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Contents

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Item 1. Business.

The Company

KaloBios is a biopharmaceutical company focused on the development of monoclonal antibody therapeutics for diseases that represent a significant burden to society and to patients and their families. We are developing patient-targeted, first-in-class medicines to treat serious medical conditions ( Figure 1 ). By focusing on disease-specific targets and patient selection criteria, we aim to provide patients with medicines that are safe and effective and offer innovative approaches to the current treatments. Our primary clinical focus is on respiratory diseases and cancer. We currently have two antibodies for the treatment of respiratory diseases scheduled to begin Phase 2 clinical trials in the third quarter of 2012 and early 2013 and one antibody in Phase 1 clinical testing for hematological malignancies. Our business model is to identify and develop products through proof-of-concept studies, and then seek partnerships for further development while retaining commercial rights in specialty or orphan indications.

Patients with ventilator-associated pneumonia (VAP) caused by Pseudomonas aeruginosa ( Pa ) have a high mortality rate, with greater hospital utilization costs than patients without pneumonia. Chronic infection with Pa is a leading contributor to respiratory deterioration that, in individuals with cystic fibrosis (CF), ultimately leads to respiratory failure and death. Our first antibody, KB001-A (a Humaneered™, recombinant Fab´ antibody fragment), is being developed for the prevention and treatment of Pa infections. VAP caused by Pa infection in patients receiving mechanical ventilation ( Pa VAP) and CF patients with chronic Pa lung colonization each represents a significant market opportunity for KB001-A. In January 2010, we entered into an agreement granting Sanofi Pasteur (Sanofi), the vaccines division of the Sanofi Group, exclusive worldwide rights to develop KB001-A for all indications, the lead indication being the prevention of Pa VAP. We retained the right to study KB001-A in CF patients. Under this agreement, Sanofi can elect to exercise its option for certain development and commercial rights to the CF indication based on pre-negotiated terms, at any time up to 90 days after the conclusion of our Phase 2 clinical trial. We are preparing to launch a randomized, placebo-controlled, Phase 2 clinical trial in CF, to investigate the efficacy and safety of KB001-A, by early 2013.

Worldwide, asthma impacts more than 300 million people. We are developing our second antibody, KB003 (a Humaneered™, recombinant, anti-granulocyte macrophage colony-stimulating factor (anti-GM-CSF) IgG1κ monoclonal antibody), for the treatment of asthma inadequately controlled by corticosteroids, an indication that needs better treatment options. Severe asthma not well treated with current standard therapies comprises approximately 5 - 10% of the asthma population in the United States, Europe, and Japan. We plan to launch a Phase 2 clinical trial in individuals with asthma inadequately controlled by corticosteroids in the third quarter of 2012.

Cancer is among the leading causes of death worldwide and the second leading cause of death in the United States. The National Institutes of Health estimates that the cost of medical treatment for cancer will be $158 billion in the year 2020. Our third antibody, KB004, is a Humaneered™, recombinant antibody directed against EphA3 receptor tyrosine kinase, which is an oncofetal antigen involved in the development and maturation of cells and is expressed on the surface of hematologic and solid tumor cells and the stem cell microenvironment but not on normal cells. As a result, we believe KB004 has the potential to be a novel approach to treating both hematologic malignancies and solid tumors. KB004 is currently in Phase 1 clinical development.

We have an early-stage antibody program, KB005, which may have application in asthma, chronic rhinosinusitis, eosinophilic esophagitis, chronic obstructive pulmonary disease (COPD), inflammatory bowel disease, and hypereosinophilic syndrome.

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Figure 1

KaloBios Patient-Targeted Therapies

All our antibodies were generated using our proprietary Humaneered™ technology, a method that converts nonhuman antibodies (typically mouse) into engineered, human antibodies that have a high binding affinity to their target and are designed for chronic therapeutic use. We believe that antibodies produced with our Humaneered™ technology offer important clinical and economic advantages over antibodies generated by other methods, in terms of high binding affinity, high manufacturing yields, and minimal to no immunogenicity (undesired immune response) upon repeat administration.

With each of our antibody programs, we take a patient-targeted approach by developing a prognostic screen or diagnostic to identify those most likely to benefit from our therapies. We believe this targeted approach will result in an enhanced treatment benefit, reduce the overall cost and risk associated with clinical development, and ultimately provide therapies that are safer and more effective than current treatments.

Our company was incorporated in California on March 15, 2000 and reincorporated as a Delaware corporation in 2001. We are located in South San Francisco, California and as of May 31, 2012 have 19 full-time employees, in development and administration.

Strategy

Our goal is to become a leading biopharmaceutical company focused on the development and commercialization of first-in-class, patient-targeted, monoclonal antibody therapeutics that address serious medical needs. Key elements of our strategy are to:

Industry

The introduction of biologic therapeutics over the last 20 years has had a dramatic impact on many areas of medicine, from infectious, inflammatory, autoimmune, and respiratory diseases to hematology and oncology. The efficacy and safety of such biologic drugs has driven impressive market growth, with worldwide sales in 2010 of $138 billion. EvaluatePharma data indicate that therapeutic monoclonal antibody products are the most rapidly growing sector in biopharmaceuticals, with 2010 global sales of greater than $48 billion and expected 2015 global sales approaching $80 billion. At least thirty antibody products have been approved by the U.S. Food and Drug Administration (FDA) and international regulatory authorities, and more than 300 antibodies are in various stages of clinical development. According to a 2010 study by Tufts University, antibody products have shown a 2.5 times higher probability of successful clinical development as compared to small-molecule drugs.

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Product Development Programs: KB001-A

Overview

KB001-A, a Humaneered™, high-affinity monoclonal antibody fragment, is being developed for the prevention and treatment of infections by Pa , a gram-negative bacterium that may cause pneumonia in mechanically ventilated patients and chronic respiratory infections in individuals with CF. In January 2010, we licensed rights to KB001-A to Sanofi, retaining the rights for development of a CF therapeutic subject to Sanofi’s right to opt in. Sanofi plans to develop and commercialize KB001-A for the prevention and/or treatment of Pa VAP. We received an up-front payment of $35 million from Sanofi in 2010 and an additional $5 million in 2011. Further, our agreement provides us with the potential to receive additional contingent payments from Sanofi of up to an aggregate of $250 million on achievement of certain clinical, regulatory, and commercial events, as well as royalty payments on commercial Pa VAP sales of KB001-A. We plan to initiate a Phase 2 clinical trial of KB001-A in Pa -infected CF patients by early 2013. Sanofi can elect to opt into the program in accordance with pre-negotiated terms at any time within 90 days after the conclusion of the Phase 2 clinical trial for ex-U.S. rights or for worldwide rights and a profit-sharing arrangement with us in the United States.

We have an exclusive license for the intellectual property rights related to the drug target and method to prevent and treat Pa , as well as the lead mouse antibody, from the University of California at San Francisco and the Medical College of Wisconsin.

Market Opportunities

Treatment and Prevention of Pa Ventilator-Associated Pneumonia

According to Decision Resources, there are approximately 250,000 acute Pa hospital infections in the United States and 410,000 such infections in Europe, with the highest percentage represented by mechanically ventilated patients. Patients on mechanical ventilation for longer than 48 hours are at increased risk for endotracheal tube Pa colonization and subsequent development of Pa VAP. VAP occurs in approximately 8-28% of mechanically ventilated patients, with Pa estimated to be the cause of approximately 25% of VAP infections each year in the United States, Japan, and Europe. The mortality of VAP is estimated at 25% to 50% despite treatment with antibiotics. In the United States, VAP survivors spend an average of 5-7 days in the intensive care unit (ICU), at a cost of approximately $40,000 per admission. U.S. hospitals, under pressure to reduce government reimbursement and faced with increased requirements for public disclosure, have strong incentive to reduce the incidence of VAP. We believe the worldwide market for KB001-A for the prevention and treatment of Pa VAP to be approximately $1 billion annually.

Chronic Pa Infections in Cystic Fibrosis

CF, most common among Caucasians, is characterized by a thick, sticky mucus buildup, most critically in the lungs. The median life expectancy for those with CF in the United States is only 37.4 years. The most common causes of death are related to CF lung deterioration, believed to be caused predominantly by chronic infection with Pa , the most prevalent pathogen found in the lungs of individuals with CF. The prevalence of chronic Pa infection in the CF population increases with age, with positive respiratory tract cultures in 20% to 30% of infants, 30% to 40% of children aged 2 to 10 years, 60% of adolescents, and approximately 80% of adults. Once individuals with CF are chronically infected with Pa, typically as teenagers, their lung function slowly deteriorates over time at a rate of 2% to 4% per year, with gradual loss of lung function leading to death. Chronic Pa infection is associated with greater morbidity and mortality, with earlier onset associated with a more severe loss of lung function and shorter life expectancy. There are approximately 1,000 new cases of CF each year in the United States, with a prevalence of approximately 30,000 individuals in the United States and 70,000 worldwide. We estimate that CF represents a market potential for KB001-A of $250 million to $500 million annually in the United States and Europe.

Background and Mechanism of Action

We believe KB001-A has a novel mechanism of action versus currently approved antibiotic treatments for Pa infections. Based on our studies, KB001-A directly blocks the means by which Pa causes serious lung infection but, unlike antibiotics, does not directly kill the bacterium. Instead, KB001-A binds to and blocks the function of the PcrV protein. The PcrV protein is an extracellular component of the type III secretion system (TTSS) which enables the bacterium to kill epithelial and immune cells either by direct puncture (oncosis) or injection of protein toxins. Free toxins also promote the release of pro-inflammatory cytokines leading to more tissue damage. Blocking PcrV function prevents immune cell killing by Pa and reduces inflammatory cytokine release. The mechanism of action of KB001-A is illustrated in Figure 2 . The KB001-A molecule has been optimized as a Fab´ fragment rather than as a full antibody so that it does not activate immune response and exacerbate inflammation. To extend its time in the bloodstream and protect against breakdown by Pa , polyethylene glycol (PEG) was added to the KB001-A molecule, which is a process called PEGylation.

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Figure 2

KB001-A Mechanism of Action against Pseudomonas aeruginosa Infection

Source: KaloBios Pharmaceuticals, Inc.

We believe the possibility for Pa to develop resistance to KB001-A is low because, unlike current antibiotics to which the bacteria develop resistance, KB001-A neutralizes or detoxifies Pa rather than killing it. Thus, KB001-A is not subject to “selective pressure” drug resistance mechanisms that affect antibiotics. KB001-A protects the host immune cells from Pa , thereby enabling the natural clearance mechanism to fight disease. In animal experiments, anti-PcrV antibodies such as KB001-A demonstrated an ability to protect the immune system and allow it to remove or kill the bacteria. Because this mechanism is different from existing treatments, KB001-A may also work in conjunction with existing CF therapies such as inhaled antibiotics and mucolytics, as well as newer CF transmembrane conductance regulator (CFTR) modulators.

Anti-PcrV Preclinical Activity Summary

In preclinical studies, anti-PcrV antibodies protected rats, mice, and rabbits from a lethal challenge of live Pa delivered directly into the airways. Bacteria were cleared from the lungs of infected animals within 48 hours of dosing with antibodies. Tobramycin, ciprofloxacin, and ceftazidime, representing three different classes of antibiotics that directly kill bacteria, have been shown to work in combination with anti-PcrV antibodies in acute Pa infection models in mice, which we believe supports their use with anti-PcrV antibodies in clinical trials. Anti-PcrV antibodies have also been shown to enhance the activity of the antibiotic imipenem against imipenem-resistant Pa lung infection in neutropenic mice. This suggests that some antibiotics that are ineffective due to drug resistance mechanisms could be effective when dosed in combination with KB001-A. It is also encouraging that neutrophils, a type of white blood cell, may not be essential for the protective effect of the antibody because some patients may be neutropenic due to their underlying disease or treatment.

In a chronic Pa lung infection animal model, anti-PcrV antibodies reduced the level of inflammatory cytokines in the lungs compared to untreated control animals. This model demonstrated the anti-inflammatory action of anti-PcrV antibodies during chronic Pa lung infection and the potential of this approach in the treatment of chronic Pa lung infection in CF.

KB001-A Clinical Development Program

We have completed three clinical trials with KB001 (the predecessor molecule to KB001-A, as described in more detail below). A Phase 1 trial in 15 healthy adult volunteers showed that KB001 was well tolerated in humans, with no immunogenicity, dose-limiting toxicities (DLTs), or drug-related serious adverse events (SAEs) observed. We subsequently completed two Phase 1/2 trials of KB001, one in France in Pa -colonized, ventilator-supported patients hospitalized in ICUs, and one in the United States in individuals with CF who are infected with Pa . Table 1 summarizes the clinical development for KB001.

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We are developing KB001-A as the successor antibody to KB001. KB001-A and KB001 bind to the same target site and have been shown to be functionally comparable. KB001-A is a slight modification to KB001 but is more efficient to produce, thus reducing manufacturing cost. We are currently conducting animal toxicity studies to demonstrate the safety of KB001-A. We plan to meet with the FDA regarding comparability and safety of KB001-A prior to initiating our Phase 2 clinical trial in CF, which we plan to initiate by early 2013. All future clinical and preclinical studies will be conducted using KB001-A.

Pa VAP Treatment and Prevention Clinical Development Program

Our Phase 1/2 study of KB001, the precursor to KB001-A, for the treatment and prevention of Pa pneumonia was designed to assess safety and tolerability. The trial design required lab culture screens to select subjects colonized with Pa , who were then randomized into three treatment groups: standard of care medications only (control group), standard of care co-administered with low-dose KB001, and standard of care co-administered with high-dose KB001.

KB001 was well tolerated, with no drug-related SAEs, and there was a greater trend toward prevention of Pa pneumonia versus standard of care, with a reduction in the occurrence of Pa pneumonia by nearly 50% 28 days following a single dose of KB001 10 mg/kg ( Figure 3 ).

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Figure 3

KB001 Was Effective in Preventing Pa Ventilator-Associated Pneumonia in a Single-Dose Study

Source: KaloBios Pharmaceuticals Inc. clinical study report.

Our partner, Sanofi, plans to continue the development of KB001-A in Pa -VAP with a Phase 1 intravenous pharmacokinetic and safety clinical trial, followed by a Phase 2 intravenous study to determine the safety and efficacy of KB001-A in preventing Pa -VAP. The Phase 2 study, along with a subsequent Phase 3 study, may serve as the basis for registration of KB001-A in the prevention of Pa -VAP. Because Sanofi has exclusive rights for the development of Pa -VAP, we do not have control over the conduct or timing of the studies for this indication. For additional information, see “Licensing and Collaborations.”

Cystic Fibrosis Clinical Development Program

We conducted a Phase 1/2 trial in individuals with CF and chronic Pa respiratory infection to assess the safety and tolerability of KB001. In this single-dose study, KB001 was found to be safe, with no drug-related SAEs. When sputum samples were assessed, KB001-treated groups (10 mg/kg) showed a trend toward reduction in inflammation biomarkers, with a statistically significant, short-term reduction in neutrophil elastase and IL-1 ( Table 2 ). Neutrophil elastase is of particular clinical interest because not only is it a marker of inflammation, it is also believed to be the cause of some of the irreversible lung damage in CF. A single dose of KB001 caused a reduction in neutrophil elastase similar to 14 days of hospital treatment with intravenous antibiotics given for exacerbation of CF. For the 10mg/kg group, a significant reduction from placebo was noted at day 28 for neutrophils in sputum. This trend toward reduction in inflammatory biomarkers is consistent with the activity of anti-PcrV treatment in a chronic disease model of Pa lung infection in mice, which caused a reduction in lung neutrophils and inflammatory cytokines.

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Table 2

KB001 Showed a Statistically Significant

Reduction in Neutrophil Elastase in a Single-Dose Study of

27 Subjects with Cystic Fibrosis and Chronic Pa Respiratory Infection

Source: KaloBios Pharmaceuticals Inc. Clinical Study Report KB001-03, Text Table 9

We plan to build on our KB001 CF clinical study experience by developing KB001-A as a treatment to reduce lung inflammation in CF patients with chronic Pa infection. If cleared by the FDA, we plan to enroll 150 such subjects in a 12-week, double-blind, placebo-controlled, repeat-dose, Phase 2 trial of KB001-A administered monthly by intravenous infusion. The primary endpoint will be time to need for antibiotics to treat worsening of respiratory tract signs and symptoms, with secondary endpoints of changes in inflammatory markers, respiratory symptoms, subject-reported outcomes, changes in forced expiratory volume in 1 second (FEV ₁ , a measure of lung function), PK, safety, and tolerability. All subjects will receive standard inhaled antibiotic therapy during the first 4 study weeks, concurrently with doses of KB001-A or placebo through week 12. The trial will be conducted primarily in North America, in conjunction with the Cystic Fibrosis Foundation Therapeutic Development Network.

Data from this trial will be used to support pivotal trials of a subcutaneous formulation of KB001-A. We anticipate that two Phase 3 trials as well as subcutaneous bridging evaluations will be required for registration of KB001-A in CF. The pivotal program would be dose ranging in nature and designed to support the approval of subcutaneous KB001-A for the management of respiratory Pa infection , either as a monotherapy or in combination with inhaled antibiotics.

Current inhaled antibiotics acutely improve FEV ₁ ; however, these treatments do not change the overall rate of lung function deterioration. Chronic use of KB001-A has the potential to reduce the inflammation caused by Pa and therefore slow the decline in FEV ₁ . Demonstration of a disease-modifying effect may be pursued following regulatory approval for a first CF indication.

The concept of using an anti-inflammatory drug as a disease-modifying therapy in CF has been tested clinically. Clinical trials of an anti-inflammatory drug (ibuprofen) have shown that the steady deterioration over years of lung function (the leading cause of death) can be altered with chronic use. However, this therapy is not approved by the FDA for use in CF. The ibuprofen doses needed are so high that patients must be monitored carefully for adverse effects. We believe KB001-A has the potential of being disease-modifying because it may act as a safe anti-inflammatory agent to reduce the rate of lung deterioration.

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Product Development Programs: KB003

Overview

KB003 is a Humaneered™, monoclonal antibody that targets and neutralizes human granulocyte macrophage colony-stimulating factor (GM-CSF), with potential for use in inflammatory and autoimmune indications. GM-CSF is an important part of an inflammatory cascade that stimulates white blood cells (granulocytes, including eosinophils, neutrophils, and macrophages) and maintains them in an active state during infection. However, excessive GM-CSF is thought to play a key role in tissue damage associated with inflammatory diseases including asthma and rheumatoid arthritis (RA). The results of anti-GM-CSF in ex vivo studies suggest KB003 has potential in treating asthma, chronic obstructive pulmonary disease (COPD), RA, multiple sclerosis (MS), and certain oncology applications.

Data from our single-dose, Phase 1/2 clinical trials with monoclonal antibody KB002, the chimeric predecessor to the Humaneered™ KB003, support our clinical trials with KB003. In these studies, KB002 was safe and well tolerated. KB003 targets the same binding site as KB002 and has been shown to be functionally similar and safe in our early clinical trials. After discussions with the FDA regarding transitioning our anti-GM-CSF clinical development program from KB002 to KB003, we initiated a repeat-dose, Phase 2 clinical trial with KB003 in RA. On completing the run-in safety portion of this trial, which showed KB003 to be safe and well tolerated with no clinically significant adverse events, we reassessed the increasingly competitive and crowded RA market and chose to redirect our study of KB003 to asthma inadequately controlled by corticosteroids. We are planning to initiate a randomized, Phase 2 clinical trial of asthma inadequately controlled by corticosteroids in the third quarter of 2012.

We licensed KB002, a low picomolar affinity, novel chimeric antibody, from the Ludwig Institute in 2004. KB003 is a Humaneered™ version of the KB002 antibody, with the same epitope target and therefore the same mechanism of action. We plan to use KB003 for all future clinical studies.

Market Opportunity for GM-CSF Inhibitors

Severe Asthma

We are targeting asthma patients who are nonresponsive to standard of care inhaled corticosteroids and beta agonists as the first indication for KB003 because of the high unmet medical need. Asthma is a respiratory condition in which pulmonary airways become inflamed and constricted, usually in response to one or more environmental triggers. Although serious and potentially fatal if left untreated, asthma usually can be managed with drug therapy and by avoiding disease triggers. More than 300 million people suffer from asthma, representing global sales of more than $17 billion annually. Though severe asthma represents approximately 5 - 10% of this market, with prevalence in the United States, Europe, and Japan, it is responsible for approximately 50% of asthma hospitalization costs. At least half of those with severe asthma are believed to suffer from non-allergic asthma.

Asthma treatments currently available on the market, such as long-acting beta agonists (LABAs), inhaled corticosteroids, and omalizumab (anti-igE), are often ineffective for more severe cases of asthma. The monoclonal antibody, omalizumab, is limited to treatment of moderate to severe, allergic asthma in patients with positive immunoglobulin E (IgE). Other monoclonal antibodies in clinical development predominantly target allergic rather than non-allergic asthma. Because anti-GM-CSF treatment reduces the activity of the eosinophils or neutrophils that predominate in both types of asthma, KB003 has the potential to treat both allergic and non-allergic severe asthma.

Background and Mechanism of Action

Two main forms of asthma exist: allergic or atopic asthma, characterized by the presence of large numbers of eosinophils in pulmonary airways, and non-allergic or non-atopic asthma, in which neutrophils predominate. Because GM-CSF plays an important role in the differentiation, proliferation, and enhanced survival of both inflammatory cell types ( Figure 4 ), we believe reduction of excess GM-CSF is a potentially effective treatment for severe asthma. We believe KB003 is unique among antibodies being developed to treat asthma because it reduces inflammation caused by both eosinophils and neutrophils, thus acting on both the allergic and non-allergic forms of asthma. Diagnosed cases of asthma are believed to be divided approximately equally between both types. Because available therapies for severe asthma treat predominantly allergic asthma, KB003 may provide a clinical and commercial advantage by treating both allergic and non-allergic severe asthma.

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Figure 4

KB003 Acts on Both Allergic and Non-Allergic Asthma

Source: Douwes J, Gibson P, Pekkanen J, Pearce N. Non-eosinophilic asthma: importance and possible mechanisms. Thorax. 2002;57(7):643-648. Adapted to show role of KB003.

Anti-GM-CSF Preclinical Activity Summary

Data from animal studies support the neutralization of GM-CSF for the treatment of allergic and non-allergic asthma. Mice sensitized to allergens respond to allergen challenge with a large increase in eosinophils in their lungs. Mutant mice lacking the GM-CSF gene are unable to mount an eosinophilic response, suggesting that GM-CSF is essential for increasing eosinophils in allergic asthma. Similarly, allergen-sensitized mice treated with anti-GM-CSF antibody show a reduction in eosinophils in the lungs following allergen challenge. In regard to non-allergic asthma, mice challenged with intranasal bacterial extract experience neutrophilic cell infiltration into their lungs. Treatment with an anti-GM-CSF antibody prevents this neutrophil infiltration. These data demonstrate the importance of GM-CSF in eosinophil and neutrophil recruitment into the lungs in allergic and non-allergic asthma.

In humans, GM-CSF levels are elevated in sputum taken from individuals with severe asthma but not mild asthma. A source of this GM-CSF appears to be lung epithelial cells. Lung epithelial cells isolated from individuals with asthma make and secrete GM-CSF, whereas similar cells from those without asthma do not. One function of lung GM-CSF in severe asthma may be to prevent the death (apoptosis) of activated eosinophils and neutrophils, which typically die off in a few days. In vitro studies have demonstrated that GM-CSF is effective at preventing cell death of human neutrophils and eosinophils for prolonged periods of time.

KB003 Clinical Development Program

We have completed seven early-stage clinical trials with intravenous KB002, the predecessor chimeric anti-GM-CSF antibody, and intravenous KB003, our Humaneered™ antibody ( Table 3 ). Our Phase 1/2 clinical trials in RA and asthma with KB002 showed the antibody to be safe and well tolerated, and generated activity data to support continued development in both indications. We plan to use information from those clinical trials to guide the development of KB003. KB003, a Humaneered™ antibody designed to be less immunogenic than KB002, will be used for all future clinical trials. KB003 was tested in a Phase 1, single-dose study in healthy adult volunteers and in the repeat-dose, safety run-in portion of a planned Phase 2 study in subjects with RA. There were no safety concerns in these studies. The main portion of the KB003 RA study was not initiated because we made the decision not to pursue the RA market because it was becoming increasingly competitive in an already crowded market. Instead, we intend to continue the development of KB003 with a randomized, Phase 2 clinical trial in inadequately controlled asthma.

Table 3 summarizes completed clinical trials with KB002 and KB003.

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In the KB002 Phase 1/2 RA study, which randomized 32 subjects (3:1, active vs. placebo) to four escalating dose groups, a single dose of KB002 was found to be safe and well tolerated, with no drug-related SAEs. Higher KB002 dose groups demonstrated an early, durable, and clinically meaningful reduction in swollen and tender joints (Disease Activity Score at Day 28 (DAS28), a measure of swollen and tender joints), an effect that persisted for more than 90 days. While we have decided not to pursue additional trials in RA at this time, these data add support to the safety and activity of KB002 and the further development of KB003.

The KB002 Phase 1/2 asthma study, which enrolled both allergic (eosinophilic) and non-allergic (neutrophilic) asthma subjects, randomized 24 subjects 2:1, active versus placebo. KB002 was found to be safe and well tolerated. Assessments of lung function, PK, and biomarkers that correlate with lung function were encouraging enough for us to decide to proceed with a repeat-dose, Phase 2 clinical trial of KB003 in this indication. The FDA has cleared our Phase 2 protocol and in the third quarter of 2012, we plan to initiate a randomized, placebo-controlled, Phase 2 clinical trial in asthma inadequately controlled with corticosteroids, enrolling 150 subjects randomized equally between KB003 and placebo. Eligible subjects will be screened for a history of asthma uncontrolled by high-dose inhaled corticosteroids, FEV ₁ function, and Asthma Control Questionnaire (ACQ) scores. Subjects will receive intravenous doses of KB003 or placebo at multiple time points through study week 20. The primary endpoint will be change in FEV ₁ through week 24. Secondary endpoints include exacerbation, effect on asthma control, asthma symptoms, use of rescue therapy, and safety.

If this Phase 2 trial meets our clinical endpoints, we plan to conduct a bridging study to switch from an intravenous to a subcutaneous formulation. After completion of the bridging study, we plan to conduct a Phase 3 trial with the subcutaneous formulation of KB003 that will be designed to support regulatory approval for the treatment of asthma inadequately controlled by corticosteroids.

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Product Development Programs: KB004

Overview

KB004 is a novel monoclonal antibody that binds to EphA3 receptor tyrosine kinase for the treatment of cancer. EphA3 plays an important role in cell positioning and tissue organization during fetal development but is not thought to play a significant role in healthy adults. However, EphA3 is aberrantly expressed on the tumor cell surface in a number of hematologic malignancies and solid tumors, as well as expressed on the stem cell compartment. This compartment includes malignant stem cells, the vasculature that feeds them, and the stromal cells that protect them. Given this expression pattern, KB004 may have the potential to kill cancer cells and the source of the cancer, the stem cell microenvironment, providing for long-term responses while sparing normal cells. We are currently conducting a Phase 1 clinical trial of KB004 in multiple hematologic malignancies.

KB004 is a Humaneered™, monoclonal antibody in which the carbohydrate chains lack fucose, thereby enhancing the targeted cell-killing activity of the antibody. We have an exclusive license to the rights to the KB004 prototype and the EphA3 intellectual property, granted by the Ludwig Institute in 2006.

Market Opportunity for Hematologic Malignancies and Solid Tumors

Cancer is one of the leading causes of death worldwide and the second leading cause of death in the United States. The American Cancer Society (ACS) estimates that in 2012 more than 1.5 million people in the United States will be newly diagnosed with cancer and more than 560,000 died from the disease. The ACS also estimates that one in every four deaths in the United States is due to cancer. Five common solid cancer types (non–small cell lung, breast, ovarian, prostate and colorectal) represent more than 50% of all new cases of cancer in the United States each year and account for more than 50% of all cancer deaths in the United States. The ACS also estimates that more than 100,000 people will be diagnosed with a hematologic malignancy in 2012 in the United States.

The increasing number of cancer diagnoses and the approval of new cancer treatments are expected to continue to fuel the growth of the worldwide market for cancer drugs. Products targeting specific cancer-related molecules are the fastest-growing market segment in the pharmaceutical industry and are driving much of the cancer market growth. Data Monitor forecasts estimated sales in the seven major markets (the U.S., Japan, France, Germany, Italy, Spain and the UK) of approximately $34.5 billion by 2017 of approximately $45 billion in 2018.

Background and Mechanism of Action

KB004 is a high-affinity, non-fucosylated antibody that can potentially kill tumor cells in three ways: (1) direct induction of programmed cell death (apoptosis), (2) enhanced (via non-fucosylation) antibody-dependent cell-mediated cytotoxicity (ADCC) activity, or (3) disruption of the tumor vasculature by binding to EphA3 on the endothelial cells that line the vasculature.

EphA3 is expressed in some hematologic malignancies including acute myelogenous leukemia (AML), chronic myelogenous leukemia (CML), myelodysplastic syndromes (MDS), myeloproliferative neoplasms (MPN), multiple myeloma (MM), chronic lymphocytic leukemia (CLL), and acute lymphoblastic leukemia (ALL). It is also expressed on some tumor stromal cells and endothelial cells in the vascular compartment in the majority of solid tumors. The expression of EphA3 in a wide variety of human tumors and tumor vasculature and on stem cells, with restricted expression in normal tissue, as well as the multiple mechanisms to kill tumors, makes this protein a promising target for anticancer therapy.

Anti-EphA3 Preclinical Activity Summary

In ex vivo testing, we found EphA3 expressed in approximately half of early-stage leukemia patient samples. Cancer cells are killed by KB004 binding to EphA3 through apoptosis, or ADCC, at relatively low concentrations. KB004 ex vivo selectively targets and kills leukemic stem cells, but not normal hematopoietic stem cells. In ex vivo assays of these cells, KB004 appears to kill all cells expressing EphA3. Whenever AML stem cells were detected, uniform killing of these stem cells by KB004 was observed. This is significant because killing stem cells may lead to durable responses in cancers and potentially may prove effective in delaying or preventing relapses in the post-transplant setting, an area of high unmet medical need.

EphA3 expression has been documented in multiple solid tumor types of cancer, including melanoma, breast, non-small cell lung, colon, renal, glioblastoma and prostate cancers. EphA3 expression in colorectal cancer is a marker of poor prognosis.

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To date, anti-EphA3 has shown encouraging preclinical proof-of-concept results in multiple tumor models. The xenograft studies we conducted show that the anti-EphA3 antibody causes growth inhibition in EphA3-positive tumors, as well as in tumors that do not express EphA3 (the latter presumably through the effect on tumor vasculature).

We completed a 14-week, multiple-dose, preclinical toxicology study of KB004 and found no DLTs in doses up to 100 mg/kg/week.

KB004 Clinical Development Program

We are currently conducting the Phase 1 portion of a Phase 1/2 program in hematologic malignancies for KB004. The study is composed of subjects with AML, CML, MDS, MPN, MM, CLL, or ALL and is designed as a dose-escalation study to determine a maximum tolerated dose (MTD), safety and the PK profile for KB004. Doses will be escalated until a MTD is determined. Subjects are dosed weekly for 3 weeks to constitute one 21-day cycle, and may be treated for up to 1 year. Subjects may continue dosing until disease progression or safety finding precludes further safe dosing. Bone marrow aspirate and biopsy specimens are assessed throughout the study for disease status and biomarker development.

Of the first 6 subjects treated, infusion reactions (chills and shivering) were observed in 4 subjects. All reactions were resolved with standard treatment. One DLT at 70 mg was observed and three other SAEs were observed in 4 subjects, two of which were fatal intracranial hemorrhages.

Bleeding is typical in late-stage AML patients and intracranial hemorrhages are the second leading cause of death in these patients. The rate of fatal bleeding events observed in the trial was higher than expected but, given the small sample size, confounding factors (e.g., fever, elevated white blood cell count, platelet-dependent thrombocytopenia), late-stage disease, and the fact that little to no drug was present in the blood at the time of the SAEs in most cases, it is inconclusive whether the events were related to the drug. Two of the three events were deemed possibly related to study drug by the study investigator. We proactively informed the FDA of these SAEs and the FDA agreed with our revised plan to continue the study with a less sick population. Future trials will have an emphasis in recruiting subjects less likely to have disease-related bleeding complications. Following this revision and as of May 31, 2012, 6 subjects have been enrolled at the lowest dose level and there have been no additional events of intracranial hemorrhage. In early 2013, we hope to select a recommended dose for the Phase 2 portion of this trial, which will screen subjects for EphA3 expression.

Early-Stage Program

KB005 is a high affinity Humaneered™, monoclonal antibody that targets and selectively depletes eosinophils. KB005 has potential application in eosinophilic mediated diseases, including subsets of severe allergic asthma (such as aspirin-sensitive asthma), chronic rhinosinusitis, eosinophilic esophagitis, COPD, inflammatory bowel disease, and hypereosinophilic syndrome. The initial clinical indication is likely to be treatment of patients with nasal polyps who have chronic rhinosinusitis or aspirin-sensitive asthma. Preclinical data show that the target is present on activated eosinophils in diseased tissue as well as on circulating eosinophils. We have demonstrated that a single, low dose of a non-human version of KB005 antibody eliminates circulating eosinophils in in vivo animal studies.

Technology Platform

Our proprietary Humaneered™ technology is a method for converting antibodies (typically mouse) into engineered, high-affinity human antibodies designed for therapeutic use, particularly for chronic conditions. The technology produces optimized antibodies that retain specificity for the target epitope. Because their sequences are very close to those of human germ-line antibodies, we believe Humaneered™ antibodies will produce fewer immunological adverse side effects in patients than chimeric or conventionally humanized antibodies. We develop or in-license targets or research (mouse) antibodies, typically from academic institutions, and then apply our Humaneered™ technology to them. KB001-A, KB003, KB004 and KB005 are all Humaneered™ antibodies or antibody fragments.

In April 2007, we granted Novartis a nonexclusive license to our proprietary Humaneered™ technology after successfully applying our Humaneered™ technology to several antibodies for them. Under the license agreement, Novartis is now able to develop Humaneered™ antibodies to create its own therapeutics. We have also successfully completed Humaneered™ projects for five United States and Japanese biotechnology and pharmaceutical companies, Biogen Idec, Inc., Daogen Inc., Novartis Pharma AG, Otsuka Pharmaceutical Co., Ltd., and Taligen Therapeutics, Inc. For each of these companies, we successfully Humaneered™ antibodies to certain targets under predefined criteria. In each case, we demonstrated the robustness and versatility of the technology by creating Humaneered™ antibodies with increased affinity and without loss of activity.

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Capabilities and Advantages of Humaneered™ Technology

Our proprietary and patented Humaneered™ technology provides the following advantages:

Disadvantage of Humaneered™ Technology

Licensing and Collaborations

Our strategy is to partner our programs while retaining rights to orphan or targeted indications. We currently have a partnership with Sanofi for the development of KB001-A and have licensed our proprietary Humaneered™ technology non-exclusively to Novartis.

Sanofi Pasteur

In January 2010, we signed an agreement with Sanofi granting Sanofi exclusive worldwide rights to develop and commercialize KB001-A for all indications. Under this agreement, Sanofi is solely responsible for the research, development, manufacture, and commercialization of KB001-A, except that KaloBios retained responsibility for developing and commercializing the product for CF and bronchiectasis. Sanofi is solely responsible for the costs and development of KB001-A for pneumonia prevention and other hospital indications. Under the agreement, we received an upfront payment of $35 million and a $5 million payment in August 2011. We have the potential to receive contingent payments aggregating $250 million if certain clinical, regulatory, and commercial events are achieved, including $5 million upon initiation of a Phase 2 clinical trial, which is estimated to start in 2014 (after completion of a Phase 1 study at a higher dose than previously tested), and $20 million upon successful completion of the Phase 2 clinical trial, currently estimated to be completed in late 2015. The Phase 2 clinical trial will be conducted by Sanofi and, therefore, the timing of the initiation and completion of this trial may differ from our estimates. We also are entitled to tiered royalties from 12% to 17 % of global net sales of KB001-A in these indications.

We are currently planning a Phase 2 trial in CF, the design of which has been agreed to by Sanofi. For a period of up to 90 days following the delivery of our Phase 2 clinical trial study report for CF to Sanofi, Sanofi has the right to exercise an option to exclusively develop and commercialize KB001-A in Pa -infected CF and bronchiectasis patients either (i) outside the United States, or (ii) worldwide with a co-development, joint marketing and profit-sharing arrangement in the United States between Sanofi and us. In the event that Sanofi exercises its option to the ex-U.S. territory, Sanofi would be solely responsible for the development, regulatory approval, and commercialization of KB001-A in countries outside the United States, would pay 50% of all joint CF program expenses, and we would be entitled to royalties of 18% on net sales of product. If Sanofi exercises the worldwide option, we and Sanofi would jointly develop, and promote KB001-A for the CF and bronchiectasis indication within the United States, such joint efforts to be coordinated through joint committees and mutually agreed plans. In addition, Sanofi would be solely responsible for the development, regulatory approval and commercialization of the product outside the United States, would pay for 75% of the shared program costs, and we would be entitled to royalties of 18% on net sales of product, except in the United States where we would split profits equally. In order to exercise its option, Sanofi would make certain pre-negotiated payments to us related to the actual costs incurred by us in developing KB001-A. If Sanofi exercises its option, we estimate, based on projected estimated costs, that the pre-negotiated payments will be in the range of $25-50 million if the option exercise occurs at the end of the Phase 2 trial.

Sanofi is responsible for the manufacture of KB001-A for its use and for the manufacture of drug substance for our use in clinical trials and commercial sale in our retained indications. If Sanofi is unable or unwilling to supply drug substance to us, we have the right to have drug substance manufactured by a third party. Both Sanofi and we have an obligation to use commercially reasonable efforts to develop and commercialize KB001-A in our respective indications, although we can terminate our obligations at any time under the terms of the agreement.

Sanofi’s royalty obligation to us in a particular country begins upon the first commercial sale of the product in that country and ends on the latest to occur of (i) ten years from first commercial sale of the product or (ii) expiration of the last to expire patent covering the product, the latest of which is scheduled to expire in 2028. The agreement will remain in effect until the expiration of all of Sanofi’s royalty obligations to us. Sanofi may terminate the agreement for convenience, and either Sanofi or we may terminate the agreement for material breach of the agreement by the other party. In the event Sanofi terminates the agreement for convenience or we terminate due to Sanofi’s material breach, worldwide rights to develop, manufacture and commercialize KB001-A revert back to us. In the event Sanofi terminates the agreement for our material breach, Sanofi will be entitled to deduct any damages awarded against future contingent payments and royalties.

Novartis

In April 2007, we entered into an agreement with Novartis granting a nonexclusive license to our proprietary Humaneered™ technology for use at Novartis’ research sites to develop human antibodies for therapeutic indications. Under the agreement, Novartis was excluded from using the technology against certain targets until March 2012. In accordance with the terms of the agreement, Novartis paid us $30 million and we transferred the know-how related to making Humaneered™ antibodies to enable Novartis to internally make its own antibodies.

This agreement will remain in effect until the expiration of the last to expire patent in 2025. However, either party may terminate for material breach, and will return all proprietary information to the non-breaching party.

University of California at San Francisco

In April 2004, we exclusively licensed rights from the University of California at San Francisco (UCSF) and the Medical College of Wisconsin to intellectual property that relate to KB001-A. These intellectual property rights include a method of treatment of Pa infection using isolated antibodies and an antibody that specifically binds to a key target epitope, as well as diagnostic methods useful in the detection of infection by Pa . Under our agreement with UCSF, we were granted rights to practice the invention as well as further develop antibodies to treat Pa . As a result, we developed and own a composition of matter patent for KB001-A that provides patent protection through 2029 in the United States. We are responsible for researching, developing and selling products covered under such intellectual property. Under our agreement with UCSF, we paid an upfront license fee of $25,000 and we are responsible for paying an annual license fee, aggregate contingent milestone payments of less than $2 million, as well as royalties on net sales of 3%. Aggregate payments made to UCSF under this license through March 31, 2012 amounted to $1.2 million. Our royalty payment obligation will begin on the first commercial sale in a particular country and end on the expiration of the last to expire patent covering UCSF’s intellectual property or 2019. We are obligated to use commercially reasonable efforts to develop, manufacture and sell KB001-A. We may terminate our agreement with UCSF for convenience. UCSF may terminate the agreement in the event of our material breach, in which case our rights to use the intellectual property will also terminate.

The Ludwig Institute for Cancer Research

In May 2004, we exclusively licensed a patent family covering chimeric anti-GM-CSF antibodies from the Ludwig Institute for Cancer Research (LICR) that formed the basis of the intellectual property for the KB003 development program. Under the agreement, we were granted the right to develop antibodies related to LICR’s antibodies against GM-CSF. Using our Humaneered™ technology, we developed and own a composition of matter patent covering KB003 and related Humaneered™ anti-GM-CSF antibodies which provides patent protection through April 2029. We are responsible for researching, developing and selling KB003. We pay LICR a quarterly license fee and are obligated to pay a royalty from 1%-3% of net sales. Aggregate payments made to LICR under this license through March 31, 2012 amounted to $1.0 million. Our royalty obligation will begin on the first commercial sale in a particular country and end on the later of the expiration of the last to expire patent (currently expected in 2029) or 10 years from first commercial sale of the product. We may terminate our license for convenience. LICR may terminate the agreement in the event of our material breach, in which case our rights to use the intellectual property will also terminate.

In April 2006, we exclusively licensed certain patents related to EphA3 from LICR that formed the basis for the KB004 program. Under the agreement, we have rights to develop human antibodies that bind to or modulate EphA3. We paid LICR an upfront license fee of $50,000 and are responsible for contingent milestone payments of less than $2.5 million and royalties of 3% of net sales. Aggregate payments made to LICR under this license through March 31, 2012 amounted to $334,000. Our royalty obligation will begin on the first commercial sale in a particular country and end on the later of the expiration of the last to expire patent (currently expected in 2030) or 10 years from first commercial sale of the product. We have current and pending patent applications for anti-EphA3 antibodies and their use, and have composition of matter patent applications that, if issued, will expire in 2030. We may terminate our license for convenience. LICR may terminate the agreement in the event of our material breach, in which case our rights to use the intellectual property will also terminate.

Intellectual Property

Patent and trade secret protection is critical to our business. Our success will depend in large part on our ability to obtain, maintain, defend and enforce patents and other intellectual property for our Humaneered™ technology and our product candidates, to extend the life of patents covering our product candidates, to preserve trade secrets and proprietary know-how, and to operate without infringing the patents and proprietary rights of third parties. We actively seek patent protection in the U.S. and select foreign countries.

We own nine issued U.S. patents and have an exclusive license to seven U.S. patents. We have more than 90 patent applications pending globally. The patents to our Humaneered™ technology cover methods of producing very specific human antibodies using only a small region from mouse antibodies.

We exclusively licensed rights from the University of California at San Francisco (UCSF) and the Medical College of Wisconsin to intellectual property that relate to KB001-A. These intellectual property rights include a method of treatment of Pa using isolated antibodies and an antibody that specifically binds to a key target epitope, as well as diagnostic methods useful in the detection of infection by Pa . This portfolio also includes issued patents covering compositions and methods of treatment of Pa infection that expire in 2019. Under our agreement with UCSF, we were granted rights to practice the invention as well as further develop antibodies to treat Pa . As a result, we developed and own a composition of matter patent for KB001-A that provides patent protection through 2029 in the United States. We also have filed counterparts in a number of foreign countries where our patents are pending.

We exclusively licensed a patent family covering chimeric anti-GM-CSF antibodies from the Ludwig Institute for Cancer Research (LICR) that formed the basis of the intellectual property for the KB003 development program. Under the agreement, we were granted rights to issued U.S. and select foreign country patents covering chimeric anti-GM-CSF antibodies, as well as the right to develop antibodies related to LICR’s antibodies against GM-CSF. Using our Humaneered™ technology, we developed and own a composition of matter patent covering KB003 and related Humaneered™ anti-GM-CSF antibodies which provides patent protection through April 2029 and have additional pending patents in the U.S. and a number of foreign countries covering various methods of treatment.

We exclusively licensed certain issued and pending patents related to EphA3 from LICR that formed the basis for the KB004 program. Under the agreement, we have rights to develop human antibodies that bind to or modulate EphA3. We have current and pending patent applications in the United States and selected foreign countries for anti-EphA3 antibodies and their use, and have composition of matter patent applications that, if issued, will expire in 2030.

We have a license from BioWa, Inc. and Lonza Sales AG to their Potelligent ^® CHOK1SV technology, a technology that is used to enhance the cell killing of antibodies.

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Competition

We compete in an industry that is characterized by rapidly advancing technologies, intense competition, and a strong emphasis on proprietary products. Our competitors include pharmaceutical companies, biotechnology companies, academic institutions, and other research organizations. We compete with these parties for promising targets for antibody-based therapeutics and in recruiting highly qualified personnel. Many competitors and potential competitors have substantially greater scientific, research, and product development capabilities as well as greater financial, marketing and sales, and human resources than we do. In addition, many specialized biotechnology firms have formed collaborations with large, established companies to support the research, development and commercialization of products that may be competitive with ours. Accordingly, our competitors may be more successful than we may be in developing, commercializing, and achieving widespread market acceptance. In addition, our competitors’ products may be more effective or more effectively marketed and sold than any treatment we or our development partners may commercialize and may render our product candidates obsolete or noncompetitive before we can recover the expenses related to developing and commercializing any of our product candidates.

There are several companies treating Pa using antibiotics or alternative approaches. For example, Intercell has a fusion protein vaccine program in Phase 3 for the prevention of Pa in mechanically ventilated ICU patients. There are two inhaled antibiotics (Tobi ^® and Cayston ^® ) that have been approved for Pa to treat CF .  However, like traditional antibiotics, data reported on both drugs show patients often become less responsive over time to these inhaled antibiotics. We are aware of only one biologic drug (Pulmozyme ^® ) that is approved in the U.S. to treat respiratory problems in CF patients. However, Pulmozyme does not directly target Pa . KALYDECO ^® , a small-molecule drug that potentiates the form of the defective protein that causes CF, was recently approved by the FDA. KALYDECO is a potentially disease-modifying drug that targets only the CF population having at least one copy of the G551D mutation in the CFTR gene (approximately 4% of the CF population). VX-809 is a compound being developed by Vertex in Phase 2 clinical trials that is a potential disease-modifying drug for CF and potentially complementary to KB001-A.

Several companies are also working on anti-GM-CSF antibodies: Morphosys is conducting a Phase 1/2 trial in RA and multiple sclerosis, Micromet (now part of Amgen) has partnered with Nycomed (now part of Takeda) in a Phase 1 trial in RA, and MedImmune is conducting a Phase 2 trial in RA with an antibody against the GM-CSF receptor. Many companies are developing drugs for asthma. Monoclonal antibody drug development has primarily focused on allergic asthma. Xolair ^® , which is co-developed by Genentech and Novartis, is currently the only monoclonal antibody that we are aware of that is approved for the treatment of severe asthma. However, Xolair only targets IgE-positive individuals, which represents only 50% of the population, but generated worldwide sales of over $1 billion annually. Genentech (Roche), MedImmune, Novartis and Pfizer each have an anti-IL-13 antibody program in Phase 2 testing for asthma. Other monoclonal antibodies in development target cytokines such as IL-4, IL-5, and IL-9 or their receptors. Although these drugs function differently, if successfully developed, these drugs will compete in the asthma market. Finally, although several companies are developing anti-GM-CSF antibodies, we are not aware that they are developing antibodies to treat asthma.

Competition in cancer drug development is intense, with more than 300 compounds in clinical trials by biotechnology and large pharmaceutical companies. Many of these companies are focused on targeted therapies. We anticipate that we will face intense and increasing competition as new treatments enter the market and advanced technologies become available.

Manufacturing

We perform our own pilot-scale process development work and manage contract manufacturers to scale up the process and manufacture bulk drug substance. Additional contract manufacturers are used to fill, label, package, and distribute investigational drug product.

Government Regulation and Product Approval

Government authorities at the federal, state, and local levels in the United States and authorities in other countries extensively regulate, among other things, the research, development, testing, manufacture, quality control, approval, labeling, packaging, storage, record-keeping, promotion, advertising, distribution, post-approval monitoring and reporting, marketing, export, and import of products such as those we are developing.

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United States Pharmaceutical Product Development Process

In the United States, the FDA regulates pharmaceutical products (drug and biologic) under the Federal Food, Drug and Cosmetic Act, and implements regulations. Pharmaceutical products are also subject to other federal, state, and local statutes and regulations. The process of obtaining regulatory approvals and the subsequent compliance with appropriate federal, state, local, and foreign statutes and regulations require the expenditure of substantial time and financial resources. Failure to comply with applicable U.S. requirements at any time during the product development and approval processes or after approval may subject an applicant to administrative or judicial sanctions. FDA sanctions could include refusal to approve pending applications, withdrawal of an approval, a clinical hold, warning letters, product recalls, product seizures, total or partial suspension of production or distribution injunctions, fines, refusals of government contracts, restitution, disgorgement, or civil or criminal penalties. Any agency or judicial enforcement action could have a material adverse effect on us. The process required by the FDA before a pharmaceutical product may be marketed in the United States generally includes the following:

The lengthy process of seeking required approvals and the continuing need for compliance with applicable statutes and regulations require the expenditure of substantial resources and approvals are inherently uncertain.

Antibody products are derived from a variety of biologic sources, including directly harvested or cultured cell lines. Product safety requires that these sources be well characterized, uniform, and not contaminated with hazardous adventitious agents. Because of the complex nature of these products a controlled, reproducible manufacturing process and facility are required and relied on to produce a uniform product. The degree of reliance on a controlled process varies depending on the nature of the product. Because complete chemical characterization of a biologic product is not feasible for quality control, the testing of the biologic potency receives particular attention and is costly.

Before testing any compounds with potential therapeutic value in humans, the pharmaceutical product candidate enters the preclinical testing stage. Preclinical tests include laboratory evaluations of product chemistry, toxicity, and formulation as well as animal studies to assess the potential safety and activity of the pharmaceutical product candidate. The conduct of the preclinical tests must comply with federal regulations and requirements including GLP. The sponsor must submit the results of the preclinical tests together with manufacturing information, analytical data, any available clinical data or literature, and a proposed clinical protocol to the FDA as part of an IND. The IND automatically becomes effective 30 days after receipt by the FDA unless the FDA places the IND on a clinical hold within that 30-day period. In such a case the IND sponsor and the FDA must resolve any outstanding concerns before the clinical trial can begin. The FDA may also impose clinical holds on a pharmaceutical product candidate at any time before or during clinical trials due to safety concerns or noncompliance. Accordingly, we cannot be certain that submission of an IND will result in the FDA allowing clinical trials to begin or that, once begun, such clinical trials will not be suspended or terminated by any issues that may arise.

Clinical trials involve the administration of the pharmaceutical product candidate to healthy volunteers or trial subjects under the supervision of qualified investigators, generally physicians not employed by the sponsor. Clinical trials are conducted under trial protocols detailing among other things the objectives of the clinical trial, dosing procedures, subject selection and exclusion criteria, and the parameters to be used to monitor subject safety. Each trial protocol and protocol amendment must be submitted to the FDA if conducted under an IND. Clinical trials must be conducted in accordance with the FDA’s GCP requirements. Further, each clinical trial must be reviewed and approved by an independent institutional review board (IRB) or ethics committee if conducted outside the U.S., at or servicing each institution where the clinical trial is be conducted. An IRB or ethics committee is charged with protecting the welfare and rights of trial participants and considers such items as to whether risks to trial participants are minimized and reasonable in relation to anticipated benefits. The IRB or ethics committee also approves the informed consent documents that must be provided to each clinical trial subject or his or her legal representative and must monitor the trial until it is completed.

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Clinical trials are typically conducted in three sequential phases that may overlap or be combined:

Post-approval or Phase 4 clinical trials may be conducted after initial marketing approval. These trials are used to gain additional experience from the treatment of subjects in the intended therapeutic indication and may be requested by the FDA as a condition of approval.

Progress reports detailing the results of the clinical trials must be submitted at least annually to the FDA and written IND safety reports must be submitted to the FDA and the investigators for any serious and unexpected adverse events or any safety findings from tests in laboratory animals that suggest a significant risk for human subjects. Phase 1, Phase 2, and Phase 3 clinical trials may not be completed successfully within any specified period, if at all. The FDA, sponsor, or a Data Safety Monitoring Committee, if used, may suspend a clinical trial at any time on various grounds, including a finding that trial participants are being exposed to an unacceptable health risk. Similarly, an IRB or ethics committee can suspend or terminate approval of a clinical trial if it is not being conducted in accordance with the IRB’s or ethics committee’s requirements or if the pharmaceutical product has been associated with unexpected serious harm.

Concurrent with clinical trials, companies usually complete additional animal studies. They must also develop additional information about the chemistry and physical characteristics of the pharmaceutical product as well as finalize a process for manufacturing in commercial quantities in accordance with GMP requirements. The manufacturing process must be capable of consistently producing quality batches of the pharmaceutical product candidate and among other things must develop methods for testing the identity, strength, quality, and purity of the final pharmaceutical product. Additionally, appropriate packaging must be selected and tested and stability studies must be conducted to demonstrate that the pharmaceutical product candidate does not undergo unacceptable deterioration over its shelf life.

United States Review and Approval Processes

The results of product development and preclinical studies and clinical trials, along with descriptions of the manufacturing process, analytical tests conducted on the chemistry of the pharmaceutical product, proposed labeling, and other relevant information are submitted to the FDA as part of an NDA/BLA requesting approval to market the product.

The NDA/BLA review and approval process is lengthy and difficult. The FDA may refuse to approve an NDA/BLA if applicable regulatory criteria are not satisfied, or it may require additional clinical data or other data and information. Even if such data and information is submitted, the FDA may ultimately decide that the NDA/BLA does not satisfy the criteria for approval. If a product receives regulatory approval, the approval may be significantly limited to specific diseases and dosages or the indications for use may otherwise be limited, which could restrict the commercial value of the product. Further, the FDA may require that certain contraindications, warnings, or precautions be included in the product labeling.

Post approval Requirements

Any pharmaceutical product for which we receive FDA approval are subject to continuing regulation by the FDA, including among other things record-keeping requirements, reporting of adverse experiences with the product, providing the FDA with updated safety and efficacy information, product sampling and distribution requirements, complying with certain electronic records and signature requirements, and complying with FDA promotion and advertising requirements, which include among other things standards for direct-to-consumer advertising, promoting pharmaceutical products for uses or in patient populations not described in the pharmaceutical product’s approved labeling (off-label use), industry-sponsored scientific and educational activities, and promotional activities involving the internet. Failure to comply with FDA requirements can have negative consequences including adverse publicity, enforcement letters from the FDA, mandated corrective advertising or communications with doctors, and civil or criminal penalties.

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The FDA also may require post-market (Phase 4) testing, risk minimization action plans, and surveillance to monitor the effects of an approved product, or may place conditions on an approval that could restrict distribution or use of the product.

Other Healthcare Laws and Compliance Requirements

In the United States, our activities are potentially subject to regulation by federal, state, and local authorities in addition to the FDA, including the Centers for Medicare and Medicaid Services (formerly the Health Care Financing Administration), other divisions of the U.S. Department of Health and Human Services (e.g., the Office of Inspector General), the U.S. Department of Justice and individual U.S. Attorney offices within the Department of Justice, and state and local governments.

International Regulation

In addition to regulations in the United States, a variety of foreign regulations govern clinical trials, commercial sales, and distribution of product candidates. The approval process varies from country to country and the time to approval may be longer or shorter than that required for FDA approval.

Pharmaceutical Coverage, Pricing and Reimbursement

In the United States and markets in other countries, sales of any products for which we receive regulatory approval for commercial sale will depend in part on the availability of reimbursement from third-party payors, including government health administrative authorities, managed care providers, private health insurers, and other organizations. Third-party payors are increasingly examining the medical necessity and cost effectiveness of medical products and services in addition to safety and efficacy and, accordingly, significant uncertainty exists as to the reimbursement status of newly approved therapeutics. Third-party reimbursement adequate to enable us to realize an appropriate return on our investment in research and product development may not be available for our products.

Employees

As of May 31, 2012, we had 19 full-time employees in preclinical and clinical development and administration.

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Item 1A. Risk Factors.

Risks Related to Capital Requirements and the Development, Regulatory Approval, and Commercialization of Our Product Candidates

We have limited sources of revenue, and we will need substantial additional funding to continue our operations, and we may be unable to raise additional capital when needed, or at all, which would force us to reduce or discontinue operations.

As of March 31, 2012, we had approximately $14.4 million in cash, cash equivalents, and marketable securities. Our revenues from licensing and research and development collaborations for the 3 months ended March 31, 2012 were $3.0 million. We consumed a net $3.4 million in cash used in operating activities during this period, or approximately $1.1 million per month. Our monthly spending levels vary based on new and ongoing development and corporate activities. As a result, our cash used in operating activities will also fluctuate from period to period. We have not sold any products and we do not expect to sell any products or derive royalty revenue from product sales for the next several years. However, in order to develop and bring our lead product candidates through clinical trials, we must commit substantial resources to additional costly and time-consuming research, preclinical testing, and clinical trials. In May 2012, we raised $15.6 million, net of offering costs, through the sale of 5,000,000 shares of Series E preferred stock. We anticipate that we will need to raise additional capital, the requirements of which will depend on many factors, including:

Since our inception in 2000, we have been financing our operations primarily through the sale of private equity, interest income earned on cash and cash-equivalent and marketable securities balances, lines of finance credit, and payments under agreements with our collaborators. In order to fund our future needs we may seek additional funding through public or private equity or debt financings, collaborative arrangements, lines of credit, or other sources. Additional funding may not be available to us on a timely basis or at acceptable terms, or at all. We believe our cash on hand will sustain our operations for the next 12 months and that we will require substantial additional funds to support our continued research and development activities and the anticipated costs of preclinical studies, clinical trials, regulatory approvals, and potential commercialization. We have based this estimate, however, on assumptions that may prove to be wrong and we could spend our available financial resources much faster than we currently expect.

If we are unable to raise additional funds when needed, we may be required to delay, reduce, or terminate some or all of our development programs and clinical trials. We may also be required to sell or license technologies or clinical products or programs to others that we would prefer to develop and commercialize ourselves.

Our product candidates are at an early stage of development and may not be successfully developed or commercialized.

Our product candidates are in the early stage of development and will require substantial further capital expenditures, development, testing, and regulatory clearances prior to commercialization. Of the large number of drugs in development, only a small percentage successfully complete the FDA regulatory approval process and are commercialized. Accordingly, even if we are able to obtain the requisite financing to fund our development programs, we cannot assure you that our product candidates will be successfully developed or commercialized. If we or our partners are unable to develop, or receive regulatory approval for or successfully commercialize, any of our product candidates, we will not be able to generate sufficient product revenues to continue our business.

The results of preclinical studies and early clinical trials are not always predictive of future results. Any product candidate we advance into clinical trials may not have favorable results in later clinical trials, if any, or receive regulatory approval.

Pharmaceutical development has inherent risk. We will be required to demonstrate through adequate and well-controlled clinical trials that our product candidates are effective, with a favorable benefit-risk profile, for use in their target indications before we can seek regulatory approvals for their commercial sale. Success in early clinical trials does not mean that later clinical trials will be successful because product candidates in later-stage clinical trials may fail to demonstrate sufficient safety or efficacy despite having progressed through initial clinical testing. Companies frequently suffer significant setbacks in advanced clinical trials, even after earlier clinical trials have shown promising results. Furthermore, the efficacy or safety demonstrated with KB001, KB002 and intravenous formulation of KB001-A and KB003 may not be reproduced in KB001-A, KB003 and subcutaneous formulation of KB001-A and KB003, respectively. In addition, only a small percentage of drugs under development result in the submission of an NDA or BLA to the FDA and even fewer are approved for commercialization.

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Any product candidates we may advance into clinical development are subject to extensive regulation, which can be costly and time consuming, cause unanticipated delays or prevent the receipt of the required approvals to commercialize our product candidates.

The clinical development, manufacturing, labeling, storage, record-keeping, advertising, promotion, import, export, marketing, and distribution of our product candidates are subject to extensive regulation by the FDA in the United States and by comparable health authorities in foreign markets. In the United States, we are not permitted to market our product candidates until we receive approval of an NDA/BLA from the FDA. The process of obtaining NDA/BLA approval is expensive, often takes many years, and can vary substantially based upon the type, complexity, and novelty of the products involved. Approval policies or regulations may change and the FDA has substantial discretion in the pharmaceutical approval process, including the ability to delay, limit, or deny approval of a product candidate for many reasons. Despite the time and expense invested in clinical development of product candidates, regulatory approval is never guaranteed.

The FDA or other regulatory agency can delay, limit, or deny approval of a product candidate for many reasons, including:

With respect to foreign markets, approval procedures vary among countries and, in addition to the aforementioned risks, can involve additional product testing, administrative review periods and agreements with pricing authorities. In addition, events raising questions about the safety of certain marketed pharmaceuticals may result in increased cautiousness by the FDA and comparable foreign regulatory authorities in reviewing new pharmaceuticals based on safety, efficacy or other regulatory considerations and may result in significant delays in obtaining regulatory approvals. Any delay in obtaining, or inability to obtain, applicable regulatory approvals would prevent us from commercializing our product candidates.

Any product candidate we or our development partners advance into clinical trials may cause unacceptable adverse events or have other properties that may delay or prevent its regulatory approval or commercialization or limit its commercial potential.

Unacceptable adverse events caused by any of our product candidates that we advance into clinical trials could cause us or regulatory authorities to interrupt, delay, or halt clinical trials and could result in the denial of regulatory approval by the FDA or other regulatory authorities for any or all targeted indications and markets. This in turn could prevent us from completing development or commercializing the affected product candidate and generating revenues from its sale.

We or our development partners have not yet completed testing of any of our product candidates for the treatment of the indications for which we intend to seek product approval in humans, and we currently do not know the extent of adverse events, if any, that will be observed in individuals who receive any of our product candidates. If any of our product candidates cause unacceptable adverse events in clinical trials, we may not be able to obtain regulatory approval or commercialize such product.

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We may experience delays in commencing or conducting our clinical trials or in receiving data from third parties or in the completion of clinical testing, which could result in increased costs to us and delay our ability to generate product revenues.

Before we can initiate clinical trials in the United States for our product candidates, we need to submit the results of preclinical testing to the FDA as part of an IND, along with other information including information about product chemistry, manufacturing, and controls and our proposed clinical trial protocol. We currently plan to rely in part on preclinical, clinical, and quality data generated by third parties for the IND submission for KB001-A. If we are unable to use such data for any reason including reasons outside of our control, it will delay our plans for IND filings and clinical trial plans. If those third parties do not make these data available to us, we will likely have to develop all necessary preclinical and clinical data on our own, which will lead to additional delays and increase development costs of the product candidate. In addition, the FDA may require us to conduct additional preclinical testing for any product candidate before it allows us to initiate clinical testing under any IND, which may lead to additional delays and increase the costs of our preclinical development. Even where there is an active IND for a product candidate, clinical trials can be delayed for a variety of reasons including delays in:

The FDA may also put a clinical trial on clinical hold at any time during product candidate development.

Once a clinical trial has begun, recruitment and enrollment of subjects may be slower than we anticipate. Clinical trials may also be delayed as a result of ambiguous or negative interim results. Further, a clinical trial may be suspended or terminated by us, an IRB, an ethics committee, or a Data Safety Monitoring Committee overseeing the clinical trial, any of our clinical trial sites with respect to that site or the FDA or other regulatory authorities due to a number of factors, including:

Any delays in the commencement of our clinical trials will delay our ability to pursue regulatory approval for our product candidates. Changes in regulatory requirements and guidance also may occur and we may need to amend clinical trial protocols to reflect these changes. Amendments may require us to resubmit our clinical trial protocols to IRBs for re-examination, which may affect the costs, timing, and likelihood of a successful completion of a clinical trial. If we experience delays in the completion of, or if we must terminate, any clinical trial of any product candidate our ability to obtain regulatory approval for that product candidate will be delayed and the commercial prospects, if any, for the product candidate may suffer as a result. In addition, many of these factors may also ultimately lead to the denial of regulatory approval of a product candidate.

If our competitors develop treatments for the target indications of our product candidates that are approved more quickly, marketed more successfully or demonstrated to be more effective than our product candidates, our commercial opportunity will be reduced or eliminated.

We operate in highly competitive segments of the biotechnology and biopharmaceutical markets. We face competition from many different sources, including commercial pharmaceutical and biotechnology enterprises, academic institutions, government agencies, and private and public research institutions. Our product candidates, if successfully developed and approved, will compete with established therapies as well as with new treatments that may be introduced by our competitors. Many of our competitors have significantly greater financial, product development, manufacturing, and marketing resources than we do. Large pharmaceutical companies have extensive experience in clinical testing and obtaining regulatory approval for drugs. In addition, many universities and private and public research institutes are active in cancer research, some in direct competition with us. We also may compete with these organizations to recruit management, scientists, and clinical development personnel. Smaller or early-stage companies may also prove to be significant competitors, particularly through collaborative arrangements with large and established companies. New developments, including the development of other pharmaceutical technologies and methods of treating disease, occur in the pharmaceutical and life sciences industries at a rapid pace. Developments by competitors may render our product candidates obsolete or noncompetitive. We will also face competition from these third parties in recruiting and retaining qualified personnel, establishing clinical trial sites, and registering subjects for clinical trials, and in identifying and in-licensing new product candidates.

