DNAG DNAPrint Genomics Inc (CE)

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Statements in this Form 10-QSB Quarterly Report may be “forward-looking statements.” Forward-looking statements include, but are not limited to, statements that express our intentions, beliefs, expectations, strategies, predictions or any other statements relating to our future activities or other future events or conditions. These statements are based on our current expectations, estimates and projections about our business based, in part, on assumptions made by our management. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in the forward-looking statements due to numerous factors, including those risks discussed in our most recent Annual Report on Form 10-KSB, under “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, as well as the factors discussed in this Form 10-QSB Quarterly Report and in other documents which we file with the Securities and Exchange Commission.

In addition, such statements could be affected by risks and uncertainties related to our financial condition, factors that affect our industry, market and customer acceptance, changes in technology, fluctuations in our quarterly results, our ability to continue and manage our growth, liquidity and other capital resources issues, competition, fulfillment of contractual obligations by other parties and general economic conditions. Any forward-looking statements speak only as of the date on which they are made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of this Form 10-QSB Quarterly Report, except as required by law.

The following discussion and analysis should be read in conjunction with the balance sheets as of December 31, 2006 and September 30, 2007 and the financial statements for the three and nine months ended September 30, 2007 and 2006 included with this Form 10-QSB.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that have a significant impact on the results we report in our financial statements. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Actual results may differ from these estimates under different assumptions or conditions. Below, we discuss this further, as well as the estimates and judgments involved.

Asset Impairment

We review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset exceeds its fair value and may not be recoverable. In performing the review for recoverability, we estimate the future cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the expected future cash flows, undiscounted and without interest charges is less than the carrying amount of the asset, an impairment loss is recognized. Otherwise, an impairment loss is not recognized. Management estimates the fair value and the estimated future cash flows expected. Any changes in these estimates could impact whether there was impairment and the amount of the impairment. Since we are in the development stage, we do not have much history to determine our estimated cash flows. If we do not meet our targeted cash flows for our services and if the estimated disposition of the equipment is lower, this could result in a write-down of our equipment. Our equipment is very specialized equipment related to genomics research, and there probably would not be a large demand for our used equipment. The amount of our net fixed assets is the amount of the maximum risk if our assumptions were not correct. Each year the assets will have higher depreciation and the maximum risk will decrease correspondingly.

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Allocation of Research and Development Costs

We allocate costs by identifying and directly expensing certain costs related to research and development and allocating certain other costs based on total labor effort that is estimated by management and employees. With some of these costs, a percentage of a total purchase order price is allocated to research and development. We base the labor time on time cards submitted each pay period by the employees.  We record inventory for our raw materials.  As raw materials are used, they are charged to research and development expense based upon actual usage for research and development.  We continue to refine our process of identifying time associated with research and development. These refinements to estimates could increase or decrease our income statement expense categories of research and development, cost of sales and selling, general and administrative expenses. As we hire employees, the department in which the employee is hired will have a direct impact on the allocation of administrative costs to research and development. For example if a person is hired in research and development, the allocation to research and development for other administrative costs will increase because labor effort percentage for research and development will have increased. If a person is hired in administration, the allocation to research and development for other administrative costs will decrease because the labor effort percentage for research and development will have decreased. Changes to these estimates could have a significant impact on the accrual and related compensation expense and/or deferred compensation.

Estimation of Fair Market Value

We use the Black Scholes Pricing Model to determine fair market value in certain instances, for example, to value warrants and the intrinsic value of the convertible debt and non-detachable warrants.  The Black Scholes Pricing Model requires estimated assumptions in its computation.   We estimate the assumptions used in each calculation based upon the transaction term and what we believe most appropriately reflects the transaction. If different estimates of the assumptions were used, it could result in different fair market value amounts being calculated.  Additionally, various methods can be used to determine the fair market value of the warrant.  If a different model were used besides the Black Scholes Pricing Model, it could result in different fair market value amounts being calculated.

Derivatives

We have reviewed our contracts and financial instruments to determine what derivatives and embedded derivatives we may have.  We have then reviewed these derivatives and embedded derivatives to determine if they should be recorded as equity or a derivative liability valued at fair value.  Judgment is used to apply the criteria of Statement of Financial Accounting Standards No. 133 and No. 155 and Emerging Issues Task Force 00-19 to the derivatives.  Also judgment and estimates are required to determine the fair value of the derivative liabilities and the fair market value of the financial instrument as a whole.  Although we believe that the estimates and assumptions used are reasonable, actual results may differ from these estimates under different assumptions or conditions.

Estimate of Accrued Default Penalties

We have recorded an amount of accrued default penalties related to our default of the Dutchess notes and have estimated it based upon 30% of the face amount of the outstanding debt.  We currently apply our payments as Dutchess applies the payments.  If we applied the payments from the puts in a different method, it could result in a different estimate.  Also, since Dutchess has not notified us of any penalties owed, we could have estimated the amount as low as -0-.  Although we believe that the methods and estimates we used are reasonable, actual results may differ from these estimates.

