**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

# **Washington, DC 20549**

# ** **

#### **FORM 10-QSB**

 

| **ý**                                             | **Quarterly  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of  1934.**  |
|--------------------------------------------------------|------------------------------------------------------------------------------------------------------|
| ** **                                             | ** **                                                                                           |
| **For the Quarterly Period Ended  June 30, 2004** |
| ** **                                             | ** **                                                                                           |
| **or**                                                 |
| ** **                                             | ** **                                                                                           |
| **o**                                                  | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of  1934.** |

 

###### **Forthe Transition Period From       To      **

###### ** **

**Commission File Number: 001-31925**

 

**VASO ACTIVE PHARMACEUTICALS, INC.**

(Exact name of small business issuer asspecified in its charter)

 

| **Delaware**                                                    | ** ** | **02-0670926**                    |
|-----------------------------------------------------------------|------------|-----------------------------------|
| (State or other jurisdiction  of incorporation or organization) |       | (IRS Employer Identification No.) |
|                                                            |       |                              |
| **99 Rosewood Drive, Suite 260  Danvers, MA**                   | ** ** | **01923**                         |
| (Address of principal executive offices)                        |       | (Zip code)                        |

 

**Issuer’stelephone number: (978) 750-1991**

 

Check whether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (or forsuch 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 ýNo o

 

State the number of sharesoutstanding of each of the issuer’s classes of common equity, as of the latestpracticable date:

 
| Common stock, Class A, $0.0001 par value |   | 5,828,613 shares outstanding on  August 6, 2004 |
|------------------------------------------|--------|------------------------------------------------------|
| Common stock, Class B, $0.0001 par value |   | 4,500,000 shares outstanding on  August 6, 2004 |

 

 

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**VASO ACTIVE PHARMACEUTICALS, INC.**

 

**INDEX TO FORM 10-QSB**

 
| ** **                                                                                                       | ** **                | **Page  Number** |
|------------------------------------------------------------------------------------------------------------------|---------------------------|------------------|
| **PART I.**                                                                                                      | **FINANCIAL INFORMATION** | ** **       |
| ** **                                                                                                       | ** **                |
| ITEM 1 – Condensed Financial Statements (unaudited):                                                        |                      |
|                                                                                                             |                      |
| Condensed Balance Sheets as of  June 30, 2004 and December 31, 2003 (audited)                          | 3                         |
| Condensed Statements of Operations for the  Three and  Six-Month Periods Ended  June 30, 2004 and 2003 | 4                         |
| Condensed Statements of Cash Flows for the  Six-Month Periods Ended June 30, 2004 and 2003                  | 5                         |
| Notes to the Condensed Financial Statements                                                                      | 6                         |
|                                                                                                             |                      |
| ITEM 2  – Management’s Discussion and Analysis of Financial Condition and Results of  Operations       | 11                        |
|                                                                                                             |                      |
| ITEM 3  – Controls and Procedures                                                                           | 39                        |
|                                                                                                             |                      |
| **PART II**                                                                                                      | **OTHER INFORMATION**     | 39               |
| ** **                                                                                                       |                      |
| ITEM 1 – Legal Proceedings                                                                                  | 39                        |
| ITEM 2 – Changes in Securities                                                                              | 42                        |
| ITEM 6 – Exhibits and Reports on Form 8-K                                                                   | 43                        |
|                                                                                                             |                      |
| Signatures                                                                                                       | 44                        |

 

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**VASO ACTIVE PHARMACEUTICALS, INC.**

**CONDENSED BALANCE SHEETS**

 
| ** **                                                                                                                                                     | ** ** | **June 30,  2004** | ** ** | **December 31  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                     | ** ** | **(unaudited)**         | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                     |       |                    |       |                       |       |
| **Current assets:**                                                                                                                                            |       |                    |       |                       |       |
| Cash and cash equivalents                                                                                                                                      |       | $                       | 3,892,959  |                       | $          | 6,109,775 |   |
| Accounts receivable                                                                                                                                            |       | 309                     |       | 1,357                      |       |
| Inventory                                                                                                                                                      |       | 71,152                  |       | 60,826                     |       |
| Prepaid expenses                                                                                                                                               |       | 121,419                 |       | 145,684                    |       |
|                                                                                                                                                           |       |                    |       |                       |       |
| **Total current  assets**                                                                                                                                      |       | 4,085,839               |       | 6,317,642                  |       |
|                                                                                                                                                           |       |                    |       |                       |       |
| Property and equipment - net                                                                                                                                   |       | 4,700                   |       | —                     |       |
|                                                                                                                                                           |       |                    |       |                       |       |
|                                                                                                                                                           |       | $                       | 4,090,539  |                       | $          | 6,317,642 |   |
|                                                                                                                                                           |       |                    |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                  |       |                    |       |                       |       |
| **Current  liabilities:**                                                                                                                                      |       |                    |       |                       |       |
| Accounts payable                                                                                                                                               |       | $                       | 299,054    |                       | $          | 125,029 |   |
| Accrued compensation                                                                                                                                           |       | 41,625                  |       | 278,438                    |       |
| Other accrued expenses                                                                                                                                         |       | 263,662                 |       | 197,564                    |       |
| Due to parent company                                                                                                                                          |       | 32,514                  |       | 89,507                     |       |
|                                                                                                                                                           |       |                    |       |                       |       |
| **Total current  liabilities**                                                                                                                                 |       | 636,855                 |       | 690,538                    |       |
|                                                                                                                                                           |       |                    |       |                       |       |
| Commitments and contingencies (Note 1)                                                                                                                         |       | 200,000                 |       |                       |       |
|                                                                                                                                                           |       |                    |       |                       |       |
|                                                                                                                                                           |       | 836,855                 |       | 690,538                    |       |
| **Stockholders’  equity:**                                                                                                                                |       |                    |       |                       |       |
| Preferred stock - $0.0001 par value;  authorized 10,000,000 shares; issued and outstanding, none                                                               |       | —                  |       | —                     |       |
| Common stock - $0.0001 par value;  authorized 30,000,000 shares; issued and outstanding, 10,328,613  June 30, 2004; and 10,103,613 December 31, 2003 |       | 1,033                   |       | 1,011                      |       |
| Additional paid-in capital                                                                                                                                     |       | 8,093,656               |       | 7,305,565                  |       |
| Deferred compensation                                                                                                                                          |       | (213,979                | )          | —                     |       |
| Accumulated deficit                                                                                                                                            |       | (4,627,026              | )          | (1,679,472                 | )          |
|                                                                                                                                                           |       |                    |       |                       |       |
| **Total stockholders’  equity**                                                                                                                           |       | 3,253,684               |       | 5,627,104                  |       |
|                                                                                                                                                           |       | $                       | 4,090,539  |                       | $          | 6,317,642 |   |

 

See notes to the unaudited condensed financial statements.

 

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**VASO ACTIVE  PHARMACEUTICALS, INC.**

**UNAUDITED CONDENSED STATEMENTS OF OPERATIONS**

 
| ** **                                                        | ** ** | **Three-Month Period Ended June 30,** | ** ** | **Six-Month Period Ended June 30,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                        | ** ** | **2004**                                   | ** ** | **2003**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                        | ** ** | ** **                                 | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                                      |       | $                                          | 862        |                                     | $          | 51,810 |   | $ | 8,009 |   | $ | 81,674 |   |
| Cost of revenues                                                  |       | 39,853                                     |       | 30,043                                   |       | 45,628 |   | 44,901 |   |
| **Gross profit**                                                  |       | (38,991                                    | )          | 21,767                                   |       | (37,619 | ) | 36,773 |   |
|                                                              |       |                                       |       |                                     |       |   |   |   |   |
| Costs and expenses:                                               |       |                                       |       |                                     |       |   |   |   |   |
| Marketing, advertising and promotion                              |       | 10,595                                     |       | 46,660                                   |       | 76,849 |   | 63,046 |   |
| Management fee                                                    |       | 8,160                                      |       | 25,481                                   |       | 16,320 |   | 56,042 |   |
| Selling, general and administrative                               |       | 1,042,714                                  |       | 65,447                                   |       | 2,572,547 |   | 152,391 |   |
| Research and development                                          |       | 47,299                                     |       | —                                   |       | 142,466 |   | — |   |
| Stock based compensation                                          |       | 15,101                                     |       | —                                   |       | 124,134 |   | — |   |
|                                                              |       |                                       |       |                                     |       |   |   |   |   |
| Loss from operations                                              |       | (1,162,860                                 | )          | (115,821                                 | )          | (2,969,935 | ) | (234,706 | ) |
|                                                              |       |                                       |       |                                     |       |   |   |   |   |
| Other income (expense), net                                       |       | 18,895                                     |       | (11,922                                  | )          | 22,381 |   | (15,004 | ) |
|                                                              |       |                                       |       |                                     |       |   |   |   |   |
| **Net loss**                                                      |       | $                                          | (1,143,965 | )                                        | $          | (127,743 | ) | $ | (2,947,554 | ) | $ | (249,710 | ) |
|                                                              |       |                                       |       |                                     |       |   |   |   |   |
| Net loss per share - basic and diluted  (Note 2)                  |       | $                                          | (0.11      | )                                        | $          | (0.23 | ) | $ | (0.29 | ) | $ | (0.91 | ) |
|                                                              |       |                                       |       |                                     |       |   |   |   |   |
| Weighted average shares outstanding - basic  and diluted (Note 2) |       | 10,328,613                                 |       | 543,956                                  |       | 10,264,570 |   | 273,480 |   |

 

See notes to the unaudited condensedfinancial statements.

 

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**VASO ACTIVE  PHARMACEUTICALS, INC.**

**UNAUDITED CONDENSED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                   | ** ** | **Six-Month Period Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| **CASH FLOWS FROM  OPERATING ACTIVITIES:**                                   |       |                                     |       |   |   |
| Net loss                                                                     |       | $                                        | (2,947,554 | ) | $ | (249,710 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                     |       |   |   |
| Depreciation and amortization                                                |       | 522                                      |       | — |   |
| Stock-based compensation (Note 4)                                            |       | 124,134                                  |       | — |   |
| Inventory write-off                                                          |       | 38,871                                   |       | — |   |
| Commitments and contingencies (Note 1)                                       |       | 200,000                                  |       | — |   |
| Increase (decrease) in cash from change in:                                  |       |                                     |       |   |   |
| Accounts receivable                                                          |       | 1,048                                    |       | (6,538 | ) |
| Inventory                                                                    |       | (49,197                                  | )          | (16,854 | ) |
| Prepaid expenses                                                             |       | 24,265                                   |       | (380,424 | ) |
| Accounts payable                                                             |       | 174,025                                  |       | 126,920 |   |
| Accrued interest                                                             |       | —                                   |       | 15,004 |   |
| Accrued compensation                                                         |       | (236,813                                 | )          | (604 | ) |
| Other accrued expenses                                                       |       | 66,098                                   |       | — |   |
| Net cash used in operating activities                                        |       | (2,604,601                               | )          | (512,206 | ) |
|                                                                         |       |                                     |       |   |   |
| **CASH FLOWS FROM  INVESTING ACTIVITIES:**                                   |       |                                     |       |   |   |
| Purchase of property and equipment                                           |       | (5,222                                   | )          | — |   |
| Net cash used in investing activities                                        |       | (5,222                                   | )          | — |   |
|                                                                         |       |                                     |       |   |   |
| **CASH FLOWS FROM  FINANCING ACTIVITIES:**                                   |       |                                     |       |   |   |
| Issuance of Class A common stock                                             |       | 450,000                                  |       | — |   |
| Issuance of Class B commons stock to parent                                  |       | —                                   |       | 450 |   |
| Issuance of convertible notes (Note 1)                                       |       | 7,500,000                                |       |   |   |
| Repayment of convertible notes (Note 1)                                      |       | (7,500,000                               | )          | — |   |
| Net proceeds from issuance of 10%  convertible promissory notes              |       | —                                   |       | 500,000 |   |
| Due to/from parent company                                                   |       | (56,993                                  | )          | 346,867 |   |
| Net cash provided by financing activities                                    |       | 393,007                                  |       | 847,317 |   |
|                                                                         |       |                                     |       |   |   |
| **NET INCREASE IN  CASH AND CASH EQUIVALENTS**                               |       | (2,216,816                               | )          | 335,111 |   |
| ** **                                                                   |       |                                     |       |   |   |
| **CASH AND CASH  EQUIVALENTS, Beginning of period**                          |       | 6,109,775                                |       | — |   |
| ** **                                                                   |       |                                     |       |   |   |
| **CASH AND CASH  EQUIVALENTS, End of period**                                |       | $                                        | 3,892,959  |   | $ | 335,111 |   |
|                                                                         |       |                                     |       |   |   |
| **SUPPLEMENTAL  DISCLOSURES:**                                               |       |                                     |       |   |   |
| Interest paid                                                                |       | $                                        | —     |   | $ | — |   |

 

See notes to the unaudited condensedfinancial statements.

 

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**VASO ACTIVE PHARMACEUTICALS, INC.**

 

**NOTES TO UNAUDITED CONDENSEDFINANCIAL STATEMENTS**

 

**1.****              NATUREOF BUSINESS AND BASIS OF PRESENTATION**

 

***The Company***

 

Vaso Active Pharmaceuticals, Inc.(the “Company”) is anearly-stage company established for the purpose of commercializing, marketingand selling over-the-counter, or OTC, pharmaceutical products that incorporatethe vaso active lipid encapsulated (“VALE”) technology or proprietary PENtoCOREtechnology.  The patents covering theVALE technology are held by BioChemics, Inc. (“BioChemics”), a privately-ownedbiopharmaceutical company. While the Company considers the PENtoCORE technologyproprietary, it is not covered by patents. In February 2003, BioChemics granted the Company an exclusive,irrevocable, worldwide license to use and practice the VALE patents andPENtoCORE technology in order to commercialize, market and sell OTCpharmaceutical products.  At June 30, 2004, BioChemicsowned approximately 44% of theCompany’s combined classes of issued and outstanding common stock and 70% ofthe voting power of the Company’s combined classes of common stock.

 

TheCompany began its operations in January 2001, as a division of BioChemics,a biopharmaceutical company engaged in the development of transdermal andtopical drug delivery systems. In January 2003, the Company incorporatedin Delaware and became an independent subsidiary of BioChemics, focused on thefurther commercialization of its existing OTC products and the development ofnew OTC product candidates.

 

BioChemics providesthe Company with certain management and administrative services includingaccounting, corporate services, data processing, telephone, office space andother corporate services and infrastructure. The financial statements of theCompany include expense allocations on bases that the Company and BioChemicsconsider to be reasonable reflections of the utilization of services providedfor the benefit received by the Company. In addition, for the three andsix-month periods ended June 30, 2003, the Company’s marketing,advertising and promotion expenses include expenses related to thecommercialization, marketing and distribution of BioChemics’ athlete’s footpreparation product, then called deFEET, the revenues of which are realized bythe Company through an assignment of BioChemics’ ownership interests in suchrevenues.

 

The Company has alimited operating history and has incurred net losses since its inception. TheCompany’s principal risks are the possibility of a material adverse effect fromthe actions and risks summarized under “Recent Events” and “Risk Factors”sections of this Quarterly Report on Form 10-QSB.

 

The accompanying unaudited financial statements have been prepared onthe same basis as the annual financial statements included in the Company’sAnnual Report on Form 10-KSB/A filed with the United States Securities andExchange Commission or SEC for the period ended December 31, 2003. In theopinion of management, all significant adjustments, which are normal, recurringin nature and necessary for a fair presentation of the financial position, cashflows and results of the operations of the Company, have been consistentlyrecorded. The operating results for the interim periods presented are notnecessarily indicative of expected performance for the entire year.

 

Certain amounts from the prior year have been reclassified to conformto the current year presentation.

 

Theunaudited information should be read in conjunction with the audited financialstatements of the Company and the notes thereto for the year endedDecember 31, 2003 included in the Company’s Annual Report on Form 10-KSB/Afiled with the SEC for that period.

 

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***Initial Public Offering***

 

OnDecember 15, 2003, the Company completed an initial public offering of1,667,500 shares of Class A common stock (5,002,500 shares on a post-splitbasis – please see “Stock Split” below) at a price of $5.00 per share ($1.67 ona post-split basis) raising approximately $6.4 million, net of issuancecosts.

 

***Stock Split***

 

OnFebruary 20, 2004, the Company announced a three-for-one stock split onall classes of common equity in the form of a 200% stock dividend paid onMarch 5, 2004 to stockholders of record on February 23, 2004.  Except where otherwise noted, all share andper share information contained in this Quarterly Report on Form 10-QSB havebeen adjusted to reflect the results of this dividend.

 

***RecentEvents***

 

***SEC and FDA Regulatory Matters.***The Company has agreed with the SEC tosettlement terms of a proposed action to be filed by the SEC, without admittingor denying the proposed allegations of the civil complaint, pursuant to whichthe Company will be permanently enjoined from violating certain of theanti-fraud provisions of the Securities Act of 1933, or the Securities Act, andthe Securities and Exchange Act of 1934, or the Exchange Act.  The SEC’s proposed complaint will allege thatthe Company’s registration statement in respect of the Company’s initial publicoffering, the Company’s annual report for 2003 and a statement on the Company’swebsite were false and misleading as a result of statements and omissionsconcerning the FDA approval or qualification of the Company’s products.  The Company expects that the settlement willbe formally approved by the SEC soon and will be presented to a court forapproval shortly thereafter.  Inaddition, the Company’s President and Chief Executive Officer has agreed tosettle a similar proposed action by the SEC against him, without admitting ordenying the proposed allegations of the civil complaint, that would similarlyenjoin him and prevent him from serving as an officer or director of any publiccompany, including the Company, for a period of five years.  If Mr. Masiz is barred from serving asan officer and director of the Company for this five-year period, he will bepermitted and intends to continue to be an active employee of the Company. The Company expects that the President andChief Executive Officer’s settlement will also be formally approved by the SECsoon and will be presented to a court for approval shortly thereafter.

 

Due to the ongoing nature of these matters, the Company is unable to definitively assess their impact, nor is itaware if the FDA is contemplating any action against it.  However, the Company has committed not tomarket or sell its products until all outstanding matters have been addressedto the satisfaction of the SEC and until the Company is reasonably sure thatthe marketing and sale of its products is consistent with the FDA’srequirements and policies.  Thiscommitment may have a material adverse impact on the Company. When appropriate,the Company will make additional public announcements and will file publicreports with the SEC regarding the status of its products under applicable FDAregulations.

 

***Nasdaq******Stock Market Matters.*** By letter dated April 2, 2004, the NasdaqListing Investigations department of The Nasdaq StockMarket, Inc. (“Nasdaq”) notified the Company that it had commenced an inquiryto ensure the Company’s ongoing compliance with Nasdaq’s inclusion requirementsand requested certain information from the Company.  The letter further disclosed that afterreview of the information provided by the Company, Nasdaqcould take any action that might be appropriate under its Marketplace Rulesincluding removal of the Company’s securities from Nasdaq.  In view of the substantial administrative andcash burdens being borne by the Company at that time and the substantial legalcosts anticipated with respect to the SEC and FDA matters, the Companydetermined that it was in the best interest of its shareholders to voluntarilycause its shares to be removed from Nasdaq and focus its attention andresources on addressing the SEC and FDA concerns.  The Company’s securities were voluntarilydelisted, effective the opening of the markets on Thursday, April 8, 2004.  At an appropriate time, the Company will seekto cause its securities to be quoted on an exchange, Nasdaqor

 

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other automated quotation system.   No estimate can be given as to the date whenthe Company’s securities will resume trading on a national exchange orautomated securities quotation system, if ever.

 

***Litigation.*******  In April,May, and June 2004, the Company and certain of its officers were sued inseveral purported securities class action lawsuits filed in the United StatesDistrict Court for the District of Massachusetts.  The complaints, which seek equitable andmonetary relief, an unspecified amount of damages, with interest, attorneysfees and costs, allegedly were filed on behalf of purchasers of the Company’sClass A common stock during the period December 11, 2003 to March 31,2004 and allege that during that period, the defendants violated the federalsecurities laws by allegedly failing to make accurate and complete disclosuresconcerning the Company, its financial condition, its business operations andfuture prospects, the clinical trial and endorsement of the Company’s Termin8anti-fungal product (previously known as “deFEET”) and the institutional demandfor the Company’s securities.  Thesecomplaints are captioned as follows:  DennisE. Smith v. Vaso Active Pharmaceuticals, Inc., *et al.*,Civ. No. 04-10708 (RCL) (D. Mass.); Richard Shapiro v. Vaso ActivePharmaceuticals, Inc., *et al.*,Civ. No. 04-10720 (RCL) (D. Mass.); Christopher Pepin v. Vaso ActivePharmaceuticals, Inc., *et al.*,Civ. No. 04-10763 (RCL) (D. Mass.); Modhi Gude, *et al.*v. Vaso Active Pharmaceuticals, Inc., *et al.*,Civ. No. 04-10789 (RCL) (D. Mass.); Kim Benedetto, *et al.*v. Vaso Active Pharmaceuticals, Inc., *et al.*,Civ. No. 04-10808 (RCL) (D. Mass.); DeanDummer v. Vaso Active Pharmaceuticals, Inc., *et al.*, Civ. No. 04-10819 (RCL) (D. Mass.); Edward Tovrea v. Vaso ActivePharmaceuticals, Inc., *et al.*, Civ.. No. 04-10851 (RCL); Kourosh Alipor v. Vaso ActivePharmaceuticals, Inc., *et al.*,Civ. No. 04-10877 (RCL); Paul E.Bostrom v.Vaso Active Pharmaceuticals, Inc., *et al.*,Civ. No. 04-10948 (RCL); Ira A.Turret Sep-Ira Dated 01/24/02 v. Vaso Active Pharmaceuticals, Inc., *et al.*, Civ. No. 04-10980 (RCL); Richard Pagona v. Vaso Active Pharmaceuticals, Inc., *et al.*, Civ. No. 04-11100 (RCL); James Karanfilian v. Vaso Active Pharmaceuticals, Inc., *et al.*, Civ. No. 04-11101 (RCL); and Charles Robinson v. Vaso Active Pharmaceuticals,Inc., *et al.*, Civ. No. 04-11221 (RCL).  TheCourt has consolidated the above-referenced cases, other than the Tovreaand Karanfilian complaints, under the caption In Re Vaso ActivePharmaceuticals Securities Litigation, Civ. No. 04-10708 (RCL).

 

The Company has also been named as a nominaldefendant in two shareholder derivative actions filed, the first filed in theUnited States District Court for the District of Massachusetts in April 2004against its directors and certain of its officers and against BioChemics, Inc.entitled Joseph Rosenkrantz v. BioChemics, Inc., *et al.*, Civ. No. 04-10792 (RCL) (D. Mass.) and thesecond filed in June 2004, also against the Company’s directors and certain ofits officers and against BioChemics, Inc. entitled William Pomeroy v.BioChemics Inc., *et al.*,  Civ. No. 04-11399 (RCL) (D. Mass.). Thecomplaints allege, among other things, that the alleged conduct challenged inthe securities cases pending against the Company in Massachusetts (describedabove) constitutes a breach of the defendants’ fiduciary duties to theCompany.  The complaints seek equitableand monetary relief, an unspecified amount of damages, and attorneys and otherfees, costs and expenses, ostensibly on behalf of the Company. On July 28,2004, the parties filed a joint motion requesting that the Court consolidatethese actions and establish a procedure for consolidation of any subsequentlyfiled derivative related case; appoint Co-Lead and Liaison Counsel forplaintiffs; stay all pretrial proceedings in these actions and any relatedactions until the earlier of (a) the resolution of any motion to dismiss filedin the above-referenced consolidated securities fraud litigation, or (b) thefiling of answers by all defendants in the same matter; and acknowledgedefendants’ acceptance of service of the Pomeroy and Rosenkrantz complaints.  The Court has not ruled on this motion.

 

Although the Company intends to vigorously defendagainst these cases, the litigation process is inherently uncertain and therecan be no guarantee as to the ultimate outcome of these matters.  There is also no guarantee that these will bethe only lawsuits brought against the Company with respect to these matters.

 

Because of the uncertainty of estimating the potential financialstatement impact of any of these actions with any reasonable degree ofaccuracy, at this time the Company has not reserved for any potential liabilityor costs that may arise as a result of this litigation except for $200,000recorded on March 31, 2004, which represents the insurance deductible thatthe Company cannot expect to recover. While the cases are in very preliminary stages and the outcomes are notpredictable, if a substantial amount is payable by the Company and is

 

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not reimbursed through its director andofficer liability insurance policy, this will have a material adverse effect onthe Company’s financial position and liquidity. On August 3, 2004, the Company’sinsurer notified the Company in writing that, based on its coverage evaluation,it intends to reject liability to reimburse the Company with respect to any ofthe claims asserted in any of the above-described litigation against theCompany or its officer or directors for a substantial majority of the policycoverage and that it may seek to rescind the policy with respect to the balanceof the policy coverage.  The Companyintends to vigorously contest the insurer’s positions.

 

***Unwinding of March 16,2004 Private Investment in Public Equity***.  On March 16, 2004, the Company enteredinto a private placement transaction in the amount of $7,500,000 with aninstitutional investor.  The investmentwas in the form of an 18-month 2% Convertible Note, or Note, convertible intoshares of the Company’s Class A common stock at a conversion rate of $9 pershare, at the option of the investor.  Inaddition, the Company issued to the investor warrants to purchase 166,667shares of Class A common stock at an exercise price of $8.75 per share.

 

Given the initiation and continuation of the April 1, 2004 tradingsuspension by the SEC constituted a breach under the Note, the Company and theinvestor agreed, pursuant to the terms of a settlement agreement entered intoon April 8, 2004, that the Company would immediately repay the investorthe sum of $7,500,000 in cash without penalty, interest, redemption premium orany other premium or penalty, plus an expense reimbursement in connection withthe settlement agreement in the amount of $15,000 in cash.   In consideration of this repayment, theinvestor surrendered the Note and warrants and the parties mutually terminatedall other agreements entered into in connection with the transaction.

 

In connection with this transaction, on March 16, 2004 the Companypaid approximately $600,000 in fees to various third parties.  These fees were not refunded when the Companyrepaid the investor and, accordingly, have been recorded as expense as ofMarch 16, 2004 and are included in the expense caption “selling, generaland administrative” for the six-month period ended June 30, 2004.

 

**2.****              NET LOSS PER SHARE**

 

Basic net loss per share is computed by dividing net loss by theweighted average number of common shares outstanding for the period.  Diluted net loss per share reflects, inaddition to the weighted average number of common shares, the potentialdilution if stock options and warrants outstanding were exercised and/orconverted into common stock, unless the effect of such equivalent shares wasantidilutive.

 

For the three and six-month periodsended June 30, 2004, the effect of stock options and other potentiallydilutive shares were excluded from the calculation of diluted net loss percommon share as their inclusion would have been antidilutive.

 

On a pro forma basis, net loss pershare (basic and diluted) would have been $0.03 and $0.05, respectively for thethree and six-month periods ended June 30, 2003. This pro forma loss pershare was calculated as if (i) the 4,500,000 shares of Class B common stockwhich were issued to BioChemics in June 2003 had been issued to BioChemicson January 1, 2003, and (ii) the 10% convertible promissory notes whichwere issued in April 2003 and converted into 601,113 shares of Class Acommon stock in December 2003 had been converted into 601,113 shares ofClass A common stock on January 1, 2003.

 

**3.****              REVENUE RECOGNITION**

 

The Company recognizes revenue from product sales in accordance withgenerally accepted accounting principles in the United States, including theguidance in Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition,”which supercedes SAB No. 101, “Revenue Recognition in Financial Statements,”and Statement of Financial Accounting Standards (“SFAS”) No. 48, “RevenueRecognition When Right of Return Exists.”

 

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Revenue from product sales is recognized when there is persuasiveevidence of an arrangement, delivery has occurred, the price is fixed anddeterminable, and collectibility is reasonably assured. However, because theCompany’s products are sold with limited rights of return, revenue isrecognized when the price to the buyer is fixed, the buyer is obligated to paythe Company and the obligation to pay is not contingent on resale of theproduct, the buyer has economic substance apart from the Company, the Companyhas no obligation to bring about the sale of the product and the amount ofreturns can be reasonably estimated.

 

The Company records allowances for product returns, rebates anddiscounts, and reports revenue net of such allowances. The Company must makejudgments and estimates in preparing the allowances that could requireadjustments in the future. For instance, customers have the right to return anyproduct that is held past the labeled expiration date. The Company bases itsestimates on historic patterns of returns and on the expiration dates ofproduct currently being shipped, or as a result of an actual event that maygive rise to a significant return amount such as the discontinuance of aproduct.

 

The Company does not recognize revenue unless collectibility isreasonably assured. The Company maintains allowances for doubtful accounts forestimated losses resulting from the inability of its customers to make requiredpayments. If the financial condition of our customers were to deteriorate andresult in an impairment of their ability to make payments, additionalallowances may be required.

 

**4.****              STOCK-BASEDCOMPENSATION**

 

TheCompany accounts for stock-based employee compensation arrangements using theintrinsic value method in accordance with Accounting Principles Board Opinion(“APB”) No. 25, “Accounting for Stock Issued to Employees,” and complieswith the disclosure provisions of SFAS No. 123, “Accounting forStock-Based Compensation.” Under the intrinsic value method, compensation associated with stockawards to employees is determined as the excess, if any, of the current fairvalue of the underlying common stock on the date compensation is measured overthe price an employee must pay to exercise the award. The Company accounts forstock options and awards to non-employees using the fair -value method.

 

TheCompany has an employee stock incentive plan and a non-employee directorcompensation plan, which are described more fully in Note 6 to theCompany’s Annual Report on Form 10-KSB/A for the period ended December 31,2003.

 

Thefollowing table illustrates the effect on net loss and net loss per share ifthe Company had applied the fair-value recognition provisions of SFASNo. 123, as amended, to options granted under the stock option plans andrights to acquire stock granted under the Company’s stock option plans. Forpurposes of this *pro-forma* disclosure, the valueof the options is estimated using a Black-Scholes option pricing model andamortized ratably to expense over the options’ vesting periods. Because theestimated value is determined as of the date of grant, the actual valueultimately realized by the employee may be significantly different.

 

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| ** **                                                                  | ** ** | **Three-Month  Period Ended  June 30, 2004** | ** ** | **Six-Month  Period Ended  June 30, 2004** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------|------------|
|                                                                        |       |                                              |       |                                            |       |
| Net loss, as reported                                                       |       | $                                                 | (1,143,965 | )                                               | $          | (2,947,554 | ) |
| Add: stock-based compensation included in  the determination of net loss    |       | 15,101                                            |       | 124,134                                         |       |
| Less: stock-based compensation had all  options been recorded at fair value |       | (121,129                                          | )          | (623,043                                        | )          |
| Adjusted net loss                                                           |       | $                                                 | (1,249,993 | )                                               | $          | (3,455,463 | ) |
|                                                                        |       |                                              |       |                                            |       |
| Weighted average shares outstanding, basic  and diluted                     |       | 10,328,613                                        |       | 10,264,570                                      |       |
| Net loss per share, basic and diluted, as  reported                         |       | $                                                 | (0.11      | )                                               | $          | (0.29 | ) |
| Adjusted net loss per share, basic and  diluted                             |       | $                                                 | (0.12      | )                                               | $          | (0.34 | ) |

 

**ITEM 2.****                                                     MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Management’s Discussion and Analysis of Financial Condition and Resultsof Operations should be read together with our unaudited condensed financialstatements and related notes included elsewhere in this Quarterly Report onForm 10-QSB. This Quarterly Report on Form 10-QSB, including thefollowing discussion, contains trend analysis and other forward-lookingstatements within the safe harbor provisions of the Private SecuritiesLitigation Reform Act of 1995. Any statements in this Quarterly Report onForm 10-QSB that are not statements of historicalfacts are forward-looking statements. These forward-looking statements arebased on a number of assumptions and involve risks and uncertainties. Actualresults may differ materially from those set forth in such forward-lookingstatements as a result of factors set forth elsewhere in this Quarterly Reporton Form 10-QSB, including under “Risk Factors.”

 

**Overview**

 

*** Formation***

 

We began our operations in January 2001 as a division ofBioChemics, a biopharmaceutical company engaged in the development oftransdermal and topical drug delivery systems. In January 2003, weincorporated in Delaware and became an independent subsidiary of BioChemics,focused on the further commercialization of our existing OTC products and thedevelopment, through BioChemics and other potential collaboration partners, ofnew OTC product candidates. We continue to rely on BioChemics to provide us withadministrative support services, manufacturing and product development servicesand VALE and PENtoCORE technology licenses.

 

On December 15, 2003, we completed an initial public offering of1,667,500 shares of our Class A common stock(5,002,500 on a post-split basis) at a price of $5.00 per share ($1.67 on apost-split basis), raising approximately $6.4 million, net of issuancecosts. Effective March 5, 2004, we completed a 200% stock dividend toholders of record of both our Class A and B common stock on February 23,2004. Except where noted, all share and per share information contained in thisQuarterly Report on Form 10-QSB have been adjusted to reflect the effectsof this dividend.

 

* **Technology***

 

Transdermaldrug delivery is generally considered to be any process of delivering drugsthrough the skin and into the bloodstream without the use of an invasiveinstrument such as a needle.  Transdermaldrug delivery

 

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offers potential advantages over other commonlyaccepted modes of drug delivery for the treatment of certain diseases andmedical conditions.  We believe thatthese potential advantages include:

 

•                  **Reduction of Route-of-Administration Related Side Effects**. Because they are absorbed through the stomach, some orally administeredmedicines can cause significant gastrointestinal side effects, sometimesleading to discontinuation of the medication. There also may be side effectsassociated with the delivery of some drugs through the nasal lining, the lungs,and the skin using traditional methods. The goal of the VALE transdermal delivery system is to provide effectivetherapy while minimizing side effects.

 

•                  **Improved Drug Performance**.  Transdermalformulations may have the potential to improve the effectiveness of a drug byavoiding the stomach and the first-pass metabolism associated with oraldelivery of drugs. Transdermal drug delivery also may have the potential tocreate a higher bioavailability index for drugs, allowing for the desiredconcentration of the drug molecule to reach the bloodstream from a smaller doseof drug applied to the patient.

 

Thereare many different technologies used to deliver drugs transdermally. The mostcommon technologies employed are: (i) patches that adhere to the skin,holding a drug in place while it is administered over time; (ii) liposome,or artificially prepared cell-like structures, which are applied topically andabsorbed; or (iii) an outside energy source producing electricity,otherwise known as iontophoresis, or sound, otherwise known as sonophoresis, tohelp move the drug through the various skin layers. We believe all three ofthese technologies have certain drawbacks that may limit their utility.

 

Our products utilize formulation technologies that we believe can beapplied to a significant array of currently off-patent drugs forcommercialization in the OTC marketplace. The VALE technology is a transdermalformulation that we believe may have the potential to introduce drugs throughthe skin and into the bloodstream in an efficient and effective manner.  The PENtoCORE technology is a topicalformulation that we believe allows for the formation of OTC products withcertain “use advantages” over competitors. “Use advantages” includecharacteristics such as odor, residue, and feel.

 

The goal behind the development of the VALE technology system is tocreate an active transdermal drug system that efficiently and effectivelydelivers drugs through the skin and into the blood supply without the need of apatch.  In order to accomplish this, adelivery system must be able to overcome three skin barriers:

 

•                                          the skin’s outer layer, or epidermis;

 

•                                          the second layer, the dermis, which is composed ofconnective tissue, glands and hair; and

 

•                                          the walls of individual capillaries, tiny, thin-walled bloodvessels that transport blood to the larger veins and arteries of the body.

 

The VALE system is intended to be a patchless, lipid-based deliverysystem which uses an active process to deliver drugs through the skin and intothe bloodstream.  It is being developedaround the unique concept of incorporating chemical vasodilators into the drugdelivery vehicle. These chemical compounds are intended to act on the networkof blood vessels located near the surface of the skin to elicit the physiologicresponse of dilating or relaxing the blood vessels in the immediate area.  This, in turn, is designed to have the effectof increasing the blood flow to the area. The theory behind the VALE system is that as blood flow increases and theblood vessels dilate, the active drug molecules incorporated into the deliverysystem are transported actively and efficiently into the bloodstream.

 

We believe that the VALE technology has the potential to eliminate theneed for a patch and to allow for the effective delivery of many activeingredients that may not otherwise be effectively delivered using existing drugdelivery technologies.

 

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The PENtoCORE technology is a topical formulation, as opposed to the VALE  transdermaltechnology.  Although the PENtoCOREtechnology does not achieve its effect by delivering the drug through the skinand into the bloodstream, we believe that this technology may enable theformulation of topical products that are pleasant to use because they do nothave the odor, greasy feel or residue often associated with othertopically-applied drug products.  Inaddition, it may be possible to use the PENtoCORE technology with certain activeingredients to develop topical formulations that facilitate a longer-lastingeffect.

 

***Manufacturing andDevelopment Agreement***

 

In February 2003, we entered into a manufacturing and developmentagreement with BioChemics with respect to the ongoing manufacturing anddevelopment of our products and product candidates. Under this agreement,BioChemics will research, develop and manufacture products for us pursuant tospecific purchase orders submitted by us from time to time. BioChemics willcharge us a development and manufacturing fee at a rate of cost plus 10%. Thedevelopment and manufacturing agreement permits BioChemics to use third partycontractors to manufacture the products that BioChemics provides to us.Currently, BioChemics uses a privately owned third party company as its solecontract manufacturer. We do not currently, nor do we intend to, engage in themanufacturing of, nor conduct any research and development with respect to, anyof our products or product candidates. However, in the event that BioChemics is unwilling or unable to meet ourmanufacturing needs in accordance with the terms of its manufacturing anddevelopment agreement with us, we have the right to retain outside thirdparties to manufacture our products. Pursuant to this agreement, during the three and six-month periods endedJune 30, 2004 we incurred research and development costs of  $47,299 and$142,466 respectively related to the formulation of an analgesic utilizing theactive ingredient ibuprofen. Pre-clinical studies utilizing animals were conducted and billed as partof this research.

 

***Administrative and Managerial Support***

 

Since BioChemics provides us with administrative and managerialsupport, our results of operations include allocations of certain BioChemicsexpenses, such as centralized accounting, data processing, utilities, officespace rental, supplies, telephone and other BioChemics corporate services andinfrastructure. These expenses have been charged back to us as a managementfee. We recorded $16,320 and $56,042 in these related-party fees in thesix-month periods ended June 30, 2004 and 2003, respectively. In addition,during the six-month period ended June 30, 2003, BioChemics providedfinancing to us in the amount of $369,506 to fund our operating losses incurredduring that six-month period as well as fund the up front costs of a privateplacement closed in May 2003, see discussion under “Liquidity and CapitalResources”.  This amount was reimbursedto BioChemics as a portion of the amount paid to BioChemics upon the closing ofour initial public offering in December 2003. The expense allocations havebeen determined on the basis that we and BioChemics consider to be reasonablereflections of the utilization of services provided for the benefit received byus.

 

Effectiveof September 1, 2003, we entered into an administrative services agreementwith BioChemics. Under this agreement, BioChemics provides to us, at ourrequest, administrative support services including secretarial support,accounting and tax services, data processing services, utilities, designatedoffice space, designated warehouse and storage space, office supplies,telephone and computer services and equipment and such other office andcorporate support services as we may reasonably require from time to time.BioChemics will charge us an administrative services fee at a rate of cost plus10%. This agreement is in effect for an initial term of 5 years and will beautomatically renewable on each anniversary date for an additional period of 12months unless sooner terminated (i) for a material breach by us, not curedwithin three months, and upon written notice (ii) upon 30 dayswritten notice by us, (iii) upon 45 days written notice by eitherparty if BioChemics ceases to own beneficially shares of our capital stock towhich are attached at least 49% of the votes that may be cast to elect ourDirectors, or (iv) upon written notice by either party in the event thatwe shall have disposed of all or substantially all of our assets.

 

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***GovernmentRegulation***

 

***General***The development, testing, manufacture, labeling, marketing, and promotion ofOTC drugs are subject to extensive regulation by the FDA under the FederalFood, Drug and Cosmetics Act, or FFDCA, and by the Federal Trade Commission, orFTC, under the Federal Trade Commission Act, or FTC Act.

 

The degree of regulation under the FFDCA is dependent, in part, uponwhether the OTC drug, as formulated, labeled, and promoted, is considered byqualified experts, based on publicly available scientific data and information,to be generally recognized as safe and effective, or GRASE, for its recommendedconditions of use.  If an OTC drug asformulated, labeled, and promoted is not considered GRASE for its recommendedconditions of use or, if so considered, if it has not been used to a materialextent or for material time, the drug is regulated under the FFDCA as a “newdrug” which requires pre-market approval in the form of a New Drug Application,or NDA, before it can be commercially marketed.

 

To determine which OTC drugs are GRASE, the FDA has undertaken arulemaking initiative in which it seeks to define by regulation which OTC drugscan be considered to be GRASE and thus can be marketed without first obtainingan approved NDA.  This rulemakinginitiative, referred to as the “OTC Review Program,” was initiated on May 11,1972, and is ongoing.  The OTC ReviewProgram sets forth in the form of an OTC Drug Monograph for specific categoriesof OTC drugs (e.g., Topical Anti-Fungal OTC drugs) the conditions under whichrecognized OTC active ingredients can be considered GRASE and notmisbranded.  These conditions include thestrength of the active ingredient, acceptable dosage forms, the use of safe andsuitable inactive ingredients, and the recommended conditions of use, includingindications, warnings, precautions, and directions for use.

 

If the active ingredient used in an OTC drug is not covered by the OTCReview Program, or even if it is covered, if the conditions of use (e.g.,strength, dosage form, indications) deviate from that eligible for GRASE statusunder the OTC Review Program, the product is considered by the FDA to be a “newdrug” subject to the NDA pre-market approval requirements.  For a full discussion of these requirementssee the discussion below in “NDA Review Process”.

 

Pending the issuance of a final and effective OTC Drug Monograph forthe category of OTC drug involved (e.g., external analgesic), the FDA hasadopted an enforcement policy of not proceeding against the continued marketingof OTC drugs subject to the OTC Review Program. This enforcement discretion does not, however, apply if: (a) the FDAconsiders the drug product involved as falling outside of the scope of the OTCReview Program in that the active ingredient or conditions of use deviate fromthose eligible for GRASE status under the OTC Review Program; (b) the productpresents a health hazard; or (c) the active ingredient at the dosage levelinvolved was not available OTC prior to December 4, 1975.  The FDA’s willingness to defer enforcementaction generally terminates upon the effective date of the final OTC DrugMonograph covering the applicable drug product.

 

Other requirements or limitations for OTC drugs imposed under the  FFDCA include: (a) a requirement that thedrug be manufactured in conformity with current good manufacturing practices,or cGMPs; (b) a requirement that the labeling for the product contain adequatedirections for use and warnings; (c) a requirement that the manufacturer of thedrug product register with the FDA; (d) a requirement that all drugsmanufactured for commercial distribution be listed with the FDA; and (e) aprohibition against making any false or misleading misrepresentations in anyparticular in any labeling for the product. As noted above,   OTC productsmarketed in accordance with OTC Drug Monographs do not require FDA premarketapproval prior to marketing.  If an OTCproduct deviates from an OTC Drug Monograph requirement in activeingredient(s), intended use, method of administration, dosage form, orlabeling, among other things, then the manufacturer or distributor must obtainpre-market approval in the form of an NDA before commercial marketing.

 

The failure to adhere to the requirements of the FFDCA can result in:(a) seizure of violative products; (b) injunctions against continued violationsof the FFDCA, including active FDA supervision in instituting

 

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appropriate corrective action and prohibition against continuedmarketing of the violative products pending an affirmative determination by theFDA and the courts that the violations have been adequately rectified; (c)civil penalties in the form of liquidated damages and/or recovery of profitsfrom illegal activities; and (d) the imposition of criminal sanctions andpenalties against responsible persons.

 

The FTC, under the FTC Act, regulates print and broadcast mediaadvertisements for OTC drugs.  The FTCAct requires that advertisements be neither false nor misleading and thatclaims for products purportedly based on scientific data be supported byadequate and well controlled studies and that a reasonable basis exists insupport of all other claims.  Claimsconsistent with the terms of an OTC Drug Monograph are usually accepted by theFTC as having been adequately substantiated. The penalties for the failure of an advertised claim to have adequatesubstantiation, or for claims that are false and misleading, include: (a) theFTC initiating administrative action for consumer redress; (b) FTC seeking acourt injunction to prevent further false and misleading advertising; (c) theimposition by a court of liquidated damages and equitable relief to recoverprofits and provide consumer redress from illegal activity; and (d) the placingof the company in receivership to assure that the assets of the company are notdissipated pending resolution of FTC claims.

 

***The NDA ReviewProcess*** The FDA has taken the position thatinsofar as our products or product candidates use a transdermal technology, theproducts fall outside that eligible for GRASE status under the OTC ReviewProgram and thus the Company must obtain NDA approval of the products beforethey can be commercially marketed.  Underthe FDA’s procedures it is generally less burdensome to obtain NDA approval ofa drug product which contains active ingredient(s): (a) considered GRASE in afinal OTC Drug Monograph, or (b) contained in a drug product eligible for anabbreviated new drug application, or ANDA, approval, but which differs incertain conditions of use (e.g., dosage form) from that covered by a final OTCDrug Monograph or eligible for ANDA approval. However, once a product becomes subject to the NDA requirements, thegeneral provisions of which are set forth below, there can be no assurance thata company can generate the additional data and information necessary to supportNDA approval of the proposed variant product or that approval can be obtainedwithout substantial expenditures and delays.

 

The steps ordinarily required before a new drug that is subject to NDAapproval may be marketed in the United States include preclinical laboratorytests, animal tests and formulation studies, the submission to the FDA of aninvestigational new drug application, or IND, which must become effectivebefore clinical testing may commence, and adequate and well-controlled clinicaltrials on human subjects to establish the safety and effectiveness of the drugfor each indication for which FDA approval is sought.  Satisfaction of FDA pre-market approvalrequirements typically takes several years and the actual time required mayvary substantially based upon the type, complexity and novelty of the productor the disease or condition for which the new drug is indicated.  Government regulation may delay or preventmarketing of potential products for a considerable period of time and imposecostly procedures upon a manufacturer’s activities.  Success in early-stage clinical trials doesnot assure success in later stage clinical trials.  Data obtained from clinical activities is notalways conclusive and may be susceptible to varying interpretations that coulddelay, limit, or prevent regulatory approval. Even if a product receives regulatory approval, later discovery ofpreviously unknown problems with a product may result in restrictions on theproduct or even complete withdrawal of the product from the market.

 

Preclinical tests include laboratory evaluation of product chemistryand formulation, as well as animal trials to assess the potential safety andefficacy of the product.  The conduct ofthe preclinical tests and formulation of compounds for testing must comply withFederal regulations and requirements. The results of preclinical testing are submitted to the FDA as part ofan IND.

 

A 30-day waiting period after the filing of each IND is required priorto the commencement of clinical testing in humans.  If the FDA has not commented on or questionedthe IND within this 30-day period, clinical trials may begin.  If the FDA has comments or questions, thequestions must be answered to the satisfaction of the FDA before initialclinical testing can begin.  In addition,the FDA may, at any time, impose a clinical hold on ongoing clinical trials.  If the FDA imposes a clinical hold, clinicaltrials cannot commence or recommence

 

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without FDA authorization and then onlyunder terms authorized by the FDA.  Insome instances, the IND process can result in substantial delay and expense.

 

Clinical trials typically involve the administration of theinvestigational new drug to volunteers or patients under the supervision of aqualified investigator.  Clinical trialsmust be conducted in compliance with Federal regulations and requirements,under protocols detailing the objectives of the trial, the parameters to beused in monitoring safety and the effectiveness criteria to be evaluated.  Each protocol involving testing on U.S.subjects must be submitted to the FDA as part of the IND.  The study protocol and informed consentinformation for patients in clinical trials must also be approved by theinstitutional review board at each institution where the trials will beconducted.

 

Clinical trials to support NDAs for marketing approval are typicallyconducted in three sequential phases, but the phases may overlap.  In Phase I, the initial introduction of thedrug into healthy human subjects or patients, the drug is tested to assessmetabolism, pharmacokinetics and pharmacological actions and safety, includingside effects associated with increasing doses. Phase II usually involves trials in limited patient populations, todetermine dosage tolerance and optimum dosage, identify possible adverseeffects and safety risks, and provide preliminary support for the efficacy ofthe drug in the indication being studied.

 

If a compound demonstrates evidence of effectiveness and an acceptablesafety profile in Phase II evaluations, Phase III trials are undertaken tofurther evaluate clinical efficacy and to further test for safety within anexpanded patient population, typically at geographically dispersed clinicaltrial sites it is possible that Phase I, Phase II, or Phase III testing ofproduct candidates may not be completed successfully within any specified timeperiod, if at all.

 

After successful completion of the required clinical testing, generallyan NDA is prepared and submitted to the FDA. FDA approval of the NDA is required before marketing of the product maybegin in the United States.  The NDA mustinclude the results of extensive clinical and other testing and a compilationof data relating to the product’s pharmacology, chemistry, manufacture, andcontrols.  The cost of preparing andsubmitting an NDA is substantial.  UnderFederal law, the submission of NDAs are additionally subject to substantialapplications user fees, currently exceeding $500,000, and the manufacturerand/or sponsor under an approved NDA are also subject to annual product andestablishment user fees, currently exceeding $30,000 per product and $200,000per establishment.  These fees aretypically increased annually.

 

The FDA has 60 days from its receipt of an NDA to determine whether theapplication will be accepted for filing based on the agency’s thresholddetermination that the NDA is sufficiently complete to permit substantivereview.  Once the submission is acceptedfor filing, the FDA begins an in-depth review of the NDA.  Under Federal law, the FDA has agreed to certainperformance goals in the review of NDAs. Most applications for non-priority drug products are reviewed within tenmonths.  The review process is oftensignificantly extended by FDA requests for additional information orclarification of information already provided in the submission.  The FDA may also refer applications for noveldrug products or drug products which present difficult questions of safety orefficacy to an advisory committee, typically a panel that includes cliniciansand other experts, for review, evaluation, and a recommendation as to whetherthe application should be approved.  TheFDA is not bound by the recommendation of an advisory committee.

 

If FDA evaluations of the NDA and the manufacturing facilities andprocedures, which typically involves an FDA on-site inspection, are favorable,the FDA may issue an approval letter, or, in some cases, an approvable letterfollowed by an approval letter.  Anapprovable letter generally contains a statement of specific conditions thatmust be met in order to secure final approval of the NDA.  If and when those conditions have been met tothe FDA’s satisfaction the FDA will typically issue an approval letter.  An approval letter authorizes commercialmarketing of the drug with specific prescribing information for specificindications.  If the FDA’s evaluation ofthe NDA submission or manufacturing facilities is not favorable, the FDA mayrefuse to approve the NDA or issue a not approvable letter.  The not approvable letter outlines thedeficiencies in the submission and often

 

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requires additional testing or informationin order for the FDA to reconsider the application.  Even with submission of this additionalinformation, the FDA ultimately may decide that the application does notsatisfy the regulatory criteria for approval. With limited exceptions, FDA may withhold approval of an NDA regardlessof prior advice it may have provided or commitments it may have made to thesponsor.  As a condition of NDA approval,the FDA may require post-approval testing and surveillance to monitor thedrug’s safety or efficacy and may impose other conditions, including labelingrestrictions.  Such labeling restrictionscan materially impact the potential market and profitability of the drug.  Once granted, product approvals can still bewithdrawn if compliance with regulatory standards is not maintained or problemsare identified following initial marketing.

 

Once the NDA is approved, a product will be subject to certainpost-approval requirements, including requirements for adverse event reportingand submission of periodic reports. Persons responsible for manufacture or distribution are subject to FDAinspections to assess compliance with applicable statutory and regulatoryrequirements.

 

Additionally, the FDA also strictly regulates the promotional claimsthat may be made about drug products. The FDA requires substantiation of any claims of superiority of oneproduct over another including, in many cases, requirements that such claims beproven by adequate and well controlled head-to-head clinical trials.  The FTC Substantiation Standards are verysimilar for the advertising of OTC products. To the extent that market acceptance of the Company’s products may dependon their superiority over existing therapies, any restriction on the Company’sability to advertise or otherwise promote claims of superiority, orrequirements to conduct additional expensive clinical trials to provide proofof such claims, could negatively affect the sales of the Company’s productsand/or the Company’s costs.

 

***Treatment of theCompany’s Products and Product Candidates*** Webelieve that the active ingredients, dosage form and strengths of our Athlete’sRelief, Osteon and Termin8 products are covered by the OTC Review Program andtherefore these products are potentially eligible for marketing under the OTCReview Program.  Accordingly, we intendto reintroduce them to the United States market once we are reasonably surethat the marketing of these products is consistent with the FDA’s requirementsand policies.  We anticipate that ourmarketing and sales of these products under revised labeling will resume by theend of 2004, although there is no guarantee of this.  With regard to product candidates that usethe VALE transdermal technology or otherwise require new drug approval, we willseek to secure a partnership with a larger marketing partner specifically forthose products.  Further, it is expectedthat the actual development work will be done by BioChemics which will be requiredto follow the more extensive regulations imposed by the FDA, including the NDArequirements, and other regulatory authorities in the United States and othercountries regarding research and development, pre-clinical studies and clinicaltrials and ultimately manufacturing of drug products subject to “new drug”status.

 

All of our OTC products and product candidates, whether subject to theOTC Review Program or NDA requirements, are required to be labeled, promoted,and manufactured to avoid the misbranding and adulteration provisions of theFFDCA, including the prohibition against false and misleading representationsand manufacturing in violation of cGMPs.

 

***Strategy***

 

Our general strategy is to commercialize, market and sell transdermaland topical OTC drugs that we believe can be delivered in an efficient,user-friendly, and reliable manner by utilizing both the VALE and PENtoCOREtechnologies.

 

The development and test marketing of our three primary products hasbeen completed.  Each of these productsuses PENtoCORE topical formulations.  Wewill market each of our three current products under the OTC Review Program.These products are:

 

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•                                          Athlete’sRelief — an OTC external analgesic designed to provide temporary relief fromthe muscle and joint pain associated with athletic activity; and

 

•                                          Osteon— an OTC external analgesic designed to provide temporary relief from themuscular-skeletal pain associated with arthritis; and

 

•                                          Termin8— an OTC antifungal lotion designed to effectively treat athlete’s foot(formerly branded under the name deFEET®).

 

We license the Osteon and PENtoCORE trademarks under our amendedlicense agreement with BioChemics.  Inaddition, we have applied for U.S. trademark protection for the mark “Termin8.”

 

In addition to and separate from our Athlete’s Relief, Osteon andTermin8 products, we have identified and are currently developing, incollaboration with BioChemics, six additional OTC product candidates that willutilize either the VALE transdermal or PENtoCORE topical technology. Each ofthese product candidates are in various stages of development and are not yetavailable for sale.  These productcandidates are as follows:

 

•                                          Ananalgesic utilizing ibuprofen;

 

•                                          Toenailfungus treatment;

 

**•**                                          Acnetreatment;

 

•                                          Firstaid treatments;

 

•                                          Handand body lotions; and

 

•                                          Psoriasistreatment.

 

In instances where the active ingredient (e.g., ibuprofen), dosage form(e.g., VALE transdermal technology), strength, route of administration,directions for use or indication (e.g., toenail fungus) of the productcandidate is not covered by the OTC Review Program or where the inactiveingredients used in the product candidate are not recognized as safe andsuitable for their intended OTC use, the product candidate cannot be marketedwithout obtaining pre-market approval in the form of an approved new drugapplication, or NDA or an abbreviated new drug application, or ANDA.Conversely, where the active ingredient, dosage form, strength, route ofadministration, directions for use, and indication of the product candidate arecovered by the OTC Review Program and the inactive ingredients used in theproduct candidate are safe and suitable for their intended OTC use, the productcandidate could be marketed without obtaining NDA or ANDA clearance, providedit conforms to the applicable OTC Monograph and is not otherwise adulterated ormisbranded.

 

**RecentEvents**

 

***SEC and FDA Regulatory Matters***.    (See“Recent Events — Trading Suspension” in the Company’s amended Annual Report onForm 10-KSB/A, filed July 21, 2004, which is incorporated herein byreference, and “Recent Events — Trading Suspension” in the Company’s QuarterlyReport on Form 10-QSB for the quarter ended March 31, 2004, filed onJuly 20, 2004, which is incorporated herein by reference.)  The Company has agreed with the SEC tosettlement terms of a proposed action to be filed by the SEC, without admittingor denying the proposed allegations of the civil complaint, pursuant to whichthe Company will be permanently enjoined from violating certain of theanti-fraud provisions of the Securities Act and the Exchange Act.  The SEC’s proposed complaint will allege thatthe Company’s registration statement in respect of the Company’s initial publicoffering, the Company’s annual report for 2003 and a statement on the Company’swebsite were false and misleading as a result of statements and omissionsconcerning the FDA approval or qualification of the Company’s products.

 

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The Company expects that the settlement will be formally approved bythe SEC soon and will be presented to a court for approval shortlythereafter.  In addition, the Company’sPresident and Chief Executive Officer has agreed to settle a similar proposedaction by the SEC against him, without admitting or denying the proposedallegations of the civil compliant, that would similarly enjoin him and preventhim from serving as an officer or director of any public company, including theCompany, for a period of five years.  IfMr. Masiz is barred from serving as an officer and director of the Company forthis five-year period, he will be permitted and intends to continue to be anactive employee of the Company. The Company expects that the President andChief Executive Officer’s settlement will also be formally approved by the SECsoon and will be presented to a court for approval shortly thereafter. Pleasesee “Changes in Management” below for additional information on Mr. Masiz’sresignation as well as “Risk Factors” – “If we fail to attract, train andretain additional highly qualified senior executives and technical andmanagerial personnel in the near future, our business will suffer.”

 

The Company is not aware that the FDA is contemplating any actionagainst the Company.  The Company,through counsel, has engaged in and will continue to maintain a dialogue withthe FDA to address any concerns.  TheCompany has submitted new labels for its previously marketed products to theFDA and has requested FDA comments on any concerns or issues pertaining tothese revised labels.  As of the date ofthis report, the FDA has not provided any comment to the Company based on theagency’s review of the labels submitted to the FDA.  There is, however, no regulatory requirementthat FDA review or provide comment on such materials.  The Company is reasonably sure that theselabels are consistent with all FDA regulations and policies.

 

Due to the ongoing nature of these matters, the Company is unable todefinitively assess their impact. However, the Company has committed not to market or sell its productsuntil all outstanding matters have been addressed to the satisfaction of theSEC and until the Company is reasonably sure that the marketing and sale of itsproducts is consistent with the FDA’s requirements and policies.  This commitment may have a material adverseimpact on the Company.  The Companyanticipates that the marketing and sale of Athlete’s Relief, Osteon and Termin8äwill resume by the end of 2004, although there is no guarantee of this.  When appropriate, the Company will makeadditional public announcements and will file public reports with the SECregarding the status of its products under applicable FDA regulations.

 

* **Nasdaq****StockMarket Matters.******* By letter dated April 2, 2004, the NasdaqListing Investigations department of The Nasdaq StockMarket, Inc., or Nasdaq, notified the Company that it had commenced an inquiryto ensure the Company’s ongoing compliance with Nasdaq’s inclusion requirementsand requested certain information from the Company.  The letter further disclosed that afterreview of the information provided by the Company, Nasdaqcould take any action that might be appropriate under its Marketplace Rulesincluding removal of the Company’s securities from Nasdaq.  In view of the substantial administrative andcash burdens being borne by the Company at that time and the substantial legalcosts anticipated with respect to the SEC and FDA matters, the Companydetermined that it was in the best interest of shareholders to voluntarilycause its shares to be removed from Nasdaq and focus its attention andresources on addressing the SEC and FDA concerns.  The Company’s securities were voluntarilydelisted, effective the opening of the markets on Thursday, April 8,2004.  At an appropriate time, theCompany will seek to cause its securities to be quoted on an exchange, Nasdaq or other automated quotation system. There can be noassurance that the Company will be successful or that an organized market forthe Company’s securities will develop. If the Company is unable to list its securities on a national exchangeor on an automated securities quotation system in the future, it could have amaterial adverse impact on our ability to raise future capital (See “Liquidityand Capital Resources”).

 

***Litigation.*******  In April,May, and June 2004, the Company and certain of its officers were sued inseveral purported securities class action lawsuits filed in the United StatesDistrict Court for the District of Massachusetts.  The complaints, which seek equitable andmonetary relief, an unspecified amount of damages, with interest, attorneysfees and costs, allegedly were filed on behalf of purchasers of the Company’sClass A common stock during the period December 11, 2003 to March 31,2004 and allege that during that period, the defendants violated the federalsecurities laws by allegedly failing to make accurate and complete disclosuresconcerning the

 

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Company, its financialcondition, its business operations and future prospects, the clinical trial andendorsement of the Company’s Termin8 anti-fungal product (previously known as“deFEET”) and the institutional demand for the Company’s securities.  These complaints are captioned as follows:  Dennis E. Smith v. Vaso ActivePharmaceuticals, Inc., *et al*.,Civ. No. 04-10708 (RCL) (D. Mass.); Richard Shapiro v. Vaso ActivePharmaceuticals, Inc., *et al*.,Civ. No. 04-10720 (RCL) (D. Mass.); Christopher Pepin v. Vaso ActivePharmaceuticals, Inc., *et al*.,Civ. No. 04-10763 (RCL) (D. Mass.); Modhi Gude, et al. v. Vaso ActivePharmaceuticals, Inc., *et al*.,Civ. No. 04-10789 (RCL) (D. Mass.); Kim Benedetto, et al. v. Vaso ActivePharmaceuticals, Inc., *et al*.,Civ. No. 04-10808 (RCL) (D. Mass.); Dean Dummer v. Vaso ActivePharmaceuticals, Inc., *et al*.,Civ. No. 04-10819 (RCL) (D. Mass.); Edward Tovrea v. Vaso ActivePharmaceuticals, Inc., *et al*.,Civ . No. 04-10851 (RCL); Kourosh Alipor v. Vaso Active Pharmaceuticals,Inc., *et al*., Civ. No.04-10877 (RCL); Paul E. Bostrom v. Vaso Active Pharmaceuticals, Inc., *et al*., Civ. No. 04-10948 (RCL); IraA. Turret Sep-Ira Dated 01/24/02 v. Vaso Active Pharmaceuticals, Inc., *et al*., Civ. No. 04-10980 (RCL); RichardPagona v. Vaso Active Pharmaceuticals, Inc., *etal*., Civ. No. 04-11100 (RCL); James Karanfilian v. VasoActive Pharmaceuticals, Inc., *et al*.,Civ. No. 04-11101 (RCL); and Charles Robinson v. Vaso ActivePharmaceuticals, Inc., *et al*.,Civ. No. 04-11221 (RCL).  The Court hasconsolidated the above-referenced cases, other than the Tovrea and Karanfiliancomplaints, under the caption In Re Vaso Active Pharmaceuticals SecuritiesLitigation, Civ. No. 04-10708 (RCL).

 

The Company has also been named as a nominaldefendant in two shareholder derivative actions filed, the first filed in theUnited States District Court for the District of Massachusetts in April 2004against its directors and certain of its officers and against BioChemics, Inc.entitled Joseph Rosenkrantz v. BioChemics, Inc., *et al*., Civ. No. 04-10792 (RCL) (D. Mass.) and thesecond filed in June 2004, also against the Company’s directors and certain ofits officers and against BioChemics, Inc. entitled William Pomeroy v.BioChemics Inc., *et a**l*., Civ. No. 04-11399 (RCL) (D. Mass.). The complaints allege, among otherthings, that the alleged conduct challenged in the securities cases pendingagainst the Company in Massachusetts (described above) constitutes a breach ofthe defendants’ fiduciary duties to the Company.  The complaints seek equitable and monetaryrelief, an unspecified amount of damages, and attorneys and other fees, costsand expenses, ostensibly on behalf of the Company.  On July 28, 2004, the parties filed a jointmotion requesting that the Court consolidate these actions and establish aprocedure for consolidation of any subsequently filed derivative related case;appoint Co-Lead and Liaison Counsel for plaintiffs; stay all pretrialproceedings in these actions and any related actions until the earlier of (a)the resolution of any motion to dismiss filed in the above-referencedconsolidated securities fraud litigation, or (b) the filing of answers by alldefendants in the same matter; and acknowledge defendants’ acceptance ofservice of the Pomeroy and Rosenkrantz complaints.  The Court has not ruled on this motion.

 

Although the Company intends to vigorously defendagainst these cases, the litigation process is inherently uncertain and therecan be no guarantee as to the ultimate outcome of these matters.  There is also no guarantee that these will bethe only lawsuits brought against the Company with respect to these matters.

 

An unfavorable outcome in one or more ofthese related cases could have a material adverse effect on the Company’sfinancial position, liquidity and results of operations.  In addition to the costs of defending thesecases, the Company may provide indemnification for expenses and losses that maybe incurred by its directors and officers as parties to one or more of thesecases.  Although the Company is seekingcoverage under its director and officer liability insurance policy, theCompany’s insurer notified us in writing on August 3, 2004, that, based on itscoverage evaluation, it intends to reject its liability to reimburse theCompany with respect to any of the claims asserted in any of theabove-described litigation against the Company or its officer or directors fora substantial majority of the policy coverage and that it may seek to rescindthe policy with respect to the balance of the policy coverage.  The Company intends to vigorously contest theinsurer’s positions. If the insurer prevails, the costs of defending thesecases and providing indemnification to our directors and officers may besubstantial.

 

Because of the uncertainty of estimating the potential financialstatement impact of any of these actions with any reasonable degree ofaccuracy, at this time the Company has not reserved for any potential liabilityor costs that may arise as a result of this litigation except for $200,000recorded on March 31, 2004, which

 

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represents the insurance deductible thatthe Company cannot expect to recover. While the cases are in very preliminary stages and the outcomes are notpredictable, if a substantial amount is payable by the Company and is notreimbursed through its director and officer liability policy, this will have amaterial adverse effect on the Company’s financial position and liquidity.

 

***Unwinding of March 16,2004 Private Investment in Public Equity***.  On March 16, 2004, the Company enteredinto a private placement transaction in the amount of $7,500,000 with aninstitutional investor.  The investmentwas in the form of an 18 month 2% Convertible Note, or Note, convertible intoshares of the Company’s Class A common stock at a conversion rate of $9 pershare. In addition, the Company issued to the investor warrants to purchase166,667 shares of Class A common stock at an exercise price of $8.75 per share.

 

Given that the initiation and continuation of the April 1, 2004trading suspension by the SEC constituted a breach under the Note, the Companyand the investor agreed, pursuant to the terms of a settlement agreemententered into on April 8, 2004, that the Company would immediately repaythe investor the sum of $7,500,000 in cash without penalty, interest,redemption premium or any other premium or penalty, plus an expensereimbursement in connection with the settlement agreement in the amount of$15,000 in cash.   In consideration ofthis repayment, the investor surrendered the Note and warrants and the partiesmutually terminated all other agreements entered into in connection with thetransaction.

 

In connection with this transaction, on March 16, 2004 the Companypaid approximately $600,000 in fees to various third parties.  These fees were not refunded when the Companyrepaid the investor and accordingly, have been recorded as an expense as ofMarch 16, 2004. They are included in the expense caption “selling, generaland administrative” for the six-month period ended June 30, 2004.

 

***Changes in Management.***  John J. Masiz, the Company’s President andChief Executive Officer, has agreed to terms with the SEC to settle a proposedaction by the SEC against him, without admitting or denying the proposed allegationsof the civil complaint, that would prevent him from serving as an officer ordirector of any public company, including the Company, for a period of fiveyears.  If Mr. Masiz is barred fromserving as an officer and director of the Company for this five-year period, hewill be permitted and intends to continue to be an active employee of theCompany.  If the offer to settle isformally accepted by the SEC and ordered by the court, Mr. Masiz would resignas the President and Chief Executive Officer of the Company, as well as theChairman of the Board of Directors of the Company.  The Company is in the process of conducting asearch for a new Chief Executive Officer to replace Mr. Masiz when he resigns.There is no assurance that we will be able to attract or retain a suitableChief Executive Officer now or in the future, and this could have a materialadverse effect on our business, financial condition and results ofoperations.  Please see “Risk Factors” –“If we fail to attract, train and retain additional highly qualified seniorexecutives and technical and managerial personnel in the near future, ourbusiness will suffer.”

 

Effective June 18, 2004, Kevin J.Seifert resigned as the Chief Operating Officer of the Company and as adirector of the Company. The Company is not currently conducting a search for anew Chief Operating Officer.  Weanticipate that our new Chief Executive Officer will assume Mr. Seifert’sformer responsibilities.

 

**Critical Accounting Policies**

 

* **Revenue Recognition***We recognize revenue from product sales in accordance with generally acceptedaccounting principles in the United States, including the guidance in StaffAccounting Bulletin, or SAB, No. 104 “Revenue Recognition”, which supercedesSAB, No. 101 “Revenue Recognition in Financial Statements,” and Statement ofFinancial Accounting Standards, or SFAS, No. 48, “Revenue Recognition WhenRight of Return Exists.”

 

Revenue from product sales is recognized when there is persuasiveevidence of an arrangement, delivery has occurred, the price is fixed anddeterminable, and collectibility is reasonably assured. However, because ourproducts are sold with limited rights of return, revenue is recognized when theprice to the buyer is fixed, the

 

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buyer is obligated to pay us and theobligation to pay is not contingent on resale of the product, the buyer haseconomic substance apart from the us, we have no obligation to bring about thesale of the product and the amount of returns can be reasonably estimated.

 

We record allowances for product returns, rebates and discounts, andreport revenue net of such allowances. We must make judgments and estimates inpreparing the allowances that could require adjustments in the future. Forinstance, our customers have the right to return any product that is held pastthe labeled expiration date. We base our estimates on historic patterns ofreturns and on the expiration dates of product currently being shipped, or as aresult of an actual event that may give rise to a significant return amountsuch as the discontinuance of a product.

 

We do not recognize revenue unless collectibility is reasonablyassured. We maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments. If thefinancial condition of our customers were to deteriorate and result in animpairment of their ability to make payments, additional allowances may berequired.

 

***Expense Allocations/ManagementFees*** BioChemics provides us with certainadministrative, marketing and management services, as well as our facilitiesand general corporate infrastructure. Our statement of operations includesallocations of these costs that BioChemics and we considered to be reasonable.

 

***Deferred Income Taxes***We account for income taxes and deferred tax assets and liabilities inaccordance with SFAS No. 109, “Accounting for Income Taxes.” Because weproject future operating losses in the near term, we have provided a fullvaluation allowance against the deferred tax assets created by these losses.

 

***Stock-based Compensation***As part of our compensation programs offered to our employees, we grant stockoptions. We grant stock options to employees based on the fair value of theClass A common stock at the grant date. Asallowed under SFAS No. 123, “Accounting for Stock-Based Compensation,” andSFAS No. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure,” we have adopted the disclosure-only requirements of these accountingstandards. Accordingly, we do not recognize stock-based compensation expensefor stock options granted to employees at their fair value. See Note 4 to ourunaudited condensed financial statements for the impact on earnings had wefully adopted SFAS 123 and 148.

 

***Off-Balance Sheet Arrangements***We do not have off-balance sheet arrangements, financings or otherrelationships with unconsolidated entities known as “special purpose entities.”

 

***Cost of Sales***Our costs of sales primarily consist of manufacturing costs charged by outsidecontractors including BioChemics which, pursuant to our manufacturing anddevelopment agreement charges us the cost of such manufacturing and developmentplus 10%.  We expect to continue to use outsidecontract manufacturers for the production of our products. As a result, all ofour inventory balances are in the form of finished goods and direct laborinitiatives are minimal.

 

***Marketing, Advertising andPromotion Expenses*** Our marketing, advertising andpromotion expenses include such costs of print, Internet and costs associatedwith our attendance and presentation at industry tradeshows and other marketingand sales programs.

 

***Researchand Development*****Expenses** Our research and development consist primarily ofcosts charged by BioChemics which, pursuant to our manufacturingand developmentagreement charges us the cost of such manufacturingand development plus10%.

 

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***Outlook for the remainder of 2004***

* *

On December 10, 2003, our Registration Statement on Form SB-2(registration no. 333-106785) for the sale of 1,667,500 shares of ourClass A common stock (5,002,500 on a post-split basis) which included217,500 shares of Class A common stock (652,500 on a post-split basis) tocover underwriter over-allotments, at a price of $5.00 per share ($1.67 on apost-split basis), became effective. We completed this initial public offeringon December 15, 2003. All of the shares sold in this offering were fromour authorized pool of Class A common stock. Kashner Davidson SecuritiesCorp. functioned as the representative of the underwriters for this publicoffering. Net of offering costs of approximately $1.9 million, we receivedapproximately $6.4 million in proceeds, which we estimated would be allocatedas follows:

 

•                                          Approximately$1.1 million to fund our continued development, commercialization and saleof our products and product candidates;

 

•                                          Approximately$1.9 million to implement our strategic marketing and commercializationplan, which approximately $1.2 million was to be allocated to fund ourradio advertising campaign.  This radiocampaign was originally to be initiated in connection with the retail rolloutof our products, which we anticipated would occur in 2004.  As a result of the cessation of the marketingand sale of our products following the initiation of the SEC trading suspensionon April 1, 2004, we do not expect that the retail rollout of ourproducts, which was designed as the second stage of our rollout strategy, willcommence until at least 2005. Consequently, we do not anticipate using any of the initial publicoffering proceeds to fund advertising, direct mail programs or otherpromotional activities related to this retail roll-out strategy before thattime and there can be no assurance that any of the initial public offeringproceeds will be used for this purpose. We have allocated approximately $372,000 in 2004 for marketing costsassociated with the first stage of our rollout strategy.

 

•                                          $200,000 torecruit and hire individuals for key senior management positions;

 

•                                          $350,000 tocover the cost of providing sales incentives, product samples and discounts;

 

•                                          To repay,without interest, BioChemics approximately $99,000 for management fees chargedback to us since we became a stand-alone entity upon our incorporation forcentralized accounting, data processing, utilities, office space rental,supplies, telephone and other BioChemics corporate services and infrastructurecosts, and approximately $347,000 for other operational charges paid byBioChemics to third parties on our behalf through September 30, 2003;these amounts increased to approximately $122,000 and $518,200 respectively,which reflect the modifications necessary for these additional type costsincurred from October 1, 2003 through December 31, 2003; and

 

•                                          Approximately$1.68 million to provide working capital for general and corporatepurposes.  We increased this to$2.2 million from the registration disclosure to reflect the net impact ofthe exercise of the over allotment option. In addition, we anticipate using the funds initially allocated for theimplementation of our strategic marketing and commercialization plan, includingthe approximately $1.2 million that was allocated to fund our anticipatedradio advertising campaign, less the approximately $372,000 budgeted formarketing costs associated with the first stage of our rollout strategy, asworking capital for general and corporate purposes.

 

We anticipate, based on our current plans and assumptions relating toour operations, that our current working capital together with our expectedcash flows from resumed marketing of our products and related operations shouldbe sufficient to satisfy our cash requirements for at least the balance of2004. We have no current plans, agreements or commitments with respect to anyacquisitions.

 

The SEC’s temporary suspension in the trading of our securities hasaffected our marketing (See “Recent Events”). Immediately upon the initiationof this suspension we voluntarily suspended the marketing and sale of Athlete’sRelief, Osteon and Termin8 until we are reasonably sure that the marketing ofthese products is

 

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consistent with the FDA’s requirements andpolicies.  We anticipate that ourmarketing and sale of these products under revised labeling will resume by theend of 2004, although there is no guarantee of this. Accordingly, we are nolonger able to provide meaningful guidance on what our 2004 or 2005 revenueswill be.  Therefore, our projections ofMarch 26, 2004 should not be relied on for any purpose.

 

If and when we resume marketing, we anticipate executing our marketingand sales strategy in two phases. We believe this two-phase approach is themost efficient and cost effective manner to quickly bring our products to themarket place.

 

In the first phase of our rollout strategy, we believe the mostefficient and economical means of obtaining market penetration is throughstrategic alliances. Accordingly, this is where we have placed our immediatefocus.  Typically under these alliances,our prospective partners will control and assume all the costs of marketing anddistribution. We will assume all the costs of manufacturing. This modeleliminates many prohibitive costs such as mass-media advertising and thedevelopment of large sales and distribution channels. We will attempt toleverage the already established market visibility, presence and experience ofour prospective partners as well as their distribution networks. We believethat these factors and our decision to outsource all our product manufacturingallows us to operate with minimal direct labor and other business costs.

 

In January 2004, we executed our first strategic alliance withOrtho Distribution Inc., or ODI, a wholly owned subsidiary ofOrthoRehab, Inc. of Tempe, Arizona. OrthoRehab has an extensivedistribution network, across the United States and in approximately 50 othercountries.  We and ODI expect to launchproduct through ODI’s distribution network by the end of 2004.  However, there can be no assurance that thisalliance will continue, or if continued, that it will be successful

 

In March 2004, in furtherance of the first phase of our rolloutstrategy, we entered into an exclusive, direct to consumer media based,strategic alliance with M2G Media of Irvine, California, a marketing anddistribution company that utilizes direct to consumer media and television asits primary forms of marketing medium. M2G Media will market privately labeledversions of our current products specifically targeting the over the countertopical and analgesic arthritis and pain relief markets. We expect M2G Media tocommence infomercial filming by the end of 2004 and we and M2G Media expect tolaunch product through its channels of distribution in the first quarter of2005.  However, there can be no assurancethat this alliance will continue, or if continued, that it will be successful.

 

In addition to our focus on the strategic alliance model as the firststage of our rollout strategy, we also intend to pursue opportunities to launchour products into retail market chains, but not before 2005.  We believe that because retail sales effortstypically require large economic outlays and long sales cycles, they produceless of an immediate impact on operations than strategic alliances.  Therefore, we have categorized this as partof the second phase of our rollout strategy. In January 2004, we appointedCommotion LLC of Golden, Colorado, a strategic product marketing company, to assistus in establishing direct brand recognition and strategic retail rollout forour products.  Our plan is focused on thesystematic rollout of our current products into major retail and drug storechains, select independent pharmacies and nontraditional channels, includingmultilevel marketing, direct marketing, web-sites and catalogues.  However, a result of the cessation of themarketing and sale of our products following the initiation of the SEC tradingsuspension on April 1, 2004, and changes in the timing for the retailrollout of our products, we do not anticipate using any of our initial publicoffering proceeds to fund our advertising, direct mail programs and relatedpromotional activities before 2005.  Therecan be no assurance that any of the initial public offering proceeds will beused for this purpose.

 

At various times, we and BioChemics have marketed Osteon, Athlete’sRelief and deFEET on a “test basis” to experiment with consumer packaging andproduct performance receptivity, packaging size, label design along with othercriteria.  We consider this informationimportant to deciding on an eventual roll out strategy for the products.  We call these programs “test marketing”because neither the Company nor its parent, BioChemics, weresufficiently capitalized to engage in advertising campaigns.  In some cases, we terminated test marketing

 

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programs and in other cases, the retailerterminated test marketing programs.  Inconnection with the test marketing program with Walgreens to sell deFEET inmid-2003, we could not provide sufficient funding for an advertising programthat would be acceptable to Walgreens. Our efforts were complicated by our needto change the product name from deFEET to Termin8 as we needed more flexibilitythan was afforded to us under our April 20, 2002 settlement and licenseagreement with DeFeet International, an independent company that owns thedeFEET registered trademark.  Because ofour inability to undertake an acceptable advertising campaign, we and Walgreensterminated this test marketing program.

 

Although we believe that our products, supported by sufficientadvertising, will earn retailers acceptance, there can be no assurance thatthis will happen, or if it does, that it will continue.

 

We believe that the systematic and multi-phased launch for each of ourthree current products as described above will allow us to maintain controlover the required costs associated with these launches and will maximize thereturn on investment for the advertising and marketing expenditures.

 

The success of our marketing and sales activities will be dependent,among other things, on our ability to retain and attract qualified marketingand sales personnel, enter into qualified strategic partnerships, place ourproducts into the market and on the consumer perception of our products.

 

** *Three-Month Periods Ended June 30, 2004 and 2003***

 

***Net Revenues***Net revenues decreased approximately 98% to $862 for the three-month periodended June 30, 2004 from $51,180 for the three-month period endedJune 30, 2003. This decrease was primarily an effect of two specificcauses.  First, in response to ourdecision to re-brand our athlete’s foot product deFEET to Termin8 inSeptember 2003, Walgreen’s returned most of the deFEET product that it hadin its possession.  Second, we did notlaunch the re-branded product, Termin8 due to the Company’s commitment onApril 8, 2004 not to market or sell its products until all outstandingmatters have been addressed to the satisfaction of the SEC and until theCompany is reasonably sure that the marketing and sale of its products isconsistent with the FDA’s requirements and policies.  See discussion under “Recent Events”.

 

***Cost of Sales***In general, our cost of sales is variable to our net revenues.  However, certain manufacturing events such asinventory adjustments may distort our cost of sales, and therefore our grossprofit, during any particular period.  Asa result of the regulatory matters discussed further under “Recent Events,”such an adjustment occurred during the three-month period ended June 30,2004.  More specifically, we submittednew labels for our previously marketed products to the FDA and requested thatthe FDA comment on these revised labels. There is no regulatory requirementthat the FDA review or provide comment on such materials and accordingly, todate, we have not received any comments or recommendations for improvement fromthe FDA based on its review.  We are,however, reasonably sure that our revised labels are consistent with all FDAregulations and policies. As a result of this process, we determined thatapproximately $39,000 of products were not recoverableunder our revised label format. Accordingly, we recorded a charge for this amount in cost of salesduring this period.  In the correspondingperiod in 2003, cost of sales solely represented the cost of the products wesold.

 

***Gross Profit***Gross profit as a percentage of net revenues for the three-month period endedJune 30, 2004 is negative as a direct result of the matters discussedunder the Cost of Sales discussion above related to the submission of newlabels to the FDA.  In our opinion, anycomparison to a prior period is not meaningful as a result of this action.

 

***Marketing, Advertisingand Promotion Expenses*** Marketing, advertising andpromotion expenses decreased approximately 77% to $10,595 for the three-monthperiod ended June 30, 2004 from $46,660 for the three-month period endedJune 30, 2003.  This decrease wasprimarily due to the Company’s commitment on April 8, 2004 not to marketor sell its products until all outstanding matters have been addressed to thesatisfaction

 

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of the SEC and until the Company isreasonably sure that the marketing and sale of its products is consistent withthe FDA’s requirements and policies

 

***Management Fee***Management fee decreased approximately 68% to $8,160 for the three-month periodended June 30, 2004 from $25,481 for the three-month period endedJune 30, 2003.  Presently, theCompany pays directly certain expenses allocated as part of Management Fees inprevious periods. Consequently, this has caused a disproportionate decreasewhen comparing the two periods.

 

***Selling, General andAdministrative*** Selling, general and administrative expenses increased by $977,267 to$1,042,714 during the three-month period ended June 30, 2004 as comparedto $65,447 in the comparable period in 2003. The increase is due primarily to our increased operations andsignificant legal and other professional expenses we continue to incur inconnection with our recent SEC, Nasdaq, and FDAmatters and shareholder class actions. See “Recent Events.”

 

During the three months ended June 30,2004, we incurred approximately $519,000 in legal and professional fees toamend our previously filed annual report, for representation before the SEC andFDA and to defend ourselves in the shareholder class actions; approximately$213,000 in salaries, wages and related personnel costs; approximately $142,000in business, financial and other professional services; approximately $56,000for various insurance premiums typical of a public company; and approximately$20,000 for board of director compensation. The remaining selling, general and administrative expense pertained toour general expansion of our operations.

 

***Research andDevelopment*** Research and development expensesincurred for the three-month period ended June 30, 2004 were $47,299.  Beginning in January 2004, we engagedBiochemics to provide services pursuant to a February 2003 manufacturingand development agreement. These services related to the formulation of ananalgesic utilizing the active ingredient ibuprofen.  Pre-clinical studies utilizing animals wereconducted and billed as part of this research. No such charges were incurred during the three-month period endedJune 30, 2003.

 

***Stock BasedCompensation*** We are required to record stock-basedcompensation when we grant options to purchase our common stock to non-employeesin accordance with SFAS 123. The value of these options is calculatedusing the Black-Scholes option-pricing model. Stock based compensation for thethree-month period ended June 30, 2004 was $15,101.   There were nocommon stock options granted to non-employees prior to June 30, 2003,accordingly there was no stock-based compensation recorded in the three-monthperiod ended June 30, 2003.

 

***Six-Month PeriodsEnded June 30, 2004 and 2003***

 

***Net Revenues***Net revenues decreased approximately 90% to $8,009 for the six-month periodended June 30, 2004 from $81,674 for the six-month period endedJune 30, 2003. This decrease was primarily an effect of two specificcauses.  First, in response to ourdecision to re-brand our athlete’s foot product deFEET to Termin8 inSeptember 2003, Walgreen’s returned most of the deFEET product that it hadin its possession.  Second, we did notlaunch the re-branded product, Termin8 due to the Company’s commitment onApril 8, 2004 not to market or sell its products until all outstandingmatters have been addressed to the satisfaction of the SEC and until theCompany is reasonably sure that the marketing and sale of its products isconsistent with the FDA’s requirements and policies.  See discussion under “Recent Events”.

 

***Cost of Sales***In general, our cost of sales is variable to our net revenues.  However, certain manufacturing events such asinventory adjustments may distort our cost of sales, and therefore our grossprofit, during any particular period.  Asa result of the regulatory matters discussed further under “Recent Events,”such an adjustment occurred during the six-month period ended June 30,2004.  More specifically, we submittednew labels for our previously marketed products to the FDA and requested thatthe FDA comment on these revised

 

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labels. There is no regulatory requirementthat the FDA review or provide comment on such materials and accordingly, todate, we have not received any comments or recommendations for improvement fromthe FDA based on its review.  We are,however, reasonably sure that our revised labels are consistent with all FDAregulations and policies. As a result of this process, we determined thatapproximately $39,000 of products were not recoverableunder our revised label format. Accordingly, we recorded a charge for this amount in cost of salesduring this period.  In the correspondingperiod in 2003, cost of sales solely represented the cost of the products wesold.

 

***Gross Profit***Gross profit as a percentage of net revenues for the six-month period endedJune 30, 2004 is negative as a direct result of the matters discussedunder the Cost of Sales discussion above related to the submission of newlabels to the FDA.  In our opinion, anycomparison to a prior period is not meaningful as a result of this action.

 

***Marketing,Advertising and Promotion Expenses*** Marketing,advertising and promotion expenses increased approximately 22% to $76,849 forthe six-month period ended June 30, 2004 from $63,046 for the six-monthperiod ended June 30, 2003.  Thisincrease was primarily due to increased advertising, marketing and thepromotion of our products including payments made to Commotion Inc. prior tothe Company’s commitment on April 8th, 2004 not to market orsell its products until all outstanding matters have been addressed to thesatisfaction of the SEC and until the Company is reasonably sure that themarketing and sale of its products is consistent with the FDA’s requirementsand policies

 

***Management Fee***Management fee decreased approximately 71% to $16,320 for the six-month periodended June 30, 2004 from $56,042 for the six-month period endedJune 30, 2003.  Presently, theCompany pays directly certain expenses allocated as part of Management Fees inprevious periods. Consequently, this has caused a disproportionate decreasewhen comparing the two periods.

 

***Selling, General andAdministrative*** Selling, general and administrative expenses increased by $2,420,156 to$2,572,547 during the six-month period ended June 30, 2004 as compared to$152,391 in the comparable period in 2003. The increase is due primarily to our increased operations,non-refundable fees we incurred in connection with our March 16, 2004 Private Investment in Public Equitytransaction and significant legal and other professional expenses we continueto incur in connection with our recent SEC, Nasdaq, and FDA matters andshareholder class actions.  See “RecentEvents.”

 

During the six months ended June 30,2004, we incurred approximately $719,000 in legal and professional fees toamend our previously filed annual report, for representation before the SEC andFDA and to defend ourselves in the shareholder class actions; approximately$615,000 in professional and settlement fees we incurred in connection with ourMarch 16, 2004 Private Investmentin Public Entity transaction; approximately $170,000 in generalcorporate legal fees; approximately $408,000 in salaries, wages and relatedpersonnel costs; approximately $286,000 in business, financial and otherprofessional services; approximately $109,000 for various insurance premiumstypical of a public company; and approximately $22,500 for board of directorscompensation.  The remaining selling,general and administrative expense pertained to our general expansion of ouroperations.

 

***Research andDevelopment*** Research and development expensesincurred for the six-month period ended June 30, 2004 were $142,466.  Beginning in January 2004, we engagedBiochemics to provide services pursuant to a February 2003 manufacturingand development agreement. These services related to the formulation of ananalgesic utilizing the active ingredient ibuprofen.  Pre-clinical studies utilizing animals wereconducted and billed as part of this research. No such charges were incurred during the six-month period endedJune 30, 2003.

 

***Stock BasedCompensation*** We are required to record stock-basedcompensation when we grant options to purchase our common stock tonon-employees in accordance with SFAS 123. The value of these options iscalculated using the Black-Scholes option-pricing model. Stock basedcompensation for the six-month period

 

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ended June 30, 2004 was $124,134.  During this six-month period the Company granted165,000 options to non-employees pursuant to its Stock Incentive Plan. Inaddition, 225,000 options were granted to a consultant, which were separatelyregistered by the Company by filing a Form S-8 with the SEC inFebruary 2004.  There were no common stock options granted to non-employees priorto June 30, 2003, accordingly there was no stock-based compensationrecorded in the six-month period ended June 30, 2003.

 

***Liquidity and Capital Resources***

 

Historically, while we were a division of BioChemics, cash was managedon a centralized basis. Cash receipts associated with our business weretransferred to BioChemics directly upon receipt and in turn BioChemics hasprovided funds to cover our disbursements. Accordingly, BioChemics made cashcontributions to our capital in the three and six–month periods endedJune 30, 2003 to cover our deficits incurred during that period and tofund the initial costs of a private placement, discussed below which closed inMay 2003.  BioChemics provided us withapproximately $370,000 during the six-month period ended June 30, 2003that we later reimbursed with a portion of the net proceeds from ourDecember 2003 initial public offering.

 

In accordance with our plan to obtain independent financing as astand-alone entity, we initiated a private placement of our 10% convertiblesubordinated pay-in-kind promissory notes in the aggregate principal amount of$500,000. The proceeds from the sale of these notes were used to fund certainexpenses related to our initial public offering, as well as for generaladministrative and operating expenses, which is discussed further below. InDecember 2003, we repurchased $35,000 principal amount of these notes atcost, without interest, from an unrelated third party investor.  The private placement closed in May 2003.

 

On December 15, 2003, we completed an initial public offering of1,667,500 shares of our Class A common stock(5,002,500 on a post-split basis) at a price of $5.00 per share ($1.67 on apost-split basis), raising approximately $6.4 million, net of issuancecosts. At June 30, 2004, we had approximately $3.9 million remainingfrom these proceeds for our working capital needs. Concurrently with thecompletion of our initial public offering, we converted our 10% convertiblesubordinated pay-in-kind promissory notes into an aggregate of 200,371 sharesof Class A common stock (601,113 shares on a post-split basis).

 

In the six-month period ended June 30, 2004, we received anaggregate of $450,000 from the exercise of warrants in February 2004 andMarch 2004 by the founder of Commotion LLC, a marketing company that weclosed a marketing agreement with on January 1, 2004. These warrants wereissued on January 16, 2004 (please see “Outlook for the remainder of 2004”for more information on our agreement with Commotion, LLC).

 

On March 16, 2004 we entered into a private placement transactionwith an institutional investor in the amount of $7.5 million. Theinvestment was in the form of an 18 month 2% Convertible Note convertibleinto shares of Class A common stock at a conversion rate of $9 per share,at the option of the investor. Both principal and interest were payable in cashor in shares of Class A common stock at our option. In addition, we issuedto the investor warrants to purchase 166,667 shares of our Class A commonstock at an exercise price of $8.75 per share. Given that the initiation and continuation of the April 1, 2004trading suspension by the SEC constituted a breach under the Note, the Companyand the investor agreed, pursuant to the terms of a settlement agreemententered into on April 8, 2004, that the Company would immediately repaythe investor the sum of $7,500,000 in cash without penalty, interest,redemption premium or any other premium or penalty, plus an expense reimbursementin connection with the settlement agreement in the amount of $15,000 incash.   In consideration of thisrepayment, the investor surrendered the Note and warrants and the partiesmutually terminated all other agreements entered into in connection with thetransaction.

 

In connection with this transaction, we paid approximately $600,000 infees to various third parties.  Thesefees were not refunded when we repaid the investor and, accordingly, wererecorded as an expense during the six-month period ended June 30, 2004.

 

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We do not expect our marketing efforts with M2G Media and OrthoDistribution, Inc. to provide us with significant revenues or cash flow in2004.

 

In addition, our financial condition has been affected by theadministrative costs and legal fees associated with both the SEC and FDAregulatory matters, as well as the preliminary aspects of our pendinglitigation.  Please see “LegalProceedings” and “Recent Events” for more information on the underlying claimsin the lawsuits against us and the SEC’s trading suspension.  We expect to use our working capital, inpart, to defray those costs for the foreseeable future.  Nevertheless, we believe we have sufficientcash to execute our business plan through the end of the 2004 fiscal year.  However, if there are adverse developments inthe lawsuits against us, or resolution of our regulatory matters with the SECand the FDA take longer than we expect, our capital resources could beadversely affected.

 

***Off-Balance Sheet Arangements***

 

We have no off balance sheet financing or financing that is notdisclosed in our unaudited condensed financial statements included in thisQuarterly Report.

 

***Quantitative and Qualitative DisclosuresRegarding Market Risk***

 

*Interest Rate Sensitivity*

 

As of June 30, 2004, we had cash and cash equivalents of$3,892,959 that consisted of highly liquid money market instruments withmaturities less than 90 days. Because of the short maturities of theseinstruments, a sudden change in market interest rates would not have a materialimpact on the fair value of the portfolio. Accordingly we do not expect ouroperating results or cash flows to be affected to any significant degree by theeffect of a sudden change in market interest rates on our portfolio.

 

*Equity Security Price Risk*

 

We do not own any equity investments. Therefore, we do not currentlyhave any direct equity price risk.

 

*Market/Price Risk*

 

We are exposed to market risk in the normal course of businessoperations. We face competition and must offer our products and services atprices the market will bear.  If and whenwe resume marketing our products, we believe we will be well positioned withour products such that price risk will not affect our operating results to anysignificant degree. However, should the prices of our products be less thananticipated, this may adversely affect our future profitability andcompetitiveness.

 

**Risk Factors**

 

**We are an early stage company with a brief history of losses and maynever achieve or sustain profitability.**

 

We do not have any continuing revenues and we have never beenprofitable and we may not achieve profitability in the foreseeable future, ifat all. Our ability to generate profits in the future will depend on a number offactors, including:

 

•                                          start-up costs relating to the commercialization, sale andmarketing of our products;

 

•                                          market acceptance of our products and product candidates;

 

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•                                          costs of acquiring and developing new product candidates;

 

•                                          ability to bring our products to market;

 

•                                          general and administrative costs relating to our operations;

 

•                                          increases in our research and development costs;

 

•                                          charges related to purchases of technology or other assets;

 

•                                          ability to raise additional capital; and

 

•                                          the favorable resolution of our current litigation (see“Legal Proceedings”).

 

At June 30, 2004, we had an accumulated deficit of approximately$4.6 million.  We expect to incuradditional operating losses as we expand our marketing, sales and developmentefforts. If we are unable to generate sufficient revenue from our operations topay expenses or we are unable to obtain additional financing on commerciallyreasonable terms, our business, financial condition and results of operationsmay be materially and adversely affected.

 

**We are an early stage company that has a limited operating history.**

 

We are an early stage company focused on commercializing, marketing andselling over-the-counter, or OTC, pharmaceutical products. We began ouroperations as a division of BioChemics, Inc. in January 2001. We haveonly operated as an entity independent of BioChemics since January 2003.Our operating history is therefore limited. Our Termin8, Athlete’s Relief andOsteon products are in the early stages of commercialization. Our productcandidates are only in the early stages of development. With the exception ofthe introduction of deFEET to the marketplace by BioChemics while we were stilla division of BioChemics, we have not yet commercialized, marketed or sold anyproducts or recognized significant revenue from product sales. You shouldevaluate the likelihood of financial and operational success in light of theuncertainties and complexities present in an early-stage company, many of whichare beyond our control, including:

 

•                                          our potential inability to market, distribute, and sell ourproducts; and

 

•                                          the significant investment of capital and other resourcesnecessary to achieve our commercialization, marketing and sales objectives.

 

Our operations have been limited to organizing and staffing ourcompany, acquiring our license, developing and testing our revenue distributionmodels and test marketing our products. These operations provide a limitedbasis for you to assess our ability to commercialize our products and productcandidates and the advisability of investing in us.

 

**Our failure to comply withextensive governmental regulation may significantly affect our operatingresults.**

 

The worldwide marketing of our products and our product candidates aresubject to extensive requirements by foreign, national, state and localgovernments. These regulations potentially impact many aspects of ouroperations, including testing, research and development, manufacturing,pre-market labeling, storage, quality control, adverse event reporting, recordkeeping, advertising and promotion. Failure to comply with applicable regulatory requirements could, amongother things, result in:

 

•  fines;

 

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•  changes to advertising;

 

•  failure to obtain necessary marketing approvals;

 

•  revocation or suspension of regulatory approvals ofproducts;

 

•  product seizures or recall;

 

•  delay, interruption or suspension of product manufacturing,distribution, marketing and sale; or

 

•  civil or criminal sanctions.

 

Thediscovery of previously unknown problems with our initial and future productsmay result in the interruption of marketing, including withdrawal from themarket.  In addition, the FDA may revisitand change its prior determinations with regard to the safety or efficacy ofour products. If the FDA’s position changes, we may be required to change ourlabeling or cease the marketing and manufacturing of the product or products atissue.  Even prior to any formalregulatory action, we could voluntarily decide to cease the distribution andsale or recall any of our future products if concerns about their safety orefficacy develop.

 

Intheir regulation of all our promotional materials, the FDA and the FTC may takeissue with some advertising or promotional practices as being false, misleadingor deceptive. The FDA or the FTC may impose a wide array of sanctions oncompanies for such advertising practices, which could result in any of thefollowing:

 

• incurringsubstantial expenses, including fines, penalties, legal fees and costs tocomply with FDA or FTC requirements;

 

• changingthe methods of marketing and selling products;

 

• takingmandated corrective action, which may include placing advertisements or sendingletters to physicians and marketing partners rescinding previous advertisementsor promotions; or

 

•disrupting the distribution of products and causing the loss of sales untilcompliance with the FDA’s or FTC’s position is obtained.

 

If we become subject to any of the above requirements, it could bedamaging to our reputation, and our business condition could be adverselyaffected.

 

**We cannot market our products unless they have been listed with theFDA, are covered by the FDA’s OTC Review Program, and are marketed inconformity with the applicable OTC Drug Monograph or unless they have attainedNDA or ANDA approval.**

 

If our topical Athlete’s Relief, Osteon and Termin8 products areformulated and promoted in accordance with the OTC Drug Monographs pursuant tothe FDA’s OTC Review Program, FDA pre-market approval is not required prior tomarketing.  If these or any of ourproduct candidates deviate from an OTC Drug Monograph requirement in activeingredients, intended use, method of administration, dosage form, or labeling,among other things, then we or our marketing partners must obtain a NDApre-market approval from the FDA before beginning commercial marketing. The FDAhas taken the position that insofar as our product candidates may use the VALEtransdermal technology, they fall outside of those eligible for GRASE statusunder the OTC Review Program and thus we must obtain, or our marketing partnersmust obtain, NDA approval of these product candidates before they can becommercially marketed.

 

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Under FDA’s procedures it is generally less burdensome to obtain NDAapproval of a drug product which contains the same active ingredient(s) asthose:  (a) considered GRASE in a finalOTC Drug Monograph, or (b) contained in a drug product eligible for ANDA,approval, but which differs in certain conditions of use (e.g., dosage form)from that covered by a final OTC Drug Monograph or eligible for ANDAapproval.  However, once a productbecomes subject to the NDA requirements there can be no assurance that acompany can generate the additional data and information necessary to supportNDA approval of the proposed variant product or that approval can be obtainedwithout substantial expenditures and delays.

 

**Clinical trials may failto demonstrate the safety and efficacy of our product candidates and couldprevent or significantly delay regulatory approval.**

 

Priorto receiving approval to commercialize any of our product candidates, we mustdemonstrate with substantial evidence from well-controlled clinical trials, andto the satisfaction of the FDA and other regulatory authorities in the UnitedStates and abroad, that the product candidate is both safe and effective.  If these trials or future clinical trials areunsuccessful, our business and reputation would be harmed and our stock pricewould be adversely affected.

 

Allof our product candidates are prone to the risks of failure. The results ofearly-stage clinical trials of our product candidates will not necessarilypredict the results of later-stage clinical trials. Product candidates inlater-stage clinical trials may fail to show desired safety and efficacy traitsdespite having progressed through initial clinical testing. Even if we believethe data collected from clinical trials of our product candidates arepromising, these data may not be sufficient to support approval by the FDA orany other U.S. or foreign regulatory approval. Preclinical and clinical datacan be interpreted in different ways. Accordingly, FDA officials couldinterpret such data in different ways than we do,which could delay, limit or prevent regulatory approval. The FDA, otherregulatory authorities, or we may suspend or terminate clinical trials at anytime. Any failure or significant delay in completing clinical trials for ourproduct candidates, or in receiving regulatory approval for the sale of anyproducts resulting from our product candidates, may severely harm our businessand reputation.

 

Because of these risks, the research and development efforts of ourcollaborative partners may not result in any commercially viable products. If asignificant portion of these development efforts is not successfully completed,required regulatory approvals are not obtained by our partners, or any approvedproducts are not commercially successful, we are not likely to generatesignificant revenues or become profitable.

 

**There is no organizedmarket for our stock; our stock price has been volatile and could experiencesubstantial****declines**.

 

        Themarket price of our common stock has experienced, and may continue toexperience, significant volatility. During 2003 and the firstsix months of 2004, the per share closing price of our common stock ranged from$0.40 to $14.11.  As a result ofthe temporary suspension of trading in our securities on April 1, 2004,our press release dated April 7, 2004 advising investors not to trade inour securities until further disclosure was made by us, and our voluntarydelisting of our securities from The Nasdaq Stock Market on April 8, 2004,there is not currently an organized market in our securities, and there can beno assurance that such a market will develop. On August 6, 2004 the closing price for a share of our Class A Common Stock as quoted by the OTC Pink Sheets was $1.44.The value of our Class A Common Stock may declineregardless of our operating performance or prospects. Factors affecting ourmarket price include:

 

•the success or failure of our product developmentefforts, especially those related to obtaining regulatory approvals;

 

•technological innovations developed by us or ourcompetitors;

 

•variations in our operating results and the extent towhich we achieve our key business targets;

 

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•differences between our reported results and thoseexpected by investors and securities analysts; and

 

•market reaction to any acquisitions or joint venturesannounced by us or our competitors.

 

Inaddition, in recent years, the stock market in general, and the market forpharmaceutical companies in particular, have experienced significant price andvolume fluctuations. This volatility has affected the market prices ofsecurities issued by many companies, often for reasons unrelated to their operatingperformance, and it may adversely affect the price of our common stock. In thepast, securities class action litigation has often been instituted followingperiods of volatility in the market price of a company’s securities.  A number of securities class action have been filed against the Company.  See “Legal Proceedings” for more information.

 

**We are defendants in anumber of class action lawsuits that may adversely affect our business.**

 

As discussed in greater detail under “LegalProceedings”, we and certain of our officers are the defendants in a number ofclass action lawsuits filed on behalf of purchasers of the Company’s Class Acommon stock during the period December 11, 2003 to March 31, 2004 which allegethat the defendants violated the federal securities laws by allegedly failingto make accurate and complete disclosures concerning the Company, its businessoperations and future prospects, the clinical trial and endorsement of theCompany’s Termin8 anti-fungal product (previously known as “deFEET”) and theinstitutional demand for the Company’s securities. The complaints seekequitable and monetary relief, an unspecified amount of damages, with interest,attorneys fees and costs.

 

BioChemics, our directors and certain of ourofficers are also party to two shareholder derivativeactions alleging a breach of the defendants’ fiduciary duties to theCompany.  The complaints seek equitableand monetary relief, an unspecified amount of damages, and attorneys and otherfees, costs and expenses, ostensibly on behalf of the Company.

 

Regardlessof whether we win or lose, these securities class action lawsuits, and otherswhich may be filed, could result in:

 

•                  potential liabilities;

•                  a materialadverse financial statement impact

•                  substantial costs for defendingthese suits; and

•                  a diversion ofmanagement’s attention and resources.

 

Ifthere are adverse developments in the lawsuits against us, or resolution of ourregulatory matters with the SEC and the FDA takes longer than we expect, ourcapital resources could be adversely affected.

 

**Our insurer notified us that it rejects itsliability to reimburse us with respect to any of the claims asserted in any ofthe current litigation against the Company or our officers or directors.  If the insurer is successful in rejecting itsliability, it may adversely affect our business.**

 

Werely on our director and officer liability insurance policy to provide us withsufficient coverage to reimburse us for the cost of defense and, up to itscoverage limit, to offset any unfavorable outcome which may result from classaction lawsuits or derivative actions filed against us or our directors andofficers.  Our insurer has notified usthat based on a coverage evaluation, it intends to rejectliability to reimburse the Company with respect to any of the claims assertedin any of the litigation summarized under “Recent Events” for a substantialmajority of the policy coverage and that it may seek to rescind the policy withrespect to the balance of the policy coverage. The Company intends to vigorously contest the insurer’s positions.

 

Ifthe insurer prevails, it may adversely affect our capital resources and in turnour business.

 

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**Provisions in our bylawsprovide for indemnification of officers and directors, which could require usto direct funds away from our business operations.**

 

Ourbylaws provide for the indemnification of our officers and directors.  We may be required to advance costs incurredby an officer or director and to pay judgments, fines and expenses incurred byan officer or director, including reasonable attorneys’ fees, as a result ofactions or proceedings in which our officers and directors are involved byreason of being or having been an officer or director of the Company.  Funds paid in satisfaction of judgments,fines and expenses may be funds we need for the operation of our business,commercialization of our current products and the development of our product candidates,thereby affecting our ability to attain profitability.

 

**We have depended on a small number of customers for the majority of ourgross revenue. As of the date of this report, we are not generating anyrevenue.  We may not be able to generatefuture revenue.**

 

At various times, we and BioChemics have marketed Osteon, Athlete’sRelief and deFEET on a “test basis” to experiment with consumer packaging andproduct performance receptivity, packaging size, label design along with othercriteria.  We consider this informationimportant to deciding on an eventual roll out strategy for the products.  We call these programs “test marketing”because neither the Company nor its parent, BioChemics, weresufficiently capitalized to engage in advertising campaigns.  In some cases, we terminated test marketingprograms and in other cases, the retailer terminated test marketingprograms.  In connection with the testmarketing program with Walgreens to sell deFEET in mid-2003, we could notprovide sufficient funding for an advertising program that would be acceptableto Walgreen’s. Our efforts were complicated by our need to change the productname from deFEET to Termin8.  Because ofour inability to undertake an acceptable advertising campaign, we andWalgreen’s terminated this test marketing program.  Although management believes that ourproducts, supported by sufficient advertising, will earn retailers acceptance,there can be no assurance that this will happen, or if it does, that it willcontinue.

 

We have, as discussed previously, established two strategic marketingand distribution alliances. If these two strategic alliances are not successfuland if other strategic alliances or retail distribution agreements are notestablished, this could result in a material adverse impact on our revenues.

 

**We have suspended the saleand marketing of our products.**

 

After the initiation of the trading suspension, we ceased marketing andselling Athlete’s Relief, Osteon and Termin8. Marketing and sale of these products has not yet resumed.  We anticipate that our marketing and sales ofthese products will resume by the end of 2004, although there is no guaranteeof this.  We expect that our sales andmarketing efforts will resume if and when all outstanding issues between theSEC, FDA and the Company have been addressed. We do not know if, or when, this will occur.

 

Failure to resolve the concerns of the SEC or the FDA will have amaterial adverse effect on our ability to market and sell our products or raisecapital.

 

**We depend on BioChemics and third parties to develop and manufactureour products and product candidates and our commercialization of our productscould be stopped, delayed or made less profitable if BioChemics or those thirdparties fail to provide us with sufficient quantities at acceptable prices.**

 

We do not possess product development capability. As a result, wedepend on collaborations with third parties, such as BioChemics, fordevelopment of our product candidates. During the three and six-month periodsended June 30, 2004, we incurred research and development costs ofapproximately $47,300 and $142,470 respectively related to the formulation ofan analgesic utilizing the active ingredient ibuprofen.  Pre-clinical studies utilizing animals wereconducted and billed as part of this research. These services were incurred pursuant

 

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to a February 2003 manufacturing anddevelopment agreement with BioChemics (see Manufacturing and Developmentagreement filed on September 9, 2003 as an exhibit to Amendment 1 of ourRegistration Statement). In addition, we have no manufacturing capability. As aresult, we will depend on BioChemics, which in turn will rely upon thirdparties to manufacture our products. Although our strategy is based onleveraging BioChemics’ ability to develop and manufacture our products forcommercialization in the OTC marketplace, we will be dependent on BioChemics’collaborations with drug development and manufacturing collaborators. If we andBioChemics are not able to maintain existing collaborative arrangements orestablish new arrangements on commercially acceptable terms, we would berequired to undertake product manufacturing and development activities at ourown expense. This would increase our capital requirements or require us to limitthe scope of our development activities. Moreover, we have limited or noexperience in conducting full scale bioequivalence studies, preparing, andsubmitting regulatory applications, and manufacturing and marketing drugproducts. There can be no assurance that we will be successful in performingthese activities and any failure to perform such activities could have amaterial adverse effect on our business, financial condition and results of ouroperations.

 

If any of our developmental collaborators, especially BioChemics,breach or terminate their agreements with us or otherwise fail to conduct theircollaborative activities in a timely manner, the preclinical and/or clinicaldevelopment and/or commercialization of our product candidates will be delayed,and we would be required to devote additional resources to product developmentand commercialization or terminate certain development programs. Also, theserelationships generally may be terminated at the discretion of ourcollaborators, in some cases with only limited notice to us. The termination ofcollaborative arrangements could have a material adverse effect on ourbusiness, financial condition and results of operations. There also can be noassurance that disputes will not arise with respect to the ownership of rightsto any technology developed with third parties. These and other possibledisagreements with collaborators could lead to delays in the development orcommercialization of our product candidates or could result in litigation orarbitration, which could be time consuming and expensive and could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

Additionally, the failure of any of our contract manufacturers tomanufacture our products in conformity with cGMPs could result in interruptionor halt of the availability of our products, pending demonstration to the FDAor a court of compliance with cGMPs.  Anysuch interruption could have a material adverse impact upon our financialposition and results of operations.

 

**If we or BioChemics fail to adequately protect or enforce ourintellectual property rights, we may be unable to operate effectively.**

 

BioChemics owns proprietary technology developed in connection with itsfour U.S. patents.  These are: Patent No.5,460,821, issued on October 24, 1995 and expiring June 23, 2013;Patent No. 5,645,854, issued on July 8, 1997 and expiring June 23,2013; Patent No. 5,853,751, issued on December 29, 1998 and expiringJune 23, 2013; and Patent No.6,635,274, issued onOctober 21, 2003 and expiring October 27, 2020. BioChemics has licensed these patents tous. In addition, foreign patents have been issued to BioChemics in 17 foreigncountries and are pending in seven others. The PENtoCORE technology is notcovered by patents but is considered proprietary. BioChemics also owns fifteenregistered trademarks, including Osteon and PENtoCORE. We have applied for U.S.Trademark protection for the mark “Termin8”. Our license agreement, as amended, with BioChemics permits us to commercialize, market and sell our products and productcandidates using these patents, proprietary formulations and the Osteon andPENtoCORE trademarks. Our success and ability to compete are substantiallydependent on these patents, proprietary formulations and trademarks. Althoughboth we and BioChemics believe that the patents and associated trademarks andlicenses are valid, there can be no assurance that they will not be challengedand subsequently invalidated and/or canceled. The invalidation or cancellationof any one or all of the patents or trademarks would significantly damage ourcommercial prospects. Further, BioChemics may find it necessary to legallychallenge parties infringing its patents or trademarks or licensed trademarksto enforce its rights thereto. There can be no assurance that any of thepatents would ultimately be held valid or that efforts to defend any of thepatents, trade secrets, know-how or other intellectual property rights would besuccessful.

 

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**If we infringe on the intellectual property rights of others, ourbusiness and profitability may be adversely affected.**

 

Our commercial success will also depend, in part, on us and BioChemicsnot infringing on the patents or proprietary rights of others. There can be noassurance that the technologies and products used or developed by BioChemicsand marketed and sold by Vaso Active will not infringe such rights. If suchinfringement occurs and neither we nor BioChemics is able to obtain a licensefrom the relevant third party, we will not be able to continue the development,manufacture, use, or sale of any such infringing technology or product. Therecan be no assurance that necessary licenses to third-party technology will beavailable at all, or on commercially reasonable terms. In some cases,litigation or other proceedings may be necessary to defend against or assertclaims of infringement or to determine the scope and validity of theproprietary rights of third parties. Any potential litigation could result insubstantial costs to, and diversion of, our resources and could have a materialand adverse impact on us. An adverse outcome in any such litigation orproceeding could subject us and/or BioChemics to significant liabilities,require us to cease using the subject technology or require us and/orBioChemics to license the subject technology from the third party, all of whichcould have a material adverse effect on our business.

 

**We operate in a competitive environment and there can be no assurancesthat competing technologies would not harm our business development.**

 

We are engaged in a rapidly evolving field. Competition from numerouspharmaceutical companies including Pfizer, Bristol-Myers Squibb,Schering-Plough, and biotechnology companies including, Alza, Cygnus and Elan,as well as research and academic institutions, is intense and expected toincrease. The market for transdermal and topical drug delivery systems is largeand growing rapidly and is likely to attract new entrants. Numerousbiotechnology and biopharmaceutical companies have focused on developing newdrug delivery systems and most, if not all of these companies,have greater financial and other resources and development capabilities than wedo. They also have greater collective experience in undertaking pre-clinicaland the clinical testing of products; obtaining regulatory approvals; andmanufacturing and marketing OTC and prescription pharmaceutical products.Accordingly, certain of our competitors may succeed in obtaining approval forproducts more rapidly than us. In addition to competing with universities andother research institutions in the development of products, technologies andprocesses, we may compete with other companies in acquiring rights to productsor technologies from universities. There can be no assurance that our products,existing or to be developed, will be more effective or achieve greater marketacceptance than competitive products, or that our competitors will not succeedin developing products and technologies that are more effective than thosebeing developed by us or that would render our products and technologies lesscompetitive or obsolete.

 

**Technological advancement by our competitors could result in theobsolescence of some or all of our products and may harm business development.**

 

The areas in which we are commercializing, distributing, and/or sellingproducts involve rapidly developing technology. There can be no assurance thatwe will be able to establish ourselves in such fields, or, if established, thatwe will be able to maintain our position. There can be no assurance that thedevelopment by others of new or improved products will not make our productsand product candidates, if any, superfluous or our products and productcandidates obsolete.

 

**Should product liability claims be brought successfully against usexceeding the product liability coverage we currently have in place there canbe no assurances that such events would not materially impact our performanceand viability.**

 

The sale of our products may expose us to potential liability resultingfrom the sale and use of such products. Liability might result from claims madedirectly by consumers or by pharmaceutical companies or by others selling suchitems. We currently maintain $5 million of product liability insurance.There can be no

 

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assurance that we will be able to renew ourcurrent insurance, renew it at a rate comparable to what we now pay, or thatthe coverage will be adequate to protect us against liability. If we were heldliable for a claim or claims exceeding the limits of our current or futureinsurance coverage, or if coverage was discontinued for any reason, it couldhave a materially adverse effect on our business and our financial condition.

 

**Our limited sales and marketing experience may adversely impact ourability to successfully commercialize and sell our products.**

 

We have limited sales and marketing experience, particularly withrespect to marketing and selling products in commercial quantities. If we areunable to expand our sales and marketing capabilities we may not be able toeffectively commercialize our products and product candidates.

 

**If we are unable to effectively promote our brand and establish aleading position in the marketplace, our business may fail.**

 

Our brand names are new and unproven. If we are unable to effectivelypromote our brands and establish a prominent position in the marketplace, ouroperations will suffer.  We believe thatthe importance of brand recognition will increase over time.  In order to gain brand recognition, we mayincrease our marketing and advertising budgets to create and maintain brandloyalty.  We do not know whether theseefforts will lead to greater recognition.

 

**We depend on BioChemics to provide us with certain support andservices. The loss of such support and services would have a material adverseeffect on our business.**

 

We were originally formed as a division of BioChemics and the viabilityand financial strength of BioChemics is critical to our success. Throughout ourdevelopment, we have relied on services and financing provided to us byBioChemics. When we became an independent operating entity, we entered into alicense agreement and, prior to the consummation of our initial publicoffering, we entered into a manufacturing and development agreement, withBioChemics. We presently maintain our executive offices on premises that weshare with BioChemics. We do not have a lease agreement with BioChemics. Webelieve that we can obtain suitable alternative space without any materialdisruption of our business and that such space will be available to us in thefuture on commercially reasonable terms. Since BioChemics provides us withadministrative and managerial support, our results of operations includeallocations of certain BioChemics expenses, such as centralized accounting,data processing, utilities, office space rental, supplies, telephone and otherBioChemics corporate services and infrastructure costs. These expenses havebeen charged back to us as a management fee. We recorded approximately $8,200and $25,500 respectively in these related-party fees in the three-month periodsended June 30, 2004 and 2003 and approximately $16,400 and $56,000respectively in the six-month periods ended June 30, 2004 and 2003. Inaddition, during the six-month period ended June 30, 2003, BioChemicsprovided financing to us in the amount of $369,506 to fund our operating lossesincurred during that six-month period as well as fund the up front costs of aprivate placement closed in May 2003, see discussion at “Liquidity and CapitalResources.  This was reimbursed as aportion of the amount paid to BioChemics upon the closing of our initial publicoffering in December 2003. The expense allocations have been determined onthe basis that we and BioChemics consider to be reasonable reflections of theutilization of services provided for the benefit received by us.  The loss of the services provided byBioChemics or the loss of the license of the VALE patents or the PENtoCOREtechnology under the license agreement would have a material adverse effect onour business, financial condition and results of operations.

 

In this regard, investors should be aware that BioChemics has neverbeen profitable and most likely will not achieve profitability in the nearfuture, if ever. Although BioChemics was founded in 1989, and incorporated in1991, it is still a development stage company. It has generated significantlosses through December 31, 2003, has limited revenue, and is likely tosustain operating losses in the foreseeable future. BioChemics’ operations aresubject to all of the risks inherent in the establishment of a businessenterprise. Through December 31, 2003, BioChemics had an unaudited,consolidated accumulated deficit of approximately $12.8 million, which includes

 

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the operations of Vaso Active. In addition,as of December 31, 2003, BioChemics was in default under debt obligationsin the approximate amount of $8.0 million, which includes accrued interest,that it has issued to private investors, of which approximately $5.3 million,inclusive of accrued interest,****is held by Mr.Masiz, members of his family and other related parties.  Although BioChemics is attempting torestructure or refinance these obligations, there can be no assurance that itwill be able to do so on acceptable terms. If BioChemics is not successful in maintaining its financial viability,our business, financial condition and results of operations may be materiallyand adversely affected. BioChemics anticipates that it will continue to incurnet losses and be unprofitable for the foreseeable future. There can be noassurance that BioChemics will ever operate at a profit even if its or ourproducts are commercialized.

 

In addition, it is expected that BioChemics will encounter significantmarketing difficulties and will also face significant regulatory hurdles. Thelikelihood of success of BioChemics must be considered in light of theproblems, expenses, difficulties, complications and delays frequentlyencountered in connection with any non-profitable business enterprise,including but not limited to the identification and development of new products,difficulties with corporate partners, vendors, and a very competitiveenvironment. Additionally, BioChemics itself requires additional capital and/orrevenues to continue its operations and there is no guarantee that it will beable to fund its own operations or those of Vaso Active.

 

**If we fail to attract, train and retainadditional highly qualified senior executives and technical and managerialpersonnel in the near future, our business will suffer.**

 

John J. Masiz, the Company’s President and Chief Executive Officer, hasagreed to terms with the SEC to settle a proposed action by the SEC against him, withoutadmitting or denying the proposed allegations in the civil complaint, thatwould prevent him from serving as an officer or director of any public company,including the Company, for a period of five years.  If Mr. Masiz is barred from serving as anofficer and director of the Company for this five-year period, he will bepermitted and intends to continue to be an active employee of the Company.  If the offer to settle is formally acceptedby the SEC and approved by the court, Mr. Masiz would resign as the Presidentand Chief Executive Officer of the Company, as well as the Chairman of theBoard of Directors of the Company.  TheCompany is in the process of conducting a search for a new Chief ExecutiveOfficer to replace Mr. Masiz when he resigns. Due to a high demand for highlytrained executives in our industry, there is no assurance that we will be ableto attract or retain a suitable Chief Executive Officer now or in the future,and this could have a material adverse effect on our business, financialcondition and results of operations.

 

Effective June 18, 2004, Kevin J. Seifert resigned as the ChiefOperating Officer of the Company and as a director of the Company. The Companyis not currently conducting a search for a new Chief Operating Officer.  We anticipate that our new Chief ExecutiveOfficer will assume Mr. Seifert’s former responsibilities.

 

Furthermore, several of our other senior officers are devoting lessthan all their time to the Company.  Forexample, our chief scientific officer, Dr. Stephen Carter, will devoteapproximately 30% of his business time to our affairs. For us to pursue ourproduct development, marketing and commercialization plans, we will need tohire personnel with experience in clinical testing, government regulation,manufacturing, marketing and finance. We may not be able to attract and retainpersonnel on acceptable terms given the intense competition for such personnelamong high technology enterprises, including biotechnology, pharmaceutical andhealthcare companies, universities and non-profit research institutions. If welose any of these persons, or are unable to attract and retain qualifiedpersonnel, our business, financial condition and results of operations may bematerially and adversely affected.

 

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**Mr. Masiz is also the principal stockholder of BioChemics which is ourprincipal stockholder and he will have substantial control over our affairs,possibly to the detriment of other holders of our Class A common stock.**

 

Our principal stockholder, BioChemics, owns 4,500,000 shares of ourClass B common stock, which at June 30, 2004 representedapproximately 70% of the combined voting power of our common stock.Mr. Masiz, as President, Chief Executive Officer and Chairman ofBioChemics and, as the principal stockholder in BioChemics, will be able tocontrol the outcome of stockholder votes, including votes concerning theelection of our directors, the adoption or amendment to provisions in ourcertificate of incorporation or by-laws, the approval of mergers and/oracquisitions, decisions affecting our capital structure and other significantcorporate transactions. This concentration of ownership may delay, deter orprevent transactions that would result in a change of control, which in turncould reduce the value of our common stock.

 

**In the event of a conflict of interest between BioChemics and us, ourstockholders could be negatively affected.**

 

There are likely to be situations where our best interests and those ofBioChemics will be in conflict.  Forexample, we are a party to a license agreement, a manufacturing and developmentagreement and an administrative services agreement with BioChemics, each ofwhich is critical to our business operations. To the extent that decisions are made by Mr. Masiz that could enhancethe value of BioChemics versus the value to us, our stockholders interestscould be negatively affected. Investors should be aware of these potentialconflicts.

 

**ITEM 3.****                                                     CONTROLSAND PROCEDURES**

 

In connection with the preparation and filing of this Quarterly Reporton Form 10-QSB, our management, including our chief executive officer and chieffinancial officer, carried out an evaluation of the effectiveness of our“disclosure controls and procedures” (as defined under Rules l3a-l5(e) and 15d-l5(e) promulgated under the Exchange Act) asthose controls existed as of June 30, 2004.  Based on this evaluation, our principalexecutive and principal financial officers have concluded that although ourdisclosure controls and procedures were not effective, certain steps that wereimplemented with the intention of improving our disclosure controls andprocedures over our prior reporting period resulted in a significantimprovement to ensure that material information is recorded, processed,summarized and reported properly by our management on a timely basis in orderto comply with our disclosure obligations. These steps included:

 

•                  hiring counselexpert in FDA regulation; and

 

•                  hiring specialcounsel expert in SEC regulation.

 

We have also concluded that it is desirable andnecessary to hire a chief executive officer with experience in FDA regulationand SEC reporting obligations.  Weanticipate completing our search for a chief executive officer with appropriateexperience by the end of 2004. We believe with the completion of that step wewill be able conclude that our disclosure controls and procedures are effectiveto ensure that material information is recorded, processed, summarized andreported by our management on a timely basis in order to comply with ourdisclosure obligations under the Exchange Act.

 

**PART II – OTHER INFORMATION**

 

**ITEM 1.****LEGAL PROCEEDINGS**

 

**Recent Events**

 

* **SEC and FDA Regulatory Matters**.*    (See“Recent Events — Trading Suspension” in the Company’s amended Annual Report onForm 10-KSB/A, filed July 21, 2004, which is incorporated herein byreference, and

 

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“Recent Events — Trading suspension” in the Company’s Quarterly Reporton Form 10-QSB for the quarter ended March 31, 2004, filed onJuly 20, 2004, which is incorporated herein by reference.)  The Company has agreed with the SEC tosettlement terms of a proposed action to be filed by the SEC, without admittingor denying the proposed allegations of the civil complaint, pursuant to whichthe Company will be permanently enjoined from violating certain of theanti-fraud provisions of the Securities Act and the Exchange Act.  The SEC’s proposed complaint will allege thatthe Company’s registration statement in respect of the Company’s initial publicoffering, the Company’s annual report for 2003 and a statement on the Company’swebsite were false and misleading as a result of statements and omissionsconcerning the FDA approval or qualification of the Company’s products.  The Company expects that the settlement willbe formally approved by the SEC soon and will be presented to a court forapproval shortly thereafter.  Inaddition, the Company’s President and Chief Executive Officer has agreed tosettle a similar proposed action by the SEC against him, without admitting ordenying the proposed allegations of the civil compliant, that would similarlyenjoin him and prevent him from serving as an officer or director of any publiccompany, including the Company, for a period of five years.  If Mr. Masiz is barred from serving as anofficer and director of the Company for this five-year period, he will bepermitted and intends to continue to be an active employee of the Company. TheCompany expects that the President and Chief Executive Officer’s settlementwill also be formally approved by the SEC soon and will be presented to a courtfor approval shortly thereafter. Please see “Changes in Management” below foradditional information on Mr. Masiz’s resignation as well as “Risk Factors” –“If we fail to attract, train and retain additional highly qualified seniorexecutives and technical and managerial personnel in the near future, ourbusiness will suffer.”

 

The Company is not aware that the FDA is contemplating any actionagainst the Company.  The Company,through counsel, has engaged in and will continue to maintain a dialogue withthe FDA to address any concerns.  TheCompany has submitted new labels for its previously marketed products to theFDA and has requested FDA comments on any concerns or issues pertaining tothese revised labels.  As of the date ofthis report, the FDA has not provided any comment to the Company based on theagency’s review of the labels submitted to the FDA.  There is, however, no regulatory requirementthat FDA review or provide comment on such materials.  The Company is reasonably sure that theselabels are consistent with all FDA regulations and policies.

 

Due to the ongoing nature of these matters, the Company is unable todefinitively assess their impact. However, the Company has committed not to market or sell its productsuntil all outstanding matters have been addressed to the satisfaction of theSEC and until the Company is reasonably sure that the marketing and sale of itsproducts is consistent with the FDA’s requirements and policies.  This commitment may have a material adverseimpact on the Company.  The Company anticipatesthat the marketing and sale of Athlete’s Relief, Osteon and Termin8äwill resume by the end of 2004, although there is no guarantee of this.  When appropriate, the Company will makeadditional public announcements and will file public reports with the SECregarding the status of its products under applicable FDA regulations.

 

***Nasdaq******Stock Market Matters.*** By letter dated April 2, 2004, the NasdaqListing Investigations department of The Nasdaq StockMarket, Inc., or Nasdaq, notified the Company that it had commenced an inquiryto ensure the Company’s ongoing compliance with Nasdaq’s inclusion requirementsand requested certain information from the Company.  The letter further disclosed that afterreview of the information provided by the Company, Nasdaqcould take any action that might be appropriate under its Marketplace Rulesincluding removal of the Company’s securities from Nasdaq.  In view of the substantial administrative andcash burdens being borne by the Company at that time and the substantial legalcosts anticipated with respect to the SEC and FDA matters, the Companydetermined that it was in the best interest of shareholders to voluntarilycause its shares to be removed from Nasdaq and focus its attention andresources on addressing the SEC and FDA concerns.  The Company’s securities were voluntarilydelisted, effective the opening of the markets on Thursday, April 8,2004.  At an appropriate time, the Companywill seek to cause its securities to be quoted on an exchange, Nasdaq or other automated quotation system. There can be noassurance that the Company will be successful or that an organized market forthe Company’s securities will develop. If the Company is unable to list its securities on a

 

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national exchange or on an automatedsecurities quotation system in the future, it could have a material adverseimpact on our ability to raise future capital (See “Liquidity and CapitalResources”).

 

*                                                **Litigation.******* In April,May, and June 2004, the Company and certain of its officers were sued inseveral purported securities class action lawsuits filed in the United StatesDistrict Court for the District of Massachusetts.  The complaints, which seek equitable andmonetary relief, an unspecified amount of damages, with interest, attorneysfees and costs, allegedly were filed on behalf of purchasers of the Company’sClass A common stock during the period December 11, 2003 to March 31,2004 and allege that during that period, the defendants violated the federalsecurities laws by allegedly failing to make accurate and complete disclosuresconcerning the Company, its financial condition, its business operations andfuture prospects, the clinical trial and endorsement of the Company’s Termin8anti-fungal product (previously known as “deFEET”) and the institutional demandfor the Company’s securities.  Thesecomplaints are captioned as follows:  DennisE. Smith v. Vaso Active Pharmaceuticals, Inc., *et al.*,Civ. No. 04-10708 (RCL) (D. Mass.); Richard Shapiro v. Vaso ActivePharmaceuticals, Inc., *et al.*,Civ. No. 04-10720 (RCL) (D. Mass.); Christopher Pepin v. Vaso ActivePharmaceuticals, Inc., *et al.*,Civ. No. 04-10763 (RCL) (D. Mass.); Modhi Gude, *et al.*v. Vaso Active Pharmaceuticals, Inc., *et al.*,Civ. No. 04-10789 (RCL) (D. Mass.); Kim Benedetto, *et al.*v. Vaso Active Pharmaceuticals, Inc., *et al.*,Civ. No. 04-10808 (RCL) (D. Mass.); DeanDummer v. Vaso Active Pharmaceuticals, Inc., *et al.*, Civ. No. 04-10819 (RCL) (D. Mass.); Edward Tovrea v. Vaso ActivePharmaceuticals, Inc., *et al.*, Civ.. No. 04-10851 (RCL); Kourosh Alipor v. Vaso ActivePharmaceuticals, Inc., *et al.*,Civ. No. 04-10877 (RCL); Paul E.Bostrom v.Vaso Active Pharmaceuticals, Inc., *et al.*,Civ. No. 04-10948 (RCL); Ira A.Turret Sep-Ira Dated 01/24/02 v. Vaso Active Pharmaceuticals, Inc., *et al.*, Civ. No. 04-10980 (RCL); Richard Pagona v. Vaso Active Pharmaceuticals, Inc., *et al.*, Civ. No. 04-11100 (RCL); James Karanfilian v. Vaso Active Pharmaceuticals, Inc., *et al.*, Civ. No. 04-11101 (RCL); and Charles Robinson v. Vaso Active Pharmaceuticals,Inc., *et al.*, Civ. No. 04-11221 (RCL).  TheCourt has consolidated the above-referenced cases, other than the Tovreaand Karanfilian complaints, under the caption In Re Vaso ActivePharmaceuticals Securities Litigation, Civ. No. 04-10708 (RCL).

 

The Company has also been named as a nominaldefendant in two shareholder derivative actions filed, the first filed in April2004 against its directors and certain of its officers and against BioChemics,Inc. entitled Joseph Rosenkrantz v. BioChemics, Inc., *et al*, Civ. No. 04-10792 (RCL) (D.Mass.)  and thesecond filed in June 2004, also against the Company’s directors and certain ofits officers and against BioChemics, Inc. entitled William Pomeroy v.BioChemics Inc., *et a**l*, Civ. No. 04-11399 (RCL) (D. Mass.). The complaints allege, among other things, that the alleged conductchallenged in the securities cases pending against the Company in Massachusetts(described above) constitutes a breach of the defendants’ fiduciary duties tothe Company.  The complaints seekequitable and monetary relief, an unspecified amount of damages, and attorneysand other fees, costs and expenses, ostensibly on behalf of the Company. On July28, 2004, the parties filed a joint motion requesting that the Courtconsolidate these actions and establish a procedure for consolidation of anysubsequently filed derivative related case; appoint Co-Lead and Liaison Counselfor plaintiffs; stay all pretrial proceedings in these actions and any relatedactions until the earlier of (a) the resolution of any motion to dismiss filedin the above-referenced consolidated securities fraud litigation, or (b) thefiling of answers by all defendants in the same matter; and acknowledgedefendants’ acceptance of service of the Pomeroy and Rosenkrantzcomplaints.  The Court has not ruled onthis motion.

 

Although the Company intends to vigorouslydefend against these cases, the litigation process is inherently uncertain andthere can be no guarantee as to the ultimate outcome of these matters.  There is also no guarantee that these will bethe only lawsuits brought against the Company with respect to these matters.

 

An unfavorable outcome in one or more ofthese related cases could have a material adverse effect on the Company’sfinancial position, liquidity and results of operations.  In addition to the costs of defending thesecases, the Company may provide indemnification for expenses and losses that maybe incurred by its directors and officers as parties to one or more of thesecases.  Although the Company is seekingcoverage under its

 

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director and officer liabilityinsurance policy, the Company’s insurer notified us in writing on August 3,2004, that, based on its coverage evaluation, it intends to reject itsliability to reimburse the Company with respect to any of the claims assertedin any of the above-described litigation against the Company or its officer ordirectors for a substantial majority of the policy coverage and that it mayseek to rescind the policy with respect to the balance of the policycoverage.  The Company intends tovigorously contest the insurer’s positions. If the insurer prevails, the costsof defending these cases and providing indemnification to our directors andofficers may be substantial.

 

Because of the uncertainty of estimating the potential financialstatement impact of any of these actions with any reasonable degree ofaccuracy, at this time the Company has not reserved for any potential liabilityor costs that may arise as a result of this litigation except for $200,000recorded on March 31, which represents the insurance deductible that theCompany can not expect to recover.  Whilethe cases are in very preliminary stages and the outcomes are not predictable,if a substantial amount is payable by the Company and is not reimbursed throughits director and officer liability policy, this will have a material adverseeffect on the Company’s financial position and liquidity.

 

**ITEM 2.****  CHANGES IN SECURITIES**

 

*Private Placement*

 

On March 16, 2004 we entered into a private placement transactionwith an institutional investor in the amount of $7.5 million. Theinvestment was in the form of an 18 month 2% Convertible Note convertibleinto shares of Class A common stock at a conversion rate of $9 pershare.  In addition, we issued to theinvestor warrants to purchase 166,667 shares of our Class A common stockat an exercise price of $8.75 per share. On April 8, 2004, we entered into a settlement agreement andrelease with the investor pursuant to which we repaid the investor the sum of$7.5 million without penalty, interest, redemption premium or any other premiumor penalty, plus an expense reimbursement in the amount of $15,000.  In consideration of this repayment, theinvestor surrendered the Note and warrants and terminated all other agreementsentered into in connection with the private placement transaction.  See “Recent Events” Unwinding ofMarch 16, 2004 Private Investment In PublicEntity” for further information.

 

*Use of Proceeds from Initial Public Offering*

 

On December 10, 2003, our Registration Statement on Form SB-2(registration no. 333-106785) for the sale of 1,667,500 shares of ourClass A common stock (5,002,500 on a post-split basis) which included217,500 shares of Class A common stock (652,500 on a post-split basis) tocover underwriter over-allotments, at a price of $5.00 per share ($1.67 on apost-split basis), became effective. We completed this initial public offeringon December 15, 2003. All of the shares sold in this offering were fromour authorized pool of Class A common stock. Kashner Davidson SecuritiesCorp. functioned as the representative of the underwriters for this publicoffering. Net of offering costs of approximately $1.9 million, we receivedapproximately $6.4 million in proceeds, which we estimated would beallocated as follows:

 

•                                          Approximately$1.1 million to fund our continued development, commercialization and saleof our products and product candidates;

 

•                                          Approximately$1.9 million to implement our strategic marketing and commercializationplan, which approximately $1.2 million was to be allocated to fund ourradio advertising campaign.  This radiocampaign was originally to be initiated in connection with the retail rolloutof our products, which we anticipated would occur in 2004.  As a result of the cessation of the marketingand sale of our products following the initiation of the SEC trading suspensionon April 1, 2004, we do not expect that the retail rollout of ourproducts, which was designed as the second stage of our rollout strategy, willcommence until at least 2005. Consequently, we do not anticipate using any of the initial publicoffering proceeds to fund advertising, direct mail

 

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programs or otherpromotional activities related to this retail roll-out strategy before thattime and there can be no assurance that any of the initial public offeringproceeds will be used for this purpose. We have allocated approximately $372,000 in 2004 for marketing costsassociated with the first stage of our rollout strategy.

 

•                                          $200,000 torecruit and hire individuals for key senior management positions;

 

•                                          $350,000 tocover the cost of providing sales incentives, product samples and discounts;

 

•                                          To repay,without interest, BioChemics approximately $99,000 for management fees chargedback to us since we became a stand-alone entity upon our incorporation forcentralized accounting, data processing, utilities, office space rental,supplies, telephone and other BioChemics corporate services and infrastructurecosts, and approximately $347,000 for other operational charges paid byBioChemics to third parties on our behalf through September 30, 2003;these amounts increased to approximately $122,000 and $518,200 respectively,which reflect the modifications necessary for these additional type costsincurred from October 1, 2003 through December 31, 2003; and

 

•                                          Approximately$1.68 million to provide working capital for general and corporatepurposes.  We increased this to$2.2 million from the registration disclosure to reflect the net impact ofthe exercise of the over allotment option. In addition, we anticipate using the funds initially allocated for theimplementation of our strategic marketing and commercialization plan, includingthe approximately $1.2 million that was allocated to fund our anticipatedradio advertising campaign, less the approximately $372,000 budgeted formarketing costs associated with the first stage of our rollout strategy, asworking capital for general and corporate purposes.

 

**Items 3, 4 and 5 are not applicable and have been omitted.**

 

**ITEM 6 (a).****  EXHIBITS AND****REPORTS ON FORM 8-K**

 
| **Exhibit    Number** | ** ** | **Description of Exhibit**                                                                                                        |
|-----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|
| 19.1                  |       | Amended  Annual Report of Vaso Active Pharmaceuticals, Inc. on Form 10-KSB/A,  filed July 21, 2004.(1)                            |
| 19.2                  |       | Quarterly  Report of Vaso Active Pharmaceuticals, Inc. on Form 10-QSB filed July  20, 2004.(2)                                    |
| 31.1                  |       | Certification  of John J. Masiz, Chief Executive Officer, pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.(3)     |
| 31.2                  |       | Certification  of Joseph Frattaroli, Chief Financial Officer, pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.(3) |
| 32.1                  |       | Certification  of John J. Masiz, Chief Executive Officer, pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.(3)     |
| 32.2                  |       | Certification  of Joseph Frattaroli, Chief Financial Officer, pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.(3) |

 

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(1) Filed with the Securities and Exchange Commissionon July 21, 2004.

(2) Filed with the Securities and ExchangeCommission on July 20, 2004.

(3) Filed herewith.

 

**ITEM 6(b).**** Reports on Form 8-K**

 

The Company filed Form 8-K on April 7, 2004, containing a pressrelease announcing the suspension of trading of its common stock and advisingthe public that its reports and certain other publicly released informationshould not be relied upon and that it caused its securities to be removed fromNASDAQ.

 

TheCompany filed Form 8-K on April 8, 2004, containing a press release announcing the execution of a SettlementAgreement and Release between the Company and The Riverview Group LLC, dated asof April 8, 2004.

 

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TheCompany filed Form 8-K on April 19, 2004 containing a press release reminding brokers and dealers to be alertto the requirements of Rule 15c2-11 under the Securities Exchange Act of1934 upon the termination of the trading suspension in its Securities.

 

TheCompany filed Form 8-K on May 4, 2004 containing a press release announcing theAnnual Meeting ofStockholders of the Company, originally scheduled to be held on May 13, 2004,has been postponed and will be rescheduled for a later date yet to bedetermined.

 

The Company filed Form 8-K on June 21,2004 containing a press release announcing Kevin J. Seifert resigned as theChief Operating Officer and a director of Vaso Active Pharmaceuticals, Inc.effective June 18, 2004.

 

 

**SIGNATURES**

 

In accordance with Section 13 and 15(d) of the Exchange Act, theregistrant caused this report to be signed on its behalf by the undersigned,thereunto duly authorized, on August 9, 2004.

 

 
| ** ** | **VASO ACTIVE PHARMACEUTICALS, INC.** | ** **              |
|------------|--------------------------------------------|-------------------------|
|       |                                       |                    |
|       | By:                                        | /s/ Joseph Frattaroli   |   |   |
|       |                                       | Joseph Frattaroli       |   |
|       |                                       | Chief Financial Officer |   |
|            |                                            |                         |  |  |

 

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