Special Note Regarding Forward-Looking Statements This discussion and analysis should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2008, and our unaudited condensed consolidated financial statements and related notes thereto appearing in Item 1 of this Quarterly Report on Form 10-Q. In addition to the other information contained or incorporated by reference in this Quarterly Report on Form 10-Q, you should carefully consider the risk factors described in Part II - Item 1A herein when evaluating an investment in our common stock. This Quarterly Report includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, or Securities Act, and Section 21E of the Securities Exchange Act of 1934, or Exchange Act. All statements other than statements of historical fact are "forward-looking statements" for purposes of these provisions, including any statements of the plans and objectives of management for future operations, any statements regarding future operations, any statements concerning proposed new products or services, any statements regarding pending or future mergers or acquisitions, any statements regarding future economic conditions or performance, and any statement of assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as "may," "will," "expects," "plans," "anticipates," "potential" or "continue" or the negative thereof or other comparable terminology.
There can be no assurance that such expectations or any of the forward-looking statements will prove to be correct, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our forward-looking statements are subject to inherent risks and uncertainties including, but not limited to, the risk factors set forth in this Quarterly Report. Factors that could cause or contribute to such differences include, but are not limited to, our limited cash resources, our significant corporate and Securities and Exchange Commission, or SEC, related expenses and limited revenue to offset these expenses, availability of appropriate prospective acquisitions or investment opportunities, litigation and the risks discussed in our other SEC filings. All forward-looking statements and reasons why results may differ included in this Quarterly Report are made as of the date hereof, and we assume no obligation to update any such forward-looking statement or reason why actual results might differ. When used in the report, unless otherwise indicated, "we," "our" and "us" refers to VaxGen, Inc.
OVERVIEW
We are a biopharmaceutical company based in South San Francisco, California. We own a state-of-the-art biopharmaceutical manufacturing facility with a 1,000-liter bioreactor that can be used to make cell culture or microbial biologic products. This facility is located within leased premises. We have ended all product development activities and sold or otherwise terminated our drug development programs. We are seeking to maximize the value of our remaining assets through a strategic transaction or series of strategic transactions. We are considering various strategic transactions to return value to our stockholders. If we are unable to identify and complete a strategic transaction, we will liquidate. Please refer to Note 13, Subsequent Events, for a description of our proposed merger with OXiGENE. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Recent Developments
On October 14, 2009, we entered into a definitive merger agreement with OXiGENE, Inc., or OXiGENE, pursuant to which OXiGENE will acquire us in exchange for common stock of OXiGENE. Upon closing of the transaction, we will become a wholly- owned subsidiary of OXiGENE, and our stockholders will become stockholders of OXiGENE. Please refer to Note 13, Subsequent Events, for a description of our proposed merger with OXiGENE.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Reference is made to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, in our Annual Report on Form 10-K for the fiscal year ended December 31, 2008, filed with the SEC on March 18, 2009, for a description of our critical accounting policies. There have been no material changes to our policies since we filed that report.

RESULTS OF OPERATIONS
Comparison of Fiscal Quarters and Nine Months Ended September 30, 2009 and 2008
Revenues

                  Three Months Ended         Percent          Nine Months Ended         Percent
                     September 30,            Change            September 30,            Change
                 2009            2008       2009/2008       2009            2008       2009/2008
                    (in thousands)                             (in thousands)

Revenues for the nine months ended September 30, 2008 were primarily 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. No services were provided to Celltrion for the nine months ended September 30, 2009.
Revenues earned in one period are not indicative of revenues to be earned in future periods. We do not expect any revenues for the remainder of 2009. Research and development expenses

                              Three Months Ended             Percent             Nine Months Ended            Percent
                                 September 30,               Change                September 30,               Change
                            2009              2008          2009/2008         2009             2008          2009/2008
                                (in thousands)                                    (in thousands)
Research and

Research and development expenses include the costs of internal personnel, outside contractors, allocated overhead and laboratory supplies. We ceased research and development activities during the first quarter of 2008 and therefore no research and development expenses were incurred during the second quarter of 2008 and the first nine months of 2009. We expect no research and development expenses to be incurred during the remainder of 2009. General and administrative expenses

                             Three Months Ended          Percent           Nine Months Ended          Percent
                               September 30,              Change             September 30,             Change
                             2009           2008        2009/2008         2009           2008        2009/2008
                               (in thousands)                               (in thousands)
General and
administrative
expenses                  $    1,865       $ 1,947              -4 %    $   5,484      $ 10,892             -50 %

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 of $0.1 million in the three months ended September 30, 2009 over the comparable period of 2008 was primarily due to lower labor and benefit costs, facilities and other expenses resulting from reductions in force ($0.4 million) partially offset from higher consultant and outside labor costs ($0.3 million) due to the proposed merger with OXiGENE.

The decrease in general and administrative expenses in the nine months ended September 30, 2009 over the comparable period of 2008 was primarily due to:
• Labor and benefits, which decreased by $2.1 million primarily associated with the 2008 reductions in force;

• Consultant and outside labor costs, which decreased by $2.6 million in 2009, following the termination of the proposed merger with Raven biotechnologies, inc., or Raven, pursuant to which we incurred $2.3 million in consultant and outside labor costs during the first nine months of 2008 partially offset by $0.6 million of consultant and outside labor costs incurred during the first nine months of 2009 resulting from the proposed merger with OXiGENE; and

• Facilities costs, which decreased by $1.1 million due to the cessation of operations during the first nine months of 2008.

Restructuring expenses

                              Three Months Ended            Percent             Nine Months Ended            Percent
                                 September 30,               Change               September 30,               Change
                            2009              2008         2009/2008         2009             2008          2009/2008
                                (in thousands)                                   (in thousands)

During the three and nine months ended September 30, 2008, we reduced our workforce to reduce operating costs. Restructuring costs included employee termination and benefit costs.
Impairment of assets held for sale

                               Three Months Ended             Percent          Nine Months Ended          Percent
                                 September 30,                Change             September 30,             Change
                             2009              2008          2009/2008         2009          2008        2009/2008
                                 (in thousands)                                  (in thousands)
Impairment of assets
held for sale             $       72         $       -                0 %    $    231       $ 8,498             -97 %

Based on subsequent impairment assessments of the facility, we estimated that the fair market value of the assets were less than the carrying value of the assets by $72,000 as of September 30, 2009 and $159,000 as of June 30, 2009, or $231,000 for the nine-months ended September 30, 2009, which was recorded as an impairment of assets held for sale in the statement of operations for the three and nine months ended September 30, 2009.
Based on the lack of success in finding a buyer for its facility and expectation of need to dismantle to sell, we performed an impairment assessment of the facility as of June 30, 2008. At June 30, 2008, we estimated that the fair market values of these assets were less than the carrying values of these assets by $8.5 million, which was recorded as an impairment of assets held for sale in the statement of operations for the nine months ended September 30, 2008. The impairment includes all leasehold improvements relating to the facility of approximately $6.5 million, as these items will have no future economic benefit.

Other income (expense)

                                           Three Months Ended               Nine Months Ended
                                              September 30,                   September 30,
                                          2009             2008            2009            2008
                                             (in thousands)                   (in thousands)
Interest expense                       $      (11 )     $     (202 )    $      (31 )     $  (1,571 )
Interest income                                43              334             206           1,582
Realized gain on sale of available
for sale investments                            -                -             357               -
Valuation adjustments                           -            3,567               -           2,612
Gain on convertible debt repurchase             -            3,078               -           3,791
Gain on sale of Anthrax Program                 -            1,000               -           3,000
Other                                           4               14              29               4

Total other income (expense), net      $       36       $    7,791      $      561       $   9,418

The decrease in other income, net, for the three months ended September 30, 2009 from the comparable period in 2008 was primarily due to:
• Gain on the sale of our Anthrax Program of $1.0 million in the third quarter of 2008;

• Valuation gain of $3.6 million in 2008 reflects the decrease in the fair value on mark-to-market adjustments related to the valuation of our outstanding derivatives on our 5 1/2% Convertible Senior Subordinated Notes, due April 1, 2010, or Notes, due to the repurchase of $22 million principal amount of the Notes;

• Decreased interest income due to lower interest rates and lower overall cash, cash equivalents and investment balances primarily due to our repurchase of Convertible Notes during 2008; and

• A partial offset of decrease in interest expense in 2009, following the repurchase of our Convertible Notes, during 2008.

The decrease in other income, net, for the nine months ended September 30, 2009 from the comparable period in 2008 was primarily due to:
• Gain on the sale of our Anthrax Program of $3.0 million in the first nine months of 2008;

• Gain of $3.8 million on the repurchase of $23.5 million principal amount of our Notes at a discount;

• Valuation gain of $2.6 million in 2008 reflects the decrease in the fair value on mark-to-market adjustments related to the valuation of our outstanding derivatives on our 5 1/2% Convertible Senior Subordinated Notes, due April 1, 2010, or Notes, due to the repurchase of $22 million principal amount of the Notes;

• Decreased interest income due to lower overall cash, cash equivalents and investment balances primarily due to our repurchase of Convertible Notes during 2008; and

• A partial offset of decrease in interest expense in 2009, following the repurchase of our Convertible Notes, during 2008.

We anticipate future investment income will fluctuate and will be primarily driven by our future cash, cash equivalent and investment balances.

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

                                                           2009         2008
                                                             (in thousands)
      As of September 30:
      Cash, cash equivalents and investment securities   $ 34,010     $  46,394
      Working capital                                      34,014        46,709

      Nine Months ended September 30:
      Cash provided by (used in)
      Operating activities                               $ (4,790 )   $  (8,745 )
      Investing activities                                   (695 )       6,963
      Financing activities                                      -       (18,790 )

Our primary capital requirements for the nine months ended September 30, 2009 were operating costs. Through September 30, 2009, we financed our operations primarily through sales of our common stock, the issuance of Series A Preferred Stock, the issuance of convertible debt, sales of our Celltrion common stock as well as through revenues from research contracts and grants. Our future capital requirements will depend upon our ability to identify and exploit business development opportunities including actively pursuing avenues to enhance stockholder value through a strategic transaction.
Net cash used in operating activities decreased to $4.8 million for the nine months ended September 30, 2009 from $8.7 million for the nine months ended September 30, 2008 and was primarily attributable to our reduced operating losses. The effect of non-cash items upon operating activities was significant in both the nine months ended September 30, 2009 and 2008 and included:
• Depreciation expense of zero in 2009 and $0.6 million in 2008, reflecting the reclassification of equipment, furniture and fixtures to assets held for sale during the first nine months of 2008;

• Impairment of assets held for sale of $0.2 million in 2009 and $8.5 million in 2008;

• Valuation gain of $2.6 million in 2008 reflecting changes in the fair value of outstanding derivatives from the Convertible Notes;

• Stock based compensation expense of $0.2 million in 2009 and $1.4 million in 2008.

• Gain on redemption of the Convertible Notes of $3.8 million in 2008;

• Gain on sale of Celltrion common stock of $0.4 million in 2009; and

• $1.9 million of Raven merger costs capitalized at December 31, 2007 that were expensed as general and administrative expense during the nine months ended September 30, 2008.

The decrease in cash used in operating activities was also affected by the following:
• Accounts payable, which decreased by $39,000 in 2009 and $2.1 million in 2008 primarily due to the timing of payments and the reduced level of operating activities; and

• Accrued and other liabilities, which decreased by $0.3 million in 2009 and increased by $1.8 million in 2008 primarily due to $1.9 million of the costs of the proposed merger with Raven capitalized at December 31, 2007 that were expensed as general and administrative expense during the nine months ended September 30, 2008.

Net cash used in investing activities of $0.7 million in nine months ended September 30, 2009 was primarily attributable to activities relating to the purchase and sale of investment securities of $1.2 million, partially offset by proceeds from the sale of our Celltrion common stock of $0.4 million. Net cash provided by investing activities of $7.0 million in the nine months ended September 30, 2008 was primarily attributable to the and $1.3 million of net repayments of amounts loaned to Raven under the bridge loan, the net proceeds of $5.0 million from investment activity and the proceeds from the sale of assets held for sale of $0.6 million.
Net cash used in financing activities in the nine months ended September 30, 2008 was attributable to the repurchase of $23.5 million principal amount of Convertible Notes at a purchase price of $18.8 million.
At September 30, 2009, $34.0 million, or 92%, of our total assets consisted of cash, cash equivalents and investment securities. We had working capital of $34.0 million at September 30, 2009, compared to $46.7 million at September 30, 2008. This decrease in working capital is primarily due to the following:
• Cash, cash equivalents and investments decreased by $12.4 million primarily due to our repurchase of Convertible Notes in 2008 and operating losses;

• Assets held for sale decreased by $0.7 million primarily due to impairment charges; and

• A partial offset by the elimination of the derivative liability of $0.9 million resulting from the repurchase of our Convertible Notes in 2008.

We believe that our existing cash, cash equivalents and investment securities will be sufficient to cover our working capital needs and commitments through at least September 30, 2010. Our future capital requirements will depend on our ability to identify and complete additional business opportunities. We are considering various strategic transactions to return value to our stockholders. If we are unable to identify and complete an alternate strategic transaction, we will liquidate.
Off-Balance Sheet Arrangements
As of September 30, 2009, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. Recent Accounting Pronouncements
Adopted
On July 1, 2009, the Financial Accounting Standards Board ("FASB") issued SFAS No. 168, "The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles", also known as FASB Accounting Standards Codification ("ASC") 105-10, "Generally Accepted Accounting Principles" ("ASC 105-10") (the "Codification"). ASC 105-10 establishes the exclusive authoritative reference for U.S. GAAP for use in financial statements, except for SEC rules and interpretive releases, which are also authoritative GAAP for SEC registrants. The Codification will supersede all existing non-SEC accounting and reporting standards. We have included the references to the Codification, as appropriate, in these consolidated financial statements. Issued but not yet adopted
In October 2009, the FASB issued Accounting Standards Update, 2009-13, Revenue Recognition (Topic 605): Multiple Deliverable Revenue Arrangements - A Consensus of the FASB Emerging Issues Task Force." This update provides application guidance on whether multiple deliverables exist, how the deliverables should be separated and how the consideration should be allocated to one or more units of accounting. This update establishes a selling price hierarchy for determining the selling price of a deliverable. The selling price used for each deliverable will be based on vendor-specific objective evidence, if available, third-party evidence if vendor-specific objective evidence is not available, or estimated selling price if neither vendor-specific or third-party evidence is available. The Company will be required to apply this guidance prospectively for revenue arrangements entered into or materially modified after January 1, 2011; however, earlier application is permitted. The Company has not determined the impact that this update may have on its financial statements.
In August 2009, the FASB issued Accounting Standards Update No. 2009-05 ("ASC Update 2009-05"), an update to ASC 820, Fair Value Measurements and Disclosures. This update provides amendments to reduce potential ambiguity in financial reporting when measuring the fair value of liabilities. Among other provisions, this update provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the valuation techniques described in ASC Update 2009-05. ASC Update 2009-05 will become effective for the Company's annual financial statements for the year ended December 31, 2009. The Company has not determined the impact that this update may have on its financial statements.
In June 2009, the FASB issued guidance related to accounting for transfers of financial assets. This guidance improves the information that a reporting entity provides in its financial reports about a transfer of financial assets; the effects of a transfer on its financial position, financial performance and cash flows; and a continuing interest in transferred financial assets. In addition, this guidance amends various ASC concepts with respect to accounting for transfers and servicing of financial assets and extinguishments of liabilities, including removing the concept of qualified special purpose entities. This guidance must be applied to transfers occurring on or after the effective date. The Company will adopt this guidance in its first annual and interim reporting periods beginning after November 15, 2009. The Company has not determined the impact that this guidance may have on its financial statements.
In June 2009, the FASB issued guidance which amends certain ASC concepts related to consolidation of variable interest entities. Among other accounting and disclosure requirements, this guidance replaces the quantitative-based risks and rewards calculation for determining which enterprise has a controlling financial interest in a variable interest entity with an approach focused on identifying which enterprise has the power to direct the activities of a variable interest entity and the obligation to absorb losses of the entity or the right to receive benefits from the entity. The Company will adopt this guidance in its first annual and interim reporting periods beginning after November 15, 2009. The Company has not determined the impact that this guidance may have on its financial statements.