

Resistance to anti-viral drugs is one of the most serious impediments to successful treatment of HIV/AIDS patients. In response to the problem of anti-viral drug resistance, physicians use combinations, or cocktails, of anti-viral drugs, attacking different targets within the virus simultaneously. However, even combination therapy eventually fails in a great majority of patients, due in large part to the fact that the virus becomes resistant to some or all of the drugs used in combination.

Anti-viral drugs approved by the U.S. Food and Drug Administration, or FDA, are generally used in various combinations to treat HIV infected patients. Combination therapy requires each drug in the combination to be active, interfering with key viral functions, for the therapy to be most effective. If any of the drugs are not active, the combination therapy will likely fail more quickly. Each treatment failure leaves the patient with fewer future treatment options. Drug resistant viruses can also be transmitted to newly infected individuals, increasing the risk that initial treatment for those individuals will not work.

There are 20 drugs approved by the FDA for treatment of HIV. These generally fall into four classes of drug. These are nucleoside reverse transcriptase inhibitors, non-nucleoside reverse transcriptase inhibitors, protease inhibitors and entry inhibitors. Most currently approved HIV therapeutics are in the first three classes. There is one approved entry inhibitor, although many are in development.

While new anti-viral drugs with increased potency and activity against drug resistant viruses are under development, the ability of HIV to mutate and replicate continues to challenge physicians, who are faced with the challenge of identifying the most appropriate therapy for the individual patient.

Viral Resistance Testing

In response to the challenge posed by drug resistant viruses and the complexity provided by multiple choices of therapeutic, tests have been developed to assess the resistance of viruses to particular drugs. Simple tests based on an analysis of the genetic composition of the virus are now quite common. In addition, more sophisticated tests are also available. The technologies available for resistance testing are:

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Both types of test can improve treatment response and can be used either to realign existing therapy or to help selection of the best initial therapy for a patient. Resistance testing has emerged as the “standard of care” in the management of patients with HIV. Current treatment guidelines from the U.S. Department of Health and Human Services, the International AIDS Society-USA and the EuroGuidelines Group recommend resistance testing to identify new potent drug combinations after therapy failure. Phenotypic testing provides the most direct measure of drug resistance and, when combined with genotypic testing, provides the most comprehensive view of a patient’s situation. The ultimate goal of resistance testing is to optimize therapies for the individual patient. Increasingly, the complexity of the virus, the sophistication of available testing, and the cost to the patient both in terms of lost future treatment options as well as funds spent on expensive but ineffective therapies, make it more and more critical that physicians have access to as much information as possible when they determine therapy for their patients.

Oncology

Over one million new cases of solid tumor cancer are diagnosed each year in the United States, with four cancer types (breast, prostate, lung and colorectal) accounting for over 700,000 of these. While the incidence of lung cancer is declining slightly, the incidence of breast and colorectal cancer is believed to be increasing at approximately five percent annually and the incidence of prostate cancer at approximately one percent annually.

Although there are often several therapeutic options for a given indication, treatment is typically expensive and accompanied by a host of adverse side effects that are detrimental to patients’ quality of life. In many cases, treatments are effective in only a small percentage of the total patient population and so multiple treatment options must be pursued sequentially until an effective one is found. Often, relatively non-specific broader acting cancer therapeutic agents, including various chemotherapies and radiotherapy are used as first-line and second-line therapies before more specific, targeted therapeutics are used. These broader agents often have serious debilitating side effects associated with them. Not until a patient has “failed” these treatments either because of intolerable or adverse side effects or because their cancer does not respond or has progressed are newer targeted therapies tried. These targeted therapies are often used in third-line treatment because the percentage of patients in the overall population for whom they are effective is relatively low (10%-20%). For patients with a life threatening disease, the sequential approach to the selection of therapies is not optimal but is a consequence of the limited information available to physicians. Despite many years of clinical studies, physicians still have inadequate information on which to base many treatment decisions and many newer targeted drugs have low levels of response in the general disease population, even though in a subset of the patient population they can be extremely effective. The consequences of suboptimal or inappropriate therapies include poor patient outcomes, both from side effects and lack of activity, as well as an economic burden on the healthcare system—the added costs of the physician’s time, wasted drugs and increased hospitalization.

Patient Selection Testing

There is growing acknowledgement that the current methods of classifying different types of cancer by the tissue of origin (e.g. breast cancer or lung cancer), are relatively crude and imprecise, and that better methods of categorizing an individual’s cancer or tumor are possible. In fact, it is now believed that individual tumors of different types (e.g. lung cancer and breast cancer) from different patients may be more closely related at the molecular level, and more likely to respond to a particular targeted therapy, than two lung tumors or two breast tumors. Separate lung cancer tissues may appear to be the same, but at the molecular level they may display very different biological processes. For a treatment to be optimally effective in killing or controlling cancer cells in an individual patient, it is desirable to have diagnostic tests that are able to “see” at this level, determine what is driving the growth of the cancer cells in that individual patient, and which drug will affect that particular process.

Cancer cells proliferate through the activation and interaction of complex biological pathways, stimulated by both extracellular signals and intracellular changes. In order to cure a patient’s cancer, or to control it and

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limit its progression, physicians must have an understanding of these complex processes, and which particular pathways have been activated and are driving cancer cell growth in each particular patient. New molecular methods and analytical techniques are attempting to provide this information. These new technologies hold the potential for revolutionizing cancer diagnosis and treatment, enabling physicians to make decisions on what treatment options are best suited for an individual patient’s “personalized medicine.”

Recently there has been scientific debate about the predictive nature of particular genetic markers or genomic structures, such as the identification of specific gene mutations present in the tumor tissue of certain patients. While this information is extremely useful in some cases, the biological patterns that result in uncontrolled cell growth and cancer are much more complex, and are influenced by many additional factors, than can be communicated in simple gene mutations. We believe that a more comprehensive understanding of the biology involved in cancer cell growth and drug response, especially at the level of proteins, protein complexes and signaling pathways, where most drugs work, is required to enable physicians to select the right therapy. Effective diagnostic tests are those that can identify the presence of the proteins and protein complexes that are the targets of the drugs in question. Even greater predictive power would likely accrue to those diagnostic tests able to measure the targets in their activated state, i.e., those target proteins actively involved in the disease process or mechanism attacked by the drug. For example, different members of the EGFR/Her receptor family are active in many types of cancer, but not in all patients with a particular type of cancer. The ability to detect activated drug targets, such as EGFR/Her receptors, is important to understanding whether particular drugs are likely to be effective.

ViroLogic’s Solution

Our solution to these challenges is based on molecular diagnostic tools that:

Infectious Diseases

Our proprietary technology identifies drug resistance in viruses that cause serious infectious diseases. Our products are used primarily in the management of patients with HIV/AIDS, and could also be applied to other serious infectious diseases. We make our tests available both to physicians to guide the management of patients’ treatment and to pharmaceutical companies to aid in the development and clinical evaluation of new drugs.

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The following table sets out the products that are offered to physicians in guiding the selection of therapy from among approved drugs and the tests available to pharmaceutical and biotechnology companies for use in drug development and clinical trial patient recruitment:

Products for HIV Testing

In addition to the HIV testing products detailed above, we have PhenoSense HCV and GeneSeq HCV assays that we make available to pharmaceutical companies for use in their drug discovery and development programs.

The products that are currently used in pharmaceutical company testing may represent potential future new products for the patient testing aspect of our business as clinical utility is established and as additional drugs are commercialized.

Physicians

Utilizing the information from the various products that we have developed, physicians are able to manage the treatment of HIV and prescribe personalized treatments for patients.

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Our GeneSeq test determines the genetic sequence of HIV and provides physicians with a prediction of expected drug resistance based on the particular mutations present in the individual patient’s virus. Our PhenoSense technology, rather than relying on known genotypic associations to make predictions of drug resistance, provides a direct measurement of the activity of each of the currently available anti-retroviral drugs against the patient’s individual virus. By directly measuring the interaction of drug with viral enzyme, it avoids the need to rely on predictions when knowledge of genotypic resistance is lacking. The quantitative nature of the phenotypic information that is provided facilitates a more useful characterization of the continuum of resistance than can be derived from basic genotypic tests. In addition, our tests can be automated and performed in large numbers, making them practical for routine use in the clinical management of patients.

We believe the information generated by our technology supports and guides the decision making process for physicians to identify optimal therapeutic treatment regimens for each patient. Through our genotypic and phenotypic tests, we provide a comprehensive report to the physician outlining the likely response of the patient’s disease to all 20 approved drugs. To provide more cost effective and timely data to the physician, we launched VLink, in March 2004, an online test reporting system for our comprehensive portfolio of HIV drug resistance assays, PhenoSense GT, PhenoSense HIV and GeneSeq HIV. Our secure online system facilitates data analysis, allowing examination of historical patient resistance data to help identify resistance patterns in patients over time, and it helps decrease the time between sample submission and reporting the results of the assays to physicians.

Pharmaceutical Companies

Pharmaceutical companies are under significant pressure to increase the productivity of their research and development functions. The most immediate impact on revenue for a pharmaceutical company can be derived from accelerating the progress of existing drugs in development through clinical trials, as opposed to enhancing drug discovery programs.

Increasing the speed and probability of success of clinical trials and accelerating the commercialization of drug candidates can be achieved through the advent of tests that are based on a personalized medicine approach. By identifying patients utilizing biomarkers that are predictive of response to the drug under investigation, clinical trials can be shorter, smaller and less costly, and have a higher probability of successful completion. In addition, the drug can be expected to have an improved economic profile because it can be prescribed with a higher degree of expected effectiveness, be brought to market more rapidly, and potentially be positioned as a first- or second-line treatment rather than a second- or third-line treatment.

Our products can be utilized by drug developers to:

Clinical trials are the most expensive part of drug development and pharmaceutical companies are now utilizing the information from pharmacogenomics, the scientific discipline focused on how genetic differences among patients determine or predict responsiveness or adverse reactions to particular drugs, to improve the outcomes of clinical trials. In a similar way, pharmaceutical companies are applying our PhenoSense technology to help select and monitor suitable patients for clinical trials. This selection process may allow pharmaceutical companies to guide important drug development decisions before large resource commitments are made. To date, we have provided testing services to almost all the pharmaceutical companies with drugs in development for treatment of HIV/AIDS and every drug approved for treatment of HIV in the past five years has benefited from the use of our tests in clinical trials. Importantly, the FDA has endorsed and emphasized the importance of resistance testing in drug development.

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Database and Virus Library

Through our products we have access to and are collecting a wealth of information on drug resistance and related clinical data that is being compiled in an interactive database and a virus library to assist our pharmaceutical customers in drug marketing and drug development. Two important components of our database include

We make this data available to pharmaceutical companies by providing defined data queries that can enhance their drug development programs. The virus library is a valuable reagent resource that facilitates novel drug characterization and clinical sample evaluations.

Oncology

Through our merger with ACLARA we plan to expand our franchise into oncology. We aim to leverage our commercial experience to develop diagnostic tests that will differentiate those patients who are likely to respond to new targeted therapies from those patients who will not respond. We are currently completing the development of our proprietary eTag assays that measure specific protein analytes and utilize tumor samples obtained from a patient’s biopsy or surgery, to aid in prescribing the new targeted cancer drugs for these patients.

Our eTag assays require only a very small amount of biological sample and can be performed directly on fresh, frozen and the standard clinical format—formalin-fixed paraffin-embedded clinically derived patient samples. This ability to utilize small amounts of human clinical samples in a wide range of formats, without extensive and time-consuming sample preparation, makes eTag assays well suited to diagnostic applications in human disease management.

Importantly, eTag assays can detect proteins and protein complexes that are not readily discernible with other technologies, especially in formalin-fixed human clinical samples. These analytes are expected to provide valuable information with respect to the activation states of key signaling pathways that drive cell proliferation and survival in tumors, and serve as biomarkers that indicate the likelihood of response to particular targeted therapeutics in individual patients and specific patient sub-groups.

Physicians

We intend to complete the development of our first commercial eTag assay product, an Epidermal Growth Factor Receptor, or EGFR, receptor assay panel that will enable physicians to identify the appropriate course of treatment for cancers that have characteristic profiles of receptors in the EGFR/Her receptor family. These assays have been developed and utilized in a research setting and have been evaluated by several pharmaceutical companies. We plan to transfer these assays into our Clinical Laboratory Improvement Amendments of 1988, or CLIA, certified clinical laboratory so that, after validation in accordance with CLIA standards, commercial tests can be launched. Retrospective clinical studies are being conducted to further evaluate and confirm the clinical utility of our assays. In these studies, we are accessing previously collected tumor samples, performing our eTag assays on those samples and comparing the results and predictions obtained from our assays with the known patient response data. A number of both retrospective and prospective studies are in progress and planned to generate this information.

Pharmaceutical Companies

Several targeted cancer drugs are already approved for marketing (e.g. Herceptin^®, Gleevec^®, Iressa^®, Tarceva^®, Erbitux^®, Avastin^®) with many more in development. As pharmaceutical companies continue to develop these targeted cancer therapies, there is an urgent need to be able to distinguish those patients who will respond to these treatments from those who will not.

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eTag assays are made available to pharmaceutical and biotechnology companies under collaborative agreements through which they can access our proprietary assay systems and development expertise for use in clinical development programs. These assays and services can be a critical aide in patient selection in clinical trials of targeted therapies that may be highly efficacious in selected patient populations while only minimally effective in the general patient population. We have conducted evaluations with several pharmaceutical and biotechnology companies and intend to develop expanded collaborations with these companies.

Reagents

Certain eTag assays used in more general pharmaceutical research and development programs are provided as research tools for multiplexed gene and protein expression analysis through the purchase of custom-made eTag assay kits, software, custom assay services, and consulting support. These assay development services and reagents are provided to pharmaceutical companies, primarily those that are significant customers or potential customers for our clinical assays in oncology.

On-Going Clinical Studies

We and independent clinical collaborators are currently conducting validation studies that are designed to show that eTag assays can be used to correctly identify patients likely to respond to particular targeted cancer therapies. For instance, in January 2005, a collaborator at Princess Margaret Hospital in Toronto presented clinical data assessing the ability of our eTag assays to accurately predict treatment outcomes for patients with metastatic colorectal cancer. The study, presented at the American Society of Clinical Oncology’s (ASCO) Gastrointestinal Cancer meeting in January, showed a correlation between the detection of EGFR/Her receptor family dimers, as measured by eTag assays, and the response as indicated by disease stability or disease progression in 18 patients being treated with erlotinib (Tarceva^®). A larger confirmatory study is underway. Several studies of this sort are in progress and planned, and are designed to provide clinical validation in support of the commercial launch of a test.

ViroLogic’s Strategy

Our objective is to be a world leader in developing and commercializing innovative products to help guide and improve the treatment of infectious diseases, cancer and other serious diseases. We have focused on developing products that meet the treatment needs for infectious diseases, primarily HIV/AIDS and believe that we have built the leading franchise in this area. Through our merger with ACLARA, we plan to expand into the area of cancer therapy and in the future will seek opportunities to address an even broader range of serious diseases. Key elements of our strategy are to:

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Sales & Marketing

We market our HIV drug resistance tests to physicians through a direct sales organization. To do so, we have built an efficient commercial infrastructure to support the industry’s most comprehensive line of drug resistance tests currently available. We currently have 26 experienced sales representatives promoting our HIV drug resistance tests in the United States. In addition, we have 11 people in our marketing, customer service and sales management functions supporting our direct sales personnel.

