UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005

OR

Commission file number: 000-31617

CIPHERGEN BIOSYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: 510-505-2100

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  ý  No  o

Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Exchange Act.

Yes  ý  No  o

Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act.

Yes  o  No  ý

Number of shares of common stock, $0.001 par value, outstanding as of November 30, 2005:  35,998,881

CIPHERGEN BIOSYSTEMS, INC.

INDEX FOR FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2005

Ciphergen, ProteinChip and Biomarker Discovery Center are registered trademarks of Ciphergen Biosystems, Inc.

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PART I.  FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

CIPHERGEN BIOSYSTEMS, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

See notes to unaudited condensed consolidated financial statements.

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CIPHERGEN BIOSYSTEMS, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)

See notes to unaudited condensed consolidated financial statements.

4

CIPHERGEN BIOSYSTEMS, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

See notes to unaudited condensed consolidated financial statements.

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CIPHERGEN BIOSYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
September 30, 2005

1.               ORGANIZATION AND BASIS OF PRESENTATION

The Company

Ciphergen Biosystems, Inc. (the “Company” or “Ciphergen”) develops, manufactures and sells ProteinChipâ Systems for life science researchers.  The core technology, which is patented, is Surface Enhanced Laser Desorption/Ionization (“SELDI”).  The systems consist of ProteinChip Readers, ProteinChip Software and related accessories, which are used in conjunction with consumable ProteinChip Arrays.  These products are sold primarily to biologists at pharmaceutical and biotechnology companies, and academic and government research laboratories.  The Company also provides research services primarily through its Biomarker Discovery Center® laboratories, and offers consulting services, customer support services and training classes to its customers and collaborators.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  The unaudited interim financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair statement have been included.  Certain financial statement items have been reclassified to conform to the current year’s format.  The results of operations for the interim periods shown herein are not necessarily indicative of operating results for the entire year or any other future interim period.

The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries.  All intercompany transactions have been eliminated in consolidation.  BioSepra S.A. was a wholly-owned subsidiary and was consolidated through November 30, 2004, at which time the Company sold BioSepra S.A., along with other assets related to its process chromatography business.  All comparative periods shown in the statements of operations have been restated to reflect the BioSepra business as a discontinued operation.

This unaudited financial data should be read in conjunction with the audited consolidated financial statements and footnotes contained in the Company’s 2004 Form 10-K.

Restatement

The Audit Committee of the Board of Directors recently completed an investigation focused on the Company's revenue recognition in connection with certain sales transactions. Upon completion of this investigation, the Audit Committee concluded that it was necessary to restate certain financial data for the three and six month periods ended June 30, 2005 in order to recognize revenue for those sales transactions on a basis consistent with Ciphergen's revenue recognition policies.

As a result of the restatement, total revenues decreased by $552,000 for the quarter ended June 30, 2005 and for the six months ended June 30, 2005; net loss increased by $354,000 for the quarter ended June 30, 2005 and for the six months ended June 30, 2005; and basic and diluted net loss per share increased $0.01 for the quarter ended June 30, 2005 and for the six months ended June 30, 2005. None of the adjustments resulting from the restatement had any impact on cash balances for any period. However, the Company's unaudited condensed consolidated balance sheet and statement of cash flows were restated to reflect the restated net loss and revisions to certain balance sheet accounts.

The accompanying Unaudited Condensed Consolidated Financial Statements give effect to the restatement of the Company's consolidated financial statements for the three and six month periods ended June 30, 2005, as more fully explained in the Company's Quarterly Report on Form 10-Q/A for the second quarter of 2005, filed on December 21, 2005.

Liquidity

From its inception through September 30, 2005, the Company has financed its operations principally with $204.4 million from the sales of products and services to customers and net proceeds from equity financings totaling approximately $160.8 million including $15.0 million from the sale of 6,225,000 shares of Ciphergen’s common stock and a warrant to purchase up to 2,200,000 shares of Ciphergen’s common stock to Quest Diagnostics Incorporated (“Quest Diagnostics”) on July 22, 2005. Ciphergen received $28.1 million of net proceeds from the sale of 4.5% convertible senior notes on August 22, 2003. These notes are due September 1, 2008.  In addition, in July 2005, Quest Diagnostics agreed to loan the Company up to $10 million solely to fund certain development activities related to the strategic alliance between Ciphergen and Quest Diagnostics.  Borrowings may be made by the Company in monthly increments of up to approximately $417,000 during the following two years, and the loan will be forgiven upon Ciphergen’s achievement of certain milestones.  Otherwise, amounts outstanding on the loan must be repaid on or before July 22, 2010.  (See note 7.)  The Company also received $27.0 million from the sale of its BioSepra business in November 2004.  The Company has incurred significant net losses and negative cash flows from operations since inception. At September 30, 2005, the Company had an accumulated deficit of $186.6 million.

Management believes that currently available resources will provide sufficient funds to enable the Company to meet its obligations for at least the next 18 months, including its obligations under its October 2005 research and license agreement with University College London and UCL BioMedica Plc.  (See note 14, Subsequent Events.)  Ciphergen currently expects to fund its liquidity needs as well as expenditures for its obligations related to the strategic alliance with Quest Diagnostics and for capital requirements from a combination of available cash and short-term investments, proceeds from the alliance with Quest Diagnostics including borrowings from Quest Diagnostics, potential sales of additional equity and/or debt securities, and the receipt of approximately $1.0 million plus $21,000 of accrued interest released from escrow subsequent to the interim periods shown herein from the sale of the BioSepra business to Pall Corporation.  If anticipated operating results are not achieved, however, management believes that planned expenditures may need to be reduced in order to extend the time period over which the currently available resources will be adequate to fund the Company’s operations. At such time as the Company requires additional funding, the Company

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may seek to raise such additional funding from various possible sources, including the public equity market, private financings, sales of assets, collaborative arrangements and debt. If additional capital is raised through the issuance of equity or securities convertible into equity, stockholders may experience dilution, and such securities may have rights, preferences or privileges senior to those of the holders of its common stock or convertible senior notes. If the Company obtains additional funds through arrangements with collaborators or strategic partners, it may be required to relinquish its rights to certain technologies or products that it might otherwise seek to retain. There can be no assurance that the Company will be able to obtain such financing, or obtain it on acceptable terms.  If Ciphergen is unable to obtain financing on acceptable terms, it may be unable to execute its business plan, it could be required to delay or reduce the scope of its operations, and it may not be able to pay off the convertible senior notes if and when they come due.

2.                                       RECENT ACCOUNTING PRONOUNCEMENTS

In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “Inventory Costs, an amendment of ARB 43, Chapter 4”. SFAS 151 requires certain inventory costs to be recognized as current period expenses. This standard also provides guidance for the allocation of fixed production overhead costs. This standard is effective for inventory costs incurred during fiscal years beginning after June 15, 2005.  The Company will adopt this standard beginning in 2006, but its adoption is not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

In December 2004, the FASB issued SFAS No. 123 (Revised), “Share-Based Payment.” This standard revises SFAS 123, APB 25 and related accounting interpretations, and eliminates the use of the intrinsic value method. As noted previously, the Company currently uses the intrinsic value method of APB 25 to value stock options and, accordingly, no compensation expense has been recognized for stock options. This new standard requires the expensing of all stock-based compensation, including stock options, using the fair value method.  The FASB’s transition provisions require implementation of SFAS 123(R) for quarters beginning after June 15, 2005. However, in April 2005, the Securities and Exchange Commission announced a deferral of the required implementation date to fiscal years beginning after June 15, 2005 or, in Ciphergen’s case, its 2006 fiscal year. SFAS 123(R) will apply to all awards granted after the implementation date and to previously-granted awards unvested as of the implementation date. The impact of SFAS 123(R) on the Company’s financial statements and related disclosures is still being evaluated by management but is expected to be material. The Company’s actual share-based compensation expense in 2006 will be dependent on a number of factors, including the amount of awards granted and the fair value of those awards at the time of grant.

