UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
SCHEDULE 14A

(Rule 14a-101)

SCHEDULE 14A INFORMATION

Proxy Statement Pursuant to Section 14(a) of the
Securities Exchange Act of 1934 (Amendment No.)

Filed by the Registrant x
Filed by a Party other than the Registrant o

Check the appropriate box:


x	Preliminary Proxy Statement	o	Soliciting Material Pursuant to 240.14a-12
o	Confidential, For Use of the Commission Only (as permitted by Rule 14a-6(e)(2))
o	Definitive Proxy Statement
o	Definitive Additional Materials

PHARMOS CORPORATION

(Name of Registrant as Specified In Its Charter)

(Name of Person(s) Filing Proxy Statement, if Other Than the Registrant)

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PHARMOS CORPORATION
99 Wood Avenue South, Suite 311
Iselin, NJ 08830
(732) 452-9556

NOTICE OF ANNUAL MEETING OF SHAREHOLDERS

NOTICE IS HEREBY GIVEN, that the Annual Meeting of the Shareholders of Pharmos Corporation (the “Company”) will be held at [____________] on [___________], 2006 at [________________________] (i) to approve the issuance of up to 19,500,000 shares of the Company’s common stock in connection with the proposed acquisition by the Company of Vela Pharmaceuticals Inc.; (ii) to elect three Class III directors to serve for a three-year term until the 2009 annual meeting of shareholders; (iii) to ratify the appointment of PricewaterhouseCoopers LLP as the independent registered public accounting firm of the Company for the fiscal year ending December 31, 2006; and (iv) to transact such other business as may properly come before the meeting or any adjournment or adjournments thereof.

The Board of Directors has fixed the close of business on [____________], 2006 as the record date for the determination of shareholders entitled to notice of, and to vote at, the Meeting.

If you do not expect to be personally present at the Meeting, but wish your stock to be voted for the business to be transacted thereat, the Board of Directors requests that you submit your proxy either a) electronically, b) by telephone (information for both provided on following page) or c) by filling in, signing and dating the enclosed proxy card and promptly returning it by mail in the postage paid envelope provided.

If you are planning to attend the annual meeting, you must have photo identification and proof of stock ownership as of the record date to be admitted. If your shares are not registered in your own name, you can obtain proof of stock ownership as of the record date from your bank or brokerage firm, typically in the form of your most recent statement.


	BY ORDER OF THE BOARD OF DIRECTORS

	Haim Aviv, Ph.D.
	Chairman of the Board

[______________], 2006

PLEASE SUBMIT PROXY EITHER A) ELECTRONICALLY, B) BY TELEPHONE (INFORMATION FOR BOTH PROVIDED ON FOLLOWING PAGE) OR C) BY FILLING IN, SIGNING AND DATING THE ENCLOSED PROXY CARD AND PROMPTLY RETURNING IT IN THE ENVELOPE PROVIDED. NO POSTAGE IS NECESSARY IF MAILED IN THE UNITED STATES.

PLEASE VOTE YOUR PROXY!

ELECTRONIC VOTING SAVES YOUR COMPANY MONEY

For the last few years, many of our shareholders have saved Pharmos money by voting their proxies via internet or telephone, rather than by return mail. This year, we encourage all of our shareholders to take advantage of electronic voting.

By internet – www.proxyvote.com; or

By touch-tone phone – please call the toll-free number on the enclosed proxy card.

Have the enclosed proxy card in hand when you access the website or call the toll-free number and follow the directions provided.

ELECTRONIC DELIVERY OF PROXY STATEMENT AND ANNUAL REPORT SAVES YOUR COMPANY MONEY

Most shareholders can elect to view future proxy statements and annual reports over the Internet instead of receiving paper copies in the mail. Doing so will save Pharmos printing and mailing expenses.

If you are a shareholder of record, you can choose this option and save Pharmos the cost of production and mailing these documents by following the instructions provided when you vote over the Internet. If you hold your Pharmos shares through a bank, broker or other holder of record, please refer to the information provided by that entity for instructions on how to elect to view future proxy statements and annual reports over the Internet.

If you choose to view future proxy statements and annual reports over the Internet, you will receive an e-mail message next year containing the Internet address to access Pharmos’ proxy statement and annual report.

PHARMOS CORPORATION
99 Wood Avenue South, Suite 311
Iselin, NJ 08830
(732) 452-9556

PROXY STATEMENT

FOR ANNUAL MEETING OF SHAREHOLDERS
TO BE HELD ON [____________], 2006

INTRODUCTION

The Meeting is being called to approve the issuance of up to 19,500,000 shares of the Company’s common stock in connection with the proposed acquisition by the Company of Vela Pharmaceuticals Inc., to elect three Class III members of the Board of Directors, and to ratify the appointment of PricewaterhouseCoopers LLP as the Company’s auditors for the fiscal year ending December 31, 2006. The Meeting will be open for the transaction of such other business as may properly come before it, although, as of the date of this proxy statement, management does not know of any other business that will come before the Meeting. If any other matters do come before the Meeting, the persons named in the enclosed form of proxy are expected to vote said proxy in accordance with their judgment on such matters.

This proxy statement and the accompanying proxy card are first being mailed on or about [__________], 2006 to shareholders of record as of [_____________], 2006. A copy of the Annual Report for the fiscal year ended December 31, 2005, which includes audited financial statements, is also included.

The solicitation of proxies in the accompanying form is made by, and on behalf of, the Board of Directors, and the Company will bear the entire cost of such solicitation. We have retained Georgeson Shareholder Communications Inc. to assist us in soliciting proxies, and estimate that their fees for such service will be approximately $20,000. There will be no solicitation of proxies other than through the proxy solicitor or by mail or personal solicitation by officers and employees of the Company, and no compensation will be paid to directors, officers or employees of the Company in connection with such services. The Company or the proxy solicitor will make arrangements with brokerage houses and other custodians, nominees and fiduciaries for the forwarding of proxy material to the beneficial owners of shares held of record by such persons, and such persons will be reimbursed for reasonable expenses incurred by them. A shareholder executing the accompanying proxy has the power to revoke it at any time prior to the exercise thereof by filing with the Secretary of the Company: (i) a duly executed proxy bearing a later date; (ii) a written instrument revoking the proxy; (iii) voting electronically or by telephone until 11:59 PM Eastern Time on the day prior to the date of the Meeting; or (iv) by attending the Meeting and voting in person. In the event that a shareholder casts more than one proxy vote, electronically or otherwise, the latest vote received will be the vote that will be recorded.

The presence, in person or by proxy, of the holders of one-third of the outstanding shares of Common Stock entitled to vote at the Meeting is necessary to constitute a quorum. Votes withheld from any nominee for election as a director, abstentions and broker “non-votes” are counted as present for purposes of determining the presence or absence of a quorum for the transaction of business. A “non-vote” occurs when a nominee holding shares for a beneficial owner votes on one proposal, but does not vote on another proposal because, in respect of such other proposal, the nominee does not have discretionary voting power and has not received instructions from the beneficial owner.

The election of directors by the shareholders shall be determined by a plurality of the votes cast by shareholders entitled to vote at the Meeting, and votes withheld will not be counted toward the achievement of a plurality. On all other matters being submitted to the shareholders,

the affirmative vote of a majority of the shares present in person or represented by proxy at the Meeting and entitled to vote on such matter is required for approval. The vote on each matter submitted to shareholders is tabulated separately. Abstentions are included in the number of shares present and voting on each matter. Broker non-votes are not considered for the particular matter and have the practical effect of reducing the number of affirmative votes required to achieve a majority for such matter by reducing the total number of votes from which the majority is calculated.

All materials filed by Pharmos with the Securities and Exchange Commission can be obtained at the Commission’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549 or through the SEC’s website at www.sec.gov. You may obtain information on the operation of the Public Reference Room by calling 1-800-SEC-0330.

VOTING SECURITIES

The Board of Directors has fixed the close of business on [____________], 2006 as the record date for the determination of shareholders entitled to notice of, and to vote at, the Meeting.

As of [_________________], 2006, the outstanding capital stock of the Company consisted of [19,065,783] shares of Common Stock. Each holder of Common Stock is entitled to one vote for each share of Common Stock held by him or her at the close of business on the record date.

The shares for which the accompanying proxy is solicited will be voted in accordance with the directions given, provided that the proxy is executed and returned by the shareholder prior to the Meeting.

ITEM 1 - APPROVAL OF THE ISSUANCE OF UP TO 19,500,000 SHARES OF THE
COMPANY’S COMMON STOCK IN CONNECTION WITH THE PROPOSED ACQUISITION BY
THE COMPANY OF VELA PHARMACEUTICALS, INC.

As you may know, on March 15, 2006, we announced our intent to acquire Vela Pharmaceuticals Inc. (“Vela”) through the merger of Vela into Vela Acquisition Corporation, our wholly-owned subsidiary (the “Merger”). Vela shareholders will receive 11.5 million shares of Pharmos common stock at the closing of the Merger in exchange for all outstanding Vela securities after conversion of any outstanding Vela bridge notes. In addition, at the closing, we will pay $5.0 million in cash to or on behalf of Vela to repay all accrued interest and a portion of the principal amount of Vela’s outstanding bridge note indebtedness and to satisfy certain of its outstanding liabilities. Vela’s shareholders will also receive up to an additional 8 million Pharmos shares upon the achievement of performance-based milestones related to Vela’s Phase II product candidate, dextofisopam, which is in development to treat irritable bowel syndrome. The number of shares to be issued in connection with the Merger and achievement of the milestones may be adjusted in the future to account for any stock splits, stock dividends or other similar recapitalizations.

One of the remaining steps to complete the Merger is securing the approval by our shareholders of the issuance of the shares of our common stock in connection with the Merger. Such approval is required under applicable rules of the Nasdaq Capital Market. No further approval is required from any regulatory body.

THE BOARD OF DIRECTORS OF PHARMOS UNANIMOUSLY RECOMMENDS A VOTE “FOR” APPROVAL OF THE ISSUANCE OF THE SHARES OF PHARMOS COMMON STOCK IN CONNECTION WITH THE PROPOSED ACQUISITION OF VELA (ITEM 1 ON THE ENCLOSED PROXY CARD).

THE PARTIES TO THE MERGER

Pharmos is a specialty pharmaceutical company that discovers and develops novel therapeutics to treat a range of indications including pain, inflammation, autoimmunity and select central nervous system (CNS) disorders. Pharmos has a portfolio of drug candidates and compounds in various development stages, including clinical, preclinical and discovery. The lead candidate from the pipeline of its CB2-selective cannabinoid platform technology, cannabinor, is scheduled to begin Phase II testing for neuropathic pain and post-surgical pain. A Phase IIa trial in patients undergoing third-molar extractions is scheduled for the second quarter of 2006, and a Phase IIa trial to treat a model of neuropathic pain is planned to begin during the third quarter of 2006. In addition, CB2 agonists in the Company’s pipeline are in preclinical development for several indications addressing unmet clinical needs. Also, Pharmos has completed a Phase I trial and is moving into a Phase II trial of the topical NSAID, diclofenac, for the treatment of osteoarthritis using its NanoEmulsion drug delivery platform for topical delivery as Pharmos continues to advance this novel, proprietary technology.

Vela is a privately-held Delaware corporation specializing in the rediscovery and development of medicines related to the nervous system, including the brain-gut axis (links between the nervous system and the digestive system). Vela seeks to minimize some of the risks of traditional drug discovery and development by working primarily with drug assets for which human safety data are already available. Vela’s principal development efforts have focused on three clinical-stage assets to treat disorders for which a large unmet medical need exists. Vela’s assets include dextofisopam (previously known as R-tofisopam) and tianeptine for the treatment of irritable bowel syndrome, and VPI-013 (previously known as OPC-14523) for the treatment of neuropathic pain and female hypoactive sexual desire disorder. Vela currently has seven employees and leases approximately 10,500 square feet of office space at 820 Bear Tavern Road, Suite 300, Ewing, New Jersey 08628. Its telephone number is (609) 771-8660.

THE MERGER

The Merger will be accomplished pursuant to the Agreement and Plan of Merger dated March 14, 2006, between Pharmos, its newly-formed, wholly-owned subsidiary, Vela Acquisition Corporation, and Vela. A copy of the Agreement and Plan of Merger is attached as Appendix A.

The key provisions of the Merger are as follows:


	•	Pharmos will acquire Vela by means of a “forward merger”, where Vela will merge into Vela Acquisition Corporation, a newly-created acquisition subsidiary of Pharmos that will be the surviving corporation in the Merger.

	•	All of Vela’s outstanding capital stock shall be cancelled.

	•	At closing, Pharmos will issue 11,500,000 shares of its common stock to those of Vela’s shareholders entitled under Vela’s certificate of incorporation to receive shares. 1,725,000 of these shares will be placed in escrow.

	•	Pharmos will also pay $5,000,000 in cash to or on behalf of Vela at closing which will be used to pay Vela’s transaction costs, Vela’s obligations under its Acquisition Bonus Plan, accrued interest on Vela’s outstanding bridge notes, and a portion of the outstanding principal on Vela’s outstanding bridge notes.

	•	At closing, all of Vela’s outstanding bridge notes will either be paid off or will be converted into equity of Vela.


	•	Pharmos will assume up to $100,000 of Vela’s qualified post-closing liabilities.

	•	Vela’s shareholders and participants in its Acquisition Bonus Plan may also receive: (i) an additional 4,000,000 shares of Pharmos’ common stock upon successful completion of a Phase IIb clinical trial related to the development of Vela’s compound dextofisopam within four years of closing; and (ii) an additional 4,000,000 shares of Pharmos’ common stock upon the filing of a New Drug Application with the U.S. Food and Drug Administration for dextofisopam within eight years of closing.

	•	After completion of the Merger, Pharmos will have complete flexibility to determine the appropriate preclinical and clinical development of Vela compounds. In the Agreement and Plan of Merger, Pharmos acknowledges that it currently intends to continue Vela’s programs for no less than two years following the closing, subject to ongoing and periodic review and analysis by management and the Board, and also subject to future budgetary needs of the combined business as well as the availability of outside financing.

	•	Upon closing, all Vela operations will be transferred to Pharmos. Pharmos anticipates hiring Dr. Steven Leventer to lead clinical development of the Vela technologies and several members of his staff, reporting to our President & COO. No additional hires of Vela employees are anticipated.

	•	Pharmos has entered into a voting agreement with the holders of a majority of Vela’s outstanding capital stock (determined on an as-converted to common stock basis) to ensure their approval of the transactions contemplated by the Merger Agreement, subject to the satisfaction of certain closing conditions set forth in the Merger Agreement.

	•	Upon closing, Pharmos will increase the size of its classified, staggered Board from seven to nine, with three new vacancies (one for a one-year term, one for a two-year term, and one for a three-year term). The three new directors, as designated by Vela’s three largest shareholders, will be Srinivas Akkaraju, designee of J.P. Morgan Partners, Anthony Evnin, designee of Venrock Associates, and Charles W. Newhall III, designee of New Enterprise Associates. [_______________], a current Pharmos director, will resign from the Board upon completion of the Merger.

	•	Under a Registration Rights Agreement to be executed at the closing, Pharmos will file an S-3 registration statement within seven days after closing to register for resale the shares issued to the former Vela shareholders. Following registration, the Vela shareholders receiving the stock will be subject to a “lock-up” providing that, without the consent of Pharmos, (i) no shares may be sold until six months after the closing, (ii) for each six-month period after that date, up to 33% of the shares originally issued to such shareholder may be sold, and (iii) after 18 months from the closing, all shares may be sold. Any milestone shares that may be issued during the lock-up period shall also be subject to such restrictions.

	•	At closing, Vela’s principal shareholders will enter into standstill agreements that for two years they will not acquire any Pharmos stock, other than as agreed to by the Pharmos Board or in a private placement or other transaction in an amount to maintain their percentage interest.

	•	The Vela shareholders that receive the Pharmos shares upon the closing of the Merger will indemnify Pharmos for material breaches of representations, warranties and covenants for a period of 18 months. The sole source of the indemnity (absent fraud) will be an escrow holdback of 1,725,000 of the 11,500,000 shares, to be reduced to 1,150,000 shares six months after the closing, 575,000 shares 12 months after the


		closing and to zero 18 months after the closing. The shares will be held in escrow pursuant to an escrow agreement. The indemnity will have a deductible of $250,000.

	•	Pharmos will indemnify the Vela shareholders for material breaches of representations, warranties and covenants for a period of 18 months. The indemnity will equal a total of the market value at closing of 15% of 11,500,000 Pharmos shares, to be reduced by one-third six months after the closing, by another one-third 12 months after the closing and to zero 18 months after closing. The indemnity will have a deductible of $250,000 and can be paid in cash or stock at Pharmos’ discretion, except for certain situations involving the indemnification of Vela’s directors and officers where satisfaction must be in cash.

	•	Either party may terminate the Agreement and Plan of Merger upon notice to the other (i) if the other party is in material breach of its obligations under the Agreement and Plan of Merger and such breach shall not have been cured within a period of ten (10) days after written notice, or (ii) if the conditions necessary to close shall not have been satisfied or waived by the other party on or prior to August 31, 2006, or (iii) if there has been a material adverse change in the representations and warranties made by either party, or (iv) upon any material adverse change in the business or operations of the other party. If either party terminates the Agreement and Plan of Merger other than in compliance with the foregoing provisions, it shall become liable to the other party for a payment of $1,500,000. In addition, a party shall be liable for such payment if it is in material breach of the Agreement and Plan of Merger and the other party terminates the Agreement as a result.

BACKGROUND AND REASONS FOR THE MERGER

HOW DID THE MERGER COME ABOUT?

Beginning in the middle of 2004, the Pharmos Board of Directors began considering specific strategic initiatives to foster the growth of the Company. Included in these initiatives was the possibility of acquiring or merging with other entities in complementary lines of business and technology licensing.

In July 2004, RBC Capital Markets Corporation (“RBC”), an investment banking firm, and Tamir Fishman & Co. LTD. (“TF”), RBC’s strategic partner in Israel, which engages in certain investment banking services, made an initial presentation to Pharmos regarding the mergers and acquisitions environment in the pharmaceutical industry and the strategic strengths and weakness of various potential acquisition candidates. Vela was included in the list of candidates.

In August 2004, Pharmos signed an engagement letter with RBC and TF for those firms to assist Pharmos’ Board of Directors in its pursuit of strategic opportunities and alternatives. Following execution of the engagement letter, RBC and TF presented certain opportunities to Pharmos. Over the subsequent months, Pharmos reviewed in depth many target companies and products and entered into discussions and diligence with several potential acquisition and merger candidates. However, after Pharmos elected not to pursue these opportunities, the parties terminated the August 2004 engagement letter in July 2005.

In October 2005 Cowen & Co., LLC (“Cowen”), the investment banking firm representing Vela, contacted Pharmos to inquire whether Pharmos would be interested in considering a partnership or other strategic relationship with Vela. Pharmos expressed preliminary interest, and on October 26, 2005, Cowen sent RBC a non-confidential executive summary of Vela. On October 28, 2005, Pharmos and Vela executed a confidentiality agreement that permitted them to exchange information in confidence as part of conducting due diligence.

On November 4, 2005, Gad Riesenfeld, the former president of Pharmos, met with members of Vela’s senior management. At the meeting, the parties engaged in a preliminary discussion concerning the potential benefits of a merger between Pharmos and Vela. The parties also discussed financial, operational and managerial issues. On November 9, 2005, senior management of Pharmos met with RBC to discuss the Vela opportunity. Following the meeting, Pharmos and RBC/TF began preparing a draft outline of terms for a potential transaction with Vela.

On November 28, 2005, Pharmos submitted a non-binding term sheet to Vela outlining the proposed terms of a merger between the two companies. On December 2, 2005, Pharmos’ senior management met with Vela’s board of directors and senior management to propose the range of terms for a potential merger between the two companies. On December 5, 2005, Pharmos entered into a new engagement letter with RBC and TF for those firms to provide financial advisory services to Pharmos in connection with a proposed merger with Vela.

While discussions and negotiations of a potential merger continued, Pharmos conducted scientific due diligence on Vela during December 2005 and January 2006. On December 20, 2005, Cowen, on behalf of Vela, sent a counterproposal to Pharmos’ term sheet.

On January 15, 2006, Pharmos’ management forwarded to the Pharmos Board of Directors materials setting forth the rationale behind the proposed merger with Vela. Also on that date, Pharmos’ management delivered a memorandum to the Pharmos Board of Directors setting forth the results of the scientific due diligence concerning Vela and a comprehensive report on the irritable bowel syndrome market on which Vela’s business is focused.

On January 18, 2006, the Clinical Development and Scientific Committee of the Pharmos Board of Directors met to discuss the results of the scientific and regulatory due diligence concerning Vela. On January 18, 2006, Vela’s Board of Directors approved the continuation of negotiations with Pharmos on the basis of the provisions outlined in a term sheet, subject to certain adjustments. On January 19, 2006, Pharmos and Vela executed the term sheet.

On January 24 and 25, 2006, Pharmos’ Board of Directors convened a special meeting. At the meeting, the Board gave extensive consideration to the Vela opportunity. The Board reviewed the principal terms of the Vela transaction and authorized Pharmos’ management to continue due diligence and negotiations with Vela.

On January 30, 2006, Pharmos’ counsel delivered a preliminary draft of the Agreement and Plan of Merger to Vela’s counsel. During February and March 2006, the parties negotiated the terms of the definitive Agreement and Plan of Merger and continued to conduct due diligence.

On March 14, 2006, Pharmos’ Board of Directors convened a special meeting to consider the final terms of the merger with Vela. At the meeting, the board authorized Haim Aviv and Alan Rubino to execute the Agreement and Plan of Merger with Vela.

REASON FOR THE MERGER – GENERAL

Pharmos has determined that it would benefit from diversifying and broadening its clinical pipeline. The acquisition of Vela adds three potential clinical or near-clinical drug candidates, including dextofisopam, a later-stage clinical drug candidate for the treatment of irritable bowel syndrome (IBS). Pharmos believes the IBS market opportunity to be large and poorly served by current therapy Overall, IBS accounts for approximately 12% of all visits to primary care physicians in the U.S. and is the second most common disease treated by gastroenterologists. In addition, IBS-associated health care costs are in the range of $20-$25 billion annually. Vela’s lead candidate for the treatment of IBS, dextofisopam, has demonstrated positive Phase IIa data for the treatment of diarrhea-predominant and alternating-type IBS. Pharmos believes, given its strong balance sheet and managerial expertise, that it can move dextofisopam into a larger,

confirmatory Phase IIb clinical trial rapidly upon consummation of the acquisition. Pharmos believes that a positive Phase IIb trial result has the potential to create significant value for Pharmos’ shareholders.

REASONS FOR THE MERGER – PHARMOS

The Pharmos board of directors views the Merger as a potentially transformative event for Pharmos. Completing the Merger would fulfill several strategic objectives for Pharmos:


	(i)	Advance Pharmos several years forward in clinical development by acquiring a high-potential drug candidate, dextofisopam, prepared to enter Phase IIb clinical trials for the treatment of IBS;

	(ii)	Broaden Phamos’ overall drug pipeline and diversify clinical risk by acquiring multiple product candidates, including tianeptine and VPI-013;

	(iii)	Strengthen Pharmos’ Board of Directors by adding representatives from three well-known, industry-leading life science venture capital firms; and

	(iv)	Expand management expertise by adding Vela’s clinical development team.

With the addition of Vela, Pharmos would accomplish the critical strategic goal of adding a pipeline of assets that best leverages Pharmos’ core operational and scientific expertise. Completing the Merger will provide Pharmos with an expanded drug portfolio that includes later-stage, early-stage, and preclinical drug candidates that better complements Pharmos’ long-term presence in the nervous system arena.

In reaching this determination, the Pharmos’ board of directors consulted with Pharmos’ management as well as its financial, accounting and legal advisors and considered a number of factors including the following:


	•	The effectiveness of the Merger in implementing and accelerating Pharmos’ growth strategy;

	•	A presentation by management of (i) its due diligence review of Vela, including the business, operations, asset quality, financial conditions, and corporate culture of Vela on an historical, prospective, and pro forma basis, (ii) product compatibility, the compatibility of corporate goals and the respective contributions the parties would bring to Pharmos, (iii) the enhanced opportunities for growth that the Merger makes possible as a result of a wider and more diversified clinical pipeline and the potential for greater market breadth and (iv) the expanded opportunities for revenue enhancement and synergies that are expected to result from the Merger and the acquisition of a later-stage drug candidate;

	•	The terms of the Agreement and Plan of Merger and other documents to be executed in connection with the Merger;

	•	The opinion of RBC and TF, discussed elsewhere in this proxy statement, that as of March 14, 2006, the Merger was fair, from a financial point of view, to Pharmos; and

	•	The opportunity to strengthen and deepen Pharmos’ board of directors and management team.

The Pharmos board of directors did not assign any specific or relative weight to the foregoing factors in the course of its consideration.

REASONS FOR THE MERGER – VELA

The Board of Directors of Vela and its principal stockholders believe that the Merger of Vela into Pharmos will bring together complementary asset portfolios and team skills and will provide several benefits to the combined entity and its stockholders, including the following:


	(i)	Broaden portfolio of product candidates by combining Vela’s later-stage assets, including dextofisopam, with Pharmos’ cannabinoid platform and assets;

	(ii)	Vela’s experience in clinical drug development and clinical trial design and implementation will complement Pharmos’ drug discovery and early-stage development capabilities;

	(iii)	Vela’s stockholders will have the opportunity to own stock in a company with greater financial and management resources than Vela would otherwise have on its own; and

	(iv)	Pharmos’ status as a publicly-traded company may provide Vela’s stockholders with greater potential liquidity on their investment.

FAIRNESS OPINION

Pursuant to an engagement letter dated December 5, 2005, RBC and TF were retained by Pharmos to furnish an opinion as to the fairness, from a financial point of view, of the total consideration to be paid pursuant to the terms of the Agreement and Plan of Merger. RBC and TF are jointly referred to in this proxy statement as RBC/TF.

On March 14, 2006, RBC/TF rendered their opinion to Pharmos’ board of directors, that, as of such date and based on the procedures followed, factors considered and assumptions made by RBC/TF and certain other limitations, the total consideration to be paid was fair, from a financial point of view, to Pharmos. A copy of RBC/TF’s written opinion is attached as Appendix B to this proxy statement and is incorporated into this proxy statement by reference. Pharmos stockholders are urged to read the opinion of RBC/TF carefully and in its entirety.

RBC/TF’s opinion was provided for the information and assistance of Pharmos’ board of directors in connection with the consideration paid by Pharmos in connection with the Merger. RBC/TF’s opinion does not constitute a recommendation to any stockholder as to how such stockholder should vote with respect to the Merger. RBC/TF’s opinion related solely to the total consideration to be paid. RBC/TF did not review, nor did its opinion in any way address, other Merger terms or arrangements, including, without limitation, the financial or other terms of any employment or non-competition agreement with any Vela employees or any break-up or termination fee. Further, RBC/TF’s opinion did not address, nor should it be construed to address, the relative merits of the underlying decision by Pharmos to engage in the Merger compared to any alternative business strategies or transaction in which Pharmos might engage. RBC/TF was not engaged as an agent or fiduciary of Pharmos’ stockholders or any other third party.

In rendering its opinion, RBC/TF assumed and relied upon the accuracy and completeness of the financial, legal, tax, operating and other information provided by Pharmos and Vela (including, without limitation, the financial statements and related notes thereto of Pharmos and Vela, as well as other publicly available information with respect to Pharmos and Vela). RBC/TF did not assume responsibility for independently verifying and did not

independently verify this information. With respect to the data and discussions relating to the business prospects and financial outlook of Pharmos and Vela, upon advice of Pharmos, RBC/TF assumed that such data was reasonably prepared on a basis reflecting the best currently available estimates and judgments of the management of Pharmos and Vela as to the future financial performance of Pharmos and Vela, respectively, and that Pharmos and Vela will perform substantially in accordance with such financial data and estimates. RBC/TF expressed no opinion as to such financial data and estimates or the assumptions on which they were based.

RBC/TF did not assume responsibility for, and did not perform, any independent evaluation or appraisal of any of the respective assets or liabilities of Pharmos or Vela, nor was RBC/TF furnished with any evaluations or appraisals. RBC/TF expressed no opinion regarding the liquidation value of any entity. RBC/TF did not assume any obligation to conduct, and did not conduct, any physical inspection of the property or facilities of Pharmos or Vela. Additionally, RBC/TF was not asked to and did not consider the possible effects of any litigation or other contingent matters.

RBC/TF’s opinion speaks only as of the date of such opinion, and is based on market conditions as they existed as of March 10, 2006 (the trading day upon which the analysis is based) and the information supplied to RBC/TF as of the date of its opinion, and is without regard to market, economic, financial, legal or other circumstances or events of any kind or nature which may exist or occur after such date. RBC/TF has not undertaken to reaffirm or revise its opinion or otherwise comment upon events occurring after the date of the opinion and RBC/TF does not have any obligation to update, revise or reaffirm its opinion. RBC/TF expressed no opinion as to the price at which shares of Pharmos common stock have traded or at which such shares may trade following the announcement or consummation of the merger.

For purposes of its opinion, RBC/TF assumed that the Merger will qualify as a reorganization for U.S. federal income tax purposes. RBC/TF assumed that the executed merger agreement was in all material respects identical to the last draft reviewed by RBC/TF. RBC/TF also assumed that the merger will be consummated pursuant to the terms of the merger agreement, without amendments thereto and without waiver by any party of any material conditions or obligations thereunder.


	In arriving at its opinion, RBC and/or TF:

•	reviewed and analyzed the financial terms of a draft of the merger agreement dated as of March 10, 2006;

•	reviewed and analyzed certain available financial and other data with respect to Pharmos and Vela and certain other historical operating data relating to Pharmos and Vela made available to RBC/TF from published sources and from the internal records of Pharmos and Vela;

•	received and reviewed financial forecasts prepared by Evidec, a third party valuation consultant hired by Vela, that projected the potential future performance of dextofisopam, or Vela’s own forecast (the “Vela Forecast”), as well as adjustments made to the Vela Forecast by Pharmos management;

•	conducted discussions with members of the senior management of Vela with respect to the business prospects and financial outlook of Vela independently and as combined;

•	conducted discussions with Cowen with respect to the business prospects and financial outlook of Vela independently and as combined;

•	conducted discussions with members of the senior management of Pharmos with respect to the business prospects and financial outlook of Pharmos independently and as combined;


•	reviewed the historical reported prices and trading activity for Pharmos common stock; and

•	reviewed publicly available materials and analysts’ reports with respect to the business and financial outlook of Pharmos.

The preparation of a fairness opinion is a complex process that involves the application of subjective business judgment in determining the most appropriate and relevant methods of financial analysis and the application of those methods to the particular circumstances and, therefore, is not necessarily susceptible to partial consideration of the analyses or summary description. RBC/TF believes that its analyses must be considered as a whole and that selecting portions of the analyses and of the factors considered, without considering all factors and analyses, could create an incomplete or misleading view of the processes underlying its opinion.

In view of the wide variety of factors considered in connection with its evaluation of the fairness of the total consideration to be paid from a financial point of view, RBC/TF did not find it practicable to assign relative weights to the factors considered in reaching its opinion. No single company or transaction used in the above analyses as a comparison is identical to Pharmos or Vela or the proposed merger. The analyses were prepared solely for purposes of RBC/TF providing an opinion as to the fairness of the total consideration to be paid, from a financial point of view, to Pharmos and do not purport to be appraisals or necessarily reflect the prices at which businesses or securities actually may be sold, which are inherently subject to uncertainty.

In connection with its analyses, RBC/TF made, and was provided by Pharmos’ management with, numerous assumptions with respect to industry performance, general business and economic conditions and other matters, many of which are beyond Pharmos’ or Vela’s control. Analyses based upon forecasts of future results are not necessarily indicative of actual future results, which may be significantly more or less favorable than suggested by these analyses. Because these analyses are inherently subject to uncertainty, and are based upon numerous factors or events beyond the control of Pharmos, Vela, or their advisors, none of Pharmos, Vela, RBC/TF, or any other person assumes responsibility if future results or actual values are materially different from these forecasts or assumptions.

In delivering its opinion to the Pharmos board of directors, RBC/TF prepared and delivered to Pharmos’ board of directors written materials containing various analyses and other information material to the opinion. The following is a summary of these materials, including information presented in tabular format. To understand fully the summary of the financial analyses used by RBC/TF, the tables must be read together with the text of each summary. The tables alone do not constitute a complete description of the financial analysis.

Transaction Overview

Given the closing stock price of Pharmos common stock of $2.19 on March 10, 2006, the implied value of the initial consideration offered by Pharmos was determined to be $25.2 million in Pharmos common stock and $5.0 million in cash consideration for a total implied initial consideration of $30.2 million at that date. Taking into account common shares, options and other dilutive securities on a fully diluted basis using the treasury stock method of accounting, new securities issued by Pharmos as part of the initial consideration would represent 37.7% on a pro forma combined basis. In addition, the merger consideration included two additional payments of 4 million shares of Pharmos common stock upon the satisfaction of two independent milestones. Given the closing stock price of Pharmos common stock of $2.19 on March 10, 2006, each milestone payment had implied value of $8.8 million at that date for a total consideration of $47.7 million at that date, including the initial consideration and first and second milestone payments.

Pharmos Stock Price History

RBC/TF reviewed the historical prices of the common stock of Pharmos from March 10, 2005 to March 10, 2006. RBC/TF reviewed the volume of shares of Pharmos traded as well as the volume weighted average prices of Pharmos shares during the 1-month, 3-month, 6-month and 12-month periods through and including March 10, 2006. In addition, RBC/TF reviewed Pharmos’ stock price performance since December 20, 2004, when Pharmos announced that its Phase III trial for Dexanabinol did not demonstrate efficacy.

Fairness Considerations and Analysis

In arriving at its opinion, in addition to reviewing the matters previously mentioned, RBC and/or TF performed the following analyses:


•	compared market valuations of selected comparable publicly-traded companies to Vela with the valuation implied by the merger consideration;

•	compared venture financing valuations of selected comparable private companies to Vela with the valuation implied by the merger consideration;

•	compared the implied valuation of Vela following its most recent venture financing round with the valuation implied by the merger consideration;

•	compared the initial consideration paid and the total valuation implied, to the extent publicly available, of selected comparable precedent transactions with the valuation implied by the merger consideration; and

•	prepared discounted cash flow analyses using the Vela Forecast, as adjusted by Pharmos management.

In addition, RBC and/or TF conducted such other analyses and examinations and considered such other financial, economic and market criteria as RBC/TF deemed necessary in arriving at its opinion.

Because the structure of the merger calls for the payment of consideration upon the successful completion of milestone events, RBC/TF performed valuation analyses at three points in time to evaluate the fairness of this merger to Pharmos shareholders. First, RBC/TF compared the current value of Vela to the value of the initial consideration to be paid by Pharmos as of the date of RBC/TF’s analysis. Second, RBC/TF compared the expected value of Vela as of the projected completion of the first milestone (discounted back to present value from the end of 2008) to the cumulative current value of the initial consideration and the first milestone consideration. Finally, RBC/TF compared the expected future value of Vela as of the projected completion of the second milestone (discounted back to present value from the midpoint of 2012) to the cumulative current value of the initial consideration, the first milestone consideration and the second milestone consideration.

For purposes of this analysis, RBC/TF determined (i) a current enterprise value range for current Vela, (ii) an enterprise value range for Vela after successful completion of the first milestone, and (iii) an enterprise value range for Vela after successful completion of the second milestone. The methodologies for calculating these value ranges are explained in detail in the sections below.

VALUATION OF VELA AT CURRENT STAGE OF DEVELOPMENT

RBC/TF utilized several approaches to determine an enterprise value range for Vela at its current stage of development. These valuation approaches are classified as either income approaches, such as the discounted cash flow, or DCF method, or aggregate market value approaches, such as comparable public companies’ market trading, comparable venture capital funding transactions, and comparable mergers and acquisition transactions. Under the income approach, the selected enterprise value range is derived from a range of present values of projected future cash flows. Under the aggregate market approaches, the enterprise value

associated with each comparable company or transaction is calculated and is the basis for deriving an enterprise value range for Vela, based on qualitative and quantitative criteria. To calculate the average enterprise value range for Vela at present, RBC/TF blended the average of each of these approaches equally, as shown in the table below.

Vela Valuation Summary – Current Company
($ in millions)


	Valuation Range

	Low			High

Enterprise Value Summary
Comparable Public Companies	$	64.4	-	$	120.7
Comparable Venture Capital Funding Transactions	$	30.0	-	$	76.0
Comparable Mergers and Acquisitions Transactions	$	18.0	-	$	86.3
Discounted Cash Flow	$	34.1	-	$	73.1

Average Enterprise Value	$	36.6	-	$	89.0

Each method considered in this analysis is described in further detail below.

Comparable Public Companies Method

RBC/TF reviewed the enterprise value of comparable companies that were publicly traded as of the date of its analysis. RBC/TF’s selection of comparable public companies was based on a comparison of Vela’s current stage of development, market opportunities, and other relevant business factors with that of the comparable public companies. Market capitalization figures are based upon fully diluted shares outstanding using the treasury stock method of accounting.

Comparable Public Companies Method – Current Company Analysis
($ in millions)


Company Name	Public Market Capitalization		Net Debt (Net Cash)			Enterprise Value

CytRx	$	106.6	$	(24.6	)	$	82.0
EntreMed		162.9		(54.6	)		108.2
Kosan Biosciences		171.8		(51.1	)		120.7
Point Therapeutics		109.0		(44.7	)		64.4
XTL Biopharmaceuticals		128.4		(16.6	)		111.8

Comparable Venture Capital Funding Transactions Method

The venture capital funding method involved developing indications of value through the review of transactions in which venture capital firms invested new capital in privately-held biotechnology companies. These transactions were deemed to be comparable to Vela if, among other things, their value was derived primarily from technologies in or near early stage proof-of-concept clinical trials. RBC/TF determined the enterprise value range of pre-money valuations based upon the qualitative similarities among the comparable companies and Vela at its current stage of development.

Comparable Venture Capital Funding Transactions – Current Company Analysis
($ in millions)


Company Name	Financing Round Type	Closing Date	Pre-Money Valuation		Money Raised		Post-Money Valuation

Surface Logix	Series D	10/28/2005	$	76.0	$	32.0	$	108.0
Dynogen	Series B	4/5/2004		30.0		50.0		80.0
Favrille	Series C	3/26/2004		46.5		44.0		90.5
Plexxikon	Series B-1	2/26/2004		56.0		15.0		71.0

Vela Financing Analysis

In January 2002, Vela solicited an investment of new preferred equity capital from current and new investors in a Series D preferred stock financing. From October 2004 through October 2005, Vela obtained additional capital in the form of bridge notes from existing investors that were convertible into Series D preferred stock. RBC/TF considered the implied post-money enterprise value of Vela at which new capital was raised to be relevant to its analysis. The post-money enterprise value of Vela following the consummation of the most recent bridge financing was approximately $69.0 million.

Comparable Mergers and Acquisitions Transactions Method

RBC/TF reviewed publicly available financial information relating to selected transactions since March 2003 involving biotechnology companies which RBC/TF deemed to be similar to Vela. RBC/TF’s selection of a range indicated by this approach was based on a comparison of Vela’s current stage of development, market opportunities, and other relevant business factors with that of the comparable transactions. Those comparable transactions are identified in the following chart.

Comparable Mergers and Acquisitions Transactions – Current Company Analysis
($ in millions)


Announcement Date	Target Name	Acquiror Name	Initial Consideration		Consideration including Milestones


1/27/2006	Montigen	SuperGen	$	18.0	$	40.0
1/9/2006	Micromet	CancerVax		86.3		86.3
9/14/2005	Cellective	MedImmune		44.0		149.0
9/1/2004	Zycos	MGI		50.0		50.0

DCF Method

The enterprise value range based upon the discounted cash flow method was determined by calculating the present value of the estimated future unlevered free cash flows that Vela’s dextofisopam could generate until patent expiry in 2023. In connection with its engagement, Evidec prepared revenue estimates for dextofisopam assuming successful marketability of the drug under various commercial scenarios, and these revenue estimates were further adjusted by Pharmos management. Furthermore, Pharmos management assumed that the likely commercial path for dextofisopam was the licensing to a pharmaceutical company partner after successful completion of Phase IIb. The Vela Forecast included research and development cost data and estimated general and administrative expenses.

The present value of interim cash flows was determined using a discount rate range of 20.3% to 24.3%. RBC/TF estimated the discount rate based upon the cost of capital of comparable public companies to Vela at its current stage of development: CytRx, EntreMed, Kosan Biosciences, Point Therapeutics, and XTL Biopharmaceuticals. These companies were chosen because, for the purposes of the cost of capital analysis, RBC/TF considered them to have operational, market and economic similarity with Vela’s current business. The selected public companies may significantly differ from Vela based on, among other things, the stage of development of their product candidates, the disease indications on which they are focused, and the market opportunities for their product candidates. A premium was included in Vela’s discount rate in correlation with its relatively small current size.

The value ranges of the cash flows were then multiplied by a factor weighing the probability of successful commercial viability from its current stage of development. RBC/TF estimated the likelihood of achieving the commercial scenarios at its current stage of development to be a range of 40% to 50%, based upon the Vela Forecast, industry reports and discussions with Pharmos management.

This analysis estimated the value for the dextofisopam compound on a stand-alone basis and RBC/TF added no value to Vela’s other scientific programs under this approach.

VALUATION OF VELA FOLLOWING COMPLETION OF FIRST MILESTONE

RBC/TF utilized several methods to determine an enterprise value range for Vela at the first milestone stage of development, projected to occur at the end of 2008. The methods utilized in this analysis are the same as those used in the valuation for Vela at its current stage of development: DCF method and analysis of comparable public companies, venture capital funding transactions and mergers and acquisition transactions. For each method, the future enterprise value ranges for Vela at the first milestone stage of development were then discounted back to present value using a time discount calculation based upon the current company’s weighted-average cost of capital.

Valuation Summary – at First Milestone
($ in millions)


	Present Valuation Range

	Low			High

Enterprise Value Summary
Comparable Public Companies	$	76.5	-	$	163.5
Comparable Venture Capital Funding Transactions	$	26.8	-	$	88.3
Comparable Mergers and Acquisitions Transactions	$	16.8	-	$	76.5
Discounted Cash Flow	$	94.8	-	$	163.5

Average Enterprise Value	$	53.7	-	$	123.0

Each method considered in this analysis is described in further detail below.

Comparable Public Companies Method

RBC/TF reviewed the enterprise value of comparable companies to Vela at its projected first milestone stage of development that were publicly traded as of the date of its analysis. RBC/TF’s selection of comparable public companies was based on a comparison of Vela’s stage of development at the first milestone, market opportunities, and other relevant business factors with that of the comparable public companies. Market capitalization figures are based upon fully diluted shares outstanding using the treasury stock method of accounting.

Comparable Public Companies Method – First Milestone Analysis
($ in millions)


Company Name	Market Capitalization		Net Debt (Net Cash)			Enterprise Value

CuraGen	$	285.8	$	(49.6	)	$	236.2
Dynavax Technologies		189.3		(55.0	)		134.3
Genitope		328.3		(151.5	)		176.8
NeoPharm		272.8		(68.8	)		204.0
Panacos Pharmaceuticals		374.1		(86.9	)		287.2

The resulting future enterprise value range at the end of 2008 was then discounted back to present value using a time discount calculation with the current company’s discount rate for a present enterprise value range of $76.5 million to $163.5 million.

Comparable Venture Capital Funding Transactions Method

The comparable venture capital funding transactions method involved the derivation of indications of value through the review of transactions in which venture capital firms invested new capital in privately-held biotechnology companies. RBC/TF deemed these transactions to be comparable to Vela at the first milestone stage of development if, among other things, their value was derived primarily from technologies that had shown encouraging trends supporting clinical efficacy in a larger, controlled Phase IIb or similar clinical trial. RBC/TF determined the enterprise value range of pre-money valuations based upon the qualitative similarities among the comparable companies and Vela following successful completion of the first milestone.

Comparable Venture Capital Funding Transactions – First Milestone Analysis
($ in millions)


Company Name	Financing Round Type	Closing Date	Pre-Money Valuation		Money Raised		Post-Money Valuation

Novacea	Series C	12/20/2005	$	135.0	$	25.0	$	160.0
Acologix	Series C	12/16/2005		119.7		29.8		149.5
Somaxon	Series D	12/15/2005		155.1		55.0		210.1
Prestwick	Series B	12/6/2004		47.1		37.0		84.1
Intarcia	Series E	11/30/2004		70.2		50.0		120.2

The resulting pre-money valuation range was then discounted back to present value from the projected first milestone date at the end of 2008 using a time discount calculation with the current company’s discount rate for a present enterprise value range of $26.8 million to $88.3 million.

Comparable Mergers and Acquisitions Transactions Method

RBC/TF reviewed publicly available financial information relating to selected transactions since January 2003 involving biotechnology companies deemed by RBC/TF to be similar to Vela at its projected stage of development following successful completion of the first milestone. RBC/TF’s selection of a range indicated by this method was based on a comparison of Vela’s stage of development, market opportunities, and other relevant business factors with that of the comparable transactions. Those transactions are identified on the following chart.

Comparable Mergers and Acquisitions Transactions – First Milestone Analysis
($ in millions)


Announcement Date	Target Name	Acquiror Name	Initial Consideration		Consideration including Milestones

9/6/2005	Epicept	Maxim	$	97.7	$	97.9
11/18/2005	Cita	Vernalis plc		29.5		64.5
7/19/2005	Arakis	Sosei		134.4		134.4
12/15/2004	Igneon	Aphton		82.0		82.0
9/1/2004	Aesgen	MGI		33.1		91.1
11/18/2003	Genesoft	Genome Therapeutics		103.8		103.8

The resulting initial consideration range was then discounted back to present value from the projected first milestone date at the end of 2008 using a time discount calculation with the current company’s discount rate for a present enterprise value range of $16.8 million to $76.5 million.

DCF Method

RBC/TF applied the same methodology in the DCF method as described above under Valuation of Vela at Current Stage of Development, with adjusted present value and probability assumptions. The unlevered free cash flows associated with dextofisopam were discounted back to the end of 2008 when the drug is expected to have successfully completed the first milestone. The value of interim cash flows was determined using a discount rate range of 16.1% to 20.1%. RBC/TF estimated the discount rate based upon the cost of capital of comparable public companies to projected Vela upon successful completion of the first milestone: CuraGen, Dynavax Technologies, Genitope, NeoPharm, and Panacos Pharmaceuticals. These companies were chosen because, for the purposes of the cost of capital analysis, RBC/TF considered them to have similarity with Vela’s projected business following successful completion of the first milestone. The selected public companies may significantly differ from Vela based on, among other things, the stage of development of their product candidates, the disease indications on which they are focused, and the market opportunities for their product candidates. A premium was included in Vela’s discount rate in correlation to its projected size at the first milestone stage of development.

The value ranges of the cash flows were then multiplied by a factor weighing the probability of successful commercial viability from the first milestone stage of development. RBC/TF estimated the likelihood of achieving the commercial scenarios following successful completion of the first milestone to be a range of 60% to 70%, based upon the Vela Forecast, industry reports and discussions with Pharmos management.

VALUATION OF VELA FOLLOWING COMPLETION OF SECOND MILESTONE

RBC/TF utilized the DCF method and comparable public companies analysis to determine an enterprise value range for Vela in the event the second milestone is successfully achieved at the projected date of the midpoint of 2012. The sample size of the other two methods, venture capital financing transactions and mergers and acquisitions transactions, was not adequate to perform these analyses for companies comparable to Vela projected at the second milestone stage of development. For each method utilized, the future enterprise value ranges for Vela at the second milestone stage of development were then discounted back to present value using a time discount calculation based upon the current company’s weighted-average cost of capital.

Valuation Summary – at Second Milestone
($ in millions)


	Present Valuation Range

	Low			High

Enterprise Value Summary
Comparable Public Companies	$	109.5	-	$	145.3
Discounted Cash Flow	$	171.1	-	$	236.6

Average Enterprise Value	$	140.3	-	$	190.9

Each method considered in this analysis is described in further detail below.

Comparable Public Companies Method

RBC/TF reviewed the enterprise value of comparable companies to Vela at its projected second milestone stage of development that were publicly traded as of the date of its analysis. RBC/TF’s selection of comparable public companies was based on a comparison of Vela’s stage of development at the second milestone, market opportunities, and other relevant business factors with that of the comparable public companies. Market capitalization figures are based upon fully diluted shares outstanding using the treasury stock method of accounting.

Comparable Public Companies Method – Second Milestone Analysis
($ in millions)


Company Name	Market Capitalization		Net Debt (Net Cash)			Enterprise Value

Avanir Pharmaceuticals	$	505.4	$	(50.4	)	$	455.0
GPC Biotech AG		557.3		(168.5	)		388.8
NPS Pharmaceuticals		404.6		111.1			515.7
Pozen		555.1		(45.8	)		509.3

The resulting future enterprise value range at the midpoint of 2012 was then discounted back to present value using a time discount calculation with the current company’s discount rate for a present enterprise value range of $109.5 million to $145.3 million.

DCF Method

RBC/TF applied the same methodology in the DCF method as described above under Valuation of Vela at Current Stage of Development, with adjusted present value and probability assumptions. The unlevered free cash flows associated with dextofisopam were discounted back to the midpoint of 2012 when the company is expected to have successfully completed and filed an NDA with the Food and Drug Administration. The value of interim cash flows was determined using a discount rate range of 14.1% to 18.1%. RBC/TF estimated the discount rate based upon the cost of capital of comparable public companies to projected Vela upon successful completion of the second milestone: Avanir Pharmaceuticals, GPC Biotech AG, NPS Pharmaceuticals, and Pozen. These companies were chosen because, for the purposes of the cost of capital analysis, RBC/TF considered them to have similarity with Vela’s projected business following successful completion of the second milestone. The selected public companies may significantly differ from Vela based on, among other things, the stage of development of their product candidates, the disease indications on which they are focused, and the market opportunities for their product candidates. A premium was included in Vela’s discount rate in correlation to its projected size at the second milestone stage of development.

The value ranges of the cash flows were then multiplied by a factor weighing the probability of successful commercial viability from the second milestone stage of development. RBC/TF estimated the likelihood of achieving the commercial scenarios following successful completion of the second milestone to be a range of 75% to 85%, based upon the Vela Forecast, industry reports and discussions with Pharmos management.

Other Considerations

Pharmos selected RBC/TF to render its opinion based on RBC/TF’s experience in mergers and acquisitions and in securities valuation generally. RBC, a member company of RBC Capital Markets, is a globally recognized investment banking firm and is regularly engaged in the valuation of businesses and securities in connection with mergers and acquisitions, corporate restructurings, underwritings, secondary distributions of listed and unlisted securities, private placements and valuations for corporate and other purposes. RBC provides research coverage on Pharmos’ common stock. TF, RBC’s strategic partner in Israel, is a recognized investment banking firm and regularly performs various investment banking services, including mergers and acquisitions, underwritings, secondary distributions of listed and unlisted securities, private placements and valuations for businesses, their securities and other purposes. RBC/TF and its affiliates actively trade securities of Pharmos for their own accounts or the accounts of their customers and, accordingly, may from time to time hold a long or short position in those securities.

Pursuant to the engagement letter, Pharmos has paid RBC/TF a customary, nonrefundable fee upon the rendering of its opinion. Payment of this fee to RBC/TF was not contingent upon the closing of the merger. RBC/TF will also be entitled to an additional fee in the event the merger is consummated. Whether or not the transaction closes, Pharmos has agreed to reimburse RBC/TF for its out-of-pocket expenses and to indemnify RBC/TF against certain liabilities relating to or arising out of services performed by RBC/TF in connection with the merger. The terms of the engagement letter were negotiated at arm’s-length between Pharmos and RBC/TF, and Pharmos’ board of directors was aware of this fee arrangement at the time of its approval of the merger agreement.

QUESTIONS AND ANSWERS ABOUT THE MERGER

What are the consequences of the Merger to me?

The material consequences for you are as follows. First, there will be more shares of our common stock outstanding if the 11.5 million shares are issued upon the closing of the Merger. There will also be an additional 8 million shares that may be issued in the future upon the achievement of certain milestones relating to the development of one of Vela’s compounds (the 11.5 million shares and the 8 million shares will be referred to collectively as the “Merger Shares”). This means that the shares of Pharmos common stock that you currently own will represent a smaller percentage of the total outstanding shares of Pharmos common stock after the Merger than before the Merger. While we believe the Merger is beneficial to Pharmos and its shareholders from a financial perspective, it is possible that the value we anticipate receiving from or occurring as a result of the Merger may not occur at all or may be delayed. If that happens, then the issuance of the Merger Shares will be dilutive to you both in terms of the percentage of the voting shares that you own and their value in the market place.

Second, immediately following the Merger, and depending upon the market price of our common stock and the extent of repayment and/or conversion of Vela’s outstanding indebtedness as of the closing, affiliates of J.P. Morgan Partners, Venrock Associates, and New Enterprise Associates, who are currently the principal shareholders of Vela, are expected to own or control approximately 4,989,282 shares, 2,283,359 shares and 3,342,373 shares of the 11,500,000 Merger Shares issued at the closing, respectively. This would represent approximately 16.32%, 7.47% and 10.94%, respectively, of our outstanding voting shares. Although these shareholders do not act in concert or constitute a “group” as defined in the Securities Exchange Act of 1934, they will be some of our largest shareholders and may be able to influence future decisions of Pharmos.

Will Vela’s shareholders be able to trade the Merger Shares that they receive in the Merger?

Not immediately. The Merger Shares are being issued pursuant to an exemption from registration under the Securities Act of 1933, as amended, and applicable state securities laws. Accordingly, the Merger Shares will be restricted in terms of transfer unless and until the Merger Shares are subsequently registered or there exists an exemption from registration with respect to the transfer of the Merger Shares. In addition, transfer of the Merger Shares is further restricted under the terms of the Registration Rights Agreement, which will be executed by representatives of Vela’s shareholders and the Company at the closing.

However, we have agreed to register the resale of the Merger Shares on behalf of Vela’s shareholders. We expect to file the registration statement covering the Merger Shares within seven days after the Merger is completed. Once the registration statement is declared effective, the Merger Shares will be freely tradable (subject to the “lock-up” described in the next sentence and applicable federal securities laws relating to filing and disclosure obligations and restrictions relating to insider trading) and will be listed on the Nasdaq Capital Market under the symbol “PARS.” Under the Registration Rights Agreement, the Vela shareholders receiving the stock will be subject to a “lock-up” providing that (i) no shares may be sold until six (6) months after the closing, (ii) for each six-month period after that date, up to 33% of the shares originally issued to such shareholder may be sold, and (iii) after 18 months from the closing, all shares may be sold. Any milestone shares that may be issued during the lock-up period shall also be subject to such restrictions.

Why is my vote important?

Under applicable Nasdaq rules, we must obtain the approval of our shareholders before we can issue the Merger Shares.

We must first establish a quorum at the meeting. A quorum will be established if one-third of the outstanding shares of Pharmos common stock are present in person or by proxy at the meeting. Thus, your failure to submit a proxy or to attend the meeting could have the effect of preventing a quorum and, thus, the approval of the issuance of the Merger Shares. If you do not submit a proxy or attend the meeting, if we nonetheless have sufficient shares to constitute a quorum, then your failure to vote will not have any effect on the outcome of any of these proposals.

Any proposal to adjourn the meeting will be approved if a majority of the shares of Pharmos stock present at the meeting votes in favor of the proposal.

The directors and executive officers of Pharmos beneficially own and have the right to vote 614,773 shares, or approximately 3.2% of the shares entitled to be voted at the meeting. We have entered into agreements with these individuals to vote in favor of approval of the issuance of the Merger Shares in connection with the Merger Agreement and Merger.

A beneficial owner of approximately 8.4% of the Company’s outstanding shares of common stock, Lloyd I. Miller, III, has filed a Schedule 13D with the Securities and Exchange Commission indicating his current intention to vote against the Merger proposal.

What happens if I return my proxy but do not indicate how to vote my shares?

If you sign and return your proxy card, but do not provide instructions on how to vote your shares, your shares will be voted FOR approval of the issuance of the Merger Shares, FOR the director nominees, FOR ratification of the appointment of Pharmos’ independent registered public accountants and FOR any adjournment proposal. If you return an unsigned proxy card, your proxy will be invalid, and your shares will not be deemed present or voted at the meeting.

Can I change my vote after I have mailed my signed proxy card?

Yes. You may change your vote at any time before your proxy is voted at the meeting, as follows:


	•	You may send a written notice stating that you would like to revoke your proxy and provide new instructions on how to vote;

	•	You may complete and submit a later-dated proxy card;

	•	If you voted electronically, you may return to the website and recast your votes; or

	•	You may attend the meeting and vote in person.

If you choose either the first, second or third method above, you must submit your notice of revocation or your new proxy card to us or cast your votes on the website prior to the meeting.

When will the Merger occur?

We currently expect to complete the Merger two business days after the issuance of the Merger Shares is approved by our shareholders and the other conditions to the Merger are satisfied or waived. Pharmos and Vela are working toward completing the Merger as quickly as possible.

What do I need to do now?

Important information is presented in greater detail elsewhere in this proxy statement and the documents attached as appendices to this proxy statement. We encourage you to read this proxy statement in its entirety, together with our Annual Report to shareholders which is being mailed together with this proxy statement.

Following review of this proxy statement, please complete, sign, and date the enclosed proxy card and return it in the enclosed envelope as soon as possible so that your shares can be voted at the meeting.

Who can help answer my questions?

If you have questions about the Merger, the meeting, or your proxy, or if you need additional copies of this document or a proxy card, you should contact Pharmos Corporation, 99 Wood Avenue South, Suite 311, Iselin, NJ 08830, Attention: President.

THE AGREEMENT AND PLAN OF MERGER AND THE MERGER

The following description of the Agreement and Plan of Merger and the Merger does not purport to be complete and is qualified in its entirety by reference to the Agreement and Plan of Merger, attached as Appendix A. Shareholders are urged to read the Agreement and Plan of Merger in its entirety.

GENERAL

Under the Agreement and Plan of Merger, two days after Pharmos’ shareholders approve the Merger, Vela will merge with and into Vela Acquisition Corporation, a wholly-owned subsidiary of Pharmos. Vela Acquisition Corporation will be the surviving corporation in the Merger and it will

hold the business and assets of Vela. Certain of the shareholders of Vela will become shareholders of Pharmos.

CLOSING DATE AND EFFECTIVE DATE OF THE MERGER

The Closing Date is defined as a date no later than the second business day after approval of the Merger by Pharmos’ shareholders, assuming satisfaction or waiver of the conditions to the Merger (unless the parties agree to another Closing Date). On the Closing Date, Pharmos and Vela shall sign the Certificate of Merger in the form attached as Exhibit A to the Agreement and Plan of Merger and shall cause the Certificate of Merger to be filed with the Secretary of State of the State of Delaware, in order to cause the Merger contemplated by the Agreement and Plan of Merger to become effective under the laws of the State of Delaware. The Effective Date of the Merger shall be the date and at the time of the filing of the Certificate of Merger with the Secretary of State of the State of Delaware.

ISSUANCE OF MERGER SHARES; CASH PAYMENT; CANCELLATION OF VELA CAPITAL STOCK

At the Effective Date of the Merger (the “Effective Date”), the outstanding shares of Vela’s capital stock shall be cancelled. Pharmos will issue 11,500,000 shares of its common stock which will be allocated in accordance with instructions from representatives of Vela’s shareholders on the basis of the provisions in Vela’s Restated Certificate of Incorporation as in effect on the Effective Date. Pharmos will also pay $5,000,000 in cash to or on behalf of Vela at the Effective Date. This cash, together with any remaining cash on hand, will be used by Vela to pay all of Vela’s costs and expenses incurred in connection with the Merger, its obligations under the Acquisition Bonus Plan, all interest accrued through the Effective Date on Vela’s outstanding bridge notes and a portion of the principal of those notes. The holders of the notes have agreed to convert the remaining principal of the notes to Vela’s Series D Redeemable Convertible Preferred Stock which will be cancelled in connection with the Merger.

MILESTONE SHARES

As part of the Merger, Pharmos may also issue (i) an additional 4,000,000 shares of its common stock upon successful completion of a Phase IIb clinical trial related to the development of dextofisopam within four years of the Effective Date and (ii) an additional 4,000,000 shares of its common stock upon the filing of a New Drug Application with the U.S Food and Drug Administration for dextofisopam within eight years of the Effective Date. If either of the milestones is attained, the shares to be issued to Vela’s shareholders will be valued on the then current market price of Pharmos’ common stock and shall be allocated in accordance with instructions from representatives of Vela’s shareholders on the basis of the provisions in Vela’s Restated Certificate of Incorporation as in effect on the Effective Date and Vela’s Acquisition Bonus Plan. The 4,000,000 shares issuable upon timely satisfaction of the second milestone may be issued even if the first milestone has not been attained in a timely manner.

EXPENSES OF THE MERGER

Under the Agreement and Plan of Merger, Pharmos and Vela will each pay their respective costs and expenses incurred in connection with the negotiation and consummation of the Merger as described in the Merger Agreement. However, Pharmos and Vela have agreed that a portion of the $5,000,000 to be paid by Pharmos on the Effective Date shall be used to pay a portion of Vela’s costs and expenses associated with completing the Merger.

SHARE OWNERSHIP AT EFFECTIVE DATE

As a result of the Merger, current Vela shareholders will own or control 11,500,000 shares of Pharmos common stock representing approximately 38% of the outstanding shares of Pharmos

common stock. Depending upon the market price of Pharmos’ common stock and the extent of repayment and/or conversion of Vela’s outstanding indebtedness as of the closing, affiliates of J.P. Morgan Partners, Venrock Associates and New Enterprise Associates are expected to own approximately 16.32%, 7.47% and 10.94%, respectively, of our outstanding voting shares.

FRACTIONAL SHARES

No fractional shares will be issued by Pharmos in connection with the cancellation of the Vela shares. Instead, Pharmos will pay cash for any fractional share that a holder of Vela shares has the right to receive under the Agreement and Plan of Merger.

RESULTING BOARD OF DIRECTORS AND BOARD OF ADVISORS

In connection with the Merger and under the terms of the Agreement and Plan of Merger, at the closing Pharmos shall expand the size of its classified Board of Directors by two, for a new total of nine members, and one current member, [____________], shall resign. In addition, one of the newly-elected Class III directors will be reclassified as a Class [__] director, replacing the resigned director. The two newly-created Board positions, together with the vacated Board position, will represent the following vacancies: (i) one vacancy with a term commencing as of the Effective Date and expiring at Pharmos’ annual shareholders meeting in 2009, (ii) one vacancy with a term commencing as of the Effective Date and expiring at Pharmos’ annual shareholders meeting in 2008, and (iii) one vacancy with a term commencing as of the Effective Date and expiring at Pharmos’ annual shareholders meeting in 2007. Such vacancies will be filled by the Board at the Closing with three designees of Vela, with each of the affiliates of (i) J.P. Morgan Partners, (ii) Venrock Associates and (iii) New Enterprise Associates each initially appointing one such designee, in each case subject to approval of Pharmos’ Board. Pharmos and Vela have agreed that Srinivas Akkaraju, Anthony B. Evnin and Charles W. Newhall III are acceptable designees. If the Merger does not close, Messrs. Akkaraju, Evnin and Newhall will not take office.

Srinivas Akkaraju, M.D., Ph.D., 38, is a co-founder and Managing Director of Panorama Capital. Prior to co-founding Panorama, Dr. Akkaraju was a partner with J.P. Morgan Partners, LLC, on the Life Sciences team of the Healthcare Group. Dr. Akkaraju joined J.P. Morgan Partners, LLC in April 2001. Prior to JPMorgan Partners, LLC, from October 1998 to April 2001, Dr. Akkaraju was in the Business and Corporate Development group at Genentech, Inc. where he served in various capacities, most recently as Senior Manager and project team leader for one of Genentech’s clinical development products. Dr. Akkaraju is currently a member of the Board of Directors of Barrier Therapeutics, Seattle Genetics, and several private biotechnology companies. Dr. Akkaraju received his undergraduate degrees in Biochemistry and Computer Science from Rice University and his M.D. and Ph.D. in Immunology from Stanford University.

Anthony B. Evnin, 65, is a Managing General Partner of Venrock Associates, a venture capital firm, where he has been a Partner since 1975. He is currently a member of the Board of Directors of Coley Pharmaceutical Group, Inc., Icagen, Inc., Memory Pharmaceuticals Corp., Renovis, Inc., and Sunesis Pharmaceuticals, Inc. as well as being on the Board of Directors of a number of private companies. Dr. Evnin received an A.B. in Chemistry from Princeton University and a Ph.D. in Chemistry from the Massachusetts Institute of Technology.

Charles W. Newhall III, 61, co-founded New Enterprise Associates in 1978 and has been a General Partner of the firm since its inception. While with NEA, his investment activities have focused on healthcare services, healthcare information services and biopharmaceutical companies. Prior to co-founding NEA, Mr. Newhall was a Vice President with T. Rowe Price Associates and Vice President of its New Horizons Fund. His board memberships include Vitae Pharmaceuticals, ElderHealth, Hospital Partners of America, Sensors for Medicine & Science, TargetRx, and Trine Pharmaceuticals. Mr. Newhall is also a founder of the Mid-Atlantic Venture Association. He received his M.B.A. from the Harvard University Graduate School of Business and his B.A. in English Literature with honors from the University of Pennsylvania.

For as long as the affiliates of each of (i) J.P. Morgan Partners, (ii) Venrock Associates and (iii) New Enterprise Associates hold at least 50% of the Pharmos shares issued on the Effective Date to them and their affiliates (including any escrow shares allocable to it not previously forfeited to Pharmos in accordance with the terms of the Escrow Agreement), then (A) its designee for Pharmos’ Board shall remain on the Board for the duration of his initial term, (B) each designated director shall be replaced during the initial term or any renewal term only by another individual designated by such shareholder, subject to the approval of Pharmos’ Board, and (C) in connection with the pending expiration of the term of any such director, the Governance and Nominating Committee of Pharmos’ Board shall consider, in connection with the deliberations in accordance with its certificate of incorporation, the re-nomination of such director to the Board.

STANDSTILL AGREEMENT

At closing, Vela’s principal shareholders will enter into standstill agreements that provide that for two years they will not acquire any additional Pharmos stock, other than as agreed to by the Pharmos Board or in a private placement or other transaction in an amount to maintain their percentage interest. Each standstill agreement also provides that it is the current intention of the shareholder not to initiate or support a proxy fight or hostile takeover of Pharmos.

EXECUTIVE OFFICERS OF PHARMOS

Except as discussed above with respect to the additional members of the Board of Directors of Pharmos, it is anticipated that each of the current executive officers of Pharmos will continue to serve in those roles following the Effective Date.

REGISTRATION OF MERGER SHARES AND LOCK-UP

In accordance with a Registration Rights Agreement that will be signed at closing, Pharmos has agreed to file a registration statement with the Securities and Exchange Commission within seven days of the Effective Date to register for resale all shares to be issued in connection with the Agreement and Plan of Merger, including the 8,000,000 milestone shares. Under the Registration Rights Agreement, sales of the 11,500,000 shares issued on the Effective Date and any milestone shares issued during the 18 months following the Effective Date shall be restricted as follows: none of such shares may be sold for a period of six months following the closing; one-third of such shares may be sold commencing six months after closing; two-thirds of such shares may be sold commencing one year after closing; and all of the shares may be sold commencing 18 months after the closing.

EFFECT OF MERGER ON PHARMOS “POISON PILL”

In October 2002, Pharmos adopted a shareholder rights plan that imposes a significant penalty upon any person or group that acquires 15% or more of our outstanding common stock in certain types of transactions without the approval of our board. Completion of the Merger will constitute a triggering event under this plan, since at least one of Vela’s shareholders will acquire more than 15% of the outstanding stock. In view of the fact that Pharmos’ Board favors completion of the Merger, the Board will amend the shareholder rights plan prior to the Effective Date to exempt acquisition of stock pursuant to the Merger from the terms of the plan.

CONDUCT OF BUSINESS BY VELA AND PHARMOS PENDING THE MERGER

Unless otherwise agreed to by Pharmos, the Agreement and Plan of Merger provides that prior to the Effective Date, Vela shall:


	•	use its best efforts to preserve all of its accounting and business records, corporate records, trade secrets and proprietary information and other intellectual property for the benefit of the surviving corporation;


	•	not declare or pay any dividends (whether in cash, shares of stock or otherwise) on, or make any other distribution in respect of, any shares of capital stock, or issue, purchase, redeem or acquire for value any shares of its capital stock, or issue any options, warrants or other rights to acquire shares of its capital stock or securities exchangeable for or convertible into shares of its capital stock, except for the issuance of shares of capital stock of Vela upon the exercise of options or warrants outstanding on the date of the Agreement and Plan of Merger or upon the conversion of its bridge notes;

	•	except for payments and allocations under its Acquisition Bonus Plan, shall not: increase the compensation payable to or to become payable to any director, officer or employee; grant any severance or termination pay to, or enter into any employment, consulting or severance agreement with, any director, officer or employee or their respective affiliates; or establish, adopt, enter into or amend any employee benefit plan or arrangement except as may be required by applicable law;

	•	not enter into any contract or commitment or engage in any transaction not in the usual and ordinary course of business and consistent with its normal business practices, including without limitation, any contract or commitment relating to its intellectual property or any contract or commitment relating to the acquisition of assets, technologies or products or the in-licensing thereof;

	•	not (i) sell, lease as lessor, license as licensor, or otherwise dispose of any capital asset with a market value in excess of $10,000, (ii) sell, lease as lessor, license as licensor, or otherwise dispose of any asset other than in the ordinary course of business; provided, that Vela shall not license any of its intellectual property, (iii) borrow money, (iv) incur or pay any material liability other than in the ordinary course of business, or (v) guarantee or otherwise incur any material liability with respect to the obligation of any other person;

	•	use its best efforts to preserve for Pharmos the present relationships with suppliers, scientists, researchers, licensors, parties to contracts and others having business relations with Vela;

	•	not amend its certificate of incorporation or by-laws;

	•	not merge or consolidate with any other corporation, or acquire any stock of, or, except in the ordinary course of business, acquire any assets or property of any other business entity whatsoever;

	•	not do any act or omit to do any act, or permit any act or omission to act, which will cause a material breach of any material contract, commitment or obligation of Vela;

	•	duly comply in all material respects with all laws, regulations and orders applicable with respect to its business;

	•	promptly advise Pharmos in writing of any development or change in circumstance (including any litigation to which it may become a party or of which it may gain knowledge) that does or could reasonably be expected to (i) call into question the validity of the Agreement and Plan or Merger or any action taken or to be taken pursuant thereto, (ii) adversely affect the ability of the parties to consummate the transactions contemplated thereby, or (iii) have any material adverse effect on the business, financial condition, or assets of Vela;


	•	either call a special meeting of its shareholders to consider and vote upon the approval of the Agreement and Plan of Merger and the Merger and the other transactions contemplated thereby or shall obtain the requisite minimum required shareholder approval by written consent in accordance with its certificate of incorporation and by-laws and applicable Delaware law. The board of directors of Vela shall recommend to its shareholders the approval of the Agreement and Plan of Merger and the Merger and the other transactions contemplated thereby and shall use its best efforts to solicit and obtain the requisite vote of approval; and

	•	secure, before the Effective Date, the consent to the consummation of the transactions contemplated by the Agreement and Plan of Merger, by each party to any material contract, commitment or obligation of Vela, in each case under which such consent is required.

Unless otherwise agreed to by Vela, the Agreement and Plan of Merger provides that prior to the Effective Date, Pharmos shall:


	•	duly comply in all material respects with all laws, regulations and orders applicable to its business;

	•	not, except in the ordinary course of business, (i) sell, lease as lessor, license as licensor, or otherwise dispose of any capital asset with a market value in excess of $10,000, (ii) sell, lease as lessor, license as licensor, or otherwise dispose of any asset; provided that Pharmos may enter into a product in-licensing agreement without the prior written consent of Vela, if (a) the in-licensed product is not competitive with, or will not reduce the value of, dextofisopam, and (b) the aggregate then-irrevocable payment obligations of Pharmos under such in-licensing agreement do not exceed $4,000,000 (that is, excluding, without limitation, any potential or contingent up-front, royalty, license maintenance or milestone based payments that would not be due and payable by Pharmos if it elected at some future date to terminate such in-licensing agreement), (iii) borrow money, (iv) incur or pay any material liability, or (v) guarantee or otherwise incur any material liability with respect to the obligation of any other person;

	•	use its best efforts to preserve its present relationships with suppliers, scientists, researchers, licensors, parties to contracts and others having business relations it;

	•	not merge or consolidate with any other corporation, or acquire any stock of, or, except in the ordinary course of business, acquire any assets or property of any other business entity whatsoever;

	•	do any act or omit to do any act, or permit any act or omission to act, which will cause a material breach of any its material contracts, commitments or obligations;

	•	advise Vela in writing of any development or change in circumstance (including any litigation to which it may become a party or of which it may gain knowledge) that does or could reasonably be expected to (i) call into question the validity of the Agreement and Plan of Merger or any action taken or to be taken pursuant thereto, (ii) adversely affect the ability of the parties to consummate the transactions contemplated thereby, or (iii) have any material adverse effect on its business or financial condition;

	•	use all commercially reasonable efforts to secure the consent to the consummation of the transactions contemplated by the Agreement and Plan of Merger by each party to any material contract, commitment or obligation of Pharmos under which such consent is required; and


	•	use its best efforts to carry on its business in the usual and ordinary course and to preserve its organization and relationships and not to (i) declare or pay any dividends to its shareholders, or repurchase any shares of its stock, (iii) amend its certificate of incorporation or by-laws, (ii) pledge or agree to pledge, any shares of its capital stock or (iii) increase the size of its Board of Directors beyond nine members.

INDEMNITY AND ESCROW

The Vela shareholders that receive Pharmos shares upon the closing of the Merger will indemnify Pharmos for damages resulting from material breaches of Vela’s representations, warranties and covenants under the Agreement and Plan of Merger for a period of 18 months after the Effective Date. The sole source of the indemnity (absent fraud) will be 1,725,000 of the 11,500,000 shares issued at closing, which shall be held in escrow pursuant to an escrow agreement. If no claims for indemnification are pending, the 1,725,000 shares shall be reduced to 1,150,000 shares six months after the closing and shall be further reduced to 575,000 shares 12 months after the closing if no claims are pending. All remaining shares shall be released from escrow 18 months after the closing if no claims are pending. The indemnity will have a deductible of $250,000 and will only apply to claims in excess of that amount.

Pharmos will indemnify the former Vela shareholders and former Vela directors and officers for damages resulting from material breaches of its representations, warranties and covenants under the Agreement and Plan of Merger for a period of 18 months after the Effective Date. The indemnity will be capped at the total market value at closing of 15% of 11,500,000 shares of Pharmos common stock. This cap amount shall be reduced by one-third six months after the closing and by another one-third 12 months after the closing. If no claims are pending, all indemnification obligations shall cease 18 months after the Effective Date. The indemnity will have a deductible of $250,000 and will only apply to claims in excess of that amount. Pharmos has the discretion to satisfy indemnification claims by tendering cash or stock in the case of the former Vela shareholders, but must use cash to satisfy claims raised by Vela’s former officers and directors.

EMPLOYMENT RELATED MATTERS

Pharmos anticipates hiring Dr. Steven Leventer to lead clinical development of the Vela technologies and several members of his staff, reporting to Alan Rubino, Pharmos’ President & COO. No additional hires of Vela employees are anticipated.

CONDITIONS TO THE MERGER

The Merger is subject to certain conditions set forth in the Agreement and Plan of Merger. In the event that those conditions remain unsatisfied and the Merger has not been completed on or before August 31, 2006, the Merger Agreement may be terminated by either party as more fully described below.

Pharmos is obligated to effect the Merger only if the following additional conditions are satisfied by Vela or waived by Pharmos:


	•	The representations and warranties of Vela set forth in the Agreement and Plan of Merger shall be true and correct in all material respects as of the Closing Date, except for changes permitted or required by the Agreement and Plan of Merger;

	•	Vela shall have performed and complied in all material respects with all covenants and agreements contained in the Agreement and Plan of Merger required to be performed or complied with by it on or before the Closing Date;


	•	The shareholders of Vela shall have authorized and approved the Agreement and Plan of Merger and the Merger contemplated thereby as required by applicable law and Vela’s restated certificate of incorporation and by-laws, and the holders of at least 95% of the issued and outstanding shares of Vela’s capital stock (voting together as a single class on an as-converted basis) shall have voted in favor of or consented to the Merger or shall have otherwise waived or failed to perfect any appraisal rights to which they may otherwise be entitled under the Delaware General Corporation Law;

	•	Vela shall have duly executed and delivered to Pharmos the Certificate of Merger;

	•	No restraining order or injunction or other order issued by any court of competent jurisdiction, or other legal restraint or prohibition shall prevent the consummation of the Merger or other transactions contemplated by the Agreement and Plan of Merger, and no petition or request for any such injunction or other order shall be pending;

	•	Counsel to Vela shall have delivered to Pharmos a legal opinion in form and substance satisfactory to Pharmos and its counsel;

	•	There shall not have been any material adverse change in the business or assets of Vela, excluding the incurrence of cash losses from operations in accordance with the conduct of Vela’s business in the ordinary course;

	•	Each outstanding stock option, warrant, and other right to acquire the capital stock of Vela shall have been exercised, waived, released and/or terminated, and Vela’s stock option plan shall have been terminated as of the Closing Date and shall be of no further force or effect;

	•	After payment by Pharmos of the $5,000,000 at closing to or on behalf of Vela and the use of the proceeds thereof, the remaining liabilities of Vela as of the Closing Date, as determined in accordance with generally accepted accounting principles, shall not exceed $100,000, provided that such liabilities do not include any expenses associated with the transactions contemplated by this Agreement and that such liabilities were incurred in the ordinary course of business;

	•	All of the employment and consulting agreements to which Vela is a party or to or by which Vela is bound shall have been terminated upon terms and conditions acceptable to Pharmos, and participants in Vela’s Acquisition Bonus Plan will have executed and delivered a general release in form and substance reasonably acceptable to Pharmos; and

	•	Vela shall have executed and/or delivered all documents and instruments required to be executed and/or delivered by it on the Closing Date under the Agreement and Plan of Merger.

Vela is obligated to effect the Merger only if the following additional conditions are satisfied by Pharmos or waived by Vela:


	•	The representations and warranties of Pharmos in the Agreement and Plan of Merger shall be true and correct in all material respects as of the Closing Date, except for changes permitted or required by the Agreement and Plan of Merger;


	•	Pharmos shall have performed and complied in all material respects with all of the covenants and agreements required to be performed or complied with by it by the Closing Date;


	•	The shareholders of Pharmos shall have authorized and approved the issuance of the Pharmos shares pursuant to the Agreement and Plan of Merger;

	•	Vela Acquisition Corporation shall have executed and delivered to Vela the Certificate of Merger;


	•	No restraining order or injunction or other order issued by any court of competent jurisdiction, or other legal restraint or prohibition shall prevent the Merger or other transactions contemplated by the Agreement and Plan of Merger, and no petition or request for any such injunction or other order shall be pending;


	•	Counsel to Pharmos shall have delivered to Vela a legal opinion in form and substance satisfactory to Vela and its counsel;

	•	There shall not have been any material adverse change in the business or assets of Pharmos, which shall not include the incurrence of cash losses from operations in accordance with the conduct of Pharmos’ business in the ordinary course or the unsuccessful outcome in Pharmos’ motions to dismiss pending class action and derivative litigations described in its SEC reports;


	•	Pharmos shall have expanded the size of its Board of Directors by two; and


	•	Pharmos shall have executed and/or delivered all documents and instruments required to be executed and/or delivered by it on the Closing Date under the Agreement and Plan of Merger.

AMENDMENT OF THE AGREEMENT AND PLAN OF MERGER

The Agreement and Plan of Merger may be amended prior to closing only by written instrument executed by Pharmos, Vela Acquisition Corporation and Vela and approved by their respective Boards of Directors (i) in any manner and at any time prior to the first to occur of (A) submission for approval of the Agreement and Plan of Merger to the shareholders of Vela and (B) submission for approval of the Agreement and Plan of Merger to the shareholders of Pharmos, and (ii) after the earliest such submission for approval, to extend the Closing Date and termination date or to make other amendments which, in the opinion of the respective counsel for Pharmos and Vela, do not substantially alter the terms of the Agreement and Plan of Merger. The Agreement and Plan of Merger may be amended after the Closing Date only by written instrument executed by Pharmos and the representatives of Vela’s former shareholders designated in the Agreement and Plan of Merger.

TERMINATION; EFFECT OF TERMINATION

Either party may terminate the Agreement and Plan of Merger upon notice to the other (i) if the other party is in material breach of its obligations under the Agreement and Plan of Merger and such breach shall not have been cured within a period of ten (10) days after written notice or (ii) if the conditions necessary to close shall not have been satisfied, or waived by the other party, on or prior to August 31, 2006 or (iii) if there has been a material adverse change in the representations and warranties made by either party or (iv) upon any material adverse

change in the business or operations of the other party. The parties may also terminate the Agreement and Plan of Merger by mutual agreement.

If either party terminates the Agreement other than in compliance with the foregoing provisions, it shall become liable to the other party for a payment of $1,500,000. In addition, a party shall be liable for such payment if it is in material breach of the Agreement and Plan of Merger and the other party terminates the Agreement as a result of such material breach. Provided that Pharmos is not otherwise in breach of the Agreement and Plan of Merger, failure to obtain approval by Pharmos’ shareholders of the issuance of shares in connection with the Merger will not give rise to the obligation to make the $1,500,000 payment.

NO DISSENTERS’ RIGHTS

Under applicable Nevada law, Pharmos shareholders do not have the right to dissent from the approval of the issuance of the Merger Shares and obtain payment for the appraised value of their shares.

BUSINESS CONDUCTED BY VELA

Overview

Vela is a privately held Delaware corporation specializing in the rediscovery and development of medicines related to the nervous system, including the brain-gut axis (links between the nervous system and the digestive system). Vela seeks to minimize some of the risks of traditional drug discovery and development by working primarily with drug assets for which human safety data are already available. Vela’s principal development efforts to date have focused on three clinical-stage assets to treat disorders for which a large unmet medical need exists. Vela currently has seven employees and leases approximately 10,500 square feet of office space at 820 Bear Tavern Road, Suite 300, Ewing, New Jersey 08628. Its telephone number is (609) 771-8660.

Principal Assets

Vela’s assets include dextofisopam and tianeptine for the treatment of irritable bowel syndrome and VPI-013 (previously known as OPC-14523) for the treatment of neuropathic pain and female hypoactive sexual desire disorder.

Dextofisopam to Treat IBS

Irritable bowel syndrome, or IBS, is a chronic, recurring condition with symptoms that affect up to 15% of American adults, more often women than men. IBS is characterized by multiple symptoms that include bowel dysmotility—diarrhea, constipation, or alternating diarrhea and constipation—and abdominal discomfort. Studies have shown that diarrhea-predominant IBS appears to be the most common subtype. For patients with diarrhea-predominant and alternating-type IBS, there are no recently approved treatments for any but the most severely affected women, and none for men.

Vela’s lead asset is dextofisopam, a novel agent in development for the treatment of IBS. Many drugs and drug candidates are produced in mixtures that include “mirror-image” versions of the molecular form of the drug, which include “right-handed” (or “R”) and “left-handed” (or “S”) forms. The mixture of equal amounts of “R” and “S” forms of the same drug are called racemic mixtures. Research has shown that in certain cases the “R” and “S” forms can exert different therapeutic effects and/or side effects. Dextofisopam is the R-enantiomer, or “R” form, of racemic tofisopam, a molecule marketed and used outside the United States for over three decades for

multiple indications, including IBS. Vela is developing the R-enantiomer, rather than the racemic mixture, of tofisopam.

Several drugs in development for the treatment of IBS and other conditions target a molecular family known as serotonin. Interacting with serotonin is known to cause several undesirable side effects. Dextofisopam exerts its therapeutic effect through a novel mechanism that does not interact with serotonin, thus minimizing the risk of causing these side effects.

Vela holds an issued composition-of-matter patent on dextofisopam in the United States which expires in 2019 and holds certain related foreign patents and patent applications; Vela has filed additional, related patent applications for the treatment of IBS in the United States, and foreign counterparts. Vela owns the dextofisopam patent portfolio free of any licensing milestones or royalties payable to third parties. Vela conducted over 100 preclinical tests with dextofisopam and conducted several Phase 1 trials to establish tolerability in humans.

Vela completed a twelve-week Phase 2 study in both women and men with diarrhea-predominant and alternating-type (alternating between diarrhea and constipation) IBS. In January 2005, Vela announced positive results from its Phase 2 clinical trial. On the primary endpoint of “adequate overall relief,” dextofisopam provided statistically significant benefit in patients with either diarrhea-predominant or alternating-type IBS. The “p-value” of this clinical trial was 0.033, meaning the likelihood that the positive results of the trial were due to chance alone was 3.3%. In patients with diarrhea-predominant IBS, reduced stool frequency and improved stool consistency were noted as early as the second day of treatment. Dextofisopam appeared well tolerated and did not cause significant constipation.

Further analyses of Vela’s Phase 2 study results indicated that while dextofisopam provided benefit in both men and women, improvement was demonstrated across more endpoints in women. Dextofisopam provided similar benefit in men and in women on the primary endpoint of adequate overall relief and on the secondary endpoint of stool consistency. For two other secondary endpoints, stool frequency and abdominal pain/discomfort, dextofisopam appeared to provide more benefit in women than in men. Vela met with the FDA in April 2005 to discuss a Phase 2b protocol, and Vela and Pharmos are planning a dose-ranging trial with dextofisopam in women with diarrhea-predominant and alternating-type IBS. This study is anticipated to enroll approximately 480 patients across up to 80 sites in the United States and is expected to begin later this year or early next year.

Tianeptine to Treat IBS or Functional Dyspepsia

Tianeptine is a racemic molecule marketed and used outside the United States since 1988 for the treatment of depression. Vela’s patent protection for tianeptine consists of a United States method-of-use patent covering tianeptine and its two enantiomers for the treatment of IBS and non-ulcer dyspepsia. This patent expires in 2023. Additional foreign patents related to this United States patent are pending. Vela does not owe any licensing milestones or royalties to any other company in connection with this asset.

In Vela’s preclinical studies, tianeptine showed significant activity in animal models of altered bowel motility, visceral hypersensitivity, and pain. Specifically, tianeptine normalized stimulated colonic motility and reduced visceral hypersensitivity following provocative colorectal distension, while having little effect on basal colonic motility. These data suggest the possibility that tianeptine might provide symptomatic relief to IBS patients without producing constipation or diarrhea. Tianeptine also demonstrated activity in animal models of visceral pain and neuropathic pain. Vela has not conducted any clinical trials with tianeptine, although, as noted earlier, tianeptine is marketed and used in certain countries outside the United States.

VPI-013 to Treat Neuropathic Pain and/or HSDD

Neuropathic pain is caused by a primary lesion or dysfunction in the nervous system. The injury can be to the central nervous system (brain and spinal cord) or the peripheral nervous system (nerves outside the brain and spinal cord). Neuropathic pain is a component of many disorders, including infections, diabetes, and lumbar disc disease. The current therapeutic market for neuropathic pain is underserved, largely by the off-label use of antidepressants and anticonvulsants. The anticonvulsant gabapentin (Neurontin^®), while not broadly approved for the treatment of neuropathic pain, is widely used off-label for this indication. Treatment with gabapentin is limited by significant side-effect issues, including high rates of dizziness, sleepiness and sedation.

Sexual dysfunction of some type has been reported in up to 31% of adult men and 43% of adult women. Hypoactive sexual desire disorder, or HSDD, is the most common form of sexual dysfunction in women. Approved therapies for sexual dysfunction currently target only a small subset of patients (e.g., men with erectile dysfunction). Most of the recent approaches to the treatment of HSDD have focused on hormonal therapies, but safety concerns about the chronic use of hormonal therapies in women have limited the success of this approach.

In March 2004, Vela in-licensed North American and European rights (and rights in select additional countries) to VPI-013 from Otsuka Pharmaceutical Co., Ltd. The VPI-013 patent estate consists of a United States composition-of-matter patent (which expires in 2014), a United States method-of-use patent, and foreign counterparts. The patents are owned by Otsuka and are licensed exclusively to Vela in the geographic areas noted above. Vela and Otsuka recently jointly filed additional patent applications covering the treatment of sexual dysfunction and neuropathic pain. Vela licensed VPI-013 with the intent of conducting a Phase 2 trial or trials and then sub-licensing the asset to a third party. Any milestones and royalties paid by a sublicensee would be shared by Vela and Otsuka.

Preclinical testing by Otsuka suggested the potential for utility of VPI-013 in multiple disorders related to the central nervous system. Otsuka tested the tolerability of VPI-013 in multiple Phase 1 studies. Otsuka also tested VPI-013 in two large Phase 2 trials for the treatment of major depression. Results indicated that while VPI-013 showed some antidepressant activity, this effect did not reach statistical significance. In Otsuka’s Phase 2 trials, VPI-013 was well tolerated and produced little or no sexual dysfunction.

Vela conducted a Phase 2 trial comparing VPI-013 to placebo in depressed patients. In this trial, VPI-013 showed some antidepressant activity but did not achieve statistical significance on the primary depression endpoint. VPI-013 was well tolerated at the trial dosage. Based on internally generated information and clinical data from the Otsuka trials, Vela assessed sexual function in this trial using the Changes in Sexual Function Questionnaire (CSFQ). At the start of the trial, most of the depressed patients were experiencing sexual dysfunction according to the CSFQ. During the trial, compared with placebo, treatment with VPI-013 significantly improved overall sexual function (CSFQ total score; p = 0.050), sexual desire/frequency (p = 0.015) and sexual desire/interest (p = 0.011). The apparent improvement in sexual function in men and women during the study did not correlate well with amelioration of depression, making it unlikely that the improvement in sexual function was driven by change in depressive symptomatology. These data suggest that VPI-013 may have improved libido in patients in the trial. Vela is exploring further development of VPI-013 as a treatment for HSDD.

Vela has also conducted preclinical studies in rodents, with results suggesting the possibility that VPI-013 may have potential as a treatment for neuropathic pain. In a preclinical model of neuropathic pain, certain doses of VPI-013 performed as well as or better than the tested dose of gabapentin. Gabapentin, while not broadly approved for the treatment of neuropathic pain, is widely used off-label for this indication. Vela is considering further development of VPI-013 as a treatment for neuropathic pain.

Vela Management’s Discussion and Analysis of Financial Condition
and Results of Operations

The following discussion should be read in conjunction with Vela’s financial statements and related notes and the other financial information included elsewhere in this proxy statement. This discussion does not take into account the impact of the contemplated merger with Pharmos.

Background

Vela specializes in the rediscovery and development of medicines related to the nervous system, including the brain-gut axis (links between the nervous system and the digestive system). Vela’s efforts over the past two years have focused primarily on three clinical-stage assets. These assets are dextofisopam for IBS, VPI-013 for neuropathic pain or HSDD (although originally tested for major depression), and tianeptine for IBS or functional dyspepsia. These medical disorders are all prevalent, and current treatment options for these are limited.

As of December 31, 2005, Vela had cumulative losses of approximately $62,174,000, negative working capital, and negative cash flows from operations, which are expected to continue for the foreseeable future. These conditions raise substantial doubt about Vela’s ability to continue as a going concern. Vela has been engaged in strategic discussions related to asset sublicensing, with the goal of bringing in cash from a partner and having such a partner assume certain clinical development costs. Vela has also from time to time considered potential asset sales to, and potential mergers with, third parties.

Results of Operations

Comparison of Years Ended December 31, 2005 and December 31, 2004

Revenues

Vela does not generate and has not generated any revenues from product sales or licensing. Vela has from time to time been in discussions with potential partners for the possible licensing of certain of its assets, but does not expect to generate revenues from product sales in the foreseeable future.

Expenses

Research and development expenses for 2005 were $5.1 million, compared to $10.3 million for 2004. The decrease in research and development expenses is primarily attributable to the completion of the dextofisopam Phase 2 trial in 2004. The majority of the 2005 research and development expenses were in connection with the VPI-013 Phase 2 trial.

General and administrative expenses for 2005 were $2.6 million, compared to $2.1 million for 2004. The factors primarily contributing to this increase were increased legal fees and other expenses in connection with the consideration of strategic alternatives and increased expenses related to the expansion and maintenance of intellectual property.

Business development expenses for 2005 were $1.1 million, compared to $1.3 million for 2004. This decrease was primarily the result of a decrease in activities related to the search for, evaluation of, and potential in-licensing of additional drug assets.

Interest expense for 2005 was $596,949, compared to $36,629 for 2004. The increase in interest expense resulted from Vela’s issuance of an aggregate of $10 million of convertible notes in 2005. The outstanding principal and accrued interest on such convertible notes were $14 million and $633,580 as of December 31, 2005, and $4 million and $36,629 as of December 31, 2004, respectively.

Income Tax Benefit

As a result of its operating losses, Vela had no federal or state income tax liability for 2005 or 2004. During 2005 and 2004, Vela sold unused state net operating loss carry-forwards through a program sponsored by the State of New Jersey and the New Jersey Economic Development Authority. Cash proceeds of $333,660, net of fees of $9,321, were received by Vela in 2005. Cash proceeds of $395,642, net of fees of $11,051, were received by Vela in 2004.

As of December 31, 2005, Vela had a net operating loss carry-forward for federal income tax purposes of approximately $57 million. The ability of Pharmos to utilize Vela’s net operating losses to offset any income after the closing of the merger will be subject to limitation under section 382 of the Internal Revenue Code. Vela also had a research and development tax credit for federal income tax purposes of approximately $2 million at December 31, 2005.

Liquidity and Capital Resources

To date, Vela’s principal sources of funding have been through the issuance and sale of convertible preferred stock and convertible bridge notes and proceeds from the sale of net operating losses. As of December 31, 2005, Vela had cash and cash equivalents of $1.8 million (and an additional $345,600 of restricted cash), compared to $1.9 million cash and cash equivalents (and no restricted cash) as of December 31, 2004. The restricted cash was set aside for the payment of one-half of the minimum stay bonuses under Vela’s Acquisition Bonus Plan and was paid in March 2006. Vela had approximately $900,000 of cash at March 31, 2006, which is not expected to be sufficient to fund operations for the remainder of 2006.

Net cash used in operating activities was $9.7 million for 2005, compared to $13.1 million for 2004. This decrease was attributable to the decreased research and development activities and expenses in 2005. Net cash used in investing activities for 2005 was $350,000 (which was primarily attributable to the need to set aside $345,600 of restricted cash for eventual payout under Vela’s Acquisition Bonus Plan), compared to net cash provided by investing activities for 2004 of $1.4 million. Net cash provided by financing activities (primarily senior convertible bridge notes described below) was $10 million for 2005, compared to $4 million for 2004.

On October 6, 2004, Vela entered into a Note and Warrant Purchase Agreement with certain of its existing investors pursuant to which Vela issued $8 million in senior convertible bridge notes in four equal installments of $2 million between October 2004 and March 2005. Interest on these notes is compounded monthly at a rate of 6% per annum. With each installment of such bridge notes, Vela issued to the lenders warrants to purchase an aggregate of 300,297 shares of its common stock. In October 2005, the maturity date of these notes was extended to June 1, 2006.

On June 1, 2005, Vela entered into a second Note and Warrant Purchase Agreement with certain of its existing investors pursuant to which Vela issued $6 million in senior convertible bridge notes in three equal installments of $2,000,000 between June 2005 and October 2005. Interest is compounded monthly at a rate of 6% per annum. With each installment of such bridge notes, the Company issued to the lenders warrants to purchase an aggregate of 400,002 shares of its common stock. The maturity date of these notes is June 1, 2006.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Financial Statements

December 31, 2005


Report of Independent Registered Public Accounting Firm				37
Balance Sheets				38
Statements of Operations				39
Statements of Stockholders’ Deficiency				40
Statements of Cash Flows				42
Notes to Financial Statements				43

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
Vela Pharmaceuticals Inc.

We have audited the accompanying balance sheets of Vela Pharmaceuticals Inc. (a development stage enterprise) as of December 31, 2005 and 2004, and the related statements of operations, stockholders’ deficiency and cash flows for the years then ended and the period from February 4, 1998 (inception) to December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Vela Pharmaceuticals Inc. at December 31, 2005 and 2004 and the results of its operations and its cash flows for the years then ended and the period from February 4, 1998 (inception) to December 31, 2005 in conformity with accounting principles generally accepted in the United States.

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As more fully described in Note 1, the Company has incurred operating losses and has a significant accumulated deficit, negative working capital and negative cash flows from operations. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.

/s/ Ernst & Young LLP

March 15, 2006

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Balance Sheets


	December 31
	2005			2004

Assets
Current assets:
Cash and cash equivalents	$	1,786,935		$	1,861,858
Restricted cash		345,600			—
Interest receivable		1,117			743
Prepaid expenses and other current assets		54,740			185,117

Total current assets		2,188,392			2,047,718

Property and equipment, net		138,246			232,257
Other assets		11,997			12,073

	$	2,338,635		$	2,292,048


Liabilities, redeemable preferred stock and stockholders’ deficiency
Current liabilities:
Accounts payable	$	106,091		$	1,269,683
Accrued bonuses		281,008			415,575
Other accrued expenses		225,187			369,517
Bridge notes payable		14,000,000			4,000,000
Accrued interest payable		633,580			36,629

Total current liabilities		15,245,866			6,091,404

Series C Redeemable Convertible Preferred Stock; par value $0.001 per share, authorized, issued and outstanding 2,859,650 shares at December 31, 2005 and 2004. Liquidation value: $40,750,013 at December 31, 2005 and 2004		21,147,128			21,136,994
Series D Redeemable Convertible Preferred Stock; par value $0.001 per share, authorized 11,959,215 and 10,048,175 shares at December 31, 2005 and 2004, respectively; issued and outstanding 7,500,075 shares at December 31, 2005 and 2004. Liquidation value: $62,500,375 at December 31, 2005 and 2004		24,906,084			24,874,779

Stockholders’ deficiency:
Series A Convertible Preferred Stock; par value 0.001 per share, authorized, issued and outstanding 1,436,651 shares at December 31, 2005 and 2004. Liquidation value: $3,591,628 at December 31, 2005 and 2004		1,437			1,437
Series B Convertible Preferred Stock; par value 0.001 per share, authorized and issued 554,859 shares at December 31, 2005 and 2004, outstanding 454,859 and 554,859 shares at December 31, 2005 and 2004, respectively. Liquidation value: $3,411,443 and $4,161,443 at December 31, 2005 and 2004, respectively		555			555
Common stock; par value 0.001 per share, authorized 25,000,000 and 22,000,000 shares at December 31, 2005 and 2004, respectively; issued 1,297,504 shares at December 31, 2005 and 2004 and outstanding 1,210,004 and 1,297,504 shares at December 31, 2005 and 2004, respectively		1,299			1,298
Additional paid-in capital		3,209,968			3,248,787
Deficit accumulated during development stage		(62,173,702	)		(53,063,206	)
Treasury Stock:
Series B Convertible Preferred Stock; at cost, 100,000 shares at December 31, 2005		—			—
Common stock; at cost, 88,500 shares at December 31, 2005		—			—

Total stockholders’ deficiency		(58,960,443	)		(49,811,129	)

	$	2,338,635		$	2,292,048

See accompanying notes.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Statements of Operations


							Period from February 4, 1998 (Inception) to December 31, 2005


	Year ended December 31
	2005			2004


Consulting revenues	$	—		$	—		$	234,018

Operating expenses:
Research and development		5,115,830			10,328,872			41,912,055
General and administrative		2,632,490			2,099,187			11,254,838
Business development		1,134,280			1,308,058			6,063,336

Total expenses		8,882,600			13,736,117			59,230,229


Operating loss		(8,882,600	)		(13,736,117	)		(58,996,211	)

Interest income		35,393			56,754			1,367,421
Interest expense		(596,949	)		(36,629	)		(643,315	)

Loss before tax		(9,444,156	)		(13,715,992	)		(58,272,105	)

Income tax benefit		333,660			395,642			975,926

Net loss		(9,110,496	)		(13,320,350	)		(57,296,179	)

Preferred stock accretion		(41,439	)		(41,439	)		(177,880	)


Net loss attributable to common stockholders	$	(9,151,935	)	$	(13,361,789	)	$	(57,474,059	)

See accompanying notes.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Statements of Stockholders’ Deficiency

See accompanying notes.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Statements of Cash Flows


							Period from February 4, 1998 (Inception) to December 31, 2005



	Year ended December 31
	2005			2004

Operating activities
Net loss	$	(9,110,496	)	$	(13,320,350	)	$	(57,296,179	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		91,036			97,761			327,162
Loss on disposal of property and equipment		7,716			7,050			14,766
Deferred stock compensation to consultants		1,821			418			164,736
Common stock issued to consultants for services and patent rights		—			—			85,618
Preferred stock issued for interest expense		—			—			9,737
Changes in operating assets and liabilities:
Other current assets		130,003			(86,174	)		(55,857	)
Other assets		76			1,184			(11,997	)
Accounts payable		(1,163,592	)		144,810			106,091
Accrued bonuses		(134,567	)		142,575			281,008
Other accrued expenses		(144,330	)		(114,193	)		225,187
Accrued interest payable		596,951			36,629			633,580

Net cash used in operating activities		(9,725,382	)		(13,090,290	)		(55,516,148	)

Investing activities
Additions to property and equipment		(9,086	)		(195,947	)		(484,519	)
Proceeds from the sale of property and equipment		4,345						4,345
Sale of marketable securities		—			1,600,000			—
Restricted cash		(345,600	)		—			(345,600	)

Net cash (used in) provided by investing activities		(350,341	)		1,404,053			(825,774	)

Financing activities
Proceeds from issuance of bridge notes		10,000,000			4,000,000			14,280,000
Proceeds from issuance of common stock		800			—			92,251
Proceeds from issuance of Series A preferred stock		—			—			1,122,592
Proceeds from issuance of Series B preferred stock		—			—			1,636,205
Proceeds from issuance of Series C preferred stock		—			—			16,216,402
Proceeds from issuance of Series D preferred stock		—			—			24,781,407

Net cash provided by financing activities		10,000,800			4,000,000			58,128,857

Net (decrease) increase in cash and cash equivalents		(74,923	)		(7,686,237	)		1,786,935
Cash and cash equivalents at beginning of period		1,861,858			9,548,095			—

Cash and cash equivalents at end of period	$	1,786,935		$	1,861,858		$	1,786,935


Schedule of noncash transactions
Deemed dividends on Series C preferred stock	$	—		$	—		$	4,877,523
Conversion of note payable to Series A preferred stock		—			—			280,000
Issuance of common stock for patent rights		—			—			8,750
Issuance of common stock for services		—			—			76,870
Issuance of common stock warrants		—			96,095			98,595

Supplemental disclosure of cash flow information
Proceeds from sale of unused NJ State NOL tax benefit		333,660			395,642			975,926

See accompanying notes.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements

December 21, 2005

1. Organization and Description of Business

Vela Pharmaceuticals Inc. (the “Company”) was incorporated in Delaware on February 4, 1998. The Company is focused on the identification, development and testing of selected and important therapeutic agents for the treatment of patients with psychiatric, neurologic and other disorders. Upon completion of development, it intends to market such products. Since inception, the Company has principally been active in performing research and product development. Accordingly, the Company has been classified as a development stage enterprise. The Company’s operations constitute one business segment.

Since August 2005, the Company has been working with an investment banker to find a merger partner or to sell some or all of its assets (see Note 15). If a merger or sale does not occur, the Company’s ability to continue as a going concern is dependent upon the continued sale of its securities for funds to meet its cash requirements. If a sale appears likely, the Company can elect to request additional support from their current investors to continue operations until a sale or license of technology can be consummated or raise additional equity funds and/or obtain additional funding to finance the development of their assets. However, there are no assurances that these plans will be achieved; as such, the Company may shut down without a merger or sale of its assets.

At December 31, 2005, the Company has cumulative losses of approximately $62,174,000, negative working capital and negative cash flows from operations. Operating losses are expected to continue for the foreseeable future. To date the Company has funded its activities through equity investments, convertible notes and the sale of net operating losses.

2. Summary of Significant Accounting Policies

Cash and Cash Equivalents

The Company considers all highly-liquid investments with an original maturity of three months or less at the date of purchase to be cash equivalents. The Company invests its cash in deposits with major financial institutions.

Fair Value of Financial Instruments

Certain financial instruments reflected in the balance sheets, (e.g., cash and cash equivalents, certain other assets, accounts payable and certain other liabilities) are recorded at cost, which approximate fair value due to their short-term nature.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

2. Summary of Significant Accounting Policies (continued)

Restricted Cash

The restricted cash as of December 31, 2005 is cash set aside and reserved for the payment of one-half of the minimum stay bonuses under the Company’s Acquisition Bonus Plan (see Note 12). This amount was paid to key employees at the Company on March 1, 2006.

Property and Equipment

Property, equipment and leasehold improvements are stated at cost. Depreciation is provided using the straight-line method over the lesser of the estimated useful lives of the related assets, which range from three to seven years, or the term of the related lease.

Liquidation Value

Liquidation value of the Company’s Preferred Stock is reflected at the stated liquidation preference amounts per share, multiplied by the number of shares of Preferred Stock outstanding for each series of Preferred Stock issued (see Note 7). Depending on future liquidation events (including a sale of the Company), realized liquidation value may be less than or greater than these amounts, but no greater than 2.5 times the liquidation preference. Liquidation values as reflected on the balance sheets at December 31, 2005 and 2004 are greater than the net assets of the Company at such dates.

Research and Development

All research and development costs are charged to operations as incurred. These costs consist of direct and indirect costs associated with specific projects as well as fees paid to various entities that perform research for the Company.

Income Taxes

The Company utilizes the asset and liability method to account for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

2. Summary of Significant Accounting Policies (continued)

Use of Estimates

The preparation of the financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Reclassifications

Certain prior year amounts have been reclassified to conform with the current year presentation.

Stock-Based Compensation

As allowed by Statement of Financial Accounting Standards (“SFAS”) No. 123 “Accounting for Stock-Based Compensation”, the Company has elected to continue to apply the intrinsic value-based method of accounting prescribed in Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” and, accordingly, does not recognize compensation expense for stock option grants made at an exercise price equal to or in excess of the fair market value of the stock at the date of grant.

Had compensation cost for the Company’s outstanding employee stock options been determined based on the fair value at the grant dates for those options consistent with SFAS No. 123, the Company’s net loss would have been changed to the following pro forma amounts:


	(ii)Year ended December 31
	2005			2004

Net loss attributable to common stockholders, as reported	$	(9,110,496	)	$	(13,320,350	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		194,048			151,953

SFAS 123 pro forma net loss	$	(9,304,544	)	$	(13,472,303	)

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

2. Summary of Significant Accounting Policies (continued)

SFAS 123 pro forma information regarding net loss is required by SFAS 123, and has been determined as if the Company had accounted for its stock-based compensation under the fair value method prescribed in SFAS 123. The fair value of the options was estimated at the date of grant using the minimum value pricing model with the following assumptions:


	(iii)Year ended December 31
	2005			2004


Risk-free interest rate		4.4	%		4.6	%
Dividend yield		0	%		0	%
Expected life		5 years			5 years

The effects of applying SFAS 123 in this pro forma disclosure may not be representative of future amounts since the estimated fair value of stock options is amortized to expense over the vesting period and additional options may be granted in future years.

The Company accounts for options issued to nonemployees under SFAS 123 and EITF No. 96-18 “Accounting for Equity Investments that are Issued to Other than Employees for Acquiring or in Conjunction with Selling Goods or Services” (“EITF 96-18”). Therefore, the fair value of options issued to nonemployees is recorded as an expense and periodically remeasured over the vesting terms.

Impairment of Long Lived Assets

In accordance with SFAS No. 144, long-lived assets, such as property, plant, and equipment, software costs and purchased intangibles subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future undiscounted net cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

2. Summary of Significant Accounting Policies (continued)

in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.

Effects of New Accounting Standards

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The Company has adopted Statement 123(R) effective January 1, 2006.

As permitted by Statement 123, the Company currently accounts for share-based payments to employees using APB 25’s intrinsic value method and as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)’s fair value method will have an impact on the Company’s results of operations, although it will have no impact on the Company’s overall financial position. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described above in the disclosure of pro forma net loss.

Preferred Stock Dividends

The Company records deemed dividends when modification to its preferred stock is required in accordance with EITF 98-5 and EITF 00-27. A modification occurred in 2002 resulting in deemed dividends for the Series C of $4,877,523.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

2. Summary of Significant Accounting Policies (continued)

Comprehensive Income

Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income,” requires components of other comprehensive income, including unrealized appreciation on marketable securities, to be included as part of total comprehensive income. The components of comprehensive income are included in the statement of redeemable preferred stock and stockholders’ deficiency.

3. Property and Equipment

Property and equipment consist of the following:


	December 31
	2005			2004


Furniture, fixtures and equipment	$	297,036		$	358,405
Leasehold improvements		65,354			79,284

		362,390			437,689
Less accumulated depreciation		(224,144	)		(205,432	)

Property and equipment, net	$	138,246		$	232,257

4. Operating Leases

In December 2003, the Company executed a lease for office space in West Trenton, New Jersey. The term of this lease is from April 1, 2004 to March 31, 2007. The existing lease, which was executed in December 2000, was to cover the term from March 1, 2001 to February 28, 2006, was terminated as of March 31, 2004 without penalty to the Company.

The future minimum lease commitments are as follows:


2006	$	155,752
2007		39,595

Total	$	195,347

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

4. Operating Leases (continued)

Rent expense for the years ended December 31, 2005 and 2004 and for the period from February 4, 1998 (inception) to December 31, 2005 was $231,548, $204,182 and $840,688, respectively.

5. Bridge Notes Payable

The Company has two Bridge notes outstanding as of December 31, 2005. Pursuant to the Note and Warrant Purchase Agreement dated as of October 6, 2004 the Company is authorized to issue up to $8,000,000 in senior convertible promissory notes in four equal installments of $2,000,000 to certain current investors (the “Lenders”). Interest is compounded monthly at a rate of 6% per annum. With each installment of the Bridge Loan, the Company will issue the Lenders 300,297 warrants to purchase common stock (see Note 6). The four installments were issued in October 2004, December 2004, January 2005 and March 2005. All installments were outstanding at December 31, 2005. In October 2005, the maturity date of the October 6, 2004 Bridge Loan was extended until June 1, 2006.

Pursuant to the Note and Warrant Purchase Agreement dated as of June 1, 2005 the Company is authorized to issue up to $6,000,000 in senior convertible promissory notes in three equal installments of $2,000,000 to certain current investors. Interest is compounded monthly at a rate of 6% per annum. With each installment of the Bridge Loan, the Company will issue the Lenders 400,002 warrants to purchase common stock (see Note 6). The three installments were issued in June 2005, August 2005 and October 2005. All installments were outstanding as of December 31, 2005. The maturity date of the Bridge Loan dated June 1, 2005 is June 1, 2006.

If the Company consummates a subsequent round of financing at an aggregate price of $30,000,000 (including outstanding bridge loan) prior to the maturity date, the outstanding principal and accrued interest will automatically convert into the subsequent round securities at the same price and at the same terms per share as such capital stock or equity securities being issued. If the Company does not consummate a subsequent round of financing, the outstanding principal and accrued interest of the notes are payable to the lenders on the maturity date. The maturity date is defined as the earlier of: stated maturity date of the note, the sale or transfer of a majority of the capital stock of the Company, a sale of the corporation or the acceleration of the notes in the event of a default.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

5. Bridge Notes Payable (continued)

In the event that a qualified public offering (see Note 7) occurs prior to a subsequent round of financing at an aggregate price of $30,000,000 (including outstanding bridge loan) or the Lenders holding at least 80% of the outstanding principal amount of the notes consent in writing, the outstanding principal and accrued interest due shall convert into shares of Series D preferred stock. The amount of shares issued will be calculated by dividing the outstanding principal and interest by the current conversion price of the Series D preferred stock.

The outstanding principal and interest payable balances as of December 31, 2005 and 2004 are $14,000,000 and $633,580 and $4,000,000 and $36,629, respectively.

6. Stockholders’ Deficiency

Common Stock

The Company is authorized to issue 25,000,000 shares of common stock. Common stockholders are entitled to one vote for each share held and to receive dividends if and when declared by the Board of Directors. During 2005 and 2004, the Company issued 1,000 and 0 shares, respectively, of common stock. As of December 31, 2005 and 2004, the Company has reserved 23,701,496 and 20,056,344 shares, respectively, of common stock for future issuance for the conversion of preferred stock and the exercise of stock options and warrants.

In connection with the issuance of the Series D Preferred Stock in 2002, the conversion price of the Series C Preferred Stock was decreased from $5.70 to $4.3872; and the number of shares of common stock to be issued upon conversion of the Series C Preferred Stock shall be increased from 2,859,650 to 3,715,359. The Company reserved an additional 855,709 shares of its common stock to the holders of Series C Preferred Stock as well as reserving 250,000 shares of its common stock for issuance to the holders of warrants upon exercise or conversion.

In connection with the Bridge Loan dated October 6, 2004, the Company is authorized to issue up to 1,201,300 warrants and as such has reserved 1,201,300 shares of common stock upon the exercise of the warrants. In connection with the Bridge Loan dated June 1, 2005, the Company is authorized to issue up to 1,200,006 warrants and as such has reserved an additional 1,200,006 shares of common stock upon the exercise of the warrants.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

6. Stockholders’ Deficiency (continued)

Warrants

In January 2002, the Company issued 250,000 warrants to purchase common stock to the holders of the Series C Preferred stock. The warrants are exercisable for a period of five years at an exercise price of $0.80 per share. As required by EITF-00-19, the warrants granted to the holders of the Series C were recorded in the financial statements as equity and are included in additional paid-in capital. The warrants are reviewed on each balance sheet date to determine if the classification as equity is still appropriate. As of December 31, 2005 and 2004 the warrants were valued at $2,500 and all warrants remain outstanding.

In October 2004, December 2004, January 2005 and March 2005 the Company issued 300,297 warrants, in each month, to purchase common stock to the Lenders of the Bridge Loan dated October 6, 2004. The warrants issued with each installment of the Bridge Loan are exercisable until October 6, 2014 at an exercise price of $0.85 per share. As required by EITF-00-19, the warrants were recorded in the financial statements as equity and are included in additional paid-in capital. The warrants are reviewed on each balance sheet date to determine if the classification as equity is still appropriate. As of December 31, 2005 and 2004 the warrants were valued at $144,159 and $54,053, respectively, and all warrants remain outstanding.

In June, August and October 2005 the Company issued 400,002 warrants, in each month, to purchase common stock to the Lenders of the Bridge Loan dated June 1, 2005. The warrants issued with each installment of the bridge loan are exercisable until June 1, 2015 – June 3, 2015 at an exercise price of $0.40 per share. As required by EITF-00-19, the warrants were recorded in the financial statements as equity and are included in additional paid-in capital. The warrants are reviewed on each balance sheet date to determine if the classification as equity is still appropriate. As of December 31, 2005 the warrants were valued at $0 and all warrants remain outstanding.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

6. Stockholders’ Deficiency (continued)

Treasury Stock

In December 2005, an investor surrendered 100,000 shares of Series B Convertible Preferred Stock and 88,500 shares of common stock. Management does not plan to reissue the shares held as Treasury Stock.

7. Redeemable Preferred Stock

The Company has authorized 16,810,375 and issued 12,351,235 shares of preferred stock and has also issued 250,000 warrants to purchase common stock to the holders of Series C Preferred Stock. The warrants were issued to Series C Preferred Stock holders during 2002, at $0.80 per share for five years.

The Company has issued Series C and Series D Redeemable Convertible Preferred Stock and Series A and Series B Preferred Stock (collectively, the “Preferred Stock”). Such stock is subject to the following rights and privileges:


	Voting

	Preferred stockholders are entitled to the number of votes equal to the number of shares of common stock into which each share of Preferred Stock is then convertible. Except for certain corporate matters described in the Company’s Amended and Restated Certificate of Incorporation or as otherwise required by law, the holders of Preferred Stock shall vote together with all other classes and series of stock of the Corporation as a class.

	Dividends

	The Company’s Preferred Stock does not bear a fixed or cumulative dividend. Preferred stockholders shall be entitled to receive dividends at the same rate as dividends are paid with respect to the common stock. Such preferred dividends will be determined by the number of shares of common stock into which each share of Preferred Stock is convertible.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

7. Redeemable Preferred Stock (continued)


	Conversion

	The holders of the outstanding shares of Preferred Stock shall be entitled, at any time, to cause their shares to be converted into common stock on a share-for-share basis. However, if there is a stock dividend, stock split or reverse stock split that takes place before conversion of Preferred Stock, then a new conversion factor would be calculated. This calculation is intended for the Preferred Stockholders to maintain the same equity interest upon conversion into common stock as before the common stock dividend or split.

	The initial conversion price for each series of Convertible Preferred Stock shall be adjusted from time to time in accordance with the agreement. In accordance with the anti-dilution feature in the Series C Preferred Stock, there was a deemed dividend in the year ended December 31, 2002 of $4,877,523.

	The Preferred Stock will convert automatically upon the closing of a Qualified Public Offering of the Company’s common stock in which the aggregate price paid for such shares by the public shall be at least $25,000,000 and the price per share paid by the public shall be at least $13.3332 per share.

	The holders of any share or shares of Preferred Stock shall have the right, at its option at any time, to convert any shares of Preferred Stock into shares of Common Stock.

	Mandatory Redemption

	Commencing on January 29, 2007 and on each of the next two anniversaries thereafter, the Company shall redeem, to the extent that it shall have funds legally available therefore, any outstanding shares of Series D Preferred Stock and Series C Preferred Stock according to the percentages listed below:

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

7. Redeemable Preferred Stock (continued)


Date of Redemption	Percentages of Shares of Series C Preferred Stock Then Outstanding to be Redeemed


January 29, 2007	33-1/3% of all the shares of Series D Preferred Stock and Series C Preferred Stock outstanding on January 29, 2007
January 29, 2008	50% of all the shares of Series D Preferred Stock and Series C Preferred Stock outstanding on January 29, 2008
January 29, 2009	100% of all the shares of Series D Preferred Stock and Series C Preferred Stock outstanding on January 29, 2009


	The shares of Series D Preferred Stock and Series C Preferred Stock shall be redeemed for cash at the redemption price of $3.3333 and $5.70 per share, respectively, plus an amount equal to all dividends declared but unpaid.

	The carrying amount of the Series C and Series D redeemable convertible preferred stock has been increased by periodic accretions so as to equal the redemption amounts at the respective dates. The future minimum accretions of the Series C and Series D redeemable convertible preferred stock based on the shares outstanding as of December 31, 2005 is as follows:


	Accretion of Redeemable Convertible Preferred Stock


2006		$	41,439
2007			41,439
2008			41,439

Total accretion		$	124,317


	Liquidation

	In the event of any liquidation, dissolution, or winding up (either voluntary or involuntary) of the Company, (the consolidation or merger of the Company with or into another entity, or the sale, lease, abandonment, transfer or other disposition by the Company of all or substantially all of its assets, shall be deemed to be a liquidation,

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

7. Redeemable Preferred Stock (continued)


	dissolution or winding up of the Company) the holders of the Preferred Stock are entitled to receive, prior to and in preference to the holders of common stock or any other capital stock of the Company ranking on liquidation junior to the Preferred Stock, an amount equal to $1.00, $3.00, $5.70 and $3.3333, respectively, for each outstanding share of Series A, B, C and D Preferred Stock, plus any and all accrued and unpaid dividends as of the date of liquidation (collectively, the “Series A, B, C and D Liquidation Preference”).

	In the event that the assets of the Company to be distributed are less than the Series A, B, C and D Liquidation Preference, then the assets of the Company shall be paid to the Series A, B, C and D preferred stockholders in the following priority: (i) to the Series D preferred stockholders; (ii) to the Series C preferred stockholders; (iii) to the Series A preferred stockholders; and (iv) to the Series B preferred stockholders.

After payment in full of the Series A, B, C, and D Liquidation Preference, the remaining net assets of the Company shall be distributed ratably to the holders of common stock and holders of Preferred Stock as if the holders of Preferred Stock had converted their shares into common stock immediately prior to the liquidation; provided that the amount payable in liquidation (including the applicable Liquidation Preference) to each series of Preferred Stock shall not exceed the greater of (i) the amount each share of such series would receive if it had been converted to common stock immediately prior to the liquidation, dissolution or winding up, and (ii) $2.50 per share for the Series A, $7.50 per share for the Series B, $14.25 per share for the Series C and $8.333 per share for the Series D; and provided further that in the event the Company obtains at least $30,000,000 in an equity financing where the price per share is at least $10.00, then after the holders of Preferred Stock shall be paid in full the greater of (x) the applicable Liquidation Preference and (y) the amount each share of such Preferred Stock would receive if it had converted to common stock immediately before such liquidation, dissolution or winding up, the remaining net assets of the Company shall be distributed ratably among the holders of common stock.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

8. Income Taxes

Due to operating losses, the Company has no current federal or state income tax liability for the years ended December 31, 2005 and 2004. The components of the income tax benefit for the years ended December 31, 2005 and 2004 are:


	December 31
	2005			2004

Federal income taxes:
Current expense	$	—		$	—
Deferred expense		—			—
State income taxes:
Current benefit		(333,660	)		(395,642	)
Deferred expense		—			—

Income tax benefit	$	(333,660	)	$	(395,642	)

During 2005 and 2004, the Company sold unused state net operating loss carryforwards through a program sponsored by the State of New Jersey and the New Jersey Economic Development Authority. Cash proceeds of $333,660, net of fees of $9,321, were received by the Company in 2005. Cash proceeds of $395,642, net of fees of $11,051, were received by the Company in 2004.

At December 31, 2005, the Company has a net operating loss carryforward for federal income tax purposes of approximately $57,019,000 which expires as follows: $27,000 in 2018, $470,000 in 2019, $2,369,000 in 2020, $7,796,000 in 2021, $13,718,000 in 2022, $10,250,000 in 2023, $13,340,000 in 2024 and $9,049,000 in 2025. The Company also has a research and development tax credit for federal income tax purposes of approximately $2,018,000, which expires between 2019 and 2025. The Company has not performed a detailed analysis to determine whether an ownership change under Section 382 of the Internal Revenue Code has occurred. The effect of an ownership change would be the imposition of an annual limitation on the use of net operating loss carryforwards attributable to periods before the change in ownership.

Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets for federal and state income taxes are as follows:

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

8. Income Taxes (continued)


	December 31
	2005			2004


Deferred tax assets – non-current:
Future tax benefits of NOL carryforwards	$	22,559,117		$	18,706,191
Future tax benefit of research and development tax credit carryforwards		2,018,134			1,758,011
Future tax benefit – other items		(6,020	)		22,400

Gross deferred tax assets		24,571,231			20,486,602
Valuation allowance		(24,571,231	)		(20,486,602	)

Net deferred tax assets	$	—		$	—

Reconciliation of the U.S. statutory income tax rate to our effective tax rate for continuing operations is as follows:


Percentages	2005			2004


U.S. statutory rate		(34.0	)%		(34.0	)%
State taxes		(6.0	)		(6.0	)
Research and development credit		(4.9	)		(6.0	)
Other		(1.9	)		3.0
Change in valuation allowance		43.3			40.1

Effective tax benefit rate		(3.5	)%		(2.9	)%

In 2005 and 2004, the Company recorded valuation allowances to offset the benefits of net operating losses, research and development tax credits, and other tax benefit items generated during those years. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The valuation allowance increased $4,084,629 and $5,493,360 during 2005 and 2004, respectively.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

9. Stock Options

The Company has two stock option plans (the “Plans”). In accordance with the Plans, the Company reserved up to 2,700,000 shares of common stock to be issued. The term of each stock option grant is generally 10 years from the date of grant. Vesting is determined by the Company’s Board of Directors and generally occurs over a period of not greater than five years.

During the years ended December 31, 2005 and 2004, and the period from February 4, 1998 to December 31, 2005, in connection with the grant of stock options to employees, the Company recorded no deferred employee stock compensation as all employee options were issued with an exercise price equal to the deemed fair value.

In December 2004, the Company’s Board of Directors approved a change to all previously issued and outstanding options to provide an additional two years of vesting in the event of a change of control. Additionally, in February 2005 the Company’s Board of Director’s approved a “double-trigger” for all of the senior management teams options. The “double trigger” allows for full vesting of the options granted to the senior management team in specific circumstances when a change of control has occurred. As required by FASB Interpretation 44—Accounting for Certain Transactions involving Stock Compensation—an interpretation of APB Opinion No. 25, the Company performed an analysis to determine if an additional charge to compensation expense would be required for the change in intrinsic value from the date of grant to the date of the modification to the outstanding stock option awards. Based upon the analysis performed no additional expense was necessary.

During the years ended December 31, 2005 and 2004 and the period from February 4, 1998 to December 31, 2005, in connection with the grant of certain stock options to non-employees, the Company recorded stock compensation expense of $1,821, $418 and $164,735, respectively. Deferred stock compensation expense to non-employees is determined by utilizing the Black-Scholes pricing model as required by SFAS 123 with the following weighted-average assumptions for 2005 and 2004, respectively: risk-free interest rate of 4.4% and 4.6%, dividend yield of 0% in each period; annualized historical volatility of 80.0% in each period.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

9. Stock Options (continued)

The minimal value pricing model is similar to the Black-Scholes option valuation model which was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable, except that it excludes the factor for volatility. In addition, option valuation models require the input of highly subjective assumptions. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

A summary of the Company’s stock option activity and related information for the years ended December 31, 2005 and 2004 follows:


	2005					2004

	Options			Weighted- Average Exercise Price		Options			Weighted- Average Exercise Price


Outstanding, beginning of year		2,529,196		$	0.76		1,806,946		$	0.74
Granted		41,200			0.21		806,900			0.84
Exercised		(1,000	)		0.80		—			0.00
Expired/cancelled		(440,341	)		0.81		(84,650	)		0.92

Outstanding, end of year		2,129,055		$	0.74		2,529,196		$	0.76


Exercisable, at end of year		1,461,349		$	0.70		1,089,846		$	0.67


Weighted-average fair value of options granted during the year	$	0.14				$	0.56


Weighted-average remaining contractual life		6.5 yrs					7.9 yrs

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

9. Stock Options (continued)

Stock options outstanding at December 31, 2005 are summarized as follows:


Range of Exercise Prices		Outstanding Options at December 31, 2005		Weighted- Average Remaining Contractual Life		Weighted- Average Exercise Price


$	0.01 – 0.21		129,533		3.5 yrs	$	0.11
	0.45 – 0.85		1,894,986		6.8 yrs		0.75
	0.90 – 1.40		104,536		4.6 yrs		1.38

10. Employee Savings Plan

Effective January 1, 2000, the Company implemented a 401(k) savings plan covering substantially all employees of the Company. The Company began contributing to the 401(k) savings plan in 2003. Total Company contribution in 2005 and 2004 and for the period from February 4, 1998 (inception) to December 31, 2005 was $20,000, $10,000 and $38,880, respectively. Total plan administration expenses recorded by the Company for the years ended December 31, 2005 and 2004 and for the period from February 4, 1998 (inception) to December 31, 2005 were $0, $900 and $5,525, respectively.

11. Reduction in Headcount

In August 2005, as a result of the failed clinical trial of one of the Company’s therapeutic agents and the failure to raise additional funds, the Company initiated a reduction in headcount. The reduction was designed to reduce unnecessary overhead. As part of the reduction in headcount each employee was given one month notice that their position was being eliminated. After their position was eliminated each employee was given one month severance and, if they signed a Release from Liability, they were given an extra two weeks of pay. If an employee had an employment agreement which had a longer severance period the employee was paid the amount of severance outlined in the employment agreement. In 2005, all costs associated with the reduction in headcount were accrued and as of December 31, 2005, the Company has a remaining liability of $6,768. Total severance costs in 2005 approximated $292,200.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

12. Acquisition Bonus Plan

In August 2005, the Board approved the Acquisition Bonus Plan. The plan is designed to provide an incentive bonus to key employees and advisors upon the sale of the Company or the license of its major assets. The plan provides for a Minimum Stay Bonus to be paid to the key employees in the event the Company does not enter into a transaction for the sale or license of its assets. The Minimum Stay Bonus is to be paid on two increments within 15 days of March 1, 2006 and June 30, 2006 and provides that one half of the Minimum Stay Bonus be put into an escrow account which was used for the March 1, 2006 payment. At December 31, 2005, the Company has recorded an accrual for the Minimum Stay Bonus, net of advances (see Note 13), of $281,008.

13. Related Party Transactions

Two of the Board members provide consulting services to the Company in exchange for a monthly fee, common stock, or stock options. Compensation paid for these consulting fees was approximately $0, $0 and $310,569 for the years ended December 31, 2005 and 2004 and for the period from February 4, 1998 (inception) to December 31, 2005, respectively.

In December 2005, the Company paid an advance of the Minimum Stay Bonus to the key employees of $86,400. The advance was equal to 20% of one half of the Minimum Stay Bonus which was paid on March 1, 2006. The advance was payable back to the Company if the employee failed to remain an employee as of March 1, 2006. As of December 31, 2005, the Company has recorded the advances to offset the accrual.

14. Co-employment Agreement with ADP TotalSource

On August 1, 2005 the Company entered into a Co-employment Agreement with ADP TotalSource (“ADP”), whereby the Company’s employees became the employees of ADP and ADP provided benefits to the employees, the costs of which were charged back to the Company. All payroll and benefits, except the Company’s 401K plan, are provided through ADP. The agreement can be cancelled by either party within 30 days with written notice or immediately with cause.

Vela Pharmaceuticals Inc.
(A Development Stage Enterprise)

Notes to Financial Statements (continued)

15. Subsequent Events

Sale of the Company

On March 14, 2006, the Company entered into a definitive agreement with Pharmos Corporation (“Pharmos”) to sell all of the Company’s rights and assets for cash and shares of common stock. The sale transaction includes an initial payment of $5 million in cash and the issuance of 11.5 million shares of Pharmos common stock for a combined value of approximately $29.7 million. The transaction also includes the issuance of up to 8 million additional Pharmos common stock shares contingent on achieving specific clinical milestones. No adjustments have been made to these financial statements as a result of this transaction.

PHARMOS AND VELA
UNAUDITED PRO FORMA CONDENSED
COMBINED FINANCIAL STATEMENTS

The following unaudited pro forma condensed combined financial statements are based on the historical financial statements of Pharmos Corp. (Pharmos) and Vela Pharmaceuticals Inc. (Vela) and have been prepared to illustrate the effects of the Pharmos acquisition of Vela announced on March 15, 2006. The following data is presented as if the merger of Pharmos and Vela was effective as of December 31, 2005 for the unaudited pro forma condensed combined balance sheet, and as of January 1, 2005 for the unaudited condensed combined statement of operations. This unaudited condensed combined pro forma financial information reflects the purchase method of accounting and represents a current estimate of the financial information based on available information from Pharmos and Vela.

The pro forma information includes adjustments to record the assets and liabilities of Vela at their estimated fair market values and is subject to adjustment as additional information becomes available and as additional analyses are performed. To the extent there are significant changes to Vela’s business, the assumptions and estimates herein could change significantly. The pro forma financial information is presented for illustrative purposes only under one set of assumptions and does not reflect the financial results of the combined companies had consideration been given to other assumptions or to the impact of possible operating efficiencies, asset dispositions, and other factors. Further, the pro forma financial information does not necessarily reflect the historical results of the combined company that actually would have occurred had the merger been in effect during the periods indicated or that may be obtained in the future. The unaudited pro forma condensed combined financial statements should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the historical financial statements, including the related notes, of Pharmos and Vela covering these periods included either in Pharmos’ Annual Report on Form 10-K for the fiscal year ended December 31, 2005, which is included in the Annual Report accompanying this proxy statement, or in this proxy statement.

The unaudited pro forma condensed combined financial information is based on agreement terms that provide for a cash payment of $5,000,000, to or on behalf of Vela, and the exchange of 11,500,000 shares of Pharmos common stock for all outstanding shares of Vela capital stock. An additional 8,000,000 shares of Pharmos common stock may be issued contingent upon the achievement of certain clinical milestones.

UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET

As of December 31, 2005


	Pharmos		Vela		Pro Forma Adjustments				Condensed Combined Pro Forma

Assets
Current Assets
Cash and cash equivalents	$	10,289,127	$	1,786,935	$	(1,786,935	)	E	$	3,239,127
						(5,000,000	)	B
						(2,050,000	)	C
Short-term investments		35,748,343		—		—				35,748,343
Restricted cash		79,527		345,600		(345,600	)	E		79,527
Research and development grants receivables		734,237		—		—				734,237
Prepaid expenses and other current assets		543,109		33,229		(1,117	)	E		575,221
Debt issuance costs		—		22,628		(22,628	)	F		—

Total current assets		47,394,343		2,188,392		(9,206,280	)			40,376,455

Fixed assets, net		742,860		138,246		(128,246	)	G		752,860
Restricted cash		62,874		—		—				62,874
Severance pay funded		772,199		—		—				772,199
Other assets		18,496		11,997		—				30,493

Total assets	$	48,990,772	$	2,338,635	$	(9,334,526	)		$	41,994,881

UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET

As of December 31, 2005


	Pharmos		Vela		Pro Forma Adjustments					Condensed Combined Pro Forma

Liabilities and Shareholders’ Equity
Accounts payable	$	519,404	$	106,091	$	(6,091	)		H	$	619,404
Accrued expenses		575,222		225,187		(225,187	)		H		575,222
Warrant liability		38,880		—		—					38,880
Accrued wages and other compensation		1,497,781		—		—					1,497,781
Accrued bonuses		—		281,008		(281,008	)		H		—
Bridge notes payable		—		14,000,000		(14,000,000	)		D		—
Accrued interest payable		—		633,580		(633,580	)		D		—
								&n


	Stockholders’ Deficiency

	Series A Convertible Preferred Stock				Series B Convertible Preferred Stock				Common Stock				Additional Paid-in Capital			Accumulated Other Comprehensive Income		Deficit Accumulated During Development Stage			Treasury Stock		Total Stockholders’ Deficiency

	Shares		Amount		Shares		Amount		Shares		Amount

Balance at February 4, 1998 (Inception)		—	$	—		—	$	—		—	$	—	$	—		$	—	$	—		$	—	$	—
Issuance of common shares in exchange for services, March 1998		—		—		—		—		530,000		530		4,770			—		—			—		5,300
Issuance of common shares in exchange for patent rights, March 1998		—		—		—		—		250,000		250		2,250			—		—			—		2,500
Issuance of common shares in exchange for services, April 1998		—		—		—		—		12,000		12		108			—		—			—		120
Net loss for the period		—		—		—		—		—		—		—					(198,680	)		—		(198,680	)

Balance at December 31, 1998		—		—		—		—		792,000		792		7,128			—		(198,680	)		—		(190,760	)
Issuance of common shares in exchange for services, January 1999		—		—		—		—		5,000		5		45			—		—			—		50
Issuance of common shares in exchange for cash, February 1999		—		—		—		—		202,500		202		20,048			—		—			—		20,250
Issuance of common shares in exchange for services, June 1999		—		—		—		—		75,000		75		675			—		—			—		750
Issuance of common shares in exchange for cash and services, September 1999		—		—		—		—		5,588		6		1,112			—		—			—		1,118
Issuance of Series A preferred in exchange for cash, July - December 1999		1,146,916		1,147		—		—		—		—		1,121,447			—		—			—		1,122,594
Issuance of Series B preferred in exchange for cash, December 1999		—		—		173,000		173		—		—		506,516			—		—			—		506,689
Conversion of note payable with interest to Series A Preferred, September 1999		289,735		290		—		—		—		—		289,445			—		—			—		289,735
Amortization of deferred stock compensation		—		—		—		—		—		—		8,179			—		—			—		8,179
Net loss for the year (restated)		—		—		—		—		—		—		—					(549,955	)		—		(549,955	)

Balance at December 31, 1999 (restated)		1,436,651		1,437		173,000		173		1,080,088		1,080		1,954,595			—		(748,635	)		—		1,208,650
Issuance of common shares in exchange for services, March 2000		—		—		—		—		10,500		11		4,714			—		—			—		4,725
Issuance of common shares in exchange for services, April 2000		—		—		—		—		6,500		6		2,919			—		—			—		2,925
Issuance of common shares in exchange for patent rights, April 2000		—		—		—		—		5,000		5		2,245			—		—			—		2,250
Issuance of common shares in exchange for services, June 2000		—		—		—		—		8,000		8		4,792			—		—			—		4,800
Issuance of common shares in exchange for services, September 2000		—		—		—		—		10,500		11		12,589			—		—			—		12,600
Issuance of Series B preferred in exchange for cash, March - June 2000		—		—		381,859		382		—		—		1,129,133			—		—			—		1,129,515
Amortization of deferred stock compensation		—		—		—		—		—		—		79,545			—		—			—		79,545
Issuance of common shares for exercise of stock options, December 2000		—		—		—		—		26,667		26		3,974			—		—			—		4,000
Net loss for the year		—		—		—		—		—		—		—			—		(2,591,658	)		—		(2,591,658	)

Balance at December 31, 2000 (restated)		—		—		554,859		555		1,147,255		1,147		3,194,506			—		(3,340,293	)		—		(142,648	)
Issuance of common shares in exchange for services, January 2001		—		—		—		—		4,500		5		6,295			—		—			—		6,300
Issuance of common shares in exchange for services, April 2001		—		—		—		—		4,500		4		6,296			—		—			—		6,300
Issuance of common shares in exchange for services, July 2001		—		—		—		—		4,500		5		6,295			—		—			—		6,300
Issuance of common shares in exchange for services, October 2001		—		—		—		—		4,500		4		6,296			—		—			—		6,300
Amortization of deferred stock compensation		—		—		—		—		—				63,600			—		—			—		63,600
Issuance of common shares for exercise of stock options at $0.45/share, December 2001		—		—		—		—		30,333		31		13,619			—		—			—		13,650
Issuance of common shares for exercise of stock options at $1.40/share, December 2001		—		—		—		—		1,200		1		1,679			—		—			—		1,680
Net loss for the year		—		—		—		—		—		—		—			—		(8,836,840	)		—		(8,836,840	)

Balance at December 31, 2001		1,436,651		1,437		554,859		555		1,196,788		1,197		3,298,586			—		(12,177,133	)		—		(8,875,358	)
Issuance of common shares in exchange for services, January 2002		—		—		—		—		4,500		4		3,596			—		—			—		3,600
Issuance of common shares in exchange for services, April 2002		—		—		—		—		7,000		7		5,593			—		—			—		5,600
Issuance of common shares in exchange for services, July 2002		—		—		—		—		4,500		4		3,596			—		—			—		3,600
Issuance of common shares in exchange for services, October 2002		—		—		—		—		4,500		5		3,595			—		—			—		3,600
Issuance of common shares in exchange for services, December 2002		—		—		—		—		4,500		4		3,596			—		—			—		3,600
Deemed dividend		—		—		—		—		—		—		—			—		(4,877,523	)		—		(4,877,523	)
Amortization of deferred stock compensation		—		—		—		—		—		—		7,840			—		—			—		7,840
Accretion of mandatorily redeemable preferred stock		—		—		—		—		—		—		(53,563	)		—		—			—		(53,563	)
Issuance of shares for exercise of stock options at $1.20/per share, March 2002		—		—		—		—		33,750		34		40,466			—		—			—		40,500
Issuance of shares for exercise of stock options at $1.40/per share, March 2002		—		—		—		—		200		—		280			—		—			—		280
Issuance of shares for exercise of stock options at $0.45/per share, June 2002		—		—		—		—		8,000		8		3,592			—		—			—		3,600
Issuance of shares for exercise of stock options at $1.40/per share, June 2002		—		—		—		—		600		1		839			—		—			—		840
Issuance of shares for exercise of stock options at $0.20/per share, December 2002		—		—		—		—		11,666		12		2,321			—		—			—		2,333
Comprehensive (loss) income:		—		—		—		—		—		—		—			—		—			—		—
Unrealized gain on marketable securities		—		—		—		—		—		—		—			3,286							3,286
Net loss		—		—		—		—		—		—		—			—		(12,487,160	)		—		(12,487,160	)

Total comprehensive loss		—		—		—		—		—		—		—			—		—			—		(12,483,874	)

Balance at December 31, 2002		1,436,651		1,437		554,859		555		1,276,004		1,276		3,320,337			3,286		(29,541,816	)		—		(26,214,925	)

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