SUMMARY

Although we have been in existence for a number of years, we continue to be a development company while we develop products for introduction to the pharmacogenomics market.  We continue to devote substantially all of our efforts to initiating and developing our planned principal operations in our pharmacogenomics products. We generate revenues in our consumer, forensic and genotyping services, but these services have not yet resulted in the generation of significant revenues. Our pharmacogenomics products are still in development, thus we do not have any revenues from these future products.

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In our pharmacogenomics area, we have established a strategic alliance with Beth Israel Deaconess Medical Center (“Beth Israel”) to develop a new, more potent and longer acting form of the anemia drug Erythropoietin, or EPO.  EPO is a glycoprotein naturally made by the body to stimulate red blood cell production; the currently marketed forms are manufactured using recombinant DNA technology and are used to treat anemia or low blood cell count.  Under the agreement, Beth Israel has granted us an exclusive license to United States and foreign patents related to certain forms of EPO. We have the right to develop, use, market and sell products derived from the licensed patents.  We have also entered into a consulting agreement with Dr. Arthur Sytkowski, the Director of Beth Israel, to consult on the EPO project.  Dr. Sytkowski has agreed to perform certain consulting services, including advising on medical, regulatory and patent issues, training personnel and providing assistance with EPO research and development.   

During late March 2006, we entered into a services agreement with KBI BioPharma for the production development of EPO.  During the fourth quarter of 2006, these services were put on hold pending receiving additional funding to fund them.

We entered into an exclusive licensing agreement with Dr. Mark Froimowitz to develop a series of compounds targeting the clinical development of enhanced pharmaceuticals for the treatment of drug addiction, attention deficit hyperactivity disorder, or ADHD, and depression.  The licensed compounds are analogs of Ritalin, a well-known drug used for treatment of ADHD.  The analogs are designed specifically to have a slow onset and increased half-life in the bloodstream, thus reducing a patient’s required daily dosage and the potential for drug abuse.  We have the exclusive right to develop, use, market and sell products derived from the licensed compounds.  During the third quarter of 2007, Dr. Froimowitz became an employee of DNAPrint.

We entered into an exclusive license agreement with Harvard College through the Laboratory for Translational Research at Harvard Medical School. The Harvard license agreement provides for sponsored research and the clinical development and commercialization of a diagnostic test targeting early identification of the population at risk of developing vascular diabetic complications. The research will be conducted under the supervision of Dr. Jose Halperin. Under the Harvard license agreement, we have the exclusive right to develop market and sell products and services derived from the research.  During December 2006, we had been given notice of default by Harvard which stated that we must pay a substantial portion of the outstanding balance by the end of February 2007, or Harvard may exercise their right of termination of the agreement.  We are currently operating under a schedule that requires us to pay them $100,000 per month.  At September 30, 2007, we owed them $156,096.  

We continue work on Ovanome, a Taxol screening diagnostic test, and Statinome, a test for the cardiac drug market, which are both currently under development. We will also continue our efforts on other research and development projects that are underway. Our Ovanome technology is under development with researchers at the Moffitt Cancer Center in Tampa, Florida.  We are currently trying to acquire enough samples to perform our research for our Ovanome work.

We have an agreement with our Scientific Advisory Board member, to continue collaboration with us to develop commercial tests for genetic ancestry and particular physical phenotypes. We continue to work with him on upgrading our current ancestry products.

During September 2007, we established BioserveDNAPrint, LLC, a joint venture agreement between BioServe Biotechnologies, Ltd and DNAPrint.  This entity is owned 50% by each party and was established to jointly develop and commercialize certain products.

Our plan of operations for the ensuing twelve months includes efforts to: 1) increase sales of our existing products and services; 2) introduce new and expanded products and services in the consumer and forensic markets; 3) promote our genotyping services while continuing to concentrate on research and development for both our existing products and our anticipated pharmacogenomic products and services.

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Although we have been in existence for a number of years, management's efforts to develop our business have not yet resulted in significant revenues.  We have chosen to focus on increasing sales volume in the consumer, forensic and genotyping markets while continuing to develop products for introduction to the pharmacogenomics market.   We intend to support research and development as a vital component of our overall growth strategy. Until (i) potential customers are familiar with our technology and products, which will come from continued research and development and proven market use, and (ii) we introduce our pharmacogenomics products, it is unlikely that we will generate significant revenue.

The following discussion of our historical financial results should be read against this background.

