As a result of the termination of the proposed merger with Raven, the Company is considering various alternate strategic transactions to return value to its stockholders. If the Company is unable to identify and complete an alternate strategic transaction, the Company will liquidate. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Celltrion
Celltrion is an FDA licensed biologics manufacturing company incorporated on February 26, 2002. Since that date, its principal activities have consisted of design, construction and operation of a manufacturing facility in Incheon, Republic of Korea, and partially funding the construction of our U.S. biopharmaceutical manufacturing facility, as well as raising capital and recruiting scientific and management personnel.
As a part of the initial capitalization of Celltrion and as part of the Celltrion joint venture agreement we signed with various Korean entities, including Nexol Co., Ltd., or Nexol, we made an in-kind contribution to Celltrion of the license and sub-license of certain cell-culture technology used for the manufacture of pharmaceutical products. We received 7.8 million shares of Celltrion's common stock for this contribution, representing approximately 48% of the then-outstanding shares. During 2004, we adopted the provisions of Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities (as revised) - an interpretation of ARB No. 51, or FIN 46R, and determined that Celltrion was a variable interest entity from its inception in the first quarter of 2002 and that we were its primary beneficiary. Accordingly, our Consolidated Financial Statements include the results of Celltrion as a variable interest entity, effective January 1, 2004. Prior to January 1, 2004 and our implementation of the consolidation provisions within FIN 46R, we had reflected our investment in Celltrion in our Consolidated Financial Statements using the equity method.
In September 2005, we entered into agreements to sell 1.2 million of our shares in Celltrion to a group of Korean investors and raised $15.1 million in gross proceeds. Nexol purchased 250,000 of these shares. Subsequent to this transaction, Nexol and its affiliates, collectively, became the largest stockholder of Celltrion. Upon this reconsideration event, we were no longer the primary beneficiary of Celltrion and, in accordance with FIN 46R, Celltrion was deconsolidated from our consolidated financial statements; therefore, from July 1, 2005 through June 30, 2006, our investment in Celltrion was again accounted for under the equity method.
During June and December 2006, we received aggregate gross proceeds of $130.3 million from the sale of substantially all of our Celltrion common stock to Nexol and affiliates of Nexol. As a result, we were no longer entitled to hold two seats on Celltrion's board of directors or appoint a Representative Director. Accordingly, we no longer had the ability to exercise significant influence over operating and financial policies of Celltrion, and beginning July 1, 2006, we accounted for our investment in Celltrion under the cost method. At December 31, 2007, we held a nominal ownership interest in Celltrion. During 2008 a public market developed for Celltrion common stock in the Republic of Korea. Based on the market price of Celltrion common stock, the value of our Celltrion investment was $0.3 million at December 31, 2008. Significant Debt Transactions
In April 2005, we raised aggregate net proceeds of $29.7 million through a private placement of $31.5 million of Notes, due April 1, 2010. During 2008 we repurchased the $31.5 million of Notes for $25.4 million resulting in a gain from note repurchase of $4.9 million, net of $0.6 million of unamortized discount and $0.6 million of deferred financing costs. Significant Equity Transaction
In February 2006, we raised net proceeds of $25.2 million through a private placement of 3.5 million shares of common stock at $7.70 per share to a group of accredited institutional investors. We also issued to the investors five-year warrants initially exercisable to purchase 698,637 shares of common stock at an exercise price of $9.24 per share. Because we did not file all of our delinquent periodic reports with the SEC by January 31, 2007, the warrants became exercisable for an additional 698,630 shares of common stock, at a price of $9.24 per share.
Subsequent Events
In February 2009, a lawsuit was filed against VaxGen by plaintiffs, Oyster Point Tech Center, LLC. The plaintiffs generally allege that the Company defaulted on the lease on the 349 Oyster Point, South San Francisco facility. The complaint seeks possession of the premises and the balance of lease plus unpaid rent and expenses totaling $22.4 million, as well as an award of plaintiffs' attorneys' fees and costs.
We may incur substantial expenses in defending against such claim, and it is not presently possible to accurately forecast the outcome. We do not believe, based on current knowledge, that the foregoing legal proceeding are likely to have a material adverse effect on its financial position, results of operations or cash flows. In the event of a determination adverse to VaxGen, we may incur substantial monetary liability that could have a material adverse effect on the Company's financial position, results of operations or cash flows.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our significant accounting policies are described in Note 2 to the Consolidated Financial Statements included herein. Our discussion and analysis of our operating results and financial condition are based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of the financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances; we review our estimates on an ongoing basis. While we believe our estimates, judgments and assumptions are reasonable, the inherent nature of estimates is that actual results will likely be different from the estimates made. We believe that our critical accounting estimates have the following attributes: (1) we are required to make judgments and assumptions about matters that are uncertain at the time of the estimate; (2) our use of reasonably different assumptions would change our estimates and (3) changes in estimates could have a material effect on our financial condition or results of operations. Our estimates, particularly estimates of the fair value of the embedded derivatives associated with our Notes have changed significantly from period to period. We expect that our estimates will continue to fluctuate in future periods. Application of the following critical accounting policies and estimates requires us to exercise judgments that affect our financial statements.
Revenue Recognition
Substantially all of our revenues to date relate to cost-plus-fixed-fee contractual arrangements with agencies of the U.S. government. Revenue is recognized as work is performed, based on allowable actual costs incurred. We generally issue invoices on a monthly basis. Under cost-plus-fixed-fee contracts, we are reimbursed for allowable costs and receive a fixed fee, which is negotiated and specified in the contract. Revenues for the fixed fee portion are recognized when milestones are achieved and accepted by the customer. Contract costs include direct and indirect research and development costs and allowable indirect general and administrative expenses.
U.S. government contracts and subcontracts are subject to annual audit, various profit and cost controls and standard provisions for termination at the convenience of the U.S. government. In April 2007, our direct and indirect contract costs were settled with the U.S. government and NIAID agreed to pay us $11.0 million.
For non-government arrangements, the Company recognizes revenues in accordance with SEC Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition in Financial Statements. In such instances, revenues are recognized when there is persuasive evidence of an arrangement, delivery has occurred or services have been performed, the selling price to the buyer is fixed or determinable and collectability is reasonably assured.
Property and Equipment
We estimate that the undiscounted future cash flows expected to result from the use of these assets and compare it to the current carrying value of these assets. Any adverse change in the estimate of these undiscounted future cash flows could necessitate an impairment charge that would adversely affect operating results if the fair market value of the assets is less than the net book value. We estimate useful lives for our assets based on historical experience, estimates of assets' commercial lives, and the likelihood of technological obsolescence. Should the actual useful life of a class of assets differ from the estimated useful life, we would record an impairment charge. We review useful lives and obsolescence and we assess commercial viability of these assets periodically.
For the year ended December 31, 2007, we recorded an impairment charge of $10.7 million triggered by the Merger Agreement signed in November 2007 as well as the October 2007 Lease Amendment. The impairment recognized the write-down of the manufacturing facility, equipment, certain software and leasehold improvements. The Company estimated the fair market value of the impaired assets related to the Merger Agreement based on estimated realizable value upon sale of the facility determined by discussions with sales agents and efforts to date in the marketing of the facility; discussions with resellers relating to the manufacturing equipment.
During 2008 the Company committed to a plan to sell the equipment and leasehold improvements related to its California manufacturing facility. These assets met the criteria for, and have been classified as "held for sale" in accordance with FASB No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144").
Assets Held for Sale
We use the criteria in SFAS 144 to determine when an asset is classified as "held for sale." Upon classification as "held for sale," the long-lived asset or asset group is measured at the lower of its carrying amount or fair value less cost to sell, depreciation is ceased and the asset or asset group is separately presented on the Consolidated Balance Sheets. When an asset or asset group meets the SFAS 144 criteria for classification as held for sale within the Consolidated Balance Sheets, we do not retrospectively adjust prior period balance sheets to conform to current year presentation.

During 2008, we committed to a plan to sell our equipment and leasehold improvements related to our California manufacturing facility. These assets have met the criteria for, and have been classified as "held for sale" in accordance with SFAS 144.
For the year ended December 31, 2008, we recorded an impairment charge of $8.8 million resulting from the lack of success in finding a buyer for our facility and expectation of the need to dismantle to sell. Valuation of Derivative Instruments
We value certain embedded features issued in connection with the financing of our Notes in 2005 as a derivative liability. We estimate the fair value of our derivative liability each quarter using the Monte Carlo Simulation methodology. This methodology allows flexibility in incorporating various assumptions such as probabilities of certain triggering events. The valuations are based on the information available as of the various valuation dates. Factors affecting the amount of this liability include the market value of our common stock, the estimated volatility of our common stock, our market capitalization, the risk-free interest rate and other assumptions such as the probability of a change in control event. Of these valuation parameters, management's assessment of the probability of a change in control is the most subjective and also has the greatest influence on fair value. At December 31, 2008, due to our repurchase of the entire $31.5 million of Notes, the derivative liability was reduced to zero.
Stock-based Compensation Expense
Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123R, using the modified prospective transition method, and therefore have not restated prior periods' results. Under this method we recognize compensation expense for all stock-based payments granted after January 1, 2006, and prior to but not yet vested as of January 1, 2006, in accordance with SFAS 123R. Under the fair value recognition provisions of SFAS 123R, we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest on a straight-line basis over the requisite service period of the award. Prior to FAS 123R adoption, we accounted for stock-based payments under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, ("APB 25"), and accordingly, recognized compensation expense for options that were granted at an exercise price below their deemed fair market value and for modifications to options. Determining the appropriate fair value model and calculating the fair value of stock-based payment awards require the input of various highly-subjective assumptions, including the expected life of the stock-based payment awards, our stock price volatility and the expected forfeiture rate of our options. Management determined the expected stock price volatility assumption based upon our historical volatility. We believe this method of computing volatility is more reflective and a better indicator of the expected future volatility, than using an average of a comparable market index or of a comparable company in the same industry. The expected term of options granted was derived from the short-cut method described in SEC's Staff Accounting Bulletin No. 107. The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The assumptions used in calculating the fair value of stock-based payment awards represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Notes 2 and 11 to the Consolidated Financial Statements for more information regarding stock-based compensation. Income Taxes
In July 2006, the Financial Accounting Standards Board, or FASB, issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 ("FIN 48"). Effective January 1, 2007, we adopted FIN 48 and FIN 48-1; see Note 12 to the Consolidated Financial Statements for more information regarding our income tax policies. We have filed tax returns with positions that may be challenged by the tax authorities. These positions relate to, among others, deductibility of certain expenses, expenses included in our research and development tax credit computations, as well as other matters. Although the outcome of tax audits is uncertain, in management's opinion, adequate provisions for income taxes have been made for potential liabilities resulting from such matters. We regularly assess the tax positions for such matters and include reserves for those differences in position. The reserves are utilized or reversed once the statute of limitations has expired and/or at the conclusion of the tax examination. We believe that the ultimate outcome of these matters will not have a material impact on our financial position, financial operations or liquidity.

RESULTS OF OPERATIONS
Comparison of Years Ended December 31, 2008, 2007 and 2006

Revenue

                                     Year Ended December 31,             Annual Percent Change
                                  2008        2007         2006       2008/2007        2007/2006
                                          (in thousands)
 Research contracts and grants   $     -     $ 4,098     $ 13,205           -100 %            -69 %
 Other services                      293         913            -            -68 %              *
 Related party services                -           -        1,631              *             -100 %


 Total revenues                  $   293     $ 5,011     $ 14,836            -94 %            -66 %

* Calculation not meaningful

Revenues for 2008 were from service revenues earned as part of a consulting services agreement with Celltrion to provide technical assistance related to the design, engineering and start-up of Celltrion's manufacturing facility. Revenue for 2007 was primarily driven by expensed activity reimbursed by the U.S. government. Research contracts and grants revenue in 2007 primarily related to the reimbursement of restructuring costs resulting from the termination of our SNS Contract in December 2006. Research contracts and grants revenue in 2006 primarily related to work performed under our Anthrax contracts. Related party services revenues in 2006 were earned as part of a consulting services agreement with Celltrion to provide technical assistance related to the design, engineering and construction of Celltrion's manufacturing facility. The amounts earned vary with the level of services required. We provided $0.9 million of services to Celltrion in 2007, which is included in other services revenue, as Celltrion is no longer considered to be a related party due to our sale of substantially all of our investment in Celltrion during 2006. Revenues earned in one period are not indicative of revenues to be earned in future periods. We do not expect any revenues in 2009. Research and development expenses

                                    Year Ended December 31,                    Annual Percent Change
                              2008           2007           2006          2008/2007            2007/2006
                                        (in thousands)
Research and development
expenses                    $   1,387      $  19,653      $  49,001              -93 %                 -60 %

Research expenses include costs associated with research and testing of our product candidates prior to reaching the development stage and include the costs of internal personnel, outside contractors, allocated overhead and laboratory supplies. Product development expenses include costs of preclinical development and conducting clinical trials, costs of internal personnel, drug supply costs, research fees charged by outside contractors, allocated overhead and co-development costs. Since inception, our research and development activities have been concentrated upon the development, manufacture and commercialization of biologic products for the prevention and treatment of human infectious disease. In 2008 and 2007, these costs primarily related to maintaining our manufacturing facility and prior research findings in support of our evaluation of various strategic transactions. We ceased research and development activities during the first quarter of 2008.
The decrease in research and development expenses in 2008 compared to 2007 was primarily due to:
• Labor and related expenses, which decreased by $5.8 million primarily due to no research and development expenses incurred after the first quarter of 2008 and decreased headcount following multiple reductions in force during 2007 and 2008; and

• Facilities and overhead costs, which decreased by $12.4 million due to reduced operations and consolidation of facilities during the first quarter of 2008 and no research and development expenses incurred after the first quarter of 2008.

The decrease in research and development expenses in 2007 compared to 2006 was primarily due to:
• Labor and related expenses, which decreased by $10.9 million primarily due to decreased headcount following multiple reductions in force during 2007;

• Facilities overhead costs, which decreased by $7.9 million due to reduced operations;

• Consultant and outside labor costs, which decreased by $6.5 million due to reduced operations; and

• Allocated overhead costs, which decreased by $4.1 million primarily due to reduced operations.

We expect to incur no research and development expenses during 2009. General and administrative expenses

                                    Year Ended December 31,                    Annual Percent Change
                              2008           2007           2006          2008/2007            2007/2006
                                        (in thousands)
General and
administrative expenses     $  12,700      $  20,437      $  27,683              -38 %                 -26 %

General and administrative expenses consist primarily of compensation costs, occupancy costs including depreciation expense, fees for accounting, legal and other professional services and other general corporate expenses.
The decrease in general and administrative expenses in 2008 compared to 2007 was primarily due to:
• Labor and benefits, which decreased by $2.4 million primarily associated with the 2007 and 2008 reductions in force; and

• Consultant and outside labor costs, which decreased by $4.5 million due to non-recurring costs incurred during 2007 to file multiple SEC filings.

The decrease in general and administrative expenses in 2007 compared to 2006 was primarily due to:
• Labor and related expenses, which decreased by $5.6 million primarily due to decreased headcount following multiple reductions in force during 2007;

• Consultant and outside labor costs, which decreased by $2.9 million due to reduced operations and reimbursements to Celltrion for their costs for U.S. GAAP audits and reviews performed on our behalf, which decreased by $1.4 million;

• Facilities, supplies and other expenses, which decreased by $2.8 million as we eliminated facilities and reduced operations; and

• Partially offset by allocations to research and development expense for facilities and other overhead costs, which decreased $4.1 million (which increased general and administrative expenses).

We expect quarterly general and administrative expenses to decrease during 2009 due to our 2008 reductions in force and the termination of our proposed merger agreement with Raven.
Impairment of Assets Held for Sale

                                         Year Ended December 31,                             Annual Percent Change
                                2008                2007               2006           2008/2007                2007/2006
                                               (in thousands)
Impairment of assets
held for sale               $      8,848       $             -      $        -                  *                          *

* Calculation not meaningful

Based on the lack of success in finding a buyer for our facility and the expectation of a need to dismantle to sell, we performed impairment assessments of our manufacturing facilities at 349 Oyster Point Blvd., South San Francisco, during 2008. Based on these assessments, we estimated that the fair market values of these assets were less than the carrying values of these assets by $8.8 million, which was recorded as an impairment of assets held for sale in the statement of operations for the year ended December 31, 2008. The impairment includes all leasehold improvements relating to the facility of approximately $6.5 million, as these items are not expected to have any future economic . . .