We also make our current products available through national, regional and hospital laboratories. In May 2004, we signed an expanded referral testing agreement with Quest Diagnostics, the nation’s leading provider of diagnostic testing, information and services. Under the terms of the agreement, Quest Diagnostics has made us its preferred provider of HIV phenotypic resistance testing. Quest Diagnostics has the largest national network of laboratories, with more than 30 full-service regional laboratories in major metropolitan areas and nearly 2,000 patient service centers, where patients’ specimens are collected. In 2004, 2003 and 2002, Quest Diagnostics, represented 12%, 9% and 10%, respectively, of our total revenue. The agreement with Quest expires in April 2005 and is subject to annual renewal on certain conditions.

We expect to leverage our existing experience and infrastructure to commercialize products for the oncology market. As we will be marketing to a separate physician group, we expect to hire sales personnel dedicated to the oncology market and are currently recruiting for a senior executive to lead this effort.

In addition we have a team of 9 employees developing and managing relationships with pharmaceutical companies related to our HIV pharmaceutical testing services, and a team of 3 employees developing relationships with pharmaceutical and biotechnology companies related to our oncology and eTag reagent products and services.

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Our marketing strategies focus on physician, patient and payor education in order to increase market awareness of our resistance testing products. We routinely sponsor and participate in conferences and scientific meetings, sponsor educational forums for physicians, and advertise in relevant journals and publications. Additionally, we target patients directly through educational programs. As part of our effort to maintain scientific leadership within the clinical community, which represents our customer base, we have a clinical advisory board consisting of leading clinicians.

We have an active reimbursement strategy, and educate both private and public payors concerning drug resistance testing in an effort to maximize reimbursement. Over an estimated 75% of HIV/AIDS patients in the United States now have access to coverage for resistance testing. At the end of 2004, 48 state Medicaid programs, including California, Florida, New Jersey and New York, the states with the largest HIV/AIDS patient populations, had favorable coverage policies for drug resistance testing. Medicare and nearly all private payors, including Aetna, the Blue Cross Blue Shield Association, Humana and United Health Care, pay for resistance testing.

Research & Development

Research and development expenditures were $7.8 million, $4.7 million and $10.4 million in 2004, 2003 and 2002, respectively. In addition, in 2004, we recorded a non-cash charge of $100.6 million as an allocation of the purchase price of ACLARA to in-process research and development programs. This reflects ACLARA’s technologies for providing eTag assays as diagnostic tools to pharmaceutical companies and physicians.

At the end of 2004 we had 49 employees in research and development, of whom 24 were focused on infectious disease programs, and 25 were focused on oncology programs and eTag-related drug discovery assays.

We maintain an active effort to seek grant funding in support of research programs. In 2003 and 2004, we were awarded a total of five grants totaling more than $5 million over three years. These grants will help support the development of analytical and database tools to facilitate the identification and characterization of drug resistant strains of HIV, and assays that will aid in the pre-clinical and clinical evaluation of the next generation of anti-viral therapeutics and vaccines. Revenue from grants in 2004 was $2.0 million.

Scientific Advisory Board

We have established an internationally renowned group of scientific advisors to provide specific expertise in areas of research and development relevant to our business. Our scientific advisors who meet periodically with our scientific and development personnel and management to discuss our present and long-term research and development activities include the following leaders in scientific and clinical research:

DAVID B. AGUS, M.D.—Research Director at the Louis Warschaw Prostate Cancer Center at Cedars-Sinai Medical Center and Assistant Professor of Medicine at UCLA.

JOSE BASELGA, M.D.—Professor of Medicine at the Universidad Autonoma de Barcelona and the Scientific Chairman of the Spanish Breast Cancer cooperative group SOLTI.

CARLOS L. ARTEAGA, M.D.—Professor of Medicine and Cancer Biology and Director of the Breast Cancer Research Program of the Vanderbilt-Ingram Cancer Center at Vanderbilt University School of Medicine.

STEPHEN P GOFF, PH.D.—Higgens Professor of Biochemistry and Molecular Biophysics at the College of Physicians and Surgeons of Columbia University, and an Investigator of the Howard Hughes Medical Institute.

ROY S. HERBST, M.D., PH.D.—Chief of the Section of Thoracic Oncology and Associate Professor at the University of Texas M. D. Anderson Cancer Center in Houston.

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MANUEL HIDALGO, M.D., PH.D.—Associate Professor of Oncology and Co-Director of the Drug Development Program at the Sidney Kimmel Comprehensive Cancer Center, Johns Hopkins University School of Medicine in Baltimore, Maryland.

DAVID D. HO, M.D.—Scientific Director and Chief Executive Officer of the Aaron Diamond AIDS Research Center, and a Professor of The Rockefeller University.

STEPHEN H. HUGHES, PH.D.—Chief of the Retroviral Replication Laboratory, HIV Drug Resistance Program at the National Cancer Institute — Frederick in Maryland.

DOUGLAS D. RICHMAN, M.D.—Professor of Pathology and Medicine at the University of California, San Diego School of Medicine and Director of the Research Center for AIDS and HIV Infection at the San Diego VA Medical Center.

ROBERT T. SCHOOLEY, M.D.—Tim Gill Professor of Medicine and Head of the Infectious Disease Division at the University of Colorado Health Sciences Center.

PJ UTZ, M.D.—Assistant Professor and directs a research laboratory in the Division of Rheumatology and Immunology at the Center for Clinical Immunology at the Stanford University School of Medicine.

OWEN N. WITTE, M.D.—Professor of Microbiology, Immunology and Molecular Genetics at UCLA. Professor Witte is also an Investigator of the Howard Hughes Medical Institute.

Competition

The markets for life science research and diagnostic products are highly competitive and are subject to rapid technological change. In particular, approaches to personalized medicine are rapidly evolving and there are many companies attempting to establish their technological approaches and products as the standard of care.

For our HIV testing products, the major competitors include manufacturers and distributors of phenotypic drug resistance technology, such as Tibotec-Virco, a division of Johnson & Johnson, and Specialty Laboratories. We also compete with makers of genotypic tests such as Applied Biosystems Group, Visible Genetics Inc., a division of Bayer Diagnostics, and laboratories performing genotypic testing as well as other genotypic testing referred to as virtual phenotyping.

For diagnostic testing for cancer therapies, we expect to compete with companies that are developing alternative technological approaches for patient testing in the cancer field. There are likely to be many competitive companies and many technological approaches in the emerging field of testing for likely responsiveness to the new class of targeted cancer therapies, including companies such as DakoCytomation A/S and Abbott Laboratories that currently commercialize testing products for guiding therapy of cancer patients. Established diagnostic product companies such as Abbott Laboratories, Roche Diagnostics and Bayer Diagnostics and established clinical laboratories such as Quest Diagnostics and LabCorp may also develop or commercialize services or products that are competitive with those that we anticipate developing and commercializing. In addition, there are a number of alternative technological approaches being developed by competitors and evaluated by pharmaceutical and biotechnology companies and being studied by the oncology community. In particular, while our anticipated oncology testing products will be based on the identification of protein-based differences among patients, there is significant interest in the oncology community in gene-based approaches that may be available from other companies.

We believe that the principal competitive factors in our markets are product capability supported by clinical validation, scientific credibility and reputation, customer service, cost effectiveness of the technology and the sales and marketing strength of the supplier.

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Many of our competitors and potential competitors in these markets have substantially greater market presence and substantially greater financial, technical and human resources than we do. We cannot assure you that they will not succeed in developing technologies and products that would render our technologies and products obsolete and noncompetitive. We also cannot assure you that we will be able to compete effectively with these competitors’ greater marketing presence and financial strength.

Operations

We perform our HIV drug resistance testing in South San Francisco, California. Our clinical laboratory is accredited by the College of American Pathologists and our facility is subject to stringent CLIA operating regulations. Patient samples for testing are delivered by courier and treated as infectious specimens. After processing of the samples with our proprietary technology, results are reported to the customer. The CLIA regulations require that we meet certain quality and personnel standards and undergo proficiency testing and inspections.

We expect to transfer our eTag assays from the research setting to our CLIA certified clinical laboratory in South San Francisco, California, during 2005. This transfer process will involve documentation, quality and validation procedures comparable to those applicable to our HIV testing products. While initial products for the cancer market will be introduced through our CLIA certified clinical laboratory, future cancer testing products may include test kits that may be subject to the regulatory authority of the Food and Drug Administration, or the FDA. The FDA regulatory framework is complicated, and we have limited experience at managing FDA compliance issues. If we develop cancer test kits, the kits could be subject to premarket FDA approval requirements, which would be expensive and time-consuming, and could delay or prevent us from marketing these tests. In addition, the production of the future cancer test kits may be subject to Good Manufacturing Practice Regulation, or GMP, under the auspices of the FDA. Our facilities are not GMP compliant. If the manufacture of the proposed kits is subject to GMP regulation, we will be required to establish a GMP compliant facility, or to enter into a relationship with a third party manufacturer that operates a GMP compliant facility. We do not have experience with GMP compliance. GMP compliance, or entry into a manufacturing relationship with a third party manufacturer, would be time-consuming and expensive.

Patents and Proprietary Rights

Our Intellectual Property Strategy

We will be able to protect our technology from unauthorized use by third parties only to the extent that our proprietary rights are covered by valid and enforceable patents or are effectively maintained as trade secrets. Patents and other proprietary rights are an essential element of our business. Our policy is to file patent applications and to protect technology, inventions and improvements to inventions that are commercially important to the development of our business. Our commercial success will depend in part on obtaining this patent protection.

With respect to our viral disease portfolio, including products and services for HIV, we currently have 27 issued patents and 128 pending applications for additional patents, including international counterparts to our U.S. patents. We have licensed and expect that we may need to license additional technology in order to continue the development and commercialization of our products. In addition, with respect to our HIV products, we have non-exclusively licensed seven patents under the Roche Molecular Systems, Inc., or Roche, license discussed below.

With respect to our planned oncology products and eTag technology, and as a result of our merger with ACLARA, we have approximately 148 granted, allowed, issued and pending patent applications in the United States and in other countries, including 15 issued or allowed patents. In addition, we have 129 granted, allowed,

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issued and pending patent applications in the United States and in other countries, including 58 issued or allowed patents, related to the historic microfluidics business of ACLARA. Our patents and patent applications related to our eTag technology and products in development address the following essential areas: Biomarkers enabled by eTag technology, including the use of selected intracellular protein-protein complexes and cell surface receptor dimers to indicate disease status, particularly in the cancer field; and eTag technology, including compositions, methods and applications in gene expression and proteomics, particularly as the latter relates to cell-based assays for measurement of receptor dimerization, analysis of signal transduction pathways, and analysis of receptor-ligand binding for receptor and ligand deorphanization and drug screening. Patents related to ACLARA’s historic microfluidics business address microfluidic and nanofluidic instruments and devices, their fabrication and their applications, particularly as they relate to high-throughput screening or diagnostic applications of eTag technology.

These patents and patent applications cover a broad range of technology applicable across our entire current and planned product line. We cannot assure you that any of the currently pending or future patent applications will be issued as patents, or that any patents issued to us will not be challenged, invalidated, held unenforceable or circumvented. Further, we cannot assure you that our intellectual property rights will be sufficiently broad to prevent third parties from producing competing products similar in design to our products.

In addition to patent protection, we also rely on protection of trade secrets, know-how and confidential and proprietary information. We generally enter into confidentiality agreements with our employees, consultants and our collaborative partners upon commencement of a relationship with us. However, we cannot assure you that these agreements will provide meaningful protection against the unauthorized use or disclosure of our trade secrets or other confidential information or that adequate remedies would exist if unauthorized use or disclosure were to occur. The exposure of our trade secrets and other proprietary information would impair our competitive advantages and could have a material adverse effect on our operating results, financial condition and future growth prospects. Further, we cannot assure you that others have not or will not independently develop substantially equivalent know-how and technology.

Further, there is a risk that some of our confidential information could be compromised during the discovery process of any litigation. During the course of any lawsuit, there may be public announcements of the results of hearings, motions and other interim proceedings or developments in the litigation. If securities analysts or investors perceive these results to be negative, it could have a substantial negative effect on the trading price of our stock.

Intellectual Property of Others

Our commercial success also depends in part on avoiding the infringement of other parties’ patents or proprietary rights and the breach of any licenses that may relate to our technologies and products. Third parties may have patents or patent applications relating to products or processes similar to, competitive with or otherwise related to our products. These products and processes may include technologies relating to HIV, hepatitis B and C, other viruses and oncology technologies. Third parties have from time to time threatened to assert infringement or other intellectual property rights against us based on their patents or other intellectual property rights.

We have had to, and expect to continue to have to, enter into licenses covering the rights at issue. Unless we are able to expand our existing licenses and obtain additional licenses, patents covering these technologies may adversely impact our ability to commercialize one or more of our potential products. We are aware of various third-party patents that may relate to our technology. We believe that we do not infringe these patents but cannot assure you that we will not be found in the future to infringe these or other patents or proprietary rights of third parties, either with products we are currently developing or with new products that we may seek to develop in the future. If third parties assert infringement claims against us, we may be forced to enter into license arrangements with them. We cannot assure you that we could enter into the required licenses on commercially reasonably

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terms, if at all. The failure to obtain necessary licenses or to implement alternative approaches may prevent us from commercializing products under development and would impair our ability to be commercially competitive. We may also become subject to interference proceedings conducted in the U.S. Patent and Trademark Office to determine the priority of inventions.

The defense and prosecution, if necessary, of intellectual property suits, U.S. Patent and Trademark Office interference proceedings and related legal and administrative proceedings will result in substantial expense to us, and significant diversion of effort by our technical and management personnel. An adverse determination in litigation or interference proceedings to which we may become a party could subject us to significant liabilities to third parties, could put our patents at risk of being invalidated or interpreted narrowly and could put our patent applications at risk of not issuing.

License Agreements

We license polymerase chain reaction, or PCR, technology from Roche for performing a step in our PhenoSense and GeneSeq tests. This license is non-exclusive and lasts for the life of the patent term of the last to expire licensed Roche patent. We believe that the last Roche patent expires in 2005. If Roche develops or acquires additional patents covering technology related to the licensed technology, we have the option of licensing that additional technology under the terms of this agreement, which may extend the term of the license. In exchange for the license, we have agreed to pay Roche a royalty based on the net service revenues we receive from our products. At least sixty days prior to introducing a new product utilizing the Roche technology, we must notify Roche of that introduction. If we fail to notify Roche, we would have to pay a higher royalty. We also agreed to participate in proficiency testing in accordance with applicable quality assurance standards and to comply with all relevant regulations and standards. Further, we have agreed to give Roche a reasonable opportunity to negotiate for a license to use any technology we develop related to the reaction technology we license from Roche, such as the automation of the method for performing the reaction. Roche has the right to terminate this license if we fail to pay royalties, make a semi-annual royalty report or participate in proficiency testing. We believe we are in compliance with these requirements. The license allows us to use technology covered by the licensed Roche patents within a broad field that includes all of our currently planned products. If we were to expand our product line beyond the licensed field, however, we would need to negotiate an expansion of the license.

We license certain technologies from Third Wave Technologies, Inc. pursuant to a License Agreement signed by ACLARA in October 2002 and assigned to us as a result of the merger. Under the License Agreement and a related Supply Agreement, we have rights to incorporate Third Wave’s Invader technology and Cleavase enzyme with our eTag technology to offer the eTag Assay System for multiplexed gene expression applications for the research market. In addition to licensing the Invader technology platform to us, Third Wave will supply Cleavase enzyme to us for incorporation into eTag-Invader gene expression assays. For 2005, the royalty payment is fixed in amount and thereafter is computed as a percentage of sales of licensed products.

In addition, we also license technology from other third parties. We recorded aggregate royalty expense of $1.6 million, $1.1 million and $1.0 million for the years ended December 31, 2004, 2003 and 2002, respectively.