RESULTS OF OPERATIONS – THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006

Revenues and Cost of Sales

During the three months ended September 30, 2007 and 2006, revenues were $227,562 and $651,753, respectively. A $424,191 or 65% decrease in revenues for the third quarter of 2007 compared to the same quarter from the prior period.  During the nine months ended September 30, 2007 and 2006, revenues were $1,405,562 and $1,907,354, respectively. A $501,792 decrease in revenues for the nine months ended September 30, 2007 compared to the same period of the prior year.  In addition to the revenues recognized in the accompanying statement of operations, we also have recorded deferred revenues of $253,746 as of September 30, 2007.  Deferred revenue is recorded when a prepaid or billed order has been received, but all the services have not been completed as of September 30, 2007. The majority of the deferred revenue will be recognized as revenue during 2007.

The decrease of $424,191 in revenues for the three months ended September 30, 2007 compared to the same period in the prior year is mainly the result of our genotyping revenues decreasing by $227,390, AncestryByDNA ^TM 2.5 revenues decreasing by $119,492, EuroDNA ^TM 1.0 revenues decreasing $61,206, MtDNA™ revenues decreasing $9,846, Y SNP revenues decreasing $500, and forensics and other revenue decreasing $5,757.  

The decrease of $501,792 in revenues for the nine months ended September 30, 2007 compared to the same period in the prior year is mainly the result of our AncestryByDNA ^TM 2.5 revenues decreasing by $235,297, EuroDNA ^TM 1.0 revenues decreasing $20,562, MtDNA™ revenues decreasing $17,882, Y SNP revenues decreasing $4,230, genotyping services revenues decreasing $303,382 and forensics revenue decreasing $ 7,417.  These decreases were offset by an increase in our Ancient DNA revenues of $72,075 and an increase in other income of $14,903 compared to the same period in the prior year.

Genotyping sales were generated primarily through one customer during 2007.  The decrease of genotyping services of $303,382 during the nine months ended September 30, 2007 compared to the same period in 2006 was the result a large project completed during the first quarter of 2006.    One of our customers accounted for 15% of our total revenue during the nine months ended September 30, 2007.

During the nine months ended September 30, 2007 compared to the same period in 2006, sales of our consumer services decreased by $277,971.  We have not been featured in as many articles and television spots which is where the consumers are made aware of our products, thus our consumer revenue has been lower.  Our consumer products are a discretionary service which as the consumer budget tightens our products sales decrease as consumers decrease their discretionary spending.  We currently contract with distributors who also sell our consumer products as well as advertise on the Internet and in paper-based publications (i.e. through Google and Family Tree magazine) to grow sales of our consumer products.  Our consistent sales come through our distributors.  We will also continue to pursue adding distributors to increase our sales volume of our consumer products. One of our distributors accounted for 26% of our total revenue during the first nine months of 2007.  

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During June 2007, we introduced our new product EuropeanDNA 2.0 which examines 1,349 markers (our EurasianDNA 1.0 test examines 320 markers). This EuropeanDNA 2.0 test will ultimately reveal more detailed European ancestry from Southeastern Europe (SEE - from western Spain through Italy, Greece and Turkey to Armenia, including those with Jewish heritage from that area [i.e. not Jewish as a religion]), Iberia (IB - most of Spain and Portugal), the Basque region (BAS) along the Pyrenees Mountains between Spain and France, Continental Europe (CE - including Ireland and Great Britain plus most of the countries of Europe such as Germany, France, the Netherlands, Switzerland, etc.), and Northeastern Europe (NEE) - Poland, the Baltic Countries, Norway, Sweden, Finland (including Lapland) and western Russia.  The EuropeanDNA 2.0 test does not replace our EurasianDNA 1.0 test, but complements it.  The first batch of results will be sent out in the fourth quarter of 2007.

During the nine months ended September 30, 2007 compared to the same period in 2006, sales of our forensic services decreased by $7,417. We continue to market our forensic services and during October 2007, we put our application in for ISO accreditation for our laboratory. When we achieve accreditation of our laboratory, this will enable us to expand our forensic offerings to the law enforcement community. During the third quarter of 2007, we engaged one forensic distributor to assist us in marketing our services to the forensic community.

While we continue to improve and refine our accounting systems, we currently do not segregate product costs by product or service. We have been and continue to be a development stage company as described in Financial Accounting Standards Board Statement No. 7. We continue to devote substantially all of our efforts to initiating and developing our planned principal operations. We expect that our pharmacogenomic products and services, once introduced, will be our major revenue generator.

During the three and nine months ended September 30, 2007 compared to the same period in 2006, cost of sales decreased by $199,425 and $194,093, respectively. The cost of sales as a percentage of revenue was 81% and 70% for the nine months ended September 30, 2007 and 2006, respectively.

The gross profit was (6,588) for the three months ended September 30, 2007 compared to $218,178 for the three months ended September 30, 2006. The negative gross profit for the three months ended September 30, 2007 was the result of low revenues for the quarter that did not cover the fixed costs.

Because of our small sales volume, these results are not indicative of the margins that we expect to attain if our long-term goals are achieved. We anticipate that as we gain experience and can begin to take advantage of economies of scale benefits through increased revenues; our margins will stabilize and begin to track in line with other companies in similar industries. However, in the near term, while we continue to be a development stage enterprise, we expect that our margins will continue to fluctuate.

Research and Development Expenses

During the three and nine months ended September 30, 2007 compared to the same period in the prior year research and development (R&D) expenses decreased $830,978 and $1,896,744, respectively.  The decrease of $1,896,744 in R&D during the nine months ended September 30, 2007 compared to the period in the prior year resulted primarily from approximately $1,352,000 of lower costs invested in our EPO project, approximately $31,000 of lower costs invested in our diabetes project, approximately $197,000 of lower costs invested in our PT-500 projects, approximately $96,000 of lower costs invested in post operative nausea and vomiting project, $108,000 of lower costs invested in samples, $382,000 lower costs invested in direct materials, $243,000 higher costs for options granted during 2007 and $26,000 of higher costs of other items.

The decrease of $830,978 in R&D during the three months ended September 30, 2007 compared to the period in the prior year resulted primarily from approximately $921,000 of lower costs invested in our EPO project, approximately $35,000 of higher costs invested in our diabetes project, approximately $124,000 of lower costs invested in our PT-500 projects, approximately $24,000 of lower costs invested in post operative nausea and vomiting project, approximately $82,000 of lower costs invested in direct materials, $127,000 of higher costs for options granted during 2007 and $158,000 higher costs of other items.

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Because we are in the development stage of our long-term business, it is not possible to directly correlate our current research and development costs to our future costs. Currently we do not manage on a project cost basis with respect to research and development. We are implementing revenue recognition and project status measures which will in the future disclose such information. Our revenue generation to date has not been substantial or steady enough to warrant segregation of time, costs and revenue. We are a development stage enterprise with new products that are not available through competitors for forensics and genealogy. For example, many of our products and services are in the development stage, and the segregation of each project by its particular cost, revenue and cash flow is currently not feasible.

We continue to support research and development to attain our long-term business strategy, and it will remain a high priority and a necessary resource to sustain future growth. We will continue to hire research and development personnel and invest in the infrastructure required to support future innovation, including equipment, supplies and other asset purchases.

In order to advance our pharmacogenomic products to commercialization, our development costs for these products will continue to be large during 2007. We have the following research and developments costs commitments in the future.

We entered into a license agreement with Beth Israel for EPO.   In exchange for the license, we agreed to make certain milestone payments linked to their progress in developing marketable products from the licensed technology.  The total of payments, if all milestones are reached, is $2,150,000. The milestone payments are nonrefundable. Up to $200,000 of this amount is creditable against future royalties.  In addition  to the  milestone  payments,  we must  also pay Beth  Israel an annual royalty of 4% of the net sales of all  products  developed  from the  licensed technology.  A minimum royalty payment of $100,000 a year is due upon the commencement of commercial sales in any territory worldwide.  

We entered into a consulting agreement with Dr. Arthur Sytkowski, the Director of Beth Israel, to consult on the EPO project. In exchange for his services,  we pay Dr. Sytkowski $10,000 a month,  five annual incentive payments of $25,000 each, and certain  milestone  payments totaling $125,000 linked to our progress under  the Beth  Israel  license  in  developing  marketable  products  from the licensed EPO  technology.  The milestone payments will be reduced - dollar for dollar - to the extent Dr.  Sytkowski receives payments from Beth Israel relating to the same milestone events under the Beth Israel license.  At September 30, 2007 we had a remaining commitment of $300,000.  On March 1, 2007, we entered into a letter agreement with Dr. Sytkowski whereby he agreed to accept shares of our common stock in lieu of payments due under the consulting agreement.

During late March 2006, we entered into a service agreement with KBI BioPharma for services to be provided totaling $2,840,000 of which $576,372 has been paid and $816,671 has been accrued.  KBI will provide us services for the production development of EPO.  KBI has placed this project on hold awaiting payment of the amounts owed.

During July 2006, we entered into a collaborative research agreement with Beth Israel to provide four researchers to us to conduct certain research work related to our EPO research. This project will cost approximately $600,000. At September 30, 2007, we had a remaining commitment of approximately $293,718 which is accrued.

We entered into an exclusive licensing agreement with Dr.  Mark  Froimowitz  to  develop a series of  compounds targeting the clinical development of enhanced pharmaceuticals  for the treatment of  drug  addiction,   ADHD  and depression. We are obligated to pay the licensor a 2% quarterly royalty fee on the net sales of products covered by the license. Minimum annual maintenance fees of $25,000 are required for the license term, but will be deducted from royalties. Additionally,  the license  requires  progress  payments  of up to  $275,000  upon  the  successful development and approval of licensed  products. The license’s initial five-year term is supplemented by options capable of extending the license term for up to twenty years.  At September 30, 2007 we had a remaining commitment of $400,000 of which $25,000 is accrued.

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We entered into an exclusive research sponsorship and license agreement with Harvard College through the Laboratory for Translational Research at Harvard Medical School. The Harvard license agreement provides for sponsored research and the clinical development and commercialization of a diagnostic test targeting early identification of the population at risk of developing vascular diabetic complications. The research will be conducted under the supervision of Dr. Jose Halperin. The remaining sponsored research payments total approximately $1.4 million and will be paid in monthly installments of approximately $100,000 through February 2008 and then $70,000 thereafter.  We have accrued for $156,096 of these costs at September 30, 2007.

Under the Harvard license agreement, we have the exclusive right to develop, market and sell products and services derived from the research. We must pay Harvard a 6% royalty on the net sales of products and services covered by the license and 30% of all non-royalty sublicense income. We are also required to pay escalating minimum annual license maintenance fees totaling $850,000 through January 1, 2012. We are obligated to make annual license maintenance fees of $250,000 through the Harvard license agreement term, but, beginning January 1, 2013, the annual license fee of $250,000 is credited against royalty payments.  We were given notice of default by Harvard which stated that we must pay a substantial portion of the outstanding balance by the end of February 2007, or Harvard may exercise their right of termination of the agreement.  We are currently operating under a schedule that requires us to pay them $100,000 per month.  

Selling, General and Administrative Expenses

Another significant component of our operating expenses is selling, general and administrative expenses. These expenses resulted from (i) accounting and other fees associated with being a public company and other regulatory compliance activities, (ii) legal fees associated with our patent filings and maintenance and preparation of our securities law filings, (iii) selling and marketing costs to promote our products and (iv) administrative and other salaries and expenses.

Selling, general and administrative expenses decreased $460,317 for the third quarter of 2007 compared to the third quarter of 2006 and decreased $971,993 for the nine months ended September 30, 2007 compared to the same period during 2006.  The selling, general and administrative expenses decrease of $971,993 for the nine months ended September 30, 2007 compared to the same period in the prior year was primarily the result of decreased advertising, marketing materials and investor relations costs of approximately $411,000, reduced legal expenses of approximately $552,000 and lower administrative costs of approximately $9,000.

The selling, general and administrative expenses decrease of $460,317 for the third quarter of 2007 compared to the same period of 2006 was primarily the result of decreased advertising, marketing materials and investor relations costs of approximately $93,000, reduced legal expenses of approximately $315,000 and reduced other administrative costs of approximately $52,000.

Interest Expense

During the three and nine months ended September 30, 2007, we recognized an increase of $2,980 and $18,153 of interest expense compared to the same periods in the prior year, respectively.  The increase in interest expense is due mainly to a loan payable that was not outstanding during 2006 but was outstanding during 2007.

Debt Default Penalties

We are in default of each of the Dutchess Notes due to not making the minimum principal payments.  The Dutchess documents purport to give Dutchess the right to charge us liquidated damages of up to 30% of the face amount of these notes.  Dutchess has not exercised this right at September 30, 2007 nor at the time this report was issued.  At September 30, 2007, we had accrued $1,729,500 for these potential liquidated damages which was $414,000 lower than the accrual at December 31, 2006 as we have an agreement with Dutchess that states the maximum penalty is $1,729,500.  This is an estimate and this estimate may change with time.

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Intrinsic Value of Convertible Debt and Non-detachable Warrants and Debt Discount Amortization

We recorded interest expense of $199,007 and $465,840 pertaining to the intrinsic value of convertible debt and non-detachable warrants and debt discount amortization during the three months ended September 30, 2007 and 2006, respectively and $922,248 and $2,178,263 during the nine months ended September 30, 2007 and 2006, respectively.  We expect this expense to continue during 2007 at a lower rate than compared to 2006 as we amortize the debt discount on our notes payable.

Amortization of Deferred Financing Fees

During the three months ended 2006, we expensed $54,733 of deferred financing fees related to the La Jolla debenture and Dutchess notes.  During the nine months ended September 30, 2007 and 2006, we expensed $60,857 and $196,411, respectively of deferred financing fees related to the La Jolla debenture and Dutchess notes. We do not expect this expense to continue during 2007 unless we enter into additional notes during the year.

Loss on Fair Market Value Conversion of Debenture to Equity

During 2007, Dutchess converted $319,088 of convertible debenture to 60,000,000 shares of our common stock.  The fair market value based upon the market price of our common stock was $462,502 which resulted in a loss of $143,414.

G ain (loss) on Derivative Contracts, Net

During the three and nine months ended September 30, 2007, we recorded a gain on derivative liabilities of $56,653 and $98,558, respectively related to recording the warrants at fair value during these periods.  

During the nine months ended September 30, 2006, we reduced our derivative liability account by and recorded a gain on derivative liabilities of $1,092,015 related to the June 2005 and August 2005 Dutchess notes payable transactions as they were paid in full.

During the three and nine months ended September 30, 2006, we recorded a gain on derivative liabilities of $55,230 and $137,329, respectively related to recording the warrants at fair value during these periods.  

During the first quarter of 2006, we converted all of our remaining preferred stock outstanding to common stock at a fair market value of $235,366 and reduced our derivative liabilities by $189,042 which resulted in us recording a loss on derivative liabilities of $46,324.

Gain on Sale of Investments Available-For-Sale

During the first quarter of 2007 we recorded a gain of $4,370,780 related to the sale of the remaining shares of our investment in Biofrontera.   During January 2007, we sold 50,000 shares of Biofrontera stock for proceeds of $644,000.  On February 15, 2007, we sold the remaining 373,324 shares of Biofrontera stock which were recorded as marketable equity securities available-for-sale on the Consolidated Balance Sheet.  These shares were sold for a total of 4,443,240 euros (approximately $5.9 million USD).  We have received 3,500,000 euros at September 30, 2007 and the remaining balance will be paid in the next few months.  

Settlement Expense

On September 13, 2006, we settled litigation with Lonnie Bookbinder who had claimed additional compensation from us.  In the settlement agreement, we agreed to issue 1.5 million shares of our common stock and pay $115,000 of cash to him.  We recorded a settlement expense of $133,000 during the third quarter of 2006.  

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Foreign Currency Gain (Loss)

During the three and nine months ended September 30, 2007, we recorded a foreign currency gains of $89,871 and $177,366, respectively.  During the three and nine months ended September 30, 2006, we recorded a foreign currency gains of $7,605 and $3,992, respectively.  The foreign currency amounts are related mainly to some transactions at our Canadian subsidiary, some note payable transactions that were in a foreign currency and a receivable from sale of investment that was in a foreign currency.

LIQUIDITY AND CAPITAL RESOURCES

General

During the nine months ended September 30, 2007, our operating requirements generated negative cash flow from operations as we continued to engage in testing and development of our products. Our cash used by operating activities for the nine months ended September 30, 2007 was $3,816,478.  We also had principal payments on capital lease obligations of $138,101 and purchases of computer equipment of $3,603.  The resulting cash shortfall was financed primarily through the sale of the Biofrontera investment which provided proceeds of $5,308,183.  We paid back $2,538,354 of notes payable which was financed by the sale of the Biofrontera shares.  The proceeds from common stock of $748,223, net of stock issuance costs resulted from the Dutchess puts and La Jolla exercise of some of their warrants.

Based upon our current plans, we will continue to focus on increasing market awareness of our products and developing sales for our currently available consumer products and genotyping services.

Although consumer products and genotyping services are cornerstones of our technology, our single largest opportunity remains applying our technology for the benefit of patients. Management has developed and has begun to implement a global strategy for our growth and development in the pharmaceutical market. Our strategy is to partner certain specialized tasks rather than create them internally. Developing a pharmaceutical product is a long, complex and diverse mission. It requires a multitude of diverse scientific expertise and technologies. This is complicated further by recent FDA promulgations that we believe will compel the pharmaceutical industry to develop genetic specific drugs that are more efficacious.

As discussed in the research and development expenses section above, we will continue to have increased research and development costs during 2007 and beyond.  See the discussion in the development expenses section above for the specifics of these costs and discussions of our current strategic alliances.

FINANCINGS

La Jolla Cove Convertible Debenture and Warrants

On November 25, 2003, we closed on a $500,000, 8% convertible debenture with non-detachable warrants with La Jolla Cove Investors, Inc. We pay interest on a monthly basis with a principal balloon payment due on the extended maturity date of November 25, 2007.  The number of common stock shares into which this debenture may be converted is equal to the dollar amount of the debenture being converted multiplied by sixteen, minus the product of the conversion price multiplied by fifteen times the dollar amount of the debenture being converted, and the entire foregoing result shall be divided by the conversion price. The conversion price is equal to the lesser of (i) $0.20 or (ii) 80% of the average of the five lowest daily value weighted average price of our common stock during the twenty trading days prior to La Jolla’s election to convert.   We have the right to reject a conversion if the stock price is below $0.50 per share.  If we exercise this right, we then are obligated to pay the portion of the debenture the conversion notice was for plus applicable unpaid accrued interest and a premium equal to 10% of those amounts.

The non-detachable warrants must be exercised concurrently with the conversion of debt to common stock by La Jolla. La Jolla has the right to exercise warrants equaling fifteen times the dollar amount of the debenture being converted at an exercise price of $1.00.  During the third quarter of 2007, DNAPrint and La Jolla agreed to the conversion of the La Jolla debt to common stock by La Jolla without any exercise of the warrants in order to facilitate the payment of the convertible debt which has a maturity date of November 25, 2007.

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Dutchess Default

We are in default of $4,380,758 of Dutchess Notes due to not making the minimum principal payments. The Dutchess documents purport to give Dutchess the right to charge us liquidated damages of up to 30% of the face amount of these notes.  Dutchess has not exercised this right at September 30, 2007 nor at the time this report was issued.  At September 30, 2007, we had accrued $1,729,500 for these potential liquidated damages.  This is an estimate based upon the maximum amount that Dutchess could charge us and this estimate may change with time.

Dutchess 2007 Investment Agreement

Effective March 30, 2007, we entered into an Investment Agreement and a Registration Rights Agreement with Dutchess Private Equities Fund, Ltd.  Pursuant to the Agreement, Dutchess committed to purchase our common stock up to an aggregate purchase price of $10 million over a five-year period. The Dutchess Agreement provides that, from time to time, we may deliver a notice to Dutchess. Such notices will state the dollar amount of common stock that we desire Dutchess to purchase subject to the limits in the Investment Agreement. Upon receipt of a put notice, Dutchess is obligated to purchase from us during the relevant pricing period shares having an aggregate purchase price equal to at our election, either: (A) Two hundred percent of the average daily volume (U.S. market only) of our common stock for the ten trading days prior to the applicable Put Notice Date, multiplied by the average of the three daily closing bid prices immediately preceding the Put Date, or (B) $600,000 times the average of the lowest closing bid prices of our common stock during the specified pricing period. Dutchess is obliged to purchase the dollar amount of common stock set forth in the notice at a purchase price equal to 93% of the lowest closing bid price of the common stock during the five trading days after the notice.

The obligation of Dutchess to purchase under the Dutchess Agreement is contingent upon us having an effective registration statement registering the resale of the shares by Dutchess. In addition, we are not permitted to provide a notice, and Dutchess is not obliged to purchase any shares, in the event that we do not have sufficient authorized shares available for purchase to fulfill such commitment.  

Sale of Biofrontera Shares

During February 2007, we reached an agreement to sell the remaining shares of Biofrontera stock. We are scheduled to receive 943,240 Euros through October 2007.  Approximately 40% of these proceeds are required to be used to pay on the Dutchess debt.

Overview

Our consolidated financial statements are prepared using accounting principles generally accepted in the United States of America applicable to a going concern, which contemplate the realization of assets and liquidation of liabilities in the normal course of business.   We have incurred losses since our inception, and have experienced and continue to experience negative cash flows from operations. In addition, we have a negative working capital of approximately $9,352,105 and accumulated deficit during the development stage of $38,792,673 at September 30, 2007, and will continue to have ongoing requirements for substantial additional capital investment to accomplish our business plan over the next several years.  Over the past few years, our operations have been funded through related party funding, sales of common and preferred stock, sales of investments, the issuance of notes, put notices to Dutchess Private Equities Fund, II, L.P (“Dutchess”), the issuance of convertible debentures and the conversion of the debenture into common stock and the related exercise of non-detachable warrants.

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We continue to experience some success generating operating revenues; however, we do not expect our revenue stream to be sufficient to cover costs of operations in the immediate future. We plan to raise additional capital for the research and development of our pharmacogenomics products.  We anticipate that the funding we expect to receive from the put notices to Dutchess, the proceeds from the sale of the Biofrontera equity investments and the minimum conversions of the outstanding debenture into common stock and the related exercise of the non-detachable warrants will fund our operating activities through 2007.  However, the rate of progression on the research and development will depend on our ability to raise additional capital.  Additionally, at September 30, 2007, we are in default of our notes payable with Dutchess and are delinquent on lease payments, certain payments on research and development agreements and certain accounts payable.   There can be no assurance that we will be able to raise additional capital or that the minimum conversions of the outstanding debenture into common stock and the related exercise of the non-detachable warrants will continue, and the put notices to Dutchess will be funded or that we will have the cash flow to meet our operating requirements.  We sold the Biofrontera shares that we owned and are scheduled to receive a total of €0.9 million (approximately $1.3 million USD) through October 2007. At September 30, 2007, the receivable from sale of investments was 43% of our total assets.  These factors, among others, indicate that we may be unable to continue as a going concern for a reasonable period of time.

We have issued securities, including our convertible debentures and our convertible preferred stock which was converted into our common stock. In addition, our Investment Agreements with Dutchess requires us, in order to raise capital from it, to sell our common stock to it at a continuously adjustable conversion price at a discount to the trading price of our common stock. As we draw down advances under the Investment Agreements with Dutchess and more of our common stock is sold pursuant thereto, the market price of our common stock could decrease significantly and make further advances impractical or impossible during time periods in which we may need to raise capital to fund our operations and market and sell our products and services. In addition, the issuance of our common stock upon exercise or conversion of our other securities may create a downward pressure on the market price of our common stock.

Implementing our plan of operations results in increased expenses for personnel, advertising, promotion, and the collateral materials associated with these plans. Availability of funding and sales growth will determine to what extent and how quickly these plans can be implemented. Costs will vary according to timing and level of commitment. To date, management has maintained a lower level of commitment in order to preserve liquidity.

We formed DNAPrint Pharmaceuticals, Inc., a wholly-owned pharmaceutical subsidiary focused on personalized medicine.  This new company will be focused on pharmacogenomics -- personalized medicine based on a patient's DNA.  To finance our pharmacogenomics products, we will also be seeking funding for DNAPrint Pharmaceuticals.

Capital Expenditures

At this time, during the remainder of 2007, we do not anticipate expending any additional monies on large capital expenditures.

Off-Balance Sheet Arrangements

As of September 30, 2007, we have no off-balance sheet arrangements.

ITEM 3.

CONTROLS AND PROCEDURES

(a) Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operations of our disclosure controls and procedures, as such term is defined in Rules 13a-1(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as of the end of the period covered by this report.  Based on our evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective such that the material information required to be included in our Securities and Exchange Commission (“SEC”) reports is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms relating to us and our consolidated subsidiary, and was made known to them by others within those entities, particularly during the period when this report was being prepared.

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(b) In addition, there were no significant changes in our internal control over financial reporting that could significantly affect these controls during the quarter.  We have not identified any significant deficiency or material weaknesses in our internal controls, and therefore, there were no corrective actions taken.

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PART II. OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

On October 27, 2003, DNAPrint Genomics, Inc. filed suit in the Circuit Court of the Twelfth Judicial Circuit of Florida in and for Sarasota County, Florida, Civil Division moving for an emergency order requiring impoundment of any and all computers and associated materials of one of our former employees. On October 28, 2003, the Circuit Court Judge granted the order. The order was carried out on the same day.

Our Complaint alleged that a former employee inappropriately took confidential company materials and then disclosed or threatened to disclose the information. The Complaint sought return of the property, a permanent injunction against further and future disclosures by the former employee, attorney's fees and related costs.

On December 19, 2003, the former employee filed an Answer, Affirmative Defenses, and Counterclaim with the Court generally denying the allegations of our claim. In addition, the Defendant counterclaimed, alleging breach of an Employment Agreement, based on a purported failure to pay certain health benefits, and stock options.

On January 9, 2004, the Court granted our Motion to Inspect, Examine and Download Information from the Impounded Computer, subject to certain limitations designed to protect the confidentiality of any information contained on the computer.

The Defendant withdrew his objection to our review of documents downloaded from his seized home computer. Based upon our review of the documents and report, we advised the Court that we believed these documents contained our confidential, proprietary and trade secret information. At that time the Court ordered a preliminary mediation to discuss resolution of the matter. We participated in the mediation, but did not reach a resolution with the Defendant. 

On August 22, 2007, a final order of dissolution of temporary injunction and dismissal of action with prejudice was executed.  This closed the matter with each party paying their own legal expenses. 

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES

During the third quarter of 2007, we issued 35,000,000 shares of common stock to Dutchess Private Equities Fund, II, L.P. in conjunction with the conversion of an incentive debenture into common stock.  The fair market value of the incentive debenture converted was $343,702.

On September 24, 2007, we granted Wall Street Group warrants to acquire 16,666,667 shares of common stock as consideration for Wall Street Group’s investor relation services.  The warrants have an exercise price of $0.006 per share and expire five years from the grant date. These warrants were valued at $94,852 based upon the Black Scholes Pricing Model.

During the third quarter of 2007, we issued to Arthur J. Sytkowski, a consultant, a total of 10,943,307 shares of our common stock in exchange for $74,868 we owed him for his consulting services.

During the third quarter of 2007, we issued to Mark Shriver, a consultant, a total of 7,500 shares of our common stock in exchange for $54 we owed him for his consulting services.

During the third quarter of 2007, we issued 5,399,026 shares of common stock in conjunction with the convertible debenture and warrants with La Jolla and received $6,686 of cash proceeds and converted $24,445 of convertible debentures.  

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The securities issued in the foregoing transactions were made in reliance upon Rule 506 of Regulation D under the Securities Act of 1933, as amended, by the fact that:

·

the sale was made to a sophisticated or accredited investor, as defined in Rule 502;

·

we gave the purchaser the opportunity to ask questions and receive answers concerning the terms and conditions of the offering and to obtain any additional information which we possessed or could acquire without unreasonable  effort or expense that is necessary to verify the accuracy of information furnished;

·

at a reasonable time prior to the sale of securities, we advised the purchaser of the limitations on resale in the manner contained in Rule502(d)2;

·

neither we nor any person acting on our behalf sold the securities by any form of general solicitation or general advertising; and

·

we exercised reasonable care to assure that the purchaser of the securities is not an underwriter within the meaning of Section 2(11) of the Securities Act of 1933 in compliance with Rule 502(d).

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

At September 30, 2007, we had notes payable in the amount of $4,380,758 to Dutchess that we were in default on due to the notes expiring.

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

NONE

ITEM 5.

OTHER INFORMATION

NONE

ITEM 6.

EXHIBITS

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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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