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets—An Amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions”. SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” and replaces it with an exception for exchanges that do not have commercial substance. SFAS 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for fiscal periods beginning after June 15, 2005.  The adoption of this standard had no effect on the Company’s financial position, results of operations or cash flows.

In December 2004, the FASB issued FASB Staff Position No. 109-2 (“FSP 109-2”), “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (“AJCA”)”. FSP 109-2 allows the Company up until October 31, 2005 to evaluate the effect of the AJCA on its plans for reinvestment or repatriation of foreign earnings for purposes of applying SFAS 109 “Accounting for Income Taxes.” On May 10, 2005, the Treasury Department and the IRS issued Notice 2005-38, the second in a series of notices, which is intended to provide additional guidance for U.S. companies evaluating the effect of the AJCA on plans for reinvestment or repatriation of foreign earnings. Management currently believes all foreign earnings will be reinvested and is not considering repatriation of any significant amounts under this provision.

In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, “Share-Based Payment”. SAB 107 provides guidance on the initial implementation of SFAS 123(R). In particular, the statement includes guidance related to share-based payment awards for non-employees, valuation methods and selecting underlying assumptions such as expected volatility and expected term. It also provides guidance on the classification of compensation expense associated with such awards and accounting for the income tax effects of those awards upon the adoption of SFAS 123(R). The Company is currently assessing the guidance provided in SAB 107 in connection with the implementation of SFAS 123(R).

In March 2005, the FASB issued Interpretation No. 47 (“FIN 47”) to clarify the guidance included in SFAS No. 143, “Accounting for Asset Retirement Obligations”. FIN 47 requires companies to recognize a liability for the fair value of a legal obligation to perform asset retirement activities that are conditional on a future event if the amount can be reasonably estimated. If amounts cannot be reasonably estimated, certain disclosures will be required about the unrecognized asset retirement obligations. The interpretation is required to be adopted in the first quarter of 2006. The Company has not yet determined the impact, if any, this standard will have on its financial statements and related disclosures, but does not expect it to have a material impact.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”. SFAS 154 is a replacement of

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Accounting Principles Board Opinion (“APB”) No. 20 and SFAS 3. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application as the required method for reporting a change in accounting principle. SFAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed by SFAS 154. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will adopt this standard beginning in 2006.

3.               INVENTORIES

Inventories consisted of the following (in thousands):

4.               GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill and other intangible assets consisted of the following (in thousands):

During the first nine months of 2005, the acquired license related to the Company’s litigation settlement in 2003 increased $463,000 as a result of cash payments made by the Company for license fees.

Amortization expense for these intangible assets was (in thousands):

Annual amortization expense for these intangible assets is expected to be approximately $1,209,000 in both 2005 and 2006, $1,085,000 in 2007 and zero thereafter.

5.               WARRANTIES AND MAINTENANCE CONTRACTS

Ciphergen has a direct field service organization that provides service for its products.  The Company generally includes a standard 12 month warranty on its ProteinChip Systems, ProteinChip Tandem MS Interfaces and accessories in the form of a maintenance contract upon initial sale, after which maintenance and support may be provided under a separately priced contract or on an individual call basis.  Ciphergen makes no distinction between a standard warranty and a maintenance (extended warranty) contract.  The Company substitutes a maintenance contract in place of a standard 12-month warranty on its instruments and accessories upon initial sale.  Ciphergen also sells separately priced maintenance (extended warranty) contracts, which are generally

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for 12 or 24 months, upon expiration of the initial warranty.  Coverage under both the standard and extended warranty maintenance contracts is identical.  Because the Company does not offer traditional warranties but enhances them such that they are identical to its separately priced maintenance contracts, management believes it is appropriate to account for them in the same way.  Revenue for

both the standard and extended warranty maintenance contracts is deferred and recognized on a straight line basis over the period of the applicable maintenance contract.  Related costs are recognized as incurred.

Changes in product warranty obligations, including separately priced maintenance obligations, were as follows (in thousands):

6.               COMMITMENTS AND CONTINGENCIES

In July 2005, the Company was notified by a supplier about a potential safety hazard in certain pumps used in some older model ProteinChip Systems.  This does not affect Ciphergen’s current Series 4000 line.  The supplier is recommending that a capacitor in the pumps it supplied be replaced.  The Company’s management has evaluated the situation with the supplier and with legal counsel, and does not believe Ciphergen’s cost for retrofitting the affected instruments or related liabilities will be material to our financial statements.

In the third quarter of 2005, Ciphergen sold nine ProteinChip Systems to one customer for $601,000. The Company also entered into a product development agreement with this same customer, whereby the customer will develop for Ciphergen a specific new product and Ciphergen may pay the customer up to $500,000 based on the customer’s attainment of specified development milestones. Under this agreement, Ciphergen paid this customer $100,000 of development fees during the third quarter of 2005. This was recorded, following EITF 01-9 (“Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)”), not as research and development expense but as a reduction to revenue, resulting in net revenue from this customer of approximately $501,000 in the third quarter of 2005. This constituted approximately 11% of products revenue and 7% of total revenue for the third quarter of 2005. In future periods, if this third party achieves a development milestone, Ciphergen will record its payment obligation as a reduction to revenue in the period in which that development milestone is met.

7.               STRATEGIC ALLIANCE WITH QUEST DIAGNOSTICS

On July 22, 2005, the Company entered into a strategic alliance agreement with Quest Diagnostics covering a three year period during which the parties will strive to develop and commercialize up to three diagnostic tests based on Ciphergen’s proprietary SELDI ProteinChip technology. Pursuant to the agreement, Quest Diagnostics will have the non-exclusive right to commercialize these tests on a worldwide basis, with exclusive commercialization rights in territories where Quest Diagnostics has a significant presence for up to five years following commercialization.  As part of the strategic alliance, there is a royalty arrangement under which Quest Diagnostics will pay royalties to Ciphergen based on fees earned by Quest Diagnostics for applicable diagnostics services, and Ciphergen will pay royalties to Quest Diagnostics based on Ciphergen’s revenue from applicable diagnostics products.  To date, no such royalties have been earned by either party.  There is also a supply agreement under which Ciphergen will sell instruments and consumable supplies to Quest Diagnostics to be used for performing diagnostics services.  In addition, for an aggregate purchase price of $15 million, Quest Diagnostics has purchased 6,225,000 shares of Ciphergen’s common stock, or approximately 17.4% of shares outstanding after the transaction, and a warrant having a term of five years to purchase up to an additional 2,200,000 shares for $3.50 per share.  The warrant was valued at approximately $2.2 million based on the fair value as determined by a Black-Scholes model using the following assumptions:  risk-free interest rate, 4.04%; expected life, 5 years; expected volatility 69%.  Quest Diagnostics has also agreed to loan Ciphergen up to $10 million with interest accrued at the prime rate plus 0.5% and paid monthly, solely to fund certain development activities related to the strategic alliance.  Borrowings may be made by Ciphergen in monthly increments of up to approximately $417,000 on the last day of each month during the first two years of the strategic alliance, and at September 30, 2005, such borrowings amounted to $1,250,000.  This loan, collateralized by certain intellectual property of Ciphergen, will be forgiven based on Ciphergen’s achievement of certain milestones related to development, regulatory approval and commercialization of certain diagnostic tests.  Should the Company fail to achieve these milestones, the outstanding principal amount of any such loans will become due and payable on July 22, 2010.  From the inception of the strategic

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alliance through September 30, 2005, the Company had spent approximately $636,000 of the loan proceeds on in-house research and development, as well as collaborations with others, directed towards achieving the milestones.  Spending for this purpose is expected to continue and to increase, partly as a result of the additional expenses associated with the collaboration with University College London et al. described in note 14.

8.               FOREIGN CURRENCY TRANSACTIONS

During the three and nine month periods ended September 30, 2005, there were no transactions related to forward contracts. Net realized foreign currency gains and losses related to foreign currency forward contracts and a related intercompany loan were not material for the three and nine month periods ended September 30, 2004.

9.               STOCK-BASED COMPENSATION

The Company accounts for its stock-based employee compensation arrangements using the intrinsic value method of accounting.  Unearned compensation expense is based on the difference, if any, on the date of the grant between the fair value of the Company’s stock and the exercise price.  Unearned compensation is amortized and expensed using an accelerated method.  The Company accounts for stock issued to non-employees using the fair value method of accounting.

Had compensation expense for options granted to employees, officers and directors been determined based on fair value at the grant date, the Company’s net loss per share would have increased to the pro forma amounts indicated below (in thousands, except per share amounts):

10.         INCOME TAXES

Based on the available objective evidence, management believes it is more likely than not that the net deferred tax assets related to the Company’s operations will not be fully realizable.  Accordingly, the Company has provided a full valuation allowance against the net deferred tax assets related to its operations at September 30, 2005.  The Company incurs income tax liabilities in most of the countries outside the U.S. in which it operates.

11.         COMPREHENSIVE LOSS

Comprehensive loss consisted of the following (in thousands):

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12.         NET LOSS PER SHARE

Basic net loss per share is calculated using the weighted average number of common shares outstanding during the period.  Because the Company is in a net loss position, diluted earnings per share is calculated using the weighted average number of common shares outstanding and excludes the effects of 11.6 million and 8.6 million potential common shares as of September 30, 2005 and 2004, respectively, that are antidilutive.  Potential common shares include shares that could be issued if all convertible senior notes were converted into common stock, shares of common stock issuable upon the exercise of an outstanding warrant held by Quest Diagnostics, common stock subject to repurchase, common stock issuable under the Company’s 2000 Employee Stock Purchase Plan, and shares of common stock potentially issuable upon the exercise of outstanding stock options.  The following table sets forth the computation of basic and diluted net loss per share for the periods indicated (in thousands, except per share amounts):

13.         SEGMENT INFORMATION AND GEOGRAPHIC DATA

Ciphergen’s revenue is derived from the sales of related products and services on a worldwide basis.  Although discrete units that earn revenues and incur expenses exist, significant expenses such as sales and marketing and corporate administration are not incurred by nor allocated to these operating units but rather are employed by the entire enterprise.  Additionally, the chief operating decision maker evaluates resource allocation not on a product or geographic basis, but rather on an enterprise-wide basis.  Therefore, management has determined that Ciphergen operates in only one reportable segment, which is the protein research tools and collaborative services business.

The Company sells most of its products and services directly to customers in North America, Western Europe and Japan, and through distributors in other parts of Europe and Asia and in Australia.  Revenue for geographic regions reported below is based upon the customers’ locations and excludes revenue from discontinued operations.  Following is a summary of the geographic information related to revenue from continuing operations for the three and nine month periods ended September 30, 2005 and 2004 (in thousands):

During the three and nine month periods ended September 30, 2005, sales to customers in Japan represented 13% and 21%, respectively, of revenue from continuing operations.  During the three and nine month periods ended September 30, 2004, sales to customers in Japan represented 20% and 25%, respectively, of revenue from continuing operations.  No other country outside the U.S. accounted for 10% or more of total revenue from continuing operations during these periods.

Long-lived assets, primarily machinery and equipment, are reported based on the location of the assets.  Long-lived asset information by geographic area as of September 30, 2005 and December 31, 2004 is presented in the following table (in thousands):

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14.   SUBSEQUENT EVENTS

On October 3, 2005, the Company entered into a two year research and license agreement with University College London and UCL BioMedica Plc. (together, “UCL”) to utilize Ciphergen’s suite of proteomic solutions (Deep Proteome™, Pattern Track™ Process and ProteinChip® System) to further UCL’s ongoing research in ovarian cancer and breast cancer.  Under the terms of the agreement, Ciphergen will have exclusive rights to license intellectual property resulting from discoveries made during the course of this collaboration for use in developing, manufacturing and selling products and services utilizing the intellectual property.  Ciphergen is obligated to make contributions of approximately $2.1 million in cash and $652,000 in the form of Ciphergen equipment, software, arrays and consumable supplies, valued at Ciphergen’s list selling price, to cover part of the costs incurred by UCL specifically for this research program.  $1.9 million of this obligation is to be paid in the first year of the agreement and is non-cancelable.  The remainder is to be paid in the second year of the agreement and is cancelable with adequate advance notice.

On November 7, 2005, the Company announced that the Audit Committee (the “Committee”) of the Board of Directors was, with the assistance of external accounting advisors, conducting an investigation primarily regarding the recognition of revenue in connection with certain sales transactions.  As a result of this investigation, the Company delayed the announcement of its results of operations for the third quarter of 2005 and was unable to timely file its Quarterly Report on Form 10-Q for that period.  The Company filed a late filing notice on Form 12b-25 with the Securities and Exchange Commission.

On November 15, 2005, the Nasdaq Listings Qualification Department (“Nasdaq”) notified the Company that its common stock would be delisted from The Nasdaq National Market effective at the opening of business on Friday, November 25, 2005 unless the Company requested a hearing in accordance with applicable Nasdaq rules.  In its letter to the Company, Nasdaq cited as the reason for delisting that the Company had not complied with its periodic reporting requirements for the filing of its Quarterly Report on Form 10-Q for the quarter ended September 30, 2005 (as required pursuant to Rule 4301(c)(14) of the Nasdaq Marketplace Rules).  Effective as of the opening of business on November 17, 2005, the trading symbol for the Company’s common stock was changed from CIPH to CIPHE.  The Company has appealed Nasdaq’s determination.

On November 16, 2005, the Company announced the Committee had determined that previously reported financial results for the three months and six months ended June 30, 2005 should be restated, after determining that certain revenues had been recognized in a manner inconsistent with the Company’s revenue recognition policy.  As a result, the Committee concluded that Ciphergen’s Quarterly Report on Form 10-Q for the second quarter of 2005 should no longer be relied upon.

On November 29, 2005, the Company was notified by the holder of a portion of the Company’s convertible senior notes that it was in default under the indenture related to the convertible senior notes due to the delinquency in Ciphergen’s SEC filing, and that Ciphergen had 60 days from the date of the notice of default to cure the default.  The Company cured this deficiency by filing its Quarterly Report on Form 10-Q covering the third quarter of 2005.

On December 1, 2005, the Company received payment of $1.0 million plus $21,000 of accrued interest released from escrow from the sale of its BioSepra business to Pall Corporation in November 2004.

On December 2, 2005, the Nasdaq Listings Qualification Department notified Ciphergen that the Company had failed to comply with the continued listing requirements of The Nasdaq National Market because the market value of the Company’s listed securities had fallen below $50,000,000 for 10 consecutive business days (pursuant to Rule 4450(b)(1)(A) of the Nasdaq Marketplace Rules).  Pursuant to Nasdaq Marketplace Rule 4450(e)(4), the Company was provided a period of 30 calendar days, or until January 3, 2006, to regain compliance.  The Company has appealed this delisting determination.

Additionally, the Company and certain of its officers have been named as defendants in a securities class action complaint filed on December 5, 2005, in the United States District Court, Northern District of California.  The complaint has been brought on behalf of all persons who purchased the Company’s common stock from August 8, 2005, when the Company issued a press release announcing unaudited financial results for the second quarter of 2005, through November 16, 2005, when the Company announced its intention to restate those financial results.  The plaintiffs do not demand any particular amount in damages.  The Company has not yet responded to the complaint.

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

We have made statements under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Factors That May Affect Our Results” and in other sections of this Form 10-Q that are forward-looking statements for purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995.  We claim the protection of such safe harbor, and disclaim any intent or obligation to update any forward-looking statement.  You can identify these statements by forward-looking words such as “may”, “will”, “expect”, “intend”, “anticipate”, “believe”, “estimate”, “plan”, “could”, “should” and “continue” or similar words.  These forward-looking statements may also use different phrases.  We have based these forward-looking statements on our current expectations and projections about future events.  Examples of forward-looking statements include statements about projections of our future revenue, gross margin, expenses, losses, results of operations and financial condition; anticipated deployment, capabilities and uses of our products and our product development activities and product innovations; the importance of proteomics as a major focus of biology research; the ability of our products to enable proteomics research; competition and consolidation in the markets in which we compete; existing and future collaborations and partnerships; our ability to operate and expand our Biomarker Discovery Center® laboratories and secure the commercial rights to biomarkers discovered at our Biomarker Discovery Center laboratories; the utility of biomarker discoveries and the effectiveness of our Biomarker Discovery Center laboratories; our plans to develop and commercialize diagnostic tests through our strategic alliance with Quest Diagnostics; our ability to comply with applicable government regulations; our ability to expand and protect our intellectual property portfolio; increasing the future sales volumes of consumables; increasing general and administrative costs; decreasing sales and marketing and research and development costs; anticipated future losses; potential expenses associated with a product retrofit; expected levels of capital expenditures; forgiveness of loan obligations to Quest Diagnostics; the rating of our convertible notes and the value of the related put options; the period of time for which our existing financial resources and interest income will be sufficient to enable us to maintain current and planned operations; foreign currency exchange rate fluctuations and our plans for mitigating foreign currency exchange risks; and the market risk of our investments.  These statements are subject to risks and uncertainties that could cause actual results to differ materially, including the risks set forth under the caption “Factors That May Affect Our Results” in this Form 10-Q and the similar factors and risks outlined in our other filings with the Securities and Exchange Commission (“SEC”).

OVERVIEW

We develop, manufacture and sell our ProteinChipâ Systems, which use patented Surface Enhanced Laser Desorption/Ionization (“SELDI”) technology.  These systems consist of a ProteinChip Reader, ProteinChip Software and related accessories which are used in conjunction with our consumable ProteinChip Arrays.  We also offer consulting services, customer support services and training classes to further our customers’ success in using SELDI technology.  We market and sell our products primarily to research biologists in pharmaceutical and biotechnology companies, and academic and government research laboratories.  In 1997, we acquired IllumeSys Pacific, Inc., which holds specific rights to the SELDI technology for the life science research market.  Our first designed and manufactured system, the ProteinChip System, Series PBS I, was available for shipment in the third quarter of 1997.  In 1997, we also established a subsidiary in the U.K. and began direct selling in Europe.  During 1999, we initiated an expanded marketing program and in May 1999 began shipping the ProteinChip System, Series PBS II, which is now referred to as the ProteinChip Biology System.  In 1999, we also established a joint venture with Sumitomo Corporation to distribute our products in Japan.  During 2000, we began offering research services and established Biomarker Discovery Center laboratories in Fremont, California; Copenhagen, Denmark; and Malvern, Pennsylvania.

In 2001, we introduced the ProteinChip Biomarker System, which utilizes sophisticated third-party software to automate pattern recognition-based statistical analysis methods and correlate protein expression patterns from clinical samples with disease phenotypes.  We also began selling the Biomek® 2000 Workstation, later superceded by the Biomek 3000 workstation, a robotic accessory which is manufactured by Beckman Coulter and which has been optimized for use with our ProteinChip Biomarker System to increase sample throughput and reproducibility.  In addition, we expanded our product offering with a SELDI ProteinChip interface to high-end tandem mass spectrometers, which we developed and which is manufactured for us by a third party manufacturing company.  On July 31, 2001, Ciphergen acquired the BioSepraâ process chromatography business from Invitrogen Corporation; this business was subsequently sold to Pall Corporation on November 30, 2004.

On August 31, 2002, we increased our ownership interest in Ciphergen Biosystems KK, the Japanese joint venture we formed with Sumitomo Corporation in 1999, from 30% to 70%.  Shortly thereafter, we opened a Biomarker Discovery Center laboratory at the Yokohama facility of Ciphergen Biosystems KK.  In October 2002, we launched the ProteinChip AutoBiomarker System, an automated version of our ProteinChip Biomarker System, which incorporates an autoloader and a Biomek robot to increase sample throughput and automate the reading of ProteinChip Arrays.  On March 23, 2004, we purchased the remaining 30% ownership interest in Ciphergen Biosystems KK.  In July 2004, we launched the ProteinChip System, Series 4000, our next generation ProteinChip System.

We have used our resources primarily to develop and expand our proprietary ProteinChip Systems and related consumables and to establish a marketing and sales organization for commercialization of our products.  We also used our funds to establish a joint

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venture to distribute our products in Japan and to increase our ownership in the joint venture to 100%.  In addition, we acquired the BioSepra process chromatography business in 2001, which we sold for a gain in 2004.  We have also used our resources to establish Biomarker Discovery Center laboratories to provide research services to our clients, to foster further adoption of our products and technology, and to discover biomarkers that we seek to patent for diagnostic and other purposes.  In early 2004, we increased our efforts to discover protein biomarkers and panels of biomarkers that can be developed into protein molecular diagnostic tests that improve patient care; to date, these efforts have not generated any revenue from diagnostic tests. Since our inception we have incurred significant losses and as of September 30, 2005, we had an accumulated deficit of $186.6 million.

Our sales are currently driven by the need for new and better tools to perform protein discovery, characterization, purification, identification and assay development.  In addition, many of our customers later enhance their ProteinChip Systems to add automation accessories and advanced software.  Most of the ProteinChip Systems sold to our customers also generate a recurring revenue stream from the sale of consumables and maintenance contracts.  Our expenses have consisted primarily of materials, contracted manufacturing services, labor and overhead costs to manufacture our ProteinChip Systems and ProteinChip Arrays and to provide customer services; marketing and sales activities; research and development programs; litigation; and general and administrative costs associated with our operations.  We expect to incur losses for at least the next year.  Our current level of revenue is insufficient for us to become profitable.  To become profitable, we will need to increase sales of our ProteinChip Systems, Arrays and collaborative services into the research and development market as well as begin achieving revenue from diagnostic tests.

We anticipate that our quarterly results of operations will fluctuate for the foreseeable future due to several factors, including market acceptance of current and new products, the length of the sales cycle and timing of significant orders, the timing and results of our research and development efforts, the introduction of new products by our competitors and possible patent or license issues.  Our limited operating history makes accurate prediction of future results of operations difficult.

RECENT DEVELOPMENTS

In January 2005 and again in July 2005, we took actions, consisting principally of headcount reductions, to reduce our operating expenses.  These cost control measures primarily involved our sales and marketing organization, leaving our resources devoted to developing diagnostic products largely unaffected.  At September 30, 2005, we had approximately 169 employees, consisting of 27 in manufacturing, 38 in research and development, 79 in sales and marketing, and 25 in administration.

In April 2005, we paid Pall Corporation approximately $1.1 million related to post-closing adjustments for the sale of our BioSepra business in November 2004, based on the final financial statements as of the closing date, as specified in the purchase agreement.  All but $67,000 of this amount was accrued at December 31, 2004.  Also, $1.0 million from the sale of our BioSepra business was placed in an escrow account on the date of sale; this amount plus accrued interest was paid to us on December 1, 2005.

On July 22, 2005, we entered into a strategic alliance agreement with Quest Diagnostics Incorporated (“Quest Diagnostics”) covering a three year period during which the parties will strive to develop and commercialize up to three diagnostic tests based on Ciphergen’s proprietary SELDI ProteinChip technology. Under this agreement, Quest Diagnostics will have the non-exclusive right to commercialize these tests on a worldwide basis, with exclusive commercialization rights in territories where Quest Diagnostics has a significant presence for up to five years following commercialization.  As part of the strategic alliance, there is a royalty arrangement under which Quest Diagnostics will pay royalties to Ciphergen based on fees earned by Quest Diagnostics for applicable diagnostics services, and Ciphergen will pay royalties to Quest Diagnostics based on Ciphergen’s revenue from applicable diagnostics products.  To date, no such royalties have been earned by either party.  There is also a supply agreement under which Ciphergen will sell instruments and consumable supplies to Quest Diagnostics to be used for performing diagnostics services.  In addition, for an aggregate purchase price of $15 million, Quest Diagnostics has purchased 6,225,000 shares of Ciphergen’s common stock, or approximately 17.4% of shares outstanding after the transaction, and a warrant having a term of five years to purchase up to an additional 2,200,000 shares for $3.50 per share.  We incurred transaction costs of approximately $46,000 related to this equity financing.  Quest Diagnostics has also agreed to loan Ciphergen up to $10 million with interest accrued at the prime rate plus 0.5% and paid monthly, solely to fund certain development activities related to the strategic alliance.  Borrowings may be made by Ciphergen, in monthly increments of up to approximately $417,000 on the last day of each month during the first two years of the strategic alliance, and at September 30, 2005, such borrowings amounted to $1,250,000.  This loan, collateralized by certain intellectual property of Ciphergen, will be forgiven based on Ciphergen’s achievement of certain milestones related to development, regulatory approval and commercialization of certain diagnostic tests.  Should we fail to achieve these milestones, the outstanding principal amount of any such loans will be become due and payable on July 22, 2010.  From the inception of the strategic alliance through September 30, 2005, we spent approximately $636,000 of the loan proceeds on in-house research and development, as well as collaborations with others, directed towards achieving the milestones.  Spending for this purpose is expected to continue and to increase, partly as a result of the additional expenses associated with our collaboration with University College London et al. described below and in note 14 of the Unaudited Condensed Consolidated Financial Statements.

In July 2005, we were notified by a supplier about a potential safety hazard in certain pumps used in some older model ProteinChip Systems.  This does not affect our current Series 4000 line.  The supplier is recommending that a capacitor in the pumps it

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supplied be replaced.  Our management has evaluated the situation with the supplier and with legal counsel, and does not believe our cost for retrofitting the affected instruments or related liabilities will be material to our financial statements.

On October 3, 2005, we entered into a two year research and license agreement with University College London and UCL BioMedica Plc. (together, “UCL”) to utilize Ciphergen’s suite of proteomic solutions (Deep Proteome™, Pattern Track™ Process and ProteinChip® System) to further UCL’s ongoing research in ovarian cancer and breast cancer.  Under the terms of the agreement, Ciphergen will have exclusive rights to license intellectual property resulting from discoveries made during the course of this collaboration for use in developing, manufacturing and selling products and services utilizing the intellectual property.  Ciphergen is obligated to make contributions of approximately $2.1 million in cash and $652,000 in the form of Ciphergen equipment, software, arrays and consumable supplies, valued at Ciphergen’s selling price, to cover part of the costs incurred by UCL specifically for this research program.  $1.9 million of this obligation is to be paid in the first year of the agreement and is non-cancelable.  The remainder is to be paid in the second year of the agreement and is cancelable with adequate advance notice.

On November 7, 2005, the Company announced that the Audit Committee (the “Committee”) of the Board of Directors was, with the assistance of external accounting advisors, conducting an investigation primarily regarding the recognition of revenue in connection with certain sales transactions.  As a result of this investigation, the Company delayed the announcement of its results of operations for the third quarter of 2005 and was unable to timely file its Quarterly Report on Form 10-Q for that period.  The Company filed a late filing notice on Form 12b-25 with the Securities and Exchange Commission.

On November 15, 2005, the Nasdaq Listings Qualification Department (“Nasdaq”) notified the Company that its common stock would be delisted from The Nasdaq National Market effective at the opening of business on Friday, November 25, 2005 unless the Company requested a hearing in accordance with applicable Nasdaq rules.  In its letter to the Company, Nasdaq cited as the reason for delisting that the Company had not complied with its periodic reporting requirements for the filing of its Quarterly Report on Form 10-Q for the quarter ended September 30, 2005 (as required pursuant to Rule 4301(c)(14) of the Nasdaq Marketplace Rules).  Effective as of the opening of business on November 17, 2005, the trading symbol for the Company’s common stock was changed from CIPH to CIPHE.  The Company has appealed Nasdaq’s determination.

On November 16, 2005, the Company announced the Committee had determined that previously reported financial results for the three months and six months ended June 30, 2005 should be restated, after determining that certain revenues had been recognized in a manner inconsistent with the Company’s revenue recognition policy.  As a result, the Committee concluded that Ciphergen’s Quarterly Report on Form 10-Q for the second quarter of 2005 should no longer be relied upon.

On November 29, 2005, the Company was notified by the holder of a portion of the Company’s convertible senior notes that it was in default under the indenture related to the convertible senior notes due to the delinquency in Ciphergen’s SEC filing, and that Ciphergen had 60 days from the date of the notice of default to cure the default.  The Company cured this deficiency by filing its Quarterly Report on Form 10-Q covering the third quarter of 2005.

On December 1, 2005, we received payment of $1.0 million plus $21,000 of accrued interest released from escrow from the sale of our BioSepra business to Pall Corporation in November 2004.

On December 2, 2005, the Nasdaq Listings Qualification Department notified Ciphergen that the Company had failed to comply with the continued listing requirements of The Nasdaq National Market because the market value of the Company’s listed securities had fallen below $50,000,000 for 10 consecutive business days (pursuant to Rule 4450(b)(1)(A) of the Nasdaq Marketplace Rules).  Pursuant to Nasdaq Marketplace Rule 4450(e)(4), the Company was provided a period of 30 calendar days, or until January 3, 2006, to regain compliance.  The Company has appealed this delisting determination.

Additionally, the Company and certain of its officers have been named as defendants in a securities class action complaint filed on December 5, 2005, in the United States District Court, Northern District of California.  The complaint has been brought on behalf of all persons who purchased the Company’s common stock from August 8, 2005, when the Company issued a press release announcing unaudited financial results for the second quarter of 2005, through November 16, 2005, when the Company announced its intention to restate those financial results.  The plaintiffs do not demand any particular amount in damages.  The Company has not yet responded to the complaint.

RESULTS OF OPERATIONS

COMPARISON OF THE THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2005 AND SEPTEMBER 30, 2004

PRODUCTS REVENUE.  Products revenue decreased to $4.5 million in the third quarter of 2005 from $6.3 million in the same period of 2004, a decrease of $1.8 million or 29%.  The decrease was primarily the result of a $1.6 million or 40% decrease in revenue from sales of our ProteinChip Systems, accessories and software.  This was largely due to a 15% decrease in unit sales of ProteinChip Systems, which we believe reflects a more competitive selling environment, reductions in our sales force, and more

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limited funding available to our academic prospects. In addition, average revenue per system sold declined approximately 30% comparing the third quarter of 2005 to the same period in 2004, due to increased discounting as a result of pricing pressure caused by generally lower funding available to academia, increased discounting and incentives we offered to expedite orders, lower prices offered to clear our inventory of older ProteinChip Systems, as well as the competitive environment.

In the third quarter of 2005, we sold nine ProteinChip Systems to one customer for $601,000. We also entered into a product development agreement with this same customer, whereby the customer will develop for us a specific new product and we may pay the customer up to $500,000 based on the customer’s attainment of specified development milestones. Under this agreement, Ciphergen paid this customer $100,000 of development fees during the third quarter of 2005. This was recorded, following EITF 01-9 (“Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)”), not as research and development expense but as a reduction to revenue, resulting in net revenue from this customer of approximately $501,000 in the third quarter of 2005. This constituted approximately 11% of products revenue and 7% of total revenue for the third quarter of 2005. In future periods, if this third party achieves a development milestone, Ciphergen will record its payment obligation as a reduction to revenue in the period in which that development milestone is met.

Products revenue decreased to $13.9 million in the first nine months of 2005 from $23.4 million in the same period of 2004, a decrease of $9.5 million or 41%.  The decrease was primarily the result of a 37% decrease in unit sales of ProteinChip Systems, which we believe reflects a more competitive selling environment, reductions in our sales force, and more limited funding available to our academic prospects.  In addition, average revenue per system sold declined approximately 29% comparing the first nine months of 2005 to the same period in 2004, due to lower list prices for the Series 4000 as well as increased discounting and incentives we offered to expedite orders, discounts offered when customers trade in their older ProteinChip Systems for a new Series 4000, and the competitive environment.

SERVICES REVENUE.  Services revenue increased to $2.6 million in the third quarter of 2005 from $2.2 million in the same period of 2004, an increase of $374,000 or 17%.  This increase was primarily due to an increase of approximately $660,000 in revenue from Biomarker Discovery Center projects due to completion of a large project for one customer.  This increase was partly offset by a decrease in training and consulting services of approximately $272,000 while revenue from our maintenance contracts remained flat at $1.3 million, a reflection of growth in our installed base and increased efforts to obtain maintenance contract renewals, but also a reduced sales force and fewer new product placements.

Services revenue increased marginally to $6.8 million in the first nine months of 2005 from $6.7 million in the same period of 2004, an increase of $58,000 or less than 1%.  Revenue from our Biomarker Discovery Center projects increased by approximately $199,000 or 14% for the first nine months of 2005 compared to the same period in 2004, due to the completion of several large contracts in 2005.  Revenue from maintenance contracts increased by $143,000 or 4% in the first nine months of 2005 compared to the same period in 2004 as a result of growth in our installed base and increased efforts to obtain maintenance contract renewals.  Training and consulting services revenue decreased by $284,000 or 19%, a reflection of a reduced sales force and fewer new product placements.

We expect revenue in the fourth quarter of 2005 to be approximately $6 to $8 million.

COST OF PRODUCTS REVENUE.  Cost of products revenue increased to $2.2 million in the third quarter of 2005 from $1.9 million in the same period of 2004, an increase of $260,000 or 14%.  Although there was a decrease in unit sales of our ProteinChip Systems, accessories and software comparing the third quarter of 2005 to the same period in 2004, cost of products revenue increased due to approximately $607,000 of unabsorbed manufacturing overhead which resulted from a decline in array production volumes compared to approximately $134,000 of unabsorbed manufacturing overhead in the comparable period in 2004, and because $491,000 of the cost of new model ProteinChip Systems sold in the third quarter of 2004 had already been treated as research and development expense.  The gross margin for products revenue decreased to 52% in the third quarter of 2005, compared to 70% in the same period of 2004.  This decrease was partly the result of amortizing unabsorbed overhead resulting from lower production volumes, as well as a decrease in the average selling price of our systems, largely due to discounting.  The gross margin comparison was also affected by the classification of the cost of early model Series 4000 instruments as research and development costs, which benefited the third quarter of 2004.

Cost of products revenue decreased to $6.8 million in the first nine months of 2005 from $8.2 million in the same period of 2004, a decrease of $1.3 million or 16%.  The decrease resulted primarily from a decrease in unit sales of our ProteinChip Systems, accessories and software.  In addition, the provision for excess and obsolete inventory declined by $319,000 comparing the first nine months of 2005 to the same period of 2004, as the earlier period included a significant increase to our inventory reserve related to older products being made obsolete by the launch of our new ProteinChip System, Series 4000.  These decreases were partly offset by approximately $1.3 million of unabsorbed manufacturing overhead due to a decline in array production volumes in the first nine months of 2005 compared to approximately $356,000 of unabsorbed manufacturing overhead in the comparable period in 2004. The decrease was also partly offset by $491,000 of costs for the new model ProteinChip Systems sold in the third quarter of 2004 which had already been treated as research and development expense.  The gross margin for products revenue decreased to 51% in the first

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nine months of 2005, compared to 65% in the same period of 2004.  This decline was partly the result of amortizing unabsorbed overhead resulting from lower production volumes, as well as a decrease in the average selling price of our new systems.  The gross margin comparison was also affected by the classification in the third quarter of 2004 of the costs of early model Series 4000 instruments as research and development expense, but this was partly offset by a lower provision for excess and obsolete inventory in the first nine months of 2005 compared to the same period in 2004.

COST OF SERVICES REVENUE.  Cost of services revenue increased to $1.2 million in the third quarter of 2005 from $1.0 million in the same period of 2004, an increase of $151,000 or 15%.  The largest component of this increase came from Biomarker Discovery Center contracts, whose costs typically vary based on the complexity and difficulty of the work being undertaken. The

gross margin for services revenue increased to 54% in the third quarter of 2005, compared to 53% in the same period of 2004.  This increase was mainly due to improved gross margins for field service and Biomarker Discovery Center contracts in the third quarter of 2005, but partly offset by lower margins realized from our training classes and consulting services.

Cost of services revenue increased to $3.2 million in the first nine months of 2005 from $3.0 million in the same period of 2004, an increase of $196,000 or 6%.  The largest component of this increase came from our training classes and consulting services.  The gross margin for services revenue decreased to 52% in the first nine months of 2005, compared to 55% in the same period of 2004.  The gross margin on Biomarker Discovery Center contracts improved, but this was offset by lower margins realized from our training classes and consulting services, and lower margins in field service which resulted primarily from higher net usage of parts for repairing instruments in the first nine months of 2005.

RESEARCH AND DEVELOPMENT EXPENSES.  Research and development expenses decreased to $3.1 million in the third quarter of 2005 from $4.3 million in the same period of 2004, a decrease of $1.2 million or 28%.  The decrease was largely due to a 39% decrease in headcount comparing September 30, 2005 to September 30, 2004, resulting in a decrease in payroll and related costs of approximately $589,000.  This also resulted in a decrease of $192,000 for materials and supplies used in the development of new products.  In addition, consulting fees declined by $238,000.

Research and development expenses decreased to $10.2 million in the first nine months of 2005 from $15.6 million in the same period of 2004, a decrease of $5.3 million or 34%.  This decrease was primarily the result of completing the development of the ProteinChip System, Series 4000 in July 2004 and scaling back or canceling other research and development projects related to new instrumentation platforms. This resulted in decreases of $1.8 million for materials and supplies used in the development of new products, $885,000 in consultant fees, and $250,000 in collaboration costs.  In addition, payroll and related expenses decreased approximately $1.6 million as a result of a 39% reduction in research and development headcount, comparing September 30, 2005 to September 30, 2004.

We expect research and development expenses to decline in 2005 relative to 2004 due to having fewer research and development employees in 2005 as well as slowing or canceling selected early-stage research and development programs related to new instrumentation platforms as part of our efforts to control expenses, partially offset by an increase in our research and development activities associated with developing and commercializing diagnostics tests as part of our strategic alliance with Quest Diagnostics, and discovering biomarkers that could potentially be developed into additional diagnostic products.

SALES AND MARKETING EXPENSES.  Sales and marketing expenses decreased to $4.1 million in the third quarter of 2005 from $6.5 million in the same period of 2004, a decrease of $2.4 million or 37%.  The decrease was largely due to a 34% decrease in headcount comparing September 30, 2005 to September 30, 2004, resulting in a decrease in payroll and related costs of approximately $895,000.  Also as a result of the decrease in staffing, travel expenses in sales and marketing declined approximately $348,000 and internal consumption of ProteinChip Arrays and other consumables for customer demonstrations and support decreased approximately $282,000.  Costs for trade shows, advertising and other marketing activities declined $440,000.  Amounts charged to cost of revenue for training, field service and customer paid projects performed by sales staff increased in the third quarter of 2005 relative to the same period in 2004, thereby reducing sales and marketing expenses by $320,000.

Sales and marketing expenses decreased to $14.2 million in the first nine months of 2005 from $19.8 million in the same period of 2004, a decrease of $5.6 million or 28%.  This decrease was primarily the result of a 34% decrease in headcount comparing September 30, 2005 to September 30, 2004, resulting in a decrease in payroll and related costs of approximately $2.3 million.  Also as a result of the decrease in staffing, travel expenses in sales and marketing declined approximately $1.2 million and internal consumption of ProteinChip Arrays and other consumables for customer demonstrations and support decreased approximately $202,000.  Costs for trade shows, advertising and other marketing activities declined $896,000.  Amounts charged to cost of revenue for training, field service and customer paid projects increased in the first nine months of 2005 relative to the same period in 2004, thereby reducing sales and marketing expenses by $894,000.  However, depreciation expense increased approximately $269,000, largely related to the addition of demonstration instruments following the introduction of the ProteinChip System, Series 4000.

We expect sales and marketing expenses to decrease in 2005 relative to 2004 as a result of a smaller sales force and reduced associated selling expenses.

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GENERAL AND ADMINISTRATIVE EXPENSES.  General and administrative expenses were approximately $3.5 million in both the third quarter of 2005 and the third quarter of 2004.  Legal fees increased approximately $243,000, of which $80,000 related to our strategic alliance with Quest Diagnostics, and our provision for bad debts increased $111,000.  These increases were almost entirely offset by decreases in other general and administrative expenses, largely as a result of a 32% decrease in headcount comparing September 30, 2005 to September 30, 2004, and a decrease of $86,000 in stock-based compensation associated with our initial public offering.

General and administrative expenses were approximately $10.7 million in both the first nine months of 2005 and the first nine months of 2004.  This was composed of increases of approximately $327,000 in payroll and related costs related to the hiring of senior-level employees for our efforts to develop diagnostic products and for business development related to pharmaceutical customers, $239,000 in accrued accounting and audit fees, and $161,000 in legal fees.  Legal fees related to the strategic alliance with Quest Diagnostics amounted to $371,000, but these were more than offset by decreases in other legal fees.  These increases in general and administrative expenses were almost entirely offset by decreases of approximately $314,000 in stock-based compensation associated with our initial public offering, $108,000 in the provision for bad debts, $142,000 in travel expenses, and $147,000 in consulting fees.

We expect general and administrative expenses to increase slightly in 2005 relative to 2004 due to normal salary increases, additional legal fees related to the strategic alliance with Quest Diagnostics, and increased legal, accounting and consulting fees associated with the restatement of our financial results for the second quarter of 2005, partly offset by a decline in stock-based compensation associated with our initial public offering.

INTEREST AND OTHER INCOME (EXPENSE), NET. Interest income in the third quarter of 2005 was $239,000 compared to $95,000 in the same period of 2004.  Interest income increased due to higher average investment balances and higher interest rates in the third quarter of 2005 compared to the same period in 2004.  Interest expense in the third quarter of 2005 was $495,000 compared to $498,000 in the same period of 2004.  Interest expense in both periods consisted largely of interest accrued for our convertible senior notes, equipment-financing loan and capital leases, and in 2005 included interest accrued for our borrowings from Quest Diagnostics.  Approximately $134,000 of the interest expense in the third quarters of 2005 and 2004 was non-cash, attributable to amortization of the beneficial conversion feature associated with the convertible senior notes.  Other income (expense) in the third quarter of 2005 was a net expense of $247,000 compared to a net expense of $223,000 in the same period of 2004.  The net expense in the third quarter of 2005 resulted primarily from $93,000 for the amortization of the offering costs related to the convertible senior notes, and realized foreign exchange losses of approximately $69,000.  The net expense in the third quarter of 2004 resulted largely from the amortization of the offering costs related to the convertible senior notes.

Interest income in the first nine months of 2005 was $591,000 compared to $390,000 in the same period of 2004.  Despite lower average investment balances in the first nine months of 2005 compared to the same period in 2004, interest income increased due to higher average interest rates in the first nine months of 2005 compared to the same period in 2004.  Interest expense was approximately $1.5 million in both the first nine months of 2005 and the first nine months of 2004.  Interest expense in both periods consisted largely of interest accrued for our convertible senior notes, equipment-financing loan and capital leases, and in 2005 included interest accrued for our borrowings from Quest Diagnostics.  Approximately $399,000 and $401,000 of the interest expense in the first nine months of 2005 and 2004, respectively, were non-cash, attributable to amortization of the beneficial conversion feature associated with the convertible senior notes.  Other income (expense) in the first nine months of 2005 was a net expense of $564,000 compared to a net expense of $483,000 in the same period of 2004.  The net expense in the first nine months of 2005 resulted primarily from $280,000 for the amortization of the offering costs related to the convertible senior notes, and realized foreign exchange losses of approximately $190,000.  The net expense in the first nine months of 2004 resulted primarily from the amortization of the offering costs related to the convertible senior notes.

INCOME TAX PROVISION (BENEFIT) FROM CONTINUING OPERATIONS.  The provision for income tax from continuing operations in the third quarter of 2005 was a benefit of $36,000, compared to an expense of $103,000 in the same period of 2004.  The decrease in expense was primarily due to the lower projected income related to our Japanese subsidiary, Ciphergen Biosystems KK, in 2005.

The provision for income tax from continuing operations in the first nine months of 2005 was an expense of $103,000, compared to an expense of $295,000 in the same period of 2004.  The decrease was primarily due to lower projected income related to our Japanese subsidiary, Ciphergen Biosystems KK in 2005.

LIQUIDITY AND CAPITAL RESOURCES

From our inception through September 30, 2005, we have financed our operations principally with $204.4 million from the sales of products and services to customers and net proceeds from equity financings totaling approximately $160.8 million.  This includes net proceeds of $92.4 million from our initial public offering in September 2000, net proceeds of $26.9 million from our

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Series E Preferred Stock financing in March 2000, and net proceeds of $15.0 million from the sale of 6,225,000 shares of common stock and a warrant for 2,200,000 shares of common stock to Quest Diagnostics on July 22, 2005.  We received $28.1 million of net proceeds from the sale of 4.5% convertible senior notes on August 22, 2003.  These notes are due September 1, 2008.  In addition, in July 2005 Quest Diagnostics agreed to loan us up to $10 million with interest accrued at the prime rate plus 0.5% and paid monthly, solely to fund certain development activities related to our strategic alliance, against which we had borrowed approximately $1.3 million as of September 30, 2005.  We also received net proceeds of $27.0 million from the sale of our BioSepra business in November 2004.  An additional $1.0 million from the sale of our BioSepra business was placed in an escrow account on the date of sale.  This amount plus accrued interest was paid to us on December 1, 2005.  Cash, cash equivalents and short-term investments at September 30, 2005 were $31.1 million, compared to $37.6 million at December 31, 2004.  Working capital at September 30, 2005 was $32.0 million, compared to $39.9 million at December 31, 2004.  The decrease in working capital was principally due to a net $22.7 million decrease in cash and investments to fund our operating losses, partly offset by a $16.3 million cash increase resulting from the sale of our common stock to, and loans from, Quest Diagnostics, and a $4.6 million decrease in accounts receivable, reflecting the decline in our revenue during the first nine months of 2005, partly offset by a $2.9 million decrease in payables and accrued liabilities.  Long-term debt and capital lease balances at September 30, 2005 totaled $30.3 million compared to $29.4 million at December 31, 2004.

Net cash used in operating activities was $18.9 million in the first nine months of 2005 compared to $23.4 million in the same period of 2004.  Reductions in payroll expense of $4.5 million, other operating and manufacturing overhead expenditures of $6.1 million and inventory purchases of $4.7 million, comparing the first nine months of 2005 to the same period of 2004, were partly offset by approximately $11.1 million less in collections from customers in the first nine months of 2005 than in the comparable period of 2004, consistent with our declining revenue.  The decrease in cash collected was partly offset by an increase in interest income, which was $591,000 in the first nine months of 2005 and $390,000 in the comparable period of 2004.  Interest expense in both periods consisted largely of interest accrued on our convertible senior notes and equipment-financing loan.

Net cash used in investing activities was $3.3 million in the first nine months of 2005 compared to net cash provided by investing activities of $5.4 million in the first nine months of 2004.  Net cash used in investing activities in the first nine months of 2005 consisted of net purchases of property and equipment of approximately $1.7 million, a payment of $1.1 million to Pall Corporation related to post-closing adjustments for the sale of our BioSepra business, and payments totaling $463,000 for a technology license related to our litigation which was settled in 2003.  Net cash provided by investing activities in the first nine months of 2004 consisted largely of maturities of investment securities of $10.2 million, offset by net property and equipment purchases of $2.8 million, the acquisition of the remaining 30% ownership in Ciphergen Biosystems KK for $1.0 million, and payments totaling $833,000 for a technology license related to our litigation which was settled in 2003.  We anticipate capital expenditures of approximately $2 to $3 million in 2005.

Net cash provided by financing activities was $16.0 million in the first nine months of 2005 compared to $619,000 in the first nine months of 2004.  Net cash provided by financing activities in the first nine months of 2005 consisted of $15.0 million in net proceeds from the issuance of common stock and a warrant to Quest Diagnostics, $1.3 million in loans from Quest Diagnostics, $350,000 from the repayment of stockholder loans, and $212,000 received from the issuance of common stock under our stock option and employee stock purchase plans, partly offset by $758,000 for repayments of an equipment financing loan and capital leases.  Net cash provided by financing activities in the first nine months of 2004 consisted of the issuance of common stock under our stock option and employee stock purchase plans of $882,000 and repayment of stockholder loans in the aggregate principal amount of $499,000, partly offset by repayments of an equipment financing loan of $491,000 and repayments of capital lease obligations of $271,000.

We believe that current cash resources will be sufficient to maintain our operations at least for the next 18 months, including our obligations under our October 2005 research and license agreement with University College London and UCL BioMedica Plc.  (See note 14, Subsequent Events.)  We currently expect to fund our liquidity needs as well as expenditures for our obligations related to the strategic alliance with Quest Diagnostics and for capital requirements from a combination of available cash and short-term investments, proceeds from the alliance with Quest Diagnostics including borrowings from Quest Diagnostics, potential sales of additional equity and/or debt securities, and the receipt subsequent to the end of the third quarter of 2005 of approximately $1.0 million plus accrued interest released from escrow from the sale of our BioSepra business to Pall Corporation.  We will be required to raise additional capital at some point in the future, which might be achieved through a variety of sources, including securities issuances and collaborative arrangements.  If additional capital is raised through the issuance of equity or securities convertible into equity, our stockholders may experience dilution, and such securities may have rights, preferences or privileges senior to those of the holders of our common stock or the notes.  If we obtain additional funds through arrangements with collaborators or strategic partners, we may be required to relinquish our rights to certain technologies or products that we might otherwise seek to retain.  Additional financing may not be available to us on favorable terms, if at all.  If we are unable to obtain financing on acceptable terms, we may be unable to execute our business plan and we could be required to delay, reduce the scope of, or eliminate our operations and we may not be able to pay off the convertible senior notes if and when they come due.

The following summarizes Ciphergen’s contractual cash obligations at September 30, 2005 and the effect such obligations

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are expected to have on our liquidity and cash flow in future periods (in thousands):