Regulation and Reimbursement

Regulation of Clinical Laboratory Operations

The Clinical Laboratory Improvement Amendments of 1988 (CLIA) extends federal oversight to virtually all clinical laboratories by requiring that laboratories be certified by the federal government, by a federally approved accreditation agency or by a state that has been deemed exempt from the regulation’s requirements. We currently offer our viral disease assays, including our PhenoSense and PhenoSense GT, under the standards of these regulations. Pursuant to these federal clinical laboratory regulations, clinical laboratories must meet quality assurance, quality control and personnel standards. Labs also must undergo proficiency testing and inspections. Standards are based on the complexity of the method of testing performed by the laboratory.

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These regulations categorize our laboratory as high complexity, and we believe we are in compliance with the more stringent standards applicable to high complexity testing for personnel, quality control, quality assurance and patient test management. Our clinical laboratory holds a Certificate of Registration under these regulations. Our clinical laboratory has been surveyed by the College of American Pathologists, a federally approved accreditation agency, which has accredited our clinical laboratory. In order to offer eTag assays in our clinical laboratory for patient use we will be required to validate those assays and related systems in accordance with our quality control, quality assurance and patient test management protocols and for specificity and reproducibility pursuant to the CLIA standards.

In addition to the Federal laboratory regulations, states, including California, require laboratory licensure and may adopt regulations that are more stringent than federal law. We believe we are in material compliance with California and other applicable state laws and regulations.

The sanctions for failure to comply with federal or state clinical laboratory regulations, or accreditation requirements of federally approved agencies, may be suspension, revocation or limitation of a laboratory’s certificate or accreditation. There also could be fines and criminal penalties. The suspension or loss of a license, failure to achieve or loss of accreditation, imposition of a fine, or future changes in applicable federal or state laws or regulations or in the interpretation of current laws and regulations, could have a material adverse effect on our business.

Under our current labeling and marketing plans, our phenotypic products have not been subject to FDA regulation, although we are aware of increasing activity by the FDA in regards to regulating homebrew HIV genotypic resistance testing such as ours. We cannot predict the extent of future FDA regulation, and we might be subject in the future to greater regulation, or different regulations, that could have a material effect on our finances and operations.

Regulation for Manufacture and Sale of Kit based Assays

The eTag assays that we currently make available for research purposes and that we plan to make available through our clinical laboratory are not subject to oversight by, nor does their sale require prior approval by the FDA. However, we may be subject to FDA and other regulation with regard to future diagnostic kits and services that we may develop. Under the Federal Food, Drug and Cosmetic Act and related regulations, the FDA regulates the design, development, manufacturing, labeling, sale, distribution and promotion of drugs, medical devices and diagnostics. Before a new drug, device or diagnostic product can be introduced in the market, the product must undergo rigorous testing and an extensive regulatory approval process implemented by the FDA under federal law. In addition, the FDA imposes additional regulations on manufacturers of approved products. We have limited experience with obtaining FDA approvals and developing, manufacturing, distributing or selling products within FDA requirements. Any failure to obtain FDA and other requisite governmental approvals with regard to any future products that we may develop could have a material adverse affect on our business, results of operations and financial condition.

Medical Waste and Radioactive Materials

We are subject to licensing and regulation under federal, state and local laws relating to the handling and disposal of medical specimens and hazardous waste and radioactive materials as well as to the safety and health of laboratory employees. Our clinical laboratory facility in South San Francisco, California is operated in material compliance with applicable federal and state laws and regulations relating to disposal of all laboratory specimens. We utilize outside vendors for disposal of specimens. Our research and development and manufacturing processes at the former ACLARA facilities in Mountain View, California involve the use of hazardous materials, including chemicals and biological materials. Our operations also produce hazardous waste products.

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We cannot eliminate the risk of accidental contamination or discharge and any resultant injury from these materials. Federal, state and local laws and regulations govern the use, manufacture, storage, handling and disposal of these materials. We could be subject to damages in the event of an improper or unauthorized release of, or exposure of individuals to, hazardous materials. In addition, claimants may sue us for injury or contamination that results from our use, or the use by third parties, of these materials, and our liability may exceed our total assets. Compliance with environmental laws and regulations is expensive, and current or future environmental regulations may impair our research, development or production efforts.

Occupational Safety

In addition to its comprehensive regulation of safety in the workplace, the Federal Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for healthcare employers, including clinical laboratories, whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis virus. These regulations, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to chemicals and transmission of the blood-borne and airborne pathogens. Although we believe that we are currently in compliance in all material respects with such federal, state and local laws, failure to comply could subject us to denial of the right to conduct business, fines, criminal penalties and other enforcement actions.

Specimen Transportation

Regulations of the Department of Transportation, the International Air Transportation Agency, the Public Health Service and the Postal Service apply to the surface and air transportation of clinical laboratory specimens.

Regulation of Coverage and Reimbursement

Revenues for clinical laboratory testing services come from a variety of sources, including Medicare and Medicaid programs; other third-party payors, including commercial insurers, health maintenance and other managed care organizations; and patients, physicians, hospitals and other laboratories. We are a Medicare laboratory services provider. Medicare has issued coverage policies and payment guidelines for resistance testing, including phenotypic and genotypic testing. Currently, nearly all public and a majority of private payors have approved the reimbursement of our existing products HIV products. However, the majority of our payors are currently reimbursing our products at varying levels from 70% to 100% of our list prices. While recently issued guidelines of the Department of Health and Human Services recommend drug resistance testing for HIV patients, this does not assure coverage or level of coverage, by state, Medicare or any other payors. Coverage has not been established for any of our eTag products under development.

Since 1984, Congress has periodically lowered the ceilings on Medicare reimbursement for clinical laboratory services from previously authorized levels. In addition, state Medicaid programs are prohibited from paying more than Medicare for clinical laboratory tests. In some instances, they pay significantly less. Similarly, other payors, including managed care organizations, have sought on an ongoing basis to reduce the costs of healthcare by limiting utilization and payment rates. Actions by Medicare or other payors to reduce reimbursement rates or limit coverage or utilization of resistance testing would have a direct adverse impact on our revenues and cash flows. We cannot predict whether reductions or limitations will occur, though we feel some reductions are likely.

Our agreements with third-party payors, including Medicare and Medicaid, require that we identify the services we perform using industry standard codes known as the Current Procedural Terminology, or CPT, codes, which are developed by the American Medical Association, or AMA. Most payors maintain a list of standard reimbursement rates for each such code, and our ability to be reimbursed for our services is therefore

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effectively limited by our ability to describe the services accurately using the CPT codes. From time to time, the AMA changes its instructions about how our services should be coded using the CPT codes. If these changes leave us unable to accurately describe our services or are not coordinated with payors such that corresponding changes are made to the payors’ reimbursement schedules, we may have to renegotiate our pricing and reimbursement rates, the changes may interrupt our ability to be reimbursed, and/or the overall reimbursement rates for our services may decrease dramatically.

Significant uncertainty exists as to the reimbursement status of new medical products such as our eTag products for oncology and our Replication Capacity and Co-Receptor Tropism assays for HIV drug resistance testing which we are currently developing, particularly if these products fail to show demonstrable value in clinical studies. If government and other third-party payors do not provide adequate coverage and reimbursement for our planned products, our revenues will be reduced.

Fraud and Abuse Regulation

Existing federal laws governing Medicare and Medicaid and other federal healthcare programs, as well as similar state laws, impose a variety of broadly described fraud and abuse prohibitions on healthcare providers, including clinical laboratories. Multiple government agencies enforce these laws. The Health Insurance Portability and Accountability Act of 1996 provides for the establishment of a program to coordinate federal, state and local law enforcement programs. Over the last several years, the clinical laboratory industry has also been the focus of major government enforcement actions.

One set of fraud and abuse laws, the federal anti-kickback laws, prohibits clinical laboratories from, among other things, making payments or furnishing other benefits intended to induce the referral of patients for tests billed to Medicare, Medicaid, or certain other federally funded programs. California also has its own Medicaid anti-kickback law, as well as an anti-kickback law that prohibits payments made to physicians to influence the referral of any patients. California laws also limit the ability to use a non-employee sales force.

Under another federal provision, known as the “Stark” law or “self-referral” prohibition, physicians who have an investment or compensation relationship with a clinical laboratory may not, unless a statutory exception applies, refer Medicare or Medicaid patients for testing to the laboratory. In addition, a laboratory may not bill Medicare, Medicaid or any other party for testing furnished pursuant to a prohibited referral. There is a California self-referral law, as well, which applies to all patient referrals.

Currently, we have a financial relationship with one referring physician, who serves as part-time medical director at our clinical laboratory. Very few of this physician’s patients, if any, are federal healthcare program patients. In addition, we do not bill for services furnished to any patients referred by this physician. The California anti-kickback law may have exceptions applicable to our relationship with this physician. We have requested a written opinion from California officials to determine whether this relationship is appropriate, but have not received any response to our request.

There are a variety of other types of federal and state anti-fraud and abuse laws, including laws prohibiting submission of false or otherwise improper claims to federal healthcare programs, and laws limiting the extent of any differences between charges to Medicare and Medicaid and charges to other parties. We seek to structure our business to comply with the federal and state anti-fraud and abuse laws. We cannot predict, however, how these laws will be applied in the future, and we cannot be sure arrangements will not be found in violation of them. Sanctions for violations of these laws may include exclusion from participation in Medicare, Medicaid and other federal healthcare programs, criminal and civil fines and penalties, and loss of license. Any of these could have a material adverse effect on our business.

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Patient Privacy

The Department of Human Health and Services, or HHS, has issued final regulations under the Health Insurance Portability and Accountability Act of 1996, or HIPAA, designed to improve the efficiency and effectiveness of the health care system by facilitating the electronic exchange of information in certain financial and administrative transactions, while protecting the privacy and security of the information exchanged. Three principal regulations have been issued:

The privacy regulations prohibit the use or disclosure of “protected health information” except for certain purposes or unless specific conditions are met. Protected health information is information transmitted or maintained in any form—by electronic means, on paper, or through oral communications that: (1) relates to the past, present, or future physical or mental health or condition of an individual, the provision of health care to an individual, or the past, present, or future payment for the provision of health care to an individual; and (2) identifies the individual or with respect to which there is a reasonable basis to believe the information can be used to identify the individual. Data that have been de-identified in accordance with the Privacy regulation’s stringent de-identification standard are not considered protected health information and are not subject to the regulation. We have implemented privacy and security changes that we believe comply with these standards. In addition, we implemented measures we believe will reasonably and appropriately meet the specifications of the security regulations and the transaction standards.

The HIPAA regulations on transaction standards establish uniform standards for electronic transactions and code sets, including the electronic transactions and code sets used for claims, remittance advices, enrollment and eligibility. These standards are complex, and subject to differences in interpretation. We cannot guarantee that our compliance measures will meet the specifications for any of these regulations. In addition, certain types of information, including demographic information not usually provided to us by physicians, could be required by certain payers. As a result of inconsistent application of requirements by payers, or our inability to obtain billing information, we could face increased costs and complexity, a temporary disruption in receipts and ongoing reductions in reimbursements and net revenues.

HHS issued additional guidance on July 24, 2003 stating that it will not penalize a covered entity for post-implementation date transactions that are not fully compliant with the transactions standards, if the covered entity can demonstrate its good faith efforts to comply with the standards. HHS’ stated purpose for this flexible enforcement position was to “permit health plans to mitigate unintended adverse effects on covered entities’ cash flow and business operations during the transition to the standards, as well as on the availability and quality of patient care.”

On September 23, 2003, the Centers for Medicare and Medicaid Services (“CMS”) announced that it will implement a contingency plan for the Medicare program to accept electronic transactions that are not fully compliant with the transaction standards after the October 16, 2003 compliance deadline. CMS’ contingency plan allows Medicare carriers to continue to accept and process Medicare claims in the traditional electronic formats now in use in order to give its healthcare providers additional time to complete the testing process, provided they are making a good faith effort to comply with the new standards. As part of its plan, CMS is expected to regularly reassess the readiness of its healthcare providers to determine how long the contingency plan will remain in effect. In its announcement, CMS encouraged other payors to assess the readiness of their trading partners and to implement contingency plans, if appropriate. A number of other major payors have announced they intend to follow CMS’ lead, but we cannot assure you that all payors will develop similar contingency plans. We have experienced payment delays related to payors inability to timely process claims submitted in the new HIPPA complaint format. At this time, we cannot estimate the potential impact of payors implementing, or failing to implement, the HIPAA transaction standards on our cash flows and results of operations.

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In addition to the HIPAA provisions described above, there are a number of state laws regarding the confidentiality of medical information, some of which apply to clinical laboratories. These laws vary widely, and new laws in this area are pending, but they most commonly restrict the use and disclosure of medical information without patient consent. Penalties for violation of these laws include sanctions against a laboratory’s state licensure, as well as civil and/ or criminal penalties. Compliance with such rules could require us to spend substantial sums, which could negatively impact our profitability.

Employees

As of March 11, 2005, we had 250 employees, of whom 17 hold Ph.D. or M.D. degrees and 34 hold other advanced degrees. Approximately 94 employees are engaged in clinical laboratory operations, including 41 licensed healthcare professionals, 57 employees are engaged in research and development, and 99 employees are engaged in sales, marketing, information systems, finance and other administrative functions.

Available Information

We file electronically with the Securities and Exchange Commission, or SEC, our annual reports on Form 10-K, quarterly interim reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. We maintain a site on the worldwide web at www.virologic.com; however, information found on our website is not incorporated by reference into this report. We make available free of charge on or through our website our SEC filings, including our annual report on Form 10-K, quarterly interim 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 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Further, a copy of our filings is located at the Securities and Exchange Commission’s Public Reference Room at 450 Fifth Street, N.W., Washington, D. C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains a website that contains reports, proxy and information statements and other information regarding our filings at http://www.sec.gov.

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RISK FACTORS RELATED TO OUR BUSINESS

Except for the historical information contained or incorporated by reference, this annual report on Form 10-K and the information incorporated by reference contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those discussed here. Factors that could cause or contribute to differences in our actual results include those discussed in the following section, as well as those discussed in Part I, Item 1 entitled “Business”, Part II, Item 7 entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere throughout this annual report and in any other documents incorporated by reference into this annual report. You should consider carefully the following risk factors, together with all of the other information included in this annual report on Form 10-K. Each of these risk factors could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our common stock.

We have not achieved profitability and both we and ACLARA had recent and anticipated continuing losses, which may cause our stock price to fall.

Prior to our merger with ACLARA, both we and ACLARA have experienced significant losses each year since inception, and we expect to incur additional losses following our merger. We have experienced losses applicable to common stockholders of $81.8 million for the year ended December 31, 2004, $9.3 million for the year ended December 31, 2003, and $33.3 million for the year ended December 31, 2002. As of December 31, 2004, we had an accumulated deficit of approximately $187.7 million. ACLARA experienced net losses of approximately $12.7 million in the nine-month period ended September 30, 2004, $20.0 million for the year ended December 31, 2003, and $37.2 million for the year ended December 31, 2002. As of September 30, 2004, ACLARA had an accumulated deficit of $175.7 million. We expect to continue to incur losses, primarily as a result of spending related to:

If our losses continue, our stock price may fall and our stockholders may lose part or all of their investment.

Holders of our contingent value rights, or CVRs, will not be able to determine the payment to be received under the contingent value rights until June 10, 2006, and the CVRs may expire or be extinguished without any payment thereunder.

