**United States**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-K**

 
| **ý**                                            | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE  ACT OF 1934**     |
|-------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| ** **                                            | ** ** | ** **                                                                                               |
| **For the  fiscal year ended December 31, 2005** |
| ** **                                            | ** ** | ** **                                                                                               |
| **o**                                                 | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**FOR THETRANSITION PERIOD FROM            TO            **

 

**CommissionFile No. 0-12943**

 

**CYPRESS BIOSCIENCE, INC.**

(Exact name of registrant asspecified in its charter)

 

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| **Delaware**                                                     | ** ** | **22-2389839**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State or  other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.) |
|                                                             |       |                                   |
| **4350  Executive Drive, Suite 325**                        |       |                                   |
| **San  Diego, California**                                       | ** ** | **92121**                              |
| (Address of  principal executive  offices)                       |       | (Zip Code)                             |

 

Registrant’s telephone number,including area code:  **(858) 452-2323**

 

SECURITIES REGISTERED PURSUANTTO SECTION 12(b) OF THE ACT:  **NONE**

 

SECURITIES REGISTERED PURSUANTTO SECTION 12(g) OF THE ACT:

 

**CommonStock $.001 Par Value**

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act. Yes o   No ý

 

Indicate by check mark if the registrant is not required to filereports pursuant to Section 13 or Section 15(d) of the Act. Yes o   No ý

 

Indicate by check mark whether the Registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the Registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes  ý   No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K (Section 229.405 of this chapter) is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer or a non-accelerated filer.

 

Large accelerated filer o     AcceleratedFiler ý     Non-acceleratedfiler o

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Act). Yes o     Noý

 

The aggregate market value of the voting stock held by non-affiliatesof the Registrant as of June 30, 2005 was approximately $289.0 million*

 

The number of shares outstanding of the Registrant’s common stock as ofMarch 10, 2006 was 32,032,314.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of the registrant’s Definitive Proxy Statement to be filedsubsequent to the date hereof with the Commission pursuant toRegulation 14A in connection with the Registrant’s 2006 Annual Meeting ofStockholders are incorporated by reference into Part III of this Report.Such Definitive Proxy Statement will be filed with the Securities and ExchangeCommission not later than 120 days after the conclusion of the Registrant’sfiscal year ended December 31, 2005.

 

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* Calculated based on 21,894,530 shares of common stock held as of June 30,2005 by non-affiliates and a per share market price of $13.20. Excludes9,472,076 shares of common stock held by directors and executive officers andstockholders whose ownership exceeds five percent of the common stockoutstanding at June 30, 2005, who are deemed to be affiliates only forpurposes of this calculation. Exclusion of such shares should not be construedto indicate that any such person possesses the power, direct or indirect, todirect or cause the direction of the management or policies of the Registrantor that such person is controlled by or under common control with theRegistrant.

 

 

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**CYPRESSBIOSCIENCE, INC.**

**FORM 10-K**

**INDEX**

 

 
| ** ** | ** **                                                                                           | ** ** | **Page** |
|------------|------------------------------------------------------------------------------------------------------|------------|----------|
|       | ** **                                                                                           | ** ** |     |
|       | **PART I**                                                                                      |       |     |
|       | ** **                                                                                           | ** ** |     |
| Item 1     | Business                                                                                             |       | 1        |
| Item  1A   | Risk  Factors                                                                                        |       | 14       |
| Item 1B    | Unresolved Staff Comments                                                                            |       | 30       |
| Item 2     | Properties                                                                                           |       | 30       |
| Item 3     | Legal Proceedings                                                                                    |       | 30       |
| Item 4     | Submission of Matters to a Vote of Security  Holders                                                 |       | 30       |
|       |                                                                                                 |       |     |
|       | **PART II**                                                                                     |       |     |
| ** ** |                                                                                                 |       |     |
| Item 5     | Market for our Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 32       |
| Item 6     | Selected Financial Data                                                                              |       | 33       |
| Item 7     | Management’s Discussion and Analysis of  Financial Condition and Results of Operations          |       | 34       |
| Item 7A    | Quantitative and Qualitative Disclosures  about Market Risk                                          |       | 44       |
| Item 8     | Financial Statements                                                                                 |       | 44       |
| Item  9    | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                |       | 44       |
| Item 9A    | Controls and Procedures                                                                              |       | 45       |
| Item 9B    | Other Information                                                                                    |       | 48       |
|       |                                                                                                 |       |     |
|       | **PART III**                                                                                    |       |     |
|       | ** **                                                                                           | ** ** |     |
| Item 10    | Directors and Executive Officers                                                                     |       | 49       |
| Item 11    | Executive Compensation                                                                               |       | 49       |
| Item 12    | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters      |       | 49       |
| Item 13    | Certain Relationships and Related  Transactions                                                      |       | 49       |
| Item 14    | Accounting Fees and Services                                                                         |       | 49       |
|       |                                                                                                 |       |     |
|       | **PART IV**                                                                                     |       |     |
|       | ** **                                                                                           | ** ** |     |
| Item 15    | Exhibits, Financial Statement Schedules                                                              |       | 50       |
|       | Signatures                                                                                           |       | 52       |

 

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**PART I**

 

*Except for the historicalinformation contained herein, the information contained herein contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended and Section 21E of the Securities Exchange Act of 1934,as amended, including, in particular, statements about our plans, strategiesand prospects. These statements, which may include words such as “may,” “will,”“expect,” “believe,” “intend,” “plan,” “anticipate,” “estimate,” or similarwords, are based on our current beliefs, expectations and assumptions and aresubject to a number of risks and uncertainties. Although we believe that ourbeliefs, expectations and assumptions reflected in these statements arereasonable, our actual results and financial performance may prove to bevery different from what we might have predicted on the date of this Form 10-K.Factors that could cause or contribute to differences include, but are notspecifically limited to, our ability to develop milnacipran for FibromyalgiaSyndrome, our ability to develop mirtazapine alone or in combination with anyother compound for the treatment of Obstructive Sleep Apnea, our ability toacquire and develop any compounds or products to treat any other indications wemay pursue in a timely manner, or at all, as well as the other risksdetailed in this Form 10-K and in our other SEC filings.*

 

**ITEM 1. Business**

 

**Company Overview**

 

We are committed to being the innovator and leaderin providing products for the treatment of patients with Functional SomaticSyndromes and other central nervous system disorders. Specifically, ourstrategy involves acquiring or in-licensing central nervous system, or CNS,active compounds and developing them for novel and typically underservedindications. The term Functional Somatic Syndromes refers to several relatedsyndromes characterized more by symptoms, suffering and disability than bydisease-specific abnormalities that are found upon physical examination andinclude many overlapping pain and psychiatric conditions. We pursueopportunities to acquire or in-license CNS active compounds in the areas inwhich the brain and body overlap, where CNS mechanisms have a strong influenceon somatic or bodily symptoms, and our two ongoing development programs arerepresentative of this strategy. In pursuit of these opportunities, we evaluatevarious potential strategic transactions, including the potential acquisitionsof products, technologies and companies, and other alternatives.

 

Our goal is to be the first to commercialize a product approved in the United States for the treatment of Fibromyalgia Syndrome, or FMS, the focus of our initial efforts in the area of Functional Somatic Syndromes. In January 2004, we entered into a collaboration agreement with Forest Laboratories, Inc., a leading marketer of CNS drugs with a strong franchise in the primary care and psychiatric markets, for the development and marketing of milnacipran. In July 2005, we completed the first Phase III trial for milnacipran, which was commenced in October 2003. We announced the top-line results from this first Phase III trial in September 2005. Although the results did not achieve statistical significance at the p<0.05 level, we believe the preliminary results support continuation of the development program and the planned development program for milnacipran is continuing. This development program includes an ongoing second Phase III study, that was commenced in October 2004, and an additional third Phase III study, that was initiated in the first quarter of 2006.

 

In June 2005, we announced the initiation of our second development program, wherein we are evaluating potential pharmaceutical treatments for Obstructive Sleep Apnea, or OSA. We entered into three licensing agreements to support and facilitate the program. Specifically, we licensed mirtazapine-related patents from Organon (Ireland) Ltd., and patents from two other parties that provide the opportunity to combine mirtazapine with a second approved agent with the goal of potentially 

 

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augmenting efficacy and improving tolerability. The series of licenses will allow Cypress to evaluate a number of potential OSA treatment modalities in proof of concept trials.

 

Cypress and Organon are each independentlyinitiating Phase IIa trials that will serve as the basis for selecting theproduct candidate for further clinical development. The companies expect thePhase IIa trials and subsequent joint development and planning meetings to runthrough at least the first half of 2006, which is also the earliest adevelopment candidate to be evaluated in further trials could be selected.

 

**Milnacipran for the Treatment of FMS**

 

***Milnacipran***

 

We are developing milnacipran for the treatment ofFMS with our partner, Forest Laboratories. Milnacipran is the first of a new class ofagents known as norepinephrine serotonin reuptake inhibitors, or NSRIs, whichincrease the level of norepinephrine more than they do serotonin. Whilemilnacipran is similar to TCAs with regard to the relative ratio ofnorepinephrine and serotonin activity, milnacipran appears to lack the sideeffects associated with TCAs, as it does not interact with several classes ofreceptors that are responsible for many of the adverse effects of TCAs.Therefore, we believe that milnacipran may have efficacy similar to TCAsin treating FMS and related chronic pain conditions, without causing the sideeffects that limit the prescribing of TCAs by physicians, and compliance bypatients. Milnacipran is approved for the treatment of depression in 32countries and is currently a leading antidepressant in Japan. Since its commerciallaunch in 1997, milnacipran has been used by over 3,000,000 patients worldwide,with side effects typically limited to transient and mild nausea and a slightincrease in heart rate, as well as the potential for urinary retention in oldermen with an enlarged prostate. Milnacipran has not been approved in the UnitedStates for any indication, and we are the first company conducting clinicaltrials of milnacipran in the United States for FMS. As a result of thefavorable side effect profile of milnacipran compared to the TCAs and itsability to increase the level of norepinephrine more than serotonin in thebrain, we believe that milnacipran may play a significant role in thetreatment of FMS.

 

***Milnacipran Development Status***

 

*Results of Phase II Trial*

 

We completed a Phase II trial evaluating milnacipranfor the treatment of FMS in the Fall of 2002. The Phase II trial was a three-month,randomized, placebo-controlled study involving 14 sites and 125 FMS patientswho were randomized to either milnacipran treatment or placebo. The studyevaluated the overall analgesic efficacy and safety of milnacipran in thispopulation of FMS patients, with a primary endpoint based on improvement inpatient-reported pain. Electronic diaries were provided to all patients for thepurpose of recording daily pain assessments in real time. We believe thatperforming daily pain assessments using electronic diaries reduces biasinvolved with asking individuals to recall symptoms over time and improvescompliance by prompting and time-date stamping each patient response. The painmeasures obtained from the electronic diaries were chosen to be the primaryvariable for the measurement of pain improvement. Secondary objectives includedassessment of the impact of dosing strategy (twice daily dosing versus oncedaily) and the impact of milnacipran on other symptoms of FMS includingfatigue, mood, physical function and sleep disturbances. Based on tolerability,patients were allowed to double their dose every week, up to a maximum of 200mg of milnacipran daily. In our Phase II trial, milnacipran was shown toprovide statistically significant improvement in pain, the primary symptom of FMS. Thirty-sevenpercent of milnacipran-treated patients randomized to the twice a day dosinggroup reported at least a 50% reduction in pain intensity, which means thattheir reported pain was half as intense as it was at the beginning of thestudy, compared to 14% of patients in the placebo group. In this analysis, 51patients received milnacipran and 28 patients received a placebo. The reductionin pain intensity was statistically 

 

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significant,with a p-value of 0.0395. A p-value is a statistical measure of probability ofdrawing an erroneous conclusion from an experimental result. A p-value of lessthan or equal to 0.05 is generally considered to signify a statisticallysignificant result, which means a result is unlikely to occur by chance.Further, 75% of all milnacipran-treated patients reported an impression ofoverall improvement compared to 38% in the placebo group. In this analysis, 68patients received milnacipran and 21 patients received a placebo. This reportedimpression of overall improvement was also statistically significant, with ap-value of 0.003. Twice daily milnacipran had significantly better analgesicproperties than once daily milnacipran, although other outcomes (e.g. fatigue,mood, patient’s global impression) were equally impacted by the two dosingregimens. No unexpected safety concerns arose from this clinical trial andthere were no serious adverse events. Milnacipran was generally well-tolerated,especially with twice daily dosing. The most common dose-related side effectreported by patients was nausea, particularly early in the study, as well as aslight increase in heart rate. Most adverse events were mild to moderate inintensity and only lasted for a short time.

 

*Results of First Phase III Trial*

 

To prepare for our Phase III clinical program, andbefore commencing the first pivotal clinical trial, we completed a specialprotocol assessment with the FDA. In the special protocol assessment process,the FDA reviews the design and size of a proposed Phase III program andprovides comments regarding the adequacy of the clinical trial design tosupport a claim of effectiveness in an approvable NDA. The FDA’s comments arebinding on its review decision, except in limited circumstances, such as when asubstantial scientific issue essential to determining the safety oreffectiveness of a drug is identified after the Phase III program commences. Asgenerally is required by the FDA, two positive pivotal trials are required foran NDA approval of milnacipran for the treatment of FMS. As part ofthe Phase III program, we also need to evaluate patients for a time periodconsistent with the minimum safety guidelines of the International Conferenceon Harmonization of Technical Requirements for the Registration ofPharmaceuticals for Human Use, or ICH. Specifically, these ICH guidelines requirethat we evaluate 300 patients on the 200 mg dose of milnacipran for six monthsand 100 patients on the 200 mg dose of milnacipran for one year.

 

We completed our first Phase III trial evaluatingmilnacipran for the treatment of FMS in July 2005 and announced thetop-line results in September 2005. The first Phase III trial was asix-month, randomized, double-blind, placebo-controlled pivotal Phase III studyinvolving 50 sites and 888 patients with FMS who were randomized to eithermilnacipran treatment or placebo. The primaryendpoint of this trial was a composite response rate of an assessment of painas measured by the Patient Experience Diary (PED) and an assessment of overallimpression of patient well-being as measured by the Patient Global Impressionof Change (PGIC). The PED data are patient self-reported pain data collectedvia an electronic diary system which asks patients to document random, dailyand weekly pain levels. The PGIC is a patient reported periodic assessment oftheir perception of the change in their condition.

 

Based on an analysis of the data atthe three-month time point using the Last Observation Carry-forward analysis,or LOCF, the p-value for patients receiving 200 mg per day of milnacipran was0.058. LOCF is astatistical analysis method that governs how missing data for patients whowithdraw from the study before reaching the analysis time point is handled. Specifically,LOCF is an analysis in which observations measured when the patient withdrawsfrom the study are carried forward to the last time point necessary in theanalysis. The LOCF analysis treats the carried-forward data as if it were theobserved data at the last time point. A p-value is a statistical measure ofprobability of drawing an erroneous conclusion from an experimental result. Ap-value of less than or equal to 0.05 is generally considered to signify astatistically significant result, which means a result is unlikely to occur bychance. In an analysis of the data at thethree-month time point using the FDA-recommended Baseline ObservationCarry-forward (BOCF) analysis the p-value for patients receiving 200 mg per dayof milnacipran was 0.048. BOCF is an alternative statistical analysismethod that governs how missing data 

 

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forpatients who withdraw from the study before reaching the analysis time point ishandled. Specifically, BOCF is an analysis thatrequires the patient remain active in the trial to be evaluated for response. Ifa patient withdraws from the trial for any reason, they are classed as anon-responder regardless of their pain and global scores at the time ofwithdrawal. Although the BOCF analysis yielded statistically significantresults, the FDA may not accept this as a registration study because theBOCF analysis was not the prospectively defined analysis method for handlingdata for those patients who withdrew from the study prior to the assessmenttime point. The magnitude of the treatment effect observed in the three-monthstudy results was maintained at the six-month analysis (p=0.053 and 0.067 forLOCF and BOCF analyses, respectively), indicating a durable response tomilnacipran treatment. An additional endpoint of fibromyalgia syndrome, whichis a composite of the primary endpoint as well as a physical functionassessment, which mean’s the patient’s ability to perform activities ofdaily living, was also evaluated. The results of this analysis were notstatistically significant compared to placebo at either the three or six monthtimeframe. Milnacipran was well tolerated by a majority of the patients, withthe majority of patient withdrawals occurring early in the trial. The adverseevent profile was generally consistent with that seen in the previous worldwideexperience with milnacipran, as well as in the Phase II trial. The most commonadverse events leading to withdrawal among the milnacipran treated patientswere nausea 6%, heart rate increase 2%, headache 2%, and depression 2%.

 

*Ongoing Phase III Trials*

 

While the results in our first Phase III trial didnot achieve a p-value of less than or equal to 0.05, we believe the results support continued development of milnacipran as atreatment for FMS. The ongoing development program for milnacipranincludes an ongoing second Phase III study and an additional third Phase IIIstudy.

 

We and Forest commenced our second Phase III trialevaluating milnacipran as a treatment for FMS in October 2004. The secondPhase III trial is a six-month, randomized, double-blind, placebo-controlledpivotal Phase III study with planned enrollment of approximately 1,200 FMSpatients. In the second Phase III trial, two milnacipran doses will beevaluated (200 mg, administered 100 mg twice daily, as well as a lower dose,also administered twice daily). Based on the anticipated time necessary torecruit the patients for this trial, we expect to announce initial results fromthe second Phase III trial no earlier than the middle of 2007. Additionally, weand Forest commenced our third Phase III trial evaluating milnacipran as atreatment for FMS in the first quarter of 2006.

 

**Treatment of Obstructive Sleep Apnea**

 

***OSA Condition***

 

Obstructive sleep apnea, or OSA, a breathingdisorder that is not currently treatable with an approved drug, affects 15 - 20million people in the United States alone (according to the National Institutesof Health National Center for Sleep Disorder Research) and another 10 to 20million in Europe, a prevalence comparable to conditions such as diabetes orasthma. OSA is characterized by brief interruptions of breathing during sleep,typically caused by a blockage of the airway, usually when the soft tissue inthe rear of the throat collapses, either partially or fully, during sleep.These interruptions in breathing are called, depending upon severity, apneic orhypopneic episodes, and people with OSA can have as many as 30 or more of theseinterruptions each hour. For many patients, OSA syndrome is characterized bythese apneic episodes along with loud snoring and inappropriate daytimesleepiness.

 

Currently, there are no safe and effective medications indicated forthe routine treatment of sleep apnea. However, the pathogenesis of the disordersuggests that patients with OSA syndrome may respond to drug therapy,including those that manipulate the brain neurotransmitter, serotonin.

 

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***OSA Development Status***

 

Cypress and Organon have each independentlyinitiated Phase IIa trials that will serve as the basis for selecting theproduct candidate, if any, for further clinical development. The companiesexpect the Phase IIa trials and subsequent joint development and planningmeetings to run through at least the first half of 2006, which is also theearliest a development candidate to be evaluated in further trials could beselected.

 

**Licenses and Collaborations**

 

***Milnacipran Agreements***

 

***Pierre FabreAgreements***

 

In January 2004, we amended and restated ourexisting license agreement with Pierre Fabre. Our license agreement with PierreFabre provides us with an exclusive license to develop and sell any productswith the compound milnacipran as an active ingredient for any indication in theUnited States and Canada. Milnacipran has been marketed outside of the UnitedStates since 1997 as an antidepressant and has been used by over 3,000,000patients worldwide. We paid Pierre Fabre a total of $2.5 million,including upfront payments of $1.5 million in connection with theexecution of the original license agreement in 2001 and a $1.0 millionmilestone payment in September 2003, and issued Pierre Fabre 1,000,000shares of common stock and warrants to purchase 300,000 shares of common stockin connection with an amendment to the agreement with Pierre Fabre. We areobligated to pay Pierre Fabre 5% of any upfront and milestone payments receivedfrom Forest Laboratories as a sublicense fee. A $1.25 million such payment hasbeen made to date. After a total of $7.5 million has been paid, anyadditional sublicense fees are credited against any subsequent milestone and royaltypayments owed by us to Pierre Fabre. If not used, these credits are carriedforward to subsequent years. We also are obligated to pay Pierre Fabre up to$4.5 million in the aggregate upon achievement of defined clinical andregulatory objectives. Forest Laboratories assumed our obligation to payroyalties to Pierre Fabre and the transfer price for the active ingredientsupplied by Pierre Fabre. Pierre Fabre retains the right to sell products inindications developed by us outside the United States and Canada, and will payus a royalty based on net sales for such products. The license agreement alsoprovides Pierre Fabre with certain rights to obtain a license outside theUnited States and Canada for new formulations and new salts developed by us.

 

The agreement is effective until the later of theexpiration of the last-to-expire of certain patents held by Pierre Fabrerelating to the development of milnacipran, or ten years after the firstcommercial sale of a licensed product, unless terminated earlier. Each partyhas the right to terminate the agreement upon 90 days’ prior writtennotice of the bankruptcy or dissolution of the other party or a breach of anymaterial provision of the agreement if such breach is not cured within90 days following such written notice. Additionally, Pierre Fabre has theright to terminate the agreement upon 90 days’ written notice if (i) weterminate all development activities, unless the termination of activities issubject to cure within 12 months and we are using commercially reasonableefforts to cure the termination of activities, (ii) we challenge thePierre Fabre patents and (iii) we effect a change in control in which athird party acquiror controls an SNRI product and certain provisions of theagreement would be breached as a result of such SNRI product, and the breach isnot cured within a specified time period.

 

In addition, in January 2004, we entered into asupply agreement with Pierre Fabre. If any product is commercialized under thelicense agreement, Pierre Fabre will have the exclusive right to manufacturethe active ingredients used in the commercial product, and we will pay PierreFabre a transfer price and royalties based on net sales. Forest Laboratorieshas assumed both of these financial obligations. Our supply agreement withPierre Fabre may be terminated for cause either by us or by Pierre Fabreupon 90 days’ prior 

 

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writtennotice to the other party upon a material breach of the agreement if the breachis not cured within 90 days following the written notice. In addition,Pierre Fabre may elect to terminate the agreement if we effect a change incontrol under specified circumstances.

 

***ForestLaboratories Agreement***

 

In January 2004, we entered into a collaborationagreement with Forest Laboratories for the development and marketing ofmilnacipran. We selected Forest Laboratories as our development and marketingcollaborator based in part on its strong franchise in central nervoussystem drugs and in the primary care and psychiatric markets. Under ouragreement with Forest Laboratories, we sublicensed our exclusive rights todevelop and commercialize milnacipran to Forest Laboratories for the UnitedStates, with an option to extend the territory to include Canada. In addition,Forest Laboratories has an option for a specified time period to acquire anexclusive license from us in the United States, and potentially Canada, to anycompounds developed under our agreement with Collegium Pharmaceutical, Inc.Forest Laboratories assumed responsibility for funding all continuingdevelopment of milnacipran, including the funding of clinical trials andregulatory approvals, as well as a certain number of our employees. However, weagreed upon an alternative cost sharing arrangement with Forest Laboratoriesfor the second Phase III trial only. In connection with this arrangement, theamount of funding that we receive from Forest Laboratories for certain of ouremployees has been eliminated as of the fourth quarter in 2004, for the secondPhase III trial only, and we will pay for a majority of the external costs ofthe second Phase III trial only, with Forest reimbursing us under specificscenarios where the second Phase III trial is used as one of the two requiredpivotal trials in the NDA submission to the FDA. Forest Laboratories is fundingthe third Phase III clinical trial, including a specified number of ouremployees that are assisting with the conduct of that clinical trial. ForestLaboratories will also be responsible for sales and marketing activitiesrelated to any product developed under the agreement, while we have the optionto co-promote using our own sales force up to 25% of the total physiciandetails and would be reimbursed by Forest in an amount equal to Forest’s costof providing the equivalent detailing calls. We share decision making authoritywith Forest Laboratories, through the joint development committee, with respectto the research, development and marketing of milnacipran. In the event thatthe joint development committee is unable to resolve any dispute, other thanany marketing related issue, Forest Laboratories and we must jointly resolvesuch issue. With respect to any marketing related issue, Forest Laboratorieshas the final decision making authority. Under our agreement with ForestLaboratories and our agreement with Pierre Fabre, each party agreed to certainlimitations on the development of products for FMS and on the development ofSNRI products.