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There are several companies treating Pa using antibiotics or alternative approaches. For example, Intercell has a fusion protein vaccine program in Phase 3 for the prevention of Pa in mechanically ventilated ICU patients. There are two inhaled antibiotics (Tobi ^® and Cayston ^® ) that have been approved for Pa to treat CF .  We are also aware of one biologic drug (Pulmozyme ^® ) that is approved in the US to treat respiratory problems in CF patients. KALYDECO ^® , a small-molecule drug that potentiates the form of the defective protein that causes CF, was recently approved by the FDA. VX-809 is a compound being developed by Vertex in Phase 2 clinical trials that is a potential disease modifying drug for CF.

Several companies are also working on anti-GM-CSF antibodies: Morphosys is conducting a Phase 1-2 trial in RA and MS, Micromet (now part of Amgen) has partnered with Nycomed (now part of Takeda) in a Phase 1 trial in RA, and MedImmune is conducting a Phase 2 trial in RA with an antibody against the GM-CSF receptor. Many companies are developing drugs for asthma. Monoclonal antibody drug development has primarily focused on allergic asthma. Xolair ^® , which is co-developed by Genentech and Novartis, is currently the only monoclonal antibody that we are aware of that is approved for the treatment of severe asthma. Genentech (Roche), MedImmune, Novartis and Pfizer, Novartis, each have an anti-IL-13 antibody program in Phase 2 testing for asthma. Other monoclonal antibodies in development target cytokines such as IL-4, IL-5, and IL-9 or their receptors. Although these drugs function differently, if successfully developed these drugs will compete in the asthma market.

Competition in cancer drug development is intense, with more than 300 compounds in clinical trials by large pharmaceutical companies. Many of these companies are focused on targeted therapies. We anticipate that we will face intense and increasing competition as new treatments enter the market and advanced technologies become available.

If any product candidate that we successfully develop does not achieve broad market acceptance among physicians, patients, healthcare payors and the medical community, the revenues that it generates will be limited.

Even if our product candidates receive regulatory approval, they may not gain market acceptance among physicians, patients, healthcare payors, and the medical community. Coverage and reimbursement of our product candidates by third-party payors, including government payors, generally is also necessary for commercial success. The degree of market acceptance of any approved products will depend on a number of factors, including:

If any product candidate is approved but does not achieve an adequate level of acceptance by physicians, hospitals, healthcare payors, and patients, we may not generate sufficient revenue from that product candidate and may not become or remain profitable.

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Reimbursement may be limited or unavailable in certain market segments for our product candidates, which could make it difficult for us to sell our products profitably.

Market acceptance and sales of our product candidates will depend significantly on the availability of adequate insurance coverage and reimbursement from third-party payors for any of our product candidates and may be affected by existing and future health care reform measures. Government authorities and third-party payors, such as private health insurers and health maintenance organizations, decide which drugs they will pay for and establish reimbursement levels. Reimbursement by a third-party payor may depend upon a number of factors including the third-party payor’s determination that use of a product is:

Obtaining coverage and reimbursement approval for a product from a government or other third-party payor is a time-consuming and costly process that could require us to provide supporting scientific, clinical, and cost effectiveness data for the use of our products to the payor. We may not be able to provide data sufficient to gain acceptance with respect to coverage and reimbursement. We cannot be sure that coverage or adequate reimbursement will be available for any of our product candidates. Also, we cannot be sure that reimbursement amounts will not reduce the demand for, or the price of, our products. If reimbursement is not available or is available only to limited levels, we may not be able to commercialize certain of our products even if approved.

In the United States and in certain foreign jurisdictions, there have been a number of legislative and regulatory changes to the health care system that could affect our ability to sell our products profitably. In particular, the Medicare Modernization Act of 2003 revised the payment methods for many products under Medicare. This has resulted in lower rates of reimbursement. There have been numerous other federal and state initiatives designed to reduce payment for pharmaceuticals.

As a result of legislative proposals and the trend toward managed health care in the United States, third-party payors are increasingly attempting to contain health care costs by limiting both coverage and the level of reimbursement of new drugs. They may also refuse to provide coverage of approved products for medical indications other than those for which the FDA has granted market approvals. As a result, significant uncertainty exists as to whether and how much third-party payors will reimburse patients for their use of newly approved drugs, which in turn will put pressure on the pricing of drugs. We expect to experience pricing pressures in connection with the sale of our products due to the trend toward managed health care, the increasing influence of health maintenance organizations, and additional legislative proposals as well as country, regional, or local healthcare budget limitations.

Governments may impose price controls, which may adversely affect our future profitability.

We intend to seek approval to market our future products in both the United States and in foreign jurisdictions. If we obtain approval in one or more foreign jurisdictions, we will be subject to rules and regulations in those jurisdictions relating to our product. In some foreign countries, particularly in the European Union, the pricing of prescription pharmaceuticals and biologics is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take considerable time after the receipt of marketing approval for a product candidate. If reimbursement of our future products is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, we may be unable to achieve or sustain profitability.

Healthcare reform measures, if implemented, could hinder or prevent our commercial success.

There have been, and likely will continue to be, legislative and regulatory proposals at the federal and state levels directed at broadening the availability of health care and containing or lowering the cost of health care. We cannot predict the initiatives that may be adopted in the future. The continuing efforts of the government, insurance companies, managed care organizations, and other payors of healthcare services to contain or reduce costs of health care may adversely affect:

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If we are unable to establish sales and marketing capabilities or fail to enter into agreements with third parties to market and sell any products we may successfully develop, we may not be able to effectively market and sell any such products and generate product revenue.

We do not currently have the infrastructure for the sales, marketing, and distribution of any of our product candidates, and must build this infrastructure or make arrangements with third parties to perform these functions in order to commercialize any products that we may successfully develop. The establishment and development of a sales force, either by us or jointly with a development partner, or the establishment of a contract sales force to market any products we may develop will be expensive and time consuming and could delay any product launch. If we or our development partners are unable to establish sales and marketing capabilities or any other nontechnical capabilities necessary to commercialize any products we may successfully develop, we will need to contract with third parties to market and sell such products. We may not be able to establish arrangements with third parties on acceptable terms, if at all.

Risks Related to Our Dependence on Third Parties

We are dependent on Sanofi for most aspects of the development and commercialization of KB001-A, and Sanofi’s failure to develop and/or commercialize KB001-A would result in a material adverse effect on our business and operating results.

We have granted Sanofi an exclusive license to KB001-A for most aspects of the development and commercialization of KB001-A. Our strategic partnership with Sanofi on KB001-A may not be scientifically, medically, or commercially successful due to a number of important factors, including the following:

Sanofi’s failure to develop or effectively commercialize KB001-A for either VAP or CF would result in a material adverse effect on our business and results of operations and would likely cause our stock price to decline.

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We intend to rely on third parties to conduct our clinical trials. If these third parties do not meet our deadlines or otherwise conduct the trials as required, our clinical development programs could be delayed or unsuccessful and we may not be able to obtain regulatory approval for or commercialize our product candidates when expected or at all.

We do not have the ability to conduct all aspects of our preclinical testing or clinical trials ourselves. We are dependent on Sanofi to conduct the Phase 2 clinical trial for KB001-A for the prevention of VAP and, therefore, the timing of the initiation and completion of this trial is controlled by Sanofi and may occur on substantially different timing from our estimates. We also intend to use CROs to conduct our planned clinical trials and will rely on medical institutions, clinical investigators, CROs, and consultants to conduct our trials in accordance with our clinical protocols. Our future CROs, investigators, and other third parties play a significant role in the conduct of these trials and subsequent collection and analysis of data.

There is no guarantee that any CROs, investigators, or other third parties on which we rely for administration and conduct of our clinical trials will devote adequate time and resources to such trials or perform as contractually required. If any of these third parties fails to meet expected deadlines, fails to adhere to our clinical protocols, or otherwise performs in a substandard manner, our clinical trials may be extended, delayed, or terminated. If any of our clinical trial sites terminates for any reason, we may experience the loss of follow-up information on subjects enrolled in our ongoing clinical trials unless we are able to transfer those subjects to another qualified clinical trial site. In addition, principal investigators for our clinical trials may serve as scientific advisors or consultants to us from time to time and may receive cash or equity compensation in connection with such services. If these relationships and any related compensation result in perceived or actual conflicts of interest, the integrity of the data generated at the applicable clinical trial site may be jeopardized.

We rely completely on third parties to manufacture our preclinical and clinical pharmaceutical supplies and intend to rely on other third parties to produce commercial supplies of approved product candidates, if any, and our dependence on third party suppliers could adversely impact our business.

We are completely dependent on third-party manufacturers for product supply. If these third-party manufacturers are unwilling to deliver sufficient quantities of any of our products to us on a timely basis and in accordance with applicable specifications and other regulatory requirements, there could be a significant interruption of our supplies, which would adversely affect clinical development of the product. Furthermore, if any of our contract manufacturers cannot successfully manufacture material that conforms to our specifications and with FDA regulatory requirements, we will not be able to secure and/or maintain FDA approval, if any, for our product candidates.

We will also rely on our contract manufacturers to purchase from third-party suppliers the materials necessary to produce our product candidates for our anticipated clinical trials. There are a small number of suppliers for certain capital equipment and raw materials used to manufacture our product candidates. We do not have any control over the process or timing of the acquisition of these raw materials by our contract manufacturers. Moreover, we currently do not have agreements in place for the commercial production of these raw materials. Any significant delay in the supply of a product candidate or the raw material components thereof for an ongoing clinical trial could considerably delay completion of that clinical trial, product testing, and potential regulatory approval of that product candidate.

We do not expect to have the resources or capacity to commercially manufacture any of our proposed products if approved, and will likely continue to be dependent on third-party manufacturers. Our dependence on third parties to manufacture and supply us with clinical trial materials and any approved products may adversely affect our ability to develop and commercialize our products on a timely basis.

We may not be successful in establishing and maintaining additional strategic partnerships, which could adversely affect our ability to develop and commercialize products.

In addition to our current strategic partnership with Sanofi, a part of our strategy is to enter into additional strategic partnerships in the future, including alliances with major biotechnology or pharmaceutical companies. We face significant competition in seeking appropriate strategic partners and the negotiation process is time consuming and complex. Moreover, we may not be successful in our efforts to establish a strategic partnership or other alternative arrangements for any future product candidates and programs because our research and development pipeline may be insufficient, our product candidates and programs may be deemed to be at too early a stage of development for collaborative effort, and/or third parties may not view our product candidates and programs as having the requisite potential to demonstrate safety and efficacy. Even if we are successful in our efforts to establish new strategic partnerships, the terms that we agree upon may not be favorable to us and we may not be able to maintain such strategic partnerships if, for example, development or approval of a product candidate is delayed or sales of an approved product are disappointing. Any delay in entering into new strategic partnership agreements related to our product candidates could delay the development and commercialization of our product candidates and reduce their competitiveness if they reach the market.

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Moreover, if we fail to establish and maintain additional strategic partnerships related to our product candidates:

Risks Relating to our Finances and Other Financial Matters

We have a history of operating losses, we expect to continue to incur losses, and we may never become profitable.

We have never been profitable and, as of March 31, 2012, we had an accumulated deficit of $75.9 million. We have incurred net losses each year since our inception except for the year ended December 31, 2007, including net operating losses of $2.3 million for the year ended December 31, 2011; $6.1 million for the year ended December 31, 2010; and $27.5 million for the year ended December 31, 2009. To date, we have only recognized revenues through payments for funded research and development and for license or collaboration fees. We expect to make substantial expenditures and incur additional operating losses in the future, to further develop and commercialize our product candidates. Our accumulated deficit is expected to increase significantly as we expand our development and clinical trial efforts. Our ability to achieve and sustain profitability depends on obtaining regulatory approvals for and successfully commercializing our lead product candidates, either alone or with third parties. We do not currently have the required approvals to market any of our product candidates and we may not receive them. We may not be profitable even if we or our commercialization partners succeed in commercializing any of our product candidates. Because of the numerous risks and uncertainties associated with developing our product candidates and their potential for commercialization, we are unable to predict the extent of any future losses or when we will become profitable, if at all.

Raising additional funds by issuing securities or through licensing or lending arrangements may cause dilution to our existing stockholders, restrict our operations or require us to relinquish proprietary rights.

To the extent that we raise additional capital by issuing equity securities, the share ownership of existing stockholders will be diluted. Any future debt financing may involve covenants that restrict our operations, including limitations on our ability to incur liens or additional debt; pay dividends; redeem our stock; make certain investments; and engage in certain merger, consolidation, or asset sale transactions, among other restrictions. In addition, if we raise additional funds through licensing arrangements, it may be necessary to relinquish potentially valuable rights to our product candidates or grant licenses on terms that are not favorable to us.

If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, which could harm our operating results, investors’ views of us and, as a result, the value of our common stock.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and related rules (collectively, “SOX”), our management will be required to report the effectiveness of our internal control over financial reporting. When and if we are a “large accelerated filer” or an “accelerated filer” and are no longer an “emerging growth company,” each as defined in the Securities Exchange Act of 1934, as amended, or the Exchange Act, our independent registered public accounting firm will be required to attest to the effectiveness of our internal control over financial reporting. The rules governing the standards that must be met for management to assess our internal control over financial reporting are complex and require significant documentation, testing, and possible remediation. To comply with the requirements of being a reporting company under the Exchange Act, we may need to upgrade our systems including information technology; implement additional financial and management controls, reporting systems, and procedures; and hire additional accounting and finance staff.

As a private company with limited resources, historically we have not had sufficient accounting and supervisory personnel with the appropriate level of technical accounting experience and training necessary, or adequate formally documented accounting policies and procedures to support, effective internal controls. We will commence the process of formally documenting, reviewing, and improving our internal controls over financial reporting for compliance with Section 404 of SOX and have already made efforts to improve our internal controls and accounting policies and procedures, including hiring new accounting personnel and engaging external temporary resources. However, we may continue to identify deficiencies and weaknesses in our internal controls. If material weaknesses or deficiencies in our internal controls exist and go undetected, our financial statements could contain material misstatements that, when discovered in the future, could cause us to fail to meet our future reporting obligations and cause the price of our common stock to decline.

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Our ability to utilize our net operating loss carryforwards and certain other tax attributes may be limited.

We have incurred substantial losses during our history and do not expect to become profitable in 2012 and may never achieve profitability. To the extent that we continue to generate taxable losses, unused losses will carry forward to offset future taxable income, if any, until such unused losses expire. We may be unable to use these losses to offset income before such unused losses expire. Under Section 382 of the Internal Revenue Code, if a corporation undergoes an “ownership change” (generally defined as a greater than 50% change (by value) in its equity ownership over a three year period), the corporation’s ability to use its pre-change net operating loss carryforwards and other pre-change tax attributes to offset its post-change income may be further limited. We may experience ownership changes in the future as a result of subsequent shifts in our stock ownership. As of December 31, 2011, we had federal and state net operating loss carryforwards of $67.0 million and $66.9 million, respectively, that could be limited if we experience an ownership change, which could have an adverse effect on our results of operations. These federal and state net operating loss carryforwards will expire commencing 2030 and 2028, respectively, if not utilized.

Risks Related to Our Business

Because we have a short operating history, there is a limited amount of information about us upon which you can evaluate our business and prospects.

Our operations began in March 2000 and we have a limited operating history upon which you can evaluate our business and prospects. In addition, as an early-stage company we have limited experience and have not yet demonstrated an ability to successfully overcome many of the risks and uncertainties frequently encountered by companies in new and rapidly evolving fields, particularly in the biopharmaceutical area. For example, to execute our business plan we will need to successfully:

If we are unsuccessful in accomplishing these objectives, we may not be able to develop product candidates, raise capital, expand our business, or continue our operations.

If we fail to attract and retain key management and clinical development personnel, we may be unable to successfully develop or commercialize our product candidates.

We will need to expand and effectively manage our managerial, operational, financial, and other resources in order to successfully pursue our clinical development and commercialization efforts. As a company with a limited number of personnel we are highly dependent on the development, regulatory, commercial, and financial expertise of the members of our senior management, in particular David W. Pritchard, our president and chief executive officer, and Geoffrey Yarranton, our executive vice president and chief scientific officer. The loss of such individuals or the services of any of our other senior management could delay or prevent the further development and potential commercialization of our product candidates and, if we are not successful in finding suitable replacements, could harm our business. Our former Chief Medical Officer resigned in February 2012, and it took us three months to hire our current Chief Medical Officer in May 2012. Our success also depends on our continued ability to attract, retain, and motivate highly qualified management and scientific personnel and we may not be able to do so in the future due to intense competition among biotechnology and pharmaceutical companies, universities, and research organizations for qualified personnel. If we are unable to attract and retain the necessary personnel, we may experience significant impediments to our ability to implement our business strategy.