Holders of our CVRs will not know the amount of payment, if any, that a contingent value right will receive until either June 10, 2006, or such earlier time as the contingent value rights are automatically extinguished. The

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payment, if any, that each contingent value right will entitle its holder to receive will depend on the average volume weighted mean of the sales prices of our common stock for the 15 trading days ending on and including June 10, 2006. For every cent that the 15 day average is below $2.90, the contingent value right will have the right to a payment of $0.01 per CVR, with a maximum payment of $0.88 per CVR. If we are required to make any payment to the holders of CVRs, the first $0.50 per CVR of any such payment must be made in cash. The balance of any such payment, up to $0.38 per CVR, may, at our election, be made in cash, shares of our common stock or a combination of the two. If we elect to make any portion of a payment to holders of CVRs through the issuance of shares of our common stock then, as a condition precedent, such shares must, among other things, be issued either in a transaction that is exempt from registration under the Securities Act through satisfaction of the requirements of Section 3(a)(9) of the Securities Act, or pursuant to an effective registration statement under the Securities Act. If these conditions precedent cannot be satisfied then we must make the entire amount of any payment due under the CVRs in cash.

If at any point during the 18 month period ending on June 10, 2006, the daily volume weighted mean of the sales prices of our common stock is greater than or equal to $3.50 for 30 consecutive trading days, the contingent value rights will be automatically extinguished and no payment will be made on them.

Our potential payments to holders of contingent value rights, which may be greater than currently estimated, would decrease our liquidity and could cause dilution to our stockholders.

Under the terms of the contingent value rights, we are obligated to make a payment to the holders of contingent value rights on June 10, 2006 if the average volume weighted mean of the sales prices of our common stock for the 15 trading days prior to June 10, 2006 is less than $2.90 (unless the CVRs have been automatically extinguished earlier, in accordance with their terms). The maximum aggregate amount payable by us under the contingent value rights is currently estimated to be approximately $54.4 million, based on approximately 36 million shares of ACLARA common stock outstanding as of the date our merger with ACLARA closed. If this total amount becomes due, we must pay the first $31 million in cash, and may, at our option, pay the $23.4 million balance in cash, shares of our common stock or a combination of the two. If we are required to make the maximum payment under the CVRs, totaling approximately $54.4 million, we may have insufficient cash balances to make this entire payment in cash, and if we did have sufficient cash balances and elected to make the entire payment in cash our liquidity would be significantly and adversely affected. If we elected to make a portion of any CVR payment in shares of our common stock, existing stockholders could suffer significant dilution of their ViroLogic holdings. In addition, the maximum amount payable under the CVRs could be greater than $54.4 million depending on the number of assumed ACLARA stock options that are exercised in the future. In connection with our merger with ACLARA, we assumed ACLARA stock options exercisable for 7.1 million shares of our common stock. If all ACLARA stock options assumed in our merger with ACLARA are exercised, the maximum aggregate amount payable under the CVRs would increase by approximately $6.2 million. We can make no assurances as to the timing or extent of any option exercise activity.

If the conditions requiring us to make payments to the holders of contingent value rights are satisfied and all assumed ACLARA options are exercised, we would be required to pay up to approximately $60.6 million, which would result in a decrease in liquidity, which may adversely impact our ongoing business.

Our financial results and financial position may be adversely impacted by, and may fluctuate as a result of, the contingent value rights.

Until June 10, 2006, or the earlier extinguishment of the contingent value rights in accordance with their terms, we will be required under generally accepted accounting principles to record adjustments in our quarterly statements of operations based on the fair value of our estimated obligation to make payments to the holders of contingent value rights and the variable accounting associated with the stock options that have attached CVRs. Our estimated obligation to make these payments under the CVRs will vary depending, at the time the estimate is

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made, the market price, if any, of the contingent value rights and the stock options associated with CVRs, and the extent to which assumed ACLARA stock options are exercised. As a result, our estimated obligation under the contingent value rights could vary from period to period, resulting in significant fluctuations in our results of operations from quarter to quarter, including our reported earnings or loss per share, which could cause the market price of our common stock to fall abruptly and significantly.

If, at June 10, 2006, we are required to make a payment under the contingent value rights, we will thereafter be obligated to make equivalent payments to holders of assumed ACLARA stock options upon the exercise of those options. The aggregate amount payable upon the exercise of assumed ACLARA stock options will be equal to the number of shares of our common stock subject to those options multiplied by the amount of cash or cash and ViroLogic common stock required to be paid with respect to a single contingent value right. For fiscal periods ending after June 10, 2006, we will be required to record a charge against our statement of operations to reflect the maximum amount payable upon the exercise of assumed ACLARA stock options, based on the number of shares of our common stock for which such options are then exercisable according to their vesting provisions. In addition, we may periodically record a benefit to our statement of operations to the extent that any assumed ACLARA stock options expire prior to exercise. The combination of these charges and benefits could lead to fluctuations in our results of operations from quarter to quarter.

An active public market may not be sustained for the CVRs, or they may trade at low volumes, both of which could depress the resale price, if any, of the securities.

The CVRs are a new security for which there is a limited public trading market. We cannot predict whether an active public trading market for the securities will be sustained. The CVRs are currently quoted on the OTC Bulletin Board (“OTCBB”) under the ticker symbol “VLGCR.OB”. Because the OTCBB is a quotation service for NASD Market Makers, and not an issuer listing service or securities market, there are no listing requirements that must be met by an OTCBB issuer. There are, however, certain requirements that an issuer must meet in order for its securities to be eligible for a market maker to enter a quotation on the OTCBB. We believe that we satisfy these requirements, and that we will continue to satisfy these requirements for the foreseeable future. Investors should note however, that because issuers are not permitted to submit applications to be quoted on the OTCBB, we cannot guarantee that the CVRs will remain listed on the OTCBB. Continued quotation of the CVRs on the OTCBB will depend on ongoing sponsorship by one or more market makers who demonstrate compliance with SEC Rule 15c2-11.

Even if a public trading market for the CVRs is sustained, there may be little or no market demand for the CVRs, making it difficult or impossible to sell CVRs on the public market, and depressing the resale price, if any, of the CVRs. In addition, holders of CVRs may incur brokerage charges in connection with the resale of the CVRs, which in some cases could exceed the proceeds realized by the holder from the resale of its CVRs. We cannot predict the price, if any, at which the CVRs will trade.

Our obligation to make payments to the holders of CVRs will be unsecured, and holders of CVRs are not assured of receiving any payments owed to them under the CVRs.

Our obligation to make payments under the CVRs, if any, will be unsecured. While we intend to maintain cash resources for potential CVR payments, any amounts owing under the CVRs will be general unsecured obligations. If, at June 10, 2006, we are required to make a payment under the CVRs, holders of the CVRs cannot be assured that we will have sufficient funds or available common stock to do so. If we are unable to make a required payment under the CVRs, the holders of CVRs will have equal priority in making claims against and receiving assets from us as will our general creditors. If we are unable to make payments owing under the CVRs, the holder of a CVR may receive none, or only a portion of, any amount that is owed under the CVRs.

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We may not realize the benefits we expect from the merger with ACLARA.

Our integration with ACLARA will be complex, time consuming and expensive, and may disrupt our business. We will need to overcome significant challenges in order to realize any benefits or synergies from our merger with ACLARA. These challenges include the timely, efficient and successful execution of a number of post-transaction integration activities, including:

We estimate that relocation of ACLARA’s former operations into our South San Francisco, California, facilities will be completed in the second quarter of 2005. We expect that the development and commercialization of the propriety eTag assays for use in clinical trials by pharmaceutical and biotechnology customers could exceed one year. In addition, we expect to commercialize clinical assays for diagnostic use in patient testing, upon the successful completion of product development and automation for high throughput, validation of these assays in a CLIA-certified laboratory format, attainment of clinical validation through clinical trials, which could also exceed one year, and successful leveraging of research and development planned to be expended on clinical assays for use in clinical trials by pharmaceutical and biotechnology companies. The completion of these research and development activities are subject to a number of risks and uncertainties including the extent of clinical trials required for regulatory and marketing purposes, the timing and results of clinical trials, failure to validate the technology in clinical trials and failure to achieve necessary regulatory approvals. These factors make it impossible to predict with any degree of certainty the costs and timing of completing the development of commercial products.

The process of integrating operations and technology could cause an interruption of, or loss of momentum in, the activities of one or more of our businesses and the loss of key personnel. The diversion of management’s attention and any delays or difficulties encountered in connection with our merger with ACLARA and the integration of our operations and technology with ACLARA’s could have an adverse effect on our business, results of operations or financial condition. Furthermore, the execution of these post-transaction integration activities will involve considerable risks and may not be successful. These risks include:

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We may not succeed in addressing these risks or any other problems encountered in connection with our merger with ACLARA. The inability to successfully integrate the operations, technology and personnel of ACLARA with ours, or any significant delay in achieving integration, could have a material adverse effect on our business and, as a result, on the market price of our common stock.

Proposed new products resulting from the integration of ACLARA’s technology into our operational infrastructure could be delayed or precluded by regulatory, clinical or technical obstacles, thereby delaying or preventing the development, introduction and commercialization of these new products and adversely impacting our revenue and profitability.

We anticipate developing testing products for use in connection with the treatment of cancer patients. These products will be based on ACLARA’s proprietary eTag technology and are expected to utilize our established commercialization infrastructure and experience in patient testing for HIV. We expect that the development and commercialization of eTag assays for use in clinical trials by pharmaceutical and biotechnology customers could exceed one year. In addition, we expect to commercialize clinical assays for diagnostic use in patient testing, upon the successful completion of product development and automation for high throughput, validation of assays in a Clinical Laboratory Improvement Amendments, or CLIA, certified laboratory format, attainment of clinical validation through clinical trials, which could also exceed one year, and successful leveraging of research and development planned to be expended on clinical assays for use in clinical trials by pharmaceutical and biotechnology companies. The completion of these research and development activities are subject to a number of risks and uncertainties including the extent of clinical trials required for regulatory and marketing purposes, the timing and results of clinical trials, failure to validate the technology in clinical trials and failure to achieve necessary regulatory approvals. These factors make it impossible to predict with any degree of certainty the costs and timing of completing the development of commercial products.

The proposed products and services will be developed under the auspices of CLIA regulatory framework. Future cancer testing products may include test kits that may be subject to the regulatory authority of the Food and Drug Administration, or the FDA. The FDA regulatory framework is complicated, and we have limited experience at managing FDA compliance issues.

The proposed cancer testing products that are planned to be delivered through our existing clinical laboratory infrastructure will be based on assays that are in development in a research setting, but have not been transferred to or validated in a CLIA-certified laboratory. We may be unable to accomplish this transfer and validation. Failure to do so would have an adverse effect on our revenue and operations.

If we develop cancer test kits, the kits could be subject to premarket FDA approval requirements, which would be expensive and time-consuming, and could delay or prevent us from marketing these tests. In addition, the production of the future cancer test kits may be subject to Good Manufacturing Practice Regulation, or GMP, under the auspices of the FDA. Our facilities are not GMP compliant. If the manufacture of the proposed kits is subject to GMP regulation, then we will be required to establish a GMP compliant facility, or to enter into a relationship with a third party manufacturer that operates a GMP compliant facility. We do not have experience with GMP compliance. GMP compliance, or entry into a manufacturing relationship with a third party manufacturer, would be time-consuming and expensive. We anticipate that if we are required to establish our own GMP compliant facility, or we elect to enter into a relationship with a GMP compliant third party, either process would be completed in parallel with developing the proposed testing products, could take over one year, and would require additional resources that could exceed $0.5 million in start-up costs and would increase on-going overhead costs.

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As our proposed testing products for use in connection with the treatment of cancer patients have not yet been developed, there are currently no revenues associated with them and no significant revenues associated with other acquired ACLARA products and services. FDA regulation, including GMP regulation, could delay or preclude the development, introduction and commercialization of the proposed cancer testing products and prevent or delay us in receiving revenues from the proposed products, adversely affecting the anticipated profitability of the combined company.

As a result of our merger with ACLARA, we are a larger and broader organization. If our management is unable to adequately manage the company, our operating results will suffer.

As a result of our merger with ACLARA, we assumed approximately 35 employees, of 55 employees based at ACLARA’s facility in Mountain View, California before the merger, bringing our total number of employees after the merger to approximately 250. Our proposed testing products using ACLARA’s eTag technology and our commercialization infrastructure have not yet been developed, and the two will need to be integrated as a necessary part of the development process. We do not have experience in commercializing testing products for use in the oncology field. We will face challenges inherent in efficiently managing an increased number of employees and addressing new markets, including the need to implement appropriate systems, policies, benefits and compliance programs.

Difficulties or delays in successfully managing the substantially larger and broader organization could have a material adverse effect on the combined company after our merger with ACLARA and, as a result, on the market price of our common stock.

We could lose key personnel, which could materially affect our business and require us to incur substantial costs to recruit replacements for lost personnel.

We consider William D. Young, Chairman and Chief Executive Officer, Christos J. Petropoulos, Ph.D., Vice President, Research and Development, Virology and Chief Scientific Officer, Sharat Singh, Ph.D., Chief Technical Officer, Oncology, Michael Bates, M.D., Vice President, Clinical Research, and Jeannette Whitcomb, Ph.D., Vice President, Operations, to be key to the management of our business and operations.

Any of our key personnel could terminate their employment at any time and without notice. We do not maintain key person life insurance on any of our key employees. Although we have not faced difficulties in attracting or retaining key personnel in the recent past, any failure to attract and retain key personnel could have a material adverse effect on our business.

Charges to operations resulting from the application of business combination accounting may adversely affect the market value of our common stock.

If the benefits of our merger with ACLARA are not achieved, our financial results, including earnings (loss) per common share, could be adversely affected. In accordance with United States generally accepted accounting principles, we have accounted for merger as a business combination. We have allocated the total purchase price to the acquired net tangible assets, amortizable intangible assets, and in-process research and development based on their fair values as of the date of completion of the merger, and have recorded the excess of the purchase price over those fair values as goodwill. We will incur additional amortization expense over the estimated useful lives of certain of the intangible assets acquired in connection with our merger with ACLARA, although this is not currently expected to be significant. In addition, to the extent the value of goodwill or intangible assets become impaired, we may be required to incur material charges relating to the impairment of those assets. The additional charges could adversely affect our financial results, including earnings (loss) per common share, which could cause the market price of our common stock to decline.

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Because we expect to have larger revenues, operations and financial strength as a result of the merger with ACLARA, third parties with potential litigation claims against either company who decided not to pursue those claims against the individual companies may now consider asserting those claims against us.

As a result of our merger with ACLARA, we anticipate we will have greater revenues and financial strength than either company individually. As a result, third parties who believe that they have claims against us or ACLARA, but who chose not to make known or assert those claims because of the size of the individual companies, might now believe that asserting those claims against the larger combined company may be advantageous. Although we are not currently aware of any such claims against the combined company, ACLARA was involved in significant litigation matters in the past and we cannot assure you that similar litigation will not occur in the future.

Our stockholders will experience substantial additional dilution if our shares of preferred stock or related warrants are converted into or exercised for shares of common stock. As of December 31, 2004, our outstanding shares of preferred stock and related warrants were convertible into or exercisable for up to an aggregate of 14,153,581 shares of our common stock, or approximately 12% of the number of shares of common stock outstanding.

As of December 31, 2004, we had 116,034,527 shares of common stock outstanding after our merger with ACLARA. However, as of December 31, 2004, we also had outstanding the following shares of preferred stock and related warrants:

We will not receive payment or other consideration for the issuance of shares of common stock upon conversion of the Series A Preferred Stock. Most of the warrants listed above have net exercise provisions, which, if elected as the method of exercise by the holder of the warrant, cause us to not receive cash consideration for the issuance of shares of common stock upon exercise. Together, the common shares reserved for issuance upon conversion of the Series A Preferred Stock and upon exercise of the warrants referenced above represented approximately 14,153,581 shares of our common stock, or 12% of the shares of our common stock outstanding on December 31, 2004. All of these shares are issuable for an approximate weighted-average effective price of $1.15 per share.

Also, the number of shares of common stock that we may be required to issue upon conversion of the Series A Preferred Stock and exercise of certain of these warrants can increase substantially upon the occurrence of several events, including if:

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We are also obligated to issue additional shares of common stock every six months to the holders of the Series A Preferred Stock as “premium payments.” As of December 31, 2004, these issuances totaled approximately 250 shares of common stock for every share of Series A Preferred Stock outstanding at the time the issuance is made. All of the previous share totals are based upon an assumed stock price of $2.79, which reflects the closing price of our common stock on the Nasdaq National Market on December 31, 2004, but the actual number of shares issued will be based upon our stock price from time to time as of the payment dates. If the 249 shares of the Series A Preferred Stock outstanding as of December 31, 2004 were to remain outstanding for five years, we will be required to issue as premium payments an additional 625,000 shares of common stock (again based on an assumed stock price of $2.79) to holders of the Series A Preferred Stock. We will not receive payment or other consideration for these issuances.

All of the foregoing issuances of our common stock would be substantially dilutive to the holders of outstanding shares of our common stock, especially where, as described above, the shares of common stock are issued without additional consideration. We cannot predict whether or how many additional shares of our common stock will become issuable due to these provisions.

Any dilution or potential dilution may cause our stockholders to sell their shares, which would contribute to a downward movement in the stock price of our common stock. Any downward pressure on the trading price of our common stock could encourage investors to engage in short sales, which could further contribute to a downward trend in the price of our common stock.

We may be obligated to redeem the Series A Preferred Stock.

Holders of Series A Preferred Stock have the right, under certain circumstances, to require us to redeem for cash all of the preferred stock that they own. The redemption price for the Series A Preferred Stock is the greater of (i) 115% of the original purchase price plus 115% of any accrued premium payment thereon and (ii) the aggregate fair market value of the shares of common stock into which such shares of Series A Preferred Stock are then convertible. As of December 31, 2004, there were 249 shares of Series A Preferred Stock outstanding, with an aggregate redemption price equal to approximately $3 million.

Shares of Series A Preferred Stock are redeemable by the holders of the respective series in any of the following situations:

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Upon the occurrence of any of the events described above, individual holders of the Series A Preferred Stock would have the option, while such event continues, to require us to purchase some or all of the then outstanding shares of Series A Preferred Stock held by such holder. If we receive any notice of redemption, we will be required to immediately (no later than one business day following such receipt) deliver a written notice to all holders of the same series of preferred stock stating the date when we received the redemption notice and the amount of preferred stock covered by the notice. Redemption of the Series A Preferred Stock in any event described above would require us to expend a significant amount of cash and could negatively impact our ability to operate our business or raise additional capital.

Our products may not achieve market acceptance, which could limit our future revenue.

Our ability to establish our testing products as the standard of care to guide and improve the treatment of viral diseases and cancer will depend on acceptance and use of these testing products by physicians and clinicians and pharmaceutical companies. Testing products for viral diseases are still relatively new, and testing products for the treatment of cancer have not yet been developed. We cannot predict the extent to which physicians and clinicians will accept and use these testing products. They may prefer competing technologies and products. The commercial success of these testing products will require demonstrations of their advantages and potential economic value in relation to the current standard of care, as well as to competing products. Market acceptance of our products will depend on:

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If the market does not continue to accept our existing testing products, such as our PhenoSense products or does not accept our future testing products such as products based on the eTag technology, our ability to generate revenue will be limited.

Our revenues will be limited or diminished if changes are made to the way that our products are reimbursed, or if government or third-party payors limit the amounts that they will reimburse for our current products, or do not authorize reimbursement for our planned products.

Government and third-party payors, including Medicare and Medicaid require that we identify the services we perform in our clinical laboratory using industry standard codes known as the Current Procedural Terminology, or CPT, codes, which are developed by the American Medical Association, or AMA. Most payors maintain a list of standard reimbursement rates for each such code, and our ability to be reimbursed for our services is therefore effectively limited by our ability to describe the services accurately using the CPT codes. From time to time, the AMA changes its instructions about how our services should be coded using the CPT codes. If these changes leave us unable to accurately describe our services or we are not coordinated with payors such that corresponding changes are made to the payors’ reimbursement schedules, we may have to renegotiate our pricing and reimbursement rates, the changes may interrupt our ability to be reimbursed, and/or the overall reimbursement rates for its services may decrease dramatically. In addition, we may spend significant time and resources to minimize the impact of these changes on reimbursement.

Government and third-party payors are attempting to contain or reduce the costs of healthcare and are challenging the prices charged for medical products and services. In addition, increasing emphasis on managed care in the United States will continue to put pressure on the pricing of healthcare products. This could in the future limit the price that we can charge for our products. This could hurt our ability to generate revenues. Significant uncertainty exists as to the reimbursement status of new medical products like the products we are currently developing and that we expect to develop, particularly if these products fail to show demonstrable value in clinical studies. If government and other third-party payors do not continue to provide adequate coverage and reimbursement for our testing products or do not authorize reimbursement for our planned products, our revenues will be reduced.

Billing complexities associated with health care payors could impair our cash flow and limit our ability to reach profitability.

Billing for laboratory services is complex. Laboratories must bill various payors, such as Medicare, Medicaid, insurance companies, doctors, employer groups and patients, all of whom have different requirements. In 2004, 2003 and 2002, approximately 31%, 29%, and 27%, respectively of our revenues were derived from tests performed for the beneficiaries of the Medicare and Medicaid programs. Medicare and Medicaid represented 35% and 26% of gross accounts receivable balance at December 31, 2004 and 2003, respectively. Billing difficulties often result in a delay in collecting, or ultimately an inability to collect, the related receivable. This impairs cash flow and ultimately reduces profitability if we are required to record bad debt expense and/or contractual adjustments for these receivables. We recorded bad debt expense of $0.3 million, $0.1 million and $0.6 million for the years ended 2004, 2003, and 2002, respectively.

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Among many other factors complicating billing are:

Ultimately, if all issues are not resolved in a timely manner, our cash flows could be impaired and ability to reach profitability could be limited

We may encounter problems or delays in processing tests, or in expanding our automated testing systems, which could impair our ability to grow our business, generate revenue and achieve and sustain profitability.

In order to meet future projected demand for our products and fully utilize our current clinical laboratory facilities, we may have to expand the volume of patient samples that we are able to process. We will also need to continue to develop our quality-control procedures and to establish more consistency with respect to test turnaround so that results are delivered in a timely manner. Thus, we will need to continue to develop and implement additional automated systems to perform our tests. We have installed laboratory information systems over the past few years to support the automated tests, analyze the data generated by our tests and report the results. If these systems do not work effectively as we scale up our processing of patient samples, we may experience processing or quality-control problems and may experience delays or failures in our operations. These problems, delays or failures could adversely impact the promptness and accuracy of our transaction processing, which could impair our ability to grow our business, generate revenue and achieve and sustain profitability. We have experienced periods during which processing of our test results was delayed and periods during which the proportion of samples for which results could not be generated were higher than expected. For example, in the fourth quarter of 2003, we completed an automation project, the implementation of which resulted in a temporary backlog of approximately $0.5 million at December 31, 2003 and in the third quarter of 2004 a higher than expected number of samples failed to generate results. While we are taking steps to minimize the likelihood of any recurrence of these issues, future delays, processing problems and backlog may nevertheless occur, resulting in the loss of our customers and/or revenue and an adverse effect on our results of operations.

We face intense competition, and if our competitors’ existing products or new products are more effective than our products, the commercial opportunity for our products will be reduced or eliminated.

The commercial opportunity for our products will be reduced or eliminated if our competitors develop and market new testing products that are superior to, or are less expensive than, the testing products that we develop using our proprietary technology. The biotechnology industry evolves at a rapid pace and is highly competitive. Our major competitors for our HIV testing products include manufacturers and distributors of phenotypic drug resistance technology, such as Tibotec-Virco (division of Johnson & Johnson) and Specialty Laboratories. We also compete with makers of genotypic test kits such as Applied Biosystems Group, Visible Genetics Inc. (division of Bayer Diagnostics) and laboratories performing genotypic testing as well as other genotypic testing referred to as virtual phenotyping.

We also compete with companies that are developing alternative technological approaches for patient testing in the cancer field. There are likely to be many competitive companies and many technological approaches in the emerging field of testing for likely responsiveness to the new class of targeted cancer therapies, including companies such as DakoCytomation A/S and Abbott Laboratories that currently commercialize testing

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products for guiding therapy of cancer patients. Established diagnostic product companies such as Abbott Laboratories, Roche Diagnostics and Bayer Diagnostics and established clinical laboratories such as Quest Diagnostics and LabCorp may also develop or commercialize services or products that are competitive with those that we anticipate developing and commercializing. In addition, there are a number of alternative technological approaches being developed by competitors and evaluated by pharmaceutical and biotechnology companies and being studied by the oncology community. In particular, while our anticipated oncology testing products will be based on the identification of protein-based differences among patients, there is significant interest in the oncology community in gene-based approaches that may be available from other companies, which may prove to be a superior technology to ours.

Each of these competitors is attempting to establish its test as the standard of care. Our competitors may successfully develop and market other testing products that are either superior to those that we may develop or that are marketed prior to marketing of our testing products. One or more of our competitors may render our technology obsolete or uneconomical by advances in existing technological approaches or the development of different approaches. Some of these competitors have substantially greater financial resources, market presence and research and development staffs than we do. In addition, some of these competitors have significantly greater experience in developing products, and in obtaining the necessary regulatory approvals of products and processing and marketing products.

We derive a significant portion of our revenues from a small number of customers and our revenues may decline significantly if any major customer cancels or delays a purchase of our products.

Our revenues to date consist, and for 2005 are anticipated to consist, largely of sales of PhenoSense products. In 2004, 2003 and 2002, Quest Diagnostics Incorporated, represented 12%, 9% and 10%, respectively, of our total revenue. The agreement with Quest expires in April 2005 and is subject to annual renewals on certain conditions. We cannot assure you that the agreement with Quest will be renewed on commercially acceptable terms or that Quest will be an effective partner in commercialization of any of our products. In 2004, 2003 and 2002, approximately 31%, 29%, and 27%, respectively of our revenues were derived from tests performed for the beneficiaries of the Medicare and Medicaid programs. Gross accounts receivable balances from Medicare and Medicaid represented 35% and 26% of gross accounts receivable balance at December 31, 2004 and 2003, respectively. It is likely that we will have significant customer concentration in the future. The loss of any major customer, a slowdown in the pace of increasing physician and physician group sales as a percentage of sales, or the delay of significant orders from any significant customer, even if only temporary, could have a significant negative impact on our revenues and our ability to fund operations from revenues, generate cash from operations or achieve profitability.

Various testing materials that we use are purchased from single qualified suppliers, which could result in our inability to secure sufficient materials to conduct our business.

We purchase some of the testing materials used in our laboratory operations from single qualified suppliers. Although these materials could be purchased from other suppliers, we would need to qualify the suppliers prior to using their materials in our commercial operations. Although we believe we have ample inventory to allow validation of another source, in the event of a material interruption of these supplies, the quantity of our inventory may not be adequate.

Any extended interruption, delay or decreased availability of the supply of these testing materials could prevent us from running our business as contemplated and result in failure to meet our customers’ demands. If significant customer relationships were harmed by our failure to meet customer demands, our revenues may decrease. We might also face significant additional expenses if we are forced to find alternate sources of supplies, or change materials we use. Such expenses could make it more difficult for us to attain profitability, offer our products at competitive prices and continue our business as currently contemplated or at all.

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We are dependent on licenses for technology we use in our resistance testing, and our business would suffer if these licenses were terminated.

We license technology from Roche that we use in our PhenoSense and GeneSeq tests. We hold a non-exclusive license for the life of the patent term of the last licensed Roche patent. We believe that the last Roche patent expires in 2005. However, if additional patents are identified that would be necessary or useful for our operations, such patents could be added to the license at our option, which may extend the term of the license. We believe that many of our competitors, including Tibotec-Virco (division of Johnson & Johnson) and other resistance testing companies, also license this technology on non-exclusive terms. Roche has the right to terminate this license if we fail to pay royalties, make a semi-annual royalty report or participate in proficiency testing. We believe we are in compliance with these requirements. The license allows us to use technology covered by the licensed Roche patents within a broad field that includes all of our currently planned products. If we were to expand our product line beyond the licensed field, however, we would need to negotiate an expansion of the license. In addition, we also license technology from other third parties. If these licenses were to be terminated, we would likely have to change a portion of our testing methodology, which would halt our testing, at least temporarily, and cause us to incur substantial additional expenses.

The intellectual property protection for our technology and trade secrets may not be adequate, allowing third parties to use our technology or similar technologies, and thus reducing our ability to compete in the market.

The strength of our intellectual property protection is uncertain. In particular, we cannot be sure that:

With respect to our viral disease portfolio, we currently have 27 issued patents and 128 pending applications for additional patents, including international counterparts to our U.S. patents. With respect to our potential oncology products and eTag technology, we currently have approximately 148 granted, allowed, issued and pending patent applications in the United States and in other countries, including 15 issued or allowed patents. We have 129 granted, allowed, issued and pending patent applications in the United States and in other countries, including 58 issued or allowed patents, relating to the historic microfluidics business of ACLARA. We have licensed seven patents under the Roche license discussed above. These patents cover a broad range of technology applicable across our entire current and planned product line. We have also licensed certain technology from Third Wave Technologies.

Other companies may have patents or patent applications relating to products or processes similar to, competitive with or otherwise related to our current and planned products. Patent law relating to the scope of claims in the technology fields in which we operate, including biotechnology and information technology, is still evolving and, consequently, patent positions in their industry are generally uncertain. We will not be able to assure you that we will prevail in any lawsuits regarding the enforcement of patent rights or that, if successful, we will be awarded commercially valuable remedies. In addition, it is possible that we will not have the required resources to pursue offensive litigation or to otherwise protect our patent rights.

In addition to patent protection, we also rely on protection of trade secrets, know-how and confidential and proprietary information. We generally enter into confidentiality agreements with our employees, consultants and

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their collaborative partners upon commencement of a relationship with them. However, we cannot assure you that these agreements will provide meaningful protection against the unauthorized use or disclosure of our trade secrets or other confidential information or that adequate remedies would exist if unauthorized use or disclosure were to occur. The unintended disclosure of our trade secrets and other proprietary information would impair our competitive advantages and could have a material adverse effect on our operating results, financial condition and future growth prospects. Further, we cannot assure you that others have not or will not independently develop substantially equivalent know-how and technology.

In addition, there is a risk that some of our confidential information could be compromised during the discovery process of any litigation. During the course of any lawsuit, there may be public announcements of the results of hearings, motions and other interim proceedings or developments in the litigation. If securities analysts or investors perceive these results to be negative, it could have a substantial negative effect on the trading price of our common stock.

Our products could infringe on the intellectual property rights of others, which may cause us to engage in costly litigation and, if we are not successful defending any such litigation or cannot obtain necessary licenses, we may have to pay substantial damages and/or be prohibited from selling our products.

Our commercial success depends upon our ability to develop, manufacture, market and sell our products and use our proprietary technologies without infringing the proprietary rights of others. Companies in our industry typically receive a higher than average number of claims and threatened claims of infringement of intellectual property rights. Numerous U.S. and foreign issued patents and pending patent applications owned by others exist in the fields in which we are selling and/or developing or expect to sell and/or develop products. We may be exposed to future litigation by third parties based on claims that our products, technologies or activities infringe the intellectual property rights of others. Because patent applications can take many years to issue, there may be currently pending applications, unknown to us, which may later result in issued patents that our products or technologies may infringe. There also may be existing patents, of which we are not aware, that our products or technologies may inadvertently infringe. Further, there may be issued patents and pending patent applications in fields relevant to our business, of which we may become aware from time to time, that we believe we do not infringe or that we believe are invalid or relate to immaterial portions of our overall business. We will not be able to assure you that third parties holding any of these patents or patent applications will not assert infringement claims against us for damages or seeking to enjoin our activities. We will also not be able to assure you that, in the event of litigation, we will be able to successfully assert any belief we may have as to non-infringement, invalidity or immateriality, or that any infringement claims will be resolved in our favor. Third parties have from time to time threatened to assert infringement or other intellectual property claims against us based on our patents or other intellectual property rights or informed us that they believe we required one or more licenses in order to perform certain of our tests. For instance, we have recently been informed by Bayer Diagnostics, or Bayer, that it believes we require one or more licenses to patents controlled by Bayer in order to conduct certain of our current and planned operations and activities. We, in turn, believe that Bayer may require one or more licenses to patents controlled by us. Although we believe we do not need a license from Bayer for our HIV products, we are in discussions with Bayer concerning the possibility of entering into a cross-licensing or other arrangement, and believe that if necessary, licenses from Bayer would be available to us on commercial terms. However, in the future, we may have to pay substantial damages, possibly including treble damages, for infringement if it is ultimately determined that our products infringe a third party’s patents. Further, we may be prohibited from selling our products before we obtain a license, which, if available at all, may require us to pay substantial royalties. Even if infringement claims against us are without merit, defending a lawsuit will take significant time, and may be expensive and divert management attention from other business concerns.

If we do not successfully introduce new products using our technology, we may not sustain long-term revenue growth.

We may not be able to develop and market new resistance testing products for HIV and other serious diseases, including hepatitis and cancer, or additional assay products. Demand for these products will depend in

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part on the development by others of additional anti-viral and targeted cancer treatment drugs. Physicians will likely use our tests to determine which drug is best for a particular patient only if there are multiple drug treatment options. Several anti-viral and targeted cancer treatment drugs currently are in development but we will not be able to assure you that they will be approved for marketing, or if these drugs are approved that there will be a need for our current or planned testing products. If we are unable to develop and market test products for other viral diseases or for cancer, or if an insufficient number of anti-viral and cancer treatment drugs are approved for marketing, we may not sustain long-term revenue growth.

Our business operations and the operation of our clinical laboratory facility are subject to stringent regulations and if we are unable to comply with them, we may be prohibited from accepting patient samples or may incur additional expense to attain and maintain compliance, which would have an adverse impact on our revenue and profitability.

The operation of our clinical laboratory facilities is subject to a stringent level of regulation under the Clinical Laboratory Improvement Amendments of 1988. Laboratories must meet various requirements, including requirements relating to quality assurance, quality control and personnel standards. Our laboratories are also subject to regulation by the State of California and various other states. We have received accreditation by the College of American Pathologists and therefore are subject to their requirements and evaluation. Our failure to comply with applicable requirements could result in various penalties, including loss of certification or accreditation, and we may be prevented from conducting our business as proposed or as we may wish to in the future.

The FDA may impose medical device regulatory requirements on our tests, including possibly premarket approval requirements, which could be expensive and time-consuming and could prevent us from marketing these tests.

In the past, the FDA has not required that genotypic or phenotypic testing conducted at a clinical laboratory be subject to premarketing clearance or approval, although the FDA has stated that it believes its jurisdiction extends to tests generated in a clinical laboratory. We received a letter from the FDA in September 2001 that asserted such jurisdiction over in-house tests like ours, but which also stated the FDA was not currently requiring premarket approval for HIV monitoring tests such as ours provided that the promotional claims for such tests are limited to its analytical capabilities and do not mention the benefit of making treatment decisions on the basis of test results. The FDA letter to us also asserted that our GeneSeq^™ test had been misbranded due to the use of purchased analyte specific reagents, or ASRs, if test reports do not include a statement disclosing that the test has not been cleared or approved by the FDA. Since 2002, we have utilized in-house prepared ASRs in our products. The FDA has indicated in discussions that the focus of the letter was our genotypic tests and not our phenotypic tests, but there is no certainty its focus will remain narrow.

We have had several discussions with the FDA related to its positions set forth in the letter. We do not at this point believe the FDA will require us to take steps that materially affect our business or financial performance, but cannot guarantee this will remain the case.

We cannot be sure that the FDA will accept the steps we take, or that the FDA will not require us to alter our promotional claims or undertake the expensive and time-consuming process of seeking premarket approval with clinical data demonstrating the sensitivity and specificity of our currently offered tests or tests in development. If premarket approval is required, we cannot be sure that we will be able to obtain it in a timely fashion or at all; and in such event the FDA would have authority to require it to cease marketing tests until such approval is granted.

In general, we cannot predict the extent of future FDA regulation of our business. We might be subject in the future to greater regulation, or different regulations, that could have a material effect on our finances and

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operations. If we fail to comply with existing or additional FDA regulations, it could cause us to incur civil or criminal fines and penalties, increase our expenses, prevent us from increasing revenues, or hinder our ability to conduct our business.

If we do not comply with laws and regulations governing the confidentiality of medical information, we may lose the state licensure we need to operate our business, and may be subject to civil, criminal or other penalties. Compliance with such laws and regulations could be expensive.

The Department of Human Health and Services, or HHS, has issued final regulations under the Health Insurance Portability and Accountability Act of 1996, or HIPAA, designed to improve the efficiency and effectiveness of the health care system by facilitating the electronic exchange of information in certain financial and administrative transactions, while protecting the privacy and security of the information exchanged. Three principal regulations have been issued:

We have implemented the HIPAA privacy regulations. In addition, we implemented measures we believe will reasonably and appropriately meet the specifications of the security regulations and the transaction standards.

These standards are complex, and subject to differences in interpretation. We will not be able to guarantee that our compliance measures will meet the specifications for any of these regulations. In addition, certain types of information, including demographic information not usually provided to us by physicians, could be required by certain payors. As a result of inconsistent application of requirements by payors, or our inability to obtain billing information, we could face increased costs and complexity, a temporary disruption in receipts and ongoing reductions in reimbursements and net revenues. We cannot estimate the potential impact of payors implementing (or failing to implement) the HIPAA transaction standards on our cash flows and results of operations.

In addition to the HIPAA provisions described above, there are a number of state laws regarding the confidentiality of medical information, some of which apply to clinical laboratories. These laws vary widely, and new laws in this area are pending, but they most commonly restrict the use and disclosure of medical information without patient consent. Penalties for violation of these laws include sanctions against a laboratory’s state licensure, as well as civil and/or criminal penalties. Compliance with such rules could require us to spend substantial sums, which could negatively impact our profitability.

We may be unable to build brand loyalty because our trademarks and trade names may not be protected. We may not be able to build brand loyalty around the broader focus of the combined company after our merger with ACLARA.

Our registered or unregistered trademarks or trade names such as the names PhenoSense, PhenoSense GT, PhenoScreen, GeneSeq, and eTag may be challenged, canceled, infringed, circumvented or declared generic or determined to be infringing on other marks. We may not be able to protect our rights to these trademarks and trade names, which we need to build brand loyalty. Brand recognition is critical to our short-term and long-term marketing strategies especially as we commercialize future enhancements to our products. In particular as we broaden the company’s commercial focus from viral diseases to oncology and other serious diseases, we will attempt to establish a corporate identity for that broader business focus, possibly including a new corporate name and logo. Doing so could be expensive and time-consuming. We cannot assure you that we will be successful in establishing brand recognition and loyalty for the combined company.

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Clinicians or patients using our products or services may sue us and our insurance may not sufficiently cover all claims brought against us, which would increase our expenses.

Clinicians, patients and others may at times seek damages from us if drugs are incorrectly prescribed for a patient based on testing errors or similar claims. Although we have obtained product liability insurance coverage of up to $6 million, and expect to continue to maintain product liability insurance coverage, we will not be able to guarantee that insurance will continue to be available to us on acceptable terms or that our coverage will be sufficient to protect us against all claims that may be brought against us. We may not be able to maintain our current coverage, or obtain new insurance coverage for our planned future testing services and products, such as planned testing service and kits for use in connection with the treatment of cancer patients, on acceptable terms with adequate coverage, or at reasonable costs. We may incur significant legal defense expenses in connection with a liability claim, even one without merit or for which we have coverage.

Decreased effectiveness of equity compensation could adversely affect our ability to attract and retain employees, and proposed changes in accounting for equity compensation could adversely affect earnings.

We have historically used stock options and other forms of equity-related incentives as a key component of our employee compensation packages. We believe that stock options and other long-term equity incentives directly motivate our employees to maximize long-term stockholder value and, through the use of long-term vesting, encourage employees to remain with us. The Financial Accounting Standards Board has issued changes to the U.S. generally accepted accounting principles that will require us to record a charge to earnings for employee stock option grants and other option plans as of the first interim period that begins after June 15, 2005. Moreover, applicable stock exchange listing standards related to obtaining stockholder approval of equity compensation plans could make it more difficult or expensive for us to grant options to employees in the future, which may result in changes in our equity compensation strategy. These and other developments in the provision of equity compensation to employees could make it more difficult to attract, retain and motivate employees, and such a change in accounting rules may adversely impact our future financial condition and operating results.

We may be subject to litigation, which would be time consuming and divert our resources and the attention of our management.

In November 2002, we implemented a business restructuring plan. With the exception of one former employee, all of the employees terminated in connection with the business restructuring signed a release of claims. We have received correspondence from the one former employee that did not sign a release threatening to bring claims against us that stem from that termination. As part of our merger with ACLARA, ACLARA terminated approximately 20 of its 55 employees. It is not possible to predict whether any of these employees will assert a claim against us. We do not have employee practices liability insurance to cover any potential claims by employees terminated in the reduction of force or other employment-related claims. Even if we are eventually successful in the defense of such claims, the time and money spent may prevent it from operating our business effectively or profitably or may distract our management.

ACLARA, with which we merged, and certain of its former officers and directors, referred to together as the ACLARA defendants, are named as defendants in a securities class action lawsuit filed in the United States District Court for the Southern District of New York. This action, which was filed on November 13, 2001 and is now captioned ACLARA BioSciences, Inc. Initial Public Offering Securities Litigation, also names several of the underwriters involved in ACLARA’s initial public offering, or IPO, as defendants. This class action is brought on behalf of a purported class of purchasers of ACLARA common stock from the time of ACLARA’s March 20, 2000 IPO through December 6, 2000. The central allegation in this action is that the underwriters in the ACLARA IPO solicited and received undisclosed commissions from, and entered into undisclosed arrangements with, certain investors who purchased ACLARA stock in the IPO and the after-market. The complaint also alleges that the ACLARA defendants violated the federal securities laws by failing to disclose in the IPO

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prospectus that the underwriters had engaged in these allegedly undisclosed arrangements. More than 300 issuers who went public between 1998 and 2000 have been named in similar lawsuits. In July 2002, an omnibus motion to dismiss all complaints against issuers and individual defendants affiliated with issuers (including ACLARA defendants) was filed by the entire group of issuer defendants in these similar actions. On February 19, 2003, the Court in this action issued its decision on the defendants’ omnibus motion to dismiss. This decision dismissed the Section 10(b) claim as to ACLARA but denied the motion to dismiss Section 11 claim as to ACLARA and virtually all of the other defendants. On June 26, 2003, the plaintiffs in the consolidated class action lawsuits announced a proposed settlement with ACLARA and the other issuer defendants. The proposed settlement, which was approved by ACLARA’s board of directors, provides that the insurers of all settling issuers will guarantee that the plaintiffs recover $1 billion from non-settling defendants, including the investment banks who acted as underwriters in those offerings. In the event that the plaintiffs do not recover $1 billion, the insurers for the settling issuers will make up the difference. Under the proposed settlement, the maximum amount that could be charged to ACLARA’s insurance policy in the event that the plaintiffs recovered nothing from the investment banks would be approximately $3.9 million. We believe that ACLARA had sufficient insurance coverage to cover the maximum amount that we may be responsible for under the proposed settlement. While the Federal District Court has preliminarily approved the settlement it is possible that it may not give its final approval to the settlement in whole or part. If a final settlement is not reached or is not approved by the court, we believe that we have meritorious defenses and intend to vigorously defend against the suit. As a result of this belief, no liability for this suit has been recorded in the accompanying financial statements. However, we could be forced to incur significant expenses in the litigation, and in the event there is an adverse outcome, our business could be harmed.

Our operating results may fluctuate from quarter to quarter, making it likely that, in some future quarter or quarters, we will fail to meet estimates of operating results or financial performance, causing our stock price to fall.

If revenue declines in a quarter, our losses will likely increase or our earnings will likely decline because many of our expenses are relatively fixed. Though our revenues may fluctuate significantly as we continue to build the market for our products, expenses such as research and development, sales and marketing and general and administrative are not affected directly by variations in revenue. The cost of our product revenue could also fluctuate significantly due to variations in the demand for our products and the relatively fixed costs to produce them. In addition, there could be significant fluctuations in the amounts recorded in our statement of operations for valuation adjustments to the CVRs and stock based compensation. We will not be able to accurately predict how volatile our future operating results will be because our past and present operating results, which reflect moderate sales activity, are not indicative of what we might expect in the future. As a result it will be very difficult for us to forecast our revenues accurately and it is likely that in some future quarter or quarters, our operating results will be below the expectations of securities analysts or investors. In this event, the market price of our common stock may fall abruptly and significantly. Because our revenue and operating results will be difficult to predict, period-to-period comparisons of our results of operations may not be a good indication of our future performance.

In the event that we need to raise additional capital, our stockholders could experience substantial additional dilution. If such financing is not available on commercially reasonable terms, we may have to significantly curtail our operations or sell significant assets and may be unable to continue as a going concern.

We anticipate that our capital resources, together with funds from the sale of our products, contract revenue and borrowing under equipment financing arrangements, will enable us to maintain our current research and development, marketing, production and general administrative activities related to HIV drug resistance in the United States, together with the planned integration of ACLARA’s business and its eTag technology into our operations, through at least December 31, 2005. The integration of ACLARA’s eTag technology into our operations is expected to include the development of a testing service and possibly test kits for use in connection

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with the treatment of cancer patients. However, we may need additional funding to accomplish these goals. To the extent operating and capital resources are insufficient to meet our obligations, including lease payments and future requirements, we will have to raise additional funds to continue the development, commercialization and expansion of our technologies, including the eTag technology and products based on that technology. Our inability to raise capital would seriously harm our business and product development efforts. In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. However, we cannot guarantee that additional financing, in any form, will be available at all, or on terms acceptable to us. If we sell equity or convertible debt securities to raise additional funds, our existing stockholders may incur substantial dilution and any shares so issued will likely have rights, preferences and privileges superior to the rights, preferences and privileges of our outstanding common and preferred stock. In the event financing is not available in the time frame required, we could be forced to reduce our operating expenses, curtail sales and marketing activities, reschedule research and development projects or delay, scale back or eliminate some or all of our activities. Further, we might be required to sell certain of our assets or obtain funds through arrangements with third parties that require us to relinquish rights to certain of our technologies or products that we would seek to develop or commercialize on our own. These actions, while necessary for the continuance of operations during a time of cash constraints and a shortage of working capital, could make it difficult or impossible to implement our long-term business plans or could affect our ability to continue as a going concern.

If a natural disaster strikes our clinical laboratory facilities and we are unable to receive and or process our customers’ samples for a substantial amount of time, we would lose revenue.

We rely on a single clinical laboratory facility to process patient samples for our tests, which are received via delivery service or mail, and have no alternative facilities. We will also use this facility for conducting other tests we develop, including eTag assays, and even if we move into different or additional facilities they will likely be in close proximity to our current clinical laboratory. Our clinical laboratories and some pieces of processing equipment are difficult to replace and could require substantial replacement lead-time. Our facilities may be affected by natural disasters such as earthquakes and floods. Earthquakes are of particular significance because our facilities are located in the San Francisco Bay Area, an earthquake-prone area, and we do not have insurance against earthquake loss. Our insurance coverage, if any, may not be adequate to cover total losses incurred in a natural disaster. However, even if covered by insurance, in the event our clinical laboratory facilities or equipment is affected by natural disasters, we would be unable to process patient samples and meet customer demands or sales projections. If our patient sample processing operations were curtailed or ceased, we would not be able to perform tests, which would reduce our revenues, and may cause us to lose the trust of our customers or market share.

We use hazardous chemicals and biological materials in our business, and any claims relating to any alleged improper handling, storage, use or disposal of these materials could adversely harm our business.

Our research and development and manufacturing processes involve the use of hazardous materials, including chemicals and biological materials. Our operations also produce hazardous waste products. We will not be able to eliminate the risk of accidental contamination or discharge and any resultant injury from these materials. Federal, state and local laws and regulations govern the use, manufacture, storage, handling and disposal of these materials. We do not maintain insurance coverage for damage caused by accidental release of hazardous chemicals, or exposure of individuals to hazardous chemicals off of our premises. We could be subject to damages in the event of an improper or unauthorized release of, or exposure of individuals to, hazardous materials. In addition, claimants may sue us for injury or contamination that results from our use, or the use by third parties, of these materials, and our liability under a claim of this nature may exceed our total assets. Compliance with environmental laws and regulations is expensive, and current or future environmental regulations may impair our research, development or production efforts.

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Concentration of ownership among some of our stockholders may prevent other stockholders from influencing significant corporate decisions.

Following our merger with ACLARA, approximately 34% percent of our common stock is beneficially held by a small number of stockholders including our directors, our executive officers, and our greater than 5 percent stockholders. The most significant of these stockholders in terms of beneficial ownership are Perry Corp., Deutsche Bank AG, Tang Capital Partners, Sharat Singh and William Young. In addition, our Series A Preferred Stock is held by a small number of stockholders, some of whom also own shares of our common stock and could acquire significant additional shares of our common stock by converting shares of preferred stock. Consequently, a small number of our stockholders may be able to substantially influence our management and affairs. If acting together, they would be able to influence most matters requiring the approval by our stockholders, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets and any other significant corporate transaction. The concentration of ownership may also delay or prevent a change in control of ViroLogic at a premium price if these stockholders oppose it. There are also certain approval rights of the Series A Preferred Stock, and the few holders of those shares could prevent certain important corporate actions by not approving those actions.

Our stock price may be volatile, and our common stock could decline in value.

The market prices for securities of biotechnology companies in general have been highly volatile and may continue to be highly volatile in the future. Our stock price has fluctuated widely during the last two years from a low of $0.72 per share in September 2002 to a high of $4.40 per share in January 2004. The following factors, in addition to other risk factors described in this section, may have a significant negative impact on the market price of our common stock:

A low or volatile stock price may negatively impact our ability to raise capital and to attract and maintain key employees.

We may be required to obtain the consent of the holders of our preferred stock before taking corporate actions, which could harm our business.

Our charter documents require us to obtain the consent of the holders of the Series A Preferred Stock before we may issue securities that have senior or equal rights to the Series A Preferred Stock, incur unsecured indebtedness for borrowed money, or take other actions with respect to the respective series or other securities. We will also be required to obtain the consent of the holders of the Series A Preferred Stock before we amend or

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modify our certificate of incorporation or bylaws to change any of the rights of such series. To obtain these consents, we would need to get consent from holders of a majority of the outstanding shares of the Series A Preferred Stock.

These obligations, and our complicated capitalization structure in general, might frustrate attempts to remove our board or management by making it difficult to find suitable replacements willing to spend substantial amounts of time and efforts on company matters. Moreover, these obligations may deter a potential acquirer from completing a transaction with us. They may also prevent us from taking corporate actions that would be beneficial to us and our stockholders, such as raising capital. Even if we are not prevented from taking such actions, they might be more expensive to us.

If our stockholders sell substantial amounts of our common stock, the market price of our common stock may fall.

If our stockholders sell substantial amounts of our common stock, including shares issued upon the exercise of outstanding options and warrants and upon the conversion of the Series A Preferred Stock, the market price of our common stock may fall. These sales might also make it more difficult for us to sell equity or equity-related securities in the future at a time and price that it deems appropriate. Sales of a substantial number of shares could occur at any time. This may decrease the price of our common stock and may impair our ability to raise capital in the future.

Provisions of our charter documents and Delaware law may make it difficult for our stockholders to replace our management and may inhibit a takeover, either of which could limit the price investors might be willing to pay in the future for our common stock.

Provisions in our certificate of incorporation and bylaws may make it difficult for our stockholders to replace or remove our management, and may delay or prevent an acquisition or merger in which we are not the surviving company. In particular:

The holders of Series A Preferred Stock also have voting rights relating to many types of transactions, such as the creation or issuance of senior or pari passu equity or debt securities and the payment of dividends or distributions, and are subject to redemption at the option of the holder upon certain mergers, consolidations or other business combinations. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law. These provisions could discourage changes of our management and acquisitions or other changes in our control and otherwise limit the price that investors might be willing to pay in the future for our common stock.

We could adopt a stockholder rights plan, commonly referred to as a “poison pill,” at any time without seeking the approval of our stockholders. Stockholder rights plans can act through a variety of mechanisms, but typically would allow our board of directors to declare a dividend distribution of preferred share purchase rights on outstanding shares of our common stock. Each such share purchase right would entitle our stockholders to buy a newly created series of preferred stock in the event that the purchase rights become exercisable. The rights would typically become exercisable if a person or group acquires over a predetermined portion of our common stock or announces a tender offer for more than a predetermined portion of our common stock. Under such a stockholder rights plan, if we were acquired in a merger or other business combination transaction which had not

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been approved by our board of directors, each right would entitle its holder to purchase, at the right’s then-current exercise price, a number of the acquiring company’s common shares at a price that is preferential to the holder of the right. If adopted by the our board of directors, a stockholder rights plan may have the effect of making it more difficult for a third party to acquire, or discourage a third party from attempting to acquire, control of us.

Item 2. Properties

As of March 11, 2005, we leased a building of approximately 41,000 square feet in South San Francisco, California, comprising laboratory and office space. The lease expires in April 2010 and provides an option to extend the term for an additional ten years. We also subleased approximately 27,000 square feet in another adjacent building in South San Francisco, California, comprising laboratory and office space. This sublease expires on December 2006 and provides us with an option to extend the term for one year. In addition, as a result of our merger with ACLARA, we assumed the lease for a building of approximately 44,200 square feet in Mountain View, California comprising laboratory and office space. This lease expires in July 2009. We expect to relocate the operations currently conducted there to our South Francisco, California, facilities during the second quarter of 2005 and are currently attempting to identify a subtenant for this space.

Item 3. Legal Proceedings

ACLARA, with which we merged, and certain of its former officers and directors, referred to together as the ACLARA defendants, are named as defendants in a securities class action lawsuit filed in the United States District Court for the Southern District of New York. See “Commitments and Contingencies” note to the financial statements for further discussion.

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

We held the Annual Meeting of Stockholders on December 10, 2004, and six matters were voted upon. A description of each matter and tabulation of votes are as follows:

The voting for the proposal was as follows:

The voting for the proposal was as follows:

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The voting for the proposal was as follows:

The voting for the proposal was as follows:

The voting for the proposal was as follows:

The following directors’ terms of office continued after the Annual Meeting of Stockholders on December 10, 2004:

Edmon R. Jennings

Cristina H. Kepner

David H. Persing

Upon completion of our merger with ACLARA, the following directors were appointed to our board:

Thomas R. Baruch

John D. Mendlein

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PART II

(a) Market Data; Dividends

Since May 2, 2000, our common stock has been traded on the Nasdaq National Market under the symbol “VLGC.” The following table sets forth, for the periods indicated, the high and low sales prices per share of common stock on the Nasdaq National Market:

The last reported sale price of our common stock on the Nasdaq National Market on March 11, 2005 was $2.31. As of March 11, 2005, there were approximately 300 stockholders of record of our common stock.

We have never declared or paid any cash dividends on our common stock. We currently intend to retain any future earnings for funding growth and, therefore, do not anticipate paying any cash dividends on our common stock in the foreseeable future. Any future determination to pay cash dividends on our common stock will be at the discretion of the board of directors and will be dependent upon our financial condition, results of operations, capital requirements and other such factors as the board of directors deems relevant. In addition, as long as any Series A Preferred Stock is outstanding, we may not, without first obtaining the written approval of the holders of such stock, declare or pay any cash dividends to common stockholders.

In addition, we are obligated to pay dividends to the Series A preferred stockholders. See “Capital Stock” note to the financial statements for further discussion.

Recent Sales of Unregistered Securities.

The following sets forth the number of shares of our common and preferred stock issued in the fourth quarter of 2003. For these issuances, we relied on the exemption provided by Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”):

In October 2004, we issued 232,259 shares of our common stock to one holder of our Series A Preferred Stock upon such holder’s conversion of certain shares of Series A Preferred Stock held by such holder.

In November 2004, we issued 101,328 shares of our common stock to one holder of our warrants upon such holder’s net exercise of warrants held by such holder.

In December 2004, we issued 86,797 shares of common stock with a market value of $0.2 million as of the date of such issuance, to the ViroLogic, Inc. 401(k) Profit Sharing Plan as a matching contribution under the terms of the plan.

Equity Compensation Plans

Information about our equity compensation plans is included in Item 12 of Part III of this Annual Report.

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Item 6. Selected Financial Data

The following selected financial information has been derived from our audited financial statements. The information below is not necessarily indicative of results of future operations, and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and related notes thereto included in Item 8 of this Annual Report on Form 10-K in order to fully understand factors that may affect the comparability of the information presented below.

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Our results for the year ended December 31, 2004 include the acquired operations of ACLARA for the period December 10, 2004 to December 31, 2004. See notes to the financial statements for a description of the number of shares used in the computation of the basic and diluted net loss per common share.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of the financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto included in this Annual Report on Form 10-K. The estimates and certain other statements below are forward-looking statements that involve risks and uncertainties. Our actual future capital requirements and the adequacies of our available funds will depend on many factors, including those under “Risk Factors Related to Our Business.”

OVERVIEW

We are a life sciences company committed to advancing personalized medicine and improving patient outcomes through the development of innovative products that guide and target the most appropriate treatments. Through a comprehensive understanding of genetic structures and the biology and pathology of disease, we have pioneered and are developing molecular diagnostics and laboratory services that will:

Over the last several years, we have built a business based on the personalized medicine approach in HIV drug resistance testing. With our merger with ACLARA BioSciences, Inc., or ACLARA, in December 2004, we intend to leverage the experience and infrastructure we have built in the HIV market to the substantially larger market opportunity of cancer utilizing the proprietary eTag technology. We were incorporated in the state of Delaware in November 1995 and commenced commercial operations in 1999. Our revenues have grown in each year since the commencement of commercial operations as our tests for HIV drug resistance have been adopted more broadly. We have two sources of revenue related to HIV—from testing of patient samples and from testing services provided to pharmaceutical companies in their clinical trials. While our revenue from pharmaceutical companies in 2004 reflected the delay of a phase III clinical trial by a large pharmaceutical customer, this trial has now commenced and is expected to generate revenues in 2005. We expect to generate oncology-related revenues from similar sources with initial revenues from pharmaceutical companies expected in 2005. We currently expect to make our first oncology test available to patients in 2006, after completion of the transfer of the assays from the research setting into the CLIA certified laboratory and after sufficient clinical data has been generated.

We have incurred losses each year since inception. In 2004, in addition to ongoing operating losses, we recorded charges related to the merger with ACLARA, including a $100.6 million charge for in process research and development, a $28.5 million favorable adjustment to the CVR liability and stock-based compensation charges of $3.4 million. We expect to incur additional operating losses at least through 2005 as we complete the development of the eTag technology, transfer the assays into the clinical laboratory, conduct clinical studies and develop the commercial infrastructure to support a commercial launch.

MERGER WITH ACLARA BIOSCIENCES, INC.

On December 10, 2004, we completed our merger with ACLARA, a Delaware corporation, pursuant to an Agreement and Plan of Merger and Reorganization dated May 28, 2004 as amended on October 18, 2004, or the Merger Agreement. Under the terms of the Merger Agreement, each outstanding share of ACLARA common stock was exchanged for 1.7 shares of our common stock and 1.7 Contingent Value Rights, or CVRs. We issued 61.9 million shares of common stock valued at $1.94 per share. The fair value of our common stock utilized in

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determining the purchase price was derived using our average stock price for the period two days before through two days after the amended terms of the acquisition were agreed to and announced on October 19, 2004. The CVRs are governed by a Contingent Value Rights Agreement and are described in more detail in this Item 7 under the heading “Contingent Value Rights.” The transaction has been accounted for as a business combination and accordingly the assets acquired and liabilities assumed have been recorded at their respective fair values. We engaged independent valuation specialists to assist us in determining the fair values of the assets acquired and liabilities assumed. Such a valuation requires us to make significant estimates and assumptions, particularly with regard to the valuation of intangible assets.

The aggregate purchase consideration comprises (in thousands):

The purchase consideration has been allocated based on the fair value of the assets acquired and liabilities assumed, as follows (in thousands):

The merger with ACLARA resulted in substantial non-cash items being recorded in our statement of operations for the year ended December 31, 2004. These include a non-recurring charge for in-process research and development of $100.6 million, other non-operating income of $28.5 million related to a favorable change in fair value of the liability established at closing of the merger for the estimated liability under the CVRs and certain stock compensation charges. These stock compensation charges amounted to $3.4 million, of which $1.2 million is recorded as research and development expense, $0.4 million is recorded as sales and marketing expense and $1.8 million is recorded as general and administrative expense. These charges are primarily the result of the impact of variable accounting, due to the CVRs, for ACLARA options assumed, and the recognition of expense for the value of CVRs related to ACLARA options that vested during the period from December 10, 2004 to December 31, 2004.

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As of the closing date of the merger, with respect to CVRs issued for common stock outstanding and issuable for vested ACLARA options outstanding, we recorded the liability based on estimated fair value using a Black-Scholes based valuation of the underlying CVR securities of $0.66 per CVR, or $43.8 million in the aggregate. Because, subsequent to the closing of the merger, an active trading market has developed for the CVR securities, the liability was revalued at December 31, 2004 based on the actual closing value of the CVRs on the OTC bulletin board of $0.23 per CVR, or $15.3 million in the aggregate. The favorable adjustment of $28.5 million has been recorded as non-operating income in the statement of operations. Further revaluations will be done each quarter based on the actual price of the CVRs at the end of the quarter while the CVRs remain outstanding.

In connection with our merger with ACLARA, we have taken actions to integrate and restructure the former ACLARA operations. We intend to relocate the ACLARA personnel and operations from the facility in Mountain View, California to our South San Francisco, California facilities in the second quarter of 2005. A restructuring accrual was established for the costs of vacating and subleasing the Mountain View facility including an estimate of the excess of our lease costs over our anticipated sublease income. The accrual established at the closing of the merger was $3.0 million, of which $1.3 million is recorded as current and $1.7 million is recorded as long-term. In addition, a restructuring accrual of $1.1 million was established for the anticipated severance costs for ACLARA employees whose employment is terminating as a result of the merger. Changes to the estimates of completing the currently approved restructuring plans that were originally recorded in goodwill will be recorded in goodwill for up to one year following the merger consummation date of December 10, 2004. After December 10, 2005, reductions to these estimates will be recorded as an adjustment to goodwill, while increases to the estimates will be recorded in our results of operations.

Our results for the year ended December 31, 2004 include the acquired operations of ACLARA for the period December 10, 2004 to December 31, 2004.

SUMMARY OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Note 1 to the financial statements describes the significant accounting policies used in the preparation of the financial statements. Certain of these significant accounting policies are considered to be critical accounting policies, as defined below.

A critical accounting policy is defined as one that is both material to the presentation of our financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations. Specifically, critical accounting estimates have the following attributes: 1) we are required to make assumptions about matters that are highly uncertain at the time of the estimate; and 2) different estimates we could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on our financial condition or results of operations.

Estimates and assumptions about future events and their effects cannot be determined with certainty. We base our estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. These changes have historically been minor and have been included in the financial statements as soon as they became known. Based on a critical assessment of our accounting policies and the underlying judgments and uncertainties affecting the application of those policies, we believe that our financial statements are fairly stated in accordance with accounting principles generally accepted in the United States, and present a meaningful presentation of our financial condition and results of operations.

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We believe the following critical accounting policies reflect our more significant estimates and assumptions used in the preparation of our financial statements:

Accounting for Merger with ACLARA

We accounted for the merger with ACLARA as a business combination which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. The judgments made in determining the estimated fair value assigned to each class of assets acquired and liabilities assumed, as well as asset lives, can materially impact our results of operations. Accordingly, for significant items, we obtained assistance from independent valuation specialists.

The excess of the aggregate purchase consideration over the fair value of assets acquired and liabilities assumed has been allocated to goodwill.

Contingent Value Rights

As part of the purchase consideration in our merger with ACLARA, we issued Contingent Value Rights, or CVRs, to ACLARA stockholders and is obligated to issue CVRs to holders of assumed ACLARA stock options upon future exercise of those options. Each CVR represents the right to receive, on June 10, 2006, a potential cash payment, up to $0.88 per CVR, of the amount by which the then-current market value of ViroLogic common stock is less than $2.90 per share. Pursuant to the terms of the related agreement, the determination of the current market value of our common stock at that date will be based on a formula averaging trading prices during the 15 consecutive trading day period immediately prior to June 10, 2006. The first $0.50 per CVR of any such payment that is made must be made in cash, with the balance of up to $0.38 per CVR being payable, at our option, in cash, shares of our common stock, or a combination of cash and our common stock. In addition, we assumed options to purchase shares of ACLARA common stock which are now exercisable for shares of our common stock and CVRs (or applicable cash payment, if any, in lieu of CVRs if exercised after June 10, 2006).

We recorded the initial liability under the CVRs based on the fair value of the liability at the closing date and will record adjustments to this liability based on changes in the fair value each quarter as non-operating income or expense in our statement of operations. As of the closing date of the merger, with respect to CVRs issued in respect of common stock outstanding and issuable in respect of assumed vested ACLARA stock options outstanding, we estimated fair value using a Black-Scholes based valuation of the underlying CVR securities of $0.66 per CVR, or $43.8 million in the aggregate. Because, subsequent to the closing of the merger, an active trading market has developed for the CVR securities, the liability was revalued at December 31, 2004 based on the actual closing value of the CVRs on the OTC bulletin board of $0.23 per CVR, or $15.3 million in the aggregate. In addition, we will record an additional liability each quarter for additional CVRs related to assumed ACLARA stock options that vest during each quarter.

Goodwill, Other Intangible Assets and Impairment of Long-Lived Assets

Goodwill represents the excess of the purchase consideration over the fair values of the identifiable assets acquired and liabilities assumed from our merger with ACLARA. In accordance with Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets”, or SFAS 142, we are required to test for impairment of goodwill on an annual basis and at any other time if events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable.

Other intangible assets include acquired developed product technology, costs of patents and patent applications related to products and products in development, which are capitalized and amortized on a straight-line basis over their estimated useful lives ranging from 8 to 15 years.

We conduct an annual impairment analysis to identify whether the carrying value of intangible assets including goodwill, developed product technology and capitalized patent costs, has been impaired.

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Circumstances that could trigger an impairment test include but are not limited to: a significant adverse change in the business or legal factors; an adverse action or assessment by a regulator; unanticipated competition or loss of key personnel. We concluded that there were no indicators of impairment as of December 31, 2004.

Revenue Recognition

Product revenue is recognized upon completion of tests made on samples provided by customers and the shipment of test results to those customers. Services are provided to certain patients covered by various third-party payor programs, such as Medicare and Medicaid. Billings for services under third-party payor programs are included in revenue net of allowances for differences between the amounts billed and estimated receipts under such programs. We estimate these allowances based on historical payment information and current sales data. If the government and other third-party payors significantly change their reimbursement policies, an adjustment to the allowance may be necessary. Revenue generated from our database of resistance test results is recognized when earned under the terms of the related agreements, generally upon shipment of the requested reports. Contract revenue consists of revenue generated from National Institutes of Health, or NIH, grants, commercial assay development and other non-product revenue. NIH grant revenue is recorded on a reimbursement basis as grant costs are incurred. The costs associated with contract revenue are included in research and development expenses. For commercial and research collaborations, we recognize non-refundable milestone payments received related to substantive at-risk milestones when performance of the milestone under the terms of the collaboration is achieved and there are no further performance obligations. Research and development fees from commercial collaboration agreements are generally recognized as revenue on a straight-line basis over the life of the collaboration agreement or as the research work is performed. Deferred revenue relates to up front payments received in advance of meeting the revenue recognition criteria described above.

In accordance with Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables,” revenue arrangements entered into after June 15, 2003, that include multiple deliverables, are divided into separate units of accounting if the deliverables meet certain criteria, including whether the stand alone fair value of the delivered items can be determined and whether there is evidence of fair value of the undelivered items. In addition, the consideration is allocated among the separate units of accounting based on their fair values, and the applicable revenue recognition criteria are considered separately for each of the separate units of accounting.

Accounts Receivable

The process for estimating the collectibility of receivables involves significant assumptions and judgments. Billings for services under third-party payor programs are recorded as revenue net of allowances for differences between amounts billed and the estimated receipts under such programs. Adjustments to the estimated receipts, based on final settlement with the third-party payors, are recorded upon settlement as an adjustment to net revenue.

In addition, we review and estimate the collectibility of our receivables based on the period of time they have been outstanding. Historical collection and payor reimbursement experience is an integral part of the estimation process related to reserves for doubtful accounts. In addition, we assess the current state of our billing functions in order to identify any known collection or reimbursement issues in order to assess the impact, if any, on our reserve estimates, which involves judgment. We believe that the collectibility of our receivables is directly linked to the quality of our billing processes, most notably those related to obtaining the correct information in order to bill effectively for the services we provide. As such, we have implemented procedures to reduce the number of requisitions that we receive from healthcare providers with missing or incorrect billing information. Adjustments in reserve for doubtful accounts estimates are recorded as an adjustment to bad debt expense within general and administrative expenses. We believe that our collection and reserves processes, along with our close monitoring of our billing processes, helps to reduce the risk associated with material revisions to reserve estimates resulting from adverse changes in collection and reimbursement experience and billing operations.

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Deemed Dividends

We estimated a beneficial conversion feature for our convertible preferred stock in accordance with Emerging Issues Task Force Consensus No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features” and No. 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments” based on the difference between the estimated conversion price and common stock fair market value at the date of issuance. We use the Black-Scholes option valuation model to estimate the conversion price at the date of issuance. This model considers a number of factors requiring judgment including the weighted-average expected life and the volatility factor of the expected market price of our common stock. We recorded the beneficial conversion feature as a deemed dividend on our statement of operations in 2002 and 2003, resulting in an increase to the loss applicable to common stockholders in the calculation of basic and diluted net loss per common share.

Deferred Tax Assets

We record a valuation allowance to reduce our deferred tax assets to the amount that we believe is more likely than not to be realized. Due to our lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance.

Stock Based Compensation

We have elected to continue to follow Accounting Principles Board Opinion No. 25 “Accounting for Stock-Based Compensation”, or APB 25, to account for employee stock options. Under APB 25, no compensation expense is recognized when the exercise price of our employee stock options equals or exceeds the market price of the underlying stock on the date of grant. Deferred compensation, if recorded, is amortized using the graded vesting method. Statement of Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation”, or SFAS 123, as amended by Statement of Financial Accounting Standards Board Statement No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123”, or SFAS 148, requires the disclosure of pro forma information regarding net loss and loss per share as if we had accounted for stock options under the fair value method. See “Summary of Significant Accounting Policies” note to the financial statements for further discussion.

We recognize compensation expense for assumed ACLARA options based on the intrinsic value of the option in accordance with APB 25 since the entitlement to CVRs upon exercise of those options causes an indeterminate exercise price for the optionee.

We account for stock option grants to non-employees in accordance with the Emerging Issues Task Force Consensus No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which requires the options subject to vesting to be periodically re-valued over their service periods. We estimate the fair value of these stock options and stock purchase rights at the date of grant using the Black-Scholes option valuation model, which considers a number of factors requiring judgment.

In December 2004, the FASB issued Statement 123R, “Share-Based Payment,” which requires public companies to measure compensation cost for all share-based payments (including employee stock options) at fair value, effective for public companies for interim or annual periods beginning after June 15, 2005. The standard requires companies to expense the fair value of all stock options that have future vesting provisions, are modified, or are newly granted beginning on the grant date of such options. We will be required to implement this standard for the quarter ending September 30, 2005. We are currently evaluating the requirements of SFAS 123R as well as option valuation methodologies related to our employee and director stock options and employee stock purchase plan. Although we have not yet determined the method of adoption or the effect of adopting SFAS 123R, we expect that the adoption of SFAS 123R will have a material impact on our results of operations

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and loss per common share. The impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on, amount other things, the levels of share-based payments granted in the future, the method of adoption and the option valuation method used.

RESULTS OF OPERATIONS

Year Ended December 31, 2004 Compared to Years Ended December 31, 2003 and 2002.

Revenue. Revenue was $36.8 million, $33.4 million and $25.3 million in 2004, 2003 and 2002, respectively. The increase of $3.4 million in 2004 as compared to 2003 and $8.1 million in 2003 as compared to 2002 was primarily due to growth in the HIV resistance testing market and demand for our PhenoSense HIV, PhenoSense GT and GeneSeq HIV products for patient and pharmaceutical testing. Contract revenue consists of revenue from NIH research grants, commercial assay development and other non-product revenue. In 2003, we were awarded four Small Business Innovation Research, or SBIR, grants from the National Institute of Allergy and Infectious Diseases, or NIAID, a division of the NIH. In 2004, we were awarded one new SBIR grant from the NIAID, for a total of five grants totaling more than $5 million over three years. These grants will help support the development of analytical and database tools to facilitate the identification and characterization of drug resistant strains of HIV, and assays that will aid in the pre-clinical and clinical evaluation of the next generation of anti-viral therapeutics. We believe increased demand for existing and new products, including the use of our assays in clinical trials by pharmaceutical customers, will be the primary factors contributing to an increased level of sales in 2005 as compared to 2004. We expect to generate initial oncology-related revenues from pharmaceutical companies in 2005 and to make our first oncology test available to patients in 2006, after completion of the transfer of the assays from the research setting into the CLIA certified laboratory and after sufficient clinical data has been generated. We anticipate quarterly variations in revenue due to the timing of various clinical studies for pharmaceutical customers and the seasonal effects observed in patient testing, which have historically occurred in the first quarter.

Cost of product revenue. Cost of product revenue was $17.8 million, $16.7 million and $14.6 million in 2004, 2003 and 2002, respectively. The increase of $1.1 million in 2004 as compared to 2003 and $2.1 million in 2003 as compared to 2002 was due to the higher volume of testing. Included in these costs are materials, supplies, labor and overhead related to product revenue. Gross margins increased to 49% in 2004 from 48% in 2003 and 41% in 2002. The increase was primarily due to improved operational efficiency and economies of scale and implementation of the 2002 business restructuring plan as discussed below. We anticipate that gross margin on product revenue will continue to improve as revenue increases and further operational efficiencies and economies of scale are achieved. We expect that expenses will be impacted by stock based compensation primarily related to variable accounting for assumed ACLARA stock options with CVRs attached and CVR expenses related to vested options during the period, and in the second half of 2005 by the implementation of SFAS 123R which will require the recognition of expense for all stock options. The impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on, among other things, the levels of share-based payments granted in the future, the method of adoption and the option valuation method used.

Research and development. Research and development costs were $7.8 million, $4.7 million and $10.4 million in 2004, 2003 and 2002, respectively. The increase of $3.1 million in 2004 as compared to 2003 was due

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to the inclusion of $1.2 million in stock based compensation related to variable accounting for assumed ACLARA stock options with CVRs attached and CVR expenses related to vested options during the period, approximately $0.4 million in other costs related to oncology and eTag research and development programs in the period from the closing of the merger on December 10, 2004 to December 31, 2004, and additional costs incurred to support grants awarded. The decrease of $5.7 million in 2003 as compared to 2002 was primarily the result of reallocating certain research and development personnel and resources to revenue generating activities, and implementation of the 2002 business restructuring plan as discussed below.

With the completion of our merger with ACLARA, we have expanded our business focus from infectious diseases to include both infectious diseases and oncology, and with the integration of the former ACLARA operations into our operations, our research and development expenditures have increased and will increase significantly in 2005 because of the full year impact of oncology related programs. In addition, we expect to incur additional expenses as we increase our expenditures on oncology programs in preparation for a planned introduction of commercial products. During 2005, we expect to incur expenses to transfer the eTag assays from the research setting to our CLIA certified clinical laboratory and to generate clinical data in support of a commercial launch of eTag assays. The successful development of our products is highly uncertain. Completion dates and research and development expenses can vary significantly for each product and are difficult to predict. For a more complete discussion of the risks and uncertainties associated with completing the development of products, see the “Risk Factors Related to Our Business” above.

We also expect that expenses will be impacted by stock based compensation primarily related to variable accounting for assumed ACLARA stock options with CVRs attached and CVR expenses related to vested options during the period, and in the second half of 2005, by the implementation of SFAS 123R which will require the recognition of expense for all stock options. The impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on, among other things, the levels of share-based payments granted in the future, the method of adoption and the option valuation method used.

Our products in development for HIV and other infectious diseases target viral diseases and reflect a number of approaches to assessing resistance in individual patients to particular drugs. Our product lines overlap and most of our research and development activities in infectious disease are advancing multiple potential product lines. Due to this substantial overlap, we do not track costs on a project by project basis, except for the costs related to contract revenue. A portion of our infectious disease research and development expenses are funded by grants and commercial contracts and the following table sets our costs that are included in research and development expenses that are associated with such revenues:

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Below is a summary of our products in development for HIV and other infectious diseases.

Following our merger with ACLARA, some of our research and development expenditures are now directed at continuing the research and development of the eTag System. Our eTag technology has potential application as a research tool in drug discovery and development in gene expression profiling and protein expression analysis. These applications have been considered as developed product technology in the allocation of the purchase consideration for ACLARA, although some ongoing research and development expenditures continue. In addition, our eTag technology has the potential, through detection of unique protein-based biomarkers, to differentiate likely responders from non-responders to certain targeted therapies in certain patient groups. Assays based on this technology have the potential to be used as aides for patient selection in pharmaceutical companies’ clinical trials of therapeutic products targeted on specific patient populations and as diagnostic services and/or kits to guide physicians in the selection of appropriate therapies for particular patients. Products in development are as follows: