Overview

Targeted Genetics Corporation is a clinical-stage biotechnology company. We are at the forefront of developing, with the goal of commercializing, a new class of therapeutic products called gene therapeutics. We believe that a wide range of diseases may potentially be treated or prevented with gene therapeutics. In addition to treating diseases for which there is no treatment, we believe that there is a significant opportunity to use gene therapeutics to more effectively treat diseases that are currently treated using other therapeutic classes of drugs such as protein-based drugs, monoclonal antibodies or small molecule drugs.

Gene therapeutics consist of a delivery vehicle, called a vector, and genetic material. The role of the vector is to carry the genetic material into a target cell. Once delivered into the cell, the gene can express or direct production of the specific proteins encoded by the gene. Gene therapeutics may be used to treat disease by facilitating the normal protein production or gene regulation capabilities of cells. Gene therapeutics may be used to enable cells to produce more of a certain protein or different proteins than they would normally produce thereby treating a disease state. Vectors can also be used to deliver specific sequences that once delivered and expressed as an interfering RNA molecule, or RNAi, can shut down or interfere with the production of disease specific genes by messenger RNA, or mRNA, production of disease specific genes.

We are a leader in the preclinical and clinical development of gene therapeutics based on adeno-associated viral, or AAV, vectors, and in the manufacture of AAV vectors. We have treated over 400 subjects in clinical trials using AAV-based gene therapeutic product candidates and, through our research and development activities, we have acquired expertise and intellectual property related to AAV-based gene therapeutic technologies. In addition, based on research developed by one of our collaborators to improve the delivery of AAV vectors, a new product opportunity emerged for a small molecule therapy to potentially treat neurological diseases associated with oxidative stress. We have applied our development expertise to this early-stage small molecule and in 2008 we initiated a product development program around that opportunity. As a result of these AAV- and small molecule-related efforts, we believe we have generated potential value through our development and manufacturing expertise, through the potential of our accumulated intellectual property portfolio and through the application of this expertise and intellectual property to promising product candidates.

Our development efforts currently focus on:

• a clinical stage AAV-based product candidate for treatment of Leber's congenital amaurosis, or LCA, developed in collaboration with Robin Ali, Ph.D. at the University College London/Moorfields Eye Hospital, or UCL/M;

• a preclinical AAV-based Huntington's disease, or HD, product candidate under development with our collaborator Beverly Davidson, Ph.D., at the University of Iowa, or UI; and

• a preclinical small molecule-based product candidate to treat amyotrophic lateral sclerosis, or ALS, under development with our collaborator John Engelhardt, Ph.D., at UI and funded by a grant from the U.S. Department of Defense, or DOD.

As of December 31, 2008, our accumulated deficit totaled $320.9 million. We expect to generate substantial additional losses for the foreseeable future, primarily due to the costs associated with funding our development programs for LCA, HD, and ALS or other product candidates we pursue in the future, and developing and maintaining our intellectual property assets.

Most of our expenses are related to the support and advancement of our research and development programs, the conduct of preclinical studies and clinical trials and general and administrative support for these activities. We have financed our operations primarily through proceeds

from public and private sales of our equity securities, through cash payments received from our collaborative partners for product development and manufacturing activities and through proceeds from the issuance of debt and loan funding under equipment financing arrangements. During 2007, we completed two private placements of our common stock generating approximately $26.0 million to fund our programs and operations. We did not sell any stock in 2008. At December 31, 2008, we had a cash balance of $5.2 million. We expect that this cash, combined with cash we expect to receive from Celladon Corporation, or Celladon, to fund certain manufacturing and product development efforts, will be sufficient to fund our operations through the second quarter of 2009. This estimate is based on our ability to successfully perform planned activities and the receipt of expected funding under our collaborations and grants, and actual results could differ from our estimates.

We will require access to significant amounts of additional capital in order to continue our operations and successfully develop our partnered product candidates and any internally funded product candidates. We may be unable to obtain this funding on acceptable terms, or at all. If we are not successful in raising additional funding to support our operations, we will have to curtail portions of our operations or cease operating as a company.

