ARQULE, INC.
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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal Year Ended December 31, 2003

Commission File Number: 000-21429

ArQule, Inc.
(Exact name of Registrant as Specified in Its Charter)
     
Delaware
  04-3221586
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)

19 Presidential Way, Woburn, Massachusetts 01801

(Address of principal executive offices including zip code)

Registrant’s telephone number, including area code:

(781) 994-0300

Securities registered pursuant to Section 12(b) of the Act:

     
(Title of Each Class) Name of Each Exchange on Which Registered


None
  None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.01 Par Value

      Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ          No o

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes þ          No o

      The aggregate market value of voting and non-voting common stock held by non-affiliates of the registrant as of June 30, 2003 was: $96,584,484.

      There were 28,731,288 shares of the registrant’s Common Stock outstanding as of March 1, 2004.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the definitive proxy statement for the Registrant’s Annual Meeting of Shareholders to be held on May 19, 2004, which definitive proxy statement will be filed with the Securities and Exchange Commission not later that 120 days after the registrant’s fiscal year end of December 31, 2003, are incorporated by reference into Part III of the Form 10-K.




TABLE OF CONTENTS

PART I
Item 1. Business
Item 1A. Executive Officers and Directors of the Registrant
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
PART II
Item 5. Market for the Registrant’s Common Stock and Related Stockholder Matters
Item 6. Selected Financial Data
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Consolidated Financial Statements and Supplementary Data
Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosures
Item 9A. Controls and Procedures
PART III
PART IV
Item 15. Exhibits, Financial Statement Schedule, and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX
AMENDED AND RESTATED R&D LICENSE AGREEMENT
R&D AGREEMENT DATED 11/11/1997
TERMINATION AGREEMENT DATED 6/30/2000
EMPLOYMENT AGREEMENT/ STEPHEN A. HILL/ 1/1/2004
EMPLOYMENT AGREEMENT/ J. DAVID JACOBS/ 1/1/2004
EMPLOYMENT AGREEMENT/ LOUISE MAWHINNEY/ 1/1/2004
AMENDMENT TO COLLABORATION AGREEMENT/ 2/12/2004
SUBSIDIARIES OF THE COMPANY
CONSENT OF PRICEWATERHOUSE COOPERS LLP
SEC 302 CERTIFICATION OF CEO
SEC 302 CERTIFICATION OF CFO
SEC 906 CERTIFICATION OF CEO AND CFO


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IMPORTANT FACTORS REGARDING FORWARD-LOOKING STATEMENTS

      You should carefully consider the risks described below together with all of the other information included in this Form 10-K before making an investment decision. An investment in our common stock involves a high degree of risk. We operate in a dynamic and rapidly changing industry that involves numerous uncertainties. The risks and uncertainties described below are not the only ones we face. Other risks and uncertainties, including those that we do not currently consider material, may impair our business. If any of the risks discussed below actually occur, our business, financial condition, operating results or cash flows could be materially adversely affected. This could cause the trading price of our common stock to decline, and you may lose all or part of your investment.

      This Form 10-K contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. All statements that are not descriptions of historical fact are forward-looking statements, based on estimates, assumptions and projections that are subject to risks and uncertainties. These statements can generally be identified by use of forward looking terminology such as “believes”, “expects”, “intends”, “may”, “will”, “should”, “anticipates” or similar terminology. Although we believe that the expectations reflected in such forward looking statements are reasonable as of the date thereof, such expectations are based on certain assumptions regarding the progress of product development efforts under collaborative agreements, the execution of new collaborative agreements and other factors relating to our growth. Such expectations may not materialize if product development efforts, including any necessary trials of our potential drug candidates, are delayed or suspended, if positive early results are not repeated in later studies or in humans, if planned acquisitions or negotiations with potential collaborators are delayed or unsuccessful, if we are unsuccessful at integrating acquired assets or technologies, if our planned transition to a drug discovery and development company takes longer or is more expensive than we anticipated or if other assumptions prove incorrect. The forward-looking statements contained herein represent the judgment of ArQule as of the date of this Form 10-K. ArQule disclaims any intent or obligation to update any forward-looking statement except to the extent required by law.

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PART I

 
Item 1. Business

Business Overview

      We are a biotechnology company engaged in the research and development of small molecule cancer therapeutics based on a novel biological approach to cancer, our Activated Checkpoint TherapySM (ACTSM) platform, and our expertise in small molecule chemistry and intelligent drug design.

      Our company was incorporated in Delaware in 1993, and completed a public offering in 1996. Since inception, we have provided fee-based services to pharmaceutical companies and biotechnology companies, using our chemistry based technology and expertise to attract collaborators. We have an experienced and highly qualified scientific and management team that can apply our chemistry technology platform to produce compounds that have medicinal attributes. We continue to provide fee-based services to our collaborators. We also use our chemical technology capabilities in our cancer drug discovery programs.

      On September 8, 2003, we acquired Cyclis Pharmaceuticals, Inc. (“Cyclis”), an early stage cancer therapeutics company. This acquisition enabled us to continue our transition to a drug discovery and development company in accordance with our stated strategy. The Cyclis acquisition provided us with the proprietary ACTSM platform, an oncology discovery pipeline and ARQ 501, which is now in Phase 1 clinical trials. We believe that the ACTSM approach to anti-cancer therapies offers the potential to deliver clinical candidates with improved activity and reduced toxicity over many other molecular approaches and traditional therapies.

Cyclis Acquisition

      In connection with our acquisition of Cyclis, we issued approximately 4.6 million shares of common stock (valued at $18.8 million), paid cash of $5 million and forgave notes receivable of $0.5 million. We incurred consulting, legal, accounting and other third-party costs of approximately $1.6 million in order to complete the transaction. These costs were accounted for as part of the acquisition, and capitalized, resulting in a total purchase price of $25.9 million.

ArQule’s Approach to Cancer — Activated Checkpoint TherapySM Platform

      Our ACTSM platform is an approach to cancer therapy that is intended to use small molecule drugs to restore and activate cellular checkpoints that are defective in cancer cells, and that, once activated, will cause the cancer cells to undergo programmed cell death.

      The cells in the human body usually grow, divide and die so that the body always has the number of each different type of cells necessary to support a healthy existence. Cell division is controlled through a series of molecular events called the cell cycle. The cell cycle is designed to ensure that cell division proceeds accurately, so that each daughter cell receives the appropriate cellular DNA and other subcellular machinery.

      The cell cycle has several built in “checkpoints,” during which quality-control mechanisms operate to ensure that each step of the cycle is completed correctly. For example, in a normal cell, checkpoint functions monitor for damage to the cellular DNA. If damage is detected, the cell attempts to repair the damage. If the DNA damage is too severe, the cell undergoes programmed cell death. Thus, a cellular checkpoint is a natural defense mechanism that ensures the genomic integrity of the cells in the body by eliminating damaged cells.

      Cancer cells, with multiple abnormalities including DNA damage, survive and proliferate because key checkpoints and pathways that should lead to cell death are often disabled during the development of cancer. As a result, cancer cells undergo cell division in an uncontrolled way.

      Our ACTSM platform is based on our current understanding that a therapeutic agent which reactivates the quality control, or checkpoint functions of a cell, has the potential to re-enable the cell to detect and respond to DNA damage. Because cancer cells contain genes relating to tumor formation (activated oncogenes) and irreparable DNA damage, we believe that restoration of their checkpoint functions will result in such cells

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undergoing cell death. In addition to the effect checkpoint activation has in cancer cells, the absence of adverse effect in normal cells is also important. Normal, healthy cells have little DNA damage compared with cancer cells. Consequently, when a checkpoint is activated in a healthy cell, we do not expect to see cell death. In other words, since non-cancer cells are genetically normal, they are more likely to be spared even if exposed to the same checkpoint-activating stimulus as the cancer cell.

      We believe therapeutics based on the ACTSM approach will be more effective and less toxic that traditional cancer therapies due to their ability to selectively cause cancer cells to undergo cell death, while leaving healthy cells unaffected. This is in contrast to conventional chemotherapy which seeks to kill cancer cells by creating further damage to DNA. A well-known side effect of this approach is that some normal cells are indiscriminately damaged, causing toxicity to patients and limiting the effectiveness of chemotherapy. Furthermore, because checkpoint functions are virtually the same in different cell types, and because many cancers have checkpoint defects, we believe that therapeutics developed using the ACTSM platform will be effective against a broad spectrum of cancers and will counteract the variable genetic makeup of cancer cells.

RESEARCH & DEVELOPMENT PIPELINE

Oncology Portfolio

      Our oncology portfolio, based on the ACTSM platform, consists of four programs that we obtained through our acquisition of Cyclis. The first two seek to target and elevate E2F, a protein related to cellular checkpoint and cell death. The third and fourth involve different targets and mechanisms related to checkpoints and cell death pathways, namely Cancer Survival Proteins (CSPs) and p53.

 
E2F Modulation — ARQ 501

      ARQ 501 entered Phase 1 clinical trials in September 2003 and is our first clinical-stage compound.

      Preclinical findings. ARQ 501 is aimed at causing rapid and sustained elevation in the checkpoint regulatory protein E2F1. Based on preclinical findings, we believe that ARQ 501 has the potential for improved activity and reduced toxicity over other molecular approaches and traditional cancer chemotherapy. In preclinical studies, ARQ 501 activated E2F-mediated checkpoints leading to selective cell death of cancer cells. The compound has demonstrated anti-cancer activity in mice when applied as both a single agent and in combination with chemotherapy. In contrast to its selectivity for tumor cells over normal cells, ARQ 501 is active against tumor cells with a broad range of genetic defects. We believe this is particularly advantageous for treatment of solid tumors, where individual tumor masses are comprised of highly heterogeneous cancer cells.

      Ongoing Phase 1 study. Our Phase 1 (monotherapy) dose-escalation study in patients with advanced solid tumors is currently underway at the Dana-Farber/ Harvard Cancer Center in three Boston hospitals: Dana-Farber Cancer Institute, Massachusetts General Hospital and Beth Israel Deaconess Medical Center. The objectives of this study are to determine the safety profile (clinical tolerability) of ARQ 501 and a recommended dose to be used in Phase 2 clinical trials. Study subjects receive ARQ 501 as a one-hour intravenous infusion on a weekly schedule. Tumor response is assessed by imaging after eight weeks of therapy. To date, the treatment dose has been safely escalated toward our pre-determined dose limit while treating a single patient at a time. Once we safely reach our pre-determined dose limit in the single patient study, groups (or cohorts) of three patients each will be enrolled for further dose escalation.

      Other clinical development plans. Based on the results of our preclinical tests, which have shown ARQ 501 to be active against a large number of solid and hematological (bloodstream) tumors, we intend to investigate ARQ 501 in solid tumors both as a single agent and in combination therapy, and in hematologic tumors initially as a single agent.

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E2F Modulation — 550 series

      Applying our platform in small molecule chemistry and intelligent drug design to our 550 series program, we are developing analogues and derivatives of ARQ 501. These new compounds are also aimed at modulating E2F. We have identified several such compounds and we are currently working to optimize these leads for further development by designing and selecting the version of a given lead compound that has the most advantageous set of drug-like characteristics possible.

 
Cancer Survival Protein Modulation — 650 series

      In our Cancer Survival Protein (“CSP”) program, we are developing compounds aimed at blocking cellular survival mechanisms that cancer cells possess and, thereby, selectively triggering cell death in such cancer cells. CSPs are certain proteins, including cytosolic and nuclear proteins, that are inappropriately elevated to excessive levels in cancer cells. In an animal model of cancer, our scientists have explored the feasibility of safely and effectively treating cancer by blocking the activity of cancer cell survival proteins with small molecule compounds. We believe we have discovered a mechanism and a proprietary series of compounds. Work is underway to advance this series of compounds to select a clinical candidate. While the potential outcome is expected to be similar (namely selective cell death), the targets, mechanism of action and chemistry involved in the 650 series are all different from those involved in the 501 and 550 programs.

 
p53 Modulation (PUMA)

      In our p53 Modulation (PUMA) program, we are validating the newly discovered intracellular protein PUMA (“p53-Upregulated Modulator of Apoptosis”) as a target for treating cancer. p53, is a protein that controls several key cell cycle checkpoints. In normal cells, when p53 is present in sufficient amounts, the PUMA protein is produced. When PUMA is produced, it rapidly induces cell death in cancer cells. In human cancer, however, the gene that expresses the p53 protein is a commonly mutated gene. The result of this mutation is that the p53 protein is either not functional, or not produced in sufficient amounts to perform its checkpoint-related functions, including the production of PUMA. In our PUMA program, we are researching a potential way to restore normal function to the p53/ PUMA pathway by inducing the production of PUMA. We are now developing cancer specific PUMA modulators. This program involves a different, but potentially equally important, checkpoint pathway to cell death, which may have application to certain types of cancer.

Other Portfolio Programs

      We have two internal drug discovery programs outside of our cancer focus, each of which were developed using our chemistry based drug discovery technology platform. In order to focus on our cancer programs, we are currently exploring opportunities to out-license both of these programs.

 
Inflammation — ARQ 101, a p38 MAP Kinase inhibitor for Rheumatoid Arthritis

      In November 2003, we commenced GLP-toxicity studies with our lead compound, ARQ 101, a p38 MAP Kinase inhibitor for rheumatoid arthritis. Throughout 2003, we had progressed several compounds through advanced lead optimization demonstrating functional oral activity in a rat model of rheumatoid arthritis. In this established animal model, the data indicated that our compounds reduced joint swelling in a dose-dependent manner and were well tolerated at all doses studied.

 
Pain — Ion Channels

      ArQule’s pain program involves the N-type Calcium channel for neuropathic pain. In the first quarter of 2003, we generated lead compounds with activity against the N-type Calcium channel and identified three families of chemicals. In the second half of 2003, in connection with our shift in resources to our oncology based programs, we held up this program just prior to beginning optimization work on the lead compounds.

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BUSINESS STRATEGY

Overview

      Our business strategy aims to balance revenues from our chemistry services with our cancer drug discovery and development. Our specific goals for the near future are as follows:

  •  Complete phase 1 clinical trials of ARQ 501.
 
  •  Accelerate the preclinical work on our ARQ 550, ARQ 650 and PUMA programs.
 
  •  Out-license ARQ 101 for rheumatoid arthritis and our series of lead compounds for the N-type Calcium Channel for neuropathic pain.
 
  •  Continue to execute our chemical technologies contracts efficiently on a cash flow positive basis.

Drug Discovery And Development Strategy

      Our strategy for developing compounds into commercial products has the following components:

      Focus on Cancer, a market with a large unmet need. Cancer is the second most common cause of death in the Western world. Estimates for 2003 suggest that approximately 1.2 million new cases of invasive cancer will be diagnosed annually in the United States. Medical therapy has evolved as an alternative to or adjunct of surgery including the introduction of cytotoxic chemotherapy and radiation over 50 years ago. While chemotherapies have evolved, they are still harmful to all rapidly dividing cells. More recently, a number of alternative therapies that are target specific have been introduced. We believe that our approach has the potential to be both more selective for cancer cells than traditional chemotherapies and applicable to a broad spectrum of cancers.

      Pursue clinical development to take advantage of available accelerated regulatory approval opportunities. Cancer compounds have been eligible for accelerated regulatory approval. On average, three new oncology agents have been approved per year over the past 14 years. Once on the market the agents may be approved for additional indications. In 2002, five oncology products were approved and the FDA granted a total of 23 new indications for cancer products. In 2003, there were seven approvals for oncology products, two of which were approved under an accelerated approval process. In 1992 the FDA implemented Accelerated Approval Procedures, to permit market approval of drugs for life threatening diseases on the basis of evidence predictive of clinical benefit followed by further post-approval study. Two medical areas (HIV and cancer) have stood to benefit from the availability of these procedures. As of December 2003, there were five cancer products in clinical trials on the accelerated approval track. We believe that our drug candidates could qualify for this fast track regulatory approval following demonstration of Phase 2 clinical responses in cancer patients for whom there is no alternative therapy.

      Focus on Small molecule drugs, which have a large market. Most prescription medicines are — and we believe will continue to be — small molecules. Approximately 88% of the top 200 prescription drugs, based on worldwide sales in 2001, are compounds described as small molecules. Small molecules can be made into pills that can be readily swallowed. In addition, small molecule drugs have a low production cost as compared to other therapeutic agents because they are easier to make, store and ship. Other therapeutic agents, such as proteins and antibodies, are more difficult to administer — requiring, for example, injections. They are also more costly to manufacture than small molecules.

      Benefit from the resources and strengths of collaborators. We intend to develop drug candidates we discover from the preclinical testing phase through human proof of principle. We then expect to out-license, co-develop or sell our drug candidates to pharmaceutical companies for completion of clinical testing and commercialization. We believe that by striking this balance at the proper time, we will be able to obtain the maximum risk-adjusted return on our investment in these potential drugs.

      Acquire new technologies as necessary. As we further our transition to oncology-focused biotechnology, we may need to supplement our portfolio and resources by acquisition, in-licensing and/or developing internal

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expertise. Such transactions could allow us to move more quickly toward developing additional candidates for clinical trials. We may also continue to invest in technology and personnel to enhance or expand our capabilities in drug discovery.

      Obtain the most benefit from our chemistry technology platform. ArQule has developed a chemistry-based drug discovery technology platform designed to create small molecules that possess drug-like characteristics. We believe that identifying drug-like characteristics prior to preclinical development increases the likelihood that small molecules reaching preclinical development will have a greater potential to become medicines. Without such a technology platform, the traditional approach is to develop small molecules that have demonstrated activity toward biological targets, with little regard to whether the molecules otherwise would make good medicines. In our view, a drug that has the best set of drug-like characteristics for its indication (i.e., one that is the most effective and has the fewest side effects) will ultimately generate the most revenue in its category, even if it is not the first to become available on the market. We are using our chemistry technology and expertise in our cancer discovery programs.

      Build on the pharmaceutical and biotechnology expertise of our management and scientific teams. Our executive team consists of leaders with experience in drug discovery and development and specific expertise in oncology. Our CEO, Dr. Stephen Hill, formerly led global drug development for F. Hoffmann-La Roche, Ltd. After the Cyclis acquisition, we retained the scientific founder of the ACTSM platform, Dr. Chiang Li and most of his research team to advance our biology research and research programs based on the ACTSM platform at ArQule Biomedical Institute. In late December, we hired Dr. Adam Craig to lead our clinical development program and direct our medical affairs. Dr. Craig was previously Senior Director of Clinical Oncology at Ilex Oncology.

Chemical Technologies Strategy

      We provide chemistry services to collaborators and customers for their discovery programs. In line with our transition to drug discovery, we intend to run our chemistry technologies as a profitable, cash flow positive business, with minimal investment in 2004.

      We are an established market leader in the production of diverse collections of chemical compounds using automated high throughput technology and computational design tools. We do not believe that any of our competitors in small molecule chemistry possess the particular combination of technology included in our chemistry technology platform and we believe our capabilities provide a competitive advantage over the industry standard techniques for designing and producing drug-like molecules. We believe it would take any competitor several years, (assuming it would be possible to work around our proprietary technology), to duplicate our technology platform and process.

      We are currently providing chemistry technology services under collaborations with Pfizer Inc, Sankyo Company, Ltd. and Novartis Institute for Biomedical Research, Inc. (NIBRI). Our collaboration with Pfizer is our largest collaboration and accounted for 84% of our revenue for 2003. During 2003 we also had active chemistry services-based collaborations with Bayer AG, Solvay Duphar B.V. and Pharmacia Corporation. The active phase under the Bayer, Solvay and Pharmacia collaborations terminated during 2003 and our obligations to Sankyo and NIBRI terminate in June 2004 and September 2004, respectively. We also completed activity under collaborations with GlaxoSmithKline, Wyeth Pharmaceuticals, Searle and Johnson & Johnson in 2002. Under our collaboration agreements, we generally receive fees for the services we provide during the active phase of the agreement. These agreements also impose trailing obligations on our collaborators to, under specified circumstances, make milestone and royalty payments to us based on their further development of compounds we provided to them. In addition, for several of our formerly active collaborators, we have agreed to provide a limited amount of compound production services, as such collaborators seek to optimize promising compounds. Wyeth has filed an IND based upon a compound derived from our Directed Array Program and made milestone payments to us in connection therewith in October 2002 and February 2004.

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      The terms of our currently active collaborations are summarized below:

      Pfizer. Since the inception of this relationship in 1999, we have produced collections of chemical compounds exclusively for Pfizer using our automated high throughput system. This agreement expires in 2008. In February 2004, the agreement was amended to maintain compound deliveries at approximately the same level from 2004 through the end of the term, instead of increasing them as previously specified. This will result in a decrease in the total potential contract value of $55 million compared to the terms agreed upon in 2001.

      As of March 1, 2004, we have received $191.0 million from Pfizer since inception of this relationship in 1999. If our relationship with Pfizer is successful, we could receive up to an additional $177.7 million over the remaining term of the contract. Pfizer has made equity investments in our company of $10 million in 2001, and $8 million in 2003, based on the achievement of certain delivery milestones. Under the amended agreement, upon notice, Pfizer may terminate the relationship beginning in December, 2005 for any reason, but would not be entitled to receive any refund for amounts paid to ArQule through the date of termination.

      Sankyo. In November 1997, we entered into a three-year agreement with Sankyo Company, Ltd. to discover and optimize drug candidates. In April 2001, we extended our agreement with Sankyo through June 2004. The total value of the extended agreement is up to $14.8 million in committed payments of which, as of March 1, 2004, we have received $14.6 million. To date, we have not received any milestone or royalty payments under this agreement.

      Novartis Institute for Biomedical Research, Inc. On September 3, 2003, we entered into a one year chemistry services collaboration with NIBRI, an affiliate of Novartis AG. Under this agreement, we are applying our integrated chemistry technology platform to generate and optimize small molecule compounds for NIBRI’s anti-infective drug discovery program. The total contract value of the agreement is $1 million, of which we have received $0.6 million as of March 1, 2004. NIBRI must also make additional payments if we achieve certain developmental milestones. This agreement expires in September 2004.

PATENTS AND PROPRIETY RIGHTS

      We believe that patent and trade secret protection is crucial to our business and that our future will depend in part on our ability to obtain patents, maintain trade secret protection and operate without infringing the proprietary rights of others, both in the U.S. and other countries. As of March 1, 2004, we had eighteen issued or allowed U.S. utility patents, one issued U.S. design patent, five granted foreign patents, and numerous patent applications in the U.S. and other countries. While many patent applications have been filed in the U.S. and other countries with respect to our cancer programs, the majority of these have not yet been issued or allowed. The patent positions of companies in the biotechnology industry and the pharmaceutical industry are highly uncertain and involve complex legal and factual questions. Therefore, we cannot predict the breadth of claims, if any, that may be allowed under any of our patent applications, or the enforceability of any of our issued patents.

      As needed, we obtain rights under patents owned by other parties through licenses. We have several exclusive and nonexclusive technology licenses from certain institutions in support of our research programs. We anticipate that we will continue to seek licenses from universities and others where applicable technology complements our research and development efforts.

      Patents extend for varying periods according to the date of patent filing or grant and the legal term of patents in the various countries where patent protection is obtained. The actual protection afforded by a patent, which can vary from country to country, depends on the type of patent, the scope of its coverage and the availability of legal remedies in the country.

      In an effort to maintain the confidentiality and ownership of our trade secrets and proprietary information, we require all of our employees and consultants to sign confidentiality agreements. Employees and consultants involved in scientific and technical endeavors also sign invention assignment agreements. We intend these confidentiality and assignment agreements to protect our proprietary information by controlling the disclosure

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and use of technology to which we have rights. These agreements also provide that we will own all the proprietary technology developed at ArQule or developed using our resources.

      “ArQule”, the ArQule logo, “Directed Array”, and “Mapping Array” are trademarks of ArQule that are registered in the U.S. Patent and Trademark Office. The terms “AMAP”, “ArQule Reactor”, “Compass Array”, “Custom Array”, “MapMaker”, “Optimal Chemical Entities”, “OCEs”, “Parallel Track”, and “PrepQule” are trademarks of ArQule. The terms Activated Checkpoint Therapy and ACT are service marks of ArQule.

COMPETITION

      The pharmaceutical and biotechnology industries are highly competitive. We face intense competition from organizations such as large pharmaceutical companies, biotechnology companies and academic and research organizations. The major pharmaceutical organizations competing with us have greater capital resources, larger overall research and development staff and facilities and considerably more experience in drug development. Biotechnology companies competing with us may have these advantages as well. In addition to competition for collaborators and investors, these companies and institutions also compete with us in recruiting and retaining highly qualified scientific and management personnel.

      With respect to our cancer drug discovery and development programs, other companies have potential drugs in preclinical and clinical trials that may result in effective, commercially successful treatments for the same cancers we target. In the area of small molecule anti-cancer therapeutics, we have identified a number of companies that have clinical development programs and focused research and development in small molecule approaches to cancer such as Ariad Pharmaceuticals; Genaera Corporation; Onyx Pharmaceuticals, OSI Pharmaceuticals, Oxigene, Inc.; Telik Inc. and Tularik Inc.

      Several organizations are actively attempting to identify and optimize compounds for internal or collaborator programs and, like us, act both as chemistry service providers and as integrated drug discovery companies. These companies include ArrayTM BioPharma and Exelixis. Other competitors in the chemistry technology services market are Pharmacopeia, Inc.; Albany Molecular Research, Inc.; Evotec OAI; and Discovery Partners International, Inc.

      We face competition in several areas of our business including:

  •  developing and protecting our novel approach to anti-cancer therapeutics, namely the compounds and science that result from our ACTSM platform;
 
  •  advancing a discovery and development portfolio of anti-cancer candidates that are selective for cancer cells and applicable across a broad spectrum of cancer types;
 
  •  securing partners to co-develop and advance our drug candidates through later-stage clinical trials and beyond;
 
  •  securing and sustaining business based on our ability to design and produce chemical compound collections for lead generation;
 
  •  securing and sustaining business based on our ability to identify, optimize and advance lead compounds toward the clinic; and
 
  •  maintaining our position as an industry leader in chemistry technology innovation.

      There can be no assurance that our competitors will not develop more effective or more affordable products or technology, or achieve earlier product development and commercialization than ArQule, thus rendering our technologies and/or products obsolete, uncompetitive or uneconomical.

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GOVERNMENT REGULATION

      Virtually all pharmaceutical and biotechnology products that we or our collaborative partners develop will require regulatory approval by governmental agencies prior to commercialization. The nature and the extent to which these regulations apply varies depending on the nature of the products. In particular, human pharmaceutical products are subject to rigorous preclinical and clinical testing and other approval procedures by the FDA. Various federal and, in some cases, state statutes and regulations also govern or influence the manufacturing, safety, labeling, storage, record keeping and marketing of these products required by the FDA. The process of obtaining these approvals and the subsequent compliance with appropriate federal statutes and regulations are time consuming and require substantial resources and the outcome is uncertain.

      Generally, in order to gain FDA approval, a company first must conduct preclinical studies in the laboratory and in animal models to gain preliminary information on a compound’s activity and to identify any safety problems. Preclinical studies must be conducted in accordance with FDA regulations. The results of these studies are submitted as a part of an IND that the FDA must review before human clinical trials of an investigational drug can start. If the FDA does not respond with any questions, a drug developer can commence clinical trials thirty days after the submission of an IND.

      In order to eventually commercialize any products, we or our collaborator first will be required to sponsor and file an IND and will be responsible for initiating and overseeing the clinical studies to demonstrate the safety and efficacy that are necessary to obtain FDA marketing approval. Clinical trials are normally done in three phases and generally take several years, but may take longer to complete. Furthermore, the FDA may suspend clinical trials at any time if the FDA believes that the subjects participating in trials are being exposed to unacceptable risks or if the FDA finds deficiencies in the conduct of the trials or other problems with our product under development.

      After completion of clinical trials of a new product, FDA marketing approval must be obtained. If the product is classified as a new pharmaceutical, we or our collaborator will be required to file a New Drug Application (“NDA”), and receive approval before commercial marketing of the drug. The testing and approval processes require substantial time and effort. NDAs submitted to the FDA can take several years to obtain approval and the FDA is not obligated to grant approval at all.

      Even if FDA regulatory clearances are obtained, a marketed product is subject to continual review. If and when the FDA approves any of our or our collaborators’ products under development, the manufacture and marketing of these products will be subject to continuing regulation, including compliance with current Good Manufacturing Practices (“GMP”) adverse event reporting requirements and prohibitions on promoting a product for unapproved uses. Later discovery of previously unknown problems or failure to comply with the applicable regulatory requirements may result in restrictions on the marketing of a product or withdrawal of the product from the market as well as possible civil or criminal sanctions. Various federal and, in some cases, state statutes and regulations also govern or influence the manufacturing, safety, labeling, storage, record keeping and marketing of pharmaceutical products.

      For marketing outside the United States, we or our partners will be subject to foreign regulatory requirements governing human clinical trials, marketing approval and post-marketing activities for pharmaceutical products and biologics. The requirements governing the conduct of clinical trials, product licensing, pricing and reimbursement vary widely from country to country.

      Our research and development processes involve the controlled use of hazardous materials and controlled substances. Although we are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of these materials and waste products, the license or sale of our chemistry services is not subject to the same degree of government regulations applicable to our drug product candidates.

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EMPLOYEES

      As of March 1, 2004, we employed 257 people across three sites: Woburn, Medford and Norwood, Mass. Of that total, 89 hold Ph.D.s and 14 hold Masters in the Sciences. As of March 1, 2004, 161 of our employees were engaged in operations, 52 were engaged in research and development and 44 were engaged in marketing and general administration.

CERTAIN OTHER INFORMATION

      We file annual and quarterly reports, proxy statements and other information with the SEC. You may read and copy any document we file at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room. We also maintain a web site at http://www.ArQule.com, which provides additional information about our company and links to documents we file with the SEC.

 
Item 1A. Executive Officers and Directors of the Registrant

      Set forth below is certain information regarding our current executive officers and directors, including their respective ages, as of March 1, 2004:

             
Name Age Position



Dr. Stephen A. Hill
    45     President, Chief Executive Officer and a Director
Dr. Chiang J. Li
    39     Vice President, Chief Scientific Officer, Head of ArQule BioMedical Institute
Louise A. Mawhinney
    48     Vice President, Chief Financial Officer and Treasurer
J. David Jacobs, J.D.
    42     Vice President, Legal, General Counsel and Secretary
Ariel Elia
    69     Director (Chairman of the Board)
Laura Avakian
    58     Director
Timothy C. Barabe
    50     Director
Werner Cautreels, Ph.D.
    51     Director
Tuan Ha-Ngoc
    51     Director
Patrick J. Zenner
    57     Director

Stephen A. Hill, B.M. B.Ch., M.A., F.R.C.S.,

      President and Chief Executive Officer. Dr. Hill has served as ArQule’s President and CEO since April 1999. Before joining ArQule, Dr. Hill was the Head of Global Drug Development at F. Hoffmann-La Roche Ltd. from 1997-1999. Dr. Hill joined Roche in 1989 as Medical Adviser to Roche Products in the United Kingdom. He held several senior positions there that included Medical Director, responsible for clinical trials of compounds across a broad range of therapeutic areas, such as CNS, HIV, cardiovascular, metabolic and oncology products. Subsequently, he served as Head of International Drug Regulatory Affairs at Roche headquarters in Basel, Switzerland, where he led the regulatory submissions for seven major new chemical entities. Dr. Hill also was a member of Roche’s Portfolio Management, Research, Development and Pharmaceutical Division Executive Boards. Prior to Roche, Dr. Hill served seven years with the National Health Service in the United Kingdom in General and Orthopedic Surgery. Dr. Hill is a Fellow of the Royal College of Surgeons of England and holds his scientific and medical degrees from St. Catherine’s College at Oxford University.

Chiang J. Li, M.D.,

      Chief Scientific Officer and Vice President, Head of ArQule BioMedical Institute. Dr. Li joined ArQule in September 2003. Prior to joining ArQule, he had served as the scientific founder and Vice President of Research at Cyclis Pharmaceuticals, Inc., a faculty member at Harvard Medical School and an attending physician at Harvard’s Beth Israel Deaconess Medical Center. At Cyclis, Dr. Li directed research

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efforts that led to a cancer therapeutic portfolio, which culminated in the successful IND filing of Cyclis’ first drug candidate, CO-501. Dr. Li is the inventor of, and has directed research efforts on, the Activated Checkpoint TherapySM (ACTSM) platform that underscores ArQule’s oncology portfolio. He has published a number of highly cited articles in over 30 publications in leading biomedical journals and holds 15 issued or filed patents. Dr. Li is a member of several professional societies, including a recent induction to the National Register’s Who’s Who in Executives and Professionals. Dr. Li has been a recipient of a number of honors, recognitions and research awards. Most recently his work was recognized by the editorial board of the journal, Cell Cycle, as one of the “Top Ten Most Outstanding Cell Cycle Research Papers” of the past year published in all biomedical journals. Dr. Li graduated from the Harvard-MIT Division of Health Science and Technology and received his M.D. degree Magna Cum Laude from Harvard Medical School.

Louise A. Mawhinney, C.P.A.,

      Vice President, Finance, Chief Financial Officer and Treasurer. Ms. Mawhinney joined the Company in December 2003 as Vice President, Finance and CFO. Ms. Mawhinney has more than 20 years of experience in finance covering audit, accounting, treasury, tax, SEC reporting, investor relations, corporate financing and merger and acquisition responsibilities. For the past three years, Ms. Mawhinney has been Chief Financial Officer, Secretary and Treasurer of Cleanwise, Inc., a Massachusetts-based third-party logistics software start-up company. From 1999 to 2000, she was Chief Financial Officer, Secretary and Treasurer of Veridiem Inc., a Massachusetts-based marketing automation software start-up. From 1993 to 1999, Ms. Mawhinney served in a variety of finance functions, and in 1996 became Chief Financial Officer, Secretary and Treasurer, for The Butcher Company, a chemical process manufacturer with annual sales of $80 million. Prior to that she was with KPMG in Boston, MA. Ms. Mawhinney holds a Masters degree from St. Andrews University in Scotland and has been a C.P.A. in Massachusetts since 1989.

J. David Jacobs, J.D.,

      Vice President, Legal, General Counsel and Secretary. Mr. Jacobs joined ArQule in June 2001 as Vice President, Legal, General Counsel and Secretary. Previously, Mr. Jacobs held the position of Senior Counsel in the Biomedical Services division of the American Red Cross where from 1997 to 2001 he was responsible for all matters involving new products, revenue generation, licensing, intellectual property and mergers and acquisitions. Prior to joining the Red Cross, Mr. Jacobs practiced in the fields of tax and international commercial transactions at the law firms of Kramer, Levin et al. in New York City from 1988 to 1994 and Shimron, Molcho in Jerusalem from 1994 to 1996. Mr. Jacobs received his J.D. with honors from Columbia Law School, an M.A. with distinction from the Jewish Theological Seminary and a B.A. from Columbia College.

      Ariel Elia was named Chairman of the Board in March 2001 and has been a director since September 2000. Since 1999, Mr. Elia has served as Chairman of the European Advisory Board of E.Med Securities, a private, U.S.-based company providing investment banking services to emerging growth companies in the life sciences industry. Mr. Elia has been a director of Altamir S.A., a French venture capital company, since 1995, and a director of Yissum, the research and development company of the Hebrew University of Jerusalem in Israel, since 1999. Mr. Elia also serves as a Governor of both the Ben Gurion University (since 1992) and the Hebrew University of Jerusalem (since 1998), in Israel. Prior to his current positions, Mr. Elia was the Chief Executive Officer of Jouveinal Laboratories, a privately held, French pharmaceutical company. Mr. Elia also spent 17 years with Merck & Co., serving both in Europe and in the U.S., most recently as Senior Vice President, International Division. Before joining Merck, Mr. Elia spent 12 years with American Home Products Corporation, serving as President of the International Household Products Division prior to his departure. Mr. Elia graduated from Victoria College in Alexandria, Egypt with an Oxford and Cambridge degree as a Bachelor of Arts. His honors include Knight of the Order of the Crown in Belgium and Doctor of Philosophy Honoris Causa of Ben Gurion University, Israel and the Hebrew University of Jerusalem.

      Laura Avakian has been a director since March 2000. Since 1999, Ms. Avakian has been Vice President for Human Resources for the Massachusetts Institute of Technology, where she directs all human resource programs and oversees the Institution’s Medical Department. Prior to joining MIT, she was Senior

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Vice President, Human Resources, for Beth Israel Deaconess Medical Center and for its parent corporation CareGroup (1996-1999). She previously served as President of The American Society for Healthcare Human Resources Administration, and received the distinguished service award, literature award and chapter leadership award from that society. She received the 1996 Award for Professional Excellence in Human Resources Management from the Society for Human Resource Management. She has also served as editor of the Yearbook of Healthcare Management and authored numerous chapters and articles on human resources management. Ms. Avakian received her B.A. degree from the University of Missouri at Columbia and her M.A. degree from Northwestern University.

      Timothy C. Barabe has been a director since November 2001. Mr. Barabe has been employed by Novartis AG since April 1982 in various capacities. Beginning in May 2003, Mr. Barabe has been the Chief Financial Officer of Sandoz Generics, the generic pharmaceutical subsidiary of Novartis. Beginning in February 2002 until April 2003, Mr. Barabe was Group Vice President and President, Specialty Lenses of CIBA Vision. From 1993 through January 2002, Mr. Barabe was the Chief Financial Officer of CIBA Vision Corp., a subsidiary of Novartis. From June 1998 through May 2003, Mr. Barabe served as a director of BioCure, Inc., a majority-owned subsidiary of Novartis. Mr. Barabe received his B.B.A. degree from the University of Massachusetts (Amherst) and his M.B.A. degree from the University of Chicago.

      Werner Cautreels, Ph.D. has been a director since September 1999. He has over 20 years of experience in the healthcare industry. Since May 1998, Dr. Cautreels has been the Global Head of Research and Development of Solvay Pharmaceuticals. Prior to that time, Dr. Cautreels served as Senior Vice President of Research and Development at Nycomed Amersham Ltd., held two senior management positions at Sterling Winthrop and served as Vice President of Scientific Affairs at Sanofi Pharmaceuticals, where he conducted clinical trials in various therapeutic areas and researched licensing opportunities. Dr. Cautreels received his Ph.D. in Chemistry from University of Antwerp, Belgium.

      Tuan Ha-Ngoc has been a director since 2002. He is the President and CEO of GenPath Pharmaceuticals, Inc., a biopharmaceutical company. He has 26 years of worldwide experience in the healthcare industry, primarily in the biotechnology sector, but also in the pharmaceutical, medical devices and Information Technology areas. From 1999 to 2002, he was co-founder, President and CEO of deNovis, Inc., an enterprise-scale software development company for the automation of healthcare administrative functions. From 1998 to 1999, he served as Corporate Vice President, Strategic Development for American Home Products Corporation. From 1984 to 1998, he was at Genetics Institute, Inc., as its Executive Vice President responsible for Corporate Development, Commercial Operations, European and Japanese Operations. From 1976 to 1984, he was in various marketing and business positions at Baxter Healthcare, Inc. Mr. Ha-Ngoc received his M.B.A. degree from INSEAD and his Master’s degree in Pharmacy from the University of Paris, France. He serves on the Board of Fellows, Harvard School of Dental Medicine and on the Boards of Directors of the International Institute of Boston.

      Patrick J. Zenner has been a director since 2002. A 32-year veteran of the pharmaceutical industry, Patrick Zenner retired in 2001 from the position of President and Chief Executive Officer of Hoffmann-La Roche Inc., North America. Hoffmann-La Roche Inc., based in Nutley, N.J., is the prescription drug unit of the Roche Group. Long active in industry, academic and civic affairs, Mr. Zenner is immediate past chairman of the HealthCare Institute of New Jersey and served on the Boards of Directors and Executive Committees of the Pharmaceutical Research & Manufacturers of America (PhRMA) and the Biotechnology Industry Organization (BIO). In addition, Mr. Zenner has been a member of numerous associations, including the American Foundation for Pharmaceutical Education, the Health Care Leadership Council and the National Committee for Quality Health Care. Mr. Zenner is currently on the Boards of Trustees of Creighton University and Fairleigh Dickinson University. In addition, Mr. Zenner is a member on the Boards of Directors of CuraGen Corporation, Dendrite International, Praecis Pharmaceuticals Inc., Geron Corporation, First Horizon Pharmaceutical Corporation, Xoma Ltd., West Pharmaceutical Services, Exact Sciences, Inc. and other private companies.

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RISKS RELATING TO OUR BUSINESS AND STRATEGY

Development of our products is at an early stage and is uncertain and our approach and technology may never result in a commercial drug.

      The discovery and development of drugs is inherently risky and involves a high rate of failure. Discovering and developing commercial drugs is relatively new to us.

      Our proposed drug products and drug research programs are in the early stages of development and require significant, time-consuming and costly research and development, testing and regulatory clearances. We do not expect that these product candidates will be commercially available for several years, if ever. We have never identified a drug candidate that has been developed into a commercial drug using this platform. It is uncertain whether our technology platform will achieve these goals at all, or whether it will be competitive with platforms used by our competitors.

We must show the safety and efficacy of our product candidates through expensive, time consuming preclinical and clinical trials, the results of which are uncertain.

      Our product candidates are at the preclinical stages of development, with the exception of ARQ 501 which is now in Phase 1 clinical studies. Although several of our product candidates have demonstrated some favorable pharmacological effects in preclinical studies, they may not prove to be effective in humans. We will need to conduct extensive further testing of all of our product candidates, expend significant additional resources and possibly partner with another company to realize commercial value from any of our product candidates.

      Before obtaining regulatory approvals for the commercial sale of our products, we must demonstrate, through preclinical studies (animal testing) and clinical trials (human testing), that our proposed products are safe and effective for use in each target indication. This testing is expensive and time-consuming, and failure can occur at any stage. Acceptable results from initial preclinical studies and clinical trials of products under development are not necessarily indicative of results that will be obtained from subsequent or more extensive preclinical studies and clinical testing in humans. Clinical trials may not demonstrate sufficient safety and efficacy to obtain the required regulatory approvals or result in marketable products. The failure to adequately demonstrate the safety and efficacy of a product under development will delay and could prevent its regulatory approval.

      A number of companies in the pharmaceutical industry, including biotechnology companies, have suffered significant setbacks in advanced clinical trials, even after promising results in earlier trials.

      Though it is our stated strategy to pursue clinical development to take advantage of available accelerated regulatory approval opportunities, there is no guarantee that our product candidates will show the evidence predictive of clinical benefit necessary to qualify for such opportunities.

      Clinical trials for the product candidates we are developing may be delayed by many factors, including that potential appropriate patients for testing are limited in number. The failure of any clinical trials to meet applicable regulatory standards could cause such trials to be delayed or terminated, which could further delay the commercialization of any of our product candidates. Any such delays will increase our product development costs, with the possibility that we could run out of funding. Consequently, if such delays are significant they could negatively affect our financial results and the commercial prospects for our products.

We have limited capabilities in clinical development of drug candidates.

      We are dependent on third-party providers of preclinical and clinical development services, including GLP synthesis and testing. If we choose to perform such studies ourselves we will be required to incur significant costs and devote significant efforts to establish our own development facilities and capabilities. If we are unable to reach agreement with third-party service providers on acceptable terms, or to establish our own development facilities, ArQule’s preclinical and clinical development of products will be delayed and our financial results will be adversely affected.

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We may face challenges in realizing the benefits of the Cyclis acquisition, and future acquisitions.

      Having acquired Cyclis Pharmaceuticals, Inc. on September 8, 2003, we have been operating the Cyclis business for less than six months. Integrating the operations and personnel of ArQule and Cyclis has been a complex process of integrating the former Cyclis business, including the ARQ 501 program, and the Cyclis molecular biology expertise into our existing operations. It is too early to be certain that the integration has been successful or that we will achieve the anticipated benefits of the merger. There may be unexpected delays or we may be unable to successfully develop the Cyclis business and technology over the long term. As noted below, we also may effect additional acquisitions, which could pose similar, or greater, risks than the Cyclis acquisition. There is also the risk that we may have greater difficulty integrating more than one acquisition at the same time.

If we choose to acquire complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions, to integrate successfully an acquired business or technology in a cost-effective and non-disruptive manner or to complete commercialization of an acquired product.

      From time to time, we may choose to acquire complementary businesses, products, or technologies instead of developing them ourselves. We do not know if we will be able to complete any acquisitions, or whether we will be able to successfully integrate any acquired businesses, operate them profitably or retain their key employees. Integrating any business, product or technology we acquire could be expensive and time-consuming, disrupt our ongoing business and distract company management. In addition, in order to finance any acquisition, we might need to raise additional funds through public or private equity or debt financings. In that event, we could be forced to obtain financing on less than favorable terms and, in the case of equity financing, that may result in dilution to our stockholders. In addition, under certain circumstances, amortization of assets or charges resulting from the costs of acquisitions could harm our business and operating results.

We may not be able to find collaborators or successfully form collaborations in furtherance of our drug development efforts.

      We plan to seek collaborators for our drug development efforts. We would like to enter into these collaborations to obtain external financing for drug development and to obtain access to commercialization expertise. The availability of partners depends on the willingness of pharmaceutical companies to collaborate in drug discovery activities. There are only a limited number of pharmaceutical companies which would fit our requirements. The number could decline further through consolidation or the number of collaborators with interest in our drugs could decline. If the number of our potential collaborators declines further, collaborators may be able to negotiate terms unfavorable to us.

      We face significant competition in seeking collaborators, both from other biotechnology companies and from the internal capabilities and compound pipelines of the pharmaceutical companies themselves. This competition is particularly intense in the oncology field. Our ability to interest such companies in forming co-development and commercialization arrangements with us will be influenced by, among other things:

  •  the compatibility of technologies;
 
  •  the potential partner’s acceptance of our approach to drug discovery;
 
  •  the quality and commercial potential of any drug candidate we may succeed in developing; and
 
  •  our ability, and collaborators’ perceptions of our ability, to achieve intended results in a timely fashion, with acceptable quality and cost.

      Even if we are able to gain the interest of potential drug development partners, the negotiation, documentation and implementation of collaborative arrangements are complex and time-consuming. Collaborative opportunities may not be available on commercially acceptable terms and, if formed, may not be commercially successful or, if successful, may not realize sufficient return for us. If we are unable to form

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collaborations, we may not gain access to the financial resources and industry expertise necessary to develop drug products or successfully market any products we develop on our own and, therefore, be unable to generate revenue from pharmaceutical products.

Our success depends on the efforts of our collaborators, whom we do not and cannot control.

      If we are able to enter into collaborations for the development and commercialization of our drug candidates, we will depend on our partners to develop and commercialize our drug candidates. Similarly, we depend on parties to whom we have provided compounds through chemistry services collaborations to develop and commercialize those compounds. Each of our current chemistry services collaborators has, and we expect that each future collaborator will have, significant discretion in determining the efforts and resources that it will apply to the development and commercialization of compounds and drug candidates covered by its collaboration with us.

      Any of our current or future collaboration partners may fail to develop or commercialize a compound or product to which they have obtained rights from us for a variety of reasons, including that our partner:

  •  decides not to devote the necessary resources because of internal constraints or other priorities, or because of a merger with another pharmaceutical company changes those priorities;
 
  •  decides to pursue a competitive potential drug or compound developed outside of our collaboration;
 
  •  cannot obtain necessary regulatory approvals; or
 
  •  exercises a right to terminate our collaboration.

We may not receive any milestone, royalty or license payments under our current or any future collaborations.

      Although we have received license and milestone fees to date under our chemistry services collaborations, we may never receive any royalty payments or additional license and milestone fees under such agreements. Likewise, even if we are able to enter into collaboration agreements relating to our drug candidates, we may never receive any milestone, royalty or license payments under such future agreements.

      Our receipt of any future milestone, royalty or license payments depends on many factors, including whether our collaborators want or are able to continue to pursue a potential drug candidate and the ultimate commercial success of the drug. Development and commercialization of potential drug candidates depends not only on the achievement of objectives by us and our collaborators, but also on each collaborator’s financial, competitive, marketing and strategic considerations and regulation in the United States and other countries. Pharmaceutical products our collaborators develop will require lengthy and costly testing in animals and humans and regulatory approval by governmental agencies prior to commercialization. These agencies may not approve the products for commercialization despite the substantial time and resources required to seek approvals and comply with appropriate statutes and regulations. If unforeseen complications arise in the development or commercialization of the potential drug candidates by our collaborators, we may not realize milestone, royalty or license payments.

We face fierce competition from competitors with greater resources.

      Even if we are successful in bringing a product to market, we face substantial competitive challenges in effectively marketing and distributing our product. Many other companies and research institutions are developing products within the field of oncology, including large pharmaceutical companies with much greater financial resources, and more experience in developing products, running clinical trials, obtaining FDA approval and bringing new drugs to market. We are in a rapidly evolving field of research, and our technology may be rendered non-competitive or obsolete by approaches and methodologies discovered by others, both before and after we have gone to market with our product. We also face competition from existing therapies that are currently accepted in the marketplace, and the impact of adverse events in our field that may affect regulatory approval or public perception.

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We may not be able to recruit and retain the scientists and management we need to compete.

      To succeed, we must attract, retain and motivate highly skilled scientists and management. We compete intensely with pharmaceutical and biotechnology companies, including our collaborators, medicinal chemistry outsourcing companies, contract research companies, and academic and research institutions to recruit scientists and management. If we cannot hire additional qualified personnel, the workload may increase for both existing and new personnel. The shortage of personnel with experience in drug development could lead to increased recruiting, relocation and compensation costs, which may exceed our expectations and resources. These increased costs also may reduce our profit margins and make hiring new scientists impractical.

We may not be able to balance successfully our primary focus of drug development with the needs of our chemical technologies operation.

      While we concentrate on drug development, there is a risk that we will pay less attention to our original, ongoing business. Furthermore, customers, potential collaborators and others may not accept our shift in strategy. Also, we may not implement the shift effectively, which may undermine our results even if the strategy, technology and management team work together effectively.

We may be exposed to potential liability related to the development, testing or manufacturing of compounds developed by ArQule.

      We develop, test and manufacture the precursors to drugs generally intended for use in humans. If our drug discovery activities result in clinical trials, or the manufacture and sale of drugs, we could be liable if persons are injured or die while using these drugs. We may have to pay substantial damages and/or incur legal costs to defend claims resulting from injury or death, and we may not receive expected royalty or milestone payments if commercialization of a drug is limited or ended as a result of such claims. We have product liability insurance that contains customary exclusions and provides coverage per occurrence at levels, in the aggregate, which we believe are customary and commercially reasonable in our industry given the stage we have achieved in drug commercialization. However, our product liability insurance does not cover every type of product liability claim that we may face or loss we may incur and may not adequately compensate us for the entire amount of covered claims or losses or for the harm to our business reputation. Also, we may be unable to maintain our current insurance policies or obtain and maintain necessary additional coverage at acceptable costs or at all.

RISKS RELATED TO OUR FINANCIAL CONDITION

We may not achieve profitability.

      From our inception in 1993 through December 31, 2003, we have incurred cumulative losses of approximately $184 million. These losses have resulted principally from the costs of our research activities and enhancements to our technology. We have derived our revenue primarily from:

  •  license and technology transfer fees for access to our chemical synthesis and production platforms such as transfer of our AMAP technology to Pfizer;
 
  •  payments for product deliveries;
 
  •  research and development funding paid under our agreements with our collaboration partners; and
 
  •  to a limited extent, milestone payments.

      To date, these revenues have generated profits only in 1997 and 2000 and our revenue from our chemistry services collaborators is expected to decline in 2004. We have not realized any revenue from royalties from the sale by any of our collaboration partners of a commercial product developed using our technology. We might never become profitable on a sustained basis.

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Our revenue from chemistry technologies collaborations is uncertain and not diversified.

      Our ability to generate revenue from chemistry services collaborations typically involves significant technical evaluation and/or commitment of capital by our collaborators and is subject to a number of significant risks, including collaborators’ budgetary constraints and internal acceptance reviews.

      To maintain our current relationships with chemistry services collaborators and to meet the performance and delivery requirements in our contracts, we must provide drug discovery capabilities and chemistry technology products and services at appropriate levels, with acceptable quality and at acceptable cost. Our ability to deliver the drug discovery capabilities, products and services we want to offer to our collaborators is limited by many factors, including the difficulty of the chemistry, the lack of predictability in the scientific process and the shortage of qualified scientific personnel. In particular, a large portion of our revenue depends on producing collections of high-quality chemical compounds, which requires a high rate of production. If we are unable to maintain the rate of compound synthesis to meet our existing or future contractual commitments, it may result in delayed or lost revenue, loss of collaborations and/or failure to expand our existing relationships.

      Also, at present we depend largely on chemistry services collaboration arrangements for our revenue and cannot be sure whether our collaborations will succeed or whether we will realize much of the potential revenue from our collaborations. In addition, 84% of our revenue was generated from our Pfizer collaboration in 2003, pursuant to which Pfizer holds certain termination rights beginning in December, 2005. Significant portions of the revenue from milestones and royalties that we may receive under these collaborations will depend upon our ability and/or our partners’ ability to successfully develop, license, introduce, market and sell new drugs developed using our chemical compounds and/or proprietary technology. We have little control over the efforts of our partners. We may not be able to achieve these milestones and may not be able to develop commercial drugs or other products on which royalties will be payable.

      Products developed in collaborations will result in commercialized drugs generating royalties only after, among other things:

  •  significant preclinical and clinical development efforts and expenditures;
 
  •  regulatory approvals;
 
  •  development of manufacturing capabilities; and
 
  •  successful marketing.

Our operating results will continue to fluctuate significantly.

      Some of our chemistry services collaborators can influence when we deliver products and perform services under their contracts with us. This could cause our operating results to fluctuate significantly. In addition, we expect to continue to experience significant fluctuations in operating results due to factors such as general and industry specific economic conditions that may affect the research and development expenditures of pharmaceutical and biotechnology companies, as well as the timing of compound shipments to our collaborators.

      Our collaboration agreements require that covered products or compounds reach significant developmental stages in the drug discovery process before we will receive milestone payments. If these milestones are not achieved as expected, our revenue will be delayed and/or reduced. For planning purposes, we estimate the timing of the accomplishment of various scientific, clinical, regulatory and other milestones, such as the commencement or completion of scientific studies and clinical trials and the submission of regulatory filings. These estimates are based on a variety of assumptions. The actual timing of these milestones can vary compared to our estimates, in many cases for reasons beyond our control.

      Revenue is recognized in accordance with generally accepted accounting principles (“GAAP”), which require us to expense certain costs as incurred and defer the related revenue over the life of the contract. This

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makes gross margin fluctuate up and down as revenue is not matched with the associated costs. See significant accounting policies in Note 2 to Item 8, the Consolidated Financial Statements.

      We thus believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. Our operating results in some periods may not meet the expectations of stock market analysts and investors, causing our stock price to decline.

We may not be able to fund our operations.

      Although we believe that we have sufficient funding in the near term, we will at some point need to obtain additional financing. Such financing could come from the proceeds of public or private debt or equity financings or corporate partnerships. We may not be able to obtain adequate funds for our operations from these sources when needed or on acceptable terms. If we raise additional capital through the sale of equity, or securities convertible into equity, each shareholder’s proportionate ownership in ArQule may be diluted.

      If we cannot obtain additional financing, we could be forced to delay or scale back our research and development programs. If adequate funds are not available, we may be required to curtail operations significantly or to obtain funds by entering into arrangements with collaboration partners or others that may require that we relinquish rights to certain technologies, product candidates, products or potential markets.

      In particular, our plans for clinical development of drug candidates will cause us to incur significant costs. If we are successful in our drug development efforts, we may be involved in multiple clinical trials with cumulative costs escalating greatly over time.

      We believe that our cash, cash equivalents and short-term investment securities balances as of December 31, 2003 will be sufficient to meet our operating and capital requirements for the next three years. We have based this estimate on assumptions and estimates that may prove to be wrong. Even if we our estimates are correct, we may need or choose to obtain additional financing during that time.

Delaware law and our Amended and Restated Certificate of Incorporation contain provisions that could prevent or delay a change of control.

      Section 203 of the Delaware General Corporation Law contains provisions restricting stockholder action to acquire control of the company. This could discourage third parties from seeking to obtain control. In addition, certain aspects of our charter documents, for example, rights to issue preferred stock without shareholder approval, a board of directors with staggered terms and limits on the ability of stockholders to call special meetings or act by written consent may be considered as hindrances to a change of control.

RISKS RELATED TO INTELLECTUAL PROPERTY

Our patents and other proprietary rights may fail to protect our business.

      To be successful and compete, we must obtain and protect patents on our products and technology and protect our trade secrets. Where appropriate, we seek patent protection for certain aspects of our technology, but patent protection may not be available for some of the compounds and drugs, and their use, synthesis, formulations and technologies we are developing. The patent position of biotechnology firms is highly uncertain, involves complex legal and factual questions, and has recently been the subject of much litigation. No consistent policy has emerged from the U.S. Patent and Trademark Office or the courts regarding the breadth of claims allowed or the degree of protection afforded under many biotechnology patents. In addition, there is a substantial backlog of biotechnology patent applications at the U.S. Patent and Trademark Office, and the approval or rejection of patent applications may take several years.

      We do not know whether our patent applications will result in issued patents. For example, we may not have developed a method for treating a disease before others have developed similar methods. In addition, the receipt of a patent might not provide much practical protection. If we receive a patent with a narrow scope, then it will be easier for competitors to design products that do not infringe on our patent. We cannot be

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certain that we will receive any additional patents, that the claims of our patents will offer significant protection of our technology, or that our patents will not be challenged, narrowed, invalidated or circumvented.

      Competitors may interfere with our patent protection in a variety of ways. Competitors may claim that they invented the claimed invention prior to us. Competitors may also claim that we are infringing on their patents and that therefore we cannot practice our technology as claimed under our patents. Competitors may also contest our patents by showing the patent examiner that the invention was not original, was not novel or was obvious. In litigation, a competitor could claim that our issued patents are not valid for a number of reasons. If a court agrees, we would lose that patent. As a company, we have no meaningful experience with competitors interfering with our patents or patent applications.

      To protect or enforce our patent rights, we may initiate patent litigation against third parties, such as infringement lawsuits or interference proceedings. Such litigation can be expensive, take significant time and divert management’s attention from other business concerns, which could increase our research and development expense and delay our product programs. Litigation that we initiate may provoke third parties to assert claims against us.

      It is also unclear whether our trade secrets will prove to be adequately protected. To protect our trade secrets, we require our employees, consultants and advisors to execute confidentiality agreements. We cannot guarantee, however, that these agreements will provide us with adequate protection against improper use or disclosure of confidential information. Our employees, consultants or advisors may unintentionally or willfully disclose our information to competitors. In addition, in some situations, these agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants or advisors had or have previous employment or consulting relationships. Like patent litigation, enforcing a claim that a third party illegally obtained and is using our trade secrets is expensive and time-consuming, and the outcome is unpredictable. In addition, courts outside the United States are sometimes less willing than our federal and state courts to protect trade secrets. Furthermore, others may independently develop substantially equivalent knowledge, methods and know-how.

      If we must spend significant additional time and money protecting our patents and trade secrets, we will have fewer resources to devote to the development of our technologies, and our business and financial prospects may be harmed.

Our success will depend partly on our ability to operate without infringing on or misappropriating the proprietary rights of others.

      There are many patents in our field of technology and we cannot guarantee that we do not infringe on those patents or that we will not infringe on patents granted in the future. If a patent holder believes a product of ours infringes on its patent, the patent holder may sue us even if we have received patent protection for our technology. Intellectual property litigation is costly and, even if we prevail, the cost of such litigation could adversely affect our business, financial condition and results of operations. In addition, litigation is time-consuming and could divert management attention and resources away from our business. If we do not prevail in litigation, we may have to pay substantial damages for past infringement.

      Also, if we lose, the court may prohibit us from selling or licensing the product that infringes the patent unless the patent holder licenses the patent to us. The patent holder is not required to grant us a license. If a license is available, it may not be available on acceptable terms. For example, we might have to pay substantial royalties or grant cross-licenses to its patents. In addition, some licenses may be nonexclusive and, accordingly, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license, we could encounter delays in product development while we attempt to design around other patents or we could even be prohibited from developing, manufacturing or selling products requiring these licenses. If we are unable to cost-effectively redesign our products so they do not infringe a patent, we may be unable to sell some of our products. Any of these occurrences will result in lost revenues and profits for us.

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Our collaborators may restrict our use of scientific information.

      We may not be able to acquire any exclusive rights to technology or products derived from our collaborations. There is also a risk that disputes may arise as to the rights to technology or products developed in collaboration with other parties.

      The success of our strategy depends, in part, on our ability to apply a growing base of knowledge, technology and data across all of our internal projects and our collaborations. Some of this data has been and will continue to be generated from our work with collaborators. Although we believe that certain of this information is not proprietary to our collaborators, our collaborators may disagree and may succeed in preventing us from using some or all of this information and/or technology ourselves or with others. Without the ability to use this information freely, we may be limited in our ability to improve the efficiency of our drug discovery and development process.

RISKS RELATED TO REGULATION

We may not obtain regulatory approval for the sale and manufacture of drug products.

      The development and commercialization of drug candidates in the United States, including those drug candidates we develop alone or in collaboration with our partners, are subject to regulation by U.S. regulatory authorities. Pharmaceutical products require lengthy and costly testing in animals and humans and regulatory approval by the appropriate governmental agencies prior to commercialization. Regulatory authorities may suspend clinical trials at any time if they believe that the subjects participating in the trials are being exposed to unacceptable risks or if an agency finds deficiencies in the conduct of the trials or other problems with our product under development. Approval of a drug candidate as safe and effective for use in humans is never certain and these agencies may delay or deny approval of the products for commercialization. Changes in regulatory policy during the period of regulatory review may result in unforeseen delays or denial of approval. Similar delays and denials may be encountered in foreign countries.

      As a company, ArQule has never obtained regulatory approval to manufacture and sell a drug. If we and/or our collaborators develop a drug candidate and cannot obtain this approval, we may not realize milestone or royalty payments based on commercialization goals for such drug candidate. Even if regulatory approval is obtained, regulatory authorities may require additional clinical studies after sales of a drug have begun. In addition, the identification of certain side effects after a drug is on the market may result in the subsequent withdrawal of approval, reformulation of the drug, additional preclinical and clinical trials, changes in labeling, recalls, warnings to physicians or the public, and negative publicity.

      Any of these events could delay or prevent us from generating revenue from the commercialization of any drug candidates we develop or help to develop.

We have only limited experience in regulatory affairs, and some of our products may be based on new technologies; these factors may affect our ability or the time we require to obtain necessary regulatory approvals.

      As we have only recently had our first product candidate in clinical trials, we have only limited experience in filing and prosecuting the applications necessary to gain regulatory approvals. Moreover, certain of the products that are likely to result from our research and development programs may be based on new technologies and new therapeutic approaches that have not been extensively tested in humans. The regulatory requirements governing these types of products may be more rigorous than for conventional products. As a result, we may experience a longer regulatory process in connection with any products that we develop based on these new technologies or new therapeutic approaches.

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RISKS RELATING TO PRODUCT MANUFACTURING

If our use of chemical and hazardous materials violates applicable laws or causes personal injury, we may be liable for damages.

      Our drug discovery activities, including the analysis and synthesis of chemical compounds, involve the controlled use of chemicals, including flammable, combustible, toxic and radioactive materials that are potentially hazardous if misused. Federal, state and local laws and regulations govern our use, storage, handling and disposal of these materials. These laws and regulations include the Resource Conservation and Recovery Act, the Occupational Safety and Health Act and local fire and building codes, and regulations promulgated by the Department of Transportation, the Drug Enforcement Agency, the Department of Energy, the Department of Health and Human Services, and the laws of Massachusetts, where we conduct our operations. We may incur significant costs to comply with these laws and regulations in the future. Notwithstanding our extensive safety procedures for handling and disposing of such materials, the risk of accidental contamination or injury from these materials cannot be completely eliminated. In the event of an accident, we could be liable for damages, and any such liability could exceed our resources, disrupt our business and have a negative impact on our financial condition and results of operations.

Because we have limited manufacturing capabilities, if we decide to outsource the manufacturing of chemical compounds, or initiate a drug manufacturing strategy, we will be dependent on third-party manufacturers or will be required to incur significant costs and devote significant efforts to establish our own manufacturing facilities and capabilities.

      We have limited experience with the FDA’s good manufacturing practices and no commercial scale manufacturing capabilities. If we expand beyond our current manufacturing activities, or apply for regulatory approvals to commercialize products and services, we will need to develop, contract for, or otherwise arrange for, the necessary manufacturing capabilities.

      There are a limited number of manufacturers that operate under the FDA’s good manufacturing practices regulations capable of manufacturing our products. As a result, we may experience difficulty finding manufacturers for our products with adequate capacity for future needs. If we are unable to arrange for outsourced manufacturing of our products, or to do so on commercially reasonable terms, we may not be able to complete development of our products or market them.

      Reliance on an outsourced manufacturer entails risks to which we would not be subject if we manufactured products ourselves, including reliance on the manufacturer for regulatory compliance and quality assurance, the possibility of breach of the manufacturing agreement because of factors beyond our control and the possibility of termination or nonrenewal of the agreement by the manufacturer, based on the manufacturer’s own business priorities, at a time that is costly or inconvenient for us.

      We may in the future elect to manufacture certain of our products in our own manufacturing facilities. We would need to invest substantial additional funds and recruit qualified personnel in order to build or lease and operate any manufacturing facilities.

 
Item 2. Properties

      In November 1999, we moved our main operations to a new facility in Woburn, Massachusetts, which includes approximately 128,000 square feet of laboratory and office space. This facility was designed to our specific requirements. In March 2001, we purchased this building and the land on which it sits and a developable adjacent parcel of land for $18.2 million and $2.3 million, respectively, in an arms-length transaction with the original developer.

      We lease approximately 56,000 square feet of laboratory and office space in Medford, Massachusetts, the majority of which is used for the Pfizer collaboration. We lease these facilities from Cummings Properties, LLC (“Cummings”) under two lease agreements, one of which expires on July 30, 2005 and the other on July 30, 2006. The Company subleases portions of these facilities pursuant to two sublease agreements. See

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LEGAL PROCEEDINGS below for a discussion of a dispute between ArQule and Cummings concerning an increase in rental rates on the lease that expires on July 30, 2006.

      In March 2002, we entered into an eight year lease with Pacific Shores Development LLC for approximately 34,000 square feet of laboratory and office space in Redwood City, California. We took occupancy in September 2002. Each base lease payment, the first of which was due and paid in September 2002, is $75,823 per month, subject to annual escalation provisions.

      In December 2002, we announced a major restructuring of our operations which included closing our facilities in Redwood City, California as of December 31, 2002 and Cambridge, United Kingdom as of March 31, 2003. In October 2003, ArQule completed an agreement with InPharmatica Ltd. to sell certain assets of its former operations in the United Kingdom and to assign its facility lease obligation. We are actively attempting to sub-lease our California facilities. See Note 11, “Restructuring Actions” in notes to Consolidated Financial Statements appearing in Item 8 in this Annual Report on Form 10-K.

 
Item 3. Legal Proceedings

      On August 1, 2001, Cummings significantly raised ArQule’s rent on the lease that expires July 30, 2006. We believe this increase to be in excess of that which is permissible under the lease agreement. Accordingly, on January 16, 2002, we brought a complaint in the Superior Court of Middlesex County in the Commonwealth of Massachusetts for declaratory relief and damages against Cummings arising, in part, out of Cummings’ attempts to increase the lease rates. Nevertheless, during the pendency of this dispute, we are paying the rental rates proposed by Cummings. The Company seeks recovery of the funds that it has already paid, and is paying, under protest. If we are unsuccessful in our claim against Cummings, and must pay all or a portion of the rental expense increase currently proposed by Cummings, we may be required to record an additional expense of up to approximately $0.8 million to record the difference between our contractual rental payments and contractual sublease rental income over the remaining period of the lease. Conversely, if the contingency is resolved in ArQule’s favor and the Company is entitled to a refund of amounts previously paid, the Company may be required to record a gain in a future period.

      ArQule has been named as one of multiple co-defendants, including Wyeth, Inc. and Solvay Pharmaceuticals, Inc., in seven related lawsuits, filed by a number of individual plaintiffs beginning in July 2003 in U.S. District Courts in the Southern and Eastern Districts in Texas and in the District Court, 281st Judicial District, Harris County, Texas. Plaintiffs in these proceedings are seeking damages relating to alleged personal injuries claimed to be the result of taking Hormone Replacement Therapy. The Company was never involved in the manufacture, marketing or sale of Hormone Replacement Therapy drugs and does not believe that it has produced or provided any compounds that have been introduced to humans relating to the products that are the subject of these claims. ArQule has filed or is filing stipulations of dismissal or a motion to dismiss in each of these cases.

      Although we cannot predict the outcome of any litigation, as of the date of this annual report, based on the information now available to us, we do not believe that these lawsuits, individually or in the aggregate, are reasonably likely to have, either individually or in the aggregate, a material adverse effect on the Company, its business, prospects, financial condition or operating results.

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Item 4. Submission of Matters to a Vote of Security Holders

      No matters were submitted to stockholders for a vote during the fourth quarter of 2003.

PART II

 
Item 5. Market for the Registrant’s Common Stock and Related Stockholder Matters

      ArQule’s common stock is traded on the NASDAQ National Market under the symbol “ARQL”.

      The following table sets forth, for the periods indicated, the range of the high and low closing sale prices for ArQule’s common stock:

                 
High Low


2002
               
First Quarter
  $ 16.90     $ 10.75  
Second Quarter
    12.40       5.43  
Third Quarter
    7.14       5.02  
Fourth Quarter
    6.37       3.04  
2003
               
First Quarter
    3.13       2.04  
Second Quarter
    5.23       2.42  
Third Quarter
    4.82       3.74  
Fourth Quarter
    5.55       4.45  
2004
               
First Quarter (through March 9, 2004)
    6.60       5.01  

      As of March 1, 2004, there were approximately 185 holders of record and approximately 6,799 beneficial shareholders of our common stock.

Dividend Policy

      We have never paid cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future. We currently intend to retain future earnings, if any, for use in our business.

Securities Authorized for Issuance under Equity Compensation Plans

      The following table provides information as of December 31, 2003 regarding compensation plans (including individual compensation arrangements) under which our equity securities are authorized for issuance.

                         
(a) (b) (c)



Number of
Number of Weighted- securities
securities to be average remaining available
issued upon exercise for future issuance
exercise of price of under equity
outstanding outstanding compensation plans
options, options, (excluding
warrants and warrants and securities reflected
Plan category rights rights in column (a))




Equity compensation plans approved by security holders
    3,895,918     $ 9.24       1,842,595  
Equity compensation plans not approved by security holders
    N/A       N/A       N/A  
     
     
     
 
Total
    3,895,918     $ 9.24       1,842,595  
     
     
     
 

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Item 6. Selected Financial Data

      The following data, insofar as it relates to the years 1999, 2000, 2001, 2002 and 2003 have been derived from ArQule’s audited consolidated financial statements, including the consolidated balance sheet as of December 31, 2002 and 2003 and the related consolidated statements of operations and of cash flows for the three years ended December 31, 2003 and notes thereto appearing in Item 8 of this Annual Report on Form 10-K. This data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Financial Statements and the Notes thereto appearing in Items 7 and 8, respectively of this Annual Report on Form 10-K. The historical results are not necessarily indicative of the results of operations to be expected in the future. This data is in thousands, except per share data.

                                             
Year Ended December 31,

2003 2002 2001 2000 1999





Statement of operations data:
                                       
Revenue
  $ 65,539     $ 62,812     $ 58,396     $ 50,296     $ 18,582  
Cost and expenses:
                                       
 
Cost of revenue
    36,060       35,231       29,441       21,343       17,457  
 
Research and development
    18,932       31,389       28,446       17,699       13,774  
 
Marketing, general and administrative
    9,560       12,876       12,353       8,293       6,022  
 
Stock-based compensation
          3,221       6,949       880       486  
 
Amortization of core technologies(a)
          3,373       3,091              
 
Amortization of goodwill(a)(b)
                4,013              
 
Impairment of core technology(c)
          17,137                    
 
Impairment of goodwill(c)
          25,890                    
 
Restructuring charges(d)(f)
    1,239       12,695                    
 
Acquired in-process research and development(a)(e)
    30,359             18,000              
     
     
     
     
     
 
   
Total costs and expenses
    96,150       141,812       102,293       48,215       37,739  
     
     
     
     
     
 
Income (loss) from operations
    (30,611 )     (79,000 )     (43,897 )     2,081       (19,157 )
Interest income, net
    610       1,125       2,870       1,774       1,724  
Loss on investment(g)
    (4,750 )                        
     
     
     
     
     
 
Net income (loss)
  $ (34,751 )   $ (77,875 )   $ (41,027 )   $ 3,855     $ (17,433 )
     
     
     
     
     
 
Basic net income (loss) per share
  $ (1.43 )   $ (3.67 )   $ (2.06 )   $ 0.28     $ (1.38 )
     
     
     
     
     
 
Weighted average common shares outstanding — basic
    24,333       21,215       19,905       13,911       12,606  
     
     
     
     
     
 
 
Diluted net income (loss) per share
  $ (1.43 )   $ (3.67 )   $ (2.06 )   $ 0.25     $ (1.38 )
     
     
     
     
     
 
Weighted average common shares outstanding — diluted
    24,333       21,215       19,905       15,208       12,606  
     
     
     
     
     
 

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December 31,

2003 2002 2001 2000 1999





Balance sheet data:
                                       
Cash, cash equivalents and marketable securities
  $ 76,724     $ 85,626     $ 98,002     $ 110,019     $ 36,421  
Working capital
    54,698       54,176       69,365       93,437       17,371  
Total assets
    128,424       145,079       208,475       149,476       77,346  
Long-term debt
    1,218       6,850       11,700       7,200       10,700  
Total stockholders’ equity
    86,477       93,715       166,739       120,420       38,753  


(a) In January 2001, ArQule acquired Camitro Corporation for $84.3 million in a stock purchase transaction. In conjunction with the transaction, we recorded intangible assets for core technology and goodwill of $23.6 million and $29.7 million, respectively, each of which was being amortized over their estimated useful lives of seven years. We also immediately charged to income the estimated fair value of purchased in-process technology that had not yet reached technological feasibility and had no future alternative use.
 
(b) Effective January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, and accordingly ceased recording periodic goodwill amortization charges in lieu of performance of annual assessments for impairment.
 
(c) In the fourth quarter of 2002, we performed impairment assessments of the carrying value of the Company’s core technology and goodwill balances. These assessments indicated that the value of the assets were fully impaired and, accordingly, we took impairment charges for the full remaining carrying value.
 
(d) In December 2002, ArQule announced a major restructuring of its operations whereby it eliminated 31% of its workforce and closed its operations in Redwood City, California and Cambridge, United Kingdom.
 
(e) In September 2003, ArQule acquired Cyclis Pharmaceuticals, Inc. for $25.9 million in a stock purchase transaction. In connection with the transaction, we immediately charged to income $30.4 million representing purchased in-process research and development that had not yet reached technological feasibility and had no future alternative use.
 
(f) In October 2003, ArQule completed an agreement with InPharmatica Ltd. to sell certain assets of its former operations in the United Kingdom and to assign its facility obligation. As a result ArQule reversed $0.3 million of restructuring accrual to reflect a change in its original estimate of the remaining leasehold obligations and assumed sublease income in the United Kingdom. In December 2003, the adequacy of the restructuring accrual and assumed sublease income relative to the lease commitment in Redwood City, California was reassessed and, based on deteriorating market conditions, an additional provision of $1.5 million was recorded.
 
(g) In the fourth quarter of 2003, the carrying value of an investment in a privately-held proteomic company was written down by $4.8 million to reflect the estimated fair value of the investment.
 
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

      We are a biotechnology company engaged in the research and development of small molecule cancer therapeutics. We also provide fee-based chemistry services to pharmaceutical and biotechnology companies to produce novel chemical compounds with drug-like characteristics.

      We have incurred a cumulative net loss of $184 million from inception through December 31, 2003. Our expenses prior to September 2003 related to development activities associated with our chemistry services, the associated administrative costs required to support those efforts, and the cost of acquisitions. We expect research and development costs to increase in 2004 as we pursue development of our cancer programs. We do not expect to make additional investments in chemistry services during 2004. Although we have generated positive cash flow from operations for the last five years, we have recorded a net loss for each of those years. We expect to record a loss for 2004. Based on our cash position at the end of 2003 we will be able to dedicate approximately $25 million per year over the next three years to our ACTSM research and development

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program. This estimate is based upon the assumption that we will continue to operate our chemistry services on a cash flow positive basis, and to invest in cancer related research and development.

      Our revenue is derived from chemistry services performed for our customers. Revenue, expenses and gross margin fluctuate from quarter to quarter based upon contractual deliverables and the timing of the recognition of revenue under our revenue recognition policy (see the discussion of this under “Critical Accounting Policies and Estimates” below). As we increase our activities in cancer related research and development, the timing and extent of these efforts, together with the length and outcome of our clinical trials will further impact the fluctuation of results from operations. While our focus will be on cancer related research and development, we will continue to pursue revenue opportunities from customers for our chemistry services.

      In February 2004, we initiated a restructuring involving a reduction in workforce of 55 people, or 19% of the total workforce. This was undertaken to better align our resources with our new focus on cancer related research and development, and in response to a decrease in chemistry services activities. We plan to aggressively hire expertise in the field of drug discovery during 2004, and anticipate no net headcount decrease by the end of the year.

Liquidity and Capital Resources

                                           
% increase (decrease)

2003 2002 2001 2002 to 2003 2001 to 2002





(In millions)
Cash, cash equivalents and marketable securities
  $ 76.7     $ 85.6     $ 98.0       (10 )%     (13 )%
Working capital
    54.7       54.2       69.4       1 %     (22 )%
Cash flow from:
                                       
 
Operating activities
    4.1       2.5       4.4       65 %     (44 )%
 
Investing activities
    (10.8 )     (1.7 )     (65.7 )     (543 )%     97 %
 
Financing activities
    (1.4 )     (3.7 )     18.4       62 %     (120 )%

      Cash flow from operating activities. For 2003 the total of $4.1 million was primarily comprised of an operating profit, excluding non-cash charges, of $9.7 million and additional restructuring provisions of $1.2 million not requiring immediate cash outlays in 2003, which were partially offset by restructuring related payments of $3.8 million, and $3.0 million of payments related to liabilities assumed in the acquisition of Cyclis.

      Cash and cash equivalents used in investing activities. The total was $10.8 million in 2003, compared to $1.7 million in 2002. The increase in 2003 was due to $7.0 million for the Cyclis acquisition and $4.5 million for capital additions, which was partially offset by net proceeds from the sale and maturity of marketable securities of $0.7 million. The composition and mix of cash, cash equivalents and marketable securities may change frequently as a result of the Company’s constant evaluation of conditions in financial markets and the timing of specific investments.

      Cash and cash equivalents used in financing activities. The total was $1.4 million in 2003, compared to $3.7 million in 2002. The 2003 use was comprised of $7.4 million of principal repayments on our term loan to Fleet National Bank and $2.5 million of long-term debt assumed in connection with the acquisition of Cyclis and subsequently repaid. This was partially offset by proceeds from the issuance of common stock of $8.5 million, of which $8.0 million represents an investment by Pfizer.

      We have been cash flow positive from operations for five consecutive years. We expect that our available cash and marketable securities of $77 million at December 31, 2003, together with operating revenues and investment income, will be sufficient to finance our working capital and capital requirements for the next three years. In addition, we are currently considering raising additional capital through a follow-on public offering of our securities. We have filed a shelf registration statement on Form S-3 with the SEC covering securities having an aggregate maximum amount of $50 million.

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      Our cash requirements may vary materially from those now planned depending upon the results of our drug discovery and development strategies, our ability to enter into any additional corporate collaborations in the future and the terms of such collaborations, results of research and development, the need for currently unanticipated capital expenditures, competitive and technological advances, acquisitions and other factors. We cannot guarantee that we will be able to obtain additional customers for our chemistry services, or that such services will produce revenues adequate to fund our operating expenses. We cannot guarantee that we will be able to develop any of our drug candidates into a commercial product. If we experience increased losses, we may have to seek additional financing from public and private sale of our securities, including equity securities. There can be no assurance that additional funding will be available when needed or on acceptable terms.

      Our contractual obligations were comprised of the following as of December 31, 2003 (in thousands):

                                           
Within Within Within After
Total 1 Year 1-4 Years 4-7 Years 7 Years





Long-term debt obligations
  $ 6,912     $ 5,840     $ 1,072     $     $  
Capital lease obligations
    289       141       148              
Operating lease obligations
    10,951       2,821       5,597       2,533        
Purchase obligations
    2,965       1,253       797       533       382  
     
     
     
     
     
 
 
Total
  $ 21,117     $ 10,055     $ 7,614     $ 3,066     $ 382  
     
     
     
     
     
 

      Included in the total minimum payments for operating leases is approximately $6.7 million related to unoccupied real estate in California which was accrued as a liability, net of assumed sublease income, as a part of the Company’s restructuring charges in 2002 (see Note 11 to the Consolidated Financial Statements in Item 8 of this Form 10K). Purchase obligations are comprised primarily of outsourced preclinical and clinical trial expenses and payments to license certain intellectual property to support the Company’s research efforts.

Critical Accounting Policies and Estimates

      A “critical accounting policy” is one which is both important to the portrayal of the Company’s financial condition and results and requires management’s most difficult, subjective or complex judgements, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management believes the following are critical accounting policies. Please see the discussion of our significant accounting policies in Note 2 to the Consolidated Financial Statements included in Item 8 of this Form 10-K for additional information.

 
Revenue Recognition

      ArQule has entered into various chemistry-based collaborative agreements with pharmaceutical and biotechnology companies. Revenue from these collaborative agreements is recognized as follows:

  •  Non-refundable technology transfer fees. Under certain circumstances these are recognized as revenue upon completion of performance of a specified deliverable. However, where the effort is relatively constant over the performance period of the contract, the revenue is recognized on a straight-line basis over the performance period of the contract.
 
  •  Funding of compound development work. Revenue is recognized over the term of the applicable contract using the proportional achievement of deliveries against a compound delivery schedule, or the development labor expended against a total research and development labor plan, as the measure of progress toward completion.
 
  •  Payments based upon delivery of compounds. Payments based upon delivery of specialized compounds meeting the collaborator’s specified criteria are recognized as revenue once our obligations are complete, the collaborator has accepted the delivery of these compounds and collection is reasonably assured.

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  •  Certain milestones and royalties on product sales. If there are no continuing performance obligations, these revenues are recognized upon achievement of the related milestone. Revenues from milestone payments related to continuing performance obligations are recognized as revenue upon achievement of the milestone only if all of a specified list of conditions are met. Otherwise, the milestone payments are deferred and recognized as revenue over the term of the performance obligations.

      We follow these guidelines to measure revenue; however, certain judgments affect the application of these policies. For example, in connection with our Pfizer collaboration we have recorded current and long term deferred revenue based on our best estimate of when such revenue will be recognized. The estimate of deferred revenue reflects our estimate of the timing and extent of services that we will provide to Pfizer. Our services to Pfizer, and the timing of those services, are difficult to estimate and are impacted by factors outside of our control. For example, the timing and quantity of compounds we provide is largely dependent on Pfizer’s internal needs. Changes to estimates could impact the timing and amount of revenue we recognize in the future.

 
Purchase Accounting and In-process Research and Development

      Upon consummation of the Cyclis acquisition, we immediately charged to income $30.4 million representing purchased in-process research and development (“IPR&D”) that had not yet reached technical feasibility and had no alternative future use. Approximately $14 million of the charge represents the fair value of the IPR&D; the remaining $16.4 million of the charge represents the allocation to IPR&D of a portion of the excess of purchase price over the fair value of assets acquired.

      We believe that this charge represents a reasonably reliable estimate of the future benefits attributed to purchased IPR&D. The value assigned IPR&D (before the step-up adjustment) was composed of the projected value of three Cyclis preclinical drug development projects based on various mechanisms of actions associated with the ACTSM technology. The valuation was determined using the income approach. Potential revenue and drug development expenses were projected through 2020 based on information obtained from management and from published third-party industry statistics for similar drug development businesses. Specifically, we estimated that the development of our current cancer programs through clinical trials to commercial viability will take approximately nine years and cost in excess of $500 million. The discounted cash flow method was applied to the projected cash flows, adjusted for the probability of success, using a discount rate of 30%. The discount rate takes into consideration the uncertainty surrounding successful development and commercialization of the IPR&D. Since the acquisition, nothing has occurred that would lead us to believe that the original estimates of the cost to develop these compounds, or their revenue potential, is materially different from the estimates used at the time of the acquisition for purposes of purchase accounting.

 
Restructuring Charges

      Accruals for abandoned facilities under lease require significant management judgment and the use of estimates, including assumptions concerning our ability to sublease certain operating leases for abandoned real estate (see Note 11 to the Consolidated Financial Statements in Item 8 of this 10-K). These estimates of the time required to sublease the facilities and sublease rates the Company will receive were based on our analysis of the local real estate markets and general economic conditions in the regions of the abandoned facilities. If it takes longer to sublease these facilities than the Company has estimated, or if the sublease rates are less favorable than estimated, the Company may be required to take an additional charge for abandoned real estate of up to $3.1 million. Conversely, if the space is subleased either earlier than estimated or if the sublease rates actually achieved are more favorable, the Company may be required to reverse a portion of its current accrual for abandoned real estate.

 
Investments in Non-marketable Equity Securities

      At December 31, 2003, we performed an assessment of the fair value of our investment in a privately held proteomics company. This assessment included analysis of that company’s current financial condition, its

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prospects for generating additional cash flow from operating activities, the current market conditions for raising capital funding for companies in this industry and the likelihood that any funding raised would significantly dilute our ownership percentage. As a result of this analysis it was our judgment that an impairment had occurred and that the fair value of our investment was $0.3 million, resulting in a non-cash loss on investment of $4.7 million. If this entity is unsuccessful in its efforts to secure additional financing it may cease operations, rendering our investment worthless and necessitating a further write down. If the value of this investment recovers, we will not write-up the investment until it is sold.
 
Lease Commitments

      We lease approximately 56,000 square feet of laboratory and office space in Medford, Massachusetts, the majority of which is used for the Pfizer collaboration. We lease these facilities from Cummings Properties, LLC (“Cummings”) under two lease agreements, one of which expires on July 30, 2005 and one of which expires on July 30, 2006. The Company subleases portions of these facilities pursuant to two sublease agreements.

      On August 1, 2001, Cummings significantly raised ArQule’s rent, as outlined in Item 3, LEGAL PROCEEDINGS. We made an estimate of the most likely outcome of this contingency and concluded that no provision is required at December 31, 2003. It is our estimation that the most likely settlement at trial would result in no net financial statement loss. Nevertheless, if we are unsuccessful at trial, the Company could be required to record an additional expense of up to $.8 million.

Results of Operations

      Years ended December 31, 2001, 2002 and 2003:

 
Revenue
                                         
% increase (decrease)

2003 2002 2001 2002 to 2003 2001 to 2002





(In millions)
Revenue
  $ 65.5     $ 62.8     $ 58.4       4 %     8 %

      2003 as compared to 2002: Revenue increased by $2.7 million, or 4%. Revenue from our chemistry collaboration with Pfizer increased by $8.5 million due to an increase in the number of compounds developed under the terms of the contract and our receipt of certain contractual milestone payments on an accelerated basis because we met delivery requirements in 2003 ahead of schedule. This increase was offset by reductions in revenue from Bayer of $2.1 million, Solvay of $1.1 million, and Pharmacia of $0.5 million as the Company completed its final contractual obligations with these companies in 2003, and from reductions in revenue from Searle of $1.0 million, Wyeth of $0.7 million and Glaxo-Smith-Kline of $0.6 million whose contracts all ended in 2002. We expect revenue from our chemical services contracts to decrease in 2004 as a result of February 2004 amendments to our Pfizer agreement that will cause our compound deliveries to Pfizer to remain stable at 2004 levels, instead of increasing as previously agreed. In addition, in 2003 we completed the Bayer, Solvay and Pharmacia agreements.

      2002 as compared to 2001: Revenue increased by $4.4 million, or 8%, primarily due to a $10.5 million increase in Custom Array library revenues from our agreement with Pfizer. This increase was partially offset by reductions in revenue from Wyeth of $3.1 million, from Johnson & Johnson of $1.7 million, and from Sankyo of $1.3 million as these collaborations wound down.

 
Cost of Revenue and Gross Margin Percentage
                                         
% increase (decrease)

2003 2002 2001 2002 to 2003 2001 to 2002





Cost of revenue
  $ 36.1     $ 35.2     $ 29.4       2%       20%  
Gross margin % of revenue
    45.0 %     43.9 %     49.6 %     1.1% pts       (5.7)% pts  

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      2003 as compared to 2002: Cost of revenue increased due to increased cost of personnel, materials and facility related expenses, including depreciation, necessary to satisfy the increase in activity under the Pfizer contract during 2003, partially offset by a reduction in material costs associated with the completion of the Bayer contract during the third quarter of 2003. Gross margin as a percentage of revenue increased primarily as a result of the one-time increase in Pfizer revenue due to our receipt of certain contractual milestone payments on an accelerated basis because we met delivery requirements in 2003 ahead of schedule and to the recognition of previously deferred revenue from Bayer as a result of our completing our contractual obligations. the associated costs for which were incurred in earlier years. We expect cost of revenue will decrease in 2004 as a result of lower revenues and the resultant decrease in direct production and material costs due to the absence of activity under the Bayer, Solvay and Pharmacia agreements, which were terminated in 2003. We expect gross margin percentage to decrease in 2004 as a result of the lower revenues available to offset fixed overhead and facility-related expenses.

      2002 as compared to 2001: Cost of revenue increased due to increased cost of personnel and materials necessary to satisfy the 2002 expansion of the Pfizer collaboration. Our gross margin as a percentage of revenue decreased by 5.7 percentage points due to the increased labor and material costs necessary to fulfill the Pfizer and Bayer collaborations.

 
Research and Development
                                         
% increase (decrease)

2003 2002 2001 2002 to 2003 2001 to 2002





(In millions)
Research and development
  $ 18.9     $ 31.4     $ 28.4       (40 )%     10 %

      2003 as compared to 2002: The $12.5 million decrease in research and development primarily reflects the cost savings associated with the Company’s decision in December 2002 to cease further development of the Camitro predictive modeling technology, to close the related facilities in Redwood City, California (effective December 31, 2002) and Cambridge, United Kingdom (effective March 31, 2003), and to realign its workforce in order to expedite its transition to a drug discovery and development company. These cost savings were partially offset by the increased cost associated with the acquisition of Cyclis in September 2003, notably the addition of approximately 14 scientists, increased laboratory supply and facility expenses and the cost of preclinical and clinical studies to develop the ACTSM platform and ARQ 501. We expect research and development expense to increase in 2004 as we expand our oncology discovery pipeline and begin clinical trials.

      2002 as compared to 2001: The $2.9 million increase primarily consists of an additional $2.1 million in personnel and related costs and $0.9 million of additional third-party information system technology as the result of our efforts to augment and enhance our chemistry, biology, predictive and computational modeling capabilities and related proprietary technologies. In 2002, the Company devoted additional personnel and resources to the integration and refinement of the respective technologies in order to advance the objective of a fully integrated drug discovery platform.

 
Marketing, General and Administrative
                                         
% increase (decrease)

2003 2002 2001 2002 to 2003 2001 to 2002





(In millions)
Marketing, general and administrative
  $ 9.6     $ 12.9     $ 12.4       (26 )%     4 %

      2003 as compared to 2002: The decrease in marketing, general and administrative expense is primarily due to the cost savings associated with the severance of 31 marketing, general and administrative employees as part of the Company’s restructuring actions in December 2002, and the closing of the Redwood City and Cambridge facilities. The decrease consists primarily of reductions in employee related expenses of $1.8 million, professional fees of $0.6 million and facility related expense of $0.6 million. We expect marketing,

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general and administrative expense to decrease in 2004 as a result of our restructuring actions in the first quarter of 2004 and due to conscious efforts to contain infrastructure spending.

      2002 as compared to 2001: Marketing, general and administrative expenses were essentially flat year-over-year.

 
Acquisition Related Charges
                         
2003 2002 2001



(In millions)
Stock based compensation
  $     $ 3.0     $ 6.9  
Amortization of core technology
          3.4       3.1  
Amortization of goodwill
                4.0  
Impairment of core technology
          17.1        
Impairment of goodwill
          25.9        
In-process research and development
    30.4             18.0  
     
     
     
 
Total acquisition related charges
  $ 30.4     $ 49.4     $ 32.0  
     
     
     
 

      2003. Acquisition related charges in 2003 relate to the September 8, 2003 acquisition of Cyclis. Upon consummation of the Cyclis acquisition, we immediately charged to income $30.4 million representing purchased in-process research and development (“IPR&D”) that had not yet reached technical feasibility and had no alternative future use. Approximately $14 million of the charge represents the fair value of the IPR&D. The remaining $16.4 million of the charge represents a step-up adjustment resulting from the excess of the purchase price over the identifiable tangible and intangible assets acquired and liabilities assumed which was allocated on a pro rata basis to the carrying value of acquired long-lived assets. See “Critical Accounting Policies and Estimates” above for a discussion of our accounting policies and significant estimates.

      2002 and 2001. Acquisition related charges in 2002 and 2001 all relate to the January 2001 acquisition of Camitro. Upon consummation of the acquisition in January 2001, we immediately charged to income $18.0 million representing the estimated fair value of purchased in-process technology that had not yet reached technological feasibility and had no alternative future use (see Note 4 of notes to Consolidated Financial Statements included in Item 8 of this 10-K).

      In 2002, we continued to recognize stock-based compensation charges based on the amortization of deferred compensation arising from the issuance of stock options issued below market value and restricted stock to former employees of Camitro, in addition to amortizing core technology. We implemented Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”) in January 2002, and accordingly ceased recording periodic goodwill amortization charges in lieu of performing annual assessments for impairment. At December 31, 2002, we assessed the recoverability of the carrying value of our core technology and goodwill balances and, based on the applicable accounting standards, recorded impairment charges of $17.1 million and $25.9 million, respectively, representing the entire remaining balances of these assets. See “Critical Accounting Policies and Estimates” above for a discussion of our accounting policies and significant estimates.

 
Restructuring Related Charges

      In December 2002, we announced a restructuring of our operations whereby we ceased further development and commercialization of the Camitro predictive modeling technology and realigned our workforce to expedite the transition towards becoming a drug discovery company.

      The restructuring actions included closing our facilities in Redwood City, California and Cambridge, United Kingdom, along with the termination of employees in these facilities and our Massachusetts facilities.

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The Company recorded a restructuring charge of approximately $12.7 million, the components of which are as follows (in thousands):
         
Termination benefits
  $ 2,140  
Facilities related
    9,607  
Other charges
    948  
     
 
Total restructuring charges
  $ 12,695  
     
 

      Termination benefits relate to severance and benefit costs associated with the elimination of 128 managerial and staff positions worldwide, comprising approximately 31% of the workforce. Facility-related costs relate to the remaining lease payment obligations associated with the abandonment of our facilities in Redwood City, California and Cambridge and the non-cash write-off of leasehold improvements and equipment no longer expected to provide future economic benefit at the abandoned facilities, less assumed proceeds from sale. Other charges include a $0.5 million non-cash stock compensation charge, contractual obligations which provided no future value to the Company, and other miscellaneous costs associated with closing the California and United Kingdom operations. See Item 11 in the Notes to the Consolidated Financial Statements at Item 2 of this 10K. We believe that these actions resulted in savings of approximately $12 million per year in personnel and facility-related expenses.

      Activities against the restructuring accrual (which is included in accrued liabilities in the Consolidated Balance Sheet) in 2002 and 2003 were as follows (in thousands):

                                 
2002 2002 2002 Restructuring
Restructuring Non-cash Cash Accrual at
Charge Write-offs Payments December 31, 2002




Termination benefits
  $ 2,140     $     $ (111 )   $ 2,029  
Facilities related
    9,607       (3,322 )           6,285  
Other charges
    948       (477 )     (35 )     436  
     
     
     
     
 
Total restructuring accrual
  $ 12,695     $ (3,799 )   $ (146 )   $ 8,750  
     
     
     
     
 
                                 
Restructuring 2003 Restructuring
Accrual at 2003 Cash Accrual at
December 21, 2002 Provisions Payments December 31, 2003




Termination benefits
  $ 2,029     $     $ (2,019 )   $ 10  
Facilities related
    6,285       1,239       (1,364 )     6,160  
Other charges
    436             (367 )     69  
     
     
     
     
 
Total restructuring accrual
  $ 8,750     $ 1,239     $ (3,750 )   $ 6,239  
     
     
     
     
 

      The Company eliminated 108 positions in December 2002; the remaining 20 were eliminated by March 31, 2003. As of December 31, 2003 virtually all termination benefits had been paid. California facility costs will be paid out through the remaining lease term of the facility, which extends through 2010, unless we are able to mitigate such costs by subleasing the facility or settling our leasehold position by paying a lump-sum payment to the landlord. In October 2003, ArQule completed an agreement with InPharmatica Ltd. to sell certain assets of its former operations in the United Kingdom. As a result, ArQule reversed $0.3 million of restructuring accrual to reflect a change in its original estimate of the remaining leasehold obligations and assumed sublease income in the United Kingdom. Throughout the latter half of 2003, ArQule was in negotiations with a third-party to sublease its facility in California on favorable terms. Those negotiations were terminated in January 2004. As a result, the adequacy of the accrual relative to the lease obligation and assumed sublease income for the California facility was reassessed, and based on continued deterioration in the local real estate market, an additional provision of $1.5 million was recorded.

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Interest Income and Expense
                                         
% (decrease)

2003 2002 2001 2002 to 2003 2001 to 2002





(In millions)
Interest income
  $ 1.1     $ 2.1     $ 4.5       (45)%       (54)%  
Interest expense
    (0.5 )     (1.0 )     (1.6 )     (44)%       (41)%  
     
     
     
     
     
 
Interest income, net
  $ 0.6     $ 1.1     $ 2.9       (46)%       (61)%  
     
     
     
     
     
 

      Interest income is derived from our portfolio of cash and short-term investments. Interest income decreased in each of the last three years due to decreasing average principal balances and continued decreasing interest rates. Interest expense decreased in each of the last three years due to lower average debt balances and lower interest rates.

 
Loss on Investment
                         
2003 2002 2001



(In millions)
Loss on investment
  $ 4.7     $     $  

      The loss on investments relates to an impairment charge taken to write down the Company’s investment in a privately-held proteomics Company to its estimated fair value. See “Critical Accounting Policies and Estimates” above for a discussion of our accounting policies and significant estimates.

 
Recent Accounting Pronouncements

      In December 2003, the FASB reached a consensus on Emerging Issues Task Force Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). This issue addresses how to account for arrangements that involve the delivery or performance of multiple products, services, and/or rights to use assets. This issue is applicable to agreements entered into after June 15, 2003. The Company is currently assessing the impact EITF No. 00-21 will have on revenue recognition in 2004, in particular as it relates to the updated Pfizer contract which was signed in February 2004.

 
Item 7A. Quantitative and Qualitative Disclosures About Market Risk

      We own financial instruments that are sensitive to market risk as part of our investment portfolio. Our investment portfolio is used to preserve our capital until it is used to fund operations, including our research and development activities. None of these market-risk sensitive instruments are held for trading purposes. We invest our cash primarily in money market mutual funds and U.S. Government and other investment grade debt securities. These investments are evaluated quarterly to determine the fair value of the portfolio. Our investment portfolio includes only marketable securities with active secondary or resale markets to help insure liquidity. We have implemented policies regarding the amount and credit ratings of investments. Due to the conservative nature of these policies, we do not believe we have material exposure due to market risk.

      Our use of derivative financial instruments is limited to the utilization of an interest rate swap agreement. Settlement accounting is used for this interest rate swap, which has a notional amount of $975,000 and expires on June 30, 2004. Any differences paid or received on interest rate swap agreements are recognized as adjustments to interest expense over the life of each swap, thereby adjusting the effective interest rate of the underlying obligations. The fair market value of this swap was an unrecognized loss of $22,000 at December 31, 2003.

      See Notes 2 and 12 to the Consolidated Financial Statements for a description of our use of derivatives and other financial instruments. The carrying amounts reflected in the consolidated balance sheet of cash and cash equivalents, trade receivables, and trade payables approximates fair value at December 31, 2003 due to the short-term maturities of these instruments.

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Item 8. Consolidated Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

         
Page

Report of Independent Accountants
    F-2  
Consolidated Balance Sheet at December 31, 2003 and 2002
    F-3  
Consolidated Statement of Operations for the years ended December 31, 2003, 2002 and 2001
    F-4  
Consolidated Statement of Stockholders’ Equity for the years ended December 31, 2003, 2002 and 2001
    F-5  
Consolidated Statement of Cash Flows for the years ended December 31, 2003, 2002 and 2001
    F-6  
Notes to Consolidated Financial Statements
    F-8  

      Consolidated Financial Statement Schedules:

        Schedules are not included because they are not applicable or the information is included in the Notes to Consolidated Financial Statements

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REPORT OF INDEPENDENT AUDITORS

To the Board of Directors and Stockholders of ArQule, Inc.:

      In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, stockholders’ equity and cash flows present fairly, in all material respects, the financial position of ArQule, Inc. and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. 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 of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit 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.

      As discussed in Notes 2 and 8 to the consolidated financial statements, the Company changed its method of accounting for goodwill in 2002 .

  /s/ PRICEWATERHOUSECOOPERS LLP

Boston, Massachusetts

February 13, 2004

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ARQULE, INC.

CONSOLIDATED BALANCE SHEET

                     
December 31,

2003 2002


(In thousands, except
share and per share data)
ASSETS
Current assets:
               
 
Cash and cash equivalents
  $ 32,139     $ 40,283  
 
Marketable securities
    44,585       45,343  
 
Accounts receivable
    741       126  
 
Prepaid expenses and other current assets
    2,455       2,545  
     
     
 
   
Total current assets
    79,920       88,297  
Property and equipment, net
    47,942       51,516  
Other assets
    562       5,266  
     
     
 
    $ 128,424     $ 145,079  
     
     
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
Current liabilities:
               
 
Current portion of long term debt
  $ 5,980     $ 7,350  
 
Accounts payable and accrued expenses
    14,468       16,207  
 
Deferred revenue
    4,774       10,564  
     
     
 
   
Total current liabilities
    25,222       34,121  
Deferred revenue
    15,507       10,393  
Long term debt
    1,218       6,850  
     
     
 
   
Total liabilities
    41,947       51,364  
     
     
 
Commitments (Note 16)
           
Stockholders’ equity:
               
 
Preferred stock, $0.01 par value; 1,000,000 shares authorized; no shares issued or outstanding
           
 
Common stock, $0.01 par value; 50,000,000 shares authorized; 28,724,771 and 21,373,848 shares issued and outstanding at December 31, 2003 and 2002, respectively
    287       214  
 
Additional paid-in capital
    270,663       243,285  
 
Accumulated other comprehensive income
    (137 )     (199 )
 
Accumulated deficit
    (184,336 )     (149,585 )
     
     
 
   
Total stockholders’ equity
    86,477       93,715  
     
     
 
    $ 128,424     $ 145,079  
     
     
 

The accompanying notes are an integral part of these consolidated financial statements.

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ARQULE, INC.

CONSOLIDATED STATEMENT OF OPERATIONS

                             
Year Ended December 31,

2003 2002 2001



(In thousands, except per share data)
Revenue
                       
 
Compound development revenue
  $ 65,077     $ 60,965     $ 53,266  
 
Compound development revenue — related parties
    462       1,847       5,130  
     
     
     
 
      65,539       62,812       58,396  
     
     
     
 
Costs and expenses:
                       
 
Cost of revenue
    35,829       34,306       22,657  
 
Cost of revenue — related parties
    231       925       6,784  
 
Research and development
    18,932       31,389       28,446  
 
Marketing, general and administrative
    9,560       12,876       12,353  
 
Stock-based compensation
          3,221       6,949  
 
Amortization of core technology
          3,373       3,091  
 
Amortization of goodwill
                4,013  
 
Impairment of core technology
          17,137        
 
Impairment of goodwill
          25,890        
 
Restructuring charges
    1,239       12,695        
 
Acquired in-process research and development
    30,359             18,000  
     
     
     
 
      96,150       141,812       102,293  
     
     
     
 
   
Loss from operations
    (30,611 )     (79,000 )     (43,897 )
Investment income
    1,146       2,078       4,491  
Interest expense
    (536 )     (953 )     (1,621 )
Loss on investment
    (4,750 )            
     
     
     
 
   
Net loss
  $ (34,751 )   $ (77,875 )   $ (41,027 )
     
     
     
 
Basic and diluted net loss per share
  $ (1.43 )   $ (3.67 )   $ (2.06 )
     
     
     
 
Weighted average common shares outstanding — basic and diluted
    24,333       21,215       19,905  
     
     
     
 

The accompanying notes are an integral part of these consolidated financial statements.

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ARQULE, INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

                                                         
Accumulated
Common Stock Additional Other Total

Paid-In Comprehensive Deferred Accumulated Stockholders’
Shares Par Value Capital Income Compensation Deficit Equity







(In thousands, except share data)
Balance at December 31, 2000
    17,072,727     $ 171     $ 151,084     $ 29     $ (181 )   $ (30,683 )   $ 120,420  
Stock option exercises
    90,310       1       753                               754  
Employee stock purchase plan
    93,958       1       827                               828  
Issuance of common stock in connection with the Camitro acquisition
    3,103,567       31       81,871               (12,552 )             69,350  
Issuance of common stock to Pfizer
    755,857       7       9,516                               9,523  
Forfeiture of deferred compensation
                    (1,404 )             1,404                
Compensation related to the grant of common stock options
                    129               (129 )              
Amortization of deferred compensation
                                    6,949               6,949  
Change in unrealized gain on marketable securities
                            49                       49  
Cumulative translation adjustment
                            (107 )                     (107 )
Net loss
                                            (41,027 )     (41,027 )
     
     
     
     
     
     
     
 
Balance at December 31, 2001
    21,116,419       211       242,776       (29 )     (4,509 )     (71,710 )     166,739  
Stock option exercises
    130,739       2       534                               536  
Employee stock purchase plan
    126,690       1       786                               787  
Forfeiture of deferred compensation
                    (883 )             883                
Compensation related to the grant of common stock options
                    72               (72 )              
Amortization of deferred compensation
                                    3,221               3,221  
Restructuring charge related to restricted stock
                                    477               477  
Change in unrealized loss on marketable securities and derivatives
                            (221 )                     (221 )
Cumulative translation adjustment
                            51                       51  
Net loss
                                            (77,875 )     (77,875 )
     
     
     
     
     
     
     
 
Balance at December 31, 2002
    21,373,848       214       243,285       (199 )           (149,585 )     93,715  
Stock option exercises
    144,791       1       135                               136  
Employee stock purchase plan
    116,984       1       384                               385  
Issuance of common stock in connection with Cyclis acquisition
    4,571,327       46       18,884                               18,930  
Issuance of common stock to Pfizer
    2,517,821       25       7,975                               8,000  
Change in unrealized loss on marketable securities and derivatives
                            94                       94  
Cumulative translation adjustment
                            (32 )                     (32 )
Net loss
                                            (34,751 )     (34,751 )
     
     
     
     
     
     
     
 
Balance at December 31, 2003
    28,724,771     $ 287     $ 270,663     $ (137 )   $     $ (184,336 )   $ 86,477  
     
     
     
     
     
     
     
 

The accompanying notes are an integral part of these consolidated financial statements.

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ARQULE, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS

                               
Year Ended December 31,

2003 2002 2001



(In thousands)
Increase (decrease) in cash and cash equivalents
                       
Cash flows from operating activities:
                       
 
Net loss
  $ (34,751 )   $ (77,875 )   $ (41,027 )
 
Adjustments to reconcile net loss to net cash provided by operating activities:
                       
     
Depreciation and amortization
    9,347       9,987       8,971  
     
Amortization of deferred compensation
          3,221       6,949  
     
Amortization of goodwill and purchased intangibles
          3,373       7,104  
     
Purchase of in-process research and development
    30,359             18,000  
     
Impairment of core technology
          17,137        
     
Impairment of goodwill
          25,890        
     
Non-cash restructuring charges
          3,799        
     
Loss on investment
    4,750              
Changes in operating assets and liabilities, net of acquisition:
                       
 
Accounts receivable
    (611 )     2,466       (303 )
 
Prepaid expenses and other current assets
    144       (480 )     (190 )
 
Other assets
          134       1,883  
 
Accounts payable and accrued expenses
    (4,475 )     8,885       2,217  
 
Deferred revenue
    (676 )     5,936       836  
     
     
     
 
   
Net cash provided by operating activities
    4,087       2,473       4,440  
     
     
     
 
Cash flows from investing activities:
                       
 
Purchases of marketable securities
    (70,332 )     (46,512 )     (66,272 )
 
Proceeds from sale or maturity of marketable securities
    71,006       55,888       35,519  
 
Investment in unconsolidated affiliates
                (5,000 )
 
Acquisitions, net of cash acquired
    (7,014 )           (1,834 )
 
Additions to property and equipment
    (4,496 )     (11,060 )     (28,095 )
     
     
     
 
   
Net cash used in investing activities
    (10,836 )     (1,684 )     (65,682 )
     
     
     
 
Cash flows from financing activities:
                       
 
Principal payments of capital lease obligations
    (35 )           (1,182 )
 
Borrowings of long term debt
          2,500       16,000  
 
Principal payments of long term debt
    (9,872 )     (7,500 )     (7,500 )
 
Proceeds from issuance of common stock, net
    8,521       1,321       11,105  
     
     
     
 
   
Net cash provided by (used in) financing activities
    (1,386 )     (3,679 )     18,423  
     
     
     
 
Effect of foreign exchange rates on cash and cash equivalents
    (9 )     (87 )      
     
     
     
 
Net decrease in cash and cash equivalents
    (8,144 )     (2,977 )     (42,819 )
Cash and cash equivalents, beginning of period
    40,283       43,260       86,079  
     
     
     
 
Cash and cash equivalents, end of period
  $ 32,139     $ 40,283     $ 43,260  
     
     
     
 

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Supplemental Disclosure of Cash Flow Information:

      During 2001, 2002, and 2003 the Company paid approximately $1,621, $953 and $536 respectively, for interest expense.

      Net assets and liabilities assumed in the Camitro and Cyclis acquisitions — see Note 4.

      The accompanying notes are an integral part of these consolidated financial statements.

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ARQULE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except share and per share data)
 
1. Organization and Nature of Operations

      We are a biotechnology company engaged in the discovery and development of novel drugs primarily for the treatment of cancer. We apply our proprietary ACTSM technology platform to develop small molecule compounds that we believe will selectively kill cancer cells by restoring and activating cellular checkpoints while sparing normal cells. Our oncology portfolio consists of our lead clinical candidate, ARQ 501 and several discovery programs based on the ACTSM platform.

      We also provide chemistry services to collaborators and customers for their discovery programs, which has been a part of our business since our inception. In our chemistry technologies business, we apply our expertise in the design, production, and evaluation of chemical compounds that have the potential to become medicines. For example, we generate libraries, or large collections, of potential drug candidates, assess the drug likeness of candidates and select the most promising candidates, all using high throughput, automated chemistry. Our chemistry services-based collaboration agreements involve several pharmaceutical companies, including Pfizer Inc., Sankyo Company, Ltd and Novartis Biomedical Research Institute.

 
2. Summary of Significant Accounting Policies

      Significant accounting policies followed in the preparation of these financial statements are as follows:

     Basis of Consolidation

      The consolidated financial statements include the accounts of ArQule, Inc. and its wholly-owned subsidiary Camitro Corporation, including Camitro, U.K. Ltd. (subsequently renamed ArQule U.K. Ltd.), which was acquired on January 29, 2001 (collectively, “we”, “us”, “our” and the “Company”). All intercompany transactions and balances have been eliminated. In September 2002, the Camitro Corporation was merged into, and made part of, ArQule, Inc. We acquired Cyclis Pharmaceuticals, Inc. (“Cyclis”) on September 8, 2003, at which time Cyclis was merged into ArQule and ceased to be a separate entity. The results of Cyclis’ operations and the estimated fair value of assets acquired and liabilities assumed are included in the financial statements from the date of acquisition.

     Use of Estimates

      The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

     Cash Equivalents and Marketable Securities

      We consider all highly liquid investments purchased within three months of maturity date to be cash equivalents. We invest our available cash primarily in money market mutual funds and U.S. government and other investment grade debt securities that have strong credit ratings. As a matter of policy, we determine on a quarterly basis the fair market value of our investment portfolio. Our securities are recorded on our balance sheet at fair market value. Unrealized gains and losses on securities are included in shareholders equity, net of related tax effects. If the fair market value of a marketable security declines below its cost basis, and, based upon our consideration of all available evidence, we conclude such decline is “other than temporary”, we mark the investment to market through a charge to current earnings. At December 31, 2002 and 2003, we have classified these investments as available-for-sale.

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     Fair Value of Financial Instruments

      At December 31, 2002 and 2003, our financial instruments consist of cash, cash equivalents, marketable securities, accounts receivable, accounts payable, accrued expenses, debt and interest rate swaps. The carrying amounts of these instruments approximate their fair values.

     Investments in Non-Marketable Equity Securities

      Investments in non-marketable equity securities are accounted for under the cost method if ArQule owns less than 20 percent of the outstanding stock of the investee and our management determines we do not exert significant influence over the management of the investee. We assess the fair value of investments in non-marketable equity securities quarterly, or whenever events or changes in circumstances indicate the carrying value may not be recoverable. In the event fair value is determined to be less than the carrying value of an investment, the carrying value is written down to fair value if the decline in value is significant and is deemed to be other than temporary. Since there is no readily available market information concerning the fair value of these investments, such assessments require significant management judgment in analyzing the investee’s financial position and projected future financial results and cash flows. Although the estimates used reflect our best estimates of fair value based upon available information, the use of different estimates could yield different conclusions concerning the recoverability of the carrying value of investments.

     Foreign Currency

      Our foreign subsidiary, ArQule, U.K. Ltd., had designated the Great Britain Pound Sterling as its functional currency. Financial statements of this foreign subsidiary are translated to U.S. dollars for consolidation purposes using current rates of exchange for monetary assets and liabilities and historical rates of exchange for non-monetary assets and related elements of expense. Revenue and other expense elements are translated at rates that approximate the rates in effect on the transaction dates. Related cumulative translation adjustments are included as a component of equity in the consolidated balance sheet.

     Property and Equipment

      Property and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives. Assets under capital leases and leasehold improvements are amortized over the shorter of their estimated useful lives or the term of the respective leases by use of the straight-line method. Maintenance and repair costs are expensed as incurred.

     Goodwill and Other Intangibles Assets

      Prior to December 2002, the Company’s intangible assets consisted primarily of the value of core technology and goodwill which was recorded in connection with the acquisition of Camitro Corporation. Both balances were amortized in 2001 using the straight-life method over their estimated useful lives of seven years. These technology assets were subject to amortization in 2002.

      In January 2002, we adopted Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). As a result, goodwill balances are no longer subject to periodic amortization, but rather assessments for impairment. In conjunction with the adoption of SFAS 142, goodwill is subject in 2002 to both a transitional goodwill impairment test as of January 1, 2002 and an annual assessment for impairment based on fair value. In addition, FAS 142 requires that a goodwill impairment review be performed whenever events or changes in circumstances (“triggering events”) indicate that the carrying value may not be recoverable.

      In addition to performing impairment assessments for goodwill, we also assess the recoverability of our core technology intangible asset annually, or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If it is determined that the carrying value of an intangible asset might not be recoverable based on one or more indications of impairment, we measure any impairment based on the projected future cash flow of the underlying asset.

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     Revenue Recognition

      ArQule has entered into various chemistry-based collaborative agreements with pharmaceutical and biotechnology companies under which ArQule produces and delivers compound arrays and other research and development services. Revenue from collaborative agreements includes non-refundable technology transfer fees, funding of compound development work, the delivery of compounds, payments based upon delivery of specialized compounds meeting the collaborators specified criteria, and certain milestones and royalties on product sales. Non-refundable technology transfer fees are recognized as revenue when we have the contractual right to receive such payment, provided a contractual arrangement exists, the contract price is fixed or determinable, the collection of the resulting receivable is reasonably assured and we have no further performance obligations under the license agreement. When we have performance obligations under the terms of a contract, non-refundable fees are recognized as revenue as we complete our obligations. Where our level of effort is relatively constant over the performance period, the revenue is recognized on a straight-line basis. Funding of compound development work is recognized over the term of the applicable contract using the proportional achievement of deliveries against a compound delivery schedule or the development labor expended against a total research and development labor plan as the measure of progress toward completion. Any significant changes in the assumptions underlying our estimates to complete a contract (e.g., changes in the number of person hours to develop compounds, or changes in throughput capacity of our machinery and equipment) could impact our revenue recognition. Payments based upon delivery of specialized compounds meeting the collaborator’s specified criteria are recognized as revenue once the collaborator has accepted the delivery of these compounds and collection is reasonably assured.

      Revenues from milestone payments related to chemistry-based collaboration arrangements under which we have no continuing performance obligations are recognized upon achievement of the related milestone. Revenues from milestone payments related to arrangements under which the Company has continuing performance obligations are recognized as revenue upon achievement of the milestone only if all of the following conditions are met: the milestone payments are non-refundable; achievement of the milestone was not reasonably assured at the inception of the arrangement; substantive effort is involved in achieving the milestone; and the amount of the milestone is reasonable in relation to the effort expended or the risk associated with achievement of the milestone. If any of these conditions are not met, the milestone payments are deferred and recognized as revenue over the term of the arrangement as we complete our performance obligations. Payments received under these arrangements prior to the completion of the related work are recorded as deferred revenue.

     Cost of Revenue

      Cost of revenue represents the actual costs incurred in connection with performance pursuant to our chemistry-based collaborative agreements and the costs incurred to develop and produce compounds under these agreements. These costs consist primarily of payroll and payroll-related costs, chemicals, supplies and overhead expenses.

     Research and Development Costs

      Costs of internal research and development and research and development done pursuant to collaborations are charged to operations as incurred. Development costs incurred in connection with funded development collaborations are included in cost of revenue. We incurred research and development expenses of $46,446, $31,389 and $49,291 in 2001, 2002 and 2003, respectively, including amounts assigned to acquired in-process technology of $18,000 in 2001 and $30,359 in 2003. The value assigned to acquired in-process technology, which was charged to operations upon acquisition, was determined by identifying and valuing those acquired in-process research projects for which (a) technological feasibility had not been established at the acquisition date, (b) there was no alternative future use, and (c) the fair value was estimable with reasonable reliability. See Note 4 for additional information.

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Restructuring Charges

      Accruals are established for involuntary employee termination benefits in the same period that the appropriate level of management and the Board of Directors approve and commit the Company to a termination plan which: a) specifically identifies the number, location and job level of employees to be terminated; b) specifies the benefits terminated employees are to receive; c) assures that employees will be terminated within one year.

      Accruals are established for property and equipment and facility-related costs for facilities to be abandoned which have no future economic benefit to the Company in the same period that the appropriate level of management and Board of Directors approve and commit the Company to an abandonment plan which: a) specifically identifies all significant actions to be taken to complete the abandonment plan; b) will begin as soon as possible after the abandonment plan is approved and; c) the period to complete that abandonment plan indicates that significant changes are not likely.

      Accruals for property and equipment and facility related costs of abandoned facilities require significant management judgment and the use of estimates, including assumptions concerning our ability to sublease certain operating leases for abandoned real estate (see Note 11). These estimates of the time required to sublease the facilities and sublease rates the Company will receive were based on management’s analysis of the local real estate markets and general economic conditions in the regions of the abandoned facilities. If it takes longer to sublease these facilities than the Company has estimated, or if the sublease rates are less favorable than estimated, the Company may be required to take an additional charge for abandoned real estate. Conversely, if the space is subleased either earlier than estimated, or if the sublease rate actually achieved are more favorable, the Company may be required to reverse a portion of its current accrual for abandoned real estate.

 
Interest Rate Swap Agreement

      We utilize an interest rate swap agreement in order to reduce the impact of changes in interest rates on our term loans. Settlement accounting is used for this interest rate swap, which expires on June 30, 2004. Any differences paid or received on interest rate swap agreements are recognized as adjustments to interest expense over the life of each swap, thereby adjusting the effective interest rate of the underlying obligations. The fair market value of this swap was an unrecognized loss of $22 at December 31, 2003.

 
Segment Data

      Management uses consolidated financial information in determining how to allocate resources and assess performance. For this reason, we have determined that we are principally engaged in one industry segment. See Note 17 with respect to significant customers. Substantially all of our revenue since inception has been generated in the United States and substantially all of our long lived assets are located in the United States.

 
Income Taxes

      The asset and liability approach is used to account for income taxes by recognizing deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. We record a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized

 
Earnings (Loss) Per Share

      The computations of basic and diluted earnings (loss) per common share are based upon the weighted average number of common shares outstanding and potentially dilutive securities. Potentially dilutive securities include stock options and warrants. Options to purchase of 3,397,277, 3,690,317 and 3,895,918 shares of common stock were not included in the 2001, 2002 and 2003 computation of diluted net loss per share, respectively, because inclusion of such shares would have an anti-dilutive effect.

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Stock-Based Compensation

      Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), requires that companies either recognize compensation expense for grants of stock options and other equity instruments based on fair value, or provide pro forma disclosure of net income (loss) and net income (loss) per share in the notes to the financial statements. At December 31, 2003, we have three stock-based compensation plans, which are described more fully in Note 14. We account for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations. Accordingly, no compensation cost has been recognized under SFAS 123 for our employee stock option plans. Had compensation cost for the awards under those plans been determined based on the grant date fair values, consistent with the method required under SFAS 123, the Company’s net loss and net loss per share would have been reduced to the pro forma amounts indicated below:

                         
Year Ended December 31,

2003 2002 2001



Net loss as reported
  $ (34,751 )   $ (77,875 )   $ (41,027 )
Add: Stock-based employee compensation expense included in reported net loss
          3,221       6,949  
Less: Stock-based employee compensation under the fair-value method of SFAS 123
    (5,602 )     (10,227 )     (12,770 )
     
     
     
 
Pro forma net loss
  $ (40,353 )   $ (84,881 )   $ (46,848 )
     
     
     
 
Basic and diluted net loss per share
                       
As reported
  $ (1.43 )   $ (3.67 )   $ (2.06 )
Pro forma
  $ (1.66 )   $ (4.00 )   $ (2.35 )

      For the purposes of pro forma disclosure, the estimated value of each employee and non-employee option grant was calculated on the date of grant using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the use of highly subjective assumptions, including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective assumptions can materially affect the fair value estimates, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock-based compensation. The model was calculated using the following weighted-average assumptions: no dividend yield for all years; volatility of 95% for 2001, 2002 and 2003; risk-free interest rates of 4.24% in 2001, 3.85% in 2002 and 2.0% in 2003; and expected lives of 4 years in 2001 and 5 years for 2002 and 2003 for options granted.

 
Comprehensive Income (Loss)

      Other comprehensive income (loss) refers to revenues, expenses, gains and losses that under accounting principles generally accepted in the United States are included in comprehensive income (loss) but are excluded from net income (loss) as these amounts are recorded directly as an adjustment to stockholders’ equity, net of tax. Our other comprehensive income (losses) were $(58), $(170) and $62 in 2001, 2002, and 2003 respectively, and is composed of unrealized gains and losses on marketable securities and interest rate swaps and foreign currency translation adjustments.

 
Reclassifications

      Certain reclassifications have been made to the 2001 and 2002 financial statements to conform to the 2003 presentation.

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Recent Accounting Pronouncements

      In December 2003, the FASB reached a consensus on Emerging Issues Task Force Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). This issue addresses how to account for arrangements that involve the delivery or performance of multiple products, services, and/or rights to use assets. This is applicable to agreements entered into in after June 15, 2003. The Company is currently assessing the impact EITF No. 00-21 will have on revenue recognition in 2004, in particular as it relates to the updated Pfizer contract which was signed in February 2004.

 
3. Related Parties

      We have entered into a number of license, research and development agreements (the “Agreements”) with corporate collaborators. Three separate agreements were entered into with Solvay Duphar B.V. (“Solvay”), Wyeth Pharmaceuticals (“Wyeth”) and Novartis Institute for BioMedical Research, Inc, an affiliate of Novartis AG (“Novartis”). Revenue related to these agreements is included in compound development revenue-related parties. Two members of our Board of Directors are currently employed by Solvay and Novartis, respectively, and Wyeth had a representative on our Board of Directors who resigned in January 2002.

 
4. Acquisitions
 
Cyclis Pharmaceuticals, Inc.

      On September 8, 2003, ArQule acquired all of the outstanding securities of Cyclis, a privately held, development stage cancer-therapeutics company based in Norwood, Massachusetts, in a transaction accounted for as a purchase business combination. At that time, Cyclis was merged with and into ArQule and Cyclis ceased to exist as a separate entity. Pursuant to the terms of the acquisition agreement, ArQule issued approximately 4.6 million shares of common stock, paid cash of $5,000 and forgave notes receivable of $500. ArQule incurred consulting, legal, accounting and other third-party costs of approximately $1,631 in order to close the transaction. The shares issued were valued at $18,808 based on the Company’s share price on the measurement date of acquisition, resulting in a total purchase price of $25,939. The results of the acquired Cyclis operations and the estimated fair value of the assets acquired and liabilities assumed are included in the financial statements from the date of acquisition.

      The purchase price was allocated to the identifiable tangible and intangible assets acquired and liabilities assumed based on the Company’s estimates of fair value at the acquisition date. The purchase price exceeded the amounts allocated to the identifiable tangible and intangible assets acquired and liabilities assumed by approximately $17,057. Since Cyclis was a development stage enterprise it is not considered a business under Emerging Issues Task Force No. 98-3, and therefore the excess purchase price cannot be allocated to goodwill. Consequently, the excess purchase price was allocated on a pro rata basis to the carrying value of the acquired long-lived assets, resulting in a step-up in basis of property and equipment and in-process research and development (“IPR&D”) of $699 and $16,359, respectively.

      The following table shows the allocation of the purchase price to acquired assets and liabilities for the acquisition of Cyclis:

         
Current assets
  $ 52  
Property, plant and equipment
    1,297  
IPR&D
    30,359  
Other assets
    46  
Current liabilities
    (3,081 )
Long-term debt, excluding current portion
    (2,540 )
Long-term capital leases, excluding current portion
    (194 )
     
 
    $ 25,939  
     
 

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      Upon consummation of Cyclis acquisition, we immediately charged to income $30,359 representing purchased IPR&D that had not yet reached technical feasibility and had no alternative future use. Approximately $14,000 of the charge represents the fair value of the IPR&D; the remaining $16,359 of the charge represents the aforementioned step-up adjustment. The value assigned IPR&D (before the step-up adjustment) was composed of the projected value of three Cyclis preclinical drug development projects based on various mechanisms of actions associated with the ACTSM technology. The valuation was determined using the income approach. Potential revenue and drug development expenses were projected through 2020 based on information obtained from management and from published third-party industry statistics for similar drug development businesses. The expenditures that will be necessary to complete the clinical trials are subject to numerous uncertainties. Completion of clinical trials may take several years or more, and the estimate of time and cost to complete can be affected by factors such as the number of patients required to participate in the trials, the number of clinical sites involved in the trials, the length of time required to enroll a suitable number of patients and the type, complexity, novelty and intended use of a product. We estimate that the development of these acquired projects through clinical trials to commercial viability will take approximately nine years and cost in excess of $500,000. The discounted cash flow method was applied to the projected cash flows, adjusted for the probability of success, using a discount rate of 30%. The discount rate takes into consideration the uncertainty surrounding successful development and commercialization of the IPR&D.

 
Camitro Corporation

      On January 29, 2001, we acquired Camitro Corporation, a privately held predictive modeling company based in Menlo Park, California, in a transaction accounted for as a purchase business combination. Pursuant to the terms of the merger agreement, we issued approximately 3.4 million shares of our common stock and $1,733 in cash in exchange for all of Camitro’s outstanding shares and the assumption of all of Camitro’s outstanding stock options and warrants. The merger transaction was valued at $84,268 based on our share price on the measurement date for the merger. The results of operations of Camitro, the estimated fair value of the assets acquired and liabilities assumed are included in our financial statements from the date of acquisition.

      The purchase price was allocated to the identifiable tangible and intangible assets acquired and liabilities assumed based on our estimates of fair value at the acquisition date. Identifiable intangible assets were being amortized over their estimated useful life of seven years. The purchase price exceeded the amounts allocated to the identifiable tangible and intangible assets acquired and liabilities assumed by $29,699. This excess was classified as goodwill, which was being amortized on a straight-line basis over its estimated useful life of seven years through December 2001. Beginning in 2002, goodwill is no longer amortized, but instead tested annually for impairment. Our goodwill and acquired core technology assets were written-off in December 2002. See Note 8 — Intangible Assets.

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      The following table shows the allocation of the purchase price to acquired assets and liabilities for the acquisition of Camitro:

           
Current assets
  $ 980  
Property, plant and equipment
    1,195  
Intangible assets:
       
 
Acquired core technology
    23,600  
 
Assembled workforce
    200  
 
In-process research and development
    18,000  
 
Deferred compensation
    12,552  
 
Goodwill
    29,699  
Other assets
    244  
Short term liabilities
    (1,442 )
Long term liabilities
    (760 )
     
 
    $ 84,268  
     
 

      Approximately $18,000 of the purchase price represents the estimated fair value of the purchased IPR&D that had not yet reached technological feasibility and had no alternative future use. Accordingly, this amount was immediately expensed in the consolidated statement of operations upon the acquisition date. The value assigned to IPR&D technology was comprised of the initial suite of ADMET (absorption, distribution, metabolism, elimination, toxicity) models and the upgrade suite of ADME models. The valuation of the IPR&D was determined using the discounted cash flow method. Revenue and expense projections, as well as technology assumptions, were prepared through 2008 based on information provided by Camitro’s management. Revenue projections for each in-process development project were identified as follows: (1) revenue derived from products relying on core technology, and (2) revenue derived from projects relying on a new IPR&D project. The projected cash flows, adjusted based on probability of success, were discounted using a 50% rate for core technology and a 60% rate for in-process technology. The fair value of IPR&D was determined separately from all other acquired assets using the income approach. Management is responsible for the assumptions used to determine the estimated fair value of the IPR&D.

      In December 2002, the Company decided to cease all further development the ADMET models and to close its facilities in California and the United Kingdom. As a result of that decision, the unamortized value of the remaining intangible asset were fully written-off at December 31, 2002. (See Note 8 — Intangible Assets for further information.)

 
5. Collaborations

      Pfizer. Our largest collaboration is with Pfizer Inc. Since the inception of this relationship in 1999, we have managed and staffed a facility that produces collections of chemical compounds exclusively for Pfizer using our automated high-speed compound production system. Pfizer received a non-exclusive license to use this system in its internal production program. We expanded this contract in December 2001 to a seven-year agreement. With this expansion, Pfizer and ArQule scientists work more closely on idea generation and library design. Pfizer has also committed to undertake one lead optimization program with ArQule and has direct access to our library design tools on a non-exclusive basis.

      We renegotiated this contract again in early February 2004. Under the amended terms of the contract, ArQule will continue to work with Pfizer’s scientists to more closely match its compound deliveries to those libraries which Pfizer believes have the greatest developmental opportunity. Under this new agreement, ArQule will maintain compound deliveries at approximately the same level to be supplied in 2004 instead of increasing compound deliveries as specified in the previous agreement. This will result in a decrease in the total potential contract value of $55,000 compared to the terms agreed upon in 2001.

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      If our amended relationship with Pfizer is successful, we could earn up to $291,000 over the term of the contract (2001-2008). As of December 31, 2003, we have received $190,320 from Pfizer since inception of this relationship in 1999. Pfizer has made equity investments in our company of $10,000 in 2001, at the onset of the expanded agreement, plus investments of $8,000 in 2003 based on the achievement of certain delivery milestones. Although Pfizer owns all rights in compounds produced pursuant to the collaboration, the activities we perform on behalf of Pfizer allow us to enhance and validate our high throughput compound production techniques as applied to lead generation. Pfizer may terminate the new agreement, beginning in December 2005, for any reason, but would not be entitled to receive any refund for amounts paid to ArQule through the date of termination.

      In addition we have, or in 2003 completed, collaborations with the following companies:

      Bayer. In October 1999, we entered into a three-year collaboration with Bayer AG to produce large collections of compounds designed exclusively for Bayer in accordance with its specifications. We refer to such collections as Custom ArrayTM libraries. In December 2002, we extended the production period until September 30, 2003. Bayer owns all rights in compounds for an initial period, after which we will co-own rights in compounds that Bayer has not claimed in a patent application. We received a $3,000 upfront payment and an additional $27,000 during the term of the agreement for delivery and success fees. As of December 31, 2003, we have completed our contractual obligations and have received the entire $30,000 due under this agreement. Bayer will pay no milestones or royalties to us on compounds that they develop and market.

      Sankyo. In November 1997, we entered into a three-year agreement with Sankyo Company, Ltd. to discover and optimize drug candidates. Under the terms of the agreement, Sankyo received a subscription to our Mapping Array™ Program. The program involved a large collection of compounds provided on a non-exclusive basis to several pharmaceutical companies as a tool to discover new lead compounds. Sankyo also committed to a minimum number of Directed Array™ Programs during the term of the agreement. In April 2001, we extended our agreement with Sankyo through June 2004 to include access to the Compass Array™ libraries, which are a subset of the Mapping Arrays™, in addition to continuing to use our Directed Array™ Program, which involves a target-focused library. The total value of the extended agreement is up to $14,800 million in committed payments of which, as of December 31, 2003, we have received $14,580. To date, we have not received any milestone or royalty payments under this agreement.

      Solvay. In November 1995, we entered into a five-year agreement with Solvay Duphar B.V. Under this agreement, Solvay subscribed to our Mapping Array™ and Directed Array™ Programs and received a non-exclusive license to our AMAP Chemistry Operating System. This agreement was superseded by an amended and restated agreement with Solvay Pharmaceuticals, B.V., which became effective on January 1, 2001. The amended agreement extended the collaboration through December 31, 2003. Under the amended agreement, Solvay received our Compass Array™ libraries and continued to access our Directed Array™ Programs. As of December 31, 2003, we have received $20,682 under the original and amended agreements, both of which are complete. Solvay must also make additional payments if we achieve certain development milestones and pay royalties on sales of any drugs that result from the relationship. To date, we have not received any milestone or royalty payments. In connection with the original collaboration in 1995, an affiliate of Solvay, Physica B.V., made a $7,000 equity investment in ArQule.

      Novartis Institute for BioMedical Research, Inc. On September 3, 2003, we entered into a one year chemistry services collaboration with Novartis Institute for BioMedical Research, Inc. (NIBRI), an affiliate of Novartis AG. As part of the collaboration we will apply our integrated chemistry technology platform to generate and optimize small molecule compounds for NIBRI’s anti-infective drug discovery program. The total contract value of the agreement is $1,000, of which we have received $328 as of December 31, 2003. NIBRI must also make additional payments if we achieve certain developmental milestones.

      Also, we successfully completed major collaborations with GlaxoSmithKline, Pharmacia, Wyeth Pharmaceuticals and Johnson & Johnson. The collaboration agreements contain trailing obligations of our collaborators to, under specified circumstances, make milestone and royalty payments. In addition, for several of our formerly active collaborators, we have agreed to provide a limited amount of compound production services, as such collaborators seek to optimize promising compounds. Wyeth has selected a compound from

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the Directed Array™ Program for its development pipeline and made milestone payments to us in connection therewith in October 2002 and February 2004.

      GlaxoSmithKline. In November 2000, we entered into a five-year collaboration and license agreement with SmithKline Beecham Corporation (now GlaxoSmithKline). Under the terms of the agreement, GlaxoSmithKline received access to our Compass Array libraries and Mapping Array libraries for screening primarily in the anti-infective field. GlaxoSmithKline elected to terminate the agreement in November 2002, before the end of the five-year term. As of December 31, 2003, we have received $1.5 million under this collaboration. GlaxoSmithKline has agreed to pay us development milestones and royalties on sales of products resulting from the collaboration. To date, we have not received any milestone or royalty payments.

      Pharmacia. We entered into a five-year collaboration with Monsanto Company (now Pharmacia Corporation) in December 1996. Under this agreement, we provided Monsanto with access to our Mapping and Directed Array Programs and Compass Array and Mapping Array libraries. Pharmacia has made payments totaling $12.7 million under this agreement. In addition, Monsanto has agreed to pay us development milestones and royalties from the sales of products resulting from the collaboration. In July 1998, we received a milestone payment for a Mapping Array compound selected by Monsanto for entry into field trials. In March 2002, we entered into a one-year technical access agreement with Pharmacia Corporation which granted Pharmacia non-exclusive access to our proprietary ADMET simulation technology. In March 2003, we extended the technical access agreement to June 30, 2003. As of December 31, 2003, we have satisfied our contractual obligations with Pharmacia.

      Wyeth Pharmaceuticals. In July 1997, we entered into a four and one half year agreement with Wyeth Pharmaceuticals (“Wyeth”). Under this agreement, Wyeth subscribed to our Mapping Array and Directed Array Programs. We discontinued our Mapping Array Program as of 2002, and as a consequence and in agreement with Wyeth, we did not renew our collaboration. Wyeth has continuing rights to screen the compounds from the Mapping and Directed Array Programs and continuing obligations to pay us development milestones and royalties from the sales of products resulting from compounds we shipped during the collaboration. Wyeth has filed an IND based upon a compound from our Directed Array Program and made milestone payments to us in connection therewith in October 2001 and February 2004. As of December 31, 2003, we have received $27.1 million under this agreement.

      Johnson & Johnson. In December 1998, we entered into a three-year collaboration with R.W. Johnson Pharmaceutical Research Institute, a division of Johnson & Johnson, Inc., in which R.W. Johnson subscribed to our Mapping Array Program. We discontinued our Mapping Array Program as of 2002, and, as a consequence and in agreement with R.W. Johnson, we did not renew our collaboration. As of December 31, 2003, we have received $9.0 million under this agreement. In addition, R.W. Johnson has agreed to pay us developmental milestones and royalties from sales of any products resulting from this collaboration. To date, we have not received any milestone or royalty payments.

 
6. Cash Equivalents and Marketable Securities

      The following is a summary of the fair market value of available-for-sale marketable securities we held at December 31, 2001 and 2002:

                         
December 31,

Maturity 2003 2002



U.S. Government obligations
    Within 1 year     $ 4,040     $ 1,000  
Corporate bonds
    Within 18  months       40,545       44,343  
             
     
 
            $ 44,585     $ 45,343  
             
     
 

      At December 31, 2002 and 2003, marketable securities are carried at fair market value and are classified as current as the funds are highly liquid and are available to meet working capital needs and to fund current operations. The gross unrealized gains (losses) on marketable securities at December 31, 2002 and 2003 were $55 and $(28), respectively.

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      The following table summarizes our investments with gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2003:

                                                 
Less than 12 Months 12 months or more Total



Fair Unrealized Fair Unrealized Fair Unrealized
Value Losses Value Losses Value Losses






U.S. Government obligations
  $     $     $ 1,000     $ 1     $ 1,000     $ 1  
Corporate bonds
    6,908       31                   6,908       31  
     
     
     
     
     
     
 
Total temporarily impaired securities
  $ 6,908     $ 31     $ 1,000     $ 1     $ 7,908     $ 32  
     
     
     
     
     
     
 

      The securities summarized above represent a total of seven investments purchased by the Company in order to maximize its return on liquid assets in excess of its immediate needs. The temporary impairments relate to unfavorable market interest rate fluctuations which have decreased the fair value of the investments below the original investment cost. The Company believes these fluctuations are temporary and therefore has not realized an impairment loss on these investments at December 31, 2003.

 
7. Property and Equipment

      Property and equipment consist of the following:

                         
Useful Life December 31,
Estimated
(Years) 2003 2002



Land
        $ 6,487     $ 6,487  
Buildings
    30       14,230       14,230  
Machinery and equipment
    5       28,938       26,110  
Leasehold improvements
    3-20       28,008       27,788  
Furniture and fixtures
    7       1,703       1,736  
Computer equipment
    3       12,928       12,251  
Construction-in-progress
          934       138  
             
     
 
              93,228       88,740  
Less-accumulated depreciation and amortization
            45,286       37,224  
             
     
 
            $ 47,942     $ 51,516  
             
     
 

See Note 11 related to restructuring charge for the write-off of leasehold improvements and equipment located in the Company’s abandoned facilities.

 
8. Intangible Assets

      In connection with our acquisition of Camitro, we recognized amortization expense in 2001 of $4,013 and $3,091 related to goodwill and core technology, respectively. In January 2002, we adopted SFAS 142, and as a result did not amortize goodwill in 2002 in lieu of performing an annual assessment for impairment. In 2002, we recognized amortization expenses of $3,373 related to core technology.

      In conjunction with the adoption of SFAS 142, goodwill is subject in 2002 to both a transitional goodwill impairment test as of January 1, 2002 and an annual assessment for impairment based on fair value. The Company has determined it consists of a single reporting unit. We completed the transitional goodwill impairment test as of January 1, 2002 by comparing the Company’s fair value to its net assets, including goodwill. If the carrying value of the Company’s net assets exceeds the Company’s fair value the goodwill is impaired. Fair value is based on quoted market prices adjusted to provide for a control premium. The fair value of the reporting unit on January 1, 2002 exceeded the net assets of the reporting unit, including goodwill. Accordingly, we concluded that no impairment existed as of the January 1, 2002 transition date. ArQule

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performed its annual assessment for 2002 as of July 1, 2002. That analysis also indicated that the fair value of the reporting unit exceeded the Company’s net assets, including goodwill, and therefore we concluded that no impairment existed as of the annual assessment date.

      The following table represents the pro forma impact SFAS 142 would have had on our net loss per share had the standard been in effect in 2001:

                         
Year Ended December 31, 2001

Goodwill
As Amortization
Reported Adjustment Pro Forma



Net loss
  $ (41,027 )   $ 4,013     $ (37,014 )
Basic and diluted net loss per share
  $ (2.06 )   $ 0.20     $ (1.86 )

      In addition to requiring transitional and annual assessments of goodwill impairment, SFAS 142 requires that a goodwill impairment review be performed whenever events or changes in circumstances (“triggering event”) indicate that the carrying value may not be recoverable. In December 2002, we announced a restructuring of operations resulting from our decision to cease further development of our ADMET predictive models and to close our facilities in Redwood City, California and Cambridge, United Kingdom. The Company concluded the restructuring charge was a triggering event and that the carrying value of our goodwill asset may be impaired. Accordingly, we conducted an impairment review as required under SFAS 142 as of December 31, 2002 and concluded that an impairment had occurred as of that date. To determine the amount of the impairment charge we calculated our implied goodwill as the difference between fair value of the reporting unit and the fair value of our assets and liabilities. We determined that the fair value of the reporting unit was significantly less than the fair value of our assets and liabilities, which implied goodwill was zero, and therefore recorded a non-cash impairment charge of $25,890 to write-off the entire carrying value as of December 31, 2002. This charge is included in operating costs and expenses within the statement of operations in 2002.

      The impairment analyses for the Company’s core technology intangible asset and goodwill asset involved considerable judgment and use of several estimates, including: control premiums and projected cash flows of our ADMET predictive models. We used a control premium of 40% in determining the Company’s fair value was based on an analysis of control premiums involved in acquisitions of companies of similar size and in similar industries. The cash flow assumptions for our ADMET predictive models were based on management’s belief that there is no future potential cash flow associated with ArQule commercializing the ADMET models for third-party use or as the basis for a collaborative agreement. All of these estimates involve significant judgment by the Company’s management. Although the estimates used reflect management’s best estimates based upon all available evidence, the use of different estimates could have yielded different conclusions concerning the impairment of the core technology and goodwill assets.

      We also performed an impairment assessment of the carrying value of the core technology in the fourth quarter of 2002 in light of our decision to cease development of the ADMET predictive modeling as a result of our inability to successfully commercialize these models and to generate any future cash flow. Based on this assessment, which included an analysis of management’s estimates that there were no future cash flows resulting from these models, we concluded that the carrying value of the core technology was not recoverable, and accordingly took an impairment charge of $17,137 representing the entire remaining carrying value of our core technology.

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9. Other Assets

      Other assets include the following:

                 
December 31,

2003 2002


Investment in unconsolidated affiliate
  $ 250     $ 5,000  
Security deposits
    312       266  
     
     
 
Total other assets
  $ 562     $ 5,266  
     
     
 

      In July 2001, we purchased approximately 1.8 million preferred shares of a privately owned proteomics company for $5,000. This represented an approximately 8% ownership interest. We are accounting for this under the cost method as we do not exert significant influence in the company. This investment is included in other assets on the Consolidated Balance Sheet. We assess the fair value of this investment quarterly or whenever events or changes in circumstance indicate that the investment value may not be recoverable. During 2003, this entity attempted to raise additional financing in order to fund its operations, but was unable to secure such financing on acceptable terms. At December 31, 2003, we performed such an assessment based on an analysis of the investment’s current financial condition, its prospects of generating additional cash flow from operating activities, the current market conditions for raising capital funding for companies in this industry and the likelihood that any funding raised would significantly dilute our ownership percentage. As a result of this analysis it was our judgment that a permanent impairment had occurred and that the fair value of our investment was $250, resulting in a non-cash loss on investment of $4,750.

 
10. Accounts Payable and Accrued Expenses

      Accounts payable and accrued expenses include the following:

                 
December 31,

2003 2002


Accounts payable
  $ 3,757     $ 3,631  
Accrued payroll
    2,304       1,678  
Accrued professional fees
    816       331  
Accrued lease termination
          400  
Accrued restructuring
    6,239       8,750  
Other accrued expenses
    1,352       1,417  
     
     
 
    $ 14,468     $ 16,207  
     
     
 

11.     Restructuring Actions

      In December 2002, we announced a major restructuring of our operations whereby we ceased further development and commercialization of the ADMET predictive models and realigned our workforce to expedite the transition towards becoming a drug discovery company. The decision was precipitated by our inability to successfully commercialize the ADMET predictive modeling technology to generate incremental cash flow through either direct access fees or a predictive model based collaborative agreement.

      The restructuring actions included closing our facilities in Redwood City, California and Cambridge, United Kingdom, along with the termination of employees in these facilities and our Massachusetts facilities.

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The Company recorded a restructuring charge of approximately $12,695, the components of which are as follows:
         
Termination benefits
  $ 2,140  
Facilities related
    9,607  
Other charges
    948  
     
 
Total restructuring charges
  $ 12,695  
     
 

      Termination benefits relate to severance and benefit costs associated with the elimination of 128 managerial and staff positions worldwide, comprising approximately 31% of the workforce, in the following areas: 97 positions in research and development functions and 31 positions in administrative functions. Facility-related costs relate to the remaining lease payment obligations associated with the abandonment of our facilities in Redwood City, California and Cambridge and the non-cash write-off of leasehold improvements and equipment no longer expected to provide future economic benefit at the abandoned facilities, less assumed proceeds from sale. Other charges include a $477 non-cash stock compensation charge related to ArQule’s contractual obligation to remove all restrictions related to restricted stock of certain employees who were involuntarily terminated, plus contractual obligations which provided no future value to the Company and other miscellaneous costs associated with closing the California and United Kingdom operations. See Note 2 “Significant Accounting Policies” for a discussion of our accounting policy for restructuring charges. We believe that these actions resulted in savings of approximately $12,000 per year in personnel and facility-related expenses.

      Activities against the restructuring accrual (which is included in accrued liabilities in the Consolidated Balance Sheet) in 2002 and 2003 were as follows (in thousands):

                                 
2002 2002 2002 Restructuring
Restructuring Non-Cash Cash Accrual at
Charge Write-Offs Payments December 31, 2002




Termination benefits
  $ 2,140     $     $ (111 )   $ 2,029  
Facilities related
    9,607       (3,322 )           6,285  
Other charges
    948       (477 )     (35 )     436  
     
     
     
     
 
Total restructuring accrual
  $ 12,695     $ (3,799 )   $ (146 )   $ 8,750  
     
     
     
     
 
                                 
Restructuring 2003 Restructuring
Accrual at 2003 Cash Accrual at
December 31, 2002 Provisions Payments December 31, 2003




Termination benefits
  $ 2,029     $     $ (2,019 )   $ 10  
Facilities related
    6,285       1,239       (1,364 )     6,160  
Other charges
    436             (367 )     69  
     
     
     
     
 
Total restructuring accrual
  $ 8,750     $ 1,239     $ (3,750 )   $ 6,239  
     
     
     
     
 

      The Company eliminated 108 positions in December 2002; the remaining were eliminated by March 31, 2003. As of December 31, 2003 virtually all termination benefits had been paid. California facility costs will be paid out through the remaining lease term of the facility, which extends through 2010, unless we are able to mitigate such costs by subleasing the facility or settling our leasehold position by paying a lump-sum payment to the landlord. In October 2003, ArQule completed an agreement with InPharmatica Ltd. to sell certain assets of its former operations in the United Kingdom. As a result, ArQule reversed $290 of restructuring accrual to reflect a change in its original estimate of the remaining leasehold obligations and assumed sublease income in the United Kingdom. Throughout the latter half of 2003, ArQule was in negotiations with a third-party to sublease its facility in California on favorable terms. Those negotiations were unsuccessfully terminated in January 2004. As a result, management reassessed the adequacy of its accrual relative to its lease obligation and assumed sublease income for the California facility, and based on continued deterioration in the local real estate market recorded an additional provision of $1,529.

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      Accruals for abandoned property and equipment and facilities require significant management judgment and the use of estimates, including assumptions concerning our ability to sublease certain operating leases for abandoned real estate with remaining lease payments of up to $9,029 as of December 31, 2003. These estimates of the time required to sublease the facilities and sublease rates the Company will receive were based on management’s analysis of the local real estate markets and general economic conditions in the regions of the abandoned facilities. If it takes longer to sublease these facilities than the Company has estimated, or if the sublease rates are less favorable than estimated, the Company may be required to take an additional charge for abandoned real estate of up to $3,143. Conversely, if the space is subleased either earlier than estimated or if the sublease rate actually achieved are more favorable, the Company may be required to reverse a portion of its current accrual for abandoned real estate.

      In February 2004, the Company announced that it was restructuring its operations to affect a shift in resources from its chemistry technologies to its internal research efforts and would be eliminating approximately 55 staff and managerial positions, representing approximately 19% of its workforce, resulting in a restructuring charge in the first quarter of 2004 of between $1,200 and $1,400. The Company expects to hire approximately the same number of employees with skill-sets which better compliment the drug discovery and development efforts, by the end of 2004.

 
12. Debt

      In March 1999, we entered into a term loan agreement with Fleet National Bank (“Fleet”). The terms of this agreement allow for borrowings up to a maximum of $15,000 based on 80% of qualifying property and equipment purchases, provided that we comply with certain covenants, including the maintenance of specified financial ratios. Borrowings under this facility are classified as either “Tranche A” (term loans entered into before June 30, 1999) or “Tranche B” (term loans entered into between July 1, 1999 and June 30, 2000). Principal amounts due are payable in 16 equal quarterly installments beginning on September 30, 1999 and September 30, 2000 for “Tranche A” and “Tranche B” borrowings, respectively. Interest payments are made monthly in arrears beginning on the first day of the month following commencement of this agreement and accrue at one month LIBOR plus 1.75%. We entered into an interest rate swap agreement with Fleet primarily to reduce the impact of changes in interest rates on our term loan agreement. At December 31, 2003 we have an interest rate swap with a notional amount of $975. Under this agreement, we will pay Fleet at the rate of 8.99%. Settlement accounting is used for this interest rate swap which expires on June 30, 2004. The impact on our financial position and results of operations from likely changes in interest rates is not material, as our hedging of transactions is limited to these specific liabilities. The fair market value of this agreement was an unrecognized loss of $22 at December 31, 2003. In March 2001, we amended and extended our term loan agreement with Fleet National Bank to borrow an additional $16,000 in order to finance our facility and land purchase (“Tranche C”). Principal amounts are payable in 16 equal quarterly installments beginning on April 1, 2001. Interest payments are made monthly in arrears beginning on the first day of the month following commencement of the amended agreement. Interest accrues at the rate of one month LIBOR plus 175 basis points. On December 31, 2003 our interest rate on Tranche C was 3.09%. As of December 31, 2003, the “Tranche A” loan had been fully repaid and we had total outstanding balances of $975 and $4,000, respectively, on our “Tranche B” and “Tranche C” loans. This facility is collateralized by all of our property and equipment.

      On September 28, 2002, the Company amended its existing loan agreement with Fleet National Bank to allow for additional borrowing of up to $2,500 to finance the build-out associated with its leased facility in Redwood City, California. The incremental new borrowing is termed the “Facility Three Term Loan.” Principal payments on the Facility Three Term Loan will be made in 36 monthly installments commencing on April 30, 2003. Interest payments will be made monthly in arrears beginning on the first day of the month following commencement of this agreement, and interest accrued at the rate of LIBOR plus 175 basis points, which was 3.13% on December 31, 2003. The Company has borrowed $2,500 against the Facility Three Term Loan.

      In connection with the Cyclis acquisition, ArQule assumed total long term debt of $2,572. Of this amount, $2,500 plus accrued interest was repaid at closing. The remaining obligation represents two

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promissory notes (“Promissory Notes”) with a lender which are payable monthly, expire in August and November 2005 and bear interest at 9.77% and 10.45%.

      Our principal amounts due under the Company’s loan agreements are as follows:

                                   
Facility
Three Term Promissory
Year Ending December 31, Tranche B Tranche C Loan Notes





2004
  $ 975     $ 4,000     $ 833     $ 33  
2005
                833       29  
2006
                209        
     
     
     
     
 
 
Total payments due
  $ 975     $ 4,000     $ 1,875     $ 62  
     
     
     
     
 
 
13. Stockholders’ Equity
 
Preferred Stock

      We are authorized to issue up to one million shares of preferred stock. As of December 31, 2003 and 2002 there were no outstanding shares of preferred stock. Our Board of Directors will determine the terms of the preferred stock if and when the shares are issued.

 
Common Stock

      Our amended Certificate of Incorporation authorizes the issuance of up to 50 million shares of $0.01 par value common stock.

      At December 31, 2003, we have 6,109,583 common shares reserved for future issuance of common stock under the Employee Stock Purchase Plan and for the exercise of common stock options pursuant to the Equity Incentive Plan, the Directors Plan and the options acquired from Camitro’s Stock Plan.

 
14. Stock Option Plans

      The number of shares authorized for award under the 1994 Amended and Restated Equity Incentive Plan (the “Equity Incentive Plan”) is 7,700,000. All shares are awarded at the discretion of our Board of Directors in a variety of stock based forms including stock options and restricted stock. Pursuant to the Equity Incentive Plan, incentive stock options may not be granted at less than the fair market value of our common stock at the date of the grant, and the option term may not exceed ten years. For holders of 10% or more of our voting stock, options may not be granted at less than 110% of the fair market value of the common stock at the date of the grant, and the option term may not exceed five years. Stock appreciation rights granted in tandem with an option shall have an exercise price not less than the exercise price of the related option. As of December 31, 2003, no stock appreciation rights have been issued. In September 2001, a sub-plan, known as the “2001 Inland Revenue Approved Sub-Plan” was added to the 1994 Amended and Restated Equity Incentive Plan and was approved by our Board of Directors. This plan grants Approved Stock Options to the employees of the United Kingdom from the Equity Incentive Plan available awards pool. No Approved Stock Options were granted during 2003 and the 2001 Inland Revenue Approved Sub-Plan was closed in 2003. At December 31, 2003, there were 1,774,595 shares available for future grant under the Equity Incentive Plan. Subject to the above restrictions, the Board of Directors is authorized to designate the options, awards, and purchases under the Equity Incentive Plan, the number of shares covered by each option, award and purchase, and the related terms, exercise dates, prices and methods of payment.

      On January 29, 2001, we assumed Camitro Corporation’s outstanding options under the Camitro Stock Plan. There are no longer any shares available for future grant under this Plan. Compensation expense for 2002 related to the acquired Camitro stock options that were unvested at the time of the acquisition was $3,036. On December 13, 2002, the remaining former employees of Camitro were terminated in connection with the Company’s closing of its Redwood City, California facility. As a result, all unvested Camitro stock

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options were canceled in accordance with the terms of the Plan, and the remaining balance of the deferred compensation was charged to additional paid-in capital. In 2003, the Camitro Stock Plan was eliminated.

      The number of shares available for award under the 1996 Amended and Restated Director Stock Option Plan (“Director Plan”) is 290,500. During 2003, our shareholders approved and amended The Director Plan to: (i) increase the number of shares of our common stock automatically granted to a director upon his or her initial election to our board of directors from 7,500 shares to 10,000 shares and (ii) increase the number of shares of our common stock automatically granted to directors upon their continuation on our board immediately after each annual meeting from 3,500 shares to 5,000 shares. All options granted pursuant to the Director Plan have a term of ten years with exercise prices equal to fair market value on the date of grant. Through December 31, 2003, options to purchase 222,500 shares of common stock have been granted under this plan of which 212,500 shares are currently exercisable. As of December 31, 2003, 68,000 shares are available for future grant.

      During 2001 and 2002 we issued 10,000 options each year to certain members of our Scientific Advisory Board under the Equity Incentive Plan. There were no such grants in 2003. Compensation expense in 2001 and 2002 was $129 and $72, respectively. Also during 2001 and 2002 compensation expenses of $69 and $113, respectively, was recorded for employees who received non-qualified stock options at below fair market value on the date of grant. There is no remaining deferred compensation expense related to these grants at December 31, 2003.

      Option activity under the Plans for the years ended December 31, 2001, 2002 and 2003 was as follows:

                 
Number Weighted Average
Stock Options of Shares Exercise Price



Outstanding as of December 31, 2000
    2,407,075     $ 9.50  
Granted
    1,112,875       13.83  
Assumed in acquisition
    150,718       1.27  
Exercised
    (122,112 )     6.16  
Cancelled
    (151,279 )     12.11  
     
     
 
Outstanding as of December 31, 2001
    3,397,277       10.18  
Granted
    1,011,092       11.84  
Exercised
    (130,739 )     4.10  
Cancelled
    (587,313 )     12.13  
     
     
 
Outstanding as of December 31, 2002
    3,690,317       10.54  
Granted
    960,115       3.76  
Exercised
    (144,791 )     .91  
Cancelled
    (609,723 )     10.44  
     
     
 
Outstanding as of December 31, 2003
    3,895,918     $ 9.24  
     
     
 
Exercisable as of December 31, 2003
    2,379,867     $ 9.98  
     
     
 
Weighted average estimated value of options granted during the year ended December 31, 2003
          $ 2.73  
             
 

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      The following table summarizes information about options outstanding at December 31, 2003:

                                         
Options Outstanding Options Exercisable


Weighted
Number Average Weighted Exercisable Weighted
Outstanding at Remaining Average as of Average
December 31, Contractual Exercise December 31, Exercise
Range of Exercise Prices 2003 Life Price 2003 Price






$ 0.00 —  2.80
    33,625       2.4     $ 1.00       33,625     $ 1.00  
  2.80 —  5.60
    1,877,671       6.7       4.28       1,067,106       4.65  
  5.60 —  8.40
    286,888       4.7       6.89       214,388       6.81  
  8.40 — 11.20
    450,340       6.4       9.98       264,289       9.99  
 11.20 — 14.00
    509,366       7.3       13.37       176,496       13.33  
 14.00 — 16.80
    48,600       4.6       15.25       41,661       15.25  
 16.80 — 19.60
    382,553       5.3       17.95       325,178       17.94  
 19.60 — 22.40
    178,750       3.6       20.02       160,687       20.02  
 22.40 — 25.20
    27,000       6.3       23.13       20,812       23.13  
 25.20 — 28.00
    101,125       4.0       28.00       75,625       28.00  
     
     
     
     
     
 
      3,895,918       6.2     $ 9.24       2,379,867     $ 9.98  
     
     
     
     
     
 

      In 1996, the stockholders adopted the 1996 Employee Stock Purchase Plan (the “Purchase Plan”). This plan enables eligible employees to exercise rights to purchase our common stock at 85% of the fair market value of the stock on the date the right was granted or the date the right is exercised, whichever is lower. Rights to purchase shares under the Purchase Plan are granted by the Board of Directors. The rights are exercisable during a period determined by the Board of Directors; however, in no event will the period be longer than twenty-seven months. The Purchase Plan is available to substantially all employees, subject to certain limitations. As of December 31, 2003, 648,900 shares have been purchased pursuant to the Purchase Plan. In May 2003, our shareholders approved an amendment to the Purchase Plan to increase the aggregate number of shares of the Company’s common stock which may be issued from 720,000 shares to 1,020,000 shares. As of December 31, 2003, there were 371,065 shares available for future sale under the Employee Stock Purchase Plan.

 
15. Income Taxes

      The current and deferred tax expenses for the years ended December 31, 2003, 2002 and 2001 are as follows:

                           
2003 2002 2001



Current:
                       
 
Federal
  $     $     $  
 
State
    10       2       2  
 
Foreign (U.K.)
          5       32  
     
     
     
 
    $ 10     $ 7     $ 34  
     
     
     
 
                           
2003 2002 2001



Deferred:
                       
 
Federal
  $     $     $  
 
State
                 
 
Foreign (U.K.)
                 
     
     
     
 
Valuation allowance
                 
     
     
     
 
    $     $     $  
     
     
     
 

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      Tax expense is included in marketing, general and administrative expense.

      The following is a reconciliation between the U.S. federal statutory rate and the effective rate for the years ended December 31, 2003, 2002 and 2001:

                           
2003 2002 2001



Income tax benefit (expense) at statutory rate
  $ 11,815     $ 26,478     $ 13,949  
State tax benefit (expense), net of Federal tax benefit (expense)
    273       3,198       1,073  
Permanent items
    (10,330 )     (8,824 )     (6,130 )
Effect of change in valuation allowance
    (2,865 )     (22,725 )     (4,070 )
Credits
    757       1,060       1,456  
Other
    340       806       (6,312 )
     
     
     
 
 
Tax expense
  $ (10 )   $ (7 )   $ (34 )
     
     
     
 

      The deferred tax consequences of temporary differences in reporting items for financial statement and income tax purposes are recognized, if appropriate. Realization of the future tax benefits related to the deferred tax assets is dependent on many factors, including our ability to generate taxable income within the net operating loss carry-forward period. Management has considered these factors in reaching its conclusion as to the valuation allowance for financial reporting purposes. The income tax effect of temporary differences comprising the deferred tax assets and deferred tax liabilities on the accompanying balance sheets is a result of the following:

                           
December 31,

2003 2002 2001



Deferred tax assets:
                       
 
Pre-operating costs capitalized for tax purposes
  $ 133     $ 183       233  
 
Net operating loss carryforwards
    25,064       24,702       20,037  
 
Tax credit carryforwards
    10,537       9,939       8,179  
 
Equity based compensation
    6,542       6,499       3,599  
 
Book depreciation in excess of tax
    (250 )     (724 )     (481 )
 
Reserves and accruals
    4,371       4,536       888  
 
Deferred revenue
    8,005       6,507       4,434  
 
Other
    1,949       (17 )     27  
     
     
     
 
      56,351       51,625       36,916  
 
Valuation allowance
    (56,351 )     (51,625 )     (28,746 )
Deferred tax liabilities:
                       
 
Intangible asset
                (8,170 )
     
     
     
 
 
Net deferred tax assets
  $     $     $  
     
     
     
 

      Of the $56,351 valuation allowance at December 31, 2003, $6,283 relating to deductions for nonqualified stock options will be credited to paid-in capital, if realized.

      As of December 31, 2003, we had federal net operating loss (“NOL”) and research and development credit carryforwards of approximately $64,556 and $6,612, respectively, which can be used to offset future federal income tax liabilities and expire at various dates through 2023. As required by Statement of Accounting Standards No. 109, we evaluated positive and negative evidence bearing upon the realizability of its deferred tax assets, which are comprised principally of net operating loss and research & development credit carryforwards. We have determined that it is more likely than not that we will not recognize the benefits of federal and state deferred tax assets and, as a result, a valuation allowance of approximately $56,351 has been established at December 31, 2003.

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      Ownership changes, as defined in the Internal Revenue Code, may have limited the amount of net operating loss carryforwards that can be utilized annually to offset future taxable income. Subsequent ownership changes could further affect the limitation in future years.

 
16. Commitments
 
Leases

      We lease facilities and equipment under non-cancelable operating leases and capital lease agreements. Assets under capital lease obligations and accumulated amortization, net of step-up adjustments, amounted to $421 and $144, respectively, at December 31, 2003. At December 31, 2003, the minimum lease commitments for all leased facilities and equipment are as follows:

                 
Operating Capital
Year Ending December 31, Leases Leases



2004
  $ 2,821     $ 141  
2005
    2,654       131  
2006
    1,844       17  
2007
    1,099        
2008
    1,144        
Thereafter
    1,389        
     
     
 
Total minimum lease payments
  $ 10,951       289  
     
         
Less: portion representing interest
            (3 )
             
 
Present value of remaining lease payments
            286  
Less: current portion
            (139 )
             
 
            $ 147  
             
 

      Included in the total minimum payments for operating leases is approximately $6,685 related to abandoned real estate which was accrued as a liability as a part of the Company’s restructuring charges. (see Note 11).

      The current and long-term portions of capital leases are included in current portion of long-term debt and long term debt, respectively, in the Consolidated Balance Sheet.

      Rent expense under non-cancelable operating leases was approximately $1,863, $2,503 and $1,150 for the years ended December 31, 2001, 2002 and 2003, respectively.

      We lease approximately 56,000 square feet of laboratory and office space in Medford, Massachusetts, the majority of which is used for the Pfizer collaboration. We lease these facilities from Cummings Properties, LLC (“Cummings”) under two lease agreements, one of which expires on July 30, 2005 and one of which expires on July 30, 2006. The Company subleases portions of these facilities pursuant to two sublease agreements.

      On August 1, 2001, Cummings significantly raised ArQule’s rent on the lease that expires July 30, 2006. We believe this increase to be in excess of that which is permissible under the lease agreement. Accordingly, on January 16, 2002, we brought a complaint for declaratory relief and damages against Cummings arising, in part, out of Cummings’ attempts to increase the lease rates. Nevertheless, during the pendency of this dispute, we are paying the rental rates proposed by Cummings. The Company seeks recovery of the funds that it has already paid, and is paying, under protest. Management has made an estimate of the most likely outcome of this contingency and has concluded that no provision is required at December 31, 2003. However, if we are unsuccessful in our claim against Cummings, and must pay all or a portion of the rental expense increase currently proposed by Cummings, we may be required to record an additional expense of up to approximately $800 to record the difference between our contractual rental payments and contractual sublease rental income over the remaining period of the lease. Conversely, if the contingency is resolved in ArQule’s favor and the

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Company is entitled to a refund of amounts previously paid, the Company may be required to record a gain in a future period.

      In November 2002, the FASB issued FIN No. 45 which requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken by issuing the guarantee. FIN No. 45 also requires additional disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees it has issued. The accounting requirements for the initial recognition of guarantees are applicable on a prospective basis for guarantees issued or modified after December 31, 2002. The disclosure requirements are effective immediately for all guarantees outstanding, regardless of when they were issued or modified. The adoption of FIN No. 45 did not have a material effect on our consolidated financial statements.

 
17. Concentration of Credit Risk

      Revenues from two of our customers accounted for 62% and 16% of total revenues during 2001. Revenue from two of our customers accounted for 74% and 14% of total revenue during 2002. Revenue from two of our customers accounted for 84% and 10% of our total revenue during 2003. There were no significant customer accounts receivable balances at December 31, 2002. One customer accounted for 95% of our accounts receivable balance at December 31, 2003. We do not require collateral on accounts receivable balances.

 
18. Selected Quarterly Financial Data (Unaudited)
                                 
First Second Third Fourth
Quarter Quarter Quarter Quarter




2003
                               
Net revenues
  $ 15,653     $ 15,482     $ 15,961     $ 18,443  
Gross profit
    6,320       6,625       7,083       9,452  
Net income (loss)
    (750 )     1,038       (29,909 )     (5,129 )
Net income (loss) per share, (basic and diluted)
  $ (0.03 )   $ 0.04     $ (1.22 )   $ (0.18 )
2002
                               
Net revenues
  $ 13,968     $ 16,231     $ 16,459     $ 16,154  
Gross profit
    5,694       7,432       7,095       7,360  
Net loss
    (8,375 )     (4,928 )     (5,468 )     (59,104 )
Net loss per share, (basic and diluted)
  $ (0.40 )   $ (0.23 )   $ (0.26 )   $ (2.78 )

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Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosures

      None.

 
Item 9A. Controls and Procedures

      Under the supervision and with the participation of the Company’s President and Chief Executive Officer, and Vice President, Chief Financial Officer and Treasurer (its principal executive officer and principal financial officer), management has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on the evaluation, the President and Chief Executive Officer and Vice President, Chief Financial Officer and Treasurer have concluded that these disclosure controls and procedures are effective as of September 30, 2003. During the quarter ended December 31, 2003 there were no changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the internal control over financial reporting.

PART III

      Certain information relating to our directors and executive officers is contained under the caption “Executive Officers of the Registrant” in Part I, Item 1A of this Annual Report on Form 10-K. The remainder of the information required by Items 10, 11, 12, 13, and 14 of Form 10-K is incorporated by reference from the discussion responsive thereto under the caption “Election of Directors” in our Proxy Statement relating to our 2004 Annual Meeting of Stockholders scheduled for May 19, 2004.

PART IV

 
Item 15. Exhibits, Financial Statement Schedule, and Reports on Form 8-K

      (a) 1.     Financial Statements

      The financial statements are listed under Item 8 of this report.

  2. Financial Statement Schedules

      The financial statement schedules listed under Item 8 of this report are omitted because they are not applicable or required information and are shown in the financial statements of the footnotes thereto.

  3. Exhibits
         
Exhibit
No. Description


   2.1     Agreement and Plan of Merger among the Company, Camitro Acquisition Corporation, Camitro Corporation, and certain stockholders of Camitro Corporation dated as of January 16, 2001. Previously filed as Exhibit 2.1 to the Company’s Current Report on Form 8-K (File No. 000-21429). Filed with the Commission on February 1, 2001 and incorporated herein by reference.
   2.2     Agreement and Plan of Reorganization by and between ArQule, Inc. and Cyclis Pharmaceuticals, Inc. dated as of July 16, 2003. Filed as Exhibit 2.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 (File No. 000-21429) and incorporated herein by reference.
   2.3     Agreement and Plan of Merger by and between ArQule, Inc. and Cyclis Pharmaceuticals, Inc. dated as of July 16, 2003. Filed as Exhibit 2.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 (File No. 000-21429) and incorporated herein by reference.
   3.1     Amended and Restated Certificate of Incorporation of the Company. Filed as Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (File No. 333-22945) and incorporated herein by reference.

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Exhibit
No. Description


   3.1.1     Certificate of amendment to Amended and Restated Certificate of Incorporation filed as Exhibit 3.1.1 to the Company’s Quarterly Report on Form 10Q for the quarter ended June 30, 2002 (File No. 000-21429) and incorporated herein by reference.
   3.2     Amended and Restated By-laws of the Company. Filed as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 1999 (File No. 000-21429) and incorporated herein by reference.
   4.1     Specimen Common Stock Certificate. Filed as Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (File No. 333-11105) and incorporated herein by reference.
  10.1*     Amended and Restated 1994 Equity Incentive Plan, as amended through May 17, 2001. Filed as Exhibit 99.1 to the Company’s Registration Statement on Form S-8 filed on August 21, 2001 amended June 30, 1998 (File No. 333-68058) and incorporated herein by reference.
  10.2*     Amended and Restated 1996 Employee Stock Purchase Plan. Filed as Exhibit 99.1 to the Company’s Registration Statement on Form S-8 filed on August 21, 2001 (File No. 333-68058)and incorporated herein by reference.
  10.3*     Amended and Restated 1996 Director Stock Option Plan. Filed As Exhibit 10.3 to the Company’s Annual Report on Form 10-K For the fiscal year ended December 31, 1997 filed with the Commission on March 17, 1998 (File No. 000-21429) and incorporated herein by reference.
  10.4     Form of Indemnification Agreement between the Company and its directors. Such agreements are materially different only as to the signing directors and the dates of execution. Filed as Exhibit 10.4 to the Company’s Registration Statement on Form S-1 (File No. 333-11105) and incorporated herein by reference.
  10.5     Lease Agreement, dated July 27, 1995, between the Company and Cummings Properties Management, Inc. as amended. Filed as Exhibit 10.7 to the Company’s Registration Statement on Form S-1 (File No. 333-11105) and incorporated herein by reference.
  10.6     Research, Development and License Agreement between the Company and Solvay Duphar B.V. dated November 2, 1995. Filed as Exhibit 10.14 to the Company’s Registration Statement on Form S-1 (File No. 333-11105) and incorporated herein by reference.
  10.6.1     Amended and Restated Research and Development and License Agreement between Solvay Pharmaceuticals B.V. and the Company, dated as of January 1, 2001. Initially filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2001 with certain confidential information omitted (File No. 000-21429) and re-filed herewith in its entirety.
  10.8*     Adoption Agreement for Fidelity Management and Research Company (the Company’s 401(k) plan). Filed as Exhibit 10.18 to the Company’s Registration Statement on Form S-1 (File No. 333-11105) and incorporated herein by reference.
  10.12     Lease Agreement, dated December 20, 1996 between the Company and Cummings Property Management, Inc. Filed as Exhibit 10.22 to the Company’s Registration Statement on Form S-1 (File No. 333-22945) and incorporated herein by reference.
  10.13+     Research and License Agreement between the Company and American Home Products Corporation acting through its Wyeth-Ayerst Research Division dated July 3, 1997. Filed as Exhibit 99.4 to the Company’s Current Report on Form 8-K filed with the Commission on August 19, 2003 (File No. 000-21249) and incorporated herein by reference.
  10.16     Research and Development Agreement between the Company and Sankyo Co., Ltd. dated November 1, 1997. Initially filed as Exhibit 10.29 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1997 with certain confidential information omitted, filed with the Commission on March 17, 1998 (File No. 000-21429) and re-filed herewith in its entirety.
  10.16.1+     Amended and Restated Research and Development Agreement between the Company and Sankyo Co., Ltd., dated as of April 2, 2001. Filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001 (File No. 000-21429) and incorporated herein by reference.

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Exhibit
No. Description


  10.24     Term loan agreement between Fleet National Bank and the Company, dated as of March 18, 1999. Filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the Quarter ended March 31, 1999 (File No. 000-21429) and incorporated herein by reference.
  10.24.6.1     Amendment to Mortgage between Fleet National Bank and the Company dated September 28, 2002. Filed as Exhibit 10.24.6 to the Company’s Quarterly Report on Form 10-Q for the quarter-ended September 30, 2002 (File No. 000-21429) and incorporated herein by reference.
  10.24.7     Second Loan Modification Agreement between Fleet National Bank and the Company dated September 28, 2002. Filed as Exhibit 10.24.7 to the Company’s Quarterly Report on Form 10-Q for the quarter-ended September 30, 2002 (File No. 000-21429) and incorporated herein by reference.
  10.24.8     Security Agreement between Fleet National Bank and the Company dated September 28, 2002. Filed as Exhibit 10.24.8 to the Company’s Quarterly Report on Form 10-Q for the quarter-ended September 30, 2002 (File No. 000-21429) and incorporated herein by reference.
  10.24.9     Third Loan Modification Agreement between Fleet National Bank and the Company dated February 12, 2003. Filed as Exhibit 10.24.9 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003 (File No. 000-21479) and incorporated herein by reference.
  10.24.10     Fourth Loan Modification Agreement between Fleet National Bank and the Company dated September 3, 2003. Filed as Exhibit 10.24.10 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 (File No. 000-21429) and incorporated herein by reference.
  10.25*     Technology Acquisition Agreement between Pfizer Inc and the Company, dated as of July 19, 1999. Filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999 (File No. 000-21429) and incorporated herein by reference.
  10.26+     Sublease between Pfizer Inc. and the Company, dated July 16, 1999. Filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999 (File No. 000-21429) and incorporated herein by reference.
  10.31     Termination Agreement between the Company and Pharmacia Corporation dated June 30, 2000. Initially filed as Exhibit 10.2 to the Company’s Quarterly report on Form 10-Q for the quarter ended June 30, 2000 with certain confidential information omitted (File No. 000-21429) and re-filed herewith in its entirety.
  10.38+     Amendment No. 1 to the Compound Supply and License Agreement between the Company and R.W. Johnson Pharmaceutical Research Institute, a division of Ortho-McNeil Pharmaceutical, Inc. dated as of August 14, 2000. Filed as Exhibit 99.1 to the Company’s Current Report on Form 8-K (File No. 000-21429) filed with the Commission on October 17, 2000 and incorporated herein by reference.
  10.39+     Collaboration Agreement between Pfizer Inc and the Company, dated as of December 19, 2001. Filed as Exhibit 10.39 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001 filed with the commission on March 27, 2002 (File No. 000-21429) and incorporated herein by reference.
  10.40     Lease by and between Pacific Shores Center LLC and the Company, dated March 1, 2002. Filed as Exhibit 10.40 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2002 (File No. 000-21429) and incorporate herein by reference.
  10.41     Consulting agreement between the Company and Michael Rosenblatt, MD dated May 1, 2002. Filed as Exhibit 10.41 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002 (File No. 000-21429) and incorporated herein by reference.
  10.43     Employment Agreement between the Company and Andrew Uprichard, dated May 28, 2002. Filed as Exhibit 10.43 to the company’s Annual Report on Form 10K for the fiscal year ended December 31, 2002 filed with the Commission on March 31, 2003 (File No. 000-21429) and incorporated herein by reference.

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Exhibit
No. Description


  10.44     Employment Agreement between the Company and Chiang J. Li, MD, dated September 5, 2003. Filed as Exhibit 10.44 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 (File No. 000-21429) and incorporated herein by reference.
  10.45     Employment Agreement between the Company and Stephen A Hill, dated as of January 1, 2004 and filed herewith.
  10.46     Employment Agreement between the Company and J. David Jacobs, dated as of January 1, 2004 and filed herewith.
  10.47     Employment Agreement between the Company and Louise A. Mawhinney, dated as of December 18, 2003 and filed herewith.
  10.48+     Amendment to the Collaboration Agreement between Pfizer Inc. and the Company dated February 11, 2004. Filed herewith.
  21.1     Subsidiaries of the Company. Filed herewith.
  23.1     Consent of PricewaterhouseCoopers LLP, independent accountants.
  31.1     Certificate of Chief Executive Officer
  31.2     Certificate of Chief Financial Officer
  32     Certificate of Chief Executive Officer and Chief Financial Officer


  Indicates a management contract or compensatory plan.

Certain confidential material contained in the document has been omitted and filed separately, with the Securities and Exchange Commission pursuant to Rule 406 of the Securities Act of 1933, as amended or Rule 24b-2 of the Securities and Exchange Act of 1934, as amended.

(b) Reports on Form 8-K During Fourth Quarter of 2003

      The Company filed a current report on Form 8-K on December 19, 2003, to furnish its press release announcing the achievement of certain contractual milestones with Pfizer, Inc. and to update its financial guidance for 2003.

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SIGNATURES

      Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Woburn, Commonwealth of Massachusetts, on March 11, 2004.

  ARQULE, INC.

  By:  /s/ STEPHEN A. HILL
 
  Stephen A. Hill
  President and Chief Executive Officer

      Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

             
Signature Title Date



 
/s/ STEPHEN A. HILL

Stephen A. Hill
  President, Chief Executive Officer and Director (Principal Executive Officer)   March 11 2004
 
/s/ LOUISE A. MAWHINNEY

Louise A. Mawhinney
  Vice President, Chief Financial Officer and Treasurer (Principal and Principal Accounting Officer)   March 11, 2004
 
/s/ LAURA AVAKIAN

Laura Avakian
  Director   March 11, 2004
 
/s/ TIMOTHY C. BARABE

Timothy C. Barabe
  Director   March 11, 2004
 
/s/ WERNER CAUTREELS

Werner Cautreels
  Director   March 11, 2004
 
/s/ ARIEL ELIA

Ariel Elia
  Director — Chairman   March 11, 2004
 
/s/ TUAN HA-NGOC

Tuan Ha-Ngoc
  Director   March 11, 2004
 
/s/ PATRICK J. ZENNER

Patrick J. Zenner
  Director   March 11, 2004

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EXHIBIT INDEX

         
Exhibit
No. Description


   2.1     Agreement and Plan of Merger among the Company, Camitro Acquisition Corporation, Camitro Corporation, and certain stockholders of Camitro Corporation dated as of January 16, 2001. Previously filed as Exhibit 2.1 to the Company’s Current Report on Form 8-K (File No. 000-21429). Filed with the Commission on February 1, 2001 and incorporated herein by reference.
   2.2     Agreement and Plan of Reorganization by and between ArQule, Inc. and Cyclis Pharmaceuticals, Inc. dated as of July 16, 2003. Filed as Exhibit 2.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 (File No. 000-21429) and incorporated herein by reference.
   2.3     Agreement and Plan of Merger by and between ArQule, Inc. and Cyclis Pharmaceuticals, Inc. dated as of July 16, 2003. Filed as Exhibit 2.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 (File No. 000-21429) and incorporated herein by reference.
   3.1     Amended and Restated Certificate of Incorporation of the Company. Filed as Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (File No. 333-22945) and incorporated herein by reference.
   3.1.1     Certificate of amendment to Amended and Restated Certificate of Incorporation filed as Exhibit 3.1.1 to the Company’s Quarterly Report on Form 10Q for the quarter ended June 30, 2002 (File No. 000-21429) and incorporated herein by reference.
   3.2     Amended and Restated By-laws of the Company. Filed as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 1999 (File No. 000-21429) and incorporated herein by reference.
   4.1     Specimen Common Stock Certificate. Filed as Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (File No. 333-11105) and incorporated herein by reference.
  10.1*     Amended and Restated 1994 Equity Incentive Plan, as amended through May 17, 2001. Filed as Exhibit 99.1 to the Company’s Registration Statement on Form S-8 filed on August 21, 2001 amended June 30, 1998 (File No. 333-68058) and incorporated herein by reference.
  10.2*     Amended and Restated 1996 Employee Stock Purchase Plan. Filed as Exhibit 99.1 to the Company’s Registration Statement on Form S-8 filed on August 21, 2001 (File No. 333-68058)and incorporated herein by reference.
  10.3*     Amended and Restated 1996 Director Stock Option Plan. Filed As Exhibit 10.3 to the Company’s Annual Report on Form 10-K For the fiscal year ended December 31, 1997 filed with the Commission on March 17, 1998 (File No. 000-21429) and incorporated herein by reference.
  10.4     Form of Indemnification Agreement between the Company and its directors. Such agreements are materially different only as to the signing directors and the dates of execution. Filed as Exhibit 10.4 to the Company’s Registration Statement on Form S-1 (File No. 333-11105) and incorporated herein by reference.
  10.5     Lease Agreement, dated July 27, 1995, between the Company and Cummings Properties Management, Inc. as amended. Filed as Exhibit 10.7 to the Company’s Registration Statement on Form S-1 (File No. 333-11105) and incorporated herein by reference.
  10.6     Research, Development and License Agreement between the Company and Solvay Duphar B.V. dated November 2, 1995. Filed as Exhibit 10.14 to the Company’s Registration Statement on Form S-1 (File No. 333-11105) and incorporated herein by reference.
  10.6.1     Amended and Restated Research and Development and License Agreement between Solvay Pharmaceuticals B.V. and the Company, dated as of January 1, 2001. Initially filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2001 with certain confidential information omitted (File No. 000-21429) and re-filed herewith in its entirety.
  10.8*     Adoption Agreement for Fidelity Management and Research Company (the Company’s 401(k) plan). Filed as Exhibit 10.18 to the Company’s Registration Statement on Form S-1 (File No. 333-11105) and incorporated herein by reference.

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Exhibit
No. Description


  10.12     Lease Agreement, dated December 20, 1996 between the Company and Cummings Property Management, Inc. Filed as Exhibit 10.22 to the Company’s Registration Statement on Form S-1 (File No. 333-22945) and incorporated herein by reference.
  10.13+     Research and License Agreement between the Company and American Home Products Corporation acting through its Wyeth-Ayerst Research Division dated July 3, 1997. Filed as Exhibit 99.4 to the Company’s Current Report on Form 8-K filed with the Commission on August 19, 2003 (File No. 000-21249) and incorporated herein by reference.
  10.16     Research and Development Agreement between the Company and Sankyo Co., Ltd. dated November 1, 1997. Initially filed as Exhibit 10.29 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1997 with certain confidential information omitted, filed with the Commission on March 17, 1998 (File No. 000-21429) and re-filed herewith in its entirety.
  10.16.1+     Amended and Restated Research and Development Agreement between the Company and Sankyo Co., Ltd., dated as of April 2, 2001. Filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001 (File No. 000-21429) and incorporated herein by reference.
  10.24     Term loan agreement between Fleet National Bank and the Company, dated as of March 18, 1999. Filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the Quarter ended March 31, 1999 (File No. 000-21429) and incorporated herein by reference.
  10.24.6     Amendment to Mortgage between Fleet National Bank and the Company dated September 28, 2002. Filed as Exhibit 10.24.6 to the Company’s Quarterly Report on Form 10-Q for the quarter-ended September 30, 2002 (File No. 000-21429) and incorporated herein by reference.
  10.24.7     Second Loan Modification Agreement between Fleet National Bank and the Company dated September 28, 2002. Filed as Exhibit 10.24.7 to the Company’s Quarterly Report on Form 10-Q for the quarter-ended September 30, 2002 (File No. 000-21429) and incorporated herein by reference.
  10.24.8     Security Agreement between Fleet National Bank and the Company dated September 28, 2002. Filed as Exhibit 10.24.8 to the Company’s Quarterly Report on Form 10-Q for the quarter-ended September 30, 2002 (File No. 000-21429) and incorporated herein by reference.
  10.24.9     Third Loan Modification Agreement between Fleet National Bank and the Company dated February 12, 2003. Filed as Exhibit 10.24.9 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003 (File No. 000-21479) and incorporated herein by reference.
  10.24.10     Fourth Loan Modification Agreement between Fleet National Bank and the Company dated September 3, 2003. Filed as Exhibit 10.24.10 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 (File No. 000-21429) and incorporated herein by reference.
  10.25*     Technology Acquisition Agreement between Pfizer Inc and the Company, dated as of July 19, 1999. Filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999 (File No. 000-21429) and incorporated herein by reference.
  10.26+     Sublease between Pfizer Inc. and the Company, dated July 16, 1999. Filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999 (File No. 000-21429) and incorporated herein by reference.
  10.31     Termination Agreement between the Company and Pharmacia Corporation dated June 30, 2000. Initially filed as Exhibit 10.2 to the Company’s Quarterly report on Form 10-Q for the quarter ended June 30, 2000 with certain confidential information omitted (File No. 000-21429) and re-filed herewith in its entirety.
  10.38+     Amendment No. 1 to the Compound Supply and License Agreement between the Company and R.W. Johnson Pharmaceutical Research Institute, a division of Ortho-McNeil Pharmaceutical, Inc. dated as of August 14, 2000. Filed as Exhibit 99.1 to the Company’s Current Report on Form 8-K (File No. 000-21429) filed with the Commission on October 17, 2000 and incorporated herein by reference.

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Exhibit
No. Description


  10.39+     Collaboration Agreement between Pfizer Inc and the Company, dated as of December 19, 2001. Filed as Exhibit 10.39 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001 filed with the commission on March 27, 2002 (File No. 000-21429) and incorporated herein by reference.
  10.40     Lease by and between Pacific Shores Center LLC and the Company, dated March 1, 2002. Filed as Exhibit 10.40 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2002 (File No. 000-21429) and incorporate herein by reference.
  10.41     Consulting agreement between the Company and Michael Rosenblatt, MD dated May 1, 2002. Filed as Exhibit 10.41 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002 (File No. 000-21429) and incorporated herein by reference.
  10.43     Employment Agreement between the Company and Andrew Uprichard, dated May 28, 2002. Filed as Exhibit 10.43 to the company’s Annual Report on Form 10K for the fiscal year ended December 31, 2002 filed with the Commission on March 31, 2003 (File No. 000-21429) and incorporated herein by reference.
  10.44     Employment Agreement between the Company and Chiang J. Li, MD, dated September 5, 2003. Filed as Exhibit 10.44 to the Company’s Quarterly Report on Form 10-Q for the
        quarter ended September 30, 2003 (File No. 000-21429) and incorporated herein by reference.
  10.45     Employment Agreement between the Company and Stephen A Hill, dated as of January 1, 2004 and filed herewith.
  10.46     Employment Agreement between the Company and J. David Jacobs, dated as of January 1, 2004 and filed herewith.
  10.47     Employment Agreement between the Company and Louise A. Mawhinney, dated as of December 18, 2003 and filed herewith.
  10.48+     Amendment to the Collaboration Agreement between Pfizer Inc. and the Company dated February 11, 2004. Filed herewith.
  21.1     Subsidiaries of the Company. Filed herewith.
  23.1     Consent of PricewaterhouseCoopers LLP, independent accountants.
  31.1     Certificate of Chief Executive Officer
  31.2     Certificate of Chief Financial Officer
  32     Certificate of Chief Executive Officer and Chief Financial Officer


  Indicates a management contract or compensatory plan.

Certain confidential material contained in the document has been omitted and filed separately, with the Securities and Exchange Commission pursuant to Rule 406 of the Securities Act of 1933, as amended or Rule 24b-2 of the Securities and Exchange Act of 1934, as amended.

F-36

<PAGE>

                                                                  Exhibit 10.6.1

                              AMENDED AND RESTATED
                  RESEARCH, DEVELOPMENT AND LICENSE AGREEMENT

         This Agreement, effective as of January 1, 2001 (the "Effective Date"),
is between ArQule, Inc. ("ArQule"), a Delaware corporation, and Solvay
Pharmaceuticals B.V. ("Solvay"), a Dutch corporation.

                                R E C I T A L S

         WHEREAS, the parties previously entered into that certain Research,
Development and License Agreement, effective as of November 2, 1995 (the "Prior
Agreement");

         WHEREAS, the Prior Agreement will, by its terms, expire on December 31,
2000; and

         WHEREAS, the parties desire to continue certain activities under the
Prior Agreement and to continue their collaboration by undertaking additional
research and development activities;

         NOW, THEREFORE, in consideration of the mutual covenants set forth in
this Agreement, the parties hereby agree as follows:

1.       Definitions.

         1.1.     "Active Compound" shall mean an ArQule Compound that has
exhibited biological activity against a Target and as to which Solvay has
provided the required notice to ArQule under the Prior Agreement or under this
Agreement pursuant to Sections 3.2. and 3.4

         1.2.     "Affiliate" shall mean a corporation or other legal entity
that controls, is controlled by, or is under common control with
 such party. For
purposes of this definition, control means the ownership, directly or
indirectly, of fifty percent (50%) or more of the outstanding equity securities
of a corporation which are entitled to vote in the election of directors or a
fifty percent (50%) or greater interest in the net assets or profits of an
entity which is not a corporation.

         1.3.     "Agreement" shall mean this Research, Development and License
Agreement, together with Exhibits A and B hereto.

         1.4.     "ArQule Compound" shall mean a chemical compound provided by
ArQule to Solvay pursuant to this Agreement or under the Prior Agreement as part
of a screening library including, without limitation, the compounds provided in
the Compass Array Library and Mapping Array Libraries.


<PAGE>

         1.5.     "ArQule Derivative Compound" shall mean a Derivative Compound
developed from a Licensed Compound by ArQule or by or for Solvay in the course
of an optimization program for the molecular Target or other Target (e.g., whole
cell screen) against which such Licensed Compound was initially discovered to
have biological activity, i.e., a compound is not an ArQule Derivative Compound
if that compound is independently developed by Solvay.

         1.6.     "Array" shall mean a set of samples of structurally related
chemical compounds arranged in a format such as a microtiter screening plate.

         1.7.     "Available Compound" shall mean an Active Compound which
ArQule has determined is not (i) licensed or otherwise committed to a third
party in the Field or (ii) committed to an internal ArQule program in the Field
and is reserved to Solvay on an exclusive basis pursuant to Section 3.

         1.8.     "Chemical Theme" shall mean the chemical or structural
characteristics shared by (i) the ArQule Compounds in a Mapping Array Library or
(ii) a group of compounds in a Directed Array Library as determined by the
Research Committee pursuant to Section 2.2.1.

         1.9.     "Compass Array(TM) Library" shall mean a collection of ArQule
Compounds that is a diverse representative subset of the Mapping Array Libraries
produced in calendar year 2001 and used for initial screening of those Mapping
Array Libraries. The description of, and the specifications for, the Compass
Array Library are set forth in Exhibit A attached hereto.

         1.10.    "Confidential Information" shall have the meaning set forth in
Section 10.1.1.

         1.11.    "Derivative Compound" shall mean a chemical compound that was
structurally derived from a parent ArQule Compound or Solvay Compound in one or
more steps by a process of modification or partial substitution of at least one
component wherein at least one structural feature is retained at each process
step. The number of intermediate steps or compounds is not relevant to the
classification of a compound as a Derivative Compound. A compound need not have
structural similarity to another compound in order to be classified as a
Derivative Compound.

         1.12.    "Directed Array(R) Library" shall mean an Array comprised of
Derivative Compounds synthesized by ArQule under the Directed Array Program. The
description of, and the specifications for, the Directed Array Libraries are set
forth in Exhibit A attached hereto.

         1.13.    "Directed Array(R) Program" or "DA Program" shall mean the
Directed Array Library component of the Research Program conducted by ArQule for
Solvay in general accordance with the Research Plan, as set forth in Section 4.

         1.14.    "Field" shall mean applications in the life sciences.

         1.15.    "Full-Time Equivalent" or "FTE" shall mean one (1) or more
employees of ArQule who, collectively, spend time and effort working on a
specific project or task equivalent

                                       2


<PAGE>

to the time and effort of one (1) full-time employee working on such project or
task (approx. 2,000 hours per year).

         1.16.    "Licensed Compound" shall mean (i) any Available Compound
that, as of the Effective Date, has already been designated as a Licensed
Compound under the Prior Agreement or (ii) any Available Compound that the
Research Committee designates as a Licensed Compound in accordance with Section
3.6.

         1.17.    "Licensed Compound Set" shall mean a set of one or more
Licensed Compounds from the same Mapping Array Library that have biological
activity for the same Target.

         1.18.    "Mapping Array(R) Library" shall mean an Array of ArQule
Compounds which ArQule makes available to its collaborators for screening on a
non-exclusive basis. ArQule previously delivered Mapping Array Libraries to
Solvay under the Prior Agreement. The description of, and the specifications
for, the Mapping Array Libraries that ArQule will deliver to Solvay under
Article 3 of this Agreement are set forth in Exhibit A attached hereto.

         1.19.    "Mapping Array(R) Program" or "MA Program" shall mean the
component of the Research Program under which ArQule previously provided to
Solvay under the Prior Agreement with Mapping Array Libraries. Under this
Agreement ArQule will provide Solvay with a portion of the Compass Array Library
and with selected Mapping Array Libraries, as further described in Section 3.

         1.20.    "Net Sales" shall mean the aggregate Net Sales Price of
Royalty-Bearing Products in any Royalty Period.

         1.21.    "Net Sales Price" shall mean the gross amount received on
sales by Solvay, its Affiliates and sublicensees of Royalty-Bearing Products in
the Field, less the following: (i) trade, quantity, and cash discounts or
rebates actually allowed, (ii) credits or allowances given for rejections or
returns, (iii) freight, shipping, or other costs of transportation including
insurance costs charged to a customer, and (iv) to the extent separately stated
on purchase orders, invoices, or other documents of sale, any taxes (e.g.,
excise tax, duties, VAT) levied on the sale of a Royalty-Bearing Product which
is paid by Solvay or its Affiliates or sublicensees. In any transfers of
Royalty-Bearing Products between Solvay and an Affiliate, the Net Sales Price
shall be calculated based on the first sale of the Royalty-Bearing Product to an
independent third party. In the event that Solvay receives non-monetary
consideration for any Royalty-Bearing Products, the Net Sales Price shall be
calculated based on the average price charged by Solvay for such Royalty-Bearing
Products during the preceding Royalty Period.

         1.22.    "Patent Rights" shall mean all issued patents and reissues,
reexaminations, extensions and supplementary protection certificates thereof and
all patent applications and any divisions, continuations, or
continuations-in-part thereof (to the extent directed to the subject matter of
the parent application) or patents issuing thereon. "ArQule Patent Rights" means
Patent Rights that are either (i) assigned solely to ArQule, (ii) assigned
jointly to ArQule and a party other than Solvay, or (iii) licensed to or
otherwise controlled by ArQule, in each case to the extent that ArQule has the
ability to license or sublicense the rights required under this

                                       3

<PAGE>

Agreement without payment to a third party. "Solvay Patent Rights" means Patent
Rights that are either (i) assigned solely to Solvay, (ii) assigned jointly to
Solvay and a party other than ArQule, or (iii) licensed to or otherwise
controlled by Solvay, in each case to the extent that Solvay has the ability to
license or sublicense the rights required under this Agreement without payment
to a third party. "Joint Patent Rights" means Patent Rights assigned to both
ArQule and Solvay as joint owners in relation to Joint Technology. Explicitly
excluded are rights in the compounds specified in Section 6.1. Joint Patent
Rights will include (i) Patent Rights claiming Joint Technology and (ii) Patent
Rights claiming both ArQule Technology and Solvay Technology in a single filing.

         1.23.    "Phase II Clinical Trials" shall mean clinical trials in a
small sample of the intended patient population commencing on the filing of a
trial protocol with the appropriate regulatory authority to assess the efficacy
for a specific indication of a compound proposed to be used as a prophylactic,
therapeutic or diagnostic pharmaceutical product, to determine dose tolerance
and the optimal dose range as well as to gather additional information relating
to safety and potential adverse effects, and meeting the requirements
established by the U. S. Food and Drug Administration for Phase II clinical
trials.

         1.24.    "Phase III Clinical Trials" shall mean clinical trials
designed to demonstrate safety and efficacy of a compound proposed to be used as
a prophylactic, therapeutic or diagnostic pharmaceutical product in an expanded
patient population at geographically dispersed study sites, meeting the
requirements established by the U.S. Food and Drug Administration for Phase III
clinical trials.

         1.25.    "Priority Substance" shall mean a compound under this
Agreement selected by Solvay or an Affiliate of Solvay to enter into the
preclinical research phase.

         1.26.    "Project Declaration" shall mean, with respect to a compound
under this Agreement, the decision to commence human clinical trials.

         1.27.    "Proprietary Materials" shall have the meaning set forth in
Section 10.2.1.

         1.28.    "Research Committee" shall mean the Research Committee
described in Section 2.

         1.29.    "Research Period" shall mean the period commencing on the
Effective Date and continuing through December 31, 2003.

         1.30.    "Research Plan" shall mean a plan of research for the DA
Program covering a six-month period, which shall be updated quarterly pursuant
to Section 2.2 to reflect developments during the previous three (3) months and
extended for the subsequent three (3) months.

         1.31.    "Research Program" shall mean, collectively, the Directed
Array Program and the Mapping Array Program.

                                       4

<PAGE>

         1.32.    "Royalty-Bearing Product" shall mean a product containing as
one of its constituents (i) any Licensed Compound; (ii) any ArQule Derivative
Compound; (iii) any Solvay Derivative Compound; or (iv) any other compound
discovered or designed by Solvay directly as a result of information obtained by
Solvay under the MA Program or DA Program from one or more Licensed Compounds or
Derivative Compounds, which information forms the primary basis for such
discovery or development and which information was not previously known to
Solvay from sources other than ArQule.

         1.33.    "Royalty Period" shall mean every calendar quarter, or partial
calendar quarter, in which a royalty is payable to ArQule pursuant to Section
9.5. commencing with the first commercial sale of a Royalty-Bearing Product in
any country.

         1.34.    "Solvay Compound" shall mean any chemical compound provided by
Solvay or its Affiliates to ArQule under the Prior Agreement or in the Directed
Array Program under this Agreement.

         1.35.    "Solvay Derivative Compound" shall mean a Derivative Compound
developed from a Solvay Compound by ArQule under the Prior Agreement or in the
Directed Array Program under this Agreement, as well as Derivative Compounds
thereof developed or by or for Solvay.

         1.36.    "Target" shall mean the biological target against which
activity of an Active Compound was revealed, together with any related
biomolecules that (i) (A) exhibit substantial structural homology with the
identified biomolecule, as measured by the degree of similarity in the primary
structure (i.e., amino acid sequence, nucleotide sequence, monosaccharide
linkages) and secondary structure (i.e., three-dimensional structure), or (B)
perform a substantially similar function as the identified biomolecule, and (ii)
have therapeutic relevance. Biological targets shall not be considered as
exhibiting substantial structural homology nor functional similarity if such
biological targets are generally recognized by the scientific community as being
different.

         1.37.    "Technology" shall mean any proprietary development,
information, know-how, idea, design, concept, technique, process, invention,
compound, discovery, improvement whether or not patentable or copyrightable.
"ArQule Technology" means Technology that is either (i) assigned solely to
ArQule, (ii) assigned jointly to ArQule and a party other than Solvay, or (iii)
licensed to or otherwise controlled by ArQule, in each case to the extent that
ArQule has the ability to license or sublicense the rights required under this
Agreement without payment to a third party. "Solvay Technology" means Technology
that is either (i) assigned solely to Solvay, (ii) assigned jointly to Solvay
and a party other than ArQule, or (iii) licensed to or otherwise controlled by
Solvay, in each case to the extent that Solvay has the ability to license or
sublicense the rights required under this Agreement without payment to a third
party. "Joint Technology" means Technology that is developed or discovered
jointly by one or more employees or consultants of Solvay and one or more
employees or consultants of ArQule pursuant to this Agreement, explicitly
excluded are the compounds specified in Section 6.1.

         1.38.    "Valid Claim" means either (i) a claim of an issued patent
that has not been held unenforceable or invalid by an agency or a court of
competent jurisdiction in any unappealable

                                       5

<PAGE>

or unappealed decision or (ii) a claim of a pending patent application that has
not been abandoned or finally rejected without the possibility of appeal or
refiling.

         1.39.    The above definitions are intended to encompass the defined
terms in both the singular and plural tenses.

2.       Management of Research Programs.

         2.1.     Composition of Research Committee. The parties hereby
establish a Research Committee comprised of six (6) members, with three (3)
representatives appointed by each party. A party may change one or more of its
representatives to the Research Committee at any time upon notice to the other
party.

         2.2.     Duties of the Research Committee. The Research Committee shall
direct and administer the Research Program in general accordance with the
following provisions:

         2.2.1.   DA Program. With respect to the DA Program, the Research
Committee has heretofore determined the general specifications for the Directed
Array Libraries to be delivered to Solvay during the Research Period. ArQule
shall have the right, at the time Solvay seeks to include any compound(s) in the
DA Program, to exclude from the DA Program any compound that ArQule has
determined is (i) licensed or otherwise committed to a third party in the Field
or (ii) committed to an internal ArQule program in the Field. The Solvay
representatives on the Research Committee shall, in consultation with the ArQule
representatives, determine the identity, scope and priority of each Chemical
Theme. The identity and scope of such Chemical Theme will be determined on the
basis of the following criteria: (i) the specific reaction or reaction sequence
used to combine members of two or more discrete chemical units in which each
chemical unit bears the functional group(s) required for the specific
reaction(s) that result in the combination of the chemical units; and (ii) the
extent to which a class of compounds is related by a recurring structural motif
associated with a particular biological activity.

         2.2.2.   Other Responsibilities. In addition, the Research Committee
shall (i) revise and extend the Research Plan each calendar quarter for the
subsequent six (6) months based on prior developments, (ii) designate Available
Compounds as Licensed Compounds as described in Section 3.6; (ii) maintain and
update the list of Licensed Compounds and Licensed Compound Sets; (iii)
determine the allocation of the funding and personnel resources to be
contributed by ArQule for the Directed Array Program; and (iv) resolve matters
involving scientific questions and publication disputes that may arise under
Section 10.4.

         2.3.     Meetings of the Research Committee. The Research Committee
shall conduct telephone conferences at least once every six (6) weeks and shall
prepare and deliver a brief written report (which may be in the form of
confirmed electronic mail) describing the significant issues and discussions
that take place during such telephone conferences. A representative of the
Research Committee jointly appointed by its members shall provide each member
with five (5) business days notice of the time of telephone conferences, unless
such notice is waived by all members. ArQule will prepare and deliver to the
members of the Research Committee a brief

                                       6

<PAGE>

progress report at least one week in advance of the telephone conference, which
report will list the ArQule employees then working on the Research Program. The
Research Committee shall meet at least twice each year with the location
alternating between the ArQule site and the Solvay site, or at such other times
and locations as the Research Committee determines. A representative of the
Research Committee jointly appointed by its members shall provide each member
with five (5) business days notice of the time and location of meetings, unless
such notice is waived by all members. If a designated representative of a party
cannot attend any meeting of the Research Committee, such party may designate a
different representative for that meeting without notice to the other party, and
the substitute member will have full power to vote on behalf of the permanent
member. Except as otherwise provided in this Section 2, all actions and
decisions of the Research Committee will require the unanimous consent of all of
its members. If the Research Committee fails to reach agreement upon any matter,
the dispute will be resolved in accordance with the procedures set forth in
Section 13.5 below. Within fourteen (14) days following each meeting, the
Research Committee shall prepare and deliver, to both parties, a written report
describing the decisions made, conclusions and actions agreed upon.

         2.4.     Cooperation. Each party agrees to provide the Research
Committee with information and documentation as reasonably required for the
Research Committee to fulfill its duties under this Agreement. In addition, each
party agrees to make available its employees and consultants as reasonably
requested by the Research Committee. The parties anticipate that members of the
Research Committee will communicate informally with each other and with
employees and consultants of the parties on matters relating to the Research
Programs.

         2.5.     Visits to Facilities. Members of the Research Committee shall
have reasonable access to the facilities of each party where activities under
this Agreement are in progress, but only during normal business hours and with
reasonable prior notice. Each party shall bear its own expenses in connection
with such site visits.

3.       Mapping Array Program.

         3.1.     Prior Agreement. Solvay acknowledges that ArQule has fully
performed and discharged its obligations under Section 3.1. of the Prior
Agreement. ArQule acknowledges that Solvay has fully satisfied and discharged
its obligations under Section 3.2. of the Prior Agreement. Solvay acknowledges
and agrees ArQule remains eligible to receive milestone and royalty payments on
Royalty-Bearing Products as set forth in this Agreement. Solvay and ArQule
expressly acknowledge and agree that the provisions of this Agreement supersede
the provisions of the Prior Agreement with respect to the Mapping Array Program.

         3.2.     Compass Array Library. ArQule will supply Solvay with one (1)
copy of the Compass Array Library corresponding to Mapping Array Libraries
produced in calendar year 2001 in four (4) quarterly portions promptly after
such ArQule Compounds become available, with the last shipment delivered not
later than July 1, 2002. ArQule will not disclose the structures of individual
ArQule Compounds in the Compass Array Library and Solvay will have no obligation
to disclose its Targets. ArQule will disclose to Solvay the Chemical Themes in
the Compass Array Library in Markush format. Solvay will diligently screen the
Compass Array

                                       7

<PAGE>

Library against its selected Targets. When Solvay detects and confirms Active
Compounds in the Compass Array Library, Solvay will inform ArQule through the
Research Committee.

         3.3.     Selection of Mapping Array Libraries. During the Research
Period, ArQule will promptly determine whether the Active Compounds identified
by Solvay in the Compass Array Library are Available Compounds, and then notify
Solvay of such determination. If any Active Compound is not an Available
Compound, ArQule shall not disclose the structure and Solvay shall have no
rights under this Agreement with respect to that Active Compound. If an Active
Compound is an Available Compound, ArQule shall reserve such Available Compound
to Solvay under this Agreement. ArQule then shall disclose to Solvay the
structure of such Available Compound correlated to its well location and its
Mapping Array Library. ArQule shall maintain the reserved status of the
Available Compound for a period of up to four (4) weeks after the date upon
which the structure was disclosed to Solvay. All such disclosed structures shall
be treated as ArQule Confidential Information. During the four-week reservation
period, Solvay will confirm its interest in that Available Compound and may
request the Mapping Array Library for that Available Compound (if Solvay does
not already have that Mapping Array Library in its possession) upon written
notice to ArQule (including by electronic mail). If Solvay does not confirm its
interest in writing and does not request the Mapping Array Library for that
Available Compound (if that Mapping Array Library is not already in the
possession of Solvay) during the four-week reservation period, the Available
Compound shall automatically lose its reserved status and Solvay shall have no
further rights to such compound. ArQule will promptly deliver to Solvay the
selected Mapping Array Libraries; provided, however, that ArQule will have no
obligation to deliver more than one (1) copy of each Mapping Array Library
pursuant to this Agreement. In addition, with each shipment of a Mapping Array
Library, or upon confirmation of interest by Solvay in the case of a Mapping
Array Library already in the possession of Solvay, ArQule will furnish Solvay
with (i) the Chemical Theme of the Mapping Array Library in Markush format, (ii)
the location of each Available Compound in the Mapping Array Library, and (iii)
at the request of Solvay, the locations (but not the structures) of ArQule
Compounds that are the nearest homologues to the Available Compounds (under
procedures established by the Research Committee) and which are not licensed or
otherwise committed to a third party in the Field or committed to an internal
ArQule program in the Field. ArQule shall not identify the structures of the
individual ArQule Compounds in the Mapping Array Libraries.

         3.4.     Mapping Array Library. Upon receipt of each Mapping Array
Library, or upon receipt of the relevant information as described in Section
3.3. in the case of Mapping Array Libraries already in the possession of Solvay,
Solvay shall diligently screen such Mapping Array Library for activity against
the relevant Target(s). ArQule will maintain the reserved status of the
Available Compound(s) identified in the Compass Array Library for a period of
four (4) months after Solvay receives the relevant Mapping Array Library and
accompanying information or, in the case of Mapping Array Libraries already in
the possession of Solvay, for a period of four (4) months after Solvay receives
the relevant information as described in Section 3.3. In addition, Solvay shall
have the right to screen all Mapping Array Libraries in its possession
irrespective of the Compass Array Library. If Solvay detects and confirms Active
Compounds, Solvay shall inform ArQule through the Research Committee in writing
(including by electronic mail) of the spatial location of Active Compounds in
the Mapping Array Libraries. ArQule will promptly determine whether the Active
Compounds identified by Solvay in the Mapping Array

                                       8

<PAGE>

Libraries are Available Compounds, and then notify Solvay of such determination.
If any Active Compound is not an Available Compound, ArQule shall not disclose
the structure and Solvay shall have no rights under this Agreement with respect
to that Active Compound. If an Active Compound is an Available Compound, ArQule
shall reserve such Active Compound as an Available Compound to Solvay under this
Agreement. ArQule then shall disclose to Solvay the structure of such Available
Compound correlated to its well location, and Solvay shall disclose to ArQule
the class of the Target involved. All such disclosed structures and the target
class shall be treated as Confidential Information. ArQule shall maintain the
reserved status of every Active Compound that is an Available Compound from the
same Mapping Array Library for a period of up to four (4) weeks after the date
upon which the last structure of these Available Compounds is disclosed to
Solvay. If Solvay requests resynthesis of one or more Available Compounds from
the same Mapping Array Library during the four-week reservation period, the
Research Committee will determine which of these Available Compounds if not all
would become a Licensed Compound Set if the resynthesized compounds are
confirmed to be Active Compounds, and ArQule will continue to reserve this group
of Available Compounds, all as more fully described below. The Research
Committee will resolve any disagreements regarding which Available Compounds
constitute the "group" represented by the compound or compounds resynthesized.
If the four-week reservation period expires for a group of Available Compounds
without any resynthesis request by Solvay or without agreement by the Research
Committee as to which Available Compounds should constitute the group pending
resynthesis and confirmation, the other Available Compounds (i.e., Available
Compounds that are not selected for resynthesis by Solvay) from that Mapping
Array Library shall automatically lose their reserved status and Solvay shall
have no further rights to such compounds.

         3.5.     Resynthesis. During the Research Period, ArQule shall
resynthesize and deliver to Solvay an additional 25 mg quantity of any Available
Compound requested by Solvay to enable Solvay to conduct confirmatory screening
activities. Solvay shall provide ArQule with written notice of the Available
Compounds that Solvay desires to have resynthesized by ArQule. ArQule shall
resynthesize the requested compounds in accordance with the specifications set
forth in Exhibit A. In each case the actual amount of, and delivery schedule
for, resynthesized Available Compounds will be determined by the Research
Committee. ArQule will maintain the reservation on each group of Available
Compounds (as determined by the Research Committee under Section 3.4.) while
ArQule prepares resynthesis quantities of selected Available Compounds from that
group and will then continue to reserve that group of Available Compound for a
period of up to three (3) months after Solvay receives the resynthesized
Available Compounds.

         3.6.     Designation of Licensed Compounds. At the request of Solvay,
the Research Committee will review and consider the pertinent confirmatory data
with respect to each group of Available Compounds (as determined by the Research
Committee under Section 3.4.) and, if the activity of the resynthesized compound
or compounds has been confirmed, designate the Available Compounds within the
group as "Licensed Compounds" under this Agreement, whereupon Solvay shall
disclose the Target and level of activity for the Licensed Compounds and, at the
request of Solvay, ArQule shall disclose the structures but not the locations of
the other ArQule Compounds in the same Mapping Array Library as the Licensed
Compounds. Upon the designation of an Available Compound as a Licensed Compound
and the disclosure by

                                       9

<PAGE>

Solvay of the Target and level of activity, the licenses set forth in Section
7.2 shall automatically apply, and ArQule shall confirm such license in writing.
If the Research Committee determines that the activity of the resynthesized
compound or compounds has not been confirmed, then the Available Compounds
within the group shall automatically lose their reserved status and Solvay shall
have no further rights to such compounds.

         3.7.     Changes to Reservation Periods. The Research Committee may
extend the reservation periods described in Sections 3.3., 3.4., and 3.5. if
requested by Solvay and approved in writing by the Chief Scientific Officer of
ArQule.

         3.8.     Optimization Rights. During the Research Period, Solvay may
submit any Licensed Compound Set to ArQule for optimization in the Directed
Array Program; however, ArQule has no obligation to increase its commitment to
the Directed Array Program as set forth in Section 4.3. At any time, Solvay may
conduct optimization of any Licensed Compound Set. In the event that Solvay
conducts optimization of a Licensed Compound Set, then at the request of Solvay,
ArQule will provide Solvay with synthetic protocols (in American Chemical
Society experimental format, not automated protocols) to enable Solvay to make
those Licensed Compounds.

         3.9.     Extension Right. If ArQule continues to offer the Mapping
Array Program during the year 2002, Solvay may extend on the same terms the
supply of ArQule Compounds in the form of the Compass Array Library and the
Mapping Array Libraries through December 31, 2002 upon written notice to ArQule
which is received by ArQule not later than October 1, 2001. In addition, ArQule
and Solvay agree to negotiate in good faith an arrangement under which Solvay
may screen the Mapping Array Compounds and have access to the structures of
Active Compounds after the conclusion of the Research Period.

4.       Directed Array Program.

         4.1.     Prior Agreement. Solvay acknowledges that ArQule has fully
satisfied and discharged its obligations under Sections 4.1. and 4.2. of the
Prior Agreement. ArQule acknowledges that Solvay has fully satisfied and
discharged its obligations under Section 4.3. of the Prior Agreement. Solvay
acknowledges and agrees ArQule remains eligible to receive milestone and royalty
payments on Royalty-Bearing Products as set forth in this Agreement. Solvay and
ArQule expressly acknowledge and agree that the provisions of this Agreement
supersede the provisions of the Prior Agreement with respect to the Directed
Array Program.

         4.2.     Description of Program. Under the direction of the Research
Committee and in accordance with the Research Plan, ArQule will synthesize
multiple Directed Array Libraries of compounds derived from (i) Solvay Compounds
provided to ArQule by Solvay or (ii) Licensed Compounds requested by Solvay to
be included in the DA Program. The parties intend that, during the Research
Period, ArQule will produce such Directed Array Libraries based on approximately
ten (10) different Chemical Themes each calendar year, which will result in the
production of up to 1,000 Derivative Compounds per Chemical Theme per year;
provided, however, that the number of Chemical Themes actually submitted to the
DA Program and the number of Derivative Compounds actually produced per Chemical
Theme will be determined by

                                       10

<PAGE>

the Research Committee. The parties also intend that ArQule will produce
approximately twenty (20) milligrams of each Derivative Compound in the Directed
Array Libraries, subject to the availability of the original Solvay Compounds or
Licensed Compounds; the amount of each Derivative Compound that ArQule actually
produces, however, will be determined by the Research Committee. ArQule agrees
that any Derivative Compounds provided to Solvay under the DA Program will not
be (i) licensed or otherwise committed to a third party in the Field or (ii)
committed to an internal ArQule program in the Field, and Solvay agrees that
ArQule may exclude from the DA Program any Derivative Compounds that ArQule has
determined are (i) licensed or otherwise committed to a third party in the Field
or (ii) committed to an internal ArQule program in the Field.

         4.3.     Conduct of Directed Array Program. The DA Program will be
conducted in accordance with the Research Plan. ArQule shall commit a total of
four (4) FTEs per calendar year to the Directed Array Program (including at
least two full-time synthetic organic chemists). ArQule shall furnish Solvay
with a quarterly report describing progress and methods used in sufficient
detail and that includes the names of the synthetic organic chemists and the
time spent in the DA Program in that quarter, as well as the total non-chemist
FTE resource applied to the DA Program in that quarter with an approximate
breakdown by function. Solvay shall propose projects to the Research Committee
for inclusion as a Directed Array Program. If the Research Committee approves
the inclusion of the proposed project, ArQule shall thereupon diligently
synthesize Directed Array Libraries of ArQule Derivative Compounds or Solvay
Derivative Compounds in accordance with the Research Plan; Solvay shall provide
ArQule with the requisite amount and purity of Solvay Compounds, as directed by
the Research Committee, for any Directed Array Library Programs based on such
Solvay Compounds. Solvay shall, in its discretion, test all compounds in the
Directed Array Libraries. The parties shall perform the Directed Array Programs
under this Agreement during the first two (2) years of the Research Period.
ArQule shall have no obligation to expand or extend its commitments to the
Directed Array Program, including without limitation the commitment of four (4)
FTEs per calendar year and the two-year performance period.

5.       Ownership of Physical Compounds.

         ArQule acknowledges and agrees that all Solvay Compounds, Solvay
Derivative Compounds, and ArQule Derivative Compounds are Solvay Proprietary
Materials and, as such, are owned by Solvay. Solvay acknowledges and agrees that
all ArQule Compounds are ArQule Proprietary Materials and, as such, are owned by
ArQule.

6.       Intellectual Property Rights.

         6.1.     Rights in Compounds. Solvay shall have the sole right to
prepare, file, prosecute, and maintain Patent Rights that claim the composition
or use of (i) ArQule Derivative Compounds or Solvay Derivative Compounds
developed by either party under this Agreement and (ii) Licensed Compounds that
come within the scope of the claims to ArQule Derivative Compounds under clause
(i) above, provided that such Licensed Compounds are not already covered by a
claim in an ArQule Patent Right. ArQule shall assign to Solvay all right, title,
and interest in any Patent Rights filed by Solvay that claim the composition or
use of such ArQule

                                       11

<PAGE>

Derivative Compounds, Solvay Derivative Compounds, or Licensed Compounds.
Therefore, such Patent Rights are considered Solvay Patent Rights under this
Agreement rather than Joint Patent Rights, and Solvay shall be the sole owner of
such Patent Rights. ArQule shall not in any way seek to rely on any ArQule
Patent Right or other intellectual property right in the ArQule Technology to
prevent Solvay from exercising its rights under this Section 6.1.

         6.2      Ownership of Patent Rights and Technology. Other than as
expressly provided herein, neither party shall have any rights in Patent Rights
and Technology that is invented, developed or discovered by the other party
prior to the Effective Date subject to the provisions of the Prior Agreement or
outside the research performed under this Agreement. Ownership of Patent Rights
and Technology arising from the research performed under this Agreement shall be
allocated in the following manner:

         (i)      ArQule shall have sole ownership of all right, title, and
                  interest in ArQule Patent Rights and ArQule Technology,
                  subject to the licenses granted to Solvay under Section 7.1.
                  and Section 7.2.;

         (ii)     Solvay shall have sole ownership of all right, title, and
                  interest in Solvay Patent Rights and Solvay Technology; and

         (iii)    ArQule and Solvay shall have joint ownership of all right,
                  title, and interest in Joint Patent Rights and Joint
                  Technology.

         6.3.     Management of Patent Rights. Solvay shall have sole
responsibility for, and control over, the management of Solvay Patent Rights and
ArQule shall have sole responsibility for, and control over, the management of
ArQule Patent Rights. Each party will bear its own expenses in connection with
such Patent Rights. In the case of Joint Patent Rights, the parties shall agree
on the allocation of responsibility for, and the expense of, the preparation,
filing, prosecution, and maintenance of any Joint Patent Rights claiming such
inventions as decided by the Research Committee. In the event of any
disagreement concerning any Joint Patent Rights, the matter shall be resolved by
the CEO of ArQule and the Vice President-Research of Solvay. The party
controlling a Joint Patent Right shall consult with the other party as to the
preparation, filing, prosecution, and maintenance of such Joint Patent Right
reasonably prior to any deadline or action with the U.S. Patent & Trademark
Office or any foreign patent office, and shall furnish to the other party copies
of all relevant documents reasonably in advance of such consultation. In the
event that the party controlling a Joint Patent Right desires to abandon such
Joint Patent Right, or if the party assuming control of a Joint Patent Right
later declines responsibility for such Joint Patent Right, the controlling party
shall provide reasonable prior written notice to the other party of such
intention to abandon or decline responsibility, and such other party shall have
the right, at its expense, to prepare, file, prosecute, and maintain such Joint
Patent Rights.

         6.4.     Cooperation of the Parties. Each party agrees to cooperate
fully in the preparation, filing, and prosecution of any Patent Rights under
this Agreement and any potential infringement issues relating to ArQule
Technology. Such cooperation includes, but is not limited to:

                                       12

<PAGE>

                  (a)      executing all papers and instruments, or requiring
its employees or agents, to execute such papers and instruments, so as to
effectuate the ownership of Patent Rights set forth in Section 6.1 above and to
enable the other party to apply for and to prosecute patent applications in any
country;

                  (b)      promptly informing the other party of any matters
coming to a party's attention that may affect the preparation, filing, or
prosecution of any such patent applications or potential infringement issues
relating to the ArQule Technology; and

                  (c)      undertaking no actions that are potentially
deleterious to the preparation, filing, or prosecution of such patent
applications.

         6.5      Representation. ArQule represents and warrants to Solvay that,
to the best of ArQule's knowledge and belief, no claim of ownership, invalidity
or patent infringement has been asserted against ArQule or its Affiliates with
respect to ArQule Patent Rights or ArQule Technology as of the Effective Date.
In addition, ArQule covenants that, during the Research Period, ArQule will use
its best efforts to ensure that the practice of the combinatorial library
design, synthesis, and analysis technology within the ArQule Technology
(commonly referred to and collectively defined herein as the "AMAP Chemistry
Operating System") will not infringe any Valid Claim of any Patent Right of a
third party in a manner that would have a material adverse effect on Solvay as a
result of the activities undertaken by ArQule under Articles 3 and 4 of this
Agreement. Solvay acknowledges and agrees that the representations and
warranties set forth in this Section 6.5. have effect only in connection with
the activities undertaken by ArQule under Articles 3 and 4 of this Agreement and
have no effect with respect to the transfer of AMAP Technology under Article 8
of this Agreement.

         6.6.     Infringement.

                  6.6.l.   Offensive Actions. With respect to infringement of
any Solvay Patent Right or any ArQule Patent Right or Joint Patent Right
exclusively licensed to Solvay claiming the composition or use of a Licensed
Compound, ArQule Derivative Compound, or Royalty-Bearing Product, Solvay shall
have the primary right, but not the obligation, to enforce such Patent Right
under its sole control and at its sole expense. In such event, Solvay shall be
exclusively entitled to all proceeds or recoveries resulting therefrom, but from
such proceeds or recoveries Solvay shall pay ArQule a royalty in accordance with
Section 9.5. on sales lost to the infringer after deduction of all costs,
including reasonable attorney fees incurred by Solvay in the action to enforce
such Patent Rights. In the event that Solvay declines to enforce such Patent
Right with respect to a Royalty-Bearing Product where the sales of the alleged
infringer are at least twenty percent (20%) of the market for said product, then
ArQule shall have the secondary right to enforce such Patent Right under its
sole control and at its sole expense. In such event, ArQule shall be exclusively
entitled to all proceeds or recoveries resulting therefrom.

                  6.6.2.   Defensive Actions. Solvay will indemnify, defend, and
hold harmless ArQule, its Affiliates, and their respective officers, directors,
employees, and agents from any and all loss, damage, cost, and expense
(including reasonable attorneys fees) and amounts paid in settlement arising
from any actual or alleged infringement claim brought by a third party, in law

                                       13

<PAGE>

or in equity, based on activities undertaken by Solvay or by ArQule at the
direction of Solvay (except for claims based solely on the practice of an ArQule
Patent Right or the use of ArQule Technology) or based on the manufacture or
sale of a Royalty-Bearing Product. In the event that ArQule intends to claim
indemnification under this Subsection, ArQule shall promptly notify Solvay of
the infringement action and Solvay shall assume the defense of the action under
its sole control, including the right to effect a settlement. A failure by
ArQule to deliver notice to Solvay within a reasonable time shall relieve Solvay
of its indemnity obligation under this Section to the extent such failure
prejudices the ability of Solvay to defend such action. ArQule shall cooperate
fully with Solvay and its legal representatives in the investigation and defense
of the action. In the event of a settlement, Solvay shall obtain the consent of
ArQule before agreeing to any settlement that imposes restrictions which are
inconsistent with the rights and obligations of the parties under this
Agreement.

7.       License Grants.

         7.1.     ArQule Screening License. Subject to the terms and conditions
of this Agreement, ArQule hereby grants Solvay and its Affiliates a
nonexclusive, worldwide, royalty-free, license (without the right to grant
sublicenses) under ArQule Patent Rights and ArQule Technology to use the ArQule
Compounds during the Research Period to screen for activity against any
biological targets in the Field.

         7.2.     ArQule Commercial License. Effective upon designation by the
Research Committee of an ArQule Compound as a Licensed Compound and the
disclosure by Solvay of the Target and level of activity pursuant to Section
3.6, ArQule hereby grants to Solvay and its Affiliates with respect to each such
Licensed Compound the following licenses in the Field:

         (i)      an exclusive (even as to ArQule), worldwide license (with the
                  right to sublicense) under the ArQule Patent Rights and other
                  rights in ArQule Technology to conduct development of Licensed
                  Compounds, including the right to develop Derivative Compounds
                  based on Licensed Compounds;

         (ii)     an exclusive (even as to ArQule), worldwide license (with the
                  right to sublicense) under the ArQule Patent Rights and other
                  rights in ArQule Technology to make, have made, use, have
                  used, sell and have sold in the Field Licensed Compounds; and

         (iii)    a non-exclusive, worldwide license (with the right to
                  sublicense) under the ArQule Patent Rights and other rights in
                  ArQule Technology to use chemical synthesis methods within the
                  ArQule Patent Rights and ArQule Technology to make
                  Royalty-Bearing Products.

Solvay further acknowledges and agrees that the license grant in clause (iii) of
this Section is subject to the terms, conditions, and limitations of any
agreement under which ArQule has acquired or will acquire rights in a chemical
synthesis method from a third party, which shall be promptly notified by ArQule
to Solvay and, in such event, ArQule may require Solvay to enter into a separate
sublicense agreement before such license grant shall take effect. ArQule

                                       14

<PAGE>

represents and warrants that Solvay will not incur any payment obligation to a
third party as a result of the practice of the license grant set forth in clause
(iii) above for third-party licenses that ArQule has executed prior to the
Effective Date. ArQule covenants that ArQule will seek to obtain such
royalty-free manufacturing licenses as part of its chemistry licenses in the
future. In the event that Solvay decides to sublicense its rights under this
Section to a third party, Solvay shall furnish ArQule with written notice of the
sublicense grant and shall ensure that all sublicense agreements conform to this
Agreement.

                  7.3.     Diligence. Solvay agrees to use reasonable commercial
efforts to develop and market Royalty-Bearing Products based on or incorporating
any Licensed Compound, or Derivative Compounds thereof, using a level of effort
consistent with that used for other Solvay products having similar commercial
potential. The parties hereby acknowledge their understanding that Solvay's
obligations under this Section do not apply to each Licensed Compound in itself,
but only to at least one Licensed Compound or Derivative Compound thereof that
is active against the same Target. Subject to Section 7.5, Solvay shall have the
sole and absolute discretion to make all decisions relating to the research,
development, marketing and other commercialization activities with respect to
any Licensed Compound or its Derivative Compounds or any Royalty-Bearing Product
derived therefrom.

                  7.4.     Reports of Development Progress. Solvay agrees to
keep ArQule informed of its development progress with respect to each Licensed
Compound or Derivative Compound thereof for which it has obtained a license
under Section 7.2 as follows:

                  (a)      Initial Research Plan. Within 60 days after obtaining
a license, Solvay will provide ArQule with a time line of its planned research
activities for that Licensed Compound and will keep ArQule periodically informed
of its progress under such schedule.

                  (b)      Lead Compound. Solvay will notify ArQule of the
designation of any Licensed Compound or Derivative Compounds thereof as a lead
compound that fulfills Solvay's primary criteria in a particular project (e.g.,
potency, selectivity, and bioavailability). Within 60 days of such designation,
Solvay will provide ArQule with a copy of a revised time line of its research
activities for that lead compound and will keep ArQule periodically informed of
its progress under such schedule.

                  (c)      Priority Substance. Solvay will notify ArQule of the
designation of any Licensed Compound or Derivative Compounds thereof as a
Priority Substance. Within 60 days of such designation, Solvay will provide
ArQule with a copy of a revised time line of its research activities for that
Priority Substance and will keep ArQule periodically informed of its progress
under such schedule.

                  (d)      Project Declaration. Solvay will promptly notify
ArQule of a Project Declaration for any Licensed Compound or Derivative
Compounds thereof.

                  (e)      Discontinuation of Development. Solvay agrees to
notify ArQule if it decides to discontinue development or marketing of any
Licensed Compound or Derivative Compounds thereof.

                                       15

<PAGE>

In addition, throughout the term of this Agreement, Solvay will submit to ArQule
annual written reports and semi-annual verbal reports of the activities of
Solvay and its Affiliates with respect to all such compounds during the
reporting period. These reports will include relevant chemical and biological
data and other information sufficient to allow ArQule to determine whether
Solvay and/or its Affiliates are engaging in significant activity with respect
to each such compound prior to Project Declaration. The information in such
reports shall be considered Confidential Information under Section 10.1. hereof.
During the Research Period, Solvay shall provide such reports on a schedule such
that they can be reviewed at the meetings of the Research Committee. In
addition, Solvay agrees to inform ArQule at least once each calendar year
regarding the status of any Solvay Derivative Compounds that Solvay develops
based on Solvay Derivative Compounds synthesized by ArQule under this Agreement.

         7.5.     Reversion of Rights. In the event that (i) Solvay notifies
ArQule pursuant to Section 7.4(e) above that it has determined to discontinue
the development of any Licensed Compound or Derivative Compounds thereof or (ii)
Solvay and/or its Affiliates fail, prior to Project Declaration with respect
thereto, to engage in significant activities for a continuous period of twelve
(12) months with respect to any Licensed Compound, or Derivative Compounds
thereof and significant activities are not resumed within six (6) months of
notice thereof, ArQule shall have the right, immediately upon notice, to
terminate the license granted to Solvay under Section 7.2 with respect to such
Licensed Compound, and ArQule will thereafter be free to grant licenses to third
parties under ArQule Patent Rights and ArQule Technology to make, use, sell and
have sold in the Field products incorporating that Licensed Compound. Any
dispute concerning whether Solvay or its Affiliates have engaged in significant
activity within the meaning of clause (ii) above shall be resolved under the
dispute resolution provisions of Section 13.5.

8.       AMAP Technology.

         Solvay acknowledges that ArQule has fully satisfied and discharged all
of its obligations under Section 8 of the Prior Agreement, except for the
transfer of certain technology that was developed prior to December 31, 2000 and
which the Research Committee has agreed to transfer during calendar year 2001,
as described in Exhibit B (the "2000 Technology"). ArQule will transfer the 2000
Technology to the extent, and in the manner, approved by the Research Committee
and documented in Exhibit B. Solvay may substitute the FTE resources in the
Directed Array Program to this technology transfer activity. For any resource
commitments beyond the FTEs that are reallocated from the Directed Array Program
Solvay shall reimburse ArQule for such activities at the rate of $250,000 per
FTE per year. In all cases Solvay shall reimburse ArQule for out-of - pocket
expenses (e.g., travel) in relation to these activities.

9.       Payments, Reports, and Records.

         9.1.     Access Fee Payments.

                  9.1.1.   Compass Array Library. In partial consideration of
the delivery of the Compass Array Library in accordance with Section 3.2, Solvay
shall pay ArQule the amount of

                                       16

<PAGE>

two hundred thousand dollars ($200,000), payable in four installments of $50,000
within thirty (30) days after Solvay receives each quarterly segment of such
Compass Array Library.

                  9.1.2.   Mapping Array Libraries. In partial consideration of
the delivery of up to ten (10) Mapping Array Libraries during the Research
Period in accordance with Section 3.3, Solvay shall pay ArQule an annual fee in
the amount of three hundred thousand dollars ($300,000), payable as follows:

         $150,000          On the Effective Date
         $150,000          On January 2, 2002

Solvay may obtain access to additional available Mapping Array Libraries during
the Research Period at a cost of fifty thousand dollars ($50,000) per Mapping
Array Library which amount shall be paid to ArQule within thirty (30) days of
shipment.

         9.2      Resynthesis Payments. In consideration of the synthesis and
delivery of resynthesis compounds during the Research Period in accordance with
Section 3.5, Solvay shall pay ArQule two thousand, five hundred dollars ($2,500)
per compound within thirty (30) days of receipt ( for requested resynthesis of
up to twenty-five (25) mg.).

         9.3.     Directed Array Program Payments. In partial consideration of
the performance by ArQule of the DA Program in accordance with Section 4, Solvay
shall pay ArQule at the rate of $250,000 per FTE per year for a total of one
million dollars ($1,000,000) per year. Solvay shall make such annual payment in
advance in equal quarterly installments.

         9.4.     Milestone Payments. In partial consideration of the
performance of the Research Program by ArQule and of the rights granted Solvay
under this Agreement, Solvay shall pay ArQule the following amounts within
thirty (30) days after each occurrence of the following milestones:

         (i)      with respect to a Royalty-Bearing Product containing as one of
                  its constituents any Licensed Compound, ArQule Derivative
                  Compound, as well as with respect to the Prior Agreement any
                  Solvay Derivative Compound, or any other compound discovered
                  or designed by Solvay directly as a result of information
                  obtained by Solvay under the MA Program or DA Program from one
                  or more Licensed Compounds, ArQule Derivative Compounds, or
                  Solvay Derivative Compounds under the Prior Agreement, which
                  information forms the primary basis for such discovery or
                  development and which information was not previously known to
                  Solvay from sources other than ArQule:

                  $2,000,000        Commencement by Solvay, at its own
                                    discretion, of Phase III Clinical Trials
                                    required by the United States Food and Drug
                                    Administration, or the foreign equivalent,
                                    for each Royalty-Bearing Product

                                       17

<PAGE>

                  $3,000,000        First commercial sale of each
                                    Royalty-Bearing Product in any of: United
                                    States; Japan; or, after obtaining EU
                                    registration, Germany, France, or the United
                                    Kingdom. This milestone is payable only once
                                    on the first sale in the first of these
                                    countries, not the first sale in each of
                                    these countries.

         (ii)     with respect to a Royalty-Bearing Product containing as one of
                  its constituents any Solvay Derivative Compound under this
                  Agreement and any other compound discovered or designed by
                  Solvay directly as a result of information obtained by Solvay
                  under the MA Program or DA Program from one or more Solvay
                  Derivative Compounds under this Agreement, which information
                  forms the primary basis for such discovery or development and
                  which information was not previously known to Solvay from
                  sources other than ArQule:

                  $500,000          Commencement by Solvay, at its own
                                    discretion, of Phase II Clinical Trials
                                    required by the United States Food and Drug
                                    Administration, or the foreign equivalent,
                                    for each Royalty-Bearing Product

                  $1,000,000        Commencement by Solvay, at its own
                                    discretion, of Phase III Clinical Trials
                                    required by the United States Food and Drug
                                    Administration, or the foreign equivalent,
                                    for each Royalty-Bearing Product

                  $2,000,000        First commercial sale of each
                                    Royalty-Bearing Product in any of: United
                                    States; Japan; or, after obtaining EU
                                    registration, Germany, France, or the United
                                    Kingdom. This milestone is payable only once
                                    on the first sale in the first of these
                                    countries, not the first sale in each of
                                    these countries.

If a Royalty-Bearing Product contains a compound discovered or designed by
Solvay directly as a result of information obtained by Solvay under the MA
Program or DA Program from (a) one or more Solvay Derivative Compounds under
this Agreement and (b) a Licensed Compound, ArQule Derivative Compound, or
Solvay Derivative Compound under the Prior Agreement (such that the
Royalty-Bearing Product could fall within clause (i) or clause (ii) above), then
the higher milestone payments shall apply. Such milestone payments shall be
non-refundable and shall not be credited against royalties payable to ArQule
under this Agreement. Solvay shall promptly notify ArQule of each occurrence of
either of the foregoing milestones.

         9.5.     Royalties. In partial consideration of the performance of the
Research Program by ArQule and the rights granted to Solvay under this
Agreement, Solvay shall pay to ArQule the following royalty on Net Sales of
Royalty-Bearing Products:

         (i)      two percent (2%) with respect to a Royalty-Bearing Product
                  containing as one of its constituents any Licensed Compound,
                  ArQule Derivative Compound, as well

                                       18

<PAGE>

                  as with respect to the Prior Agreement any Solvay Derivative
                  Compound, or any other compound discovered or designed by
                  Solvay directly as a result of information obtained by Solvay
                  under the MA Program or DA Program from one or more Licensed
                  Compounds, ArQule Derivative Compounds, or Solvay Derivative
                  Compounds under the Prior Agreement, which information forms
                  the primary basis for such discovery or development and which
                  information was not previously known to Solvay from sources
                  other than ArQule; or

         (ii)     one percent (1%) with respect to a Royalty-Bearing Product
                  containing as one of its constituents any Solvay Derivative
                  Compound under this Agreement and any other compound
                  discovered or designed by Solvay directly as a result of
                  information obtained by Solvay under the MA Program or DA
                  Program from one or more Solvay Derivative Compounds under
                  this Agreement, which information forms the primary basis for
                  such discovery or development and which information was not
                  previously known to Solvay from sources other than ArQule.

If a Royalty-Bearing Product contains a compound discovered or designed by
Solvay directly as a result of information obtained by Solvay under the MA
Program or DA Program from (a) one or more Solvay Derivative Compounds under
this Agreement and (b) a Licensed Compound, ArQule Derivative Compound, or
Solvay Derivative Compound under the Prior Agreement (such that the
Royalty-Bearing Product could fall within clause (i) or clause (ii) above), then
the higher royalty rate shall apply. Such royalty shall be payable on a
country-by-country basis for as long as a Royalty-Bearing Product is covered by
a Valid Claim of a Patent Right.

         9.6.     Other Milestone and Royalty Payments. The parties shall
negotiate in good faith the commercially reasonable financial terms pertaining
to payments for achievement of development milestones relating to
Royalty-Bearing Products and for a royalty on Royalty-Bearing Products for uses
within the Field other than as a human therapeutic, which terms shall be set
forth in a separate agreement and shall be no higher than those set forth in
Sections 9.4. and 9.5. above. Solvay shall not develop or sell a Royalty-Bearing
Product for uses within the Field other than as a human therapeutic until such
agreement is executed by both parties.

         9.7.     Reports and Payments. Within thirty (30) days after the
conclusion of each Royalty Period, Solvay shall deliver to ArQule a report
containing the following information:

                           (a)      gross sales of Royalty-Bearing Products by
         Solvay and its Affiliates and sublicensees during the applicable
         Royalty Period in each country of sale;

                           (b)      calculation of Net Sales for the applicable
         Royalty Period in each country of sale; and

                           (c)      total Net Sales in U.S. dollars, together
         with the exchange rates used for conversion.

All such reports shall be maintained in confidence by ArQule. If no royalties
are due to ArQule for any reporting period, the report shall so state.
Concurrent with this report, Solvay shall remit

                                       19

<PAGE>

to ArQule any payment due for the applicable Royalty Period. The method of
payment shall be mutually agreed to. All amounts payable to ArQule under this
Section will first be calculated in the currency of sale and then converted into
U.S. dollars in accordance with Section 9.8.

         9.8.     Invoices; Payments in U.S. Dollars. With the exception of
royalty payments due under Section 9.5, ArQule shall submit invoices to Solvay
for each payment due ArQule hereunder, and Solvay shall pay such invoices within
thirty (30) days of receipt thereof. All payments due under this Agreement
shall, except as provided in Section 9.9 below, be payable in United States
dollars. Conversion of foreign currency to U.S. dollars shall be made at the
conversion rate existing in the United States (as reported in the Wall Street
Journal) on the last working day of the calendar quarter preceding the
applicable calendar quarter. Such payments shall be without deduction of
exchange, collection, or other charges.

         9.9.     Payments in Other Currencies. If by law, regulation, or fiscal
policy of a particular country, conversion into United States dollars or
transfer of funds of a convertible currency to the United States is restricted
or forbidden, Solvay shall give ArQule prompt written notice of such
restriction, which notice shall satisfy the thirty-day payment deadline
described in Section 9.7. Solvay shall pay any amounts due ArQule through
whatever lawful methods ArQule reasonably designates; provided, however, that if
ArQule fails to designate such payment method within thirty (30) days after
ArQule is notified of the restriction, then Solvay may deposit such payment in
local currency to the credit of ArQule in a recognized banking institution
selected by Solvay and identified by written notice to ArQule, and such deposit
shall fulfill all obligations of Solvay to ArQule with respect to such payment.

         9.10.    Records. Solvay and its Affiliates shall maintain complete and
accurate records of Royalty-Bearing Products made, used or sold by them or their
sublicensees under this Agreement, and any amounts payable to ArQule in relation
to such Royalty-Bearing Products, which records shall contain sufficient
information to permit ArQule to confirm the accuracy of any reports delivered to
ArQule in accordance with Section 9.7. The relevant party shall retain such
records relating to a given Royalty Period for at least three (3) years after
the conclusion of that Royalty Period.

         ArQule will maintain complete and accurate records of the activities
engaged in by the ArQule FTEs, which records shall contain sufficient
information to permit Solvay to confirm the compliance of ArQule with Section 4.

         Each party (acting as the "Auditing Party") shall have the right, at
its own expense, to cause an independent, certified public accountant to inspect
such records of the other party (the "Audited Party") during normal business
hours for the sole purpose of verifying any reports and payments delivered under
this Agreement. Such accountant shall not disclose to the Auditing Party any
information other than information relating to accuracy of reports and payments
delivered under this Agreement and shall provide the Audited Party with a copy
of any report given to the Auditing Party. The parties shall reconcile any
underpayment or overpayment within thirty (30) days after the accountant
delivers the results of the audit. In the event that any audit performed under
this Section reveals an underpayment in excess of five percent (5%) in any
Royalty Period, the Audited Party shall bear the full cost of such audit. Each
party may

                                       20

<PAGE>

exercise its rights under this Section only once every year and only with
reasonable prior notice to the other party.

         9.11.    Late Payments. Any payments by Solvay that are not paid on or
before the date such payments are due under this Agreement shall bear interest,
to the extent permitted by law, at two percentage points above the Federal
Reserve Bank discount rate on the last day of the month the payments are due,
calculated based on the number of days that payment is delinquent.

         9.12.    Withholding Taxes. Any tax required to be withheld by Solvay
or any Affiliate or sublicensee under the laws of any foreign country for the
account of ArQule under this Article 9 shall be promptly paid by Solvay or said
Affiliate or sublicensee for and on behalf of ArQule to the appropriate
governmental authority, and Solvay or the Affiliate or sublicensee shall furnish
ArQule with proof of payment of such tax together with official or other
appropriate evidence issued by the appropriate governmental authority sufficient
to enable ArQule to support a claim for income tax credit in respect of any sum
so withheld.

10.      Confidential Information and Proprietary Materials.

         10.1.    Confidential Information.

                  10.1.1.  Definition of Confidential Information. Confidential
Information shall mean any technical or business information furnished by one
party (the "Disclosing Party") to the other party (the "Receiving Party") in
connection with this Agreement and specifically designated as confidential. Such
Confidential Information may include, without limitation, the identity of or
other information pertaining to Proprietary Materials, the identity of a
chemical compound, the use of a chemical compound, trade secrets, know-how,
inventions, technical data or specifications, testing methods, business or
financial information, research and development activities, product and
marketing plans, and customer and supplier information. The parties expressly
agree that the structures of Active Compounds and the identity of the related
Target shall be considered Confidential Information until such time as the
parties have mutually agreed to disclose such information in patent filings
pursuant to Section 6.3.

                  10.1.2.  Designation of Confidential Information. Confidential
Information that is disclosed in writing shall be marked with a legend
indicating its confidential status. Confidential Information that is disclosed
orally or visually shall be documented in a written notice prepared by the
Disclosing Party and delivered to the Receiving Party within thirty (30) days of
the date of disclosure; such notice shall summarize the Confidential Information
disclosed to the Receiving Party and reference the time and place of disclosure.

                  10.1.3.  Obligations. The Receiving Party agrees that it
shall:

                           (a)      maintain all Confidential Information in
         strict confidence, except that the Receiving Party may disclose or
         permit the disclosure of any Confidential Information to its, and its
         Affiliates, directors, officers, employees, consultants, Solvay
         sublicensees, and advisors who are obligated to maintain the
         confidential nature of such

                                       21

<PAGE>

         Confidential Information and who need to know such Confidential
         Information for the purposes set forth in this Agreement;

                           (b)      use all Confidential Information solely for
         the purposes set forth in, or as permitted by, this Agreement; and

                           (c)      allow its directors, officers, employees,
         consultants, and advisors to reproduce the Confidential Information
         only to the extent necessary to effect the purposes set forth in this
         Agreement, with all such reproductions being considered Confidential
         Information.

                  10.1.4.  Exceptions. The obligations of the Receiving Party
under Section 10.1.3 above shall not apply to the extent that the Receiving
Party can demonstrate that certain Confidential Information:

                           (a)      was in the public domain prior to the time
         of its disclosure under this Agreement;

                           (b)      entered the public domain after the time of
         its disclosure under this Agreement through means other than an
         unauthorized disclosure resulting from an act or omission by the
         Receiving Party;

                           (c)      was independently developed or discovered by
         the Receiving Party without use of the Confidential Information;

                           (d)      is or was disclosed to the Receiving Party
         at any time, whether prior to or after the time of its disclosure under
         this Agreement, by a third party having no fiduciary relationship with
         the Disclosing Party and having no obligation of confidentiality to the
         Disclosing Party with respect to such Confidential Information; or

                           (e)      is required to be disclosed to comply with
         applicable laws or regulations (such as disclosure to the United States
         Food and Drug Administration or the United States Patent and Trademark
         Office or to their foreign equivalents), or to comply with a court or
         administrative order, provided that the Disclosing Party receives prior
         written notice of such disclosure and that the Receiving Party takes
         all reasonable and lawful actions to obtain confidential treatment for
         such disclosure and, if possible, to minimize the extent of such
         disclosure.

         10.2.    Proprietary Materials.

                  10.2.1.  Definition of Proprietary Materials. Proprietary
Materials shall mean any tangible chemical, biological, or physical research
materials that are furnished by one party (the "Transferring Party") to the
other party (the "Receiving Party") in connection with this Agreement regardless
of whether such materials are specifically designated as proprietary to the
Transferring Party. Proprietary Materials shall include, without limitation, all
ArQule

                                       22

<PAGE>

Compounds, ArQule Derivative Compounds, Solvay Compounds and Solvay Derivative
Compounds..

                  10.2.2.  Limited Use. The Receiving Party shall use
Proprietary Materials solely for the purposes set forth in this Agreement. The
Receiving Party shall use the Proprietary Materials only in compliance with all
applicable governmental laws and regulations.

                  10.2.3.  Limited Disposition. The Receiving Party shall not
transfer or distribute any Proprietary Materials to any third party, except to
its Affiliates, without the prior written consent of the Transferring Party.

                  10.2.4.  Reverse Engineering. Solvay shall not attempt to
reverse engineer, or attempt to determine the structure of, any ArQule Compound
until the structure of such compound has been disclosed to Solvay by ArQule
following notification by Solvay of the location of an Active Compound pursuant
to Sections 3.3. and 3.4.

         10.3.    Return of Confidential Information and Proprietary Materials.
Upon the termination of this Agreement, at the request of the Disclosing Party,
the Receiving Party shall destroy or return to the Disclosing Party all
originals, copies, and summaries of documents, materials, and other tangible
manifestations of Confidential Information in the possession or control of the
Receiving Party, except that the Receiving Party may retain one copy of the
Confidential Information in the possession of its legal counsel (for ArQule) and
its Legal and Trademarks Department (for Solvay) solely for the purpose of
monitoring its obligations under this Agreement. Upon the termination of this
Agreement, the Receiving Party shall at the instruction of the Transferring
Party either destroy or return any unused Proprietary Materials.

         10.4.    Publications. In the event that either party desires to
publicly disclose (through journals, lectures, or otherwise) any results
relating to the Research Programs, such party (the "Publishing Party") shall
furnish the other party (the "Reviewing Party") with (i) a copy of any written
publication at least sixty (60) days prior to submission or (ii) a summary or
abstract of an oral disclosure at least thirty (30) days prior to the intended
disclosure date. The Reviewing Party shall have the right to (i) consent to the
disclosure with modifications to protect patentable inventions or prevent
disclosure of Confidential Information, (ii) delay the disclosure for a period
of ninety (90) days to enable the preparation and filing of a patent
application, or (iii) refuse to allow the disclosure in order to maintain
certain information as a trade secret, which refusal shall not be unreasonably
exercised. Any disagreements arising under this Section shall be referred to the
Research Committee.

         10.5.    Survival of Obligations. The obligations set forth in this
Article shall remain in effect for a period of five (5) years after termination
of this Agreement, except that the obligations of the Receiving Party to return
or destroy Confidential Information to the Disclosing Party and to return or
destroy Proprietary Materials received from the Transferring Party shall survive
until fulfilled.

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<PAGE>

11.      Indemnification and Insurance.

         11.1.    Indemnification. Each party (the "Indemnitor") shall
indemnify, defend, and hold harmless the other party and its Affiliates and
their directors, officers, employees, and agents and their respective
successors, heirs and assigns (the "Indemnitees"), against any liability,
damage, loss, or expense (including reasonable attorneys fees and expenses of
litigation) incurred by or imposed upon the Indemnitees or any one of them in
connection with any claims, suits, actions, demands, or judgments arising out of
any theory of product liability (including, but not limited to, actions in the
form of tort, warranty, or strict liability) concerning any product (or any
process or service) that is made, used, or sold by such other party pursuant to
any right or license granted under this Agreement or arising out of any breach
of a representation or warranty under this Agreement; provided, however, that
such indemnification right shall not apply to any liability, damage, loss, or
expense to the extent directly attributable to the negligent activities,
reckless misconduct, or intentional misconduct of the Indemnitees.

         11.2.    Procedures. Any Indemnitee that intends to claim
indemnification under Section 11.1 shall promptly notify the appropriate
Indemnitor of any claim in respect of which the Indemnitee intends to claim such
indemnification, and the Indemnitor shall assume the defense thereof with
counsel selected by the Indemnitor (Indemnitor shall consult with Indemnitee
with respect to a possible conflict of interest of such counsel retained by
Indemnitor); provided, however, that an Indemnitee shall have the right to
retain its own counsel at its cost; provided, further, that if representation of
such Indemnitee by the counsel retained by the Indemnitor would be inappropriate
due to actual or potential conflict of interest between such Indemnitee and any
other party represented by such counsel in such proceedings, the Indemnitor and
Indemnitee will each pay an equal share of the costs of the Indemnitee. The
indemnity agreement in Section 11.1. shall not apply to amounts paid in
settlement of any loss, claim, liability or action if such settlement is
effected without the consent of Solvay, which consent shall not be withheld
unreasonably. The failure to deliver notice to the Indemnitor within a
reasonable time after the commencement of any such action, if prejudicial to its
ability to defend such action, shall relieve the Indemnitor of any liability to
the Indemnitee under Section 11.1. Each party and its Affiliates and their
employees and agents shall cooperate fully with the other party and its legal
representatives in the investigation of any action, claim or liability covered
by this indemnification.

         11.3.    Insurance. Each party shall maintain reasonably adequate
insurance or self-insurance coverage for its own potential liabilities to the
Indemnitees as set forth in this Article.

12.      Term and Termination.

         12.1.    Term. This Agreement shall commence on the Effective Date and
shall remain in effect until the expiration of the Research Period, unless
earlier terminated as provided in this Article 12.

         12.2.    Breach of Payment Obligations. In the event that Solvay fails
to make timely payment of any amounts due to ArQule under this Agreement, ArQule
may terminate this Agreement upon thirty (30) days written notice to Solvay,
unless Solvay (i) pays all past-due

                                       24

<PAGE>

amounts within such thirty-day notice period or (ii) invokes dispute resolution
under Section 13.5. within such thirty-day notice period.

         12.3.    Material Breach. In the event that either party commits a
material breach of any of its obligations under this Agreement and such party
fails (i) to remedy that breach within ninety (90) days after receiving written
notice thereof from the other party or (ii) to commence dispute resolution
pursuant to Section 13.5., within ninety (90) days after receiving written
notice of that breach from the other party, the other party may immediately
terminate this Agreement upon written notice to the breaching party.

         12.4.    Effect of Termination. The following provisions shall survive
the expiration or termination of this Agreement: Articles 5, 10, and 11;
Sections 3.9, 6.1 through 6.4, 6.6, 7.2 through 7.5, 9.4 through 9.12, 12.4,
13.3, 13.4, 13.5, and 13.10.

13.      Miscellaneous.

         13.1.    Relationship of Parties. Nothing in this Agreement is intended
or shall be deemed to constitute a partnership, agency, employer-employee or
joint venture relationship between the parties. No party shall incur any debts
or make any commitments for the other, except to the extent, if at all,
specifically provided therein.

         13.2.    Publicity. Neither party shall use the name of the other party
or reveal the terms of this Agreement in any publicity or advertising without
the prior written approval of the other party, except that (i) either party may
use the text of a written statement approved in advance by both parties without
further approval, (ii) either party shall have the right to identify the other
party and to disclose the terms of this Agreement as required by applicable
securities laws or other applicable law or regulation, and (iii) either party
may use the name of the other party and reveal the existence of this Agreement.

         13.3.    Non-Solicitation. During the term of this Agreement and
thereafter for a period of two (2) years, each party agrees not to seek to
persuade or induce any employee of the other party to discontinue his or her
employment with that party in order to become employed by or associated with any
business, enterprise, or effort that is associated with its own business.

         13.4.    Governing Law. The License Agreement shall be governed by and
construed in accordance with the laws of England.

         13.5.    Dispute Resolution Procedures.

                           (a)      The parties hereby agree that they will
         attempt in good faith to resolve any controversy, claim or dispute
         ("Dispute") arising out of or relating to this Agreement promptly by
         negotiations. Any such Dispute which is not settled by the parties
         within fifteen (15) days after notice of such Dispute is given by one
         party to the other in writing shall be referred to a senior executive
         of ArQule and the Vice President-Research of Solvay who are authorized
         to settle such Disputes on behalf of their respective companies
         ("Senior Executives"). The Senior Executives will meet for

                                       25

<PAGE>

         negotiations within fifteen (15) days of the end of the 15 day
         negotiation period referred to above, at a time and place mutually
         acceptable to both Senior Executives. If the Dispute has not been
         resolved within thirty (30) days after the end of the 15 day
         negotiation period referred to above (which period may be extended by
         mutual agreement), subject to any rights to injunctive relief and
         unless otherwise specifically provided for herein, any Dispute will be
         settled first by non-binding mediation and thereafter by binding
         arbitration as described in subsections (b) and (c) below.

                           (b)      Any Dispute which is not resolved by the
         parties within the time period described in subsection (a) shall be
         submitted to an alternative dispute resolution process ("ADR"). Within
         five (5) business days after the expiration of the thirty (30) day
         period set forth in subsection (a), each party shall select for itself
         a representative with the authority to bind such party and shall notify
         the other party in writing of the name and title of such
         representative. Within ten (10) business days after the date of
         delivery of such notice, the representatives shall schedule a date for
         engaging in non-binding ADR with a neutral mediator or dispute
         resolution firm mutually acceptable to both representatives. Any such
         mediation shall be held in London, England. Thereafter, the
         representatives of the parties shall engage in good faith in an ADR
         process under the auspices of such individual or firm. If the
         representatives of the parties have not been able to resolve the
         Dispute within thirty (30) business days after the conclusion of the
         ADR process, or if the representatives of the parties fail to schedule
         a date for engaging in non-binding ADR within the ten (10) day period
         set forth above, the Dispute shall be settled by binding arbitration as
         set forth in subsection (c) below. If the representatives of the
         parties resolve the dispute within the thirty (30) day period set forth
         above, then such resolution shall be binding upon the parties. If
         either party fails to abide by such resolution, the other party can
         immediately refer the matter to arbitration under Section 13.5(c).

                           (c)      If the parties have not been able to resolve
         the Dispute as provided in subsections (a) and (b) above, the Dispute
         shall be finally settled by binding arbitration. Any arbitration
         hereunder shall be conducted under the Rules of Arbitration of the
         International Chamber of Commerce. The arbitration shall be conducted
         in the English language before three arbitrators chosen according to
         the following procedure: each of the parties shall appoint one
         arbitrator and the two so nominated shall choose the third. If the
         arbitrators chosen by the parties cannot agree on the choice of the
         third arbitrator within a period of thirty (30) days after their
         appointment, then the third arbitrator shall be appointed by the Court
         of Arbitration of the International Chamber of Commerce. Any such
         arbitration shall be held in London, England. The arbitrators shall
         have the authority to grant specific performance, and to allocate
         between the parties the costs of arbitration in such equitable manner
         as they determine. The arbitral award (i) shall be final and binding
         upon the parties; and (ii) may be entered in any court of competent
         jurisdiction in accordance with the 1958 Convention on the Recognition
         and Enforcement of Arbitral Awards.

                           (d)      Nothing contained in this Section or any
         other provisions of this Agreement shall be construed to limit or
         preclude a party from bringing any action in any

                                       26

<PAGE>

         court of competent jurisdiction for injunctive or other provisional
         relief to compel the other party to comply with its obligations
         hereunder before or during the pendency of mediation or arbitration
         proceedings. The parties hereby irrevocably consent to submit to the
         jurisdiction of the courts of England and/or any other court having
         jurisdiction for this purpose.

         13.6.    Counterparts. This Agreement may be executed in one or more
counterparts, each of which shall be deemed an original, and all of which
together shall be deemed to be one and the same instrument.

         13.7.    Headings. All headings in this Agreement are for convenience
only and shall not affect the meaning of any provision hereof.

         13.8.    Binding Effect. This Agreement shall inure to the benefit of
and be binding upon the parties, their Affiliates, and their respective lawful
successors and assigns.

         13.9.    Assignment. This Agreement may not be assigned by either party
without the prior written consent of the other party, except that either party
may assign this Agreement to a successor in connection with the merger,
consolidation, or sale of all or substantially all of its assets or that portion
of its business pertaining to the subject matter of this Agreement.

         13.10.   Notices. All notices, requests, demands and other
communications required or permitted to be given pursuant to this Agreement
shall be in writing and shall be deemed to have been duly given upon the date of
receipt if delivered by hand, recognized international overnight courier,
confirmed facsimile transmission, or registered or certified mail, return
receipt requested, postage prepaid to the following addresses or facsimile
numbers:

If to Solvay:                       If to ArQule:

Solvay Pharmaceuticals B.V.         ArQule, Inc.
C.J. van Houtenlaan 36              19 Presidential Way
1381 CP Weesp                       Woburn, MA  01801
The Netherlands                     Attention:  President
Attention:                          Tel: (781) 994-0300
Manager Technology Development      Fax: (781) 503-0009

Tel: +31 294 479696
Fax: +31 294 477148

with a copy to:                     with a copy to:

Same Address                        Same Address
Attention: Head Legal Department    Attention:  General Counsel
Tel: +31 294 477479                 Tel: (781) 994-0300
Fax: +31 294 477126                 Fax: (781) 503-0009

                                       27

<PAGE>

Either party may change its designated address and facsimile number by notice to
the other party in the manner provided in this Section.

         13.11.   Amendment and Waiver. This Agreement may be amended,
supplemented, or otherwise modified only by means of a written instrument signed
by both parties. Any waiver of any rights or failure to act in a specific
instance shall relate only to such instance and shall not be construed as an
agreement to waive any rights or fail to act in any other instance, whether or
not similar.

         13.12.   Severability. In the event that any provision of this
Agreement shall, for any reason, be held to be invalid or unenforceable in any
respect, such invalidity or unenforceability shall not affect any other
provision hereof, and the parties shall negotiate in good faith to modify the
Agreement to preserve (to the extent possible) their original intent.

         13.13.   Entire Agreement. This Agreement constitutes the entire
agreement between the parties with respect to the subject matter hereof and
supersedes all prior agreements or understandings between the parties relating
to the subject matter hereof, including without limitation the Prior Agreement.

         13.14.   Hardship. The underlying objective of this Agreement is to
realize in an economical and reasonable way the mutual interests and
requirements of the parties. If at any time this Agreement should no longer meet
this objective because of technical developments, economic developments or
political changes that could not reasonably be foreseen at the time of signing
this Agreement thus causing undue and prolonged hardship, the parties shall meet
in order to bring about a mutually agreeable solution according to the economic
and reasonable objectives of this Agreement.

         13.15.   Force Majeure. Neither party shall be held liable or
responsible to the other party, nor be deemed to be in breach of this Agreement,
for failure or delay in fulfilling or performing any provisions of this
Agreement when such failure or delay is caused by or results from any cause
whatsoever outside the reasonable control of the party concerned including, but
not limited to, fire, explosion, breakdown of plant, strike, lock-out, labor
disputes, casualty or accident, lack or failure of transportation facilities,
flood, lack or failure of sources of supply or of labor, raw materials or
energy, civil commotion, blockage or embargo, any law, regulation, decision,
demand or requirement of any national or local government or authority. The
party claiming relief shall, without delay, notify the other party by registered
airmail or by telefax of the interruption and cessation thereof and shall use
its best efforts to remedy the effects of such hindrance with all reasonable
dispatch. The onus of proving that any such Force Majeure event exists shall
rest upon the party so asserting. During the period that one party is prevented
from performing its obligations under this Agreement due to a Force Majeure
event, the other party may, in its sole discretion, suspend any obligations that
relate thereto. Upon cessation of such Force Majeure event the parties hereto
shall use their best efforts to make up for any suspended obligations. If such
Force Majeure event is anticipated to continue, or has existed for nine (9)
consecutive months or more, this Agreement may be forthwith terminated by either
party by registered airmail or by telefax. In case of such termination the
terminating party will not be required to pay to the other party any indemnity
whatsoever.

                                       28

<PAGE>

         IN WITNESS WHEREOF, the undersigned have duly executed and delivered
this Agreement as a sealed instrument effective as of the date first above
written.

         SOLVAY PHARMACEUTICALS  BV                ARQULE, INC.

         By:__________________________             By:__________________________
              E.A.A.M. Koopmans                          Stephen A. Hill, M.D.
              President, Solvay Pharmaceuticals BV,      President and Chief
               Weesp                                      Executive Officer

         By:__________________________
              Prof. S.G. Schaefer
              Vice President Global Research
              Solvay Pharmaceuticals

                                       29


<PAGE>

                                    EXHIBIT A

                             Compound Specifications

1.       Compass Array Library.

The Compass Array Library is a diverse subset of approximately 25,000 compounds
that have been computationally selected to represent at least 12.5% of the
ArQule Compounds in the Mapping Array Libraries that ArQule produces 2001.

ArQule will provide approximately 100 micrograms of each Compass Array Library
compound dissolved in 25 microliters of 100% DMSO at a concentration of 10 mM in
96-well plates, with 80 filled wells per plate. Because ArQule performs 25%
quality control analysis of each Mapping Array Library corresponding to the
Compass Array Library, the purity and confirmation of molecular weight is
similar to the Mapping Array Library, as described below.

2.       Mapping Array Libraries.

A Mapping Array Library is an Array of ArQule Compounds that ArQule generally
makes available to its collaborators for screening on a non-exclusive basis.
Each Mapping Array Library is based upon a single Chemical Theme.

ArQule will provide approximately 1mg of each Mapping Array Library compound
dissolved in 250 microliters of 100% DMSO at a concentration of 10 mM. The
compounds will be provided in 96-well plates with up to 80 filled wells per
plate. ArQule performs 25% quality control analysis of each Mapping Array
Library by HPLC/UV/ELSD for purity and flow injection mass spectrometry for
confirmation of molecular weight. Each Mapping Array Library is on average more
than 85% pure as determined by HPLC analysis. A Markush structure file defining
each chemical theme is supplied with every shipment.

3.       Confirmation Samples and Resynthesized Compounds.

As determined by the Research Committee, ArQule shall resynthesize and deliver
to Solvay up to twenty-five (25) mg of any Active Compound. ArQule will provide
each resynthesized Compound as a dry, solid power or oil with a purity of 95%
based on HPLC/UV, ELSD. Typically, resynthesis compounds consist of preparative
HPLC-purified, dry, solid compound supplied with proton NMR and mass
spectrometry data.

4.       Directed Array Compounds.

Unless otherwise agreed to by the Research Committee, all ArQule Compounds
delivered as part of the Directed Array Libraries will be provided as 30 mmol of
compound in DMSO in 96-well plates with up to 80 filled wells per plate. ArQule
performs 100% quality control analysis of each Directed Array compound tested by
HPLC/UV/ELSD. The average purity of each Directed

                                       30

<PAGE>

Array Library is 85% as determined by HPLC analysis. An SD file is supplied with
every shipment.

<PAGE>

                                    EXHIBIT B

                            AMAP Technology Transfer

List of 2000 Technology to be transferred and implemented in 2001

1.   CRS-WAD Technology Transfer

2.   Implement process for Solvay to allow direct procurement of fine mechanical
     parts

3.       a. Supply of source code for all Instrument Control Application via CD
         or FTP site (No documentation of source code)

         b. Make LLE quantitation and APD/LLE quantitation operational

4.   New Septum Piercing Technology for OCS

5.   Modifications to LLE 32-bit application modifications

6.   Update WAD.exe with modified rack sequence

7.   Transfer TOCS software

8.   AIMS Feasibility Study to be completed by March 15, 2001

9.   Transfer Solid Phase Synthesis prototype application

10.  Supply electronic documentation for all sections of the binders previously
     delivered to Solvay.

11.  Transfer existing Culling and Reformatting application to Solvay


<PAGE>

                                                                   EXHIBIT 10.16

                       RESEARCH AND DEVELOPMENT AGREEMENT

                                     BETWEEN

                                 SANKYO CO., LTD

                                       and

                                  ARQULE, INC.


<PAGE>

                                                                   EXHIBIT 10.16

                                Table of Contents

1.       Definitions
         1.1.     "Active Homolog"
         1.2.     "Active ArQule Compound"
         1.3.     "Active Compound"
         1.4.     "Active Sankyo Compound"
         1.5.     "Affiliate"
         1.6.     "Agreement"
         1.7.     "ArQule Compound"
         1.8.     "ArQule Derivative Compound"
         1.9.     "ArQule Patent Rights"
         1,10.    "ArQule Technology"
         1.11.    "Array"
         1.12.    "Base Rate of Interest"
         1.13.    "Chemical Theme"
         1.14.    "Confidential Information"
         1.15.    "Contract Year"
         1.16.    "Derivative Compound"
         1.17.    "Directed Array (tm)"
         1.18.    "Directed Array (tm) Program"
         1.19.    "Disclosing Party"
         1.20.    "Effective Date"
         1.21.    "Extraordinary Expenses"
         1.22.    "FDA"
         1.23.    "Joint Patent Rights"
         1.24.    "Licensed Compound"
         1.25.    "Licensed Compound Set"
         1.26.    "Mapping Array (tm)"
         1.27.    "Mapping Array (tm) Program"
         1.28.    "Net Sales"
         1.29.    "Net Sales Price"
         1.30.    "Party"
         1.31.    "Patent Rights"
         1.32.    "Phase I Clinical Trials"
         1.33.    "Phase II Clinical Trials"
         1.34.    "Phase III Clinical Trials"
         1.35.    "Preclinical Compound"
         1.36.    "Preclinical Development"
         1.37.    "Receiving Party"
         1.38.    "Research Period"
         1.39.    "Research Program"
         1.40.    "Research Plan"
         1.41.    "Royalty-Bearing Product"
         1.42.    "Royalty Period"


<PAGE>

                                                                   EXHIBIT 10.16

         1.42.    "Sankyo Compound"
         1.44.    "Sankyo Derivative Compound
         1.45.    "Sankyo Patent Rights"
         1.46.    "Steering Committee
         1.47.    "Sublicensee"

         1.48.    "Target"
         1.49.    "U.S. Territory"
         1.50     "Valid Claim"
         1.51     "Worldwide Territory `

2.       Management of Research Program
         2.1.     Composition of Steering Committee
         2.2.     Duties of the Steering Committee
         2.3.     Compounds Excluded from the Directed Array (tm) Program
         2.4.     Meetings of the Steering Committee
         2.5.     Cooperation
         2.6.     Visits to Facilities

3.       Mapping Array" (tm) Program
         3.1.     Conduct of Mapping Array (tm) Program
         3.2.     Mutual Disclosure
         3.3.     Reservation of Active ArQule Compounds
         3.4.     Mapping Array (tm) Program Payments
         3.5.     Term of Mapping Array (tm) Program
         3.6.     Performance of Mapping Array (tm) Program

4.       Directed Array (tm) Program
         4.1.     Description of Directed Array (tm) Program
         4.2.     Conduct of Directed Array (tm) Program
         4.3.     Directed Array (tm) Program Payments
         4.3.1.   Delivery Fee
         4.3.2.   Expenses
         4.4.     Term of Directed Array (tm) Program

5.       License Grants: Reversion of Rights
         5.1.     Screening Licenses
         5.2.     Preclinical and Clinical Licenses
         5.3.     Commercialization License
         5.4.     Reversion of Rights: Return of Materials

6.       Ownership of Compounds
         6.1.     Sankyo Compounds; Sankyo Derivative Compounds
         6.2.     ArQule Compounds: ArQule Derivative Compounds


<PAGE>

                                                                   EXHIBIT 10.16

7.       Intellectual Property Rights
         7.1.     Ownership of Patent Rights
         7.2.     Management of Joint Patent Rights
         7.3.     Cooperation of the Parties
         7.4.     Infringement by Third Parties

8.       Payments, Reports, and Records
         8.1.     Milestone Payments
         8.2.     Alternative to Milestone Payments
         8.3.     Royalties
         8.4.     Reports and Payments
         8.5.     Invoices: Payments in U.S. Dollars
         8.6.     Payments in Other Currencies
         8.7.     Records
         8.8.     Late Payments
         8,9.     Withholding Tax Payments
               8.9.1. Payments
               8.9.2. Royalty Payments

9.       Confidential Information
         9.1.     Definition of Confidential Information
         9.2.     Definition of Confidential Information
         9.3.     Obligations
         9.4.     Exceptions
         9.5.     Return of Confidential Information
         9.6.     Survival of Obligations

10.      Representations and Warranties
         10.1.    Authorization

11.      Indemnifications and Insurance
         11.1.    Sankyo Indemnity Obligations
         11.2.    Procedure
         11.3.    Insurance

12.      Term and Termination
         12.1.    Term
         12.2.    Breach of Payment Obligations
         12.3.    Material Breach


<PAGE>

                                                                   EXHIBIT 10.16

         12.4.    Effect of Termination

13.      Miscellaneous
         13.1     Relationship of Parties
         13.2.    Publicity
         13.3.    Non-Solicitation
         13.4.    Governing Law
         13.5.    Dispute Resolution Procedures
         13.6.    Counterparts
         13.7.    Headings
         13.3.    Binding Effect
         13.9.    Assignment
         13.10.   Notices
         13.11.   Amendment and Waiver
         13.12.   Severability
         13.13.   Entire Agreement
         13.14.   Force Majeure

EXHIBIT A


<PAGE>

                                                                   EXHIBIT 10.16

                       RESEARCH AND DEVELOPMENT AGREEMENT

         This Agreement, dated as of November 1, 1997, is between Sankyo Co.,
     LTD ("Sankyo"), a Japanese corporation, having a business address at 5-1,
     Nihonbashi Honcho 3-chome, Chuo-ku Tokyo 103, Japan, and ArQule, Inc.
     ("ArQule"), a Delaware corporation, having a business address at 200 Boston
     Avenue, Medford, Massachusetts, U.S.A.

                                    RECITALS

         WHEREAS, ArQule has developed certain technology that has applications
     in the discovery and development of pharmaceutical compounds;

         WHEREAS, Sankyo desires that ArQule apply its technologies to the
     research and development of pharmaceutical compounds for Sankyo; and

         WHEREAS, in exchange for payment by Sankyo of research funds, milestone
     payments and royalties, ArQule is willing to perform certain research and
     development activities for Sankyo, subject to the terms and conditions of
     this Agreement;

         NOW, THEREFORE, in consideration of the mutual covenants set forth in
     this Agreement, the Parties hereby agree as follows:

1.       Definitions.

         1.1.     "Active Homologs" shall mean any ArQule Derivative Compound or
Sankyo Derivative Compound that exhibits substantial homology with an Active
Compound as determined by the Steering Committee.

         1.2.     `Active ArQule Compound" shall mean any ArQule Compound or
ArQule Derivative Compound which exhibits confirmed significant functional
activity against a Target. The Steering Committee shall establish the criteria
for "significant functional activity" at the time of selection of each Target.

         1.3.     "Active Compound" shall mean any Active ArQule Compound or
Active Sankyo Compound.

         1.4.     "Active Sankyo Compound" shall mean any Sankyo Compound or
Sankyo Derivative Compound which exhibits confirmed significant functional
activity against a Target. The Steering Committee shall establish the criteria
for "significant functional activity" at the time of selection of each Target.

         1.5.     "Affiliate" shall mean a corporation or other legal entity
that controls, is


<PAGE>


                                                                   EXHIBIT 10.16

controlled by, or is under common control with such Party. For purposes of this
definition, "control" means the ownership, directly or indirectly, of fifty
percent. (50%) or more of the outstanding equity securities of a corporation
which are entitled to vote in the election of directors or a fifty percent (50%)
or greater interest in the net assets or profits of an entity which is not a
corporation

         1.6. "Agreement" shall mean this Research and Development Agreement,
together with Exhibit A hereto.

         1.7.    "ArQule Compound" shall mean any organic chemical molecule
that is synthesized by ArQule using its proprietary technology and provided by
ArQule to Sankyo under the Mapping Array (tm) Program.

         1.8.     "ArQule Derivative Compound" shall mean a Derivative Compound
synthesized by ArQule from an ArQule Compound under the Directed Array (tm)
Program described in Section 4.

         1.9.     "ArQule Patent Rights" shall mean Patent Rights controlled or
owned by ArQule as of the Effective Date or during the Research Period; all to
the extent and only to the extent that ArQule now has or hereafter will have the
right to grant licenses, immunities or other rights thereunder.

         1.10.    "ArQule Technology" shall mean all information and data which
is owned by ArQule or licensed by third parties to ArQule prior to or during the
Research Program and is necessary or useful to conduct the screening to discover
Active ArQule Compounds and Active Homologs thereto or to develop, make, use,
sell or seek regulatory approval in any country to market a product containing a
Licensed Compound; all to the extent and only to the extent that ArQule now Las
or hereafter will have the right to grant licenses, immunities or other rights
thereunder.

         1.11.    "Array" shall mean a set of samples of structurally related
chemical compounds arranged in a format such as a microtiter screening plate.

         1.12.    "Base Rate of Interest" shall mean the base rate of interest
declared from time to time by the Bank of Boston.

         1.13.    "Chemical Theme" shall mean the chemical or structural
characteristics shared by a group of compounds as determined by the Steering
Committee pursuant to Section 2,2.

         1.14.    "Confidential Information" shall have the meaning set forth in
Section 9.1.

         1.15.    "Contract Year" shall mean each twelve (12) month period of
the Research Period, commencing on the Effective Date.

         1.16.    "Derivative Compound" shall mean a chemical compound
structurally derived in


<PAGE>

                                                                   EXHIBIT 10.16

one or more steps from another by a process of modification or partial
substitution of at least one component wherein at least one structural feature
is retained at each process step. The number of intermediate steps or compounds
is not relevant to the classification of a compound as a Derivative Compound. A
compound need not have structural similarity to another compound in order to be
classified as a Derivative Compound.

         1.17.    "Directed Array (tm) shall mean an Array comprised of ArQule
Derivative Compounds synthesized by ArQule under the Directed Array (tm) Program
described in Section 4.

         1.18.    "Directed Array (tm) Program" shall mean a Directed Array (tm)
Program conducted by ArQule as set forth in Section 4, with each Directed Array
(tm) Program consisting of multiple Arrays derived from one (1) Sankyo Compound
or one (1) Active ArQule Compound.

         1.19.    "Disclosing Party" shall mean that Party disclosing
Confidential Information to the other Party under Section 9.

         1.20,    "Effective Date" shall mean the first business day of the
month immediately following the date of execution of this Agreement by the
Parties hereto.


         1.21.    "Extraordinary Expenses" shall mean those expenses incurred
from time to time by ArQule in connection with the Directed Array (tm) Program
which are not (a) direct, out-of-pocket costs provided for in the Research Plan
which are directly attributable to the Directed Array (tm) Program or (b) fixed
overhead costs provided for in the Research Plan which are allocable to the
Directed Array (tm) Program.

         1.22.    "FDA" shall mean the United States Food and Drug
Administration (or its foreign equivalent in Japan or Europe).

         1.23.    "Joint Patent Rights" shall mean any Patent Rights that are
jointly owned by the Parties, as set forth in Section 7.1(b).

         1.24.    "License Compound" shall mean any Active Compound or Active
Homolog thereto with respect to which the Steering Committee has designated in
accordance with Sections 2.2 and 3.2.

         1.25.    "Licensed Compound Set" shall mean, with respect to a Licensed
Compound, such Licensed Compound and any Active Homolog thereto.

         1.26.    "Mapping Array (tm) " shall mean an Array of ArQule Compounds
synthesized by ArQule under the Mapping Array (tm) Program set forth in 
Section 3.

         1.27.    "Mapping Array (tm) Program" shall mean the Mapping Array (tm)
component of the Research Program as set forth in Section 3.


<PAGE>

                                                                   EXHIBIT 10.16

         1.28. "Net Sales" shall mean the aggregate Net Sales Price of
Royalty-Bearing Products in any Royalty Period.

         1.29. "Net Sales Price" shall mean the gross amount received on
sales by Sankyo, its Affiliates and Sublicensees of Royalty-Bearing Products,
less the following; (i) trade, quantity, and cash discounts or rebates actually
allowed, (ii) credits or allowances given for rejections or returns, and (iii)
freight, shipping, or other costs of transportation charged to a customer. In
any transfers of Royalty-Bearing Products between Sankyo and an Affiliate, the
Net Sales Price shall be calculated based on the final sale of the
Royalty-Bearing Product to an independent third party. In the event that Sankyo
receives non-monetary consideration for any Royalty-Bearing Products, the Net
Sales Price shall be calculated based on the average price charged by Sankyo for
such Royalty-Bearing Products during the preceding Royalty Period.

         1.30.    "Party" means ArQule or Sankyo or their respective Affiliates;
"Parties" means ArQule and Sankyo and theft respective Affiliates,

         1.31.    "Patent Rights" shall mean all rights arising under issued
patents and reissues, reexaminations, extensions and supplementary protection
certificates thereof and all patent applications and any divisions,
continuations, or continuations-in-part thereof or patents issuing thereon,

         1.32,    "Phase I Clinical Trials" shall mean clinical trials in
healthy adults and/or in a small number of patients commencing upon the filing
of a trial protocol with the appropriate regulatory body and designed to
determine the metabolism and pharmacologic actions of a product in humans, the
side effects associated with increasing doses and to gather evidence on
effectiveness and meeting the requirements established by the FDA or by the
equivalent Japanese agency for Phase I clinical trials, The completion of the
Phase I Clinical Trials will be deemed to have occurred upon the first formal
internal issuance of trial results as measured by trial objectives, or in any
event no later than the commencement of the Phase II Clinical Trials.

         1.33.    "Phase II Clinical Trials" shall mean clinical trials in a
small sample of the intended patient population commencing upon the filing of a
trial protocol with the appropriate regulatory body and designed to assess the
efficacy for a specific indication of a compound proposed to be used as a
therapeutic or diagnostic pharmaceutical product, to determine dose tolerance
arid the optimal dose range as well as to gather additional information relating
to safety and potential adverse effects, and meeting the requirements
established by the FDA or the equivalent Japanese agency for Phase H clinical
trials. The completion of the Phase II Clinical Trials will be deemed to have
occurred upon the first formal internal issuance of trial results as measured by
trial objectives, or in any event no later than the commencement of the Phase UI
Clinical Trials.


<PAGE>

                                                                   EXHIBIT 10.16

         1.34.    "Phase III Clinical Trials" shall mean clinical trials
commencing upon the filing of a trial protocol with the appropriate regulatory
body and designed to demonstrate safety and efficacy of a compound proposed to
be used as a prophylactic, therapeutic or diagnostic pharmaceutical product in
an expanded patient population at geographically dispersed study sites, meeting
the requirements established by the FDA or the equivalent Japanese agency for
Phase In clinical trials. The completion of the Phase Ill Clinical Trials will
be deemed to have occurred upon the first formal internal issuance of trial
results as measured by trial objectives, or in any event no later than the
filing of an NDA.

         1.35.    "Preclinical Compound" shall mean any Licensed Compound
selected by Sankyo or an Affiliate of Sankyo to enter into Preclinical
Development.

         1.36.    "Preclinical Development" shall mean, with respect to any
Preclinical Compound, the commencement of potency and efficacy testing in animal
models,

         1.37.    "Receiving Party" mean that Party receiving Confidential
Information under Section 9.1,

         1.38.    "Research Period" shall mean the period during which the
Research Program remains in effect. The duration of the Research Period shall be
a minimum of three (3) years, unless extended by the mutual agreement of the
Parties.

         1.39.    "Research Program" shall mean, collectively, each of the
Directed Array (tm) Programs and the Mapping Array (tm) Program.

         1.40.    "Research Plan" shall mean a plan of research for the Directed
Array (tm) Program covering a minimum of a six-month period, which shall be
updated quarterly pursuant to Section 2.2 to reflect developments during the
previous three (3) months and extended for the subsequent three (3) months. The
parties will begin development of the initial Research Plan by December 31,
1997. The parties will complete the Research Plan for the first Directed Array
(tm) Program by January 31, 1998 and will complete the Research Plan for the
second Directed Array (tm) Program by March 31, 1998. The completed Research
Plan will be attached to this Agreement as & Exhibit A

         1.41.    "Royalty Bearing Product" shall mean a product containing as
one of its constituents (a) any Active ArQule Compound; (b) any ArQule
Derivative Compound; (c) any Sankyo Derivative Compound; or (d) any other
Derivative Compound discovered or designed by Sankyo from any ArQule Compound,
ArQule Derivative Compound or Sankyo Derivative Compound, or otherwise as a
result of information provided by ArQule to Sankyo under the Mapping Array (tm)
Program described in Section 3, or the Directed Array (tm) Program described in
Section 4 developed.

         1.42.    "Royalty Period" shall mean, with respect to each
Royalty-Bearing Product, every calendar quarter, or partial calendar quarter,
commencing with the first commercial sale of


<PAGE>

                                                                   EXHIBIT 10.16

such Royalty-Bearing Product in any country and ending on the later to occur of
(i) the end of the quarter during which all Valid Claims of all Patent Rights
covering such Royalty-Bearing Product expire in the applicable country, or (ii)
ten (10) years after such first commercial sale in the applicable country.

         1.43.    "Sankyo Compound" shall mean any chemical compound provided by
Sankyo or its Affiliates to ArQule under the Directed Array (tm) Program
described in Section 4.

         1.44.    "Sankyo Derivative Compound" shall mean a Derivative Compound
synthesized by ArQule from a Sankyo Compound under the Directed Array (tm)
Program describe in Section 4.

         1.45.    "Sankyo Patent Rights" shall mean Patent Rights controlled or
owned by Sankyo as of the Effective Date or during the Research Period; all to
the extent and only to the extent that Sankyo now has or hereafter will have the
right to grant licenses, immunities or other rights thereunder.

         1.46,    "Steering Committee" shall have the meaning set forth in
Section 2.1.

         1.47.    "Sublicensee" shall mean any non-Affiliate third party
licensed by Sankyo to make, use (except where the right to use accompanies the
sale of any Royalty-Bearing Product by Sankyo or its Affiliates or Sublicensees)
or sell any Royalty-Bearing Product.

         1.48.    "Target" shall mean any biological target selected by
Sankyo for which Sankyo has certain proprietary technology and/or expertise.

         1.49.    "U.S. Territory" shall mean the fifty states comprising the
United States of America and all American possessions.

         1.50.    "Valid Claim" shall mean either (a) a claim of an issued
patent that has not been held unenforceable or invalid by an agency or a court
of competent jurisdiction in any unappealable or unappealed decision or (b) a
claim of a pending patent application that has not been abandoned or finally
rejected without the possibility of appeal or refiling.

         1.51.    "Worldwide Territory" shall mean the world excluding the U.S.
Territory.

         1.52.    The above definitions are intended to encompass the defined
terms in both the singular and plural tenses.

2.       Management of Research Program,


<PAGE>



                                                                   EXHIBIT 10.16

         2.1.     Composition of Steering Committee. The Parties hereby
establish a Steering Committee comprised of six (6) members, with three (3)
representatives appointed by each Party. The initial members of the Steering
Committee shall be as follows:

                                                  Sankyo Representative

               Douglas Burdi, Ph.D.

               Dayid L Coffen, Ph.D.

               Kaplan, Ph.D.

A Party may change one or more of its representatives to the Steering Committee
at any time upon notice to the other Party. Each Party will designate one of its
representatives as its team leader.

         2.2.     Duties of the Steering Committee. The Steering Committee shall
direct and administer the Research Program. With respect to each Directed Array
(tm) Program, the Steering Committee shall specifically determine the following:
(i) the appropriate objectives of each Chemical Theme and/or Active Compound to
be submitted to the Directed Array (tm) Program; (ii) the appropriate number and
type of Chemical Themes to be submitted to the Directed Array (tm) Program,
subject to ArQule's right to exclude certain compounds as set forth in Section
2.3 below; (iii) the appropriate number of compounds that ArQule should generate
in a Directed Array (tm) for a particular Chemical Theme; and (iv) the
appropriate amount of each compound in a Directed Array (tm) that ArQule should
deliver to Sankyo for further research and development. The scope of each
Chemical Theme will be determined on the basis of the following criteria: (i)
the specific reaction or reaction sequence used to combine members of two or
more discrete chemical units in which each chemical unit bears the functional
group(s) required for the specific reaction(s) that result in the combination of
the chemical units; and (ii) the extent to which a class of compounds is related
by a recurring structural motif associated with a particular biological
activity. In addition, the Steering Committee shall (i) determine whether any
Active Compound should be designated as a Licensed Compound; (ii) determine and
update the list of Licensed Compounds; (iii) determine the allocation of the
funding and personnel resources to be contributed by ArQule under this
Agreement; (iv) revise and extend the Research Plan each calendar quarter for
the subsequent six (6) months based on prior developments; and (v) resolve
matters involving scientific questions.

         2.3.     Compounds Excluded from the Directed Array (tm) Program.
ArQule shall have the right, at the time Sankyo seeks to include any Active
ArQule Compound or Active Homolog thereto in any Directed Array (tm) Program, to
exclude from such Directed Array (tm) Program any Active ArQule Compound or
Active Homolog thereto that is at that time either (I) included within a
Directed Array (tm) Program for a third party(1) (ii) being optimized by a third
party from a Mapping Array (tm) Program, (iii) previously licensed or reserved
by a third party, or (iv) is


<PAGE>

                                                                   EXHIBIT 10.16

included within an existing ArQule internal development program.

         2.4.     Meetings of the Steering Committee. The Steering Committee
shall communicate regularly, but in no event less than monthly, via written
project status reports through written communications means, including, without
limitation, electronic mail. A member of the committee from each Party will
promptly respond to such communications where appropriate within seven (7) days
of its receipt by such member, In the event that questions or issues arise from
such written communications that cannot be, or are not being effectively
addressed by such written communications, or upon request by any member of the
Steering Committee, the Steering Committee shall promptly conduct one or more
telephone conferences to address such questions or issues and shall prepare and
deliver to each Party a brief written report describing the significant issues
and discussions that take place during such telephone conference(s). A
representative of the Steering Committee jointly appointed by its members shall
provide each member with five (5) business days notice of the time of any such
telephone conferences and the proposed agenda with respect thereto, unless
waived by all members. The Steering Committee shall meet at least once each
quarter at the facilities of ArQule, or at such other times and locations as the
Steering Committee determines. A representative of the Steering Committee
jointly appointed by its members shall provide each member with five (5)
business days notice of the time and location of meetings, unless such notice is
waived by all members. If a designated representative of a Party cannot attend
any meeting of the Steering Committee, such Party may designate a different
representative for that meeting without notice to the other Party, and the
substitute member will have full power to vote on behalf of the permanent
member. Except as otherwise provided in this Section 2, all actions and
decisions of the Steering Committee will require the unanimous consent of all of
its members. If the Steering Committee fails to reach agreement upon any matter,
the dispute will be resolved in accordance with the procedures set forth in
Section 13.5 below. Within ten (10) days following each quarterly meeting of the
Steering Committee, the Steering Committee shall prepare and deliver, to both
Parties, a written report describing the decisions made, conclusions and actions
agreed upon.

         2.5.     Cooperation. Each Party agrees to provide the Steering
Committee with information and documentation as reasonably required for the
Steering Committee to fulfill its duties under this Agreement. In addition, each
Party agrees to make available its employees and consultants as reasonably
requested by the Steering Committee, The Parties anticipate that members of the
Steering Committee will communicate informally with each other and with
employees and consultants of the Parties on matters relating to the Directed
Array (tm) Program.

         2.6.     Visits to Facilities. Members of the Steering Committee shall
have reasonable access to the facilities of each Party where activities under
this Agreement are in progress, but only during normal business hours and with
reasonable prior notice. Each Party shall bear its own expenses in connection
with such site visits.

3.       Mapping Array (tm) Program.


<PAGE>

                                                                   EXHIBIT 10.16

         3.1,     Conduct of Mapping Array (tm) Program. ArQule will supply
Sankyo with Mapping Arrays (tm) containing approximately one (1) milligram each
of approximately 100,000 different ArQule Compounds during the first Contract
Year- selected by ArQule from the 1996 and 1997 Mapping Arrays (tm) of
approximately 200,000 different ArQule Compounds (which includes approximately
100,000 ArQule Compounds from ArQule's 1996 Mapping Array (tm) and approximately
100,000 ArQule Compounds from ArQule's 1997 Mapping Array (tm)) based on no more
than fifteen (15) Chemical Themes selected by Sankyo and approved by the
Steering Committee. Subject to Section 3.6, ArQule will supply Sankyo with
Mapping Arrays (tm) containing approximately one (1) milligram each of
approximately 100,000 different ArQule Compounds during each subsequent Contract
Year of the term of the Mapping Array (tm) Program provided for in Section 3.5,
selected at the start of such subsequent Contract Year from the then available
Mapping Array (tm) compounds based on no more than fifteen (15) Chemical Themes
selected by Sankyo and approved by the Steering Committee. ArQule agrees to ship
such 100,000 Mapping Array (tm) compounds (i) for the first Contract Year by
December 31, 1997, (ii) for the second Contract Year on or after the earlier to
occur of (a) three (3) months after Sankyo completes initial screening, as
determined by the Steering Committee, of the Mapping Array (tm) compounds
shipped to Sankyo during the first Contract Year, or (ii) July 1, 1999, or
earlier when available if so requested by Sankyo in writing, and (iii) for the
third Contract Year by the end of the second Contract Year. Sankyo agrees to
accept each such shipment of Mapping Array (tm) compounds unless Sankyo has
terminated the Mapping Array (tm) Program pursuant to Section 3.6 prior to the
date of such shipment, provided, however, notwithstanding any such termination
of the Mapping Array (tm) Program, Sankyo agrees to accept any such shipment
requested by Sankyo in writing. Promptly upon its receipt of any such Mapping
Arrays (tm), Sankyo shall commence testing of such Mapping Arrays (tm) for
activity against Targets. Upon the completion by Sankyo of its testing of any
such Mapping Arrays (tm), Sankyo shall promptly provide each member of the
Steering Committee with notice by telefax communication detailing the discovery
of Active Compounds, together with relevant information concerning the
functional activity identified, which telefax shall be followed by a
confirmatory letter,

         3.2.     Mutual Disclosure, Initially, ArQule will identify the
Chemical Themes of each Mapping Array (tm) but not the structures of the
individual ArQule Compounds in the Mapping Arrays (tm). Sankyo may screen the
Mapping Arrays (tm) against any Targets during the term of this Agreement and
thereafter, Initially, Sankyo will not disclose the Targets screened. If Sankyo
detects any Active ArQule Compound in a Mapping Array (tm), ArQule will disclose
(a) the structure of each Active ArQule Compound and (b) the structures, but not
the locations in the Mapping Array (tm), of all other ArQule Compounds in the
Mapping Array (tm) and Sankyo will disclose (a) the identity of the Target and
(b) the level of activity. All such disclosed information shall be treated as
Confidential Information by both Parties. Sankyo shall submit each such Active
ArQule Compound to the Directed Array (tm) Program pursuant to Section 4.
Sankyo, at its discretion, may request that the Steering Committee designate any
such Active ArQule


<PAGE>


                                                                   EXHIBIT 10.16

Compound and Active Homologs thereto as Licensed Compounds comprising a Licensed
Compound Set if such Active ArQule Compound and Active Homologs are still
available as Licensed Compounds, ArQule shall have the right, at the time Sankyo
seeks to designate any Active ArQule Compound or Active Homolog thereto as a
Licensed Compound, to exclude from such Licensed Compound designation any Active
ArQule Compound or Active Homolog thereto that is at that time either (1)
included within a Directed Array (tm) Program for a third party, (ii) being
optimized by a third party from a Mapping Array (tm) Program, (iii) previously
licensed or reserved by a third party, or (iv) is included within an existing
ArQule internal development program. Subject to the foregoing, (a) ArQule shall
notify the Steering Committee that such Active ArQule Compound and Active
Homologs thereto are properly designated as Licensed Compounds and (b) provide
Sankyo with the confirmed chemical composition structure, purity information and
location of all Active ArQule Compounds and Active Homologs thereto so
designated as Licensed Compounds belonging to such Licensed Compound Set.

         3.3.     Reservation of Active ArQule Compounds. Prior to designating
any Active ArQule Compounds and Active Homologs thereto as Licensed Compounds
pursuant to Section 3.2 hereof, Sankyo, at its discretion, may notify ArQule of
its intent to license such Active ArQule Compounds and Active Homologs, and
request a reservation of such Active ArQule Compounds and Active Homologs
thereto (collectively the "Reserved Compounds"). Upon ArQule receiving from
Sankyo (i) a written request to reserve such Reserved Compounds, and (ii)
disclosure of the Target and activity information pursuant to Section 3.2
hereof, ArQule shall reserve such Reserved Compounds for subsequent designation
by Sankyo as Licensed Compounds for a period ending upon the earlier to occur of
(i) Sankyo's notification to ArQule that it no longer has an interest in
licensing or developing such Reserved Compounds, or (ii) sixty (60) days.

         3.4.     In consideration of the performance by ArQule of the Mapping
Array (tm) Program, during each Contract Year, Sankyo shall pay ArQule a
delivery fee equal to $1,000,000 in the initial Contract Year, payable one-third
(1/3) upon the Effective Date and two-thirds (2/3) within thirty (30) days of
the delivery of the Mapping Arrays (tm) to be provided by ArQule in such first
Contract Year. Thereafter, Sankyo shall make the following annual payment to
ArQule during each Contract Year, in the second Contract Year payable in full
with thirty (30) days of the delivery of the Mapping Arrays (tm) to be provided
by ArQule in such Contract Year, and in the third Contract Yeas payable
one-third (1/3) on the first day of such Contract Year and two-thirds (2/3)
within thirty (30) days of the delivery of the Mapping Arrays (tm) to be
provided by ArQule in such Contract Year:

         Annual Payment = $1,000,000 x (1 + CPI)

         Where CPI is a fraction, the numerator of which is the difference
         between the Consumer Price Index (CPI-U; ITS. City Average for all
         items; 1982-84 = 100) as of the last month of the immediately preceding
         Contract Year and the Consumer Price Index as of the month immediately
         preceding the Effective Date and the denominator of which is the
         Consumer Price Index as of the month immediately preceding the
         Effective Date.


<PAGE>


                                                                   EXHIBIT 10.16

         3.5.     The Mapping Array (tm) Program shall commence on the Effective
Date, continue for a period of three (3) Contract Years, unless earlier
terminated as provided in Section 3.6 or Article 12 below. Termination of the
Mapping Array (tm) Program shall have no effect on the continuation of any
Directed Array (tm) Program.

         3.6.     Performance of Mapping Array (tm) Program. Sankyo shall have
the right to terminate the Mapping Array (tm) Program on or before the earlier
to occur of (i) three (3) months after Sankyo completes initial screening, as
determined by the Steering Committee, of the Mapping Array (tm) compounds
shipped to Sankyo during the first Contract Year, or (ii) June 30, 1999, upon
Written notice to ArQule, in the event that (i) ArQule is unable to deliver to
Sankyo Mapping Arrays (tm) containing at least fifteen (15) Chemical Themes (or
a lesser number of Chemical Themes pursuant to selection of such Chemical Themes
in accordance with Section 3.1), (ii) Sankyo fails to obtain any functional
activity, as determined by the Steering Committee, from any Mapping Array (tm)
compound against any Target falling within a broad range of representative
Target categories selected by Sankyo, approved by the Steering Committee and
disclosed by Sankyo to ArQule, (iii) there develops a clear pattern of false
positive screening results attributable to the quality of Mapping Array (tm)
compounds, or (iv) ArQule is consistently unable to provide Mapping Array (tm)
compounds in accordance with purity criteria as determined by the Steering
Committee. ArQule shall be under the obligation to deliver Mapping Arrays (tm)
for the successive Contract Years unless Sankyo exercises its right to terminate
the Mapping Array (tm) Program pursuant to this Section 3.6 by formally
declaring such termination right and notifying ArQule in writing.

4. Directed Array (tm) Program,

         4.1.     Description of Directed Array (tm) Program. Under the 
direction of the Steering Committee and in accordance with the Research Plan,
ArQule will synthesize multiple Directed Arrays (tm) of compounds derived from
(i) each Sankyo Compound provided to ArQule by Sankyo and/or (ii) each Active
ArQule Compound provided by ArQule to Sankyo under the Mapping Array (tm)
Program, subject to Section 2.3 above. The Parties intend that, during the
Research Period, ArQule will produce such Directed Arrays (tm) in two (2)
separate Directed Array (tm) Programs, each based on a different Chemical Theme
and intended to produce approximately 1000 compounds, per Contract Year for a
minimum of three (3) Contract Years beginning on the Effective Date. However,
the number of closely related Chemical Themes actually submitted to each
Directed Array (tm) Program for the same Target pursuant to a given Research
Plan and the number of ArQule Derivative Compounds and/or Sankyo Derivative
Compounds actually produced per Chemical Theme will be determined by the
Steering Committee. The Parties also intend that ArQule will produce
approximately twenty (20) milligrams of each ArQule Derivative Compound and/or
Sankyo Derivative Compound in the Directed Arrays (tm), subject to the
availability of the original Sankyo Compounds and/or the ArQule Compounds;
provided, however, that the amount of each ArQule Derivative Compound and/or
Sankyo Derivative Compound that ArQule actually produces will ultimately be
determined by the Steering Committee.

         4.2.     Conduct of Directed Array (tm) Program. The Directed Array
(tm) Program shall be


<PAGE>

                                                                   EXHIBIT 10.16

conducted in a good scientific manner and in compliance with all applicable
legal requirements. The conduct of the Directed Array (tm) Program shall be the
primary responsibility of ArQule with participation by Sankyo. Sankyo shall
propose Chemical Themes to the Steering Committee for inclusion in the Directed
Array (tm) Program. If the Steering Committee approves the inclusion of the
proposed Chemical Theme(1) Sankyo shall provide ArQule with the requisite amount
and purity of Sankyo Compounds for that Chemical Theme, as directed by the
Steering Committee. ArQule shall thereupon diligently synthesize Directed Arrays
(tm) of ArQule Derivative Compounds and/or Sankyo Derivative Compounds, as the
case may be, in accordance with the Research Plan. Sankyo shall, in its
discretion, test all compounds in the Directed Arrays (tm). The Parties shall
continue the procedure described in this Section 4.2 for each Active Compound
until the earliest to occur of (1) the determination by the Steering Committee,
in accordance with Section 2.2, to designate any such Active Compound and any
Active Homolog thereto as a Licensed Compound Set, (ii) the determination by the
Steering Committee to cease further testing of such Active Compound, or (iii)
the termination of this Agreement in accordance with Section

         4.3.     Directed Array (tm) Program Payments.

                  4.3.1.   Delivery Fee. In consideration of the performance by
ArQule of the Directed Array (tm) Program, Sankyo shall pay ArQule a delivery
fee equal to $1,000,000 per Directed Array (tm) Program during the first
Contract Year, payable one-third (1/3) upon commencement of the first Directed
Array (tm) Program and two-thirds (2/3) within thirty (30) days of the delivery
of the final Directed Array (tm) to be provided by ArQule in the first Contract
Year. Thereafter, Sankyo shall make the following annual payment to ArQule
during each Contract Year, payable one-third (1/3) on the first day of such
Contract Year and two-thirds (2/3) within thirty (30) days of the delivery of
the Directed Arrays (tm) to be provided by ArQule in such Contract Year:

         Annual Payment = $1,000,000 x (1 + CPI)

Notwithstanding the foregoing, if the number of Active Compounds submitted to
all Directed Array (tm) Programs exceeds six (6) for the first three (3)
Contract Years, the Parties shall use their respective best efforts to negotiate
a discount for all such additional Active Compounds submitted to the Directed
Array (tm) Program.

                  4.3.2.   Expenses. In addition to the amounts payable pursuant
to Section 4.3.1 above, Sankyo shall pay any and all Extraordinary Expenses of
ArQule, as required and approved by the Steering Committee.

         4.4.     Term of Directed Array (tm) Program. The term of each Directed
Array (tm) Program shall begin upon the commencement of the Research Plan and
terminate no later than the first anniversary of such commencement date unless
extended by the Steering Committee because of extraordinary circumstances. The
period for initiating and completing all Directed Array (tm) Programs commenced
pursuant to Section 4.1 hereof shall terminate at the end of the third Contract
Year, provided, however, that upon six (6) months prior written notice by
Sankyo,


<PAGE>

                                                                   EXHIBIT 10.16

such period may be extended for one additional two (2) year period at Sankyo's
option on terms and conditions to be mutually agreed upon by the Parties.

5.       License Grants; Reversion of Rights.

         5.1.     Screening Licenses ArQule hereby grants to Sankyo, under
ArQule Patent Rights and ArQule Technology (a) a nonexclusive, royalty-free
license (without the right to sublicense) to test each Mapping Array (tm) for
significant functional activity against Targets; and (b) an exclusive,
royalty-free license to test each Directed Array (tm) for significant functional
activity against Targets.

         5.2.     Preclinical and Clinical Licenses. Upon the identification by
Sankyo of any Active Compound and the determination by the Steering Committee
that such Active Compound and any Active Homolog thereto should properly be
designated as a Licensed Compound Set, ArQule shall grant to Sankyo, under any
intellectual property rights covering the composition, manufacture or use of
such Licensed Compound Set, an exclusive, worldwide license (with the right to
grant sublicenses subject to notifying ArQule in advance) to conduct Preclinical
Development, Phase I Clinical Trials, Phase U Clinical Trials and Phase III
Clinical Trials of such Licensed Compound Set, with Sankyo's specific
responsibilities to be determined by the Steering Committee.

         5.3.     Commercialization License. ArQule hereby grants to Sankyo an
exclusive, worldwide royalty-bearing license (with the right to grant
sublicenses subject to notifying ArQule in advance) (i) to make or have made
Royalty-Bearing Products incorporating Licensed Compound Sets for use,
distribution and sale, (ii) to distribute for sale and sell Royalty-Bearing
Products incorporating Licensed Compound Sets, and (iii) to make Active
Compounds within a Licensed Compound Set and sell such Active Compounds to a
Sublicensee that incorporates those compounds in a Royalty-Bearing Product.

         5.4.     Reversion of Rights Return of Materials. In the event that (i)
Sankyo determines not to develop any Active ArQule Compound or Active Homolog
related to such Active ArQule Compound within a Licensed Compound Set or to
discontinue Preclinical Development of all Active ArQule Compounds and Active
Homologs related to such Active ArQule Compound within a Licensed Compound Set;
or (ii) no Active ArQule Compound or Active Homolog related to such Active
ArQule Compound within a Licensed Compound Set is commercially developed within
the timetable specified in the Research Plan, then ArQule shall have the right
to terminate the license granted to Sankyo under Section 5.2 with respect to all
Active ArQule Compounds and Active Homologs related to such Active ArQule
Compounds within such Licensed Compound Set. In such event, ArQule shall
thereafter be free to grant licenses covering such Active ArQule Compounds and
Active Homologs related to such Active ArQule Compounds to third parties. Upon
termination of such license by ArQule, Sankyo shall (i) grant to ArQule an
exclusive, royalty-free license, with the right to grant sublicenses, to
manufacture, use or sell such Active ArQule Compounds and Active Homologs
related to such Active ArQule Compounds under any patent rights of Sankyo
covering the composition or use of such Active ArQule Compounds and Active
Homologs related to such Active ArQule Compounds and (ii)


<PAGE>

                                                                   EXHIBIT 10.16

return to ArQule all Proprietary Materials and Confidential Information supplied
by ArQule which relate to such Active ArQule Compounds and Active Homologs
related to such Active ArQule Compounds. Notwithstanding the foregoing, the
provisions of this Section 5.4 shall not apply to Sankyo Compounds or Sankyo
Derivative Compounds.

6.       Ownership of Compounds.

         6.1.     Sankyo Compounds: Sankyo Derivative Compounds. All Sankyo
Compounds and Sankyo Derivative Compounds shall be owned by Sankyo or its
Affiliates, except, and only to the extent that, with respect to the Directed
Array (tm) Program, ArQule can show that any such compound (i) was under
development by ArQule (including programs with academic collaborators or
corporate partners) before such compound was proposed to be included in the
Directed Array (tm) Program or first synthesized, as the case may be; (ii) was
independently developed by ArQule employees who had no access to Sankyo
Confidential Information regarding the particular compound, or (iii) was already
within a screening array before such compound was proposed to be included in the
Directed Array (tm) Program or was first synthesized, as the case may be.

         6.2.     ArQule Compounds; ArQule Derivative Compounds. All ArQule
Compounds and ArQule Derivative Compounds shall be owned by ArQule except, and
only to the extent that, Sankyo can show that any such compound was in the
possession of Sankyo before it was provided by ArQule to Sankyo or its
Affiliates.

7.       Intellectual Property Rights.

         7.1.     Ownership of Patent Rights

                  (a)      ArQule Patent Rights. Any Patent Rights filed by
         either Party covering Active ArQule Compounds only will be owned solely
         by ArQule except as provided in Section 7.1(b).

                  (b)      Joint Patent Rights. Any Patent Rights (i) filed by
         either Party covering both Active ArQule Compounds and Active Sankyo
         Compounds, (ii) claiming an Active ArQule Compound and uses thereof
         discovered by Sankyo; and/or (iii) claiming an Active Sankyo Compound
         and uses thereof discovered by ArQule, shall be owned jointly by ArQule
         and Sankyo.

                  (c)      Sankyo Patent Rights. Any Patent Rights filed by
         either Party covering solely Active Sankyo Compounds will be owned
         solely by Sankyo.

                  (d)      Patent Rights Generally. Any Patent Rights arising
         out of or related to this Agreement, the ownership of which cannot be
         determined from Subsections a), (b) or (c) of this Section 7.1, will be
         owned by the Party(ies) having inventorship under the patent laws of
         the United States.


<PAGE>

                                                                   EXHIBIT 10.16

         7.2.     Management of Joint Patent Rights. In the case of Joint Patent
Rights, the Parties shall agree on the allocation of responsibility for, and the
expense of, the preparation, filing, prosecution, and maintenance of any Joint
Patent Rights claiming such inventions. In the event of any disagreement
concerning any Joint Patent Rights, the matter shall be resolved by the Steering
Committee or, in the absence thereof, by the President of ArQule and The
Director of the Patent Department of Sankyo. The Party controlling a Joint
Patent Right shall consult with the other Party as to the preparation, filing,
prosecution, and maintenance of such Joint Patent Right reasonably prior to any
deadline or action with the U.S. Patent & Trademark Office or its foreign
equivalent in Japan or Europe, and shall furnish to the other Party copies of
all relevant documents reasonably in advance of such consultation. In the event
that the Party controlling a Joint Patent Right desires to abandon such Joint
Patent Right, or if the Party assuming control of a Joint Patent Right later
declines responsibility for such Joint Patent Right, the controlling Party shall
provide reasonable prior written notice to the other Party of such intention to
abandon or decline responsibility, and such other Party shall have the right, at
its expense, to prepare, file, prosecute, and maintain such Joint Patent Rights.

         7.3.     Cooperation of the Parties. Each Party agrees to cooperate
fully in the preparation, filing, and prosecution of any Patent Rights under
this Agreement. Such cooperation includes, but is not limited to:

                  (a)      executing all papers and instruments, or requiring
         its employees or agents, to execute such papers and instruments, so as
         to effectuate the ownership of Patent Rights set forth in Section 7.1
         above and to enable the other Party to apply for and to prosecute
         patent applications in any country;

                  (b)      promptly informing the other Party of any matters
         coming to such Party's attention that may affect the preparation,
         filing, or prosecution of any such patent applications; and

                  (c)      undertaking no actions that are potentially 
         deleterious to the preparation, filing, or prosecution of such patent
         applications.

         7.4.     Infringement by Third Parties. ArQule and Sankyo shall each
promptly notify the other in writing of any alleged or threatened infringement
by a third party of any ArQule Patent Right, Sankyo Patent Right or Joint Patent
Right of which they become aware. The parties shall consult concerning the
action(s) to be taken.

8.       Payments. Reports, and Records,

         8.1.     Milestone Payments. In partial consideration of the rights
granted Sankyo under this Agreement, Sankyo shall pay ArQule the following
amounts within thirty (30) days after each occurrence of the following
milestones;

Payment for Royalty


<PAGE>

                                                                   EXHIBIT 10.16


<TABLE>
<CAPTION>
Bearing Products                        Milestone
---------------     ---------------------------------------------------
<S>                 <C>
$        500,000    First IND Filing (or non-U.S. equivalent) for each
                    Royalty-Bearing Product

$        500,000    Completion of Phase I Clinical Trials (or non-U.S.
                    equivalent) for each Royalty-Bearing
                    Product

$        500,000    Completion of Phase II Clinical Trials (or non-U.S.
                    equivalent) for each Royalty-Bearing
                    Product

$      1,000,000    Commencement of Phase III Clinical Trials (or
                    non-U.S. equivalent) for each Royalty-Bearing
                    Product

$        500,000    Completion of Phase III Clinical Trials (or non-
                    U.S. equivalent) for each Royalty-Bearing
                    Product

$      1,000,000    First NDA filing (or non-U.S. equivalent) for each
                    Royalty-Bearing Product

$      2,000,000    Approval of first NDA (or non-U.S. equivalent) for
                    each Royalty-Bearing Product
</TABLE>


Such milestone payments shall be non-refundable and shall not be credited
against royalties payable to ArQule under this Agreement, provided, however,
that twenty-five percent (25%) of any such milestone payments made with respect
to any Royalty-Bearing Product consisting of an ArQule Compound provided to
Sankyo pursuant to the Mapping Array (tm) Program, and not submitted to a
Directed Array (tm) Program, shall be creditable up to $1,000,000 per year
against royalties due ArQule for such Royalty-Bearing Product pursuant to
Section 8.3. Sankyo shall promptly notify ArQule of each occurrence of any of
die foregoing milestones.

         8.2.     Alternative to Milestone Payments. If any time on or before
sixty (60) days prior to the filing of an IND application with respect to any
Royalty-Bearing Product, Sankyo elects, in lieu of paying the foregoing
milestone payments for such Royalty-Bearing Product, to share with ArQule the
proceeds of the commercial exploitation of such Royalty-Bearing Product, it
shall so notify ArQule in writing. Promptly upon its receipt of such written
notice, ArQule shall enter into good faith negotiations with Sankyo for an
appropriate amendment to this Agreement under which either (i) the Parties would
share equally in the aggregate revenues from such Royalty-Bearing Product on a
worldwide basis or (ii) ArQule would be granted the exclusive right to
commercially exploit such Royalty-Bearing Product in certain agreed-upon
territories. If the Parties are unable to reach agreement with respect to the


<PAGE>

                                                                   EXHIBIT 10.16

foregoing by the expiration of sixty (60) days from the commencement of such
negotiations, Sankyo shall remain obligated to pay the full amount of milestone
payments set forth in Section 8.1 above for such Royalty-Bearing Product.

         8.3.     Royalties. In consideration of the licenses granted to Sankyo
hereunder, for each Royalty Period, Sankyo shall pay to ArQule a royalty for
each Royalty-Bearing Product as follows:


<TABLE>
<CAPTION>
 Source of Royalty-Bearing Product      Royalty Rate    (percentage of Net Sales)
 ---------------------------------   ------------------  ------------------------
                                     Worldwide Territory    U.S. Territory
                                     -------------------    ---------------
<S>                                  <C>                    <C>
Sankyo Derivative Compound                   3%                   4%

ArQule Compound or ArQule                    4%                   5%
  Derivative Compound
</TABLE>


         8.4.     Reports and Payments. Within thirty (30) days after the
conclusion of each Royalty Period, Sankyo shall deliver to ArQule a report
containing the following information:

                  (a)      gross sales of Royalty-Bearing Products by Sankyo,

         its Affiliates and Sublicensees during the applicable Royalty Period in
         each country of sale;

                  (b)      adjustments and calculation of Net Sales for the
         applicable Royalty Period in each country of sale; and

                  (c)      total Net Sales in U.S. dollars, together with the
         exchange rates used for conversion.

All such reports shall be maintained in confidence by ArQule. If no royalties
are due to ArQule for any reporting period, the report shall so state.
Concurrent with this report, Sankyo shall remit to ArQule any payment due for
the applicable Royalty Period. The method of payment shall be mutually agreed
to. All amounts payable to ArQule under this Section will first be calculated in
the currency of sale and then converted into U.S. dollars in accordance with
Section 8.6, and such amounts shall be paid without deduction of any withholding
taxes, value-added taxes, or other charges applicable to such payments, except
as provided for in Section 8.9.

         8.5.     Invoices; Payments in U.S. Dollars. With the exception of
royalty payments due under Section 8.3, ArQule shall submit invoices to Sankyo
for each payment due ArQule hereunder (including without limitation all payments
due pursuant to Section 3.4, and Sankyo shall pay such invoices within thirty
(30) days of receipt thereof. All payments due under this Agreement shall,
except as provided in Section 8.6 below, be payable in United States dollars.
Conversion of foreign currency to U.S. dollars shall be made at the conversion
rate existing in the United States (as reported in the Wall Street Journal) on
the last working day of the calendar quarter preceding the applicable calendar
quarter. Such payments shall be without deduction of exchange, collection, or
other charges, except as provided for in Section 8.9.


<PAGE>

                                                                   EXHIBIT 10.16

         8.6.     Payments in Other Currencies. If by law, regulation, or fiscal
policy of a particular country, conversion into United States dollars or
transfer of funds of a convertible currency to the United States is restricted
or forbidden, Sankyo shall give ArQule prompt written notice of such
restriction, which notice shall satisfy the thirty-day payment deadline
described in Section 8.4. Sankyo shall pay any amounts due ArQule through
whatever lawful methods ArQule reasonably designates; provided, however, that if
ArQule falls to designate such payment method within thirty (30) days after
ArQule is notified of the restriction, then Sankyo may deposit such payment in
local currency to the credit of ArQule in a recognized banking institution
selected by Sankyo and identified by written notice to ArQule, and such deposit
shall fulfill all obligations of Sankyo to ArQule with respect to such payment.

         8.7.     Records. Sankyo and its Affiliates shall maintain complete and
accurate records of Royalty-Bearing Products made, used or sold by them or their
Sublicensees under this Agreement, and any amounts payable to ArQule in relation
to such Royalty-Bearing Products, which records shall contain sufficient
information to permit ArQule to confirm the accuracy of any reports delivered to
ArQule in accordance with Section 8.4. The relevant Party shall retain such
records relating to a given Royalty Period for at least three (3) years after
the conclusion of that Royalty Period, Each Party (acting as the "Auditing
Party") shall have the right, at its own expense, to cause an independent
certified public accountant to inspect such records of the other Party (the
"Audited Party") during normal business hours for the sole purpose of verifying
any reports and payments delivered under this Agreement. Such accountant shall
not disclose to the Auditing Party any information other than information
relating to accuracy of reports and payments delivered under this Agreement and
shall provide the Audited Party with a copy of any report given to the Auditing
Party. The Parties shall reconcile any underpayment or overpayment within thirty
(30) days after the accountant delivers the results of the audit. In the event
that any audit performed under this Section reveals an underpayment in excess of
five percent (5%) in any Royalty Period, the Audited Party shall bear the full
cost of such audit. Each party may exercise its rights under this Section only
once every year and only with reasonable prior notice to the other Party.

         8.8.     Late Payments, Any payments by Sankyo that are not paid on or
before the date such payments are due under this Agreement shall bear interest,
to the extent permitted by law, at two percentage points above the Base Rate of
Interest calculated based on the number of days that payment is delinquent.

         8.9.     Withholding Tax Payments,

                  8.9.1.   Payments. All amounts payable under Section 3.4, 4.3
         and 8.1 shall represent the actual proceeds to be received by ArQule
         after any applicable deductions have been made, including without
         limitation any withholding taxes. ArQule agrees to reasonably cooperate
         with Sankyo in obtaining a refund of any withholding taxes paid by
         Sankyo with respect to any payments to ArQule hereunder, In the event
         that ArQule is successful in obtaining any refund of tax withholding
         amounts paid by Sankyo under Sections 3.4, 4.3 and 8.1. of this
         Agreement, ArQule agrees to promptly remit such refund amount received
         by ArQule to Sankyo.


<PAGE>

                                                                   EXHIBIT 10.16

                  8.9.2.   Royalty Payments, Sankyo may only withhold from
         royalties due to ArQule under Section 8.3 amounts for payment of
         Japanese withholding tax that is required by law to be paid to the
         Japanese taxing authority with respect to such royalty amounts due to
         ArQule; provided, however, that such amount withheld shall not exceed
         the lesser of (i) ten percent (10%) of such royalties due to ArQule, or
         (ii) such amount actually creditable by ArQule as a foreign tax credit
         against taxes currently payable by ArQule to the United States
         government; and further provided, however, that in regard to any such
         tax withholding Sankyo shall give ArQule such documents, and provide
         any other cooperation or assistance on a reasonable basis, as may be
         necessary to enable ArQule to claim exemption therefrom, to receive a
         full allowance of such withholding tax or claim a foreign tax credit,
         and Sankyo shall upon ArQule's request give proper evidence as to the
         payment of such tax. In the event that Sankyo is successful in
         obtaining any refund of tax withholding amounts paid by Sankyo under
         Sections 8.3 of this Agreement, Sankyo agrees to promptly remit such
         refund amount received by Sankyo to ArQule,

9. Confidential Information.

         9.1.     Definition of Confidential Information Confidential
Information shall mean any technical or business information furnished by the
Disclosing Party to the Receiving Party in connection with this Agreement and
specifically designated as confidential. Such Confidential Information may
include, without limitation, the identity of a chemical compound, the use of a
chemical compound, trade secrets, know-how, inventions, technical data or
specifications, testing methods, business or financial information, research and
development activities, product and marketing plans, and customer and supplier
information,

         9.2.     Definition of Confidential Information, Confidential
Information that is disclosed in writing shall be marked with a legend
indicating its confidential status. Confidential Information that is disclosed
orally or visually shall be documented in a written notice prepared by the
Disclosing Party and delivered to the Receiving Party within thirty (30) days of
the date of disclosure; such notice shall summarize the Confidential Information
disclosed to the Receiving Party and reference the time and place of disclosure.

         9.3.     Obligations. The Receiving Party agrees that it shall:

                  (a)      maintain all Confidential Information in strict
confidence, except that the Receiving Party may disclose or permit the
disclosure of any Confidential Information to its, and its Affiliates,
directors, officers, employees, consultants, and advisors who are obligated to
maintain the confidential nature of such Confidential Information and who need
to know such Confidential Information for the purposes set forth in this
Agreement;

                  (b)      use all Confidential Information solely for the
purposes set forth in, or as permitted by, this Agreement; and


<PAGE>

                                                                   EXHIBIT 10.16

                  (c)      allow its directors, officers, employees,
consultants, and advisors to reproduce the Confidential Information only to the
extent necessary to effect the purposes set forth in this Agreement, with all
such reproductions being considered Confidential Information.

         9.4.     Exceptions. The obligations of the Receiving Party under
Section 9.3 above shall not apply to the extent that the Receiving Party can
demonstrate that certain Confidential Information:

                  (a)      was in the public domain prior to the time of its
         disclosure under this Agreement;

                  (b)      entered the public domain after the time of its
         disclosure under this Agreement through means other than an
         unauthorized disclosure resulting from an act or omission by the
         Receiving Party;

                  (c)      was independently developed or discovered by the
         Receiving Party without use of the Confidential Information;

                  (d)      is or was disclosed to the Receiving Party at any
         time, whether prior to or after the time of its disclosure under this
         Agreement, by a third party having no fiduciary relationship with the
         Disclosing Party and having no obligation of confidentiality to the
         Disclosing Party with respect to such Confidential Information; or

                  (e)      is required to be disclosed to comply with applicable
         laws or regulations (such as disclosure to the FDA or the United States
         Patent and Trademark Office or to theft foreign equivalents), or to
         comply with a court or administrative order, provided that the
         Disclosing Party receives prior written notice of such disclosure and
         that the Receiving Party takes all reasonable and lawful actions to
         obtain confidential treatment for such disclosure and, if possible, to
         minimize the extent of such disclosure.

         9.5.     Return of Confidential Information. Upon the termination of
this Agreement, at the request of the Disclosing Party, the Receiving Party
shall destroy or return to the Disclosing Party all originals, copies, and
summaries of documents, materials, and other tangible manifestations of
Confidential Information in the possession or control of the Receiving Party,
except that the Receiving Party may retain one copy of the Confidential
Information in the possession of its legal counsel (for ArQule) and its Legal
Department (for Sankyo) solely for the purpose of monitoring its obligations
under this Agreement.

         9.6.     Survival of Obligations. The obligations set forth in this
Article shall remain in effect for a period of five (5) years after termination
of this Agreement, except that the obligations of the Receiving Party to destroy
or return Confidential Information to the Disclosing Party shall survive until
fulfilled.


<PAGE>

                                                                   EXHIBIT 10.16

10.      Representations and Warranties.

         10.1.    Authorization. Each Party represents and warrants to the other
that it has the legal right and power to enter into this Agreement, to extend
the rights and licenses granted to the other in this Agreement, and to fully
perform its obligations hereunder, and that the performance of such obligations
will not conflict with its charter documents or any agreements, contracts, or
other arrangements to which it is a Party.

11.      Indemnification and Insurance,

         11.1.    Sankyo Indemnity Obligations. Sankyo agrees to defend,
indemnify arid hold ArQule, its Affiliates and their respective directors,
officers, employees and agents harmless from all costs, judgments, liabilities
and damages assessed by a court of competent jurisdiction arising from claims
asserted by a third party against ArQule, its Affiliates or their respective
directors, employees or agents as a result of: (a) actual or asserted violations
of any applicable law or regulation by Sankyo, its Affiliates, sublicensees or
third party manufacturers by virtue of which the Royalty-Bearing Products
manufactured, distributed or sold shall be alleged or determined to be
adulterated, misbranded, mislabeled or otherwise not in compliance with such
applicable law or regulation; (b) claims for bodily injury, death or property
damage attributable to the manufacture, distribution, sale or use of the
Royalty-Bearing Products by Sankyo, its Affiliates, sublicensees or third party
manufacturers; or (c) a recall ordered by a governmental agency, or required by
a confirmed failure, of Royalty-Bearing Products manufactured, distributed, or
sold by Sankyo, its Affiliates, sublicensees or third party manufacturers as
reasonably determined by the Parties hereto.

         11.2.    Procedure. In the event that ArQule or any of its Affiliates
or their respective employees or agents (the "Indemnitee') intends to claim
indemnification under this Article 11, such Party shall promptly notify Sankyo
of any loss, claim, damage, liability or action in respect of which the
Indemnitee intends to claim such indemnification, and Sankyo shall assume the
defense thereof with counsel mutually satisfactory to the Parties; provided,
however, that an Indemnitee shall have the right to retain its own counsel, with
the fees and expenses to be paid by Sankyo, if representation of such Indemnitee
by the counsel retained by Sankyo would be inappropriate due to actual or
potential differing interests between such Indernnitee and any other Party
represented by such counsel in such proceedings. The indemnity agreement in this
Article 11 shall not apply to amounts paid in settlement of any loss; claim,
damage, liability or action if such settlement is effected without the consent
of Sankyo, which consent shall not be withheld unreasonably. The failure to
deliver notice to Sankyo within a reasonable time after the commencement of any
such action, if prejudicial to its ability to defend such action, shall relieve
Sankyo of any liability to the Indemnitee under this Article 11, but the
Omission so to deliver notice to Sankyo will not relieve it of any liability
that it may have to any Indeninitee otherwise than under this Article 11. The
Indemnitee under this Article 11, its employees and agents, shall cooperate
fully with Sankyo and its legal representatives in the investigation of any
action, claim or liability covered by this indemnification.


<PAGE>

                                                                   EXHIBIT 10.16

         11.3.    Insurance. Sankyo shall maintain appropriate product liability
insurance with respect to development, manufacture and sales of the
Royalty-Bearing Products by Sankyo in such amount as Sankyo customarily
maintains with respect to sales of its other products. Sankyo shall each
maintain such insurance for so long as it continues to manufacture or sell the
Royalty-Bearing Products, and thereafter for so long as Sankyo maintains
insurance for itself covering such manufacture or sales.

12.      Term and Termination

         12.1.    Term. This Agreement shall commence on the Effective Date and
shall remain in effect until the expiration of the last Royalty Period covering
any Royalty-Bearing Product, unless earlier terminated as provided in this
Article 12.

         12.2.    Breach of Payment Obligations. In the event that Sankyo fails
to make timely payment of any amounts due to ArQule under this Agreement, ArQule
may terminate this Agreement upon thirty (30) days written notice to Sankyo,
unless Sankyo pays all past-due amounts within such thirty-day notice period.

         12.3.    Material Breach. In the event that either Party continues a
material breach of any of its obligations under this Agreement (other than as
provided in Section 12.2) and such Party fails (i) to remedy that breach within
ninety (90) days after receiving written notice thereof from the other Party or
(ii) to commence dispute resolution pursuant to Section 13.5, within ninety (90)
days after receiving written notice of that breach from the other Party, the
other Party may immediately terminate this Agreement upon written notice to the
breaching Party.

         12.4.    Effect of Termination. Termination of this Agreement shall not
relieve the Parties of any obligation accruing prior to such termination. The
provisions of Article 5, Article .6, Article 7 and Article S (with respect only
to milestone payments and royalties accrued at the time of termination but not
yet paid), Article 9, Article 11 and Article 13 shall survive the expiration or
termination of this Agreement.

13. Miscellaneous.

         13.1. Relationship of Parties. Nothing in this Agreement is intended or
shall be deemed to constitute a partnership, agency, employer-employee or joint
venture relationship between the Parties. No Party shall incur any debts or make
any commitments for the other, except to the extent, if at all, specifically
provided therein.

         13.2. Publicity. Neither Party shall use the name of the other Party or
reveal the terms of this Agreement in any publicity or advertising without the
prior written approval of the other Party, except that (i) either Party may use
the text of a written statement approved in advance by both Parties without
further approval, (ii) either Party shall have the right to identify the other
Party and to disclose the terms of this Agreement as required by applicable
securities laws or


<PAGE>

                                                                   EXHIBIT 10.16

other applicable law or regulation, and (iii) either Party may use the name of
the other Party and reveal the existence of this Agreement.

         13.3.    Non-Solicitation. During the term of this Agreement and
thereafter for a period of two (2) years, each Party agrees not to seek to
persuade or induce any employee of the other Party to discontinue his or her
employment with that Party in order to become employed by or associated with any
business, enterprise, or effort that is associated with its own business.

         13.4.    Governing Law, This Agreement shall be governed by and
construed in accordance with the laws of the Commonwealth of Massachusetts.

         13.5.    Dispute Resolution Procedures.

(a)      The Parties hereby agree that they will attempt in good faith to
resolve any controversy, claim or dispute ("Dispute") arising out of or relating
to this Agreement promptly by negotiations. Any such Dispute which is not
settled by the Parties within fifteen (15) days after notice of such Dispute is
given by one Party to the other in writing shall be referred to a senior
executive of ArQule and the Director of the Research Institute of Sankyo who are
authorized to settle such Disputes on behalf of their respective companies
("Senior Executives'). The Senior Executives will meet for negotiations within
fifteen (15) days of the end of the 15 day negotiation period referred to above,
at a time and place mutually acceptable to both Senior Executives, If the
Dispute has not been resolved within thirty (30) days after the end of the 15
day negotiation period referred to above (which period may be extended by mutual
agreement), subject to any rights to injunctive relief and unless otherwise
specifically provided for herein, any Dispute will be settled first by
non-binding mediation and thereafter by arbitration as described in subsections
(b) and (c) below.

         (b)      Any Dispute which is not resolved by the Parties within the
time period described in subsection (a) shall be submitted to an alternative
dispute resolution process ("ADR"). Within five (5) business days after the
expiration of the thirty (30) day period set forth in subsection (a), each Party
shall select for itself a representative with the authority to bind such Party
and shall notify the other Party in writing of the name and title of such
representative. Within ten (10) business days after the date of delivery of such
notice, the representatives shall schedule a date for engaging in non-binding
ADR with a neutral mediator or dispute resolution firm mutually acceptable to
both representatives. Any such mediation shall be held in Boston, Massachusetts.
Thereafter, the representatives of the Parties shall engage in good faith in an
ADR process under the auspices of such individual or firm. If the
representatives of the Parties have not been able to resolve the Dispute within
thirty (30) business days after the conclusion of the ADR process, or if the
representatives of the Parties fail to schedule a date for engaging in
non-binding ADR within the ten (10) day period set forth above, the Dispute
shall be settled by binding arbitration as set forth in subsection (c) below. If
the representatives of the Parties resolve the dispute within the thirty (30)
day period set forth above, then such resolution shall be binding upon the
Parties. If either Party fails to abide by such resolution, the other Party can
immediately refer the matter to arbitration under Section 13.5(c).


<PAGE>

                                                                   EXHIBIT 10.16

         (c)      If the Parties have not been able to resolve the Dispute as
provided in subsections (a) and (b) above, the Dispute shall be finally settled
by binding arbitration. Any arbitration hereunder shall be conducted under rules
of the American Arbitration Association. The arbitration shall be conducted
before three arbitrators chosen according to the following procedure: each of
the Parties shall appoint one arbitrator and the two so nominated shall choose
the third. If the arbitrators chosen by the Parties cannot agree on the choice
of the third arbitrator within a period of thirty (30) days after theft
appointment, then the third arbitrator shall be appointed by the Court of
Arbitration of the American Arbitration Association. Any such arbitration shall
be held in Boston, Massachusetts. The arbitrators shall have the authority to
grant specific performance, and to allocate between the Parties the costs of
arbitration in such equitable manner as they determine. The arbitral award (i)
shall be final and binding upon the Parties; and (ii) may be entered in any
court of competent jurisdiction.

         (d)      Nothing contained in this Section or any other provisions of
this Agreement shall be construed to limit or preclude a Party from bringing any
action in any court of competent jurisdiction for injunctive or other
provisional relief to compel the other Party to comply with its obligations
hereunder before or during the pendency of mediation or arbitration proceedings.
The Parties hereby irrevocably consent to submit to the jurisdiction of the
courts of the Commonwealth of Massachusetts and/or any other court having
jurisdiction for this purpose.

         13.6.    Counterparts. This Agreement may be executed in one or more
counterparts, each of which shall be deemed an original, and all of which
together shall be deemed to be one and the same instrument.

         13.7.    Headings. All headings in this Agreement are for convenience
only and shall not affect the meaning of any provision hereof.

         13.8.    Binding Effect. This Agreement shall inure to the benefit of
and be binding upon the Parties, their Affiliates, .and their respective lawful
successors and assigns.

         119.     Assignment. This Agreement may not be assigned by either Party
without the prior written consent of the other Party, except that either Party
may assign this Agreement to a successor in connection with the merger,
consolidation, or sale of all or substantially all of its assets or that portion
of its business pertaining to the subject matter of this Agreement.

         13.10.   Notices. All notices, requests, demands and other
communications required or permitted to be given pursuant to this Agreement
shall be in writing and shall be deemed to have been duly given upon the date of
receipt if delivered by hand, recognized international overnight courier,
confirmed facsimile transmission, or registered or certified mail, return
receipt requested, postage prepaid to the following addresses or facsimile
numbers:

If to Sankyo:                    If to ArQule:
Sankyo Co., LTD                  ArQule, Inc.
2-58, Hiromachi 1-Chome          200 Boston Avenue, Suite 3600
Shinagawa-ku                     Medford, MA 02155
Tokyo 140 Japan                  Attention: Eric B. Gordon


<PAGE>

                                                                   EXHIBIT 10.16

Attention: Hiroshi Fukunai
Tel: 03 3492 3131                Tel: (617) 395-4100
Fax: 03 5436 856/                Fax: (617) 395-1225

                                   with a copy to:
                                 Palmer & Dodge
                                 One Beacon Street
                                 Boston, MA 02108

                                  Attention: Michael Lytton, Esquire
                                 Tel: (617) 573-0327
                                 Fax: (617) 227-4420

Either Party may change its designated address and facsimile number by notice to
the other Party in the manner provided in this Section.

         13.11.   Amendment and Waiver. This Agreement may be amended,
supplemented, or otherwise modified only by means of a written instrument signed
by both Parties. Any waiver of any rights or failure to act in a specific
instance shall relate only to such instance and shall not be construed as an
agreement to waive any rights or fail to act in any other instance, whether or
not similar.

         13.12.   Severability. In the event that any provision of this
Agreement shall, for any reason, be held to be invalid or unenforceable in any
respect, such invalidity or unenforceability shall not affect any other
provision hereof, and the Parties shall negotiate in good faith to modify the
Agreement to preserve (to the extent possible) their original intent.

         13.13.   Entire Agreement, This Agreement constitutes the entire
agreement between the Parties with respect to the subject matter hereof and
supersedes all prior agreements or understandings between the Parties relating
to the subject matter hereof.

         13.14.   Force Majeure. Neither Party shall be held liable or
responsible to the other Party, nor be deemed to be in breach of this Agreement,
for failure or delay in fulfilling or performing any provisions of this
Agreement when such failure or delay is caused by or results from any cause
whatsoever outside the reasonable control of the Party concerned including, but
not limited to, fire, explosion, breakdown of plant, strike, lock-out, labor
disputes, casualty or accident, lack or failure of transportation facilities,
flood, lack or failure of sources of supply or of labor, raw materials or
energy, civil commotion, embargo, any law, regulation, decision, demand or
requirement of any national or local government or authority. The Party claiming
relief shall, without delay, notify the other Party by registered airmail or by
telefax of the interruption and cessation thereof and shall use its best efforts
to remedy the effects of such hindrance with all reasonable dispatch. The onus
of proving that any such Force Majeure event exists shall rest upon the Party so
asserting, During the period that one Party is prevented from performing its
obligations under this Agreement due to a Force Majeure event, the other Party
may, in its sole discretion, suspend any obligations that relate thereto. Upon
cessation of such Force Majeure


<PAGE>

                                                                   EXHIBIT 10.16

event the Parties hereto shall use their best efforts to make up for any
suspended obligations. If such Force Majeure event is anticipated to continue,
or has existed for nine (9) consecutive months or more, this Agreement may be
forthwith terminated by either Party by registered airmail or by telefax. In
case of such termination the terminating Party will not be required to pay to
the other Party any indemnity whatsoever.

              [THE REMAINDER OF THIS PAGE INTENTIONALLY LEFT BLANK]

IN WITNESS WHEREOF, the undersigned have duty executed and delivered this
Agreement as a sealed instrument effective as of the date first above written.

SANKYO CO., LTD                         ARQULE, INC.
By:____________                         By:_______________
Name: Tetsun Hiraoka. Ph.D.             Name: Eric B. Gordon
      ---------------------
Title: Member of the Board and          Title: President and Chief Executive
      ------------------------
    Director of Research Institute


<PAGE>

                                                                   EXHIBIT 10.16
                                       27

                                    EXHIBIT A

                                  Research Plan

                  [THIS PAGE HAS BEEN INTENTIONALLY LEFT BLANK]


<PAGE>

                                                                   EXHIBIT 10.31

                            TERMINATION OF AGREEMENT

         This Termination of Agreement, dated as of June 30, 2000, is between
ArQule, Inc. ("ArQule"), a Delaware corporation, and Pharmacia Corporation,
formerly known as Monsanto Company ("Pharmacia"), a Delaware corporation.

                                    RECITALS

         WHEREAS, ArQule and Pharmacia have previously entered into an Array
Delivery and Testing Agreement dated December 23, 1996, as subsequently amended
and restated on January 11, 2000 (the "Prior Agreement"), with respect to which
ArQule provides certain compound arrays for testing by Pharmacia and its
Affiliates and performs certain other compound development activities in
exchange for payment by Pharmacia of research thuds, milestone payments and
royalties; and

         WHEREAS, Pharmacia has decided, and ArQule is willing to, terminate the
Prior Agreement.

         NOW, THEREFORE, in consideration of the mutual covenants set forth in
this Agreement, the parties hereby agree as follows:

         1. Termination. The Prior Agreement previously executed and delivered
by and between ArQule and Pharmacia entitled "Amended and Restated Array
Delivery and Testing Agreement" dated January 2000 (including its predecessor
agreement entitled "Array Delivery and Testing
 Agreement" dated December 23,
1996, and any other understandings and agreements relating to the subject matter
thereon, and the obligations and rights of the parties with respect thereto,
except as set forth below, are hereby terminated in theft entirety.

         2. Termination Payment. In consideration of the termination of the
Prior Agreement, and the satisfaction and discharge of any and all of
Pharmacia's obligations to make research and development and array delivery
payments thereunder, including without limitation all payments pursuant to
Subsections 3.2.5 and 3.3.2, Pharmacia shall pay to ArQule, within sixty (60)
days following the date hereof, the sum of Four Million One Hundred Thirty Two
Thousand and Five Hundred Ninety Five Dollars (US$4,132,595). ArQule represents
that, upon payment of the foregoing amount, there are no amounts outstanding or
due from Pharmacia as of the date hereof under the Prior Agreement of which
ArQule is aware or should have been aware.

         3. Survival of Provisions. Notwithstanding the foregoing or anything to
the contrary in Section 11.4 of the Prior Agreement, the following provisions of
the Prior Agreement shall survive termination: Articles 8, 10, and 12 (except
for Section 12.15 which shall not survive).

         IN WITNESS WHEREOF, the undersigned have duly executed and delivered
this Agreement as a sealed instrument effective as of the date first above
written.


<PAGE>

                                                                   EXHIBIT 10.31

PHARMACIA CORPORATION                         ARQULE, INC.
By: _________                          By: _____
         Name:                                Name:
         Title:                               Title:


<PAGE>

                                                                   EXHIBIT 10.45

                              EMPLOYMENT AGREEMENT

         This Employment Agreement (the "Agreement") dated as of January 1, 2004
(the "Execution Date") is made by and between ArQule, Inc., a Delaware
corporation (the "Company") with its principal offices at 19 Presidential Way,
Woburn, Massachusetts 01801, and Stephen A. Hill, M. D. ("Executive") whose
current principal residential address is 26 Dole Hill Lane, Boxford, MA 01921.

         WHEREAS, the Company desires to continue to employ and retain Executive
in a senior executive capacity and to enter into an agreement embodying the
terms of such employment; and

         WHEREAS, Executive desires to accept such continued employment and
enter into such an agreement;

         NOW, THEREFORE, in consideration of the premises, and the mutual
covenants and agreements contained herein and for other good and valuable
consideration, the receipt, adequacy and sufficiency of which are hereby
acknowledged, the Company and Executive (the "Parties") hereby agree as follows:

         1.       Term of Employment. The Company hereby agrees to continue to
employ Executive, and Executive hereby accepts such continued employment with
the Company, upon the terms and subject to the conditions set forth in this
Agreement, for a period commencing
 on January 1, 2004 (the "Effective Date") and
continuing until terminated in accordance with the provisions of Section 5 (the
"Employment Term").

         2.       Title; Duties. During the Employment Term, Executive shall
serve as President and Chief Executive Officer of the Company reporting directly
to the Board of Directors of the Company or its designee (the "Board").
Executive hereby agrees to undertake the duties and responsibilities inherent in
such position and such other duties and responsibilities consistent with such
position as the Board shall from time to time reasonably assign to Executive.

         3.       No Conflict. During the Employment Term, Executive shall
devote substantially all of Executive's business time and efforts to the
performance of Executive's duties hereunder and shall not, directly or
indirectly, engage in any other business, profession or occupation for
compensation or otherwise which would conflict with the rendition of such duties
without the prior written consent of the Board, which consent shall not be
unreasonably withheld, delayed or conditioned. Executive represents and warrants
that Exhibit A attached hereto states all current business relationships,
including, but not limited to, consulting agreements, confidentiality agreements
and non-competition agreements to which Executive is a party as of the Execution
Date.


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         4.       Compensation and Benefits.

                  4.1.     Base Salary and Bonus. During the Employment Term,
the Company shall pay Executive for Executive's services hereunder a base salary
at the initial annual rate of $412,000, payable in regular installments in
accordance with the Company's usual payment practices and subject to annual
review and upward adjustment by the Board in its sole discretion. Such amount
(as it may be raised (but not decreased) from time to time in accordance with
this Section 4.1) shall be referred to herein as the "Base Salary." Executive
shall also be eligible to receive a discretionary annual cash bonus based on a
target amount (either as a percentage or a fixed dollar amount) established by
the Board and on Company and individual performance. Executive shall also be
eligible to participate in any and all other bonus plans and packages that are
made available to the Company's executives, on a basis consistent with
Executive's position and then-current Base Salary and in accordance with the
policies and practices of the Company and the Company's Board of Directors (the
"Board").

                  4.2.     Stock Option Grant. As further compensation for
Executive's services hereunder, the Company shall grant to Executive, on the
Effective Date, a stock option (the "Execution Stock Option") to purchase zero
(0) shares of the Company's Common Stock, $0.01 par value per share (the "Common
Stock"), pursuant to the Company's Amended and Restated 1994 Equity Incentive
Plan (the "Plan") and in accordance with the terms, and subject to a vesting
schedule pursuant to which twenty-five percent of the shares shall vest annually
commencing on the first anniversary of the Effective Date, and other conditions,
set forth in the form of Option Certificate (attached hereto as Exhibit B in the
event the Execution Stock Option grants an option to purchase more than zero
shares of Common Stock). The method of determining the exercise price of the
Execution Stock Option is set forth in the attached Exhibit C. Subject to the
discretion of the Board, the Company may grant to Executive from time to time
other stock options to purchase additional shares of Common Stock, also pursuant
to the Plan and such other terms and conditions set forth at the time of such
grant (the Execution Stock Option and such other stock options, together with
any stock options to purchase Common Stock which the Company has previously
granted to Executive, collectively, the "Stock Options").

                  4.3.     Executive Benefits. During the Employment Term and
subject to any contributions therefor generally required of senior executives of
the Company, Executive shall be entitled to receive such employee benefits
(including fringe benefits, 401(k) plan participation, and life, health, dental,
accident and short and long term disability insurance) which the Company may, in
its sole and absolute discretion, make available generally to its senior
executives or personnel similarly situated; provided, however, that it is hereby
acknowledged and agreed that any such employee benefit plans may be altered,
modified or terminated by the Company at any time in its sole discretion without
recourse by Executive.

                  4.4.     Paid Time Off. Executive shall be entitled to four
weeks (20 working days) of paid time off ("PTO") per annum during the Employment
Term, to be taken at such time or times as shall be mutually convenient for the
Company and Executive; provided, however, that the Company may elect to increase
the annual time to which Executive shall be entitled to PTO. Unused PTO shall be
allocated pursuant to the Company's existing policies and practices.

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                  4.5.     Business Expenses and Perquisites. Upon delivery of
adequate documentation of expenses incurred in accordance with the policies and
practices of the Company, Executive shall be entitled to reimbursement by the
Company during the Employment Term for reasonable travel, entertainment and
other business expenses incurred by Executive in the performance of Executive's
duties hereunder in accordance with such policies as the Company may from time
to time have in effect.

         5.       Termination.

                  5.1.     Without Cause by the Company.

                           5.1.1.   The Severance Package. The Company may
terminate Executive's employment hereunder at any time without Cause (as defined
in Section 5.2) upon not less than fourteen (14) days prior written notice from
the Company to Executive. The effective date of Executive's termination shall be
referred to herein as the "Termination Date." If Executive's employment is
terminated by the Company pursuant to this Section 5.1, the Company shall pay
Executive all amounts owed to Executive for work performed prior to the
Termination Date plus the following amounts and consideration (the "Severance
Package"), subject to standard payroll deductions and withholdings: (i) two
times the Base Salary through the end of the twelve (12) month period commencing
on the Termination Date to be paid in a lump sum; (ii) a lump sum payment equal
to two times the average bonus, if any, paid by the Company to Executive with
respect to the two (2) years preceding the year in which the Termination Date
occurs; (iii) the costs associated with continuing the benefits which Executive
is entitled to receive pursuant to Section 4.3 of this Agreement at the level in
effect as of the Termination Date (subject to any employee contribution
requirements applicable to Executive on the Termination Date) through the twelve
(12) month period commencing on the Termination Date; and (iv) the cash value of
any accrued but unused PTO, as of the Termination Date. The payment to Executive
of any benefits or consideration other than the Severance Package following the
termination of Executive's employment pursuant to this Section 5.1 shall be
determined by the Board in its sole discretion in accordance with the policies
and practices of the Company and applicable laws, including that the Board, in
its sole discretion, may accelerate the vesting of any Stock Option held by
Executive as of the Termination Date.

                           5.1.2.   Deemed Termination. For purposes of this
Section 5.1, a "termination without cause" shall be deemed to occur, and
Executive shall be entitled to the Severance Package, in the event any of the
following occurs and Executive provides to the Company Notice of Termination (as
defined in Section 5.6) within forty-five (45) days thereafter: (a) the Company
substantially reduces or diminishes Executive's responsibilities or title
without Cause; (b) the Company reduces Executive's Base Salary or bonus target
(other than in connection with a Company-wide decrease in salary or bonus,
respectively); (c) the Company materially breaches any of its obligations to
Executive pursuant to this Agreement, and fails to cure such breach within 30
days of receipt of notice thereof; (d) the Company relocates Executive's place
of employment without Executive's written consent by a distance of more than
fifty (50) miles, excluding any relocation to the Company's existing offices in
Medford or Woburn, MA which would not constitute a deemed termination; or (e) a
successor in interest to the Company fails to assume the obligations of this
Agreement.

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                           5.1.3.   Accelerated Vesting in Change of Control. In
the event that the Company terminates or is deemed to terminate Executive's
employment pursuant to this Section 5.1 within one year of the latest possible
date of a Change of Control, in addition to the Severance Package, any Stock
Option held as of the Termination Date shall become immediately exercisable as
to all option shares without regard to the vesting schedule set forth on the
applicable Option Certificate. For purposes of this Agreement, any one of the
following events shall be considered a "Change of Control" of the Company:

                           (a)      the acquisition by any "person" (as such
                                    term is defined in Section 3(a)(9) of the
                                    Securities Exchange Act of 1934) of any
                                    amount of the Company's Common Stock so that
                                    such person holds or controls fifty percent
                                    (50%) or more of the Company's Common Stock;

                           (b)      the merger or consolidation of the Company
                                    with or into any other entity in which the
                                    holders of the Company's outstanding shares
                                    of capital stock immediately before such
                                    merger or consolidation do not, immediately
                                    after such merger or consolidation, retain
                                    capital stock representing a majority of the
                                    voting power of the surviving entity of such
                                    merger or consolidation;

                           (c)      a sale of all or substantially all of the
                                    assets of the Company to a third party;

                           (d)      within any twenty-four (24) month period,
                                    the election by the stockholders of the
                                    Company of twenty percent (20%) or more of
                                    the directors of the Company other than
                                    pursuant to nomination by the Company's
                                    management; or

                           (e)      the execution of a legally binding,
                                    definitive agreement approved by the Board
                                    of Directors providing for any of the events
                                    set forth in (a), (b), (c) or (d) above.

                  5.2.     For Cause by the Company. Notwithstanding any other
provision of this Agreement, Executive's employment hereunder may be terminated
by the Company at any time for Cause. For purposes of this Agreement, "Cause"
shall mean: (i) Executive's arbitrary, unreasonable, or willful failure to
follow the reasonable instructions of the Board or otherwise perform Executive's
duties hereunder (other than as a result of a Disability (as defined in Section
5.3)) for thirty (30) days after a written demand for performance is delivered
to Executive on behalf of the Company which demand specifically identifies the
manner in which the Company alleges that Executive has not substantially
followed such instructions or otherwise performed Executive's duties; (ii)
Executive's willful misconduct that is materially injurious to the Company
(whether from a monetary perspective or otherwise); (iii) Executive's willful
commission of an act constituting fraud with respect to the Company; (iv)
conviction of Executive for a felony under the laws of the United States or any
state thereof; or (v) Executive's material breach of Executive's obligations
under Section 6 hereof. If Executive's employment is

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terminated by the Company for Cause, the Company shall pay Executive all amounts
owed to Executive for work performed prior to the Termination Date, plus the
cash value of any accrued but unused PTO, as of the Termination Date. The
payment to Executive of any other benefits following the termination of
Executive's employment pursuant to this Section 5.2 shall be determined by the
Board in its sole discretion in accordance with the policies and practices of
the Company and applicable laws.

                  5.3.     Disability. Subject to the requirements of the
Americans with Disabilities Act, Massachusetts General Laws Chapter 151B and any
other applicable laws, Executive's employment hereunder may be terminated by the
Company at any time in the event of the Disability of Executive. For purposes of
this Agreement, "Disability" shall mean the inability of Executive to perform
substantially Executive's duties hereunder due to physical or mental disablement
which continues for a period of four (4) consecutive months during the
Employment Term, as determined by an independent qualified physician mutually
acceptable to the Company and Executive (or Executive's personal representative)
or, if the Company and Executive (or such representative) are unable to agree on
an independent qualified physician, as determined by a panel of three
physicians, one designated by the Company, one designated by Executive (or such
representative) and one designated by the two physicians so designated. If
Executive's employment is terminated by the Company for Disability, (a) the
Company shall pay Executive all amounts owed to Executive for work performed
prior to the Termination Date, plus the Severance Package, except that the Base
Salary paid as a part of the Severance Package shall be reduced by the amount of
Base Salary, salary continuation (short-term disability), and cash disability
benefits (long-term disability) paid to Executive for the corresponding period
under the Company's employee benefit plans as then in effect, and (b) any Stock
Option held as of the Termination Date shall become immediately exercisable as
to all option shares without regard to the vesting schedule set forth on the
applicable Option Certificate. The payment to Executive of any benefits other
than as described in the immediately preceding sentence following the
termination of Executive's employment pursuant to this Section 5.3 shall be
determined by the Board in its sole discretion in accordance with the policies
and practices of the Company and applicable laws.

                  5.4.     Death. Executive's employment hereunder shall
automatically terminate in the event of Executive's death. If Executive's
employment is terminated by the death of Executive, (a) the Company shall pay to
Executive's estate or legal representative all amounts owed to Executive for
work performed through the last day of Executive's actual employment by the
Company plus the Severance Package, and (b) any Stock Option held as of the
Termination Date shall become immediately exercisable as to all option shares
without regard to the vesting schedule set forth on the applicable Option
Certificate. The payment to Executive of any benefits other than as described in
the immediately preceding sentence following the termination of Executive's
employment pursuant to this Section 5.4 shall be determined by the Board in its
sole discretion in accordance with the policies and practices of the Company and
applicable laws.

                  5.5.     Termination by Executive. Executive's employment
hereunder may be terminated by Executive at any time upon not less than thirty
(30) days prior written notice from Executive to the Company. Executive agrees
that such notice period is reasonable and necessary in light of the duties
assumed by Executive pursuant to this Agreement and fair in light of the

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consideration Executive is receiving pursuant to this Agreement. If Executive
terminates Executive's employment with the Company pursuant to this Section 5.5,
the Company shall pay Executive only an amount equal to the Base Salary through
the Termination Date, plus the cash value of any accrued but unused PTO as of
the Termination Date.

                  5.6.     Notice of Termination. Any purported termination of
employment by the Co