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If we fail to effectively integrate our new executive officers into our organization, the future development and commercialization of our product candidates may suffer, harming future regulatory approvals, sales of our product candidates or our results of operations.

Our Chief Medical Officer recently joined us in May 2012, and our Chief Financial Officer joined us in July 2012. As a result, certain members of our executive team have not worked together as a group for a significant period of time. Our future performance will depend, in part on our ability to successfully integrate our newly hired executive officers into our management team and our ability to develop an effective working relationship among senior management. Our failure to integrate these individuals and create effective working relationships among them and other members of management could result in inefficiencies in the development and commercialization of our product candidates, harming future regulatory approvals, sales of our product candidates and our results of operations.

We may encounter difficulties in managing our growth and expanding our operations successfully.

As we seek to advance our product candidates through clinical trials we will need to expand our development, regulatory, manufacturing, marketing, and sales capabilities or contract with third parties to provide these capabilities for us. As our operations expand we expect that we will need to manage additional relationships with various strategic partners, suppliers, and other third parties. Future growth will impose significant added responsibilities on members of management. Our future financial performance and our ability to commercialize our product candidates and to compete effectively will depend in part on our ability to manage any future growth effectively. To that end, we must be able to manage our development efforts and clinical trials effectively and hire, train, and integrate additional management, administrative, and sales and marketing personnel. We may not be able to accomplish these tasks and our failure to accomplish any of them could prevent us from successfully growing our company.

We face potential product liability exposure and, if successful claims are brought against us, we may incur substantial liability for a product candidate and may have to limit its commercialization.

The use of our product candidates in clinical trials and the sale of any products for which we may obtain marketing approval expose us to the risk of product liability claims. Product liability claims may be brought against us or our partners by participants enrolled in our clinical trials, patients, health care providers, or others using, administering, or selling our products. If we cannot successfully defend ourselves against any such claims, we would incur substantial liabilities. Regardless of merit or eventual outcome, product liability claims may result in:

We have obtained limited product liability insurance coverage for our clinical trials domestically and in selected foreign countries where we are conducting clinical trials. Our coverage is currently limited to $10 million per occurrence and $10 million in the aggregate per year. As such, our insurance coverage may not reimburse us or may not be sufficient to reimburse us for any expenses or losses we may suffer. Moreover, insurance coverage is becoming increasingly expensive and in the future we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect us against losses due to product liability. We intend to expand our insurance coverage for products to include the sale of commercial products if we obtain marketing approval for our product candidates in development; however, we may be unable to obtain commercially reasonable product liability insurance for any products approved for marketing. Large judgments have been awarded in class action lawsuits based on drugs that had unanticipated side effects. A successful product liability claim or series of claims brought against us, particularly if judgments exceed our insurance coverage, could decrease our cash and adversely affect our business.

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Our insurance policies are expensive and protect us only from some business risks, which will leave us exposed to significant uninsured liabilities.

We do not carry insurance for all categories of risk that our business may encounter. For example, we do not carry earthquake insurance. In the event of a major earthquake in our region, our business could suffer significant and uninsured damage and loss. Some of the policies we currently maintain include general liability, employment practices liability, property, auto, workers’ compensation, products liability, and directors’ and officers’ insurance. We do not know, however, if we will be able to maintain existing insurance with adequate levels of coverage. Any significant, uninsured liability may require us to pay substantial amounts, which would adversely affect our cash position and results of operations.

Our employees may engage in misconduct or other improper activities including noncompliance with regulatory standards and requirements and insider trading.

We are exposed to the risk of employee fraud or other misconduct. Misconduct by employees could include intentional failures to comply with FDA regulations, provide accurate information to the FDA, comply with manufacturing standards we have established, comply with federal and state health care fraud and abuse laws and regulations, report financial information or data accurately, or disclose unauthorized activities to us. In particular, sales, marketing, and business arrangements in the health care industry are subject to extensive laws and regulations intended to prevent fraud, kickbacks, self-dealing, and other abusive practices. These laws and regulations may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs, and other business arrangements. Employee misconduct could also involve improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation.

In addition, during the course of our operations our directors, executives, and employees may have access to material, nonpublic information regarding our business, our results of operations, or potential transactions we are considering. We may not be able to prevent a director, executive, or employee from trading in our common stock on the basis of, or while having access to, material, nonpublic information. If a director, executive, or employee was to be investigated or an action was to be brought against a director, executive, or employee for insider trading, it could have a negative impact on our reputation and our stock price. Such a claim, with or without merit, could also result in substantial expenditures of time and money, and divert attention of our management team from other tasks important to the success of our business.

We use biological materials and may use hazardous materials, and any claims relating to improper handling, storage, or disposal of these materials could be time consuming or costly.

We may use hazardous materials, including chemicals and biological agents and compounds that could be dangerous to human health and safety or the environment. Our operations also produce hazardous waste products. Federal, state, and local laws and regulations govern the use, generation, manufacture, storage, handling, and disposal of these materials and wastes. Compliance with applicable environmental laws and regulations may be expensive and current or future environmental laws and regulations may impair our product development efforts. In addition, we cannot entirely eliminate the risk of accidental injury or contamination from these materials or wastes. We do not carry specific biological or hazardous waste insurance coverage and our property, casualty, and general liability insurance policies specifically exclude coverage for damages and fines arising from biological or hazardous waste exposure or contamination. Accordingly, in the event of contamination or injury we could be held liable for damages or be penalized with fines in an amount exceeding our resources, and our clinical trials or regulatory approvals could be suspended.

Our internal computer systems, or those of third party clinical research organizations or other contractors or consultants, may fail or suffer security breaches, which could result in a material disruption of our product development programs.

Despite the implementation of security measures, our internal computer systems and those of third party clinical research organizations and other contractors and consultants are vulnerable to damage from computer viruses, unauthorized access, natural disasters, terrorism, war, and telecommunication and electrical failures. While we have not experienced any such system failure, accident, or security breach to date, if such an event were to occur and cause interruptions in our operations, it could result in a material disruption of our programs. For example, the loss of clinical trial data for any of our product candidates could result in delays in our regulatory approval efforts and significantly increase our costs to recover or reproduce the data. To the extent that any disruption or security breach results in a loss of or damage to our data or applications, or inappropriate disclosure of confidential or proprietary information, we could incur liabilities and the further development of our product candidates could be delayed.

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Risks Related to Intellectual Property

Our success depends on our ability to protect our intellectual property and our proprietary technologies.

Our commercial success depends in part on our ability to obtain and maintain patent protection and trade secret protection for our product candidates, proprietary technologies, and their uses as well as our ability to operate without infringing upon the proprietary rights of others. There can be no assurance that our patent applications or those of our licensors will result in additional patents being issued or that issued patents will afford sufficient protection against competitors with similar technology, nor can there be any assurance that the patents issued will not be infringed, designed around, or invalidated by third parties. Even issued patents may later be found unenforceable or may be modified or revoked in proceedings instituted by third parties before various patent offices or in courts. The degree of future protection for our proprietary rights is uncertain. Only limited protection may be available and may not adequately protect our rights or permit us to gain or keep any competitive advantage. This failure to properly protect the intellectual property rights relating to these product candidates could have a material adverse effect on our financial condition and results of operations.

The patent application process is subject to numerous risks and uncertainties, and there can be no assurance that we or our partners will be successful in protecting our product candidates by obtaining and defending patents. These risks and uncertainties include the following:

In addition to patents, we and our partners rely on trade secrets and proprietary know-how. Although we have taken steps to protect our trade secrets and unpatented know-how, including entering into confidentiality agreements with third parties, and confidential information and inventions agreements with employees, consultants, and advisors, third parties may still obtain this information or may come upon this or similar information independently. If any of these events occurs or if we otherwise lose protection for our trade secrets or proprietary know-how, the value of this information may be greatly reduced.

If we or our partners are sued for infringing intellectual property rights of third parties, it will be costly and time consuming, and an unfavorable outcome in that litigation would have a material adverse effect on our business.

Our success also depends on our ability and the ability of any of our future collaborators to develop, manufacture, market, and sell our product candidates without infringing upon the proprietary rights of third parties. Numerous U.S.-issued and foreign-issued patents and pending patent applications owned by third parties exist in the fields in which we are developing products, some of which may be directed at claims that overlap with the subject matter of our intellectual property. Because patent applications can take many years to issue there may be currently pending applications, unknown to us, that may later result in issued patents upon which our product candidates or proprietary technologies may infringe. Similarly, there may be issued patents relevant to our product candidates of which we are not aware.

There is a substantial amount of litigation involving patent and other intellectual property rights in the biotechnology and biopharmaceutical industries generally. If a third party claims that we or any of our licensors, suppliers, or collaborators infringe upon a third party’s intellectual property rights, we may have to:

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We may be involved in lawsuits to protect or enforce our patents or the patents of our licensors, which could be expensive, time consuming and unsuccessful.

Competitors may infringe upon our patents or the patents of our licensors. To counter infringement or unauthorized use, we may be required to file infringement claims, which can be expensive and time consuming. An adverse result in any litigation or defense proceedings could put one or more of our patents at risk of being invalidated, found to be unenforceable, or interpreted narrowly and could put our patent applications at risk of not issuing. Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential information could be compromised by disclosure during this type of litigation.

Most of our competitors are larger than we are and have substantially greater resources. They are, therefore, likely to be able to sustain the costs of complex patent litigation longer than we could. In addition, the uncertainties associated with litigation could have a material adverse effect on our ability to raise the funds necessary to continue our clinical trials, continue our internal research programs, in-license needed technology, or enter into strategic partnerships that would help us bring our product candidates to market.

In addition, any future patent litigation, interference, or other administrative proceedings will result in additional expense and distraction of our personnel. An adverse outcome in such litigation or proceedings may expose us or our strategic partners to loss of our proprietary position, expose us to significant liabilities, or require us to seek licenses that may not be available on commercially acceptable terms, if at all.

We may fail to comply with any of our obligations under existing agreements pursuant to which we license rights or technology, which could result in the loss of rights or technology that are material to our business.

We are a party to technology licenses that are important to our business and we may enter into additional licenses in the future. We currently hold licenses from Medical College of Wisconsin, University of California at San Francisco, Ludwig Institute, BioWa, Lonza, and Sanofi. These licenses impose various commercial, milestone payment, royalty, insurance, indemnification, and other obligations on us. If we fail to comply with these obligations, the licensor may have the right to terminate the license, in which event we would lose valuable rights under our collaboration agreements and our ability to develop product candidates.

We may be subject to claims that our consultants or independent contractors have wrongfully used or disclosed alleged trade secrets of their other clients or former employers to us.

As is common in the biotechnology and pharmaceutical industry, we engage the services of consultants to assist us in the development of our product candidates. Many of these consultants were previously employed at, or may have previously or may be currently providing consulting services to, other biotechnology or pharmaceutical companies including our competitors or potential competitors. We may become subject to claims that our company or a consultant inadvertently or otherwise used or disclosed trade secrets or other information proprietary to their former employers or their former or current clients. Litigation may be necessary to defend against these claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to our management team.

Changes in U.S. patent law could diminish the value of patents in general, thereby impairing our ability to protect our products.

As is the case with other biopharmaceutical companies, our success is heavily dependent on intellectual property, particularly patents. Obtaining and enforcing patents in the biopharmaceutical industry involve technological and legal complexity. Therefore, obtaining and enforcing biopharmaceutical patents is costly, time consuming, and inherently uncertain. In addition, Congress may pass patent reform legislation. The Supreme Court has ruled on several patent cases in recent years, either narrowing the scope of patent protection available in certain circumstances or weakening the rights of patent owners in certain situations. In addition to increasing uncertainty with regard to our ability to obtain patents in the future, this combination of events has created uncertainty with respect to the value of patents, once obtained. Depending on decisions by the U.S. Congress, the federal courts, and the U.S. Patent and Trademark Office, the laws and regulations governing patents could change in unpredictable ways that would weaken our ability to obtain new patents or to enforce our existing patents and patents we might obtain in the future.

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Risks Associated with our Capital Stock

No public market exists for our securities and we cannot assure you that our common stock will be listed on any securities exchange or quoted on any over-the-counter quotation system or that an active trading market will ever develop for any of our securities.

There is no public market for our capital stock. Following the effectiveness of this Form 10, we intend to register for resale under the Securities Act of 1933, as amended, or the Securities Act, the common stock issuable upon conversion of our preferred stock and will seek to list our common stock on the NYSE, Amex, or the NASDAQ Stock Market within the next eighteen months. We cannot assure you that we will be able to meet the initial listing standards of any of such markets or any other stock exchange, or predict the timing of such listing or that, if quoted, we will be able to maintain such a listing. If our common stock is listed on an over-the-counter system, an investor may find it more difficult to dispose of shares or obtain accurate quotations as to the market value of our common stock that would be the case if and when we list on the NYSE, Amex, the NASDAQ Stock Market or other stock exchange.

Because we are becoming a reporting company under the Exchange Act by means of filing this Form 10, we may not be able to attract the attention of research analysts at major brokerage firms.

Because we do not intend to become a reporting company by conducting an underwritten initial public offering (IPO) of our common stock, we do not expect security analysts of major brokerage firms to provide coverage of our company in the near future. In addition, major investment banks may be less likely to agree to underwrite secondary offerings on our behalf than they might if we were to become a public reporting company by means of an IPO. The failure to receive research coverage or support in the market for our shares would have an adverse effect on our ability to develop a liquid market for our common stock.

Requirements associated with being a public company will increase our costs significantly, as well as divert significant company resources and management attention.

Prior to this offering, we have not been subject to the reporting requirements of the Exchange Act or the other rules and regulations of the SEC or any securities exchange relating to public companies. We are working with our legal, independent accounting and financial advisors to identify those areas in which changes should be made to our financial and management control systems to manage our growth and our obligations as a public company. These areas include corporate governance, corporate control, disclosure controls and procedures and financial reporting and accounting systems. We have made, and will continue to make, changes in these and other areas. However, the expenses that will be required in order to adequately prepare for being a public company could be material. Compliance with the various reporting and other requirements applicable to public companies will also require considerable time and attention of management. In addition, the changes we make may not be sufficient to allow us to satisfy our obligations as a public company on a timely basis.

In addition, being a public company could make it more difficult or more costly for us to obtain certain types of insurance, including directors’ and officers’ liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers.

Our common stock may become subject to the SEC’s penny stock rules, so broker-dealers may experience difficulty in completing customer transactions and trading activity in our securities may be adversely affected.

The SEC has adopted regulations that generally define “penny stock” to be an equity security that has a market price of less than $5.00 per share, subject to specific exemptions. The market price of our common stock may be less than $5.00 per share for some period of time and therefore would be a “penny stock” according to SEC rules, unless we are listed on a national securities exchange. Under these rules, broker-dealers who recommend such securities to persons other than institutional accredited investors must:

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If required to comply with these rules, broker-dealers may find it difficult to effectuate customer transactions and trading activity in our securities may be adversely affected.

Even if an active trading market develops for our common stock, our stock price may experience substantial volatility as a result of a number of factors, including:

Many of these factors are beyond our control. The stock markets in general, and the market for pharmaceutical and biotechnological companies in particular, have historically experienced extreme price and volume fluctuations. These fluctuations often have been unrelated or disproportionate to the operating performance of these companies. These broad market and industry factors could reduce the market price of our common stock regardless of our actual operating performance

Following the effectiveness of this Form 10, we may file a registration statement to register for resale the shares underlying our preferred stock. The availability of a substantial number of shares for resale could cause our stock price to decline, even if our business is doing well.

Following the effectiveness of this Form 10, we may file a registration statement under the Securities Act to permit the resale of the shares of common stock underlying our outstanding preferred stock. Following the effective date of such registration statement, a large number of shares of common stock will become available for sale in the public market. In addition, there are a substantial number of shares of our common stock underlying outstanding options and warrants. The availability of a substantial number of shares for resale under the registration statement or pursuant to Rule 144 promulgated under the Securities Act could cause our stock price to decline, even if our business is doing well.

We currently have outstanding shares of Series A preferred stock, Series B-1 preferred stock, Series B-2 preferred stock, Series C preferred stock, Series D preferred stock, and Series E preferred stock that have special rights that could limit our ability to undertake corporate transactions, inhibit potential changes of control and reduce the proceeds available to our common stockholders in the event of a change in control.

We currently have outstanding two classes of stock, common stock and preferred stock, and there are six series of preferred stock, Series A preferred stock, Series B-1 preferred stock, Series B-2 preferred stock, Series C preferred stock, Series D preferred stock, and Series E preferred stock. The holders of preferred stock, voting together, are entitled to elect two directors to our board. Pursuant to the terms of our amended and restated voting agreement, the parties to the agreement have agreed to vote their shares in such a way as to ensure that one director elected by the holders of preferred stock shall be a nominee of Sofinnova Ventures for so long as Sofinnova Ventures (or its affiliates) continues to hold at least five percent of our outstanding common stock, including shares of common stock issuable upon conversion of our preferred stock, options, and warrants. See “Certain Relationships and Related Transactions, and Director Independence—Voting Agreement.”

The holders of our preferred stock are entitled to various protective rights and certain consents from them are required before we are able to take certain actions, including the following:

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In addition, the holders of our preferred stock have anti-dilution protection under our amended and restated certificate of incorporation, which provides that in the event we issue additional shares of our common stock, options or rights to purchase our common stock or securities convertible into our common stock without consideration or at a price per share that is less than the then-effective conversion price of any series of our preferred stock, the conversion price of such series of preferred stock will be adjusted on a weighted average formula. As a result of such adjustments, each share of preferred stock would convert into a greater number of shares of our common stock.

As a result of the rights our preferred stockholders have, we may not be able to undertake certain corporate transactions, including equity or debt offerings necessary to raise sufficient capital to run our business, change of control transactions, or other transactions that may otherwise be beneficial to our businesses. In addition, the holders of our preferred stock will receive preferential payment in the event of certain change of control or liquidation transactions, possibly reducing the proceeds that would be available to our common stockholders. These provisions may discourage, delay, or prevent a merger, acquisition, or other change in control of our company that stockholders may consider favorable, including transactions in which our common stockholders might otherwise receive a premium price for their shares. Share of our preferred stock are also entitled to cumulative dividends. See “Item 11. Description of Registrant’s Securities to be Registered—Preferred Stock” for more detailed description of the rights of our preferred stock. If a trading market for our common stock were to be established, the market price of our common stock could be adversely affected by the rights of our preferred stockholders and lead investors. In addition, because our board of directors is responsible for appointing the members of our management team, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors.

We have never paid and do not intend to pay cash dividends.

We have never paid cash dividends on any of our capital stock and we currently intend to retain future earnings, if any, to fund the development and growth of our business.

Anti-takeover provisions in our charter documents and Delaware law could discourage, delay or prevent a change in control of our company and may affect the trading price of our common stock.

We are a Delaware corporation and the anti-takeover provisions of the Delaware General Corporation Law may discourage, delay, or prevent a change in control by prohibiting us from engaging in a business combination with an interested stockholder for a period of 3 years after the person becomes an interested stockholder, even if a change in control would be beneficial to our existing stockholders. In addition, our amended and restated certificate of incorporation and amended and restated bylaws may discourage, delay, or prevent a change in our management or control over us that stockholders may consider favorable. Our amended and restated certificate of incorporation and amended and restated bylaws:

We are an emerging growth company and we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.

We are an emerging growth company. Under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards until such time as those standards apply to private companies. We plan to avail ourselves of this exemption from new or revised accounting standards and, therefore, we may not be subject to the same new or revised accounting standards as other public companies that are not “emerging growth companies.”

For as long as we continue to be an emerging growth company, we also intend to take advantage of certain other exemptions from various reporting requirements that are applicable to other public companies including, but not limited to, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, exemptions from the requirements of holding a nonbinding advisory stockholder vote on executive compensation and any golden parachute payments not previously approved, exemption from the requirement of auditor attestation in the assessment of our internal control over financial reporting and exemption from any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis). If we do, the information that we provide stockholders may be different than what is available with respect to other public companies. We cannot predict if investors will find our common stock less attractive because we will rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile.

We will remain an emerging growth company until the earliest of (i) the end of the fiscal year in which the market value of our common stock that is held by non-affiliates exceeds $700 million as of the end of the second fiscal quarter, (ii) the end of the fiscal year in which we have total annual gross revenues of $1 billion or more during such fiscal year, (iii) the date on which we issue more than $1 billion in non-convertible debt in a three-year period or (iv) the end of the fiscal year following the fifth anniversary of the date of the first sale of our common stock pursuant to an effective registration statement filed under the Securities Act.

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Item 2. Financial Information.

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

Forward-Looking Statements

Statements in the following discussion and throughout this report that are not historical in nature are “forward-looking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. You can identify forward-looking statements by the use of words such as “expect,” “anticipate,” “estimate,” “may,” “will,” “should,” “intend,” “believe,” and similar expressions. Although we believe the expectations reflected in these forward-looking statements are reasonable, such statements are inherently subject to risk and we can give no assurances that our expectations will prove to be correct. Actual results could differ from those described in this report because of numerous factors, many of which are beyond our control. These factors include, without limitation, those described under Item 1A “Risk Factors.” We undertake no obligation to update these forward-looking statements to reflect events or circumstances after the date of this report or to reflect actual outcomes. The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes thereto and other financial information appearing elsewhere in this Form 10.

Overview

We are a biopharmaceutical company focused on monoclonal antibody therapeutics for diseases that are a significant burden to society and patients and their families. We are developing patient-targeted, first -in-class medicines to treat serious medical conditions. Our primary clinical focus is on respiratory diseases and cancer. Our principal pharmaceutical product candidates in clinical development are:

KB001-A and KB003 are scheduled to begin randomized placebo controlled Phase 2 clinical trials for the treatment of respiratory diseases in the third quarter of 2012 and early 2013, respectively. KB004 is in Phase 1 clinical testing for hematological malignancies. We will need to raise additional capital in order to complete our Phase 2 clinical trials.

In January 2010, we entered into an agreement granting Sanofi exclusive worldwide rights to commercialize KB001-A for all indications, the lead indication being the prevention of ventilator associated pneumonia caused by Pa infection ( Pa VAP) in patients receiving mechanical ventilation. Under the agreement, we received an upfront payment of $35 million and a $5 million payment in August 2011. We have the potential to receive additional clinical and regulatory contingent payments up to an aggregate $250 million if certain events are achieved, together with tiered royalties based upon global net sales of KB001-A.

We licensed our proprietary Humaneered™ antibody technology to Novartis in 2007 on a non-exclusive basis and received a license fee of $30 million. We are not currently actively pursuing the license of our Humaneered™ technology to third parties and we are not expecting to receive future revenue from additional licenses to this technology.

Critical Accounting Policies and Use of Estimates

Our management's discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. We base our estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances and review our estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.

We are an emerging growth company. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards until such time as those standards apply to private companies. We plan to avail ourselves of this exemption from new or revised accounting standards and, therefore, we may not be subject to the same new or revised accounting standards as other public companies that are not “emerging growth companies.”

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While our significant accounting policies are described in more detail in Note 2 of our consolidated financial statements included in this Form 10, we believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our financial statements.

Revenue Recognition

Our contract revenues are generated primarily through research and development collaboration agreements, which may include nonrefundable, non-creditable upfront fees, funding for research and development efforts, and milestone or other contingent payments for achievements with regards to our licensed products. We have not materially modified any previous collaboration agreements or entered into any new agreements in 2011, nor have we received any milestone payments in 2011. Therefore, all collaboration agreements have been accounted for in accordance with the accounting guidance applicable to such arrangements prior to the adoption of Accounting Standards Update (ASU) 2009-13, Multiple-Deliverable Revenue Arrangements, and ASU 2010-17, Revenue Recognition – Milestone Method.

We recognize revenue when persuasive evidence of an arrangement exists; transfer of technology has been completed, services are performed or products have been delivered; the fee is fixed and determinable; and collection is reasonably assured.

For multiple element arrangements, we evaluate whether the components of each arrangement were to be accounted for as separate units of accounting based on certain criteria. Upfront payments for licensing our intellectual property to date have not been separable from the activity of providing research and development services because the license has not been assessed to have stand-alone value separate from the research and development services provided. Such upfront payments are recorded as deferred revenue in the balance sheet and are recognized as contract revenue over the contractual or estimated substantive performance period, which is consistent with the term of the research and development obligations contained in the research and development collaboration agreement.

Payments resulting from our research and development efforts under license agreements are recognized as the activities are performed and are presented on a gross basis. Revenue is recorded gross because we act as a principal, with discretion to choose suppliers, bear credit risk and perform part of the services.

Substantive, at-risk milestone payments are recognized as revenue when the milestone is achieved and collectability is reasonably assured. When contingent payments are not for substantive and at-risk milestones, revenue is recognized over the estimated remaining term of the related service period or, if there are no continuing performance obligations under the arrangement, upon receipt provided that collection is reasonably assured and other revenue recognition criteria have been satisfied.

Research and Development Expenses

As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing contracts and purchase orders, reviewing the terms of our license agreements, communicating with our applicable personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of actual cost. The majority of our service providers invoice us monthly in arrears for services performed. We make estimates of our accrued expenses as of each balance sheet date in our consolidated financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. Examples of estimated accrued research and development expenses include fees to:

We base our expenses related to clinical studies on our estimates of the services received and efforts expended pursuant to contracts with multiple research institutions and contract research organizations that conduct and manage clinical studies on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows and expense recognition. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual accordingly. Our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in our reporting changes in estimates in any particular period. Adjustments to prior period estimates have not been material for each of the years ended December 31, 2009, 2010 and 2011 and the three months ended March 31, 2011 and 2012.

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Stock-Based Compensation

We expense stock-based compensation to employees over the requisite service period based on the estimated grant-date fair value-based measurement of the awards and considering estimated forfeiture rates. For stock-based compensation awards to non-employees, we re-measure the fair value-based measurement of the non-employee awards at each reporting period prior to vesting and finally at the vesting date of the award. Changes in the estimated fair value-based measurement of these non-employee awards are recognized as compensation expense in the period of change.

Determining the appropriate fair value-based measurement of stock-based awards requires the use of subjective assumptions. In the absence of a public trading market for our common stock, we conducted periodic assessments of the valuation of our common stock. These valuations were performed concurrently with the achievement of significant milestones, with major financing transactions or when prior valuations became stale under Section 409A of the Internal Revenue Code. The determination of the fair value-based measurement of options using an option-pricing model is affected by our estimated common stock fair value as well as assumptions regarding a number of other subjective variables. These other variables include the expected term of the options, our expected stock price volatility over the expected term of the options, stock option exercise and cancellation behaviors, risk-free interest rates, and expected dividends, which are estimated as follows:

The estimation of the number of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period in which estimates are revised. Forfeitures are estimated such that we only recognize expense for those shares expected to vest, and adjustments are made if actual forfeitures differ from those estimates.

For the years ended December 31, 2009, 2010, and 2011, stock-based compensation expense was $0.3 million, $0.3 million and $0.2 million, respectively. For the three month periods ended March 31, 2011 and 2012, stock-based compensation expense was $55,000 and $21,000, respectively. As of December 31, 2011 and March 31, 2012, we had approximately $0.2 million of total unrecognized compensation expense, net of related forfeiture estimates, which we expect to recognize over a weighted-average period of approximately 2.6 years and 2.7 years, respectively.

If any of the assumptions used in a Black-Scholes model changes significantly, stock-based compensation for future awards may differ materially compared with the awards granted previously.

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Common Stock Valuations

The fair value of the common stock underlying our stock options and restricted stock was determined by our board of directors, which intended all options granted to be exercisable at a price per share not less than the per share fair value of our common stock underlying those options on the date of grant. All stock awards previously granted or to be granted in the future were or are expected to be granted at the grant date fair value of the award. The valuations of our common stock were determined in accordance with the guidelines outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Valuation analysis of our common stock was performed by third party valuation specialists. The methodology used by the third party valuation specialists to determine the fair value of our common stock included estimating the fair value of the enterprise, subtracting the fair value of debt from this enterprise value, and then allocating this value using the Option Pricing Method to all of the equity interests. The assumptions used in the valuation model to determine the fair value of our common stock as of the date of each option and restricted stock award, are based on numerous objective and subjective factors combined with management judgment including the following:

We have granted stock options during the period from December 31, 2010 through March 31, 2012 as summarized below:

We also issued restricted stock awards during the period from December 31, 2010 through March 31, 2012 as summarized below:

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Management and our board of directors performed valuation analyses with the assistance of independent valuation specialists to determine the then current fair value of our common stock. To facilitate these valuation analyses, we developed projections of our future revenues and operating expenses. Key assumptions reflected in the income approach calculations included the anticipated timing of a potential liquidity event, the estimated volatility of our common stock, the discount rate applied to the future cash flows and the discount for lack of marketability of our common stock. These income approach assumptions are set forth below for each of the valuations performed as of November 30, 2010 and 2011:

For grants of stock awards made on dates for which there was no valuation performed by an independent valuation specialist, our board of directors determined the fair value of our common stock on the date of grant based upon the immediately preceding valuation and other pertinent information available to it at the time of grant.

A valuation was performed by management and our board of directors with the assistance of an independent valuation specialist as of November 30, 2010 that determined the fair value of our common stock to be $0.41 per share. This valuation was performed in accordance with applicable elements of the technical practice aid issued by the American Institute of Certified Public Accountants entitled Valuation of Privately Held Company Equity Securities Issued as Compensation , or the Practice Aid. Given our current stage of development, risks and considering we are not expected to realize any revenues from our three products in the near future, the market approach is not practical for application. Furthermore, the applicability of Guideline Public Companies Trading Multiples Approach is limited due to lack of close comparable guideline public companies in terms of business description, size, business model, stage of development and risks. Accordingly, income approach was used. For the income approach, the specialist utilized the capital asset pricing model to estimate the rate of return required by investors. To facilitate the valuation, we prepared a discounted cash flow analysis by developing projections of revenues and operating expenses and the specialist used a weighted-average cost of capital of 14%, which takes into consideration a company specific risk premium, market risk premium and an assumed risk free rate of return. We applied a marketability discount of 20%. In calculating the marketability discount as of November 30, 2010 using the same commonly-applied industry model as in our previous valuations, we made the following assumptions: 0.5 year period of restriction; 57% volatility metric using a 50:50 weighting of historical volatility and implied volatility; a 0% dividend yield as a percentage of stock price; and a risk-free interest rate of 0.21%. We used a time to liquidity of 0.5 of a year as we anticipated at the time of the valuation that we were likely to be acquired by companies interested in our programs and technology. The volatility factor used was estimated by taking the average historic price volatility for publicly traded industry peers based on daily price observations over the period. The risk-free interest rate was based on the yields of U.S. Treasury securities with maturities similar to the time to liquidity. A marketability discount is used to factor in that private companies are generally less liquid than public companies. Based on the income approach valuation analyses, our board of directors determined the fair value of our common stock at November 30, 2010 to be $0.41 per share.

To provide a reasonable estimate of the fair value of our common stock as of November 30, 2011, an independent valuation specialist prepared an updated discounted cash flow analysis, based on updating our revenue and operating expense projections for changes in product candidates, including our decision to pursue the asthma market for our KB003 program in a Phase 2 study rather than rheumatoid arthritis, as well as an assessment of industry and market trends and risks associated with achieving success, including our declining cash balances. For the income approach, the specialist utilized the capital asset pricing model to estimate the rate of return required by investors. In performing the valuation, a weighted-average cost of capital of 14% was applied to the projections, which takes into consideration a company specific risk premium, market risk premium and an assumed risk free rate of return. A marketability discount of 27% was applied using the same commonly-applied industry model as in our previous valuations. In the second half of 2011, because we did not receive any further acquisition interest from other companies, we continued to focus our development efforts on our programs and initiated Series E preferred stock fund raising efforts. Accordingly, we modified our estimated time to liquidity to 2.0 years, when we estimated that we would have data from one or both of our trials for the KB001-A program for treating patients with cystic fibrosis and KB003 for treating patients with asthma not adequately controlled by corticosteroids, which could attract potential acquirers and new partners or possibly lead to an initial public offering of our common stock. The volatility factor used was estimated by taking the average historic price volatility for publicly traded industry peers based on daily price observations over the period. The risk-free interest rate is based on the yields of U.S. Treasury securities with maturities with similar time to liquidity. The marketability discount is used to factor in that private companies are generally less liquid than public companies. Based on the income approach valuation analyses, our board of directors determined the fair value of our common stock at November 30, 2011 to be $0.61 per share. No significant events occurred between the common stock valuation date of November 30, 2011 and the stock option grant date of March 12, 2012.

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Results of Operations

General

To date, we have not generated any net income from operations and at March 31, 2012 had an accumulated deficit of $75.9 million primarily as a result of expenditures for research and development and general and administrative expenses. While we may in the future generate revenue from a variety of sources, including license fees, milestone payments, research and development payments in connection with strategic partnerships, our product candidates are at an early stage of development and may never be successfully developed or commercialized. Accordingly, we expect to continue to incur substantial losses from operations for the foreseeable future and there can be no assurance that we will ever generate significant revenue.

Contract Revenue

Our recent revenue is comprised primarily of collaboration agreement-related revenue. Collaboration agreement-related revenue has included license fees, payments for research and development services and milestone and other contingent payments.

Research &Development Expenses

Conducting research and development is central to our business model. For the years ended December 31, 2009, 2010 and 2011 and the three months ended March 31, 2011 and 2012, research and development expenses were $22.9 million, $18.9 million, $18.5 million, $5.0 million and $3.2 million, respectively. We expense both internal and external research and development costs as incurred. We currently track the external research and development costs incurred for each of our KB001-A, KB003 and KB004 projects. We have not tracked our external costs by project since inception. We began tracking our external costs by project beginning January 1, 2008. Our external research and development expenses consist primarily of:

Internal research and development costs consist primarily of salaries and related fringe benefit costs for our employees (such as workers compensation and health insurance premiums), stock-based compensation charges, travel costs, lab supplies and overhead expenses. Internal costs generally benefit multiple projects and are not separately tracked per project. The following table shows our total research and development expenses for the years ended December 31, 2009, 2010, 2011 and for the three months ended March 31, 2011 and 2012:

We expect to continue to incur substantial expenses related to our development activities for the foreseeable future as we continue product development and initiate Phase 2 clinical trials for our KB001-A CF program and KB003 severe asthma program, as well as our ongoing Phase 1 clinical trial for our KB004 program. Since product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later stage clinical trials, we expect that our research and development expenses will increase in the future. In addition, if our product development efforts are successful, we expect to incur substantial costs to prepare for potential clinical trials and activities beyond the currently planned Phase 2 trials for KB001-A and KB003 as well as a Phase 1 trial for KB004.

General and Administrative Expenses

General and administrative expenses consist principally of personnel-related costs, professional fees for legal, consulting, audit and tax services, rent and other general operating expenses not otherwise included in research and development. For the years ended December 31, 2009, 2010 and 2011 and the three months ended March 31, 2011 and 2012, general and administrative expenses were $5.2 million, $4.9 million, $4.0 million, $1.0 million and $0.9 million, respectively. We anticipate general and administrative expenses will increase in future periods, reflecting an expanding infrastructure and increased professional fees associated with being a public reporting company under the Exchange Act.

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Contract revenue in each period related solely to our arrangement with Sanofi in which we licensed the KB001-A program to Sanofi in 2010. Contract revenue decreased $1.3 million from the three months ended March 31, 2011 to the three months ended March 31, 2012. This decrease was mainly attributable to a change in the estimated period of our substantive performance obligations with Sanofi originally estimated to be completed by March 2012. We agreed to provide Sanofi with additional transition services through June 2012. This decrease was partially offset by the additional $0.9 million revenue recognized related to the $5 million payment received from Sanofi in August 2011 that was recognized ratably through June 30, 2012.

Research and development expenses decreased $1.8 million, from $5.0 million to $3.2 million for the three months ended March 31, 2011 and 2012, respectively. This was primarily due to a $0.9 million decrease in payroll related expenses, including travel and supplies, resulting from a headcount reduction of 19 employees in our research and development organization during 2011, and a $0.7 million decrease related to less spending for clinical trial expenses for our KB003 rheumatoid arthritis program and less development and manufacturing activities for our KB004 program. These decreases were partially offset by increased spending for our KB001-A program for cystic fibrosis. We discontinued our KB003 rheumatoid arthritis program because we believed the RA market was becoming increasingly competitive. We intend to continue the development of KB003 in the third quarter of 2012 with a Phase 2 study in asthma inadequately controlled with corticosteroids.

General and administrative expenses decreased $0.1 million from $1.0 million for the three months ended March 31, 2011 to $0.9 million for the three months ended March 31, 2012. The decrease in general and administrative expenses was primarily due to a $0.2 million decrease in personnel related costs from a headcount reduction of 5 employees in our general and administrative organization during 2011, offset partially by an increase in legal and accounting fees of $0.1 million to support our financing activities and preparations to become a public company.

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Contract revenue in each period related solely to our arrangement with Sanofi in which we licensed the KB001-A program to Sanofi in 2010. Contract revenue increased $2.5 million from the year ended December 31, 2010 to the year ended December 31, 2011. This increase was primarily attributable to an additional $5.0 million non-refundable payment received in August 2011, of which we recognized $3.3 million in license revenue. This payment represented a second installment of the upfront fees due to us under the agreement with Sanofi for the licensing of our KB001-A program that was being recognized ratably through March 31, 2012, the estimated period over which our substantive performance obligations with Sanofi were expected to be completed. This increase was partially offset by a decrease of $1.0 million in reimbursements from Sanofi for the transition efforts related to the collaboration.

Research and development expenses decreased $0.4 million from the year ended December 31, 2010 to the year ended December 31, 2011. This decrease was attributable to a decrease in clinical trial cost of $0.6 million in 2011 and decreases in consulting and personnel related expenses, including salaries, travel and supplies of $0.6 million. The decrease in clinical trial costs is primarily related to higher spending for our KB003 RA program during 2010 as we discontinued the program during 2011. This decrease was partially offset by initiating patient recruitment for our KB004 Phase 1 clinical trial in 2011. The decrease in personnel related expenses was primarily attributed to a reduction of 19 employees in our research and development organization. These decreases from the year ended December 31, 2010, were partially offset by an increase in development expenses of $0.9 million as we initiated six-month toxicity studies and subcutaneous formulation feasibility work for our KB001-A cystic fibrosis program as well as ongoing development of flow assay and screening methods for our KB004 program.

General and administrative expenses decreased $0.9 million from the year ended December 31, 2010 to the year ended December 31, 2011. This decrease is primarily attributable to a decrease in consulting and personnel related expenses, including salaries, travel and supplies of $0.6 million from headcount reduction of 5 employees in our general and administrative organization during 2011, as well as decreases in legal expenses of $0.3 million attributable to fewer foreign patent filings for the year ended December 31, 2011.

Interest income was $43,000 for the year ended December 31, 2011 and $108,000 for the year ended December 31, 2010. The decrease was attributed to lower yields from lower investment balances in our portfolio which consisted primarily of government securities, high grade commercial paper and money market funds.

Other expense of $8,000 for the year ended December 31, 2011 consists primarily of $48,000 related to the revaluation of our preferred stock warrant liability, offset in part by foreign currency transaction gains of $40,000. Other income of $0.9 million for the year ended December 31, 2010 primarily reflects cash grants of $1.0 million received from the Internal Revenue Service under Section 48D of the Internal Revenue Code for the Qualified Therapeutic Discovery Project Program. All conditions to earn the grant were completed in the year ended December 31, 2010.

Contract revenue increased $17.1 million from the year ended December 31, 2009 to the year ended December 31, 2010. This increase was primarily related to the upfront payment of $35 million received from Sanofi in connection with the collaboration agreement we executed in January 2010. Of the upfront payment, $15.4 million was recognized as revenue in 2010. We also recorded $2.3 million in contract revenue for the year ended December 31, 2010, for the development services provided related to this agreement.

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Research and development expenses were $22.9 million for the year ended December 31, 2009, compared to $18.9 million for the year ended December 31, 2010. Of the $4.0 million decrease, approximately $3.4 million was attributable to the completion of our Phase 1/2 clinical trials for KB001 for cystic fibrosis and ventilated associated pneumonia and Phase 1/2 clinical trials for KB003 for rheumatoid arthritis and asthma in 2009. We also spent less development expenses related to our KB001 program for ventilated associated pneumonia after we signed our collaboration agreement with Sanofi in January 2010, as Sanofi assumed the ongoing development costs under the terms of the agreement. The decrease in research and development expense from 2009 was also attributed to a decrease of personnel related expenses, includes salaries, travel and supplies of approximately $0.8 million from headcount attrition during 2010. These decreases from 2009 were partially offset by an increase of $0.6 million in 2010 for sublicense fees paid to a third party in connection with the Sanofi agreement. Additionally, during 2010, we incurred expenses due to recruiting patients for a follow on safety run-in study for KB003 in rheumatoid arthritis.

General and administrative expenses were $5.2 million for the year ended December 31, 2009, compared to $4.9 million for the year ended December 31, 2010. The decrease from 2009 was attributed primarily to less spending for market research studies and consulting fees for our programs.

Interest income was $0.3 million for the year ended December 31, 2009 and $0.1 million for the year ended December 31, 2010. The decrease was attributed to lower yields from our portfolio which consisted primarily of government securities, high grade commercial paper and money market funds.

Other income (expense), net, consisted primarily of the revaluation of our warrant liability of $0.3 million for the year ended December 31, 2009 and cash grants of $1.0 million from the Internal Revenue Service under Section 48D of the Internal Revenue Code for the Qualified Therapeutic Discovery Project Program for the year ended December 31, 2010. All conditions to earn the grant were completed in the year ended December 31, 2010.

Income Taxes

As of December 31, 2011, we had net operating loss carryforwards of approximately $67.0 million to offset future federal income taxes through 2030 and approximately $66.9 million that may offset future state income taxes through 2028. Current federal and state tax laws include substantial restrictions on the utilization of net operating losses and tax credits in the event of an ownership change. Even if the carryforwards are available, they may be subject to annual limitations, lack of future taxable income, or future ownership changes that could result in the expiration of the carryforwards before they are utilized. At December 31 2011, we recorded a 100% valuation allowance against our deferred tax assets of approximately $31.0 million, as our management believes it is uncertain that they will be fully realized. If we determine in the future that we will be able to realize all or a portion of our net operating loss carryforwards, an adjustment to our net operating loss carryforwards would increase net income in the period in which we make such a determination.

Liquidity and Capital Resources

To date, we have funded our operations through the sale of equity securities and collaborations with third parties. From September 2008 to March 2009, we completed a private placement of our Series D Convertible Preferred Stock which resulted in net proceeds, after offering expenses, of approximately $35.7 million. At March 31, 2012, we had cash and cash equivalents and marketable securities of $14.4 million. In May 2012, the Company issued 5,000,000 million shares of Series E Convertible Preferred Stock at $3.40 per share, resulting in net proceeds of approximately $15.6 million. We will need to continue to raise capital to complete our ongoing and planned clinical trials.

The following table summarizes our equity funding sources as of May 31, 2012:

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Cash Flows for the Three Months Ended March 31, 2011 and 2012 and The Years Ended December 31, 2009, 2010 and 2011

Operating Activities

Cash used in operating activities decreased $2.0 million from the three months ended March 31, 2011, compared to the three months ended March 31, 2012, primarily due to a $1.6 million net change in the components of operating assets and liabilities and a $0.6 million decrease in net loss. Cash used in operating activities decreased $39.4 million from the year ended December 31, 2009 to the year ended December 31, 2010 primarily due to $36.8 million received from the Sanofi collaboration as well as $1.0 million of grants received from the Internal Revenue Service under Section 48D of the Internal Revenue Code for the Qualified Therapeutic Discovery Project Program in 2010 together with a reduction in operating expenses in 2010. Cash used in operating activities decreased $29.7 million from the year ended December 31, 2010, to the year ended December 31, 2011 primarily due to cash used in operations from a $32.4 million net change in the components of operating assets and liabilities driven by a $33.6 million reduction in our deferred revenue related to the Sanofi arrangement partially offset by a $2.9 million decrease in net loss.

Investing Activities

Cash used in and provided by investing activities for the three months ended March 31, 2011 and 2012 and the years ended December 31, 2009, 2010 and 2011 consists primarily of purchases of marketable securities offset primarily by proceeds from maturities of marketable securities. Additionally, purchases of property and equipment for the three months ended March 31, 2011 and 2012 and the years ended December 31, 2009, 2010 and 2011 were $214,000, $0, $293,000, $68,000 and $463,000, respectively.

Financing Activities

Cash provided by financing activities decreased $4.9 million from the year ended December 31, 2009 to the year ended December 31, 2010 primarily due to the issuance of additional shares of our Series D Convertible Preferred Stock which resulted in net proceeds of $5.0 million in 2009. Other financing activities for the three months ended March 31, 2011 and 2012 and the years ended December 31, 2010 and 2011 consisted primarily of proceeds from stock option exercises.

Management believes that cash and cash equivalents as of May 2012, are sufficient to sustain operations for the next 12 months based on our existing business plan and given the ability to control the timing of significant expense commitments.

We expect to incur substantial expenditures in the foreseeable future for the research, development and potential commercialization of our product candidates. We will continue to require additional financing to develop our products and fund operating losses. We will seek funds through equity or debt financings, collaborative or other arrangements with corporate sources, or through other sources of financing, including a public offering. Adequate additional funding may not be available to us on acceptable terms or at all. Our failure to raise capital as and when needed could have a negative impact on our financial condition and our ability to pursue our business strategies. If adequate funds are not available to us, we may be required to delay, reduce or eliminate research and development programs.

Contractual Obligations and Commitments

We have lease obligations consisting of an operating lease for our operating facility that commenced in July 2011 and expires June 2014, for approximately 40,000 square feet. We also sublease out approximately 19,000 square feet of our space to separate third parties.

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The following table summarizes our contractual obligations as of March 31, 2012 as described below.

Additionally, from October 1, 2013 to the date on which there is an automatic conversion of all of the outstanding shares of our convertible preferred stock, the holders of Series E Preferred Stock shall be entitled to receive cumulative dividends of $0.17 per share payable whether or not they have been declared by the board of directors. If we fail to pay such dividends, then the dividend rate for the Series E preferred stock will increase to $0.34 per share annually, until such dividends are paid in full All such dividends shall accrue automatically on a daily basis and all accrued and unpaid dividends shall be fully paid quarterly prior to payment of any other dividend.

Off-Balance Sheet Arrangements

We do not currently have, nor have we ever had, any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts.

Quantitative and Qualitative Disclosures about Market Risks

Our primary exposure to market risk is interest rate sensitivity, which is affected by changes in the general level of U.S. interest rates. We are exposed to market risk related to fluctuations in interest rates, market prices, and foreign currency exchange rates. However, since a majority of our investments are in short-term FDIC-insured government securities, corporate bonds, and money market funds, we do not believe we are subject to any material market risk exposure. As of December 31, 2011, and March 31, 2012, we did not have any derivative financial instruments. The fair value of our marketable securities, including those included in cash equivalents and marketable securities, was $17.8 million and $14.4 million as of December 31, 2011 and March 31, 2012, respectively.

Our investment policy is to limit credit exposure through diversification and investment in highly rated securities. We actively review, along with our investment advisors, current investment ratings, company specific events and general economic conditions in managing our investments and in determining whether there is a significant decline in fair value that is other-than-temporary. We monitor and evaluate our investment portfolio on a quarterly basis for other-than-temporary impairment charges.

Internal Control Over Financial Reporting

Pursuant to Section 404 of SOX, our management will be required to report on, the effectiveness of our internal control over financial reporting. The rules governing the standards that must be met for management to assess our internal control over financial reporting are complex and require significant documentation, testing and possible remediation. To comply with the requirements of being a reporting company under the Exchange Act, we may need to upgrade our systems, including information technology, implement additional financial and management controls, reporting systems and procedures and hire additional accounting and finance staff.

As a private company with limited resources, historically we have not had sufficient accounting and supervisory personnel with the appropriate level of technical accounting experience and training necessary for, or adequate documented accounting policies and procedures to support effective internal controls to comply with Section 404 of SOX. We are in the process of commencing the documentation, review and improvement of our internal controls over financial reporting for compliance with Section 404 of SOX and will make additional efforts to improve our internal controls and accounting policies and procedures, which will include hiring new accounting personnel and engaging external temporary resources. We recently hired our Chief Financial Officer who began employment in July 2012. We may identify deficiencies and weaknesses in our internal controls. If material weaknesses or deficiencies in our internal controls exist and go undetected, our financial statements could contain material misstatements that, when discovered in the future could cause us to fail to meet our future reporting obligations and cause the price of our common stock to decline.

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Item 3. Properties.

Our principal laboratory and administrative facilities are located in South San Francisco, California. We currently lease approximately 40,000 square feet of laboratory and office space in South San Francisco, California under a lease that expires in June 2014. Of the space leased, we sublease approximately 19,000 square feet of laboratory and office space to two other companies. Both those subleases also expire June 2014.

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Item 4. Security Ownership of Certain Beneficial Owners and Management.

The following table sets forth, as of May 31, 2012, certain information concerning the beneficial ownership of our capital stock, including our common stock, Series A preferred stock, Series B-1 preferred stock, Series B-2 preferred stock, Series C preferred stock, Series D preferred stock and Series E preferred stock, by:

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