Critical Accounting Policies, Estimates and Assumptions

Our discussion and analysis of our financial condition and results of operations is based upon financial statements that we have prepared in accordance with accounting principles generally accepted in the United States. As we prepare our financial statements we are required to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an ongoing basis, we evaluate these estimates, including those related to revenue, accrued restructure charges, goodwill and stock-based compensation. Estimates are based on historical experience, information received from third parties and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from these estimates under different assumptions or conditions. Note 1 of the notes to our consolidated financial statements, "Description of Business and Summary of Significant Accounting Policies," summarizes our significant accounting policies that we believe are critical to the presentation of our consolidated financial statements. Our most critical accounting policies, estimates and assumptions are:

Revenue Recognition Policy

We generate revenue from technology licenses, collaborative research arrangements and agreements to provide research, development and manufacturing services. Revenue under technology licenses and collaborative agreements typically consists of nonrefundable, up-front license fees, collaborative research funding, technology access fees and various other payments.

For collaboration agreements, we initially defer revenue from nonrefundable, up-front license fees and technology access payments and then recognize it systematically over the service period of the collaboration agreement, which is often the development period. We recognize revenue associated with performance milestones as earned, typically based upon the achievement of the specific milestones defined in the applicable agreements. We generally recognize revenue under research and development contracts as the related costs are incurred. When contracts include multiple elements we follow the Emerging Issues Task Force, or EITF, Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables," which requires us to satisfy the following before revenue can be recognized:

1) the delivered items have value to the customer on a stand-alone basis;

2) any undelivered items have objective and reliable evidence of fair value; and

3) delivery or performance is probable and within our control for any delivered items that have a right of return.

We have determined that, for these contracts, the manufacturing activities and research and development activities can be accounted for as separate units of accounting and we allocate the revenue to each unit based on relative fair value. We recognize revenue for manufacturing activities when the manufacturing campaign is substantially complete and we recognize revenue for research and development activities on a percentage-of-completion basis. We classify advance payments received in excess of amounts earned as deferred revenue.

Based upon the terms specified in our collaboration agreements, we receive advance payments from some of our collaboration partners before the project work has been performed. These payments are deferred and recognized as revenue when the costs are incurred.

Estimated Restructure Charges Associated with the Bothell Facility

We follow the provisions of Statement of Financial Accounting Standards, or SFAS, No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," or SFAS No. 146, as it relates to our facility in Bothell, Washington (which we have never occupied) and we have recorded restructure charges on the related operating lease. Accrued restructure charges, and in particular, those charges associated with exiting a facility, are subject to many assumptions and estimates. Under SFAS No. 146, an accrued liability for lease termination costs is initially measured at fair value, based on the remaining lease payments due under the lease and other costs, reduced by any sublease rental income that could be reasonably obtained from the property, and discounted using a credit-adjusted risk-free interest rate.

We have periodically evaluated our restructure estimates and assumptions and recorded additional restructure charges as necessary to reflect current market conditions and delays in subleasing the Bothell facility. Prior to 2007, we updated our restructure estimates and assumptions based on our evaluation of our ability to sublease the Bothell facility in light of tightening credit markets and deteriorating conditions in the Bothell real estate market. In the fourth quarter of 2007, based on a number of factors, including a continued increase in vacancy rates in the Bothell market and an increase in available office space in the competing downtown real estate markets, we concluded that we would not be able to successfully sublease the facility. Accordingly, we removed from our restructure estimates the assumed Bothell facility sublease income and the related tenant improvement and brokerage commission cost assumptions and recorded additional restructure charges of $1.2 million. As of December 31, 2008, we continued to believe that we would not be able to successfully sublease the facility and there were no changes to our remaining assumptions. We have recorded $8.5 million in restructure charges for this property since December 2002, when we first established a restructure reserve for exiting the Bothell facility. We also record accretion expense based upon the estimated remaining lease costs and the present value of these costs at an assumed discount rate of 10%. We recorded accretion expense as a restructure charge of $788,000 in 2008, $727,000 in 2007 and $751,000 in 2006.

We will continue to evaluate any additional information that may become available with respect to the estimates and assumptions as they relate to the facility. For example, on February 3, 2009 we communicated to the owner of the Bothell facility that we were surrendering the building to them and discontinuing payments on the lease, such actions constituting a default under the lease, and are seeking to negotiate a settlement for our remaining obligations under the lease. This action had no financial impact on our 2008 financial statements. There can be no assurance that we will be successful in negotiating a settlement with the landlord, and the landlord may terminate the lease as a result of our default and, among other potential remedies, accelerate our obligations due under the lease. If circumstances with the lease for this facility change, including a successful negotiation of reduced charges for the lease, some portion of the remaining accrued restructure charges related to the facility may be reversed. A reversal, if any, would be reflected as a reduction of restructure expenses and a non-recurring gain in the period in which our obligations under this lease change. We are currently unable to determine the likelihood of any future adjustments to our accrued restructure charges.

Goodwill and Other Intangible Assets

When we purchased Genovo, Inc. in 2000, we recorded intangible assets of $39.5 million on our financial statements, which represented know-how, an assembled workforce and goodwill. Between 2000 and 2002, we recognized $8.1 million of amortization of the goodwill and intangible assets. In 2002, we adopted SFAS No. 142, "Goodwill and Other Intangible Assets," or SFAS No. 142. SFAS No. 142 discontinued amortization of goodwill and requires us to perform goodwill impairment tests annually or more frequently if events and changes in business conditions indicate that the carrying amount of our goodwill may not be recoverable. We assess any potential impairment using a two-step process. Since we have only one reporting unit for purposes of applying SFAS No. 142, the first step requires us to compare the fair value of our total company, measured by market capitalization, to our net book value of our assets. If our fair value is less than the net book value, goodwill is potentially impaired and we are required to proceed to step two of the impairment analysis. In step two, the implied fair value of goodwill is calculated as described below and compared to its carrying amount. If the goodwill carrying amount exceeds the implied fair value, we recognize an impairment loss equal to that excess.

For the step two portion of the valuation analysis we generally base our measurement of our fair value on a weighted analysis of the present value of future discounted cash flows and market valuation approach. The discounted cash flows model indicates the fair value of the company based on the present value of the cash flows that we expect to generate in the future. Our significant estimates in the discounted cash flows model include: our weighted average cost of capital; the probability associated with bringing our product candidates to market; and our long-term rate of growth and profitability of our business. The market valuation approach indicates the fair value of the company based on our fully diluted market capitalization, using either the stock price on the valuation date or the average stock price over a range of dates around the valuation date, plus the book value of our interest-bearing debt, and an estimated acquisition premium which is based on observable transactions of comparable companies.

We believe the weighted use of discounted cash flows and market approach for the second step of the analysis is the best method for determining the fair value of the company because these are the most common valuation methodologies used within our industry and the weighted use of both models compensates for the inherent risks associated with either model if used on a stand-alone basis.

The implied goodwill amount is determined by allocating our fair value, calculated as described above, to all of our assets and liabilities, including intangible assets such as in-process research and development, developed technology and trademarks and trade names, as if we had been acquired in a hypothetical business combination as of the date of the impairment test.

As a result of an interim goodwill impairment test performed in 2006, we recognized a non-cash loss on impairment of goodwill of $23.7 million, based on an assessment that the implied value of goodwill was $7.9 million. In the fourth quarter of 2008, due to the continued decline in the market price of our common stock and a restructuring implemented in November 2008 to realign and narrow our product development priorities, we concluded that sufficient indicators existed to require us to perform an interim assessment of goodwill to determine if our remaining $7.9 million goodwill balance was impaired. We performed the two-step analysis described above, which indicated an implied goodwill balance of zero, resulting in a non-cash impairment loss of $7.9 million for 2008. For additional information about our goodwill impairment recorded in 2008, see Note 8 in the notes to the consolidated financial statements.

The process of evaluating the potential impairment of goodwill is subjective and requires significant judgment. In estimating our fair value, we make estimates and judgments about our future revenues and cash flows, application of a discount rate, and the potential control premium relative to the market price of our stock at the valuation date. In estimating the fair value of our net assets, including intangible assets, we make estimates and judgments relating to the fair value of specific

assets and liabilities. These estimates generally involve projections of the cash flows that may be provided by specific assets such as in-process research and development, completed technology and trademarks and trade names, including assumptions as to the probability of bringing drug candidates to market, the timing of product development, the market size addressed by our potential products, and the application of discount rates. Changes in these estimates could affect our conclusion as to whether an impairment has occurred and could significantly impact the amount of impairment recorded.

Stock-Based Compensation

We apply SFAS No. 123R, "Share-Based Payment," or SFAS No. 123R, fair value recognition provisions using the modified prospective transition method. Under the modified prospective method, compensation expense includes: (a) compensation cost for all share-based stock awards granted prior to, but not yet vested as of, the January 1, 2006 required implementation date, based on the grant-date fair value used for prior pro forma disclosures, adjusted for forfeitures and
(b) compensation cost for all stock awards granted after January 1, 2006, based on the grant-date fair value estimate in accordance with the provisions of SFAS No. 123R. According to the guidelines of SFAS No. 123R, we did not restate results for periods prior to the required January 1, 2006 implementation date. Following SFAS No. 123R, we recorded stock compensation expense of $718,000 for 2008, $966,000 for 2007 and $861,000 for 2006. This expense is classified as follows in the consolidated statement of operations:

                                                 Year Ended December 31,
                                              2008        2007        2006
           Stock-based compensation:
           Research and development         $ 393,000   $ 508,000   $ 465,000
           General and administrative         261,000     458,000     396,000
           Restructure charges                 64,000           -           -

           Total stock-based compensation   $ 718,000   $ 966,000   $ 861,000

Determining the appropriate fair value model and calculating the fair value of stock awards requires the input of highly subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We base our volatility and expected life estimates on our historical data. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates, and as estimates they involve inherent uncertainties and the application of judgment. As a result, if factors change and we use different assumptions, our future stock-based compensation expense could be materially different from the amounts currently recorded in our financial statements. For example, in the fourth quarter of 2007, we booked an additional $229,000 of stock-based compensation due to refinements to our estimates of forfeitures. There were no significant adjustments related to changes in our assumptions in 2008. In addition, we are required to estimate the expected forfeiture rate and recognize expense only 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 Note 1 of the notes to our consolidated financial statements for a further discussion of stock-based compensation.

Application of New Accounting Standards

In September 2006, the Financial Accounting Standards Board, or FASB, issued SFAS No. 157, "Fair Value Measurements," or SFAS No. 157. SFAS No. 157 provides guidance for using fair value to measure assets and liabilities and requires expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. SFAS No. 157 does not expand the use of fair value in any new circumstances. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 157 did not have an effect on our financial position or results of operations.

In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - including an amendment of FASB Statement No. 115," or SFAS No. 159. SFAS No. 159 permits entities to choose to measure certain financial assets and liabilities at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 159 did not have an effect on our financial position or results of operations.

In July 2007, the EITF reached a consensus on Issue No. 07-3, "Accounting for Advance Payments for Goods or Services to Be Used in Future Research and Development Activities," or EITF 07-3. The consensus requires companies to defer and capitalize prepaid, nonrefundable research and development payments to third parties over the period that the research and development activities are performed or the services are provided, subject to an assessment of recoverability. EITF 07-3 is effective for fiscal years beginning after December 15, 2007 and early adoption was not permitted. The adoption of EITF 07-3 changed our policy on nonrefundable prepayments for research and development services: such costs are now deferred and recognized as the services are rendered, whereas under the previous policy such payments were charged to research and development expense as paid. This change did not have a material effect on our financial position or results of operations for 2008.

In December 2007, the EITF reached a consensus on Issue No. 07-1, "Accounting for Collaborative Arrangements," or EITF 07-1. EITF 07-1 defines collaborative arrangements and establishes reporting requirements for transactions between participants in a collaborative arrangement and between participants in the arrangement and third parties. It also establishes the appropriate income statement presentation and classification for joint operating activities and payments between participants, as well as the sufficiency of the disclosures related to these arrangements. EITF 07-1 is effective for fiscal years beginning after December 15, 2008. EITF 07-1 is effective for all of our collaborations in place after January 1, 2009. We are in the process of evaluating the effect of the adoption of EITF 07-1.

The summary of significant accounting policies should be read in conjunction with our consolidated financial statements and related notes and the following discussion of our results of operations and liquidity and capital resources.

Results of Operations

Revenue



                                                     Year Ended December 31,
                                                2008           2007          2006
    Revenue from collaborative agreements:
    Heart failure - Celladon                 $ 4,843,000   $  3,982,000   $ 4,220,000
    HIV/AIDS vaccine - NIAID                   3,668,000      5,389,000     1,548,000
    HIV/AIDS vaccine - IAVI                            -        309,000     2,262,000
    Huntington's disease - Sirna                       -         52,000        47,000
    Other                                        107,000              -        37,000
    Other revenues:
    License agreements - AMT                     100,000        600,000     1,750,000

    Total revenue                            $ 8,718,000   $ 10,332,000   $ 9,864,000

Revenue in 2008 was $8.7 million, compared to $10.3 million in 2007, representing revenue from collaborative agreements and licenses. The decrease in revenue reflects a decrease in research and development and manufacturing activities under our HIV/AIDS vaccine project in collaboration with Children's Hospital of Philadelphia, or CHOP, and Nationwide Children's Hospital, or NCH, which is funded by the National Institute of Allergy and Infectious Disease, or NIAID, to $3.7 million in 2008 from $5.4 million in 2007. As expected, we did not receive any revenue from our International AIDS Vaccine

Initiative, or IAVI, collaboration in 2008 due to less development activity. Licensing revenue decreased to $100,000 in 2008 from $600,000 in 2007 due to revenue received from a milestone earned in 2007 related to a non-exclusive license to certain of our AAV1 vector gene delivery system patent rights we granted to Amsterdam Molecular Therapeutics B.V., or AMT. Revenue under our heart failure collaboration with Celladon increased to $4.8 million in 2008 compared to $4.0 million in 2007, reflecting higher research and development and manufacturing activities as we planned and prepared for the next phase of development.

Revenue in 2007 was $10.3 million, compared to $9.9 million in 2006. Revenue earned under the NIAID-funded HIV/AIDS vaccine project in collaboration with CHOP and NCH increased to $5.4 million in 2007 from $1.5 million in 2006, reflecting increased research and development activities, support of preclinical studies and initiation of vector manufacturing for clinical trials. Revenue earned under our heart failure collaboration with Celladon decreased slightly to $4.0 million in 2007 from $4.2 million in 2006. Revenue from our IAVI collaboration decreased to $309,000 in 2007 from $2.3 million in 2006. We recognized $600,000 in licensing revenue in 2007, compared to $1.8 million in 2006, related to our non-exclusive license agreement with AMT.

We expect our 2009 revenue to consist primarily of revenue from the Celladon program; our ALS effort, funded by the DOD, which was initiated in the fourth quarter of 2008 and is expected to be completed during 2009; and the NIAID-funded HIV/AIDS vaccine subcontract with CHOP and NCH, which we also expect to complete in 2009. We expect that our revenue for 2009 will decrease as compared to 2008 because our revenue-generating collaborative programs will . . .