We begin Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) with the company's business overview to give you an understanding of the technology of our business and the direction in which our business and our product candidates are moving. This is followed by a discussion of the Critical Accounting Estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. We then discuss our Results of Operations for 2004 compared to 2003, and for 2003 compared to 2002, separated by our functions. We then provide an analysis of changes in our balance sheet and cash flows, and discuss our financial commitments in the section entitled "Liquidity and Capital Resources".

This MD&A should be read in conjunction with the other sections of this Annual Report on Form 10-K, including "Item 1: Business," "Item 6: Selected Financial Data," and "Item 8: Financial Statements and Supplementary Data." This MD&A and various other sections of this Annual Report on Form 10-K contain a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this filing. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors, including those described under "Risk Factors" included under Item 1. Except to fulfill our obligations under the federal securities laws, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date on which it is made.

Business Overview

Sirna Therapeutics, Inc., ("Sirna" or the "Company") is focused on developing therapeutics based on RNA interference (RNAi). We are using our expertise to design, stabilize, manufacture and deliver short interfering nucleic acids (siRNAs) that activate selectively the process of RNA interference. We are in research, preclinical and/or clinical development with product candidates in the following areas: Age-related Macular Degeneration (AMD), Huntington's disease (HD), dermatology (initially permanent hair removal), asthma, chronic hepatitis, and diabetes. Sirna is also evaluating other disease targets and indications for the development of RNA interference-based therapeutics on our own, and in collaboration with academic research institutions and commercial enterprises such as the Company's ongoing collaboration in oncology with Eli Lilly and Company (Lilly). In addition, Sirna manufactures and sells oligonucleotides in order to generate revenue for the purpose of subsidizing our ongoing operations.

Since our inception as Ribozyme Pharmaceuticals, Inc. in 1992, we have dedicated ourselves to engineering RNA-based molecules for therapeutic and diagnostic purposes. In 2001 we began to study RNAi and in 2003, based on scientific advancements and the potential of the field, we directed our research and development activities entirely to RNAi technology. Coinciding with our redirection, we changed our name to Sirna Therapeutics, Inc. We believe siRNA-based drugs may present an entirely new platform of therapeutics in the future. Our expertise in nucleic acid technology enables us to be a leader in this very promising field.

RNA Interference

RNA interference is an endogenous mechanism that generally relies on a sequence of double-stranded nucleic acid capable of reducing the expression of genes through the degradation of messenger RNA (mRNA) and viral RNA in a sequence-specific manner. We refer to such RNA molecules facilitating this process of RNAi as a short interfering RNA (siRNA). The RNAi mechanism induces the destruction of target RNA using naturally occurring cellular protein machinery.

Harnessing the natural phenomenon of RNAi through the production and targeted delivery of synthetic siRNAs holds potential for a new and important future class of drugs. Although there is widespread use of RNAi-based reagents for target validation, the development of RNAi-based pharmaceuticals for therapeutic uses to target disease is currently in an early stage of development.

Product Candidate Programs

The Company is seeking to develop a new class of drugs using siRNAs that address significant and unmet medical needs. Currently, we are in research, preclinical and clinical development with product candidates in the following areas:

Local Delivery (Directly to Target Area)

• Age-related Macular Degeneration. Our first program to advance into the clinic targets age-related macular degeneration (AMD), a degenerative eye disease that is the leading cause of blindness in the elderly in the United States. In November 2004, we initiated Phase 1 testing of Sirna-027, a chemically modified siRNA targeting Vascular Endothelial Growth Factor Receptor-1 (VEGFR-1), which is a key component of the clinically validated vascular endothelial growth factor (VEGF) pathway.

• Asthma. We are also in the preclinical stages of developing a drug candidate for local delivery to treat asthma. We are working with Dr. Erwin Gelfand of the National Jewish Medical & Research Center to test siRNAs that target IL-4, IL-4 receptor, IL-13 and/or IL-13 receptor, which play a critical role in inflammation and bronchconstriction in the airways.

Systemic Delivery (Directly to the Blood Stream)

• Type 2 Diabetes. We are in the preclinical stages of developing siRNA targeting the PTP-1B gene. Our researchers have demonstrated that up to 28% of an administered formulated siRNA dose gets into the liver, the main target in treating diabetes. By approaching Type 2 diabetes early in the mechanistic cascade, we believe siRNAs will become the most important innovation in the treatment of this devastating and rapidly growing disease.

• Hepatitis C. We are in the preclinical stages of development of siRNAs that target the viral RNA to treat the Hepatitis C infection.

• Oncology. In January 2004, we initiated a collaboration with Eli Lilly and Company (Lilly) to apply our RNAi technology against Lilly's proprietary models in oncology. To date, the collaboration has demonstrated target mRNA knockdown in vitro in human and mouse cell lines. Demonstration of in vivo target knockdown is currently in progress.

Topical Delivery (Directly to the Skin Surface)

• Hair Removal. In December 2004, we launched a dermatology division following the acquisition of Skinetics Biosciences, Inc. (Skinetics). Skinetics founder, and a leader in the field of hair biology, Dr. Angela Christiano of Columbia University, is now an exclusive consultant to the Company. Our first dermatology program is focused on the permanent removal of unwanted hair. We are in the preclinical stages of developing siRNA targeting the "hairless" protein.

The Drug Discovery and Development Process

The new drug discovery and development process is generally considered a long (5 to 7 years or greater) and expensive (greater than $100 million) undertaking, which is subject to many uncertainties and regulatory oversight. These generalized timelines and costs are estimates and as such involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from estimates. Research and development project costs, among others, include costs of salaries, benefits, clinical trial site costs, outside services, materials and supplies incurred to support the clinical programs. Indirect costs allocated to projects include facility and occupancy costs, license and royalty payments. The primary phases of new drug discovery and development include:

• Preclinical research - Preclinical research includes development from conception to small scale manufacturing of the drug and through completion of animal toxicity and pharmacokinetic studies necessary to file an IND application.

• Phase 2 clinical trials - Phase 2 clinical trials are generally expanded safety, optimal dosing and efficacy studies in small groups of patients afflicted with the targeted disease.

• Phase 3 clinical trials - Phase 3 clinical trials are large-scale, multi-center, comparative trials with patients afflicted with the targeted disease in order to provide enough data to demonstrate the efficacy and safety required by the FDA prior to commercialization of the drug.

The most significant costs associated with clinical development are the Phase 3 trials, as they tend to be the longest and largest studies conducted during the drug development process. The FDA closely monitors the progress of each phase of clinical testing. The FDA may, at its discretion, re-evaluate, alter, suspend or terminate testing based upon the data accumulated to that point and the FDA's assessment of the risk/benefit ratio to patients. If Phase 3 trials are successful, the final step in a drug approval timeline is submission of a New Drug Application (NDA) with the FDA. The NDA process may last several years.

In addition, development stage companies, like Sirna Therapeutics, often seek collaborations and/or partnerships with large, established pharmaceutical companies to assist in the cost and complexities of developing and marketing new drugs. At this time, the Company believes it may be too early to enter into such business arrangements as the full potential and value of its product candidate programs are unknown.

Intellectual Property

Obtaining patent protection as well as protecting patents and other proprietary rights is crucial to developing our business. In addition to patents, we rely upon trade secrets, know-how and continuing technological innovations. As part of our overall intellectual property strategy, we selectively enter into agreements with third parties, such as academic institutions, either to license pre-existing technology or to support the development of new technologies. For example, in 2003 we entered into a worldwide licensing agreement with the University of Massachusetts (UMass) Medical School for its undivided interest in intellectual property relating to the seminal RNA interference technology covering siRNA (the "Tuschl 1 Patent") for uses relating to human and veterinary therapeutic, prophylactic, diagnostic and health care applications. This pending Tuschl 1 Patent broadly covers siRNAs, including those with blunt ends and ends with 3'-overhangs. In 2003, we obtained a non-exclusive license to the early RNAi patents filed jointly by Carnegie Institution of Washington and UMASS (Carnegie Patent). The Carnegie Patent is based on the work of Drs. Andrew Fire and Craig Mello governing genetic inhibition of genes by double-stranded RNA via RNAi. In June 2004, we entered into a worldwide exclusive license agreement with the University of Iowa Research Foundation for intellectual property relating to RNAi technology covering siRNA for targeting neurological disease indications, including Huntington's disease and Alzheimer's Disease. In December 2004, we entered into a worldwide exclusive license agreement with Columbia University for intellectual property relating to genes involved in the hair growth pathway. This license includes rights to siRNAs targeting the "hairless" gene that can be used to inhibit hair growth. This intellectual property is based on pioneering work of Dr. Angela Christiano at Columbia University on identifying genes involved in promotion and inhibition of hair growth.

It is our policy to file patent applications when appropriate to protect technology, inventions and improvements that are considered important in the development of our business. We seek patent protection in the United States as well as in several key foreign countries. The following table summarizes the Company's current intellectual property estate (excluding ribozyme technology):

Sirna Controlled and Licensed Intellectual Property                 U.S. Filings         Status
------------------------------------------------------------   ----------------------   ---------
Seminal RNAi or siRNA Technology:

  Tuschl et al. Patent                                         2 patent applications    Pending
    Worldwide Exclusive License from UMass Medical School

  Fire et al. Patent                                           3 patent applications    1 Issued
    Worldwide Nonexclusive License Carnegie Institution

  Sirna - "No-ribo" siNA Technology                            10 patent applications   1 granted
                                                                                        in UK

  Sirna - Multifunctional siRNA Technology                     5 patent applications    Pending

  Sirna - RNAi Gene Targets                                    >135 patent              1 granted
  (including those covering targets in the VEGF, IL-4,         applications             in UK
IL-13, Hairless, PTP-1B, HCV and HD   pathways)

Sirna - Oligonucleotide Chemistry & Delivery Technology        >70 patent               23 Issued
                                                               applications

Sirna - Oligonucleotide Manufacturing & Process Technology     >25 patent               15 Issued
                                                               applications

Summary of Intellectual Property Estate:                       >250 Patent              41 Issued
                                                               Applications

We believe our intellectual property holdings adequately enable the Company to pursue its business plans. We cannot however guarantee that any patents will issue from any pending or future patent applications owned by or licensed to us or that such patents, if issued, will have scope sufficient to prevent competing products. In addition, the scope of our present or future patents may not be sufficiently broad to prevent competitive products. The Company, to the best of its ability, will defend its intellectual property estate from infringement. There is however inherent uncertainty in administrative proceedings and litigation relating to our patents that could cause us to incur substantial costs and delays in obtaining and enforcing our patents and other proprietary rights. The ultimate result of any patent litigation could be the loss of some or all protection for the patent involved. We may also decide to oppose or challenge third party patents. When prudent and for appropriate consideration, the Company is willing to out license its intellectual property. The manufacture, use or sale of our products may infringe on the patent rights of others. We may not have identified all United States and foreign patents and patent applications that pose a risk of infringement. We may be forced to in-license or litigate if an intellectual property dispute arises.

Licensing, Process Development and Pilot Manufacturing

In addition to our work with RNAi, we also have developed an extensive expertise in nucleic acid technologies. We intend to leverage our nucleic acid expertise through licensing, process development and pilot manufacturing opportunities. In July 2004, we entered into an exclusive four-year process development and manufacturing alliance with Archemix Corporation (Archemix), a privately held company. Archemix is currently developing ARC183, an anti-thrombin aptamer. Pursuant to the agreement, we will manufacture all of Archemix's aptamers through Phase 2a clinical development. In addition, in 2003 we completed a collaboration with Geron Corporation, a biopharmaceutical company focused on oncology and regenerative medicine. Our first program, which began in 2001, was a process development collaboration with Geron for GRN163, a nucleic acid-based telomerase agonist for cancer. We successfully completed the program and renewed the agreement to manufacture GMP clinical-grade GRN163 for Geron's Phase 1 clinical study. Delivery under the agreement was completed in June 2003.

Critical Accounting Policies and Estimates

The methods, estimates and judgments we use in applying our accounting policies may have an impact on the results we report in our financial statements, which we discuss under the heading "Results of Operations" following this section of our MD&A. Some of our accounting policies require us to make subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain.

Revenue Recognition

Revenues recorded from our collaborative agreements may consist of: research revenue, contract manufacturing revenue, milestone revenue and license or royalty revenue. We generally recognize revenue when we have satisfied all

contractual obligations and we are reasonably assured of collecting the resulting receivable. Given the nature of our business and the infrastructure that we need to support, we often enter into collaborations where we receive nonrefundable up-front payments for prior or future expenditures. In compliance with current accounting rules, we recognize revenue related to up-front payments over the period of the contractual arrangements as we satisfy our performance obligations. Occasionally, we are required to estimate the period of a contractual arrangement or our performance obligation when the information is not clearly defined in the agreements we enter into. Should different estimates prevail, revenue recognized could be different. As of December 31, 2004, we evaluated our estimates for the periods of contractual arrangements and determined that our estimates are appropriate.

Patent Expenses

Due to the early stage of development of RNAi technology, we expense all legal costs directly incurred in connection with patent applications or patents until we determine that the estimated recoverability of such costs is sufficiently probable, at which time such costs are capitalized. If capitalized, such deferred patent costs are then amortized over the estimated economic life of the patent on a straight-line basis. We review all capitalized patent costs on a quarterly basis and, if we decide to abandon a patent or a patent application or determine that an issued patent or a patent application no longer has significant economic value, the unamortized balance in deferred patent costs related to that patent or patent application is immediately expensed.

In 2003, we changed our business strategy which focused on development of ribozyme-based therapeutics and diagnostics to developing a new class of nucleic acid-based therapeutics based on RNAi. As a result of finalizing this change in strategic direction during the quarter ended June 30, 2003, we undertook a detailed review of our existing patent portfolio. Based on this review, we wrote off $447,000 of patent costs related to patents or patents that we abandoned in the second quarter of 2003. In addition, because we are no longer pursuing the development of ribozymes internally, we expensed approximately $4.9 million of capitalized patent costs related to the ribozyme technology. This expense is reflected as a separate line item in our statement of operations for the year ended December 31, 2003. Legal expenses related to patents are included in general and administrative expenses.

Results of Operations for Twelve Months Ended December 31, 2004, 2003 and 2002



Revenues



The following table sets forth information on revenues earned from our
collaborations for the periods indicated (in thousands):



                                                         December 31,
                                                  ---------------------------
                                                   2004      2003      2002
                                                  -------   -------   -------
            Revenues
            Contract revenues
            Eli Lilly                             $   153   $    -    $    -
            Geron                                      -      2,783       718
            Chiron                                     -        550     2,188
            Fujirebio                                 475       169       556
            Other                                      50       254        26
                                                  - -----   - -----   - -----
                                                      678     3,756     3,488
            Contract revenues-joint venture
            Medizyme                                   -          2     1,069

            Contract revenues - related parties
            Atugen                                      9       417       591

            Contract revenues-manufacturing
            Archemix                                  860        -         -
                                                  - -----   - -----   - -----
            Total Revenues                        $ 1,547   $ 4,175   $ 5,148
                                                  - -----   - -----   - -----

Generally, revenue fluctuations result from changes in the number of funded research projects as well as the timing and completion of contractual obligations. Our revenues for 2004 were $1.5 million, a decrease of $2.6 million compared to 2003.

The decrease is a result of our change in business strategy in 2003 and the subsequent termination of ribozyme-related programs and the associated revenues from Chiron, Fujirebio and atugen AG. However, in the fourth quarter of 2004, we received a final payment from Fujirebio related to our discontinued ribozyme related diagnostic program. Offsetting our loss in revenues in the ribozyme programs are revenues related to our Archemix manufacturing collaboration. Archemix revenues were $860,000 in 2004. In addition, during the first quarter of 2004, we entered into an eighteen-month collaboration with Eli Lilly and Company to jointly investigate our proprietary modified siRNAs against specific oncology targets provided by Lilly. Revenues recognized during 2004 are from Lilly's access to a non-exclusive research license to certain of our technologies in oncology during the eighteen-month collaboration. The decrease of revenues year to date is primarily due to the completion of our process development and manufacturing scale-up for Geron's anti-cancer drug, GRN163 in June 2003. During the second quarter of 2003, we completed our manufacturing contract with Geron, whereby we recognized $2.7 million upon the release of the product.

Our revenues for 2003 were $4.2 million, a decrease of $973,000 compared to 2002. The decrease was primarily due to lower research revenues associated with ANGIOZYME (a ribozyme drug candidate targeting tumors) and HERZYME (a ribozyme drug candidate targeting breast cancer). Revenues for ANGIOZYME and HERZYME are based on the fully loaded expense of a researcher working on the project. As both ANGIOZYME and HERZYME had moved beyond the research phase and forward in clinical trials, less time was required of our researchers and more third party expenses were incurred. Reimbursements from our collaborators for third party expenses are credited against expenses and not recognized as revenue. We are not pursuing independent development of ANGIOZYME and discontinued clinical trials in 2003. In addition, in April 2003, we terminated our joint venture with Elan and are not pursuing independent development of HERZYME. Offsetting our loss in revenues in the ribozyme programs are the revenues related to our Geron manufacturing collaboration. Geron revenues increased $2.0 million in 2003 compared to 2002. During the second quarter of 2003, we recognized revenue of $2.7 million upon the completion of the contract and the release of product to Geron. Revenues attributable to atugen have decreased due to an overall reduction in services provided.

At the completion of the Lilly contract, a milestone payment of $1.8 million may be earned by us in August 2005. Since this is a substantive at risk milestone, it has not yet been recognized in 2004 as contract success has not been determined. The collaborations with Lilly and Archemix are expected to continue in 2005, however, we are actively pursuing additional partnerships and collaborations to fund our research and development programs.

Expenses



Research and Development



The following table sets forth information on research and development expenses
for the periods indicated (in thousands):



                                                    December 31,
                                           ------------------------------
                                             2004       2003       2002
                                           --------   --------   --------
               Research and development:
               Salaries and benefits       $  7,380   $  7,144   $  9,536
               Chemicals and supplies         2,420      1,703      1,763
               License fees                   2,914      6,197          5
               Outside services               2,471      1,116      9,619
               Depreciation                   1,283      1,415      1,697
               Other                          4,669      4,690      4,731
                                           - ------   - ------   - ------
               Total R&D expenses          $ 21,137   $ 22,265   $ 27,351
                                           - ------   - ------   - ------
               R&D average staffing              61         66         82

Our research and development expenses for 2004 were $21.1 million, a decrease of $1.2 million compared to 2003. The decrease is primarily due to the acquisition of a license to the University of Massachusetts' rights in RNAi technology for $6.0 million in September 2003. Under the terms of the license agreement, we paid $3.0 million in cash and issued 579,150 shares of our common stock, valued at $3.0 million, to its Medical School in exchange for the license. The purchase price was expensed as in-process research and development due to the uncertainty of both the technological feasibility and alternative future uses of the technology as of the acquisition date. In 2004, upon the first anniversary of the license agreement, the filing of our first IND and the initiation of our first Phase 1 clinical trial, we paid the Medical School a total of $1.4 million in cash. The net $4.6 million decrease in the licenses paid to the Medical School was offset by approximately $4.1 million in increases in 2004 due to the scale up of our research and outside services costs as we progress in our preclinical activities for Sirna-027, our RNAi drug candidate targeting AMD, as . . .