 

Under our agreement with Forest Laboratories, wereceived an upfront payment of $25.0 million, of which $1.25 millionwas paid to Pierre Fabre as a sublicense fee. The total upfront and milestonepayments to us under the agreement could be approximately $205.0 millionrelated to the development of milnacipran for the treatment of FMS, a largeportion of which will depend upon achieving certain sales of milnacipran and anadditional $45.0 million in the event that we and Forest Laboratoriesdevelop other indications for milnacipran, as well as potential royaltypayments based on sales of licensed product under this agreement. In addition,Forest Laboratories assumed the royalty payments due to Pierre Fabre and thetransfer price for the active ingredient used in milnacipran. The agreementwith Forest Laboratories extends until the later of (i) the expiration ofthe last to expire of the applicable patents, (ii) 10 years after thefirst commercial sale of a product under the agreement or (iii) the lastcommercial sale of a generic product, unless terminated earlier. Each party hasthe right to terminate the agreement upon prior written notice of thebankruptcy or dissolution of the other party, or a breach of any materialprovision of the agreement if the breach has not been cured within the requiredtime period following the written notice. Forest Laboratories may alsoterminate our agreement upon an agreed notice period in the event ForestLaboratories reasonably determines that the development program indicatesissues of safety or efficacy that are likely to prevent or significantly delaythe filing or approval of an NDA or to result in labeling or indications thatwould have a significant adverse affect on the marketing of any productdeveloped under the agreement.

 

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***CollegiumAgreement***

 

In August 2002, we entered into a reformulationand new product agreement with Collegium pursuant to which Collegium isattempting to develop new formulations of milnacipran and new products that areanalogs of milnacipran. In January 2004, we exercised our option toacquire an exclusive license to technology developed under this agreement. Inthe event we commercialize any of the reformulations or new products developedunder our agreement with Collegium, we will be obligated to pay Collegiummilestone payments and royalty payments. The agreement with Collegium iseffective until the expiration of the last-to-expire of the issued patents, ifany, unless terminated earlier. Each party has the right to terminate theagreement upon 60 days’ prior written notice of the bankruptcy ordissolution of the other party or a breach of any material provision of theagreement if the breach has not been cured within the 60-day period followingthe written notice.

 

***OSA Agreement***

 

***Organon Agreement***

 

In June 2005, we entered into a license agreement with Organon in connection with the initiation of our second development program, wherein we are evaluating potential pharmaceutical treatments for OSA. We entered into three licensing agreements to support and facilitate the program. Specifically, we licensed mirtazapine-related patents from Organon and patents from two other parties that provide the opportunity to combine mirtazapine with a second approved agent with the goal of potentially augmenting efficacy and improving tolerability. The series of licenses will allow us to evaluate a number of potential OSA treatment modalities in proof of concept trials.

 

Upon execution of the license agreement with Organon, we issued to Organon as a license fee a warrant to purchase 62,656 shares of our common stock. These warrants, which have an exercise price of $15.96 per share and expire in June 2010, were valued at $615,000 and recorded as a non-cash compensation charge, classified as research and development expenses, during the second quarter of 2005 since the underlying technology still requires substantial development effort. Under the agreement with Organon, Cypress and Organon will jointly fund development activities in the event a candidate from the proof of concept trials has been selected for continued development. If we are able to select a development candidate, the following is the structure of our agreement with Organon. We will have operational control of the development activities and, depending on the candidate selected, will fund 40% or 50% of the development-related expenses. If the FDA approves this product, Organon will have operational control of sales and marketing activities, with Cypress having the opportunity to co-promote up to 25% of the physician promotion and details using its own sales force in the United States, Mexico and Canada. Expenses and revenue in the United States, Mexico and Canada are to be shared between Cypress and Organon based on the level of promotional effort each party contributes, with Cypress having the ability to share up to 40% or 50% depending on the candidate selected. Organon will be solely responsible for commercialization in the rest of the world and will pay us a royalty on net sales (as defined in the agreement).

 

Assuming the decision is made by Cypress and Organon to proceed with the commencement of the first Phase III clinical trial, at any time thereafter, either Cypress or Organon may elect to change the structure of the financial agreement to provide that the party that makes such election will no longer share in expenses and revenue, and instead will have the potential right to receive potential milestone and royalty payments in the event a product is commercialized.

 

In connection with our related licensingtransactions with two other parties, Cypress paid the parties aggregate licensepayments totaling $2.5 million, with the potential for additional milestone 

 

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paymentsof up to $25.3 million related to our OSA program, as development progresses.The parties will also participate in royalties from any marketed products that may bedeveloped under the respective agreements.

 

**Other Potential Uses of Milnacipran**

 

We also believe that milnacipran may beeffective in the treatment of other Functional Somatic Syndromes, such asirritable bowel syndrome, or IBS. With our development and marketing partnerForest Laboratories, we may in the future investigate the use ofmilnacipran in the treatment of IBS or other disorders. Should we and ForestLaboratories choose to pursue additional indications beyond FMS and obtain FDAapproval for such indications, we could receive up to an additional$45 million in milestone payments. Since we are entitled to royalty paymentsbased on sales of any licensed product under the agreement with ForestLaboratories, we would receive royalty payments for any additional indications.The decision regarding which, if any, additional indications are pursued, isone that we make together with Forest Laboratories, through the jointdevelopment committee. Such decisions relate to the research and development ofmilnacipran, so in the event the joint development committee is unable toresolve any dispute regarding potential indications, Forest Laboratories and wemust jointly resolve such issue.

 

**Patents, Trademarks and Proprietary Technology**

 

We believe that patents, trademarks, copyrights andother proprietary rights are important to our business. We also rely on tradesecrets, know-how, continuing technological innovations and licensingopportunities to develop and maintain our competitive position. We seek toprotect our intellectual property rights by a variety of means, includingpatents, maintaining trade secrets and proprietary know-how, and technologicalinnovation to develop and maintain our competitive position. We actively seekpatent protection both in the United States and internationally and have filed8 patent applications related to FMS and milnacipran. It is possible that apatent application will not issue from any of our patent applications and thebreadth or scope of protection allowed under any issued patents may notprovide adequate protection to protect any of our future products. We intend toenforce our patents, trademarks and brand names. We have also obtained alicense from Pierre Fabre to certain patents and patent applications related tomilnacipran. Under the license, which we have sublicensed to ForestLaboratories, we have rights to a method of synthesis patent for milnacipran inthe United States and Canada. Both the United States patent (U.S. Patent5,034,541) and the Canadian patent (No. 2,006,464) terminate in December 2009.The composition of matter patent for milnacipran expired in June 2002.Pursuant to the terms of the license agreement, Pierre Fabre is responsible forthe prosecution and maintenance of the patents and patent applications licensedthereunder at its sole expense. In addition, Pierre Fabre has the first rightto take actions with respect to the infringement or potential infringement ofsuch patents and patent applications, except for any action in connection withan abbreviated NDA filed by a third party, and provided that we may takeappropriate actions with respect to the infringement of such patents and patentapplications in the United States and Canada if Pierre Fabre fails to do sowithin a specified period of time. We or Forest Laboratories has the firstright to take any action with respect to any proceeding in connection with anabbreviated NDA filed by a third party. Although we have filed use patents onmilnacipran, three of which have issued (U.S. Patent 6,602,911, U.S. Patent6,635,675, and U.S. Patent 6,992,110, all expiring in 2021), we may not beable to secure any additional patent protection and the existing patents may notensure exclusivity through the patent term. As a new chemical entity in theUnited States, milnacipran also qualifies under the terms of the Hatch-WaxmanAmendments to the Federal Food, Drug and Cosmetic Act, or Hatch-WaxmanAmendments, under which it would receive five years of marketing exclusivityupon marketing approval, during which time a generic milnacipran may notbe approved. Even so, recent amendments to the Hatch-Waxman Amendments havebeen proposed and it, therefore, may not apply to us in the future.

 

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We have licensed the rights to two issued patentspertaining to the use of mirtazapine in the treatment of OSA. United Statespatent (U.S. Patent 6,303,595) related to the use of mirtazapine in thetreatment of OSA expires in 2017. In addition, we have licensed the rights totwo other patent application families that directly pertain to our treatmentmethodology that are being domestically and internationally prosecuted. Finally,we are pursuing two additional families, pertaining to OSA related patentsinvented at Cypress. It is possible that a patent application will not issuefrom any of our patent applications and the breadth or scope of protectionallowed under any issued patents may not provide adequate protection toprotect any of our future products. We intend to enforce our patents,trademarks and brand names. Pursuant to the terms of the license agreement,Organon is responsible for the prosecution and maintenance of the patents andpatent applications licensed thereunder at its sole expense. We may not beable to secure any additional patent protection and the existing patents may notensure exclusivity through the patent term.

 

Although patents are enforceable from the date ofissuance and presumed to be valid, future litigation or reexaminationproceedings regarding the enforcement or validity of our existing patents orfuture patents, if issued, could result in a ruling adverse to us that couldinvalidate such patents or substantially reduce the scope of protectionafforded by such patents. Our patents may not afford commerciallysignificant protection of our proprietary technology or have commercialapplication. There has been no judicial determination of the validity or scopeof our proprietary rights. Moreover, the patent laws in foreign countries may differfrom those of the United States, and the degree of protection afforded byforeign patents may be different.

 

Others have filed applications for, or have beenissued, patents and may obtain additional patents and other proprietaryrights relating to products or processes competitive with us. The scope andvalidity of such patents is presently unknown. If existing or future patentsare upheld as valid by courts, we may be required to obtain licenses touse technology covered by such patents.

 

**Competition**

 

We are currently focusing on developing milnacipranto treat patients with FMS. Currently, there are no approved treatmentsspecifically for FMS in the United States or elsewhere. As a result, the firstoption for treatment of FMS is physical therapy, followed by analgesics toattempt to alleviate the pain. If the analgesics do not alleviate the pain,then muscle relaxants and antidepressants are often prescribed. TCAs, which areavailable in inexpensive generic formulations, are currently viewed as thedrugs of choice in treating FMS. We are also focusing on the developmentof products for the treatment of patients with Functional Somatic Syndromes.

 

Clinical trials have been conducted by otherpharmaceutical companies for the treatment of FMS. In particular,Pfizer Inc. has publicly disclosed that it has conducted a Phase IIclinical trial evaluating the efficacy and safety of its compound, pregabalin,as a treatment for FMS. In addition, Eli Lilly and Company has publiclydisclosed that it has conducted two Phase II clinical trials evaluating theefficacy and safety of its compound, duloxetine, as a treatment for FMS. BothPfizer and Eli Lilly and Company have also publicly disclosed that they areconducting Phase III clinical trials to evaluate the efficacy and safety oftheir respective compounds as a treatment for FMS. The market potentialfor Functional Somatic Syndromes, including FMS, is considerable and a numberof pharmaceutical companies focused on therapies for alleviating pain orantidepressant therapies could decide to evaluate their current productcandidates for the treatment of Functional Somatic Syndromes, including FMS, atany time. Due to the high incidence of Functional Somatic Syndromes, includingFMS, we anticipate that most, if not all, of the major pharmaceutical companieswill have significant research and product development programs in these areas.We expect to encounter significant competition both in the United States and inforeign markets for each of the drugs we seek to develop.

 

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Currently, there are no safe and effective medications indicated forthe routine treatment of sleep apnea. For those with moderate to severe OSA,the treatment approaches include surgery, or medical devices that keep theairway open during sleep through the use of air pressure. The type of surgerydepends on the cause of the sleep apnea, and includes procedures to removetonsils, adenoids, or other tissue in the airway, or to insert implants into aportion of the airway. However, in general, surgery has a limited success rate,estimated at 30% to 60%, in moderate to severe OSA.

 

Continuous Positive Airway Pressure, or CPAP, or similar devicesrepresent the most common and most successful treatment for OSA. CPAP treatmentinvolves a mask worn over the nose during sleep. The mask blows air into theairway in order to keep the throat open during sleep. CPAP has a 100% successrate in reducing AHI, the apnea-hypopnea index, or respiratory disturbanceindex, or RDI, which refers to the total number of apneas and hypopneas dividedby the total amount of sleep during the sleep study) and associated nighttimeoxygen desaturations, when the patient is compliant and utilizes the treatmenteach night for the entire night. However, CPAP devices are cumbersome and haveachieved only moderate acceptance by patients, with compliance estimated to bebetween 50 - 70%.

 

Competitors for all of our potential productsinclude fully-integrated pharmaceutical and biotechnology companies both in theUnited States and in foreign markets which have expertise in research anddevelopment, manufacturing processes, testing, obtaining regulatory clearancesand marketing, and may have financial and other resources significantlygreater than we do. Smaller companies may also prove to be significantcompetitors. Academic institutions, United States and foreign government agenciesand other public and private research organizations conduct research relatingto Functional Somatic Syndromes, including FMS and OSA, and may developproducts for the treatment of these diseases that compete directly with anyproducts we develop. Our competitors may compete with us forcollaborations. These companies and institutions also compete with us inrecruiting and retaining highly qualified scientific personnel.

 

Our competition will be partially determined by thepotential indications that are ultimately cleared for marketing by regulatoryauthorities, the timing of any clearances and market introductions and whetherany currently available drugs, or drugs under development by others, areeffective in the same indications. Accordingly, the relative speed with whichwe can develop milnacipran or our product candidate for OSA, complete theclinical trials, receive regulatory clearance and supply commercial quantitiesof the products to the market is expected to be an important competitivefactor. We expect that competition among products approved for sale will bebased, among other things, on product efficacy, safety, reliability,availability and patent protection.

 

**Manufacturing and Supply**

 

Pursuant to the terms of our purchase and supplyagreement with Pierre Fabre, Pierre Fabre is the exclusive supplier to us andForest Laboratories of the active pharmaceutical ingredient for milnacipran inexchange for a transfer price. Forest Laboratories has assumed the obligationto pay the transfer price directly to Pierre Fabre. Currently, Pierre Fabremanufactures the active pharmaceutical ingredient for milnacipran in itsfacility located in Gaillac, France. This facility will need to be inspected bythe FDA. Due to the projected commercial quantities of milnacipran that we may requireand to provide a second manufacturing site, Pierre Fabre has agreed that withina certain time period after commercial launch of milnacipran, it will qualifyan additional manufacturing facility. In addition, because Pierre Fabre is oursole supplier of the active pharmaceutical ingredient for milnacipran and iscurrently the only supplier of the active pharmaceutical ingredient formilnacipran in the world, we have the right, but not the obligation, to qualifyus or Forest Laboratories as an additional manufacturing facility tomanufacture the active pharmaceutical ingredient for milnacipran. We do notcurrently have this capability. In addition, we have the right to manufacturemilnacipran if Pierre Fabre does not have the required buffer stock or in theevent 

 

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thatwe terminate our license agreement with Pierre Fabre under certaincircumstances. Currently, Forest Laboratories is responsible for encapsulatingand packaging milnacipran for our clinical trials.

 

Pursuant to the terms of our License andCollaboration Agreement with Organon, Organon is responsible for manufacturingboth clinical and commercial supplies of mirtazapine.

 

**Government Regulation**

 

Our research, preclinical testing, clinical trials,manufacturing and marketing activities are subject to extensive regulation bynumerous governmental authorities in the United States and other countries. Inthe United States, pharmaceutical drugs are subject to rigorous FDA regulationunder the Federal Food, Drug and Cosmetic Act and other federal and statestatutes and regulations. These laws and regulations govern, among otherthings, the preclinical and clinical testing, manufacture, quality control,safety, efficacy, labeling, storage, record keeping, approval, marketing,advertising and promotion of our drug products and drug product candidates. Theproduct development and regulatory approval process requires the commitment ofsubstantial time, effort and financial resources.

 

The steps required before a pharmaceutical agent may bemarketed in the United States generally include:

 

•                                          completion of preclinical laboratory tests,animal pharmacology and toxicology studies and formulation studies performed incompliance with the FDA’s Good Laboratory Practice, or GLP regulations;

 

•                                          the submission of an investigational new drugapplication, or IND, to the FDA for human clinical testing that must beaccepted by the FDA before human clinical trials may commence;

 

•                                          performance of adequate and well-controlledhuman clinical trials to establish the safety and efficacy of the productcandidate for the proposed indication of use;

 

•                                          the submission of an NDA to the FDA; and

 

•                                          FDA approval of the NDA prior to anycommercial sale or shipment of the drug.

 

Preclinical studies include the laboratoryevaluation of in vitro pharmacology, product chemistry and formulation, as wellas animal studies to assess the potential safety and efficacy of a product.Compounds must be formulated according to the FDA’s current good manufacturingpractices, or cGMP, requirements and preclinical safety tests must be conductedby laboratories that comply with GLP requirements. The results of thepreclinical tests, together with manufacturing information and analytical data,are submitted to the FDA as part of an IND application and are reviewed bythe FDA before human clinical trials may begin. The IND must also containprotocols for any clinical trials that will be carried out. The INDautomatically becomes effective 30 days after receipt by the FDA unlessthe FDA raises concerns or questions regarding the conduct of the proposedclinical trial during the 30-day waiting period. If the FDA objects to an INDapplication during this 30-day waiting period or at any time thereafter, theFDA may halt proposed or ongoing clinical trials or may authorizetrials only under specified terms. Such a halt, called a clinical hold,continues in effect until and unless the FDA’s concerns are adequatelyaddressed. In some cases, clinical holds are never lifted. Imposition by theFDA of a clinical hold can delay or preclude further product development. TheIND process may be extremely costly and may substantially delayproduct development.

 

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Clinical trials must be sponsored and conducted inaccordance with good clinical practice, or GCP, requirements and underprotocols and methodologies that, among other things:

 

•                                          ensure receipt from participants of signedconsents that inform them of risks;

 

•                                          detail the protocol and objectives of thestudy;

 

•                                          detail the parameters to be used to monitorsafety; and

 

•                                          detail the efficacy criteria to be evaluated.

 

Furthermore, each clinical study must be conductedunder the supervision of a principal investigator operating under the auspicesof an institutional review board, or IRB, at the institution where the study isconducted. The IRB must review and approve the plan for any clinical trialbefore it commences at that institution and it must monitor the study until itis completed. The IRB will consider, among other things, ethical factors, thesafety of human subjects and the possible liability of the institution.Sponsors, investigators and IRB members are obligated to avoid conflicts of interestsand ensure compliance with all legal requirements. The FDA, the IRB or thesponsor may suspend or discontinue a clinical trial at any time on variousgrounds, including potential health risks to study subjects.

 

Clinical trials are conducted in accordance withprotocols that detail the objectives of the study, the parameters to be used tomonitor safety and the efficacy criteria to be evaluated. Each protocol issubmitted to the FDA as part of the IND, and the FDA must grant permissionbefore each clinical trial may begin. Clinical trials typically areconducted in three sequential phases that may overlap. In Phase I, theinitial introduction of the drug into a small number of healthy volunteers, thedrug is evaluated for safety by assessing the adverse effects, dosagetolerance, metabolism, distribution, excretion and clinical pharmacology. ThePhase I trial must provide pharmacological data that is sufficient to devisethe Phase II trials.

 

Phase II trials involve a limited patient populationin order to:

 

•                                          obtain initial indications of the efficacy ofthe drug for specific, targeted indications;

 

•                                          determine dosage tolerance and optimaldosage; and

 

•                                          identify possible adverse affects and safetyrisks.

 

When a compound is determined preliminarily to beeffective and to have an acceptable safety profile in Phase II evaluation,Phase III trials—commonly referred to as pivotal studies—can be undertaken toevaluate safety and efficacy endpoints further in expanded and diverse patientpopulations at geographically dispersed clinical trial sites. Positive resultsin Phase I or II are not necessarily predictive of positive results in PhaseIII.

 

The results of the pharmaceutical development,preclinical studies and clinical trials, together with detailed information onthe manufacture and composition of the product, are submitted to the FDA in theform of an NDA, which must be complete, accurate and in compliance withFDA regulations. Once the submission has been accepted for filing by the FDA, aprocess that may take up to 60 days after submission, by law the FDAhas 180 days to review the application and respond to the applicant. Thereview process is often significantly extended by FDA requests for additionalinformation or clarification. The FDA may deny an NDA filed by us or ourcollaborators if the applicable scientific and regulatory criteria are notsatisfied, or it may require additional clinical data and/or an additionalpivotal trial. Moreover, data obtained from 

 

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clinicaltrials are not always conclusive and may be susceptible to varyinginterpretations that could delay, limit or prevent regulatory approval. Theapproval of an NDA permits commercial-scale manufacturing, marketing,distribution and sale of the drug in the United States and, with somelimitations, export from the United States. Upon approval, a drug may onlybe marketed in those dosage forms, for those indications and subject to thoselimitations approved in the NDA. Moreover, after approval, the FDA may requireadditional post-approval testing, surveillance and reporting to monitor theproducts. Thus, even if approval for a drug is granted, it can be limited orrevoked if evidence subsequently emerges casting doubt on the safety or efficacyof a product, as has happened recently with respect to several high profilemarketed drugs, or if the manufacturing facility, processes or controls do notcomply with regulatory requirements. Finally, an approval may entaillimitations on the uses, labeling, dosage forms, distribution and packaging ofthe product.

 

Among the conditions for new drug approval is therequirement that the prospective manufacturer’s quality control, recordkeeping, notifications and reporting and manufacturing systems conform tothe FDA’s cGMP regulations. To obtain approval, the drug manufacturing facilitymust be registered with the FDA and must pass a pre-approval inspectiondemonstrating compliance with cGMP requirements. If milnacipran iscommercialized in the United States, Pierre Fabre’s facility will need to beinspected by the FDA for compliance with cGMP requirements. Manufacturingestablishments also are subject to periodic, ongoing compliance inspections. Incomplying with the standards contained in these regulations, manufacturers mustcontinue to expend time, money, resources and effort in order to ensurecompliance. Failure to comply with these requirements can result in legal orregulatory action, including warning letters, suspension of manufacture,product seizure or recalls, injunctive action or civil or criminal penalties.

 

The FDA closely regulates the post-approvalmarketing and promotion of drugs, including standards and regulations fordirect-to-consumer advertising, off-label promotion, industry sponsoredscientific and educational activities and promotional activities involving theInternet. Failure to comply with these requirements can result in adversepublicity, warning letters, corrective advertising and potential civil andcriminal penalties.

 

Outside the United States, including Canada, ourability to market a product is contingent upon receiving a marketingauthorization from the appropriate regulatory authority. This foreignregulatory approval process includes many of the same steps associated with FDAapproval described above.

 

In addition to regulations enforced by the FDA, weare and will be subject to regulation under the Occupational Safety and HealthAct, the Environmental Protection Act, the Toxic Substances Control Act, theResource Conservation and Recovery Act and other present and future federal,state or local regulations. Our research and development activities involve thecontrolled use of hazardous materials, chemicals and various radioactivecompounds. Although we believe that the safety procedures used by third partiesfor handling and disposing of these materials comply with the standardsprescribed by state and federal regulations, the risk of accidentalcontamination or injury from these materials cannot be completely eliminated.In the event of an accident, we could be liable for any damages that result.

 

The approval process for milnacipran, mirtazapine orany of our future products is expensive, time consuming and uncertain, and anyapplicable regulatory agency may not grant marketing approval. We may nothave sufficient resources to complete the required testing and regulatoryreview processes. Furthermore, we are unable to predict the extent of adversegovernmental regulation, which might arise from future United States or foreignlegislative or administrative action.

 

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**Employees**

 

As of February 28, 2006, we employed 15full-time employees. None of our employees are covered by a collectivebargaining agreement. We believe that our relationship with our employees isgood.

 

**Available Information**

 

Our website address is *www.cypressbio.com*. We make available free of charge throughour website our annual reports on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K and all amendments to those reports as soon asreasonably practicable after such material is electronically filed with theSecurities and Exchange Commission.

 

**Item 1A. Risk Factors**

 

***There are limited data regardingmilnacipran as a treatment of FMS and it may not work for FMS, especiallyin light of the results from our first Phase III clinical trial, or there may besafety issues with its use in this patient population.***

 

There are limited data supporting the use ofmilnacipran for the treatment of FMS and no data supporting the use ofmilnacipran for indications other than depression. In September 2005, wereported top line results from our first Phase III clinical trial for patientswith FMS and our trial did not achieve statistical significance on our primaryendpoint. These reported topline results from our first Phase III clinicaltrial have had a material negative impact on our stock price. Althoughmilnacipran is currently being sold by Pierre Fabre outside North America as anantidepressant, it has only been tested as a treatment for FMS in our Phase IItrial and one Phase III trial, which did not achieve its primary endpoint. Wemust conduct and obtain favorable results in at least two pivotal Phase IIItrials to support an application for FDA approval of the product candidate.Under our current agreement with the FDA, our first completed Phase IIIclinical trial may not qualify as one of the registration quality studiesnecessary to support an application to the FDA. Although we have disclosed thatan alternative analysis than the one we agreed to with the FDA, the BOCF analysis, yielded statistically significantresults, the FDA may not accept this as a registration study because theBOCF analysis was not the prospectively defined analysis method for handlingdata for those patients who withdrew from the study prior to the assessmenttime point. In light of the fact that our first Phase III clinical trialdid not achieve statistical significance using the analysis we agreed to withthe FDA, it is possible that our second and third trials will also not achievestatistical significance. We are experiencing higher patient drop out rates inour second Phase III trial than in our Phase II trial for milnacipran. Milnacipranmay not prove to be effective to treat FMS in our ongoing Phase III trialsor any future trial and although we believe based on our analysis of the data,that the effect was durable, further studies may prove that any positiveeffects from patients taking milnacipran may not be durable. Furthermore,even if we elect to pursue the development of milnacipran for any otherFunctional Somatic Syndromes, such as IBS, it may not prove to beeffective.

 

In addition, all or any of our clinical trials may revealthat milnacipran is not safe. The FDA has never approved a drug for thetreatment of FMS. If milnacipran is not demonstrated to be a safe andeffective treatment for FMS to the satisfaction of the FDA or other regulatoryagencies, including because we do not comply with the Special ProtocolAssessment, we will not receive regulatory approval and our business would bematerially harmed. Furthermore, the recent publicity related to safety issuesin the market may make approval of any drug by the FDA more difficult.

 

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***We are dependent on ourcollaboration with Forest Laboratories to develop and commercialize milnacipranand to obtain regulatory approval. Events or circumstances may occur thatdelay or prevent the development and commercialization of milnacipran.***

 

Pursuant to the terms of our collaboration agreementwith Forest Laboratories, we granted Forest Laboratories an exclusivesublicense for the development and marketing of milnacipran, for allindications in the United States, with an option to extend the territory toinclude Canada. In addition, Forest Laboratories has the option to acquire anexclusive license from us in the United States, and potentially Canada, to anycompounds developed under our agreement with Collegium Pharmaceutical. ForestLaboratories is responsible for funding the development of milnacipran,including clinical trials and regulatory approval, other than the externalcosts of the second Phase III trial, which we have agreed to fund. If the FDAapproves this product candidate, Forest Laboratories will also have primaryresponsibility for the marketing and sale of the approved product and willshare responsibility for compliance with regulatory requirements. We havelimited control over the amount and timing of resources that ForestLaboratories will dedicate to the development, approval and marketing ofmilnacipran. Although Forest has indicated that they intend to continuedevelopment of milnacipran, there is always the possibility that they may insteadchoose to terminate development and our license agreement with them. Even ifthey continue to develop milnacipran, they may do so on a slower timelinethan originally predicted. Furthermore, because the size of the second PhaseIII clinical trial has been increased from 800 patients to 1,200 patients ouroriginal timeline for announcing our topline results has been extended, and may beextended even further. Our ability to generate milestone and royalty paymentsfrom Forest Laboratories depends on Forest Laboratories’ ability to establishthe safety and efficacy of milnacipran, obtain regulatory approvals and achievemarket acceptance of milnacipran for the treatment of FMS, all of which hasbeen impacted by the reported results from our first Phase III clinical trial.

 

We are subject to a number of additional risksassociated with our dependence on our collaboration with Forest Laboratories,including:

 

•                                          Forest Laboratories could stop either or bothof the ongoing phase III trials of milnacipran for the treatment of FMS ***\***or any other clinical trials formilnacipran or abandon or underfund the development of milnacipran, repeat orconduct additional clinical trials or require a new formulation of milnacipranfor clinical testing; or delay the commencement of any additional clinicaltrials for milnacipran for the treatment of FMS;

 

•                                          We and Forest Laboratories could disagree asto development plans, including the number and timing of clinical trials orregulatory approval strategy, or as to which additional indications formilnacipran should be pursued, if any, and therefore milnacipran may neverbe developed for any indications other than FMS;

 

•                                          Forest Laboratories could independentlydevelop, develop with third parties or acquire products that could compete withmilnacipran, including drugs approved for other indications used by physiciansoff-label for the treatment of FMS;

 

•                                          Forest Laboratories could fail to devotesufficient resources to the development, approval, commercialization, ormarketing and distribution of any products developed under our collaborationagreement, including by failing to develop specialty sales forces if such salesforces are necessary for the most effective distribution of any approvedproduct; and

 

•                                          Disputes regarding the collaboration agreementthat delay or terminate the development, commercialization or receipt ofregulatory approvals of milnacipran, may delay or prevent 

 

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the achievement of clinical or regulatory objectivesthat would result in the payment of milestone payments or result in significantlitigation or arbitration.

 

Furthermore, Forest Laboratories may terminateour collaboration agreement upon our material breach or our bankruptcy and may alsoterminate our agreement upon 120 days’ notice in the event ForestLaboratories reasonably determines that the development program indicatesissues of safety or efficacy that are likely to prevent or significantly delaythe filing or approval of a NDA or to result in labeling or indications thatwould significantly adversely affect the marketing of any product developedunder the agreement. If any of these events occur, we may not be able tofind another collaborator for development or commercialization, especiallygiven the existing Phase III clinical trial data as reported from our firstPhase III trial, and even if we elected to pursue further development andcommercialization of milnacipran, we would experience substantially increasedcapital requirements that we might not be able to fund.

 

***We rely upon an exclusive licensefrom Pierre Fabre in order to develop and sell our milnacipran productcandidate, and our ability to pursue the development and commercialization ofmilnacipran for the treatment of FMS depends upon the continuation of ourlicense from Pierre Fabre.***

 

Our license agreement with Pierre Fabre provides uswith an exclusive license to develop and sell any products with the compoundmilnacipran as an active ingredient for any indication in the United States andCanada, with a right to sublicense certain rights to Forest Laboratories underour collaboration with Forest Laboratories. Either we or Pierre Fabre may terminatethe license agreement for cause upon 90 days’ prior written notice to theother party upon the bankruptcy or dissolution of the other party, or upon abreach of any material provision of the agreement if the breach is not curedwithin 90 days following the written notice. Furthermore, Pierre Fabre hasthe right to terminate the agreement upon 90 days’ prior notice to us ifwe and Forest terminate our development and marketing activities with respectto milnacipran, if we challenge certain patent rights of Pierre Fabre and underspecified other circumstances. If our license agreement with Pierre Fabre were terminated,we would lose our rights to develop and commercialize products using thecompound milnacipran as an active ingredient, as the compound is manufacturedunder Pierre Fabre patents and using Pierre Fabre know-how and trade secrets,and it would be unlikely that we could obtain the active ingredient inmilnacipran from any other source.

 

***We rely upon Pierre Fabre as ourexclusive supplier of the compound used as the active ingredient in ourmilnacipran product candidate and if Pierre Fabre fails to supply us sufficientquantities of the active ingredient it may delay or prevent us fromdeveloping and commercializing milnacipran.***

 

Pursuant to our purchase and supply agreement withPierre Fabre, Pierre Fabre is the exclusive supplier to us and Forest Laboratoriesof the compound used as the active pharmaceutical ingredient in our milnacipranproduct candidate. Neither we nor Forest Laboratories have facilities for themanufacture of the product candidate. Currently, Pierre Fabre manufactures theactive ingredient of milnacipran in its facility in Gaillac, France and PierreFabre is the only worldwide supplier of the active ingredient of milnacipranthat is currently approved for sale as an antidepressant outside the UnitedStates, but is not approved for sale in the United States. If any product iscommercialized under the agreement, Pierre Fabre will have the exclusive rightto manufacture the active ingredient used in our commercial product. Ifmilnacipran is commercialized in the United States, Pierre Fabre’s facilitywill need to be inspected by the FDA for compliance with current goodmanufacturing practices, or cGMP, requirements. Due to the projected commercialquantities of milnacipran that we may require and to provide a secondmanufacturing site, Pierre Fabre has agreed that within a certain time periodafter commercial launch of milnacipran, it will qualify an additionalmanufacturing facility. We do not have control over Pierre Fabre’s compliancewith cGMP requirements or Pierre Fabre’s compliance with its obligation toqualify a second manufacturing facility. If Pierre Fabre fails or is unable toprovide, in a timely and economic manner, required quantities of the activeingredient that Forest Laboratories or we request for clinical purposes, our developmentprogram 

 

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couldbe delayed. In addition, if Pierre Fabre fails to timely and economicallysupply us sufficient quantities for commercial sale, if milnacipran is evercommercialized, our product sales and market acceptance of the product could beadversely affected.

 

Furthermore, our purchase and supply agreement may beterminated for cause either by us or by Pierre Fabre upon 90 days’ priorwritten notice to the other party upon a material breach of the agreement ifthe breach is not cured within 90 days following the written notice. Wehave the right to manufacture milnacipran if Pierre Fabre does not have arequired buffer stock or in the event that we terminate our license agreementwith Pierre Fabre under certain circumstances. If our purchase and supplyagreement with Pierre Fabre is terminated, we are unlikely to be able toqualify another supplier of the active ingredient within a reasonable timeperiod, and our ability to develop and commercialize milnacipran will besignificantly impaired.

 

***Our agreements with Pierre Fabre andForest Laboratories restrict our ability to develop specified compounds, whichlimits how we can expand our product candidates.***

 

Under our agreements with Pierre Fabre and ForestLaboratories, Forest Laboratories has agreed to pay Pierre Fabre and us aroyalty, in the event that Forest Laboratories sells a product other thanmilnacipran for FMS for a specified period of time, which shall not be lessthan three years. We are, in turn, obligated to pay a portion of the royalty wereceive from Forest Laboratories to Pierre Fabre. In addition, each of us issubject to limitations related to each party’s development of any serotoninnorephinephrine reuptake inhibitors, or SNRI, products other than milnacipran.These limitations include: (i) a prohibition on developing an SNRI productfor specified indications for which milnacipran is being developed; and (ii) aprohibition on developing an SNRI product for any indication for a specifiedtime period, and after such specified time period, a requirement that if one ofthe parties launches and sells an SNRI product that is prescribed off-label forany indication for which milnacipran is being developed, the selling party mustreimburse the other parties for lost sales due to the off-label use.

 

***There are very limited data supporting the use ofmirtazapine for the treatment of OSA and it may not work.***

 

There are very limited data supporting the use ofmirtazapine alone, and no data supporting the use of mirtazapine in combinationwith another compound, for the treatment of OSA. We have made certainassumptions about mirtazapine as a potential treatment for OSA based on ourassumptions about OSA and its causes and the pharmacology of mirtazapine andother compounds that we intend to combine with mirtazapine. However, theseassumptions may prove to be wrong. Although mirtazapine is currently beingsold as an antidepressant, it has only been tested as a treatment for OSA inanimals. Results obtained in animals are not highly predictive of results inhumans and therefore, mirtazapine may not be effective in treating humanswith OSA. Mirtazapine has been tested in 10 human patients in one study and hasnever been tested for the treatment of OSA in combination with any other drug. Theresults that were obtained in this very small human study may not berepeated in our study. We must conduct and obtain favorable results in at leasttwo pivotal Phase III trials to support an application for FDA approval of anyproduct candidate we develop using mirtazapine for the treatment of OSA. OurPhase IIa trials for mirtazapine, alone or in combination, may not work totreat OSA. The FDA has approved medical devices for the treatment of OSA buthas never approved a drug for the treatment of OSA. Further, the medical devicethat has been approved is very effective when used and it is possible the FDAwill require similar efficacy results for a drug, which would likely beimpossible to achieve. In addition, our clinical trials may reveal thatmirtazapine, alone or in combination with another compound, is not safe. Ifmirtazapine is not demonstrated to be a safe and effective treatment for OSA tothe satisfaction of the FDA or other regulatory agencies, we will not receiveregulatory approval and our business would be materially harmed.

 

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***We will rely upon an exclusivelicense from Organon in order to develop and sell mirtazapine for OSA, and ourability to pursue the development and commercialization of mirtazapine for thetreatment of OSA depends upon the continuation of our license from Organon, andpotentially two other third parties, depending upon whether or not acombination compound is selected.***

 

Our license agreement with Organon provides us witha license to develop and sell any products with the compound mirtazapine as anactive ingredient for OSA. Either we or Organon may terminate the licenseagreement for cause upon 60 days’ prior written notice to the other partyupon the bankruptcy or dissolution of the other party, or upon a breach of anymaterial provision of the agreement if the breach is not cured within60 days, 45 days with respect to payments, following the written notice.Furthermore, either party has the right to terminate the agreement upon60 days’ prior notice if we and Organon determine to cease all developmentunder the agreement. If our license agreement with Organon were terminated, wewould lose our rights to develop and commercialize mirtazapine for OSA.

 

We have also entered into two other licenseagreements that provide us with the flexibility to develop mirtazapine incombination with other compounds. These agreements may also be terminatedby either party under similar circumstances to those under our agreement withOrganon.

 

***Provisions in our collaborationagreement with Forest Laboratories, our license agreement with Pierre Fabre andour agreement with Organon may prevent or delay a change in control.***

 

Our collaboration agreement with Forest Laboratoriesprovides that Forest Laboratories may elect to terminate our co-promotionrights for milnacipran or any other product developed under the collaborationagreement and we may lose our decision making authority with respect tothe development of milnacipran if we engage in a merger, consolidation or saleof all or substantially all of our assets, or if another person or entityacquires at least 50% of our voting capital stock. Our license agreement withPierre Fabre provides that Pierre Fabre may elect to terminate theagreement upon a change in control transaction in which a third party acquirorof us controls an SNRI product, and the acquiror does not take certain actions(e.g., divestiture of such SNRI product) within a specified time period to curethe breach of certain restrictions in the agreement that results from such SNRIproduct. Our agreement with Organon provides that Organon may elect tocause Cypress to exercise its option to receive potential royalty and milestonepayments instead of participating in the cost and revenue sharing arrangementupon a change in control in the event that an acquiring company has an approvedproduct in the market or in a Phase III or later clinical development thatwould compete with mirtazapine as a potential treatment for OSA and theacquirer does not agree to divest such product within 12 months following thechange in control.

 

These provisions may have the effect ofdelaying or preventing a change in control or a sale of all or substantiallyall of our assets, or may reduce the number of companies interested inacquiring us.

 

***We have limited experience inidentifying, completing and integrating acquisitions, including acquisitions ofproduct candidates, and other targets, and we may incur unexpected costsand disruptions to our businesses if we make mistakes in our selection offuture acquisitions or fail to integrate any future acquisitions.***

 

As part of our strategy, we are continuing toevaluate potential strategic transactions, including potential acquisitions ofproducts, technologies and companies, in order to expand our product pipeline.As we did with our in-licensing of milnacipran and mirtazapine, we may seekto in-license compounds or we may acquire products or businesses. Futureacquisitions and licensing transactions would expose us to operational andfinancial risks, including:

 

•                                          higher development costs than we anticipate;

 

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•                                          higher than expected licensing or acquisitionand integration costs;

 

•                                          exposure to liabilities of licensed oracquired intellectual property, compounds or products;

 

•                                          disruption of our business and diversion ofour management’s time and attention to developing licensed or acquiredcompounds or products;

 

•                                          incurrence of dilutive issuances ofsecurities or substantial debt to pay for licensing or acquisitions; and

 

•                                          impairment of relationships with keycollaborators, suppliers or customers of any acquired businesses due to changesin management or ownership.

 

We also may devote resources to potentialstrategic transactions that require several agreements and that we nevercomplete or may fail to realize the anticipated benefit of any strategictransaction we do complete. Finally, we may incur unexpected costs inconnection with the disposition of products or businesses, including ourdisposition of our PROSORBA column for which we indemnified Fresenius HemoCarefor any losses related to patent or trademark infringement claims.

 

***We are at an early stage ofdevelopment and we do not have and may never develop any commercial drugsor other products that generate revenues.***

 

We are at an early stage of development as abiotechnology company and do not have any commercial products. We have only twoproduct candidates, milnacipran, which we sublicensed to Forest Laboratories inJanuary 2004 and mirtazapine, which we partnered with Organon in June 2005.Milnacipran, our OSA candidate mirtazapine, or any future product candidates wemay acquire or develop, will require significant additional development,clinical trials, regulatory approvals and additional investment before they canbe commercialized. Our product development and product acquisition efforts may notlead to commercial drugs, either because the product candidates are not shownto be safe and effective in clinical trials, because we have inadequatefinancial or other resources to pursue clinical development of the productcandidate, or because the FDA does not grant regulatory approval. We do notexpect milnacipran to be marketed for a number of years, if at all, andmirtazapine as a potential treatment for OSA is at an even earlier stage ofdevelopment. We may not achieve our internal timelines and the resultsfrom our second Phase III trial for milnacipran may not be available inmid 2007 and we may not be in a position to select a development candidatewith Organon by mid 2006. If we and Forest Laboratories are unable to developmilnacipran or if we and Organon are unable to develop mirtazapine as acommercial drug in the United States, or if such development is delayed, wewill be unable to generate revenues, may be unsuccessful in raisingadditional capital, and may cease our operations.

 

***The FDA approval of milnacipran,mirtazapine, or any future product candidate is uncertain and will involve thecommitment of substantial time and resources.***

 

Even if our Phase III trials for milnacipran, ourproof of concept trials for mirtazapine, or any future clinical trials aresuccessful, we may not receive required regulatory approval from the FDAor any other regulatory body required for the commercial sale of milnacipran,mirtazapine, or any future products in the United States. In addition, even ifwe do obtain approval to market milnacipran or mirtazapine, the approvalprocess by the FDA may take longer than we anticipate. The regulatoryapproval of a new drug typically takes many years and the outcome is uncertain.Despite the time and resources expended, regulatory approval is neverguaranteed. If we fail to obtain regulatory approval for milnacipran,mirtazapine, or any future product candidates, we will be unable to market andsell any products and therefore may never generate any revenues fromproduct sales or become profitable. In addition, our collaborators, or ourthird 

 

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partymanufacturers’ failure to comply with the FDA and other applicable UnitedStates or foreign regulations may subject us to administrative orjudicially imposed sanctions, including warning letters, civil and criminalpenalties, injunctions, product seizure or detention, product recalls, total orpartial suspension of production and refusal to approve new drug approvalapplications.

 

As part of the regulatory approval process, wemust conduct, at our own expense, preclinical research and clinical trials foreach product candidate sufficient to demonstrate its safety and efficacy to thesatisfaction of the FDA and other regulatory agencies in the United States andother countries where the product candidate will be marketed if approved. Thenumber of preclinical studies and clinical trials that will be required variesdepending on the product, the disease or condition that the product is indevelopment for and the regulations applicable to any particular product. Theregulatory process typically also includes a review of the manufacturingprocess to ensure compliance with applicable regulations and standards,including the cGMP requirements. The FDA can delay, limit or decline to grantapproval for many reasons, including:

 

•                                          a product candidate may not be safe oreffective;

 

•                                          we may not achieve statistical significancefor the primary endpoint;

 

•                                          FDA officials may interpret data frompreclinical testing and clinical trials in different ways than we interpretsuch data;

 

•                                          the FDA might not approve our manufacturingprocesses or facilities, or the processes or facilities of any futurecollaborators or contract manufacturers, including Pierre Fabre’s facility forthe manufacture of the active ingredient in milnacipran; and

 

•                                          the FDA may change its approval policiesor adopt new regulations.

 

***We have agreed to pay certainexternal expenses associated with our second Phase III clinical trialevaluating milnacipran for FMS, currently being run by Forest Laboratories, andwe may never be reimbursed for these amounts.***

 

Theamounts we are funding for external expenses for the second Phase III clinicaltrial evaluating milnacipran, which will now be increased because we haveincreased the number of patients to be enrolled, are only reimbursed to us byForest Laboratories under specific scenarios where the second Phase III trialis used as one of the two required pivotal trials in the NDA submission to theFDA. The second Phase III trial may not be utilized as one of the pivotaltrials in the NDA submission, and, in such event, we will not be reimbursed byForest Laboratories for the external expenses that we fund in connection withthe second Phase III clinical trial. It is also possible that Forest couldalter the development plan for milnacipran or even terminate our collaborationagreement plan, which would prevent us from ever being reimbursed for ourfunding of the external expenses for the second Phase III trial formilnacipran.

 

***If we receive regulatory approvalfor milnacipran, mirtazapine or any other future product candidate, we will besubject to ongoing FDA obligations and continuing regulatory review.***

 

Any regulatory approvals that we or ourcollaborators receive for milnacipran, mirtazapine, or any future productcandidates will be limited to the indications, dosages and restrictions on theproduct label. We currently intend to seek approval for milnacipran in thetreatment of FMS and mirtazapine for the treatment of OSA. The FDA may notapprove milnacipran or mirtazapine for our preferred indications at all, may approvemilnacipran or mirtazapine for a more limited indication, or may imposeadditional limitations on the indicated uses or contain requirements forpost-marketing surveillance or the performance of potentially 

 

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costlypost-marketing studies. Even if we receive FDA and other regulatory approvals,as we have seen with other products on the market for pain, milnacipran, ormirtazapine or any of our other future product candidates may later exhibit adverseeffects that limit or prevent their widespread use or that force us to withdrawthose product candidates from the market. In our Phase II trial evaluatingmilnacipran for the treatment of FMS, the most common dose-related side effectsreported by patients were nausea, particularly early in the study, as well as aslight increase in heart rate. In our first Phase III trial the most common adverse events leading to withdrawalamong the milnacipran treated patients were nausea 6%, heart rate increase 2%,headache 2%, and depression 2%. Mirtazapine has a side effect profilethat includes both sedation and weight gain, both of which could be significantin patients with OSA. Any marketed product and its manufacturer continue to besubject to strict FDA regulation after approval, including regulation ofproduct labeling and packaging, adverse event reporting, manufacture, storage,advertising, promotion and recordkeeping. Any unforeseen problems with anapproved product or any violation of regulations could result in restrictionson the product, including its withdrawal from the market.

 

***We rely on third parties to conductall of our clinical trials. If these third parties do not successfully carryout their contractual duties or meet expected deadlines, we may not beable to obtain regulatory approval for or commercialize milnacipran,mirtazapine, or any of our other future product candidates.***

 

As of February 28, 2006, we had only 15full-time employees. We have in the past and expect to continue to rely onthird parties to conduct all of our clinical trials. We and Forest Laboratoriesused the services of Scirex, a contract research organization, to conduct thefirst Phase III trial with respect to milnacipran, and have used Scirex toassist in the conduct of the second Phase III trial with respect to milnacipran.We are also using a contract research organization to conduct our Phase IIatrials for mirtazapine, alone and in combination with other compounds. Becausewe do not conduct our own clinical trials, we must rely on the efforts ofothers and cannot always control or predict accurately the timing of suchtrials, the costs associated with such trials or the procedures that arefollowed for such trials. We do not plan on significantly increasing ourpersonnel in the foreseeable future and therefore, expect to continue to relyon third parties to conduct all of our future clinical trials. If these thirdparties do not successfully carry out their contractual duties or obligationsor meet expected deadlines, or if the quality or accuracy of the clinical datathey obtain is compromised due to their failure to adhere to our clinicalprotocols or for other reasons, or if they fail to maintain compliance withapplicable government regulations and standards, our clinical trials may beextended, delayed or terminated, and we may not be able to obtainregulatory approval for or successfully commercialize milnacipran, mirtazapine,or any of our other future product candidates.

 

***Even if our product candidates are approved, the market may notaccept these products.***

 

Even if our product development efforts aresuccessful and even if the requisite regulatory approvals are obtained,milnacipran, mirtazapine, or any future product candidates that we may developmay not gain market acceptance among physicians, patients, healthcare payorsand the medical community. The FDA has never approved a drug for the treatmentof FMS and has only approved medical devices for the treatment of OSA, and wecannot predict whether milnacipran or mirtazapine, if approved for theseindications, will gain market acceptance. A number of additional factors may limitthe market acceptance of products including the following:

 

•                                          timing of market entry relative tocompetitive products;

 

•                                          extent of marketing efforts by us and third-partydistributors or agents retained by us;

 

•                                          rate of adoption by healthcare practitioners;

 

•                                          rate of a product’s acceptance by the targetcommunity;

 

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•                                          availability of alternative therapies;

 

•                                          price of our product relative to alternativetherapies;

 

•                                          availability of third-party reimbursement;and

 

•                                          the prevalence or severity of side effects orunfavorable publicity concerning our products or similar products.

 

If milnacipran, mirtazapine, or any future productcandidates that we may develop do not achieve market acceptance, we may loseour investment in that product candidate, which may cause our stock priceto decline.

 

***Our competitors may develop andmarket products that are less expensive, more effective or safer, which may diminishor eliminate the commercial success of any products we may commercialize.***

 

The biotechnology market is highly competitive.Large pharmaceutical and biotechnology companies have developed or areattempting to develop products that will compete with any products we may developto target Functional Somatic Syndromes***,*** such asFMS, or other central nervous system disorders, including OSA. With respect toour FMS program, Pfizer, Inc. has publicly disclosed that it has conducteda Phase II clinical trial evaluating the efficacy and safety of its compound,pregabalin, as a treatment for FMS. In addition, Eli Lilly and Company haspublicly disclosed that it has conducted two Phase II clinical trialsevaluating the efficacy and safety of its compound, duloxetine, as a treatmentfor FMS. Both companies have also publicly disclosed they are currentlyconducting Phase III programs with their compounds in FMS. Duloxetine is aserotonin norepinephrine reuptake inhibitor, and as a dual reuptake inhibitoris therefore similar in pharmacology to milnacipran, which is a norepinephrineserotonin reuptake inhibitor. Based on the similar pharmacology, it isanticipated that duloxetine, which is currently approved for the treatment ofdepression, is receiving some off-label use for the treatment of FMS. Tricyclicantidepressants, or TCAs, which are inexpensive generic formulations, arecurrently viewed as the drugs of choice in treating FMS.

 

It is possible that our competitors will develop andmarket products for FMS and OSA prior to us, especially in light of our recentmilnacipran Phase III clinical trial in FMS that did not achieve statisticalsignificance at the p<0.05 level, and that our competitors will marketproducts that are less expensive and more effective than milnacipran ormirtazapine or any of our future products or that will render any of ourproducts obsolete. With respect to OSA, there is already competition frommedical device companies. We also expect that, in the treatment of FunctionalSomatic Syndromes and other central nervous system disorders, competition fromother biopharmaceutical companies, pharmaceutical companies, universities andpublic and private research institutions will increase. Many of thesecompetitors have substantially greater financial resources, technicalexpertise, research capabilities and other resources than we do. We may nothave the financial resources, technical expertise or marketing, distribution orsupport capabilities to compete successfully.

 

***We have the right to co-promotemilnacipran and mirtazapine, but we do not have the marketing, sales ordistribution experience or capabilities.***

 

Our ability to co-promote any product developedunder our agreements with Forest Laboratories and Organon is subject to ourbuilding our own marketing and sales capabilities, and we currently do not havethe ability to directly sell, market or distribute any product. In addition, inthe event our agreement with Forest Laboratories or our agreement with Organonis terminated or with respect to any other product we may develop that isnot covered by our collaborations with Forest Laboratories or Organon, we wouldhave 

 

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toobtain the assistance of a pharmaceutical company or other entity with a largedistribution system and a large direct sales force or build a substantialmarketing and sales force with appropriate technical expertise and supportingdistribution capabilities. We may not be able to enter into sucharrangements with third parties in a timely manner or on acceptable terms orestablish sales, marketing and distribution capabilities of our own. To theextent that we enter into co-promotion or other licensing arrangements, ourproduct revenues are likely to be lower than if we directly marketed and soldour products, and any revenues we receive will depend upon the efforts of thirdparties, which efforts may not be successful.

 

***We are subject to uncertaintyrelating to health care reform measures and reimbursement policies which,if not favorable to our product candidates, could hinder or prevent our productcandidate’s commercialization success.***

 

The continuing efforts of the government, insuranceand management care organizations and other health care payors to contain orreduce prescription drug costs may adversely affect:

 

•                                          our ability to set a price we believe is fairfor our products;

 

•                                          our ability to generate revenues and achieveor maintain profitability;

 

•                                          the future revenues and profitability of ourpotential customers, suppliers and collaborators; and

 

•                                          the availability of capital.

 

Successful commercialization of milnacipran andmirtazapine in the United States will depend in part on the extent towhich government, insurance and management care organizations and other healthcare payors establish appropriate coverage and reimbursement levels for thecost of our products and related treatments. Third-party payors areincreasingly challenging the prices charged for prescription drugs. Third-partypayors are also encouraging the use of generic drugs. These trends couldinfluence health care purchases, as well as legislative proposals to reform healthcare or reduce government insurance programs and result in the exclusion of ourproduct candidates from coverage and reimbursement programs or lower the pricesof our product candidates. Our revenues from the sale of any approved productscould be significantly reduced as a result of these cost containment measuresand reforms.

 

***We rely on our employees andconsultants for their scientific and technical expertise in connection with ourbusiness operations.***

 

We rely significantly on the scientific andtechnical expertise of our employees and consultants to conduct our business. Asof February 28, 2006, we had only 15 full time employees and therefore, werely heavily on our employees. In addition, because we have a small number ofemployees, we rely much more on consultants than do other companies. If any ofour relationships with our employees or consultants are terminated, we may loseaccess to scientific knowledge and expertise necessary for the research,development and commercialization of milnacipran, mirtazapine, or any furtherproducts. We do not anticipate significantly increasing our personnel in theforeseeable future and therefore, we expect to continue to rely on consultantsand our current employees for scientific and technical knowledge and expertiseessential to our business.

 

Our employment agreement with our chief executiveofficer provides for “at will” employment, which means that he may terminatehis services to us at any time. In addition, our scientific advisors may terminatetheir services to us at any time.

 

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***We may be subject to productliability claims that could cause us to incur liabilities beyond our insurancecoverage.***

 

We plan to continue conducting clinical trials onhumans using milnacipran and mirtazapine, and the use of milnacipran andmirtazapine may result in adverse effects. Although we are aware thatthere are side effects associated with both milnacipran and mirtazapine, wecannot predict all possible harm or side effects that may result from thetreatment of patients with milnacipran, mirtazapine, or any of our futureproducts, and the amount of insurance coverage we currently hold may notbe adequate to protect us from any liabilities. We currently maintain$10,000,000 in insurance for product liability claims. We may not havesufficient resources to pay any liability resulting from such a claim beyondour insurance coverage.

 

***We have a history of operatinglosses and we may never be profitable.***

 

We have incurred substantial losses during ourhistory. For the years ended December 31, 2005, 2004 and 2003, we incurrednet losses of $8.6 million, $11.2 million and $21.7 million, respectively.As of December 31, 2005, we had an accumulated deficit of $146.1 million.Our ability to become profitable will depend upon our and Forest Laboratories’ability to develop, market and commercialize milnacipran and our and Organon’sability to develop, market and commercialize mirtazapine with sufficient salesvolumes, and our ability to develop, market and commercialize any otherproducts. We do not expect to generate revenue from the sale of products forthe next several years or become profitable in the foreseeable future and may neverachieve profitability.

 

***We will need substantial additionalfunding and may be unable to raise capital when needed, which could forceus to scale back or discontinue the completion of any proposed acquisitions oradversely affect our ability to realize the expected benefits of any completedacquisitions.***

 

We agreed to pay certain expenses in connection withthe second Phase III clinical trial for milnacipran in FMS. In addition,we will incur certain non-reimbursable expenses in connection with thedevelopment of milnacipran. We are funding our current Phase IIa clinicaltrials for mirtazapine, which is being tested alone and in combination withother compounds, and in the event a candidate is selected to be developed forOSA, we will share development costs with Organon. We are also incurringexpenses in connection with the evaluation of potential acquisitions or otherstrategic transactions and will incur additional expenses in the event we closeany such transactions. We do not have any committed external sources of fundingand we will likely need to raise additional capital through the sale of equityor debt. The amount of capital we will require will depend upon many factors,including but not limited to, our OSA program, the evaluation and potentialclosing of any strategic transactions and the development strategy formilnacipran. If we are unable to raise capital when we need it, we may haveto scale back or discontinue the evaluation or completion of any proposedacquisitions or strategic transaction(s).

 

***Raising additional funds by issuingsecurities or through collaboration and licensing arrangements may causedilution to existing stockholders, restrict our operations or require us torelinquish propriety rights.***

 

We will likely attempt to raise additional fundsthrough public or private equity offerings, including through our shelfregistration statement, debt financings or corporate collaborations andlicensing arrangements. To the extent that we raise additional capital byissuing equity securities, our existing stockholders’ ownership percentage willbe diluted. In addition, if we raise additional funds through collaborationsand licensing arrangements, it may be necessary to relinquish potentialvaluable rights to our potential products on terms that are not favorable tous.

 

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***We may lose our net operatingloss carryforwards, which could prevent us from offsetting future taxableincome.***

 

We have incurred substantial losses during ourhistory and do not expect to become profitable in the foreseeable future and may neverachieve profitability. To the extent that we continue to generate taxablelosses, unused losses will carry forward to offset future taxable income, ifany, until such unused losses expire. All unused federal net operating losseswill expire 15 or 20 years after any year in which they were generated.The carryforward period is 15 years for losses incurred prior to 1996 and20 years for losses incurred subsequent to 1997. Our federal net operatinglosses will begin to expire in 2008, and our California tax loss carryforwardswill begin to expire in 2007.

 

***Our stock price has been very volatile and will likely continue to bevolatile.***

 

The market prices of the stock of technologycompanies, particularly biotechnology companies, have been highly volatile. Forthe period from January 1, 2003 through December 31, 2005, the highand low closing sales prices for our common stock ranged from $2.20 to $16.05. Thenegative results of our first Phase III clinical trial for milnacipran had avery material impact on our stock price. Our stock price has been and willlikely continue to be affected by market volatility, as well as by our ownperformance. We do not expect our stock price to increase in the near future,if at all. The following factors, among other risk factors, may have asignificant effect on the market price of our common stock:

 

•                                          the results of our second Phase III clinicaltrial for milnacipran and any other clinical trials for milnacipran;

 

•                                          developments in our relationship with ForestLaboratories, including the termination of our agreement;

 

•                                          developments in our relationship with PierreFabre, including the termination of our agreement;

 

•                                          the results and timing of our and Organon’sPhase IIa trials for mirtazapine;

 

•                                          developments in our relationship withOrganon, including the termination of our agreement;

 

•                                          our entering into, or failing to enter into,an agreement for the acquisition of any products or companies, or an agreementwith any corporate collaborator;

 

•                                          our available cash;

 

•                                          announcements of technological innovations ornew products by us or our competitors;

 

•                                          developments in our patent or otherproprietary rights;

 

•                                          fluctuations in our operating results;

 

•                                          litigation initiated by or against us;

 

•                                          developments in domestic and internationalgovernmental policy or regulation; and

 

•                                          economic and other external factors or otherdisaster or crisis.

 

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***The concentration of ownership amongour existing officers, directors and principal stockholders may result inthe entrenchment of management, prevent other stockholders from influencingsignificant corporate decisions and depress our stock price.***

 

As of January 31, 2006, our executive officers,directors and stockholders who hold at least 5% of our stock beneficially ownedand controlled approximately 44% of our outstanding common stock. If these officers,directors and principal stockholders act together, they will be able to helpentrench management and to influence significantly and possibly control mattersrequiring approval by our stockholders, including a financing in which we sellmore than 20% of our voting stock at a discount to the market price, theremoval of any directors up for election, the election of the members of ourboard of directors, mergers, a sale of all or substantially all of our assets,going private transactions and other fundamental transactions. Thisconcentration of ownership could also depress our stock price.

 

***We expect to continue incurringsignificant costs as a result of enacted and proposed changes in laws andregulations relating to corporate governance matters.***

 

Changes in the laws and regulations affecting publiccompanies, including the provisions of the Sarbanes-Oxley Act of 2002 and rules adoptedby the Securities and Exchange Commission and by the Nasdaq National Market,have and we expect will continue to result in significant costs to us. Inparticular, our efforts to comply with Section 404 of the Sarbanes-OxleyAct of 2002 and the related regulations regarding our required assessment ofour internal controls over financial reporting and our external auditors’ auditof that assessment has required the commitment of significant financial andmanagerial resources. We expect these efforts to require the continuedcommitment of significant financial resources and management time related tocompliance activities. Additionally, these laws and regulations could make itmore difficult or costly for us to obtain certain types of insurance, includingdirector and officer liability insurance, and we may be forced to acceptreduced policy limits and coverage or incur substantially higher costs toobtain the same or similar coverage. The impact of these events could also makeit more difficult for us to attract and retain qualified persons to serve onour board of directors, our board committees or as executive officers.

 

**Risks Related to Our Intellectual Property**

 

***We rely primarily on method of usepatents to protect our proprietary technology for the development ofmilnacipran and mirtazapine, and our ability to compete may decrease or beeliminated if we are not able to protect our proprietary technology.***

 

Our ability to compete may decrease or beeliminated if we are not able to protect our proprietary technology. Thecomposition of matter patent for milnacipran (U.S. Patent 4,478,836) expired inJune 2002. Accordingly, we rely on the patent for the method of synthesisof milnacipran (U.S. Patent 5,034,541), which expires on December 27, 2009and was assigned to Pierre Fabre and licensed to us and on patents on themethod of use of milnacipran to treat symptoms of FMS (U.S. Patent 6,602,911and U.S. Patent 6,992,110) and the method of use of milnacipran to treatsymptoms of chronic fatigue syndrome (U.S. Patent 6,635,675) issued to us, toprotect our proprietary technology with respect to the development ofmilnacipran. We have also filed additional patent applications related tomilnacipran and to the use of milnacipran for FMS (and other related painsyndromes and disorders), although no patents have issued on these patentapplications. Because there is very limited patent protection for thecomposition of matter of milnacipran, other companies may be able to sellmilnacipran in competition with us and Forest Laboratories unless we and ForestLaboratories are able to obtain additional protection through milnacipran-relatedpatents or additional use patents that may issue from our pending patentapplications or other regulatory exclusivity. It may be more difficult toestablish infringement of methods of synthesis, formulation or use patents ascompared to a patent on a compound. If we or Forest Laboratories are not able 

 

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toobtain and enforce these patents, a competitor could use milnacipran for atreatment or use not covered by any of our patents.

 

We also will rely on method of use patents toprotect our proprietary technology for the development of mirtazapine for OSA. Thecomposition of matter patent for mirtazapine has expired. United States patent(U.S. Patent 6,303,595) related to the use of mirtazapine in the treatment ofOSA expires in 2017. Because mirtazapine is sold as a generic drug, othercompanies may be able to sell mirtazapine for indications other than OSAin competition with us unless we, Organon and other license partners, dependingupon which combination compound is selected, are able to obtain additionalpatent protection under the various patent applications that have been filed.

 

We also expect to rely on the United States DrugPrice Competition and Patent Term Restoration Act, commonly known as the Hatch-WaxmanAmendments, for protection of milnacipran and our other future products. TheHatch-Waxman Amendments provide data exclusivity for new molecular entities,such as that in milnacipran. Once a drug containing a new molecule is approvedby the FDA, the FDA cannot accept an abbreviated NDA for a generic drugcontaining that molecule for five years, although the FDA may accept andapprove a drug containing the molecule pursuant to an NDA supported byindependent clinical data. Recent amendments have been proposed that wouldnarrow the scope of Hatch-Waxman exclusivity and permit generic drugs tocompete with our drug. After the Hatch-Waxman exclusivity period expires,assuming our patents are valid, we still expect to rely on our method of usepatents to protect our proprietary technology with respect to the developmentof milnacipran. The patent positions of pharmaceutical companies are uncertainand may involve complex legal and factual questions. We may incursignificant expense in protecting our intellectual property and defending orassessing claims with respect to intellectual property owned by others. Anypatent or other infringement litigation by or against us could result insignificant expense to us, including diversion of the resources of management.

 

Others may file patent applications or obtainpatents on similar technology or compounds that compete with milnacipran forthe treatment of FMS or mirtazapine in the treatment of OSA. We cannot predictthe breadth of claims that will be allowed and issued in patent applications.Once patents have issued, we cannot predict how the claims will be construed orenforced. We may infringe on intellectual property rights of otherswithout being aware of the infringement. If another party claims we areinfringing their technology, we could have to defend an expensive and timeconsuming lawsuit, pay a large sum if we are found to be infringing, or beprohibited from selling or licensing our products unless we obtain a license orredesign our product, which may not be possible.

 

We also rely on trade secrets and proprietaryknow-how to develop and maintain our competitive position. Some of our currentor former employees, consultants or scientific advisors, or current orprospective corporate collaborators, may unintentionally or willfullydisclose our confidential information to competitors or use our proprietarytechnology for their own benefit. Furthermore, enforcing a claim alleging theinfringement of our trade secrets would be expensive and difficult to prove,making the outcome uncertain. Our competitors may also independentlydevelop similar knowledge, methods and know-how or gain access to ourproprietary information through some other means.

 

***Our ability to compete may decline if we do not adequately protectour proprietary rights.***

 

Our commercial success depends on obtaining andmaintaining proprietary rights to our product candidates and technologies andtheir uses as well as successfully defending these rights against third partychallenges. We will only be able to protect our product candidates, proprietarytechnologies and their uses from unauthorized use by third parties to theextent that valid and enforceable patents or effectively-protected tradesecrets cover them.

 

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Our ability to obtain patent protection for ourproducts and technologies is uncertain due to a number of factors, including:

 

•                                          we may not have been the first to makethe inventions covered by our pending patent applications or issued patents;

 

•                                          we may not have been the first to filepatent applications for our product candidates or the technologies we relyupon;

 

•                                          others may independently develop similaror alternative technologies or duplicate any of our technologies;

 

•                                          our disclosures in patent applications may notbe sufficient to meet the statutory requirements for patentability;

 

•                                          any or all of our pending patent applicationsmay not result in issued patents;

 

•                                          we may not seek or obtain patentprotection in all countries that will eventually provide a significant businessopportunity;

 

•                                          any patents issued to us or our collaboratorsmay not provide a basis for commercially viable products, may notprovide us with any competitive advantages or may be challenged by thirdparties;

 

•                                          some of our proprietary technologies may notbe patentable;

 

•                                          others may design around our patentclaims to produce competitive products which fall outside of the scope of ourpatents; or

 

•                                          others may identify prior art whichcould invalidate our patents.

 

Even if we obtain patents covering our productcandidates or technologies, we may still be barred from making, using andselling our product candidates or technologies because of the patent rights ofothers. Others may have filed and in the future are likely to file patentapplications covering compounds, assays, genes, gene products or therapeuticproducts that are similar or identical to ours. Numerous U.S. and foreignissued patents and pending patent applications owned by others exist in the areaof central nervous system disorders and the other fields in which we aredeveloping products. These could materially affect our ability to develop ourproduct candidates or sell our products. Because patent applications can takemany years to issue, there may be currently pending applications, unknownto us, which may later result in issued patents that our productcandidates or technologies may infringe. These patent applications may havepriority over patent applications filed by us. Disputes may arise regardingthe ownership or inventorship of our inventions. It is difficult to determinehow such disputes will be resolved. Others may challenge the validity ofour patents. If our patents are found to be invalid we will lose the ability toexclude others from making, using or selling the inventions claimed therein.

 

Some of our research collaborators and scientificadvisors have rights to publish data and information to which we have rights.If we cannot maintain the confidentiality of our technology and otherconfidential information in connection with our collaborations, then ourability to receive patent protection or protect our proprietary informationwill be impaired. In addition, in-licensed technology is important to ourbusiness. We generally will not control the patent prosecution, maintenance orenforcement of in-licensed technology.

 

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***A dispute concerning theinfringement or misappropriation of our proprietary rights or the proprietaryrights of others could be time consuming and costly and an unfavorable outcomecould harm our business.***

 

There is significant litigation in the industryregarding patent and other intellectual property rights. We may be exposedto future litigation by third parties based on claims that our productcandidates, technologies or activities infringe the intellectual propertyrights of others. If our drug development activities are found to infringe anysuch patents, we may have to pay significant damages. There are many patentsrelating to chemical compounds and the uses thereof. If our compounds are foundto infringe any such patents, we may have to pay significant damages. Apatentee could prevent us from making, using or selling the patented compounds.We may need to resort to litigation to enforce a patent issued to us,protect our trade secrets or determine the scope and validity of third partyproprietary rights. From time to time, we may hire scientific personnelformerly employed by other companies involved in one or more areas similar tothe activities conducted by us. Either we or these individuals may besubject to allegations of trade secret misappropriation or other similar claimsas a result of their prior affiliations. If we become involved in litigation,it could consume a substantial portion of our managerial and financialresources, whether we win or lose. We may not be able to afford the costsof litigation. Any legal action against our company or our collaborators couldlead to:

 

•                                          payment of damages, potentially trebledamages, if we are found to have willfully infringed such parties’ patentrights;

 

•                                          injunctive or other equitable relief that may effectivelyblock our ability to further develop, commercialize and sell products; or

 

•                                          we or our collaborators having to enter intolicense arrangements that may not be available on commercially acceptableterms, if at all.

 

Asa result, we could be prevented from commercializing current or futureproducts.

 

***The patent applications ofpharmaceutical and biotechnology companies involve highly complex legal andfactual questions, which could negatively impact our patent position.***

 

The patent positions of pharmaceutical andbiotechnology companies can be highly uncertain and involve complex legal andfactual questions. The United States Patent and Trademark Office’s standardsare uncertain and could change in the future. Consequently, the issuance andscope of patents cannot be predicted with certainty. Patents, if issued, may bechallenged, invalidated or circumvented. United States patents and patentapplications may also be subject to interference proceedings and UnitedStates patents may be subject to reexamination proceedings in the UnitedStates Patent and Trademark Office (and foreign patents may be subject toopposition or comparable proceedings in the corresponding foreign patentoffice), which proceedings could result in either loss of the patent or denialof the patent application or loss or reduction in the scope of one or more ofthe claims of the patent or patent application. In addition, such interference,reexamination and opposition proceedings may be costly. Accordingly,rights under any issued patents may not provide us with sufficientprotection against competitive products or processes.

 

In addition, changes in or different interpretationsof patent laws in the United States and foreign countries may permitothers to use our discoveries or to develop and commercialize our technologyand products without providing any compensation to us. The laws of somecountries do not protect intellectual property rights to the same extent asUnited States laws and those countries may lack adequate rules andprocedures for defending our intellectual property rights. For example, somecountries, including many in 

 

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Europe,do not grant patent claims directed to methods of treating humans, and in thesecountries patent protection may not be available at all to protect ourproduct candidates.

 

If we fail to obtain and maintain patent protectionand trade secret protection of our product candidates, proprietary technologiesand their uses, we could lose our competitive advantage and competition we facewould increase, reducing our potential revenues and adversely affecting ourability to attain or maintain profitability.

 

**ITEM 1B. Unresolved Staff Comments**

 

None.

 

**ITEM 2. Properties**

 

We currently occupyapproximately 5,200 square feet of leased office space in San Diego, California.The San Diego facility houses our executive and administrative offices. Thelease for this facility expires in July 2007 and contains monthly rentalpayments ranging from $13,465 to $15,753 over the lease term.

 

**ITEM 3. Legal Proceedings**

 

From time to time, in thenormal course of business, we are involved in litigation arising out of ouroperations. We are not currently engaged in any legal proceedings that weexpect would materially harm our business or financial condition.

 

**ITEM 4. Submission of Matters to a Vote ofSecurity Holders**

 

No matter was submittedto a vote of security holders during the fourth quarter of the fiscal yearended December 31, 2005.

 

**Executive Officers**

 

Our executive officers are as follows:

 
| **NAME**                         | ** ** | **AGE** | ** ** | **POSITION**                                                      |
|----------------------------------|------------|---------|------------|-------------------------------------------------------------------|
|                             |       |    |       |                                                              |
| Jay D. Kranzler, M.D., Ph.D.     |       | 48      |       | Chief Executive Officer and Chairman of the  Board of Directors   |
| Sabrina Martucci Johnson         |       | 39      |       | Chief Financial Officer and Senior Vice  President                |
| R. Michael Gendreau, M.D., Ph.D. |       | 50      |       | Vice President of Clinical Development and  Chief Medical Officer |
| Denise L. Wheeler                |       | 36      |       | Vice President of Business and Legal  Affairs                     |

 

***JAY D. KRANZLER,M.D., Ph.D.,*** wasappointed as our Chief Executive Officer and Vice-Chairman in December 1995.In April 1998, Dr. Kranzler was appointed as Chairman of the Board.From January 1989 until August 1995, Dr. Kranzler served asPresident, Chief Executive Officer and a director of Cytel Corporation, apublicly held biotechnology company. Dr. Kranzler has been an adjunctmember of the Research Institute of Scripps Clinic since January 1989.Before joining Cytel, from 1985 to January 1989, Dr. Kranzler wasemployed by McKinsey & Company, a management-consulting firm, as aconsultant specializing in the pharmaceutical industry. Dr. Kranzler hasan M.D. with a concentration in psychiatry and a Ph.D. in pharmacology fromYale University. He graduated summa cum laude from Yeshiva University.

 

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***SABRINA MARTUCCIJOHNSON*** wasappointed as our interim Chief Financial Officer in February 2002 and in April 2002,she was appointed as our Vice President and Chief Financial Officer. In April 2005,she was promoted to Senior Vice President. Ms. Johnson served as our VicePresident of Marketing from March 2001 to April 2002. Ms. Johnsonjoined us in August of 1998 and held various positions from 1998 through2000, including Product Director, Executive Director of Marketing and Sales,and Vice President of Marketing and Sales. From 1993 to 1998, Ms. Johnsonheld marketing and sales positions with Advanced Tissue Sciences and Clonetics.Ms. Johnson began her career in the biotechnology industry in 1990 as aresearch scientist with Baxter Healthcare, Hyland Division. Ms. Johnsonhas an MBA from the American Graduate School of International Management(Thunderbird), a MSc. in Biochemical Engineering from the University of Londonand a BSc. in biomedical engineering from Tulane University.

 

***R. MICHAELGENDREAU, M.D., Ph.D.,*** was appointed as our Vice President of Research and Development andChief Medical Officer in December 1996 and is currently serving as theVice President of Clinical Development and Chief Medical Officer. Dr. Gendreaujoined us in 1994 and held various positions from 1994 through 1996, includingExecutive Director of Scientific Affairs. From 1991 to 1994, Dr. Gendreauwas Vice President of Research and Development and Chief Medical Officer forMicroProbe Corporation, a developer and manufacturer of DNA probe-baseddiagnostic equipment. Dr. Gendreau has a B.S. in chemistry from OhioUniversity and an M.D./Ph.D. in medicine and pharmacology from the Ohio StateUniversity.

 

***DENISE L. WHEELER*** was appointed as our Vice President ofBusiness and Legal Affairs and Corporate Secretary in February 2004. Priorto joining us, from September 1997 until January 2004, Ms. Wheelerworked as a corporate attorney at the law firm of Cooley Godward LLP. Ms. Wheelerhas a B.A. from Old Dominion University and a J.D. from the University of SanDiego, School of Law.

 

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**PART II**

 

**ITEM 5**. **Market for our Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities**

 

Our common stock is traded on the Nasdaq NationalMarket under the symbol “CYPB”. Prior to March 1, 2004, our stock wastraded on the Nasdaq SmallCap Market. Set forth below are the high and lowclosing sales prices for our common stock for the periods indicated as reportedon the Nasdaq National Market and the Nasdaq SmallCap Market, as applicable.

 
| ** **                             | ** ** | **Price Range of Common Stock** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                             | ** ** | **High**                                            | ** ** | **Low** | ** ** |
|                                   |       |                                                |       |   |   |
| **Year Ended December 31, 2005:** |       |                                                |       |   |   |
| First  Quarter                         |       | $                                                   | 14.05      |   | $ | 9.09 |   |
| Second  Quarter                        |       | 13.65                                               |       | 8.50 |   |
| Third  Quarter                         |       | 14.68                                               |       | 5.41 |   |
| Fourth  Quarter                        |       | 6.15                                                |       | 4.42 |   |
|                                   |       |                                                |       |   |   |
| **Year Ended December 31, 2004:** |       |                                                |       |   |   |
| First  Quarter                         |       | $                                                   | 15.71      |   | $ | 10.94 |   |
| Second  Quarter                        |       | 16.05                                               |       | 11.92 |   |
| Third  Quarter                         |       | 13.67                                               |       | 8.94 |   |
| Fourth  Quarter                        |       | 14.06                                               |       | 9.28 |   |

 

Asof March 1, 2006, there were approximately 725 holders of record of ourcommon stock. On March 1, 2006, the last reported sale price of our commonstock on the Nasdaq National Market was $6.02 per share. We have never paid anycash dividends on our common stock, and we do not anticipate paying any cashdividends in the foreseeable future as we intend to retain any earnings for usein our business.

 

**Equity Compensation Plan Information**

 

The following table summarizes the securitiesauthorized for issuance under our equity compensation plans as of December 31,2005:
| ** **                                                       | ** ** | **Number of Shares  to be Issued Upon  Exercise of  Outstanding  Options** | ** ** | **Weighted Average  Exercise Price of  Outstanding  Options** | ** ** | **Number of Shares  Remaining  Available for  Future Issuance  Under Equity  Compensation  Plans (b)** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by stockholders** (a)** |       | 3,319,190                                                                                                |       | $                                                                            | 7.25       |                                                                                                                                 | 3,416,063  |   |
| Equity  compensation plans not approved by stockholders          |       | —                                                                                                   |       | —                                                                       |       | —                                                                                                                               |       |
|                                                                  |            |                                                                                                          |            |                                                                              |            |                                                                                                                                      |            |  |

 

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**(a)**          Includes our 1996 EquityIncentive Plan and our 2000 Equity Incentive Plan.

 

**(b)****         **In February 2001,the shareholders of the Company approved a provision to amend the 2000 EquityIncentive Plan, whereby the total number of shares reserved for issuance underthe 2000 Equity Incentive Plan and the 1996 Equity Incentive Plan, in theaggregate, may be increased quarterly such that the number equals 21.1% ofthe number of shares of the Company’s common stock issued and outstanding as ofthe end of that day.

 

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**ITEM 6. Selected Financial Data**

 

The following table presents our selected financialdata, which is derived from our audited financial statements. The informationset forth below is not necessarily indicative of the results of futureoperations and should be read in conjunction with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” in Item 7 of thisreport and the financial statements and the related notes thereto included inthis Form 10-K.

 
| ** **                                                            | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Statement of Operations Data:**                                     |       |                                        |       |   |   |   |   |   |   |   |   |
|                                                                  |       |                                        |       |   |   |   |   |   |   |   |   |
| Revenues:                                                             |       |                                        |       |   |   |   |   |   |   |   |   |
| Revenues  under collaborative agreement                               |       | $                                           | 8,384,636  |   | $ | 14,414,619 |   | $ | — |   | $ | — |   | $ | — |   |
| Revenue from  Fresenius agreement                                     |       | —                                      |       | — |   | — |   | 6,400,000 |   | 1,600,000 |   |
|                                                                  |       | 8,384,636                                   |       | 14,414,619 |   | — |   | 6,400,000 |   | 1,600,000 |   |
|                                                                  |       |                                        |       |   |   |   |   |   |   |   |   |
| Costs and  expenses:                                                  |       |                                        |       |   |   |   |   |   |   |   |   |
| Research and  development                                             |       | 15,519,975                                  |       | 15,201,192 |   | 11,443,693 |   | 5,094,079 |   | 3,677,544 |   |
| General and  administrative                                           |       | 4,770,329                                   |       | 5,732,641 |   | 4,120,156 |   | 2,985,862 |   | 4,281,283 |   |
| Non-cash  compensation charges                                        |       | 997,593                                     |       | 6,479,308 |   | 416,659 |   | 222,377 |   | 194,493 |   |
| Compensation  expense (benefit) – variable stock options         |       | (1,749,135                                  | )          | (699,033 | ) | 5,879,277 |   | (688,376 | ) | 784,874 |   |
|                                                                  |       | 19,538,762                                  |       | 26,714,108 |   | 21,859,785 |   | 7,613,942 |   | 8,938,194 |   |
| Other income  (expense):                                              |       |                                        |       |   |   |   |   |   |   |   |   |
| Interest  income                                                      |       | 2,525,327                                   |       | 1,092,404 |   | 121,679 |   | 199,678 |   | 434,363 |   |
| Interest  expense                                                     |       | (2,382                                      | )          | (5,826 | ) | (9,097 | ) | (33,529 | ) | (273,083 | ) |
| Gain (loss)  on disposal of assets                                    |       | 4,186                                       |       | (2,095 | ) | 4,931 |   | (1,090 | ) | (16,714 | ) |
|                                                                  |       | 2,527,131                                   |       | 1,084,483 |   | 117,513 |   | 165,059 |   | 144,566 |   |
|                                                                  |       |                                        |       |   |   |   |   |   |   |   |   |
| Net loss                                                              |       | $                                           | (8,626,995 | ) | $ | (11,215,006 | ) | $ | (21,742,272 | ) | $ | (1,048,883 | ) | $ | (7,193,628 | ) |
|                                                                  |       |                                        |       |   |   |   |   |   |   |   |   |
| Net loss per  share – basic and diluted                          |       | $                                           | (0.28      | ) | $ | (0.40 | ) | $ | (1.21 | ) | $ | (0.09 | ) | $ | (1.15 | ) |
|                                                                  |       |                                        |       |   |   |   |   |   |   |   |   |
| Shares used  in computing net loss per share – basic and diluted |       | 31,105,271                                  |       | 27,764,975 |   | 17,924,353 |   | 11,572,101 |   | 6,249,917 |   |

 
| ** **                                         | ** ** | **As of December 31,** | ** **  |
|----------------------------------------------------|------------|---------------------------------------|-------------|
| ** **                                         | ** ** | **2005**                              | ** **  | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Balance  Sheet Data:**                           |       |                                  |        |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term investments |       | $                                     | 109,613,278 |   | $ | 112,023,998 |   | $ | 23,524,646 |   | $ | 12,209,383 |   | $ | 5,867,083 |   |
| Total assets                                       |       | 110,791,798                           |        | 118,389,524 |   | 23,806,681 |   | 12,477,519 |   | 6,685,108 |   |
| Total  stockholders’ equity (deficit)         |       | 89,975,440                            |        | 94,173,809 |   | 22,129,122 |   | 11,785,137 |   | (1,968,943 | ) |
| Working  capital (deficit)                         |       | 105,536,094                           |        | 112,837,533 |   | 22,049,874 |   | 11,680,864 |   | (2,113,492 | ) |
|                                                    |            |                                       |             |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM 7**.     **Management’s Discussionand Analysis of Financial Condition and Results of Operations**

 

**OVERVIEW**

 

We are committed to being the innovator and leaderin providing products for the treatment of patients with Functional SomaticSyndromes and other central nervous system disorders. Specifically, ourstrategy involves acquiring or in-licensing central nervous system, or CNS,active compounds and developing them for novel and typically underservedindications. The term Functional Somatic Syndromes refers to several relatedsyndromes characterized more by symptoms, suffering and disability than bydisease-specific abnormalities that are found upon physical examination andinclude many overlapping pain and psychiatric conditions. We pursueopportunities to acquire or in-license CNS active compounds in the areas inwhich the brain and body overlap, where CNS mechanisms have a strong influenceon somatic or bodily symptoms, and our two ongoing development programs arerepresentative of this strategy.

 

Our goal is to be the first to commercialize a product approved in the United States for the treatment of Fibromyalgia Syndrome, or FMS, the focus of our initial efforts in the area of Functional Somatic Syndromes. In January 2004, we entered into a collaboration agreement with Forest Laboratories, Inc., a leading marketer of CNS drugs with a strong franchise in the primary care and psychiatric markets, for the development and marketing of milnacipran. In July 2005, we completed the first Phase III trial for milnacipran, which was commenced in October 2003. We announced the top-line results from this first Phase III trial in September 2005. Although the results did not achieve statistical significance at the p<0.05 level, we believe the preliminary results support continuation of the development program and the planned development program for milnacipran is continuing. This development program includes an ongoing second Phase III study and an additional third Phase III study that was initiated in the first quarter of 2006.

 

We obtained an exclusive license for milnacipranfrom Pierre Fabre Medicament in 2001. Milnacipran has been marketed outside ofthe United States since 1997 as an antidepressant and has been used by over3,000,000 patients worldwide. We have paid Pierre Fabre a total of$2.5 million, including upfront payments of $1.5 million inconnection with the execution of the original license agreement in 2001 and a$1.0 million milestone payment in September 2003, and issued PierreFabre 1,000,000 shares of common stock and warrants to purchase 300,000 sharesof common stock in connection with an amendment to the agreement with PierreFabre. We are obligated to pay Pierre Fabre 5% of any upfront and milestonepayments received from Forest Laboratories as a sublicense fee. A $1.25 millionsuch payment has been made to date. After a total of $7.5 million has beenpaid, any additional sublicense fees are credited against any subsequentmilestone and royalty payments owed by us to Pierre Fabre. If not used, thesecredits are carried forward to subsequent years. Additional payments to PierreFabre of up to a total of $4.5 million will be due to Pierre Fabre basedon meeting certain clinical and regulatory milestones. Under our agreement withForest Laboratories, we sublicensed our rights to milnacipran to ForestLaboratories for the United States, with an option to extend the territory toinclude Canada. Additionally, Forest Laboratories assumed responsibility forfunding all continuing development of milnacipran, including the funding ofclinical trials and regulatory approval, as well as a specified number of ouremployees. However, in light of the increased expense and risk associated withrunning two parallel trials, we have agreed upon an alternative cost sharingarrangement with Forest Laboratories for the second Phase III trial only. Inconnection with this arrangement, the amount of funding that we receive fromForest Laboratories for certain of our employees has been eliminated as of thefourth quarter in 2004 for the second Phase III trial only, and we will pay fora majority of the external costs of the second Phase III trial only, withForest reimbursing us under 

 

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specificscenarios where the second Phase III trial is used as one of the two requiredpivotal trials in the NDA submission to the FDA. Forest Laboratories is fundingthe third Phase III clinical trial, including a specified number of ouremployees that are assisting with the conduct of that clinical trial. ForestLaboratories will also be responsible for sales and marketing activitiesrelated to any product developed under the agreement, while we have the optionto co-promote using our own sales force up to 25% of the total physiciandetails and would be reimbursed by Forest in an amount equal to Forest’s costof providing the equivalent detailing calls.

 

In June 2005, we announced the initiation of our second development program, wherein we are evaluating potential pharmaceutical treatments for Obstructive Sleep Apnea, or OSA. We entered into three licensing agreements to support and facilitate the program. Specifically, we licensed mirtazapine-related patents from Organon (Ireland) Ltd., and patents from two other parties that provide the opportunity to combine mirtazapine with a second approved agent with the goal of potentially augmenting efficacy and improving tolerability. The series of licenses will allow Cypress to evaluate a number of potential OSA treatment modalities in proof of concept trials.

 

Upon execution of the license agreement with Organon, we issued to Organon as a license fee a warrant to purchase 62,656 shares of our common stock at an exercise price of $15.96. Under the agreement with Organon, Cypress and Organon will jointly fund development activities in the event a candidate from the proof of concept trials has been selected for continued development. If we are able to select a development candidate, the following is the structure of our agreement with Organon. We will have operational control of the development activities and, depending on the candidate selected, will fund 40% or 50% of the development-related expenses. If the FDA approves this product, Organon will have operational control of sales and marketing activities, with Cypress having the opportunity to co-promote up to 25% of the physician promotion and details using its own sales force in the United States, Mexico and Canada. Expenses and revenue in the United States, Mexico and Canada are to be shared between Cypress and Organon based on the level of promotional effort each party contributes, with Cypress having the ability to share up to 40% or 50% depending on the candidate selected. Organon will be solely responsible for commercialization in the rest of the world and will pay Cypress a royalty on net sales.

 

Assuming the decision is made by Cypress and Organon to proceed with the commencement of the first Phase III clinical trial, at any time thereafter, either Cypress or Organon may elect to change the structure of the financial agreement to provide that the party that makes such election will no longer share in expenses and revenue, and instead will have the potential right to receive potential milestone and royalty payments in the event a product is commercialized.

 

In connection with our related licensingtransactions with two other parties, Cypress paid the parties aggregate licensepayments totaling $2.5 million, with the potential for additional milestonepayments of up to $25.3 million related to our OSA program, as developmentprogresses. The parties will also participate in royalties from any marketedproducts that may be developed under the respective agreements.

 

Cypress and Organon have each independentlyinitiated Phase IIa trials that will serve as the basis for selecting theproduct candidate, if any, for further clinical development. The companiesexpect the Phase IIa trials and subsequent joint development and planningmeetings to run through at least the first half of 2006, which is also theearliest a development candidate to be evaluated in further trials could beselected.

 

We are continuing to evaluate other variouspotential strategic transactions, including the potential acquisitions ofproducts, technologies and companies, and other alternatives.

 

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As of December 31, 2005, we had working capitalof approximately $105.5 million and an accumulated deficit ofapproximately $146.1 million. Our future success depends on our ability todevelop and market new products for the treatment of Functional SomaticSyndromes, such as FMS, and other central nervous system disorders.

 

**Resultsof Operations**

 

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

 

***Revenues***

 

We recognized revenuesunder our collaborative agreement of $8.4 million for the year ended December 31,2005 compared to $14.4 million for the year ended December 31, 2004. Thedecrease in revenues under our collaborative agreement is due to a decrease insponsored development reimbursements during 2005 for costs incurred inconnection with the first Phase III trial, which was completed during thesecond half of 2005, and the elimination of funding from Forest Laboratoriesfor certain of our employees devoted to the development of milnacipran as ofthe fourth quarter in 2004. This decrease in revenues under our collaborativeagreement was partially offset by an increase in sponsored developmentreimbursements during 2005 for costs incurred in connection with the extensiontrial to our first Phase III trial, which commenced during the third quarter of2004 and had a full year of activity during 2005. The revenues recorded during2005 and 2004 consist solely of amounts earned pursuant to our collaborationagreement with Forest Laboratories for the development and marketing ofmilnacipran, entered into in January 2004. Such revenues include therecognition of the upfront payment of $25.0 million from Forest Laboratories ona straight-line basis over a period of 8 years, sponsored developmentreimbursements and funding received from Forest Laboratories during 2004 forcertain of our employees devoted to the development of milnacipran.

 

We currently are not generating any revenues from product sales and wedo not expect to generate revenues from product sales for at least the nextseveral years, if at all. Unless and until we generate revenues from productsales, we expect our revenues to consist of the continued recognition on astraight-line basis of the upfront payment of $25.0 million and sponsoreddevelopment reimbursements. We may also recognize future milestonepayments under our agreement with Forest Laboratories, which are contingentupon the achievement of agreed upon objectives and which are not guaranteedpayments. In connection with our arrangement with Forest Laboratories regardingcost sharing arrangements for the second Phase III trial only, the amount offunding that we receive from Forest Laboratories for certain of our employeeswas eliminated as of the fourth quarter in 2004. Additionally, the amount ofsponsored development reimbursements from Forest Laboratories may changeperiodically based on the level of development activity. Our collaborationagreement is subject to early termination by Forest Laboratories upon specifiedevents, including breach of the agreement.

 

***Research and Development***

 

Research and developmentexpenses for the year ended December 31, 2005 were $15.5 million comparedto $15.2 million for the year ended December 31, 2004. The increase inresearch and development expenses is primarily attributable to costs incurredduring 2005 in connection with the extension trial to our first Phase IIItrial, which commenced during the third quarter of 2004 and had a full year ofactivity during 2005, and our second Phase III trial for milnacipran, whichcommenced during the fourth quarter of 2004 and had a full year of activityduring 2005, payment of license fees of $2.5 million and a non-cash charge of$0.6 million incurred due to the issuance of a warrant to Organon in connectionwith the licensing agreement related to our OSA program and costs incurred inconnection with various proof of concept studies for our sleep apnea program. Thisincrease in research and development 

 

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expenses during2005 was partially offset by several non-recurring expenses incurred in 2004,including a $1.25 million sublicense fee paid to Pierre Fabre recorded duringthe first quarter of 2004 in connection with our collaboration agreement withForest Laboratories and a payment for the exercise of our option in January 2004to acquire an exclusive license to technology developed under our reformulationand new product agreement with Collegium, and a decrease during 2005 in costsincurred in connection with the first Phase III trial, which was completed duringthe second half of 2005. During 2005, we incurred total costs of $8.3 millionin connection with our Phase III programs compared to a total of $12.9 million(including the $1.25 million sublicense fee to Pierre Fabre) during 2004. Thecosts for the first Phase III clinical trial and extension trial are beingreimbursed by Forest Laboratories as noted below.

 

Effective January 9, 2004, pursuant toour collaboration agreement with Forest Laboratories, Forest Laboratoriesassumed responsibility for funding all continuing development of milnacipran,including the funding of clinical trials and regulatory approvals. This fundingreceived from Forest Laboratories for sponsored development reimbursements isincluded as a component of our revenue under collaborative agreement on thestatement of operations. We agreed upon an alternative cost sharing arrangement with ForestLaboratories for the second Phase III trial only. In connection with thisarrangement, we will pay for a majority of the external costs of the secondPhase III trial only, with Forest reimbursing us under specific scenarios wherethe second Phase III trial is used as one of the two required pivotal trials inthe NDA submission to the FDA.

 

Inaddition, as discussed below in “Non-Cash Compensation Charges,” we recognizednon-cash compensation expense of $320,000 and $449,000 related to research anddevelopment expenses for the years ended December 31, 2005 and 2004,respectively, and as discussed below in “Compensation Benefit—Variable StockOptions,” we recognized a compensation benefit for variable stock options of $0and $180,000 related to research and development expenses for the years ended December 31,2005 and 2004, respectively.

 

***General and Administrative***

 

General andadministrative expenses for the year ended December 31, 2005 were $4.8million compared to $5.7 million for the year ended December 31, 2004. Thedecrease in general and administrative expenses is primarily due tonon-recurring costs incurred during 2004, consisting of a success-based feepaid to our investment bankers in connection with the closing of ourcollaboration agreement with Forest Laboratories in January 2004 and aone-time fee associated with our being listed during the first quarter of 2004on the Nasdaq National Market, and lower consulting fees and travel expensesduring 2005 in connection with business development activities. This decreasein general and administrative expenses during 2005 was partially offset by asuccess-based fee paid to advisors during the second quarter of 2005 inconnection with the closing of our licensing agreement with Organon.

 

In addition, as discussed below in “Non-CashCompensation Charges,” we recognized non-cash compensation expense of $678,000and $6.0 million related to general and administrative expenses for the yearsended December 31, 2005 and 2004, respectively, and as discussed below in “CompensationBenefit—Variable Stock Options,” we recognized a compensation benefit forvariable stock options of $1.7 million and $519,000 related to general andadministrative expenses for the years ended December 31, 2005 and 2004,respectively.

 

***Non-Cash Compensation Charges***

 

Non-cash compensation charges for the year ended December 31,2005 were $998,000, consisting of approximately $320,000 related to researchand development expenses and $678,000 related 

 

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togeneral and administrative expenses, compared to $6.5 million, consisting ofapproximately $449,000 related to research and development expenses and $6.0million related to general and administrative expenses, for the year ended December 31,2004. The decrease in non-cash compensation charges is primarily due tonon-recurring, non-cash compensation charges recorded during the first quarterof 2004, consisting of $2.4 million related to stock options previously grantedto consultants and two former board members for services that vested upon thecompletion of the collaboration agreement with Forest Laboratories and $2.8million in connection with the accounting treatment for stock options relatedto the resignation of certain board members to roles as consultants during thefirst quarter of 2004, as well as a decrease in the Black-Scholes valuation forstock options granted to consultants due to the overall decrease in our stockprice experienced during 2005.

 

***Compensation Benefit – Variable Stock Options***

 

In June 2001, weimplemented an option cancel and re-grant program, which resulted in variableaccounting for the newly issued options under Financial Accounting StandardsBoard Interpretation No. 44 (“FIN 44”), *Accountingfor Certain Transaction Involving Stock Compensation – An Interpretation of APB 25*. Duringthe year ended December 31, 2005, as the intrinsic value of the commonstock underlying the options declined due to a decrease in our stock priceduring the period, we recognized a compensation benefit of $1.7 million,consisting of $0 related to research and development expenses and $1.7 millionrelated to general and administrative expenses. Similarly, due to a decrease inour stock price during the year ended December 31, 2004, we recognized acompensation benefit of $699,000, consisting of $180,000 related to researchand development expenses and $519,000 related to general and administrativeexpenses. In the event our stock price is above $5.78 (closing price on December 31,2005) on March 31, 2006, we will record additional compensation charges(however, we cannot predict what our stock price will be in the future and it may besubstantially lower than $5.78).

 

***Interest Income***

 

Interest income for theyear ended December 31, 2005 was $2.5 million compared to $1.1 million forthe year ended December 31, 2004. The increase in interest income for theyear ended December 31, 2005 compared to the corresponding period in 2004is due to higher cash and investment balances during 2005 and a generalincrease in interest rates and related yields experienced during 2005.

 

***Comparison of Years Ended December 31,2004 and 2003***

 

***Revenues***

 

We recognized revenuesunder our collaborative agreement of $14.4 million for the year ended December 31,2004 compared to no revenue for the year ended December 31, 2003. Therevenues recorded during 2004 consist solely of amounts earned pursuant to ourcollaboration agreement with Forest Laboratories for the development andmarketing of milnacipran, entered into in January 2004. Such revenuesinclude the recognition of the upfront payment of $25.0 million from ForestLaboratories on a straight-line basis over a period of 8 years, fundingreceived from Forest Laboratories for certain of our employees devoted to thedevelopment of milnacipran and sponsored development reimbursements.

 

***Research and Development***

 

Research and developmentexpenses for the year ended December 31, 2004 were $15.2 million comparedto $11.4 million for the year ended December 31, 2003. The increase inresearch and development expenses is primarily attributable to increased costsin connection with our first Phase III clinical trial for milnacipran due to afull year of activity during 2004 and costs incurred during 2004 in 

 

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connection withthe extension trial and our second Phase III trial for milnacipran. During2004, we incurred total costs of $12.9 million in connection with our Phase IIIprograms compared to a total of $3.3 million during 2003. Research anddevelopment expenses during 2003 included a non-cash charge in the amount of$5.0 million recognized during the second quarter of 2003 in connection withthe issuance of 1,000,000 shares of our common stock and warrants to purchase300,000 shares of our common stock to Pierre Fabre under the Restated PierreFabre Agreement and costs incurred during the first quarter of 2003 related tothe Phase II clinical trial for milnacipran, which was in its final completionstage during the first quarter of 2003. The costs for the first Phase IIIclinical trial and extension trial incurred during 2004 are being reimbursed byForest Laboratories.

 

Inaddition, as discussed below in “Non-Cash Compensation Charges,” we recognizednon-cash compensation expense of $449,000 and $201,000 related to research anddevelopment expenses for the years ended December 31, 2004 and 2003,respectively, and as discussed below in “Compensation Expense(Benefit)—Variable Stock Options,” we recognized a compensation (benefit) forvariable stock options of $(180,000) and compensation expense for variablestock options of $646,000 related to research and development expenses for theyears ended December 31, 2004 and 2003, respectively.

 

***General and Administrative***

 

General andadministrative expenses for the year ended December 31, 2004 were $5.7million compared to $4.1 million for the year ended December 31, 2003. Theincrease in general and administrative expenses is primarily due to asuccess-based fee paid to our investment bankers in connection with the closingof our collaboration agreement with Forest Laboratories, a one-time feeassociated with our being listed during the first quarter of 2004 on the NasdaqNational Market, increased wages and benefits expense associated with anincrease in headcount, increased consulting fees and travel expenses inconnection with business development activities surrounding potential strategictransactions and increased business insurance costs.

 

In addition, as discussed below in “Non-CashCompensation Charges,” we recognized non-cash compensation expense of $6.0million and $216,000 related to general and administrative expenses for theyears ended December 31, 2004 and 2003, respectively, and as discussedbelow in “Compensation Expense (Benefit)—Variable Stock Options,” we recognizeda compensation (benefit) for variable stock options of $(519,000) andcompensation expense for variable stock options of $5.2 million related togeneral and administrative expenses for the years ended December 31, 2004and 2003, respectively.

 

***Non-Cash Compensation Charges***

 

Non-cash compensation charges for the year ended December 31,2004 were $6.5 million, consisting of approximately $449,000 related toresearch and development expenses and $6.0 million related to general andadministrative expenses, compared to $417,000, consisting of approximately$201,000 related to research and development expenses and $216,000 related togeneral and administrative expenses, for the year ended December 31, 2003.The increase in non-cash compensation charges is primarily due to: (i) non-recurring,non-cash compensation charges recognized during the first quarter of 2004,consisting of $2.4 million related to stock options previously granted toconsultants and two former board members for services that vested upon theexecution of the collaboration agreement with Forest Laboratories and $2.8million related to the accounting treatment for stock options in connectionwith the resignation of certain board members to roles as consultants duringthe first quarter of 2004; (ii) a non-recurring, non-cash compensationcharge in the amount of $385,000 recognized during the second quarter of 2004related to the issuance of warrants to purchase 50,000 shares of our commonstock to an outside consultant as compensation for services provided; and (iii) anincrease in the Black-Scholes 

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valuationfor stock options previously granted to consultants due to the overall averageincrease in our stock price. These options are being expensed over theirrelated vesting period.

 

***Compensation Expense (Benefit) – Variable Stock Options***

 

In connection with theoption cancel and re-grant program implemented in 2001, which resulted invariable accounting for the newly issued options under FIN 44, we recognized acompensation (benefit) of $(699,000), consisting of $(180,000) related toresearch and development expenses and $(519,000) related to general andadministrative expenses, during the year ended December 31, 2004 as theintrinsic value of the common stock underlying the options declined due to adecrease in our stock price during the period. In contrast, due to an increasein our stock price during the year ended December 31, 2003, we recognizedcompensation expense of $5.9 million, consisting of $646,000 related toresearch and development expenses and $5.2 million related to general and administrativeexpenses.

 

***Interest Income***

 

Interest income for theyear ended December 31, 2004 was $1.1 million compared to $122,000 for theyear ended December 31, 2003. The increase in interest income for the yearended December 31, 2004 compared to the corresponding period in 2003 isdue to higher cash and investment balances during 2004 achieved primarilythrough the upfront payment received from Forest Laboratories in January 2004and the proceeds from our secondary offering completed in April 2004, and ageneral increase in interest rates and related yields experienced during 2004.

 

**Liquidity and Capital Resources**

 

At December 31, 2005, we had cash, cashequivalents and short-term investments of $109.6 million compared to cash,cash equivalents and short-term investments of $112.0 million at December 31,2004. Working capital at December 31, 2005 totaled $105.5 million comparedto $112.8 million at December 31, 2004. We have invested a substantialportion of our available cash in high quality marketable debt instruments ofgovernmental agencies and certificates of deposit, which are within federallyinsured limits. We have established guidelines relating to our investments topreserve principal and maintain liquidity.

 

Net cash used in operating activities totaled$6.9 million for the year ended December 31, 2005 compared to netcash provided by operating activities of $11.1 million for the year ended December 31,2004. The primary use of cash during 2005 were actual expenditures to fund ouroperating activities during the period, offset by net collections of amountsdue from Forest Laboratories. The primary source of cash from operations during2004 was the upfront payment of $25.0 million received from ForestLaboratories, offset by cash used in operations of approximately $13.9 million.

 

Net cash provided by investing activities was$18,000 for the year ended December 31, 2005 compared to net cash used ininvesting activities of $81.0 million for the year ended December 31,2004. The much smaller amount in net cash from investing activities during 2005compared to 2004 was primarily a result of the purchase of short-termsecurities during 2004 with the proceeds from the secondary offering of ourcommon stock completed during April 2004.

 

Net cash provided by financing activities was $3.8million for the year ended December 31, 2005 compared to $77.4 million forthe year ended December 31, 2004. The decrease in net cash provided byfinancing activities during 2005 compared 2004 was primarily the result of proceedsof approximately $3.8 million from the exercise of stock options and warrantsduring 2005 compared to proceeds of approximately 

 

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$74.2million from the completion of our public offering of common stock during April 2004and proceeds of approximately $3.0 million from the exercise of stockoptions and warrants during 2004.

 

The following table summarizes our long-termcontractual obligations at December 31, 2005:

 
| ** **               | ** ** | **Total** | ** ** | **Less than  1 year  (2006)** | ** ** | **1 – 3 years  (2007 – 2009)** | ** ** | **After 4 years  (2010 +)** | ** ** |
|--------------------------|------------|-----------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|--------------------------------------------|------------|
| Operating leases         |       | $         | 295,074    |                                    | $          | 184,804                                                           |       | $                                          | 110,270    |   | $ | — |   |
| Purchase obligations (1) |       | 2,021,203 |       | 1,770,200                               |       | 251,003                                                           |       | —                                     |       |
| Total                    |       | $         | 2,316,277  |                                    | $          | 1,955,004                                                         |       | $                                          | 361,273    |   | $ | — |   |

 

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(1)                                  Purchase obligations include agreements topurchase goods or services, including consulting services, that are enforceableand legally binding on us and that specify all significant terms. This includescontracts that are cancelable with notice and the payment of an early terminationpenalty. Purchase obligations exclude agreements that are cancelable withoutpenalty and also exclude liabilities to the extent presented on the balancesheet as of December 31, 2005.

 

Other commercial commitments include certainpotential milestone, sublicense and royalty payments to Pierre Fabre and otherparties from whom we licensed patents in connection with our OSA program asdiscussed in the “Overview” section and milestone payments of up to $5.4million to Collegium Pharmaceutical, Inc. in connection with thereformulation and new product agreement entered into with Collegium.Contractual obligations for which we will be reimbursed by Forest Laboratoriesare not included in the table above. The above also does not include theexternal costs of the second Phase III trial for FMS that we have agreed tofund.

 

Unless and until we can consistently generatesignificant cash from our operations, we expect to continue to fund ouroperations with existing cash resources that were primarily generated from theproceeds of offerings of our equity securities and from revenue under ourcollaboration agreement with Forest and if available to us, cash fromfinancings. We currently have a shelf registration statement on file that wouldallow us to issue up to $100 million in shares but we do not have any currentintentions to engage in a financing and no current intended purchasers. Additionally,in connection with the sale of most of our assets related to the PROSORBAcolumn to Fresenius Hemocare in January 2001, a contingent payment is dueto us on January 30, 2008 in the amount of $1 million if sales duringthe first seven years exceed 35,000 units, $2 million if they exceed50,000 units and none if the sales are less than 35,000 units.

 

Our current expected primary cash needs on both ashort term and long-term basis are for the development of current products,working capital and other general corporate purposes and the identification,acquisition or license, and development of potential future products. Inaddition to the amounts required to pay any amounts payable under ouragreements with Pierre Fabre and Collegium, the costs of in-licensing oracquiring additional compounds or companies and funding clinical developmentfor any product (other than our FMS or OSA product) that we may in-licenseor acquire, we estimate that based on our current business plan, which nowincludes the development of a candidate for OSA, we will require approximately$16 million to fund our operations for the year 2006. One of our ongoing goalsis to identify and in-license new products. In the event we acquire, license ordevelop any new products, the amount to fund our operations for 2006 wouldincrease, possibly materially. Our net losses will continue for at least thenext several years as we seek to acquire, license or develop additionalproducts for the treatment of 

 

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FunctionalSomatic Syndromes and other central nervous system disorders. Such losses may fluctuate,and the fluctuations may be substantial.

 

Based on our current business plan, we believe ourcash and cash equivalents and short-term investments balances at December 31,2005 are sufficient to fund operations for at least the next year. However, weare actively continuing to evaluate various potential strategic transactions,including the potential acquisitions of products and companies, and otheralternatives. In order to acquire or develop additional products, we willrequire additional capital. The amount of capital we require is dependent uponmany forward-looking factors that could significantly increase our capitalrequirements, including the following:

 

•                                          the extent to which we acquire or invest inother products and businesses;

 

•                                          the costs of in-licensing drug candidates;

 

•                                          the ability of Forest Laboratories and us toreach milestones, and other events or developments under our collaborationagreement;

 

•                                          the ability of Organon and our other OSArelated collaborators to reach milestones, and other events or developmentsunder our collaboration agreements;

 

•                                          the costs and timing of development andregulatory approvals for milnacipran and our OSA product candidate; and

 

•                                          the costs of commercialization of any futureproducts.

 

Because we are unable to predict the outcome of theforegoing factors, some of which are beyond our control, we are unable toestimate with certainty our mid to long-term capital needs. Unless and until wecan generate a sufficient amount of product revenue, if ever, we expect to financefuture capital needs through public or private debt or equity offerings orcollaboration and licensing arrangements, as well as interest income earned oncash balances. We do not currently have any commitments or specific plans forfuture external funding. We may not be able to raise additional capitaland the funds we raise, if any, may not allow us to maintain our currentand planned operations. If we are unable to obtain additional capital, we may berequired to delay, scale back or eliminate some or all of our development ofexisting or future product candidates.

 

To date, we have not had any relationships withunconsolidated entities or financial partnerships, such as entities referred toas structured finance or special purpose entities, which are established forthe purpose of facilitating off-balance sheet arrangements or othercontractually narrow or limited purposes.

 

**Critical Accounting Policies and Estimates**

 

Our discussion and analysis of our financialcondition and results of operations are based upon our financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities. On an ongoing basis, we evaluate ourestimates, including those related to revenue recognition, research anddevelopment expenses and stock-based compensation. We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basisfor making judgments about the carrying values of assets and liabilities thatare not readily apparent from other sources. Actual results may differfrom these estimates under different assumptions or conditions. We believe thefollowing are the 

 

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criticalaccounting policies that affect the significant judgments and estimates used inthe preparation of our financial statements (see also the notes to ourfinancial statements).

 

***Revenue Recognition***

 

In accordance withStaff Accounting Bulletin (“SAB”) No. 101, *Revenue Recognition in Financial Statements* (as amended by SAB 104), revenuesare recognized when persuasive evidence of an arrangement exists, delivery hasoccurred or services have been rendered, the price is fixed and determinableand collectibility is reasonably assured. Amounts received for upfront licensefees under multiple-element arrangements are deferred and recognized over theperiod of such services or performance if such arrangements require on-goingservices or performance. Accordingly, the upfront payment of $25.0 million fromForest Laboratories is being recognized over a period of 8 years, whichrepresents the estimated period of significant on-going services andperformance, including the development period, under our agreement with ForestLaboratories. Amounts received for sponsored development activities, includingfunding received for certain of our employees, are recognized as research costsare incurred over the period specified in the related agreement or as theservices are performed. Amounts received for milestones are recognized uponachievement of the milestone, which requires substantive effort and was notreadily assured at the inception of the agreement. Any amounts received priorto satisfying revenue recognition criteria will be recorded as deferredrevenue.

 

***Research and Development Expenses***

 

Research and development expenses consist primarily of salaries andrelated personnel expenses for our research and development personnel, feespaid to external service providers to conduct clinical trials, patientenrollment costs, fees and milestone payments under our license and developmentagreements and costs for facilities, supplies, materials and equipment. Allsuch costs are charged to research and development expenses as incurred. Clinicaltrial costs are a significant component of research and development expensesand include costs associated with third-party contractors. We accrue clinicaltrial expenses based on work performed, which relies on estimates of totalcosts incurred based on completion of patient studies and other events. Actualclinical trial costs may differ from estimated clinical trial costs andare adjusted for in the period in which they become known. Historically,adjustments have not resulted in material changes to research and developmentexpenses; however, a modification in the protocol of a clinical trial orcancellation of a trial could result in a charge to our results of operations.

 

***Stock Based Compensation***

 

Wegrant stock options for a fixed number of shares to employees in accordancewith Accounting Principles Board Opinion No. 25 (“APB 25”), *Accounting for Stock Issued to Employees*,as amended by SFAS No. 123, *Accountingfor Stock Based Compensation*. Accordingly, we ordinarily recognizeno compensation expense for stock option grants to employees provided that theoption exercise price is not less than the fair market value of the underlyingstock on the date of grant. The value of options or stock awards issued tonon-employees has been determined in accordance with SFAS 123 and EmergingIssues Task Force No. 96-18, *Accountingfor Equity Instruments that are Issued to Other than Employees for Acquiring orin Conjunction with selling Goods and Services*, and is periodicallyre-measured as the options vest. For the years ended December 31, 2005 and2004, we recorded compensation expense of $864,000 and $3.1 million (including$2.4 million related to stock options that vested upon the execution of thecollaboration agreement with Forest Laboratories), respectively, related tooptions issued to consultants. Additionally, during the year ended December 31,2004, we recorded compensation expense of $2.8 million in connectionwith the accounting treatment for stock options related to the resignation ofcertain board members during the first quarter of 2004 and compensation expenseof $385,000 in connectionwith the

 

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issuance of warrants to purchase 50,000 shares of ourcommon stock to an outside consultant as compensation for services provided.

 

***New Accounting Pronouncements***

 

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards No. 123 (revised 2004), *Share-Based Payment* (SFAS 123R), which is a revision ofStatement of Financial Accounting Standards No. 123, *Accountingfor Stock-Based Compensation* (SFAS 123). SFAS 123R supersedes APBOpinion No. 25, *Accounting for StockIssued to Employees*, and amends Statement of Financial AccountingStandards No. 95, *Statement of Cash Flows*(SFAS 95). Generally, the approach in SFAS 123R is similar to the approachdescribed in SFAS 123. However, SFAS 123R requires all share-based payments toemployees, including grants of employee stock options, to be recognized in theincome statement based on their fair values. Pro forma disclosure is no longeran alternative. SFAS 123R must be adopted no later than January 1, 2006.Early adoption will be permitted in periods in which financial statements havenot yet been issued. The Company will adopt SFAS 123R on January 1, 2006.

 

Aspermitted by SFAS 123, we currently account for share-based payments toemployees using Opinion 25’s intrinsic value method and, as such, generallyrecognize no compensation cost for employee stock options. Accordingly, theadoption of SFAS 123R’s fair value method will have a significant impact on ourresults of operations, although it will have no impact on our overall financialposition. Determining the exact impact of adoption of SFAS 123R cannot be predictedat this time because it will depend on levels of share-based payments grantedin the future and the assumptions for the variables which affect thecomputation. However, had we adopted SFAS 123R in prior periods, the impact ofthat standard would have approximated the impact of SFAS 123 as described inthe disclosure of pro forma net loss and net loss per share in Note 1 to ourfinancial statements.

 

**ITEM 7A. Quantitative and QualitativeDisclosure about Market Risk**

 

We have invested our excess cash in United Statesgovernment securities, certificates of deposit and money market funds withstrong credit ratings. As a result, our interest income is most sensitive tochanges in the general level of United States interest rates. We do not usederivative financial instruments, derivative commodity instruments or othermarket risk sensitive instruments, positions or transactions in any materialfashion. Accordingly, we believe that, while the investment-grade securities wehold are subject to changes in the financial standing of the issuer of suchsecurities, we are not subject to any material risks arising from changes ininterest rates, foreign currency exchange rates, commodity prices, equityprices or other market changes that affect market risk sensitive instruments. Ahypothetical 1% adverse move in interest rates along the entire interest rateyield curve would not materially affect the fair value of our financialinstruments that are exposed to changes in interest rates.

 

**ITEM 8. Financial Statements**

 

Refer to the Index on Page F-1of the Financial Report included herein.

 

**ITEM 9.****                 Changes in andDisagreements with Accountants on Accounting and Financial Disclosure**

 

None.

 

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**ITEM 9A. Controls and Procedures**

 

**Conclusions Regarding the Effectiveness of Disclosure Controls andProcedures**

 

We maintain disclosure controls and procedures that are designed toensure that information required to be disclosed in our Exchange Act reports isrecorded, processed, summarized and reported within the timelines specified inthe Securities and Exchange Commission’s rules and forms, and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, as appropriate, to allowtimely decisions regarding required disclosure. In designing and evaluating thedisclosure controls and procedures, management recognized that any controls andprocedures, no matter how well designed and operated, can only providereasonable assurance of achieving the desired control objectives, and inreaching a reasonable level of assurance, management necessarily was requiredto apply its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.

 

As required by SEC Rule 13a-15(b), we carried out an evaluation,under the supervision and with the participation of our management, includingour Chief Executive Officer and Chief Financial Officer, of the effectivenessof the design and operation of our disclosure controls and procedures as of theend of the period covered by this report. Based on the foregoing, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were effective at the reasonable assurance level.

 

There has been no change in our internal controls over financialreporting during the most recent fiscal quarter that has materially affected,or is reasonably likely to materially affect, our internal controls overfinancial reporting.

 

**Management’s Report on Internal Control Over Financial Reporting**

 

Our management is responsible for establishing and maintaining adequateinternal control over financial reporting, as such term is defined in ExchangeAct Rules 13a-15(f). Under the supervision and with the participation ofour management, including our Chief Executive Officer and Chief FinancialOfficer, we conducted an evaluation of the effectiveness of our internalcontrol over financial reporting based on the framework in *Internal Control - Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission. Basedon our evaluation under the framework in *InternalControl — Integrated Framework*, our management concluded that ourinternal control over financial reporting was effective as of December 31,2005.

 

Our management’s assessment of and on the effectiveness of our internalcontrol over financial reporting as of December 31, 2005 has been auditedby Ernst & Young LLP, an independent registered public accountingfirm, as stated in their report which is included herein.

 

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**Reportof Independent Registered Public Accounting Firm on Internal Control OverFinancial Reporting**

 

**The Boardof Directors and Stockholders**

**CypressBioscience, Inc.**

** **

We have audited management’s assessment,included in the accompanying **“**Management’s Report on Internal Control OverFinancial Reporting”****that CypressBioscience, Inc. maintained effective internal control over financialreporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission (the COSOcriteria). Cypress Bioscience, Inc.’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

 

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtainreasonable assurance about whether effective internal control over financialreporting was maintained in all material respects. Our audit included obtainingan understanding of internal control over financial reporting, evaluating management’sassessment, testing and evaluating the design and operating effectiveness ofinternal control, and performing such other procedures as we considerednecessary in the circumstances. We believe that our audit provides a reasonablebasis for our opinion.

 

A company’s internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples. A company’s internal control over financial reporting includesthose policies and procedures that (1) pertain to the maintenance ofrecords that, in reasonable detail, accurately and fairly reflect thetransactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

**In ouropinion, management’s assessment that Cypress Bioscience, Inc. maintainedeffective internal control over financial reporting as of December 31,2005, is fairly stated, in all material respects, based on the COSO criteria. Also,in our opinion, Cypress Bioscience, Inc. maintained, in all materialrespects, effective internal control over financial reporting as of December 31,2005, based on** the COSO criteria.

 

46

----

 

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the balance sheets of Cypress Bioscience, Inc. as of December 31,2005 and 2004, and the related statements of operations, stockholders’ equityand cash flows for each of the three years in the period ended December 31,2005 of Cypress Bioscience, Inc. and our report dated March 3, 2006expressed an unqualified opinion thereon.

 

 
|                  | /s/  Ernst & Young LLP |   |
|-----------------------|---------------------------------|--------|
|                  |
|                  |
| San Diego, California |
| March 3, 2006    |

 

47

----

 

**Item 9B. Other Information**

 

None.

 

48

----

 

**PART III**

 

**ITEM 10. Directors and Executive Officers**

 

Information required by this item will be contained in our DefinitiveProxy Statement for our 2006 Annual Meeting of Stockholders (except thatinformation pertaining to executive officers of the Registrant is contained in Part Iof this report). Such information is incorporated herein by reference.

 

We have adopted a Code of Business Conduct andEthics, which covers all employees, including our principal executive, financialand accounting officers. A copy of our Code of Business Conduct and Ethics isposted on our website, *www.cypressbio.com*.We also will post on our website any waiver or amendment (other than technical,administrative and other non-substantive amendments) to our Code of BusinessConduct and Ethics that is granted to or affects the duties of any of ourdirectors or our principal executive, financial and accounting officers. Suchposting will be made within five business days after the date of the waiver oramendment and will remain on the website for at least twelve months.

 

**ITEM 11. Executive Compensation**

 

Information required by this item will be containedin our Definitive Proxy Statement for our 2006 Annual Meeting of Stockholdersand is incorporated herein by reference.

 

**ITEM 12. Security Ownership of Certain Beneficial Owners andManagement and Related Stockholder Matters**

 

Information required by this item will be containedin our Definitive Proxy Statement for our 2006 Annual Meeting of Stockholdersand is incorporated herein by reference.

 

**ITEM 13. Certain Relationships and Related Transactions**

 

Information required by this item will be containedin our Definitive Proxy Statement for our 2006 Annual Meeting of Stockholdersand is incorporated herein by reference.

 

**ITEM 14. Accounting Fees and Services**

 

Information required by this item will be contained in our DefinitiveProxy Statement for our 2006 Annual Meeting of Stockholders and is incorporatedherein by reference.

 

49

----

 

**PART IV**

 

**ITEM 15. Exhibits, Financial StatementSchedules**

 

(a)  Financial Statements

 

Our financialstatements are included herein as required under Item 8 of this Annual Reporton Form 10-K. See Index on page F-1.

 

Financial statementschedules have been omitted since they are either not required, not applicableor the information is otherwise included.

 

(b)  Exhibits

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                                                        | ** ** | **Incorporated by Reference to**                                                                     |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                                                                                   |       |                                                                                                                |
| 3.1              |       | Second Amended and Restated Certificate of  Incorporation                                                                                                                                                                                              |       | Appendix C to Definitive Proxy Statement  filed with the Securities and Exchange Commission on August 11, 2003 |
| 3.2              |       | Second Amended and Restated By-Laws                                                                                                                                                                                                                    |       | Appendix D to Definitive Proxy Statement  filed with the Securities and Exchange Commission on August 11, 2003 |
| 4.1              |       | Form of Stock Certificate                                                                                                                                                                                                                         |       | Exhibit 4.1 to Form S-1  Registration Statement No. 33-41225                                         |
| 10.1             |       | 1996 Equity Incentive Plan (the ***“1996 Plan”***)(†)                                                                                                                                                                                   |       | Exhibit 99.2 to Form 10-Q for the  quarter ended March 31, 1996 (File No. 0-12943)              |
| 10.2             |       | Form of Incentive Stock Option  Agreement under the 1996 Plan(†)                                                                                                                                                                             |       | Exhibit 99.3 to Form 10-Q for the  quarter ended March 31, 1996 (File No. 0-12943)              |
| 10.3             |       | Form of Non-Statutory Stock Option  Agreement under 1996 Equity Incentive Plan(†)                                                                                                                                                            |       | Exhibit 99.4 to Form 10-Q for the  quarter ended March 31, 1996 (File No. 0-12943)              |
| 10.4             |       | Incentive Stock Option and Appreciation  Plan, as amended June 29, 1992(†)                                                                                                                                                                   |       | Exhibit 99.4 to Form S-8  Registration Statement No. 333-06771                                       |
| 10.5             |       | Form of Stock Option Agreement for  issuances of all non-plan options(†)                                                                                                                                                                     |       | Exhibit 99.8 to Form S-8  Registration Statement No. 333-06771                                       |
| 10.7             |       | Sublease dated February 1, 1999  between the Registrant and Cardia Pacemakers, Inc. and related lease  dated August 1991 between Michael R. Mastro and Redmond East Associates  and Incontrol, Inc. and Amendments One through Ten |       | Exhibit 10.41 to Form 10-K for  the year ended December 31, 1998                                     |
| 10.8             |       | Amended and Restated License and  Distribution Agreement dated January 19, 2001 among the Registrant,  Fresenius HemoCare, Inc. and Fresenius HemoCare GmbH(*)                                                                               |       | Exhibit 2.2 to Form 8-K filed on January 23,  2001                                                   |
| 10.9             |       | 2000 Equity Incentive Plan(†)                                                                                                                                                                                                                     |       | Exhibit 10.25 to Form 10-K for  the year ended December 31, 2000                                     |
| 10.10            |       | Form of Stock Option Agreement for use  with the 2000 Equity Incentive Plan(†)                                                                                                                                                               |       | Exhibit 10.26 to Form 10-K for  the year ended December 31, 2000                                     |
| 10.11            |       | Letter Amendment dated February 1,  2002 to the Amended and Restated License Agreement dated January 19,  2001 among the Registrant, Fresenius HemoCare, Inc. and Fresenius  HemoCare GmbH                                              |       | Exhibit 10.24 to Form 10-K for  the year ended December 31, 2001                                     |
| 10.12            |       | Reformulation and New Product Agreement  dated August 22, 2002 between the Registrant and Collegium  Pharmaceuticals, Inc.(*)                                                                                                                |       | Exhibit 10.2 to Form 10-Q for the  quarter ended September 30, 2002                                  |

 

50

----

 
| 10.13 |   | Common Stock Issuance Agreement dated October 31,  2002 between the Registrant and Collegium Pharmaceuticals, Inc.(*)                                                                                          |   | Exhibit 10.3 to Form 10-Q for the  quarter ended September 30, 2002   |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------|
| 10.14 |   | Equity Investment Agreement dated June 6,  2003 between the Registrant and Pierre Fabre Medicament                                                                                                                  |   | Exhibit 10.2 to Form 10-Q for the  quarter ended June 30, 2003        |
| 10.15 |   | Warrant to purchase Common Stock of the  Registrant issued to Pierre Fabre Medicament on June 6, 2003                                                                                                               |   | Exhibit 10.3 to Form 10-Q for the  quarter ended June 30, 2003        |
| 10.16 |   | Amended and Restated Employment Agreement  dated August 11, 2003 between the Registrant and Jay D. Kranzler, M.D.,  Ph.D(†)                                                                                    |   | Exhibit 10.4 to Form 10-Q for the  quarter ended June 30, 2003        |
| 10.17 |   | Employment Agreement dated February 4,  2004 between the Registrant and Denise Woolard(†)                                                                                                                      |   | Exhibit 10.22 to the Form 10-K  for the year ended December 31, 2003. |
| 10.18 |   | Third Restated License Agreement dated January 9,  2004 between the Registrant and Pierre Fabre Medicament(*)                                                                                                       |   | Exhibit 10.23 to the Form 10-K  for the year ended December 31, 2003. |
| 10.19 |   | First Restated Trademark Agreement dated January 9,  2004 between the Registrant and Pierre Fabre Medicament(*)                                                                                                     |   | Exhibit 10.24 to the Form 10-K  for the year ended December 31, 2003. |
| 10.20 |   | Purchase and Supply Agreement dated January 9,  2004 between the Registrant and Pierre Fabre Medicament(*)                                                                                                          |   | Exhibit 10.25 to the Form 10-K  for the year ended December 31, 2003. |
| 10.21 |   | License and Collaboration Agreement dated January 9,  2004 between the Registrant and Forest Laboratories(*)                                                                                                        |   | Exhibit 10.26 to the Form 10-K  for the year ended December 31, 2003. |
| 10.22 |   | Side Letter dated January 9, 2004  among the Registrant, Forest Laboratories and Pierre Fabre Medicament(*)                                                                                                         |   | Exhibit 10.27 to the Form 10-K  for the year ended December 31, 2003. |
| 10.23 |   | Letter Agreement dated January 9, 2004  among the Registrant, Forest Laboratories and Pierre Fabre Medicament(*)                                                                                                    |   | Exhibit 10.28 to the Form 10-K  for the year ended December 31, 2003. |
| 10.24 |   | 2005 Bonus Plan(†)                                                                                                                                                                                                  |   | Exhibit 10.24 to the Form 10-K  for the year ended December 31, 2004  |
| 10.25 |   | Amendment to Forest Agreement(**)                                                                                                                                                                                        |   | Exhibit 10.1 to Form 10-Q for the  quarter ended June 30, 2005        |
| 10.26 |   | License and Collaboration Agreement dated June 29,  2005 between Organon (Ireland) Ltd. and Cypress(**)                                                                                                             |   | Exhibit 10.1 to Form 10-Q for the  quarter ended September 30, 2005   |
| 10.27 |   | 2006 Bonus Plan(†)                                                                                                                                                                                                  |   |                                                                                 |
| 21.1  |   | Subsidiaries of the registrant                                                                                                                                                                                           |   | The registrant has no subsidiaries                                                   |
| 23.1  |   | Consent of Independent Registered Public  Accounting Firm                                                                                                                                                                |   |                                                                                 |
| 24.1  |   | Power of Attorney                                                                                                                                                                                                        |   | Reference is made to page 52                                                    |
| 31.1  |   | Certification of Chief Executive Officer  pursuant to Section 302 of the Public Company Accounting Reform and  Investor Protection Act of 2002 (18 U.S.C. §1350, as adopted)                              |   |                                                                                 |
| 31.2  |   | Certification of Chief Financial Officer  pursuant to Section 302 of the Public Company Accounting Reform and  Investor Protection Act of 2002 (18 U.S.C. §1350, as adopted)                              |   |                                                                                 |
| 32.1  |   | Certification of Chief Executive Officer  and Chief Financial Officer pursuant to Section 906 of the Public  Company Accounting Reform and Investor Protection Act of 2002 (18 U.S.C.  §1350, as adopted) |   |                                                                                 |

 

----

* Confidential Treatment has been granted to certain portions of thisagreement.

 

**                                  ConfidentialTreatment has been requested for certain portions of this agreement.

 

†                                          Indicatesmanagement contract or compensatory plan or arrangement.

 

51

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, as amended, the Registranthas duly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|                      | CYPRESS BIOSCIENCE, INC. |
|---------------------------|-------------------------------|
|                      |                          |
| Date: March 15, 2006 | By:                           | /s/ Jay D. Kranzler |   |
|                      |                          | Chief Executive Officer and Chairman of the   Board |
|                      |                          |   |
| Date: March 15, 2006 | By:                           | /s/ Sabrina Martucci Johnson |   |
|                      |                          | Chief Financial Officer and Senior Vice President |
|                           |                               |  |  |  |

 

**POWER OFATTORNEY**

 

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints Jay D. Kranzler, M.D.,Ph.D. and Sabrina Martucci Johnson, and each of them, as his or her true andlawful attorneys-in-fact and agents, with full power of substitution and resubstitution,for him or her and in his or her name, place and stead, in any and allcapacities, to sign any and all amendments to this Form 10-K, and to filethe same with all exhibits thereto, and other documents in connectiontherewith, with the Securities and Exchange Commission, granting unto saidattorneys-in-fact and agents, and full power and authority to do and perform eachand every act and thing requisite and necessary to be done in connectiontherewith, as fully to intents and purposes as he or she might or could do inperson, hereby ratifying and confirming that all said attorneys-in-fact andagents, or any of them or their substitute or resubstitute, may lawfullydo or cause to be done by virtue hereof.

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, as amended, this report has been signed below by thefollowing person on behalf of the Registrant and in the capacities and on thedates indicated.

 
| **Signature**                | ** ** | **Title**                             | ** **                              | **Date**   |
|------------------------------|------------|---------------------------------------|-----------------------------------------|------------|
| ** **                   | ** ** | ** **                            | ** **                              | ** ** |
| /s/ Jay D. Kranzler          |       |                                  | Chief Executive Officer and Chairman of |       | March 15, 2006 |
| Jay D. Kranzler, M.D., Ph.D. |       | the Board                        |                                    |       |
|                         |       | *(Principal Executive Officer)*       |                                    |       |
| /s/ Sabrina Martucci Johnson |       |                                  | Chief Financial Officer and Senior Vice |       | March 15, 2006 |
| Sabrina Martucci Johnson     |       | President                        |                                    |       |
|                         |       | *(Principal Financial and Accounting* |                                    |       |
|                         |       | *Officer)*                            |                                    |       |
| /s/ Samuel D. Anderson       |       |                                  | Director                                |       | March 15, 2006 |
| Samuel D. Anderson           |       |                                  |                                    |       |
|                         |       |                                  |                                    |       |
| /s/ Jon W. McGarity          |       |                                  | Director                                |       | March 15, 2006 |
| Jon W. McGarity              |       |                                  |                                    |       |
|                         |       |                                  |                                    |       |
| /s/ Jean-Pierre Millon       |       |                                  | Director                                |       | March 15, 2006 |
| Jean-Pierre Millon           |       |                                  |                                    |       |
|                              |            |                                       |                                         |            |  |  |  |  |  |

 

52

----

 
| /s/ Perry B. Molinoff |   |   | Director |   | March 15, 2006 |
|-----------------------|--------|--------|----------|--------|---------------------|
| Perry B. Molinoff     |   |   |     |   |
|                  |   |   |     |   |
| /s/ Daniel H. Petree  |   |   | Director |   | March 15, 2006 |
| Daniel H. Petree      |   |   |     |   |
|                  |   |   |     |   |
| /s/ Gary D. Tollefson |   |   | Director |   | March 15, 2006 |
| Gary D. Tollefson     |   |   |     |   |
|                  |   |   |     |   |
| /s/ Jack H. Vaughn    |   |   | Director |   | March 15, 2006 |
| Jack H. Vaughn        |   |   |     |   |
|                       |        |        |          |        |                     |  |  |  |

 

53

----

 

**CYPRESS BIOSCIENCE, INC.**

 

**INDEX TO FINANCIAL STATEMENTS**

 
| Report  of Independent Registered Public Accounting Firm                                            | F-2    |
|-----------------------------------------------------------------------------------------------------|--------|
|                                                                                                |   |
| Balance Sheets as of  December 31, 2005 and 2004                                               | F-3    |
|                                                                                                |   |
| Statements  of Operations for the years ended December 31, 2005, 2004 and 2003                 | F-4    |
|                                                                                                |   |
| Statements  of Stockholders’ Equity for the years ended December 31, 2005, 2004 and  2003 | F-5    |
|                                                                                                |   |
| Statements  of Cash Flows for the years ended December 31, 2005, 2004 and 2003                 | F-7    |
|                                                                                                |   |
| Notes  to Financial Statements                                                                      | F-8    |

 

F-1

----

 

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

The Board of Directors and Stockholders

Cypress Bioscience, Inc.

 

We have audited the accompanying balance sheets ofCypress Bioscience, Inc. as of December 31, 2005 and 2004, and therelated statements of operations, stockholders’ equity and cash flows for eachof the three years in the period ended December 31, 2005. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements basedupon our audits.

 

We conducted our audits in accordance with the standardsof the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the financial position ofCypress Bioscience, Inc. as of December 31, 2005 and 2004, and theresults of its operations and its cash flows for each of the three years in theperiod ended December 31, 2005, in conformity with generally accepted accountingprinciples in the United States.

 

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of Cypress Bioscience’s internal control over financial reportingas of December 31, 2005, based on criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated March 3,2006 expressed an unqualified opinion thereon.

 

 
|                  | /s/ Ernst & Young LLP |   |
|-----------------------|--------------------------------|--------|
|                  |                           |
| San Diego, California |                           |
| March 3, 2006    |                           |

 

F-2

----

 

**CYPRESS BIOSCIENCE, INC.**

 

**BALANCESHEETS**

 
| ** **                                                                                                                                                                                                                                                                   | ** ** | **As of December 31,** | ** **  |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|
| ** **                                                                                                                                                                                                                                                                   | ** ** | **2005**                    | ** **  | **2004** | ** ** |
|                                                                                                                                                                                                                                                                         |       |                        |        |   |   |
| **ASSETS**                                                                                                                                                                                                                                                                   |       |                        |        |   |   |
| Current assets:                                                                                                                                                                                                                                                              |       |                        |        |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                                                                   |       | $                           | 5,213,587   |   | $ | 8,303,388 |   |
| Short-term investments                                                                                                                                                                                                                                                       |       | 104,399,691                 |        | 103,720,610 |   |
| Receivable from Forest  Laboratories                                                                                                                                                                                                                                         |       | 534,933                     |        | 5,656,964 |   |
| Prepaid expenses and  other current assets                                                                                                                                                                                                                                   |       | 561,330                     |        | 601,721 |   |
| Total current assets                                                                                                                                                                                                                                                         |       | 110,709,541                 |        | 118,282,683 |   |
|                                                                                                                                                                                                                                                                         |       |                        |        |   |   |
| Property and equipment, net                                                                                                                                                                                                                                                  |       | 50,795                      |        | 75,379 |   |
| Other assets                                                                                                                                                                                                                                                                 |       | 31,462                      |        | 31,462 |   |
| Total assets                                                                                                                                                                                                                                                                 |       | $                           | 110,791,798 |   | $ | 118,389,524 |   |
|                                                                                                                                                                                                                                                                         |       |                        |        |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                |       |                        |        |   |   |
| Current liabilities:                                                                                                                                                                                                                                                         |       |                        |        |   |   |
| Accounts payable                                                                                                                                                                                                                                                             |       | $                           | 347,946     |   | $ | 712,843 |   |
| Accrued compensation                                                                                                                                                                                                                                                         |       | 58,594                      |        | 308,855 |   |
| Accrued liabilities                                                                                                                                                                                                                                                          |       | 726,907                     |        | 461,582 |   |
| Payable to Forest  Laboratories                                                                                                                                                                                                                                              |       | 915,000                     |        | 800,000 |   |
| Current portion of  long-term obligations                                                                                                                                                                                                                                    |       | —                      |        | 36,870 |   |
| Current portion of  deferred revenue                                                                                                                                                                                                                                         |       | 3,125,000                   |        | 3,125,000 |   |
| Total current  liabilities                                                                                                                                                                                                                                                   |       | 5,173,447                   |        | 5,445,150 |   |
|                                                                                                                                                                                                                                                                         |       |                        |        |   |   |
| Deferred rent                                                                                                                                                                                                                                                                |       | 17,911                      |        | 20,565 |   |
| Deferred revenue, net of current portion                                                                                                                                                                                                                                     |       | 15,625,000                  |        | 18,750,000 |   |
|                                                                                                                                                                                                                                                                         |       |                        |        |   |   |
| Commitments and contingencies                                                                                                                                                                                                                                                |       |                        |        |   |   |
|                                                                                                                                                                                                                                                                         |       |                        |        |   |   |
| Stockholders’ equity:                                                                                                                                                                                                                                                   |       |                        |        |   |   |
| Common stock, $.001 par  value; 60,000,000 shares of common stock authorized; 31,920,632 and  30,363,994 shares issued and outstanding at December 31, 2005 and 2004,  respectively; 15,000,000 shares of preferred stock authorized; no shares  issued and outstanding |       | 31,921                      |        | 30,364 |   |
| Additional paid-in  capital                                                                                                                                                                                                                                                  |       | 235,202,784                 |        | 231,474,500 |   |
| Accumulated other  comprehensive income                                                                                                                                                                                                                                      |       | 860,112                     |        | 161,327 |   |
| Accumulated deficit                                                                                                                                                                                                                                                          |       | (146,119,377                | )           | (137,492,382 | ) |
| Total stockholders’  equity                                                                                                                                                                                                                                             |       | 89,975,440                  |        | 94,173,809 |   |
|                                                                                                                                                                                                                                                                         |       | $                           | 110,791,798 |   | $ | 118,389,524 |   |

 

*See accompanying notes to the financial statements.*

 

F-3

----

 

**CYPRESS BIOSCIENCE, INC.**

 

**STATEMENTSOF OPERATIONS**

 
| ** **                                                                                                    | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                    | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                    | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues under collaborative agreement                                                                        |       | $                                 | 8,384,636  |   | $ | 14,414,619 |   | $ | — |   |
|                                                                                                          |       |                              |       |   |   |   |   |
| Costs and expenses:                                                                                           |       |                              |       |   |   |   |   |
| Research and  development                                                                                     |       | 15,519,975                        |       | 15,201,192 |   | 11,443,693 |   |
| General and  administrative                                                                                   |       | 4,770,329                         |       | 5,732,641 |   | 4,120,156 |   |
| Non-cash compensation  charges **(A)**                                                                        |       | 997,593                           |       | 6,479,308 |   | 416,659 |   |
| Compensation expense  (benefit) – variable stock options **(B)**                                         |       | (1,749,135                        | )          | (699,033 | ) | 5,879,277 |   |
|                                                                                                          |       | 19,538,762                        |       | 26,714,108 |   | 21,859,785 |   |
|                                                                                                          |       |                              |       |   |   |   |   |
| Other income (expense):                                                                                       |       |                              |       |   |   |   |   |
| Interest income                                                                                               |       | 2,525,327                         |       | 1,092,404 |   | 121,679 |   |
| Interest expense                                                                                              |       | (2,382                            | )          | (5,826 | ) | (9,097 | ) |
| Gain (loss) on disposal  of assets                                                                            |       | 4,186                             |       | (2,095 | ) | 4,931 |   |
|                                                                                                          |       | 2,527,131                         |       | 1,084,483 |   | 117,513 |   |
|                                                                                                          |       |                              |       |   |   |   |   |
| Net loss                                                                                                      |       | $                                 | (8,626,995 | ) | $ | (11,215,006 | ) | $ | (21,742,272 | ) |
|                                                                                                          |       |                              |       |   |   |   |   |
| Net loss per share– basic and diluted                                                                    |       | $                                 | (0.28      | ) | $ | (0.40 | ) | $ | (1.21 | ) |
|                                                                                                          |       |                              |       |   |   |   |   |
| Shares used in computing net loss per share – basic  and diluted                                         |       | 31,105,271                        |       | 27,764,975 |   | 17,924,353 |   |
|                                                                                                          |       |                              |       |   |   |   |   |
|                                                                                                               |
| **(A) **Non-cash  compensation charges include the following related expenses:                           |       |                              |       |   |   |   |   |
| Research and development                                                                                      |       | $                                 | 319,762    |   | $ | 449,136 |   | $ | 200,801 |   |
| General and  administrative                                                                                   |       | 677,831                           |       | 6,030,172 |   | 215,858 |   |
|                                                                                                          |       | $                                 | 997,593    |   | $ | 6,479,308 |   | $ | 416,659 |   |
|                                                                                                          |       |                              |       |   |   |   |   |
| **(B) **Compensation  expense (benefit)-variable stock options includes the following related  expenses: |       |                              |       |   |   |   |   |
| Research and  development                                                                                     |       | $                                 | —     |   | $ | (179,928 | ) | $ | 646,302 |   |
| General and  administrative                                                                                   |       | (1,749,135                        | )          | (519,105 | ) | 5,232,975 |   |
|                                                                                                          |       | $                                 | (1,749,135 | ) | $ | (699,033 | ) | $ | 5,879,277 |   |

 

*See accompanying notes to the financial statements.*

 

F-4

----

 

**CYPRESS BIOSCIENCE, INC.**

 

**STATEMENTS OF STOCKHOLDERS’EQUITY**

 

**YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**

 
| ** **                                                                             | ** ** | **Common Stock** | ** **     | ** **    | ** **      | ** **          | ** **        | **Accumulated** | ** **      | ** ** | ** ** | ** **   | ** ** |
|----------------------------------------------------------------------------------------|------------|------------------|----------------|---------------|-----------------|---------------------|-------------------|-----------------|-----------------|------------|------------|--------------|------------|
| ** **                                                                             | ** ** | ** **       | ** **     | ** **    | ** **      | ** **          | **Other**         | ** **      | ** **      | ** ** | ** ** | ** **   |
| ** **                                                                             | ** ** | ** **       | **Additional** | ** **    | **Shareholder** | ** **          | **Comprehensive** | ** **      | **Accumulated** | ** ** | ** ** | ** **   |
| ** **                                                                             | ** ** | **Shares**       | ** **     | **Par Value** | ** **      | **Paid-in Capital** | ** **        | **Receivable**  | ** **      | **Income** | ** ** | **Deficit**  | ** ** | **Total** | ** ** |
|                                                                                   |       |             |           |          |            |                |              |            |            |       |       |         |       |   |   |
| Balance at December 31, 2002                                                      |       | 13,197,226       |           | 263,944       |            | 116,238,083         |              | (189,973        | )               | 8,187      |       | (104,535,104 | )          | 11,785,137 |   |
| Issuance of stock and  warrants in private placement, net of placement fees            |       | 4,029,342        |           | 80,587        |            | 9,427,716           |              | —          |            | —     |       | —       |       | 9,508,303 |   |
| Issuance of stock and  warrants in connection with restated license agreement          |       | 1,000,000        |           | 20,000        |            | 5,001,000           |              | —          |            | —     |       | —       |       | 5,021,000 |   |
| Issuance of stock upon  options exercised                                              |       | 148,708          |           | 2,670         |            | 301,235             |              | —          |            | —     |       | —       |       | 303,905 |   |
| Issuance of stock upon  warrants exercised                                             |       | 3,800,045        |           | 30,714        |            | 10,869,380          |              | —          |            | —     |       | —       |       | 10,900,094 |   |
| Compensation related to  stock options issued to consultants for services              |       | —           |           | —        |            | 351,159             |              | —          |            | —     |       | —       |       | 351,159 |   |
| Issuance of stock to  match 401(k) contributions                                       |       | 9,631            |           | 148           |            | 65,352              |              | —          |            | —     |       | —       |       | 65,500 |   |
| Stock compensation on  variable employee stock options                                 |       | —           |           | —        |            | 5,879,277           |              | —          |            | —     |       | —       |       | 5,879,277 |   |
| Change in par value from  $0.02 to $0.001                                              |       | —           |           | (375,878      | )               | 375,878             |              | —          |            |       |       |         |       | — |   |
| Comprehensive loss:                                                                    |       |             |           |          |            |                |              |            |            |       |       |         |       |   |   |
| Net loss                                                                               |       | —           |           | —        |            | —              |              | —          |            | —     |       | (21,742,272  | )          | (21,742,272 | ) |
| Unrealized gain on  short-term investments                                             |       | —           |           | —        |            | —              |              | —          |            | 57,019     |       | —       |       | 57,019 |   |
| Comprehensive loss                                                                     |       | —           |           | —        |            | —              |              | —          |            | —     |       | —       |       | (21,685,253 | ) |
| Balance at December 31, 2003                                                      |       | 22,184,952       |           | 22,185        |            | 148,509,080         |              | (189,973        | )               | 65,206     |       | (126,277,376 | )          | 22,129,122 |   |
| Issuance of stock in  secondary offering, net of placement fees                        |       | 6,900,000        |           | 6,900         |            | 74,211,997          |              | —          |            | —     |       | —       |       | 74,218,897 |   |
| Issuance of stock upon  options exercised                                              |       | 885,135          |           | 885           |            | 1,780,285           |              | —          |            | —     |       | —       |       | 1,781,170 |   |
| Issuance of stock upon  warrants exercised                                             |       | 384,939          |           | 385           |            | 1,192,872           |              | —          |            | —     |       | —       |       | 1,193,257 |   |
| Compensation related to  stock options and warrants issued to consultants for services |       | —           |           | —        |            | 6,355,545           |              | —          |            | —     |       | —       |       | 6,355,545 |   |
| Issuance of stock to  match 401(k) contributions                                       |       | 8,968            |           | 9             |            | 123,754             |              | —          |            | —     |       | —       |       | 123,763 |   |
| Stock benefit on  variable employee stock options                                      |       | —           |           | —        |            | (699,033            | )                 | —          |            | —     |       | —       |       | (699,033 | ) |
| Payment of shareholder  receivable                                                     |       | —           |           | —        |            | —              |              | 189,973         |            | —     |       | —       |       | 189,973 |   |
| Comprehensive loss:                                                                    |       |             |           |          |            |                |              |            |            |       |       |         |       |   |   |
| Net loss                                                                               |       | —           |           | —        |            | —              |              | —          |            | —     |       | (11,215,006  | )          | (11,215,006 | ) |
| Unrealized gain on  short-term investments                                             |       | —           |           | —        |            | —              |              | —          |            | 96,121     |       | —       |       | 96,121 |   |
| Comprehensive loss                                                                     |       | —           |           | —        |            | —              |              | —          |            | —     |       | —       |       | (11,118,885 | ) |
| Balance at December 31, 2004                                                      |       | 30,363,994       |           | 30,364        |            | 231,474,500         |              | —          |            | 161,327    |       | (137,492,382 | )          | 94,173,809 |   |

 

F-5

----

 
| ** **                                                                             | ** ** | **Common Stock** | ** **     | ** **    | ** **      | ** **          | ** **        | **Accumulated** | ** **      | ** ** | ** ** | ** **  | ** ** |
|----------------------------------------------------------------------------------------|------------|------------------|----------------|---------------|-----------------|---------------------|-------------------|-----------------|-----------------|------------|------------|-------------|------------|
| ** **                                                                             | ** ** | ** **       | ** **     | ** **    | ** **      | ** **          | **Other**         | ** **      | ** **      | ** ** | ** ** | ** **  |
| ** **                                                                             | ** ** | ** **       | **Additional** | ** **    | **Shareholder** | ** **          | **Comprehensive** | ** **      | **Accumulated** | ** ** | ** ** | ** **  |
| ** **                                                                             | ** ** | **Shares**       | ** **     | **Par Value** | ** **      | **Paid-in Capital** | ** **        | **Receivable**  | ** **      | **Income** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
|                                                                                   |       |             |           |          |            |                |              |            |            |       |       |        |       |   |   |
| Issuance of stock upon  options exercised                                              |       | 361,958          |           | 362           |            | 1,097,506           |              | —          |            | —     |       | —      |       | 1,097,868 |   |
| Issuance of stock upon  warrants exercised                                             |       | 1,179,048        |           | 1,179         |            | 2,767,336           |              | —          |            | —     |       | —      |       | 2,768,515 |   |
| Issuance of warrants in  connection with Organon agreement                             |       | —           |           | —        |            | 615,000             |              | —          |            | —     |       | —      |       | 615,000 |   |
| Compensation related to  stock options and warrants issued to consultants for services |       | —           |           | —        |            | 864,191             |              | —          |            | —     |       | —      |       | 864,191 |   |
| Issuance of stock to  match 401(k) contributions                                       |       | 15,632           |           | 16            |            | 133,386             |              | —          |            | —     |       | —      |       | 133,402 |   |
| Stock benefit on  variable employee stock options                                      |       | —           |           | —        |            | (1,749,135          | )                 | —          |            | —     |       | —      |       | (1,749,135 | ) |
| Comprehensive loss:                                                                    |       |             |           |          |            |                |              |            |            |       |       |        |       |   |   |
| Net loss                                                                               |       | —           |           | —        |            | —              |              | —          |            | —     |       | (8,626,995  | )          | (8,626,995 | ) |
| Unrealized gain on  short-term investments                                             |       | —           |           | —        |            | —              |              | —          |            | 698,785    |       | —      |       | 698,785 |   |
| Comprehensive loss                                                                     |       | —           |           | —        |            | —              |              | —          |            | —     |       | —      |       | (7,928,210 | ) |
| Balance at December 31,  2005                                                     |       | 31,920,632       |           | $             | 31,921          |                | $                 | 235,202,784     |            | $          | —     |        | $          | 860,112 |   | $ | (146,119,377 | ) | $ | 89,975,440 |   |
|                                                                                        |            |                  |                |               |                 |                     |                   |                 |                 |            |            |             |            |  |  |  |  |  |  |  |  |

 

*See accompanying notes to thefinancial statements.*

 

F-6

----

 

**CYPRESS BIOSCIENCE, INC.**

 

**STATEMENTSOF CASH FLOWS**

 
| ** **                                                                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                 | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Operating Activities**                                                                   |       |                              |       |   |   |   |   |
| Net loss                                                                                   |       | $                                 | (8,626,995 | ) | $ | (11,215,006 | ) | $ | (21,742,272 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                              |       |   |   |   |   |
| Depreciation and  amortization                                                             |       | 30,127                            |       | 45,653 |   | 56,793 |   |
| Stock and warrants  issue in connection with restated license agreement                    |       | —                            |       | — |   | 5,021,000 |   |
| Warrants issued in  connection with licensing agreement                                    |       | 615,000                           |       | — |   | — |   |
| Stock compensation on  variable employee options                                           |       | (1,749,135                        | )          | (699,033 | ) | 5,879,277 |   |
| Stock and options  issued for services                                                     |       | 997,593                           |       | 6,479,308 |   | 416,659 |   |
| (Gain) loss on disposal  of property and equipment                                         |       | (4,186                            | )          | 2,095 |   | (4,931 | ) |
| Changes in operating  assets and liabilities:                                              |       |                              |       |   |   |   |   |
| Prepaid expenses and  other current assets                                                 |       | 40,391                            |       | (452,183 | ) | (37,936 | ) |
| Receivable from Forest  Laboratories                                                       |       | 5,122,031                         |       | (5,656,964 | ) | — |   |
| Accounts payable and  other accrued liabilities                                            |       | (349,833                          | )          | (126,556 | ) | 987,510 |   |
| Payable to Forest  Laboratories                                                            |       | 115,000                           |       | 800,000 |   | — |   |
| Deferred rent                                                                              |       | (2,654                            | )          | 4,186 |   | 10,768 |   |
| Deferred revenue                                                                           |       | (3,125,000                        | )          | 21,875,000 |   | — |   |
| Net cash provided by (used in) operating activities                                        |       | (6,937,661                        | )          | 11,056,500 |   | (9,413,132 | ) |
|                                                                                       |       |                              |       |   |   |   |   |
| **Investing Activities**                                                                   |       |                              |       |   |   |   |   |
| Purchases of short-term  investments                                                       |       | (456,312,296                      | )          | (540,338,663 | ) | (44,633,827 | ) |
| Proceeds from sale of  short-term investments                                              |       | 456,332,000                       |       | 459,379,000 |   | 27,000,000 |   |
| Purchase of property  and equipment                                                        |       | (37,536                           | )          | (22,092 | ) | (33,325 | ) |
| Proceeds from sale of  property and equipment                                              |       | 36,179                            |       | — |   | 5,500 |   |
| Net cash provided by (used in) investing activities                                        |       | 18,347                            |       | (80,981,755 | ) | (17,661,652 | ) |
|                                                                                       |       |                              |       |   |   |   |   |
| **Financing Activities**                                                                   |       |                              |       |   |   |   |   |
| Proceeds from exercise  of stock options and warrants                                      |       | 3,866,383                         |       | 2,974,427 |   | 11,203,999 |   |
| Proceeds from secondary  offering of common stock, net                                     |       | —                            |       | 74,218,897 |   | — |   |
| Proceeds from private  placement of common stock and warrants, net                         |       | —                            |       | — |   | 9,508,303 |   |
| Proceeds from payment  of shareholder receivable                                           |       | —                            |       | 189,973 |   | — |   |
| Payments on capital  lease obligation                                                      |       | (36,870                           | )          | (14,474 | ) | (13,101 | ) |
| Net cash provided by financing activities                                                  |       | 3,829,513                         |       | 77,368,823 |   | 20,699,201 |   |
|                                                                                       |       |                              |       |   |   |   |   |
| **Increase (decrease) in cash and cash equivalents**                                       |       | (3,089,801                        | )          | 7,443,568 |   | (6,375,583 | ) |
| Cash and cash  equivalents at beginning of the year                                        |       | 8,303,388                         |       | 859,820 |   | 7,235,403 |   |
| Cash and cash  equivalents at end of the year                                              |       | $                                 | 5,213,587  |   | $ | 8,303,388 |   | $ | 859,820 |   |
|                                                                                       |       |                              |       |   |   |   |   |
| **Supplemental disclosure of cash flow information**                                       |       |                              |       |   |   |   |   |
| Interest paid                                                                              |       | $                                 | 2,382      |   | $ | 5,826 |   | $ | 9,097 |   |

 

*See accompanying notes to the financial statements.*

 

F-7

----

 

**CYPRESS BIOSCIENCE, INC.**

 

**NOTES TO FINANCIAL STATEMENTS**

 

**1.**              THECOMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES

** **

***The Company***

** **

Cypress Bioscience, Inc. (the “Company”) is committed to being theinnovator and leader in providing products for the treatment of patients withFunctional Somatic Syndromes, such as Fibromyalgia Syndrome, or FMS, and other centralnervous system disorders, such as Obstructive Sleep Apnea, or OSA. Specifically,the Company’s strategy involves acquiring or in-licensing central nervoussystem, or CNS, active compounds and developing them for novel and typicallyunderserved indications.

 

*Accounting Estimates in the Preparation ofFinancial Statements*

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ fromthose estimates.

 

*Cash and Cash Equivalents*

 

The Company considers cash equivalents to be thoseinvestments which are highly liquid, readily convertible into cash and whichmature within three months from the date of purchase.

 

*Short-Term Investments*

 

The Company’s short-term investments consist ofsecurities of the U.S. government or its agencies and certificates of depositwith maturities ranging from one to twelve months. The Company has classifiedits short-term investments as “available-for-sale” and carries them at fairvalue with unrealized gains and losses, if any, reported as a separatecomponent of stockholders’ equity and included in comprehensive loss. Realizedgains and losses are calculated on the specific identification method andrecorded as interest income. Realized gains on the sale of available for salesecurities during the years ended December 31, 2005, 2004 and 2003 were$1,814,189, $615,872 and $79,837, respectively. There were no realized losses.

 

At December 31, 2005 and 2004, short-terminvestments consisted of the following:

 
| ** **                      | ** ** | **December 31, 2005** | ** **  |
|---------------------------------|------------|----------------------------|-------------|
| ** **                      | ** ** | **Amortized  Cost**        | ** **  | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|                            |       |                       |        |   |   |   |   |   |   |
| U.S. government and agency debt |       | $                          | 100,839,457 |   | $ | 866,172 |   | $ | — |   | $ | 101,705,629 |   |
| Certificates of deposit         |       | 2,700,122                  |        | — |   | (6,060 | ) | 2,694,062 |   |
|                            |       | $                          | 103,539,579 |   | $ | 866,172 |   | $ | (6,060 | ) | $ | 104,399,691 |   |

 

F-8

----

 
| ** **                      | ** ** | **December 31, 2004** | ** **  |
|---------------------------------|------------|----------------------------|-------------|
| ** **                      | ** ** | **Amortized  Cost**        | ** **  | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|                            |       |                       |        |   |   |   |   |   |   |
| U.S. government and agency debt |       | $                          | 95,058,608  |   | $ | 175,347 |   | $ | — |   | $ | 95,233,955 |   |
| Certificates of deposit         |       | 8,500,675                  |        | — |   | (14,020 | ) | 8,486,655 |   |
|                            |       | $                          | 103,559,283 |   | $ | 175,347 |   | $ | (14,020 | ) | $ | 103,720,610 |   |

 

*Concentrations of Credit Risk*

 

Financial instruments that potentially subject theCompany to concentrations of credit risk consist primarily of cash, cashequivalents and short-term investments. The Company has established guidelinesto limit its exposure to credit risk by placing investments with high creditquality financial institutions, diversifying its investment portfolio andplacing investments with maturities that maintain safety and liquidity.

 

*Property and Equipment*

 

Property and equipment, including assets acquiredunder capital leases, are recorded at cost and depreciated or amortized overthe estimated useful lives of the assets (three to five years) or the leaseterm using the straight-line method.

 

*Long-Lived Assets*

 

The Company evaluates the carrying value of itslong-lived assets when events or changes in circumstances indicate that anasset’s carrying value may not be recoverable. An impairment loss isrecognized when the sum of the expected future undiscounted net cash flows isless than the carrying value of the asset. To date, the Company has notidentified any indicators of impairment or recorded any impairment oflong-lived assets.

 

*Fair Value of Financial Instruments*

 

The carrying amounts offinancial instruments, including cash and cash equivalents, prepaid expenses,receivables, accounts payable, accrued compensation and accrued liabilities,approximate fair value due to the nature of their short-term maturities.

 

*Revenue Recognition*

 

In accordance withStaff Accounting Bulletin (“SAB”) No. 101, *RevenueRecognition in Financial Statements* (as amended by SAB 104),revenues are recognized when persuasive evidence of an arrangement exists,delivery has occurred or services have been rendered, the price is fixed anddeterminable and collectibility is reasonably assured. Amounts received forupfront license fees under multiple-element arrangements are deferred andrecognized over the period of such services or performance if such arrangementsrequire on-going services or performance. Amounts received for sponsoreddevelopment activities, including funding received for certain of the Company’semployees, are recognized as research costs are incurred over the periodspecified in the related agreement or as the services are performed. Amountsreceived for milestones are recognized upon achievement of the milestone, whichrequires substantive effort and was not readily assured at the inception of theagreement. Any amounts received prior to satisfying revenue recognitioncriteria will be recorded as deferred revenue.

 

*Research and Development*

 

Research anddevelopment expenses consist primarily of salaries and related personnelexpenses for the Company’s research and development personnel, fees paid toexternal service providers to conduct clinical trials, patient enrollment costs,fees and milestone payments under the Company’s license and developmentagreements

 

F-9

----

 

and costs forfacilities, supplies, materials and equipment. All such costs are charged toresearch and development expenses as incurred. Clinical trial costs are asignificant component of research and development expenses and include costsassociated with third-party contractors. The Company accrues clinical trialexpenses based on work performed, which relies on estimates of total costsincurred based on completion of patient studies and other events. Actualclinical trial costs may differ from estimated clinical trial costs andare adjusted for in the period in which they become known.

 

Research anddevelopment expenses also include costs incurred in connection with the firstPhase III clinical trial and extension trial for milnacipran, for which suchcosts are reimbursed by Forest Laboratories pursuant to the collaborationagreement.

 

*Stock-Based Compensation*

 

The Company measures compensation costs related tostock option plans using the intrinsic value method and provides pro forma disclosuresof net loss per common share as if the fair value based method had been appliedin measuring compensation costs. Accordingly, no compensation expense isrecognized if the exercise price of stock options equals the fair value of theunderlying stock at the date of grant.

 

Compensation expense for options granted tonon-employees has been determined at the grant date in accordance with Statementof Financial Accounting Standards (“SFAS”) No. 123, *Accounting for Stock-Based Compensation,*and Emerging Issues Task Force (“EITF”) No. 96-18, *Accounting for Equity Instruments That are Issued toOther Than Employees for Acquiring or in Conjunction with Selling Goods orServices,* and has been recorded at the fair value of theconsideration received or the fair value of the equity instruments issued,whichever is more reliably measured. Such compensation is recognized over therelated vesting period of the underlying option.

 

Had compensation cost for the Company’s stock-basedcompensation plans been determined based on the fair value at the grant datesfor awards under those plans, the Company’s net loss and net loss per sharewould have been adjusted to the pro forma amounts presented below:

 
| ** **                                                                                      | ** ** | **2005**   | ** **  | **2004**   | ** ** | **2003**    | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
|                                                                                            |       |       |        |       |       |        |       |
| Net loss, as reported                                                                           |       | $          | (8,626,995  | )          | $          | (11,215,006 | )          | $ | (21,742,272 | ) |
| Add: Stock-based  employee compensation expense (benefit) included in reported net loss         |       | (1,749,135 | )           | (699,033   | )          | 5,879,277   |       |
| Deduct: Additional  stock-based employee compensation determined under fair value based methods |       | (4,540,250 | )           | (2,725,218 | )          | (1,421,697  | )          |
|                                                                                            |       |       |        |       |       |        |       |
| Pro forma net loss                                                                              |       | $          | (14,916,380 | )          | $          | (14,639,257 | )          | $ | (17,284,692 | ) |
|                                                                                            |       |       |        |       |       |        |       |
| Net loss per  share—basic and diluted, as reported                                         |       | $          | (0.28       | )          | $          | (0.40       | )          | $ | (1.21 | ) |
| Pro forma net loss per  share—basic and diluted                                            |       | $          | (0.48       | )          | $          | (0.53       | )          | $ | (0.96 | ) |

 

The fair value of each option grant was estimated asof the date of grant using the Black-Scholes option pricing model with thefollowing weighted-average assumptions used for grants during the years ended December 31,2005, 2004 and 2003: no dividend yield; a risk-free interest rate of 3.5%, 2.6%and 2.9%, respectively; an expected term of 4.0 years for all years presented;and an expected volatility of 95%, 112% and 117%, respectively. The weightedaverage fair value of options granted during the years ended December 31,2005, 2004 and 2003 was $9.13, $9.45 and $2.68, respectively.

 

F-10

----

 

*Earnings (Loss) Per Share*

 

Earnings (loss) per share is computed using theweighted average number of shares of common stock outstanding and is presentedfor basic and diluted earnings (loss) per share. Basic earnings (loss) pershare is computed by dividing net income (loss) by the weighted average numberof common shares outstanding during the period. Diluted earnings (loss) pershare is computed by dividing net income (loss) by the weighted average numberof common shares outstanding during the period increased to include, ifdilutive, the number of additional common shares that would have beenoutstanding if the potential common shares had been issued. The dilutive effectof outstanding stock options and warrants is reflected in diluted earnings(loss) per share by application of the treasury stock method. The Company hasexcluded all outstanding stock options and warrants from the calculation ofdiluted loss per share for the years ended December 31, 2005, 2004 and2003 because such securities are antidilutive for these periods. The totalnumber of potential common shares excluded from the calculation of diluted lossper common share for the years ended December 31, 2005, 2004 and 2003 was2,146,976, 3,444,888 and 2,718,175, respectively.

 

*ComprehensiveIncome (Loss)*

 

Comprehensive income (loss) is calculated inaccordance with SFAS No. 130, *Comprehensive Income*.SFAS No. 130 requires the disclosure of all components of comprehensiveincome (loss), including net income (loss) and changes in equity during aperiod from transactions and other events and circumstances generated fromnon-owner sources. