As of March 31, 2006, we had an accumulated deficit of approximately $61.2 million. We expect to continue to incur net losses as we proceed with the commercialization and development of our technologies. The size of these losses will depend on the rate of growth, if any, in our revenues and on the level of our expenses. Our cash and cash equivalents have increased from $38.4 million as of December 31, 2005 to $68.8 million as of March 31, 2006, due to financing activities involving a private placement of shares of our common stock and warrants to purchase our common stock and warrant exercises, partially offset by cash used in operations.
On November 18, 2005, we entered into a definitive agreement for a private placement of common stock and warrants to purchase common stock that raised approximately $23.3 million, net of expenses, in the fourth quarter of 2005. On January 19, 2006, we received the balance of net proceeds of approximately $37.8 million pursuant to this agreement. In aggregate, we raised a total of approximately $61.1 million net of issuance costs in connection with the two closings of the private placement.
Prior to the business combination with Lynx, Solexa Limited was a development stage company with minimal revenue. As a result of the business combination, Solexa is no longer a development stage company. Until our instrument system is available for commercial use, our primary revenue source will be from our genomics services business based on MPSS technology, which had previously been conducted by Lynx Therapeutics. Lynx historically received, and we expect to continue to receive in the future, a significant portion of our genomics services revenues from a small number of customers. We intend to discontinue services based on MPSS in 2006 and are in the process of renegotiating our current MPSS customer contracts in order to provide these customers with services based on our SBS chemistry.
Revenues from the genomics services business in each quarterly period have in the past, and could in the future, fluctuate due to: the level of service fees, which is tied to the price, number and timing of biological samples received from our customers, as well as our performance of the related genomics services on the samples; the timing and amount of any technology access fees and the period over which the revenue is recognized; the number, type and timing of new, and the termination of existing, agreements with customers; and the sale of instruments, reagents and other consumables, if any. In addition, our plans to introduce genomics services based on our next-generation technology and to discontinue MPSS-based services could adversely impact our genomics services revenues.
We expect revenues from the sale of our genetic analysis systems to commence in 2006. We anticipate that systems revenues will fluctuate due to a number of factors, including: the level and timing of sales of instruments, reagents and other consumables and service contracts; the timing and ability of Solexa to manufacture or procure these items; the pricing and technical performance levels of our products; and the existence of competing genetic analysis systems.
Our operating costs and expenses include cost of service revenue, research and development expenses, and sales, general and administrative expenses. Cost of service revenue includes primarily, the cost of direct labor, materials and supplies, outside expenses, equipment and overhead including instrument depreciation, as well as period spending on work-in-process samples that exceeds the expected revenue for those samples. Cost of service revenue in the first quarter of 2006 excludes amounts charged to a forward loss contingency that we established in the third quarter of 2005, of which $364,000 and $1.0 million remained outstanding at March 31, 2006 and December 31, 2005, respectively. We did not incur cost of service revenue until completion of the business combination transaction between Lynx and Solexa Limited.
Research and development expenses include the cost of personnel, materials and supplies, outside expenses, equipment and overhead incurred by us in research and development related to our genetic analysis instrument systems and process development and improvements related to our genomics services business. Research and development expenses are expected to increase due to spending for ongoing technology development and implementation, including building additional instruments for internal use in research and development.

Sales, general and administrative expenses include the cost of personnel, materials and supplies, outside expenses, equipment and overhead incurred by us primarily in our administrative, sales and marketing, legal and investor relations activities. Sales, general and administrative expenses are expected to increase in support of our research and development and commercial efforts. Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in conformity with US generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. The items in our financial statements requiring significant estimates and judgments include determining the useful lives of fixed assets for depreciation and amortization calculations, determining the fair value of goodwill and intangibles for impairment considerations, assumptions for valuing options and warrants, estimates of future losses for contracts in our genomics services business and assumptions for tax credits that we can claim for research and development activities. Actual results could differ materially from these estimates.
Revenue
Revenues are related principally to services that we perform on biological samples we receive from our customers. We recognize revenue when persuasive evidence of an arrangement exists, services have been rendered and materials are delivered, the fee is fixed or determinable, and collectibility is reasonably assured. Should conditions cause management to determine these criteria have not yet been met, then any amounts billed to the customer are recorded as deferred revenue.
Forward Loss Contingency
In our genomics services business, we enter into service contracts to provide genetic analyses on samples provided to us by customers. If management considers it probable that performance on the contract will result in a loss and this loss can be reasonably estimated, a loss reserve is recorded. Management makes estimates of the costs to complete the applicable genetic analyses based on historical experience; expectations of the nature and volume of future samples; the proportion of fixed and variable costs; expectations with respect to production capacity, yields and efficiency in our genomics services business; expectations with respect to the timing and expense of implementing our next-generation technology in our genomics services business; the expected rate of adoption by current customers of our next-generation technology in lieu of MPSS to perform genetic analyses on their biological samples; and expectations of genomic services business sample volume as a whole, including both MPSS and our next-generation technology. If our assumptions or conditions change, the forward loss contingency will be adjusted accordingly.

Inventory
Inventory is stated at the lower of cost (which approximates first-in, first-out cost) or market. The balance at March 31, 2006 was classified as raw materials and work in process. Raw material inventories consist primarily of reagents and other chemicals utilized while performing genomics services. Work-in-process inventories consist of the accumulated cost of experiments not completed. Amounts in excess of the inventory's net realizable value are charged to cost of service revenue or to the forward loss contingency reserve, as appropriate. Inventory used in providing genomics services and for reagent sales is charged to cost of service revenue when the related revenue is recognized. Reagents, chemicals and flow cells purchased for internal development purposes are charged to research and development expenses upon receipt or as consumed.
Goodwill and Other Intangible Assets
Goodwill represents the excess of the purchase price over the fair value of net tangible and identifiable intangible assets acquired in the business combination. Other intangibles including patents, acquired technology rights and developed technology are being amortized using the straight-line method over estimated useful lives of seven to ten years.
Goodwill is not amortized. We review goodwill for impairment annually (or more frequently if impairment indicators exist). We review other intangible assets for impairment when indicators of impairment exist.
Stock-based Employee Compensation
Commencing January 1, 2006, we adopted the provisions of SFAS No. 123R, "Share-Based Payment", which required us to expense the fair value of grants made under our equity incentive plans over the requisite service period. We adopted the "Modified Prospective Application" transition method, which does not result in the restatement of previously issued financial statements. Awards that were granted after January 1, 2006 were measured and non-cash employee compensation expenses were recognized in the condensed consolidated statements of operations in accordance with SFAS No. 123(R). In addition, the non-vested portion of awards as of January 1, 2006 also resulted in recognition of non-cash employee compensation expense. We recognize share-based employee compensation expense ratably over the vesting period of options, adjusted for the expected forfeiture rate.
We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of SFAS 123R. SFAS 123R requires the use of subjective assumptions, including the options' expected life and the price volatility of the underlying stock. The expected volatility is based on the Company's trading activity since the business combination and that of comparable companies in our industry.
In accordance with SFAS No. 123R, we recognized non-cash employee compensation expenses of approximately $846,000 or 7.65% of total operating costs and expenses for the three months ended March 31, 2006. The share-based employee compensation expenses for the three months March 31, 2006 were based on the fair values of 467,500 shares of options granted during the period, in addition to the fair value of approximately 1.8 million shares of options granted before January 1, 2006 which were unvested as of that date, net of the capitalized portion. The operating expenses discussed above include the following allocations of share-based compensation expense for the three months ended March 31, 2006 (in thousands):

                                                          Three Months Ended
                                                            March 31, 2006
    Cost of service revenue                              $                  6
    Research and development                                              315
    Sales, general and administrative                                     525

    Non-cash stock-based employee compensation expense   $                846

Stock-based employee compensation costs capitalized into inventory and charged against the forward loss contingency during the three months ended March 31, 2006 were approximately $7,000 and $7,000, respectively.

Recent Accounting Pronouncements
FASB Staff Position No. 123(R)-3 In November 2005, the FASB issued FASB Staff Position No. 123(R)-3 ("FSP FAS 123(R)-3"), "Transition Election to Accounting for Tax Effects of Share-Based Payment Awards." This pronouncement provides an alternative method of calculating the excess tax benefits available to absorb any tax deficiencies recognized subsequent to the adoption of SFAS 123R. We have until November 2006 to make a one-time election to adopt the transition method. We are currently evaluating FSP FAS 123(R)-3 and whether to make this election. This one-time election will not affect operating loss or net loss.
Results of Operations
Revenues
Revenues for the three months ended March 31, 2006 were approximately $768,000, compared to revenues of $605,000 for the three months ended March 31, 2005. The increase in revenue of $163,000 was primarily due to revenue generated by the genomics service business subsequent to the business combination of Lynx and Solexa Limited. The three months ended March 31, 2005 only included the genomics service business revenue of Lynx from March 5 through March 31, 2005. We had been a development stage company prior to that time. We have experienced variability from period to period in revenues attributable to our genomics services business based in part on the timing of receipt of biological samples, variability in outstanding contracts and the presence of non-service fee revenues, including sales of reagents and other consumables. We expect this variability to continue through 2006 and beyond.
During the remainder of 2006, we anticipate beginning to perform genomics services using our SBS reversible terminator chemistry and Clonal Single Molecule Array technology and ceasing to perform MPSS experiments for customers. Our contract with E.I. du Pont de Nemours and Company has been amended to reduce the remaining maximum amount payable to Solexa to $1.5 million, of which a portion is related to the delivery of an instrument and related consumables and the balance to genomics services to be performed under the agreement. Our revenues could vary in 2006 and beyond due to interruptions in genomics services production until the new instrumentation is ready to be deployed in our genomics services business and as the new instrumentation is brought on line as well as due to variable customer demand until the new technology has demonstrated equivalence or superiority to the MPSS technology. During the remainder of 2006, we also anticipate the first deliveries to customers of our first-generation Solexa Genome Analysis Systems.
Operating Costs and Expenses
Total operating costs and expenses were approximately $11.1 million for the three months ended March 31, 2006, compared to $5.9 million for the three months ended March 31, 2005. The increase in operating costs for 2006 over 2005 is due primarily to increased operating costs following the business combination between Lynx and Solexa Limited, the expensing of stock-based compensation under SFAS 123R, increased material costs for research and development and increased professional fees for SEC reporting and compliance partially offset by the absence of costs related to execution of the business combination. The three months ended March 31, 2005 only included operating costs and expenses of Lynx from March 5 through March 31, 2005.
Cost of Service Revenue. Cost of service revenue primarily reflects the cost of providing our genomics services, including a reserve for future loss contingencies, direct labor, materials and supplies, outside expenses, equipment and overhead, including instrument depreciation. In addition, we include in cost of service revenue period spending on work-in-process samples that exceeds the expected revenue for those samples. For the three months ended March 31, 2006, cost of service fees were $912,000, compared to $540,000 for the three months ended March 31, 2005. Cost of service revenue increased $372,000 as a result of the addition of revenue from the genomics services business of Lynx after completion of the business combination, charges for work-in process samples that exceed the expected revenue and charges for stock-based compensation.

Cost of service revenue is net of amounts charged to a future loss contingency that we recorded in the third quarter of 2005 for future loss contingencies with respect to existing service fee contracts. At March 31, 2006, the forward loss contingency which remained on the balance sheet was $364,000. We update this reserve based on an evaluation of contracts with samples performed at a loss; an assessment of our future obligations under these contracts; and a range of forecast assumptions for our future performance of these obligations, including but not limited to the timing of sample receipt, genomics services business sample volume as a whole, our plans to cease operation of our MPSS technology and to deploy our next-generation technology, and operating efficiencies. This reserve may vary in future periods due to additional data on our costs to process these samples; expectations of the nature and volume of future samples; the proportion of fixed and variable costs; expectations with respect to production capacity, yields and efficiency in our genomics services business; expectations with respect to the timing and expense of implementing our next-generation technology in our genomics services business; the expected rate of adoption by current customers of our next-generation technology in lieu of MPSS to perform genetic analysis on their biological samples; and expectations of the genomic service business sample volume as a whole, for both MPSS and our next-generation technology.
At the time that we begin to perform genomics services using our next-generation technology, we anticipate that our material and labor costs per sample may decline; however, we could experience periods of higher spending in the event we process samples using both the older MPSS and the new technology in parallel and we experience efficiency levels below expectations as we work with the new technology.
We expect cost of goods sold to increase in the future from zero at present as we initiate the manufacturing of our next-generation instrument and associated consumables. These costs will include personnel, materials and overhead. We anticipate that production activities will take place both in the US and the UK in the remaining months of 2006.
Research and Development Expenses. Research and development expenses were approximately $6.3 million for the three months ended March 31, 2006, compared to $3.0 million for the three months ended March 31, 2005. The $3.3 million increase in research and development expenses was primarily due to increases in personnel and related expenses resulting from the business combination, increases in material expenses, particularly our spending on components for the production of instrument prototypes based on the new technology and charges for stock-based compensation.
We expect research and development expenses to increase in the future as we continue product development efforts for our next-generation genetic analysis instrument system, build and operate a fleet of instruments for internal R&D projects, including our plan to sequence a human genome in 2006, and build out additional leasehold improvements.
We cannot reasonably estimate the timing and costs of our research and development programs due to the risks and uncertainties associated with developing a novel genetic analysis instrument system and subsequent improvements. We expect that there will be significant additional work required to optimize the instrument and consumable portions of the system to achieve target performance levels even after we begin to ship and recognize revenue on the sale of our next-generation instrument system. Furthermore, we anticipate continued spending on research and development related to future-generation systems and to additional applications of our genetic analysis instrument systems.
Sales, General and Administrative Expenses. Sales, general and administrative expenses were approximately $3.8 million for the three months ended March 31, 2006, compared to $2.3 million for the three months ended March 31, 2005. The increase of $1.5 million in sales, general and administrative spending was primarily due to increased operating costs following the business combination due both to the business combination and to subsequent recruiting, including increased personnel and related expenses; increased professional fees related to SEC compliance; and charges for stock-based compensation.

We expect sales, general and administrative expense to increase in the near future as we hire increased personnel to support the commercialization of our next-generation genetic analysis instrument system and to increase non-personnel sales and marketing spending, including but not limited to promotional materials and activities, market research, travel and training. We expect to hire sales and marketing personnel, including salespeople, application specialists and field service and customer service/technical support personnel. We may need to establish additional places of business in conjunction with this hiring.
Interest Income
Interest income for the three months ended March 31, 2006 was $655,000, compared to $136,000 for the three months ended March 31, 2005. The increase in interest income of $519,000 was primarily due to increased amounts of cash and cash equivalents as a result of sales of our common stock in private placement transactions.
Interest Expense
Interest expense was approximately $156,000 for the three months ended March 31, 2006, compared to $132,000 for the three months ended March 31, 2005. Interest expense is related principally to the business combination, including the assumption of an idle facility that had been written off prior to the business combination and for which a portion of the rental payments are treated as interest expense and the assumption of $3.0 million of Lynx's note obligations.
Income Tax Provision (Benefit)
We maintained a full valuation allowance on our deferred tax assets as of March 31, 2006. The valuation allowance was determined in accordance with the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"), which requires an assessment of both positive and negative evidence of possible sources of taxable income and then a determination of whether it is more likely than not that deferred tax assets are recoverable. This assessment is required on a jurisdiction by jurisdiction basis. Cumulative losses incurred by us in recent years represented sufficient negative evidence under SFAS No. 109, and, accordingly, a full valuation allowance was recorded against deferred tax assets. We intend to maintain a full valuation allowance on the deferred tax assets until sufficient positive evidence exists to support reversal of the valuation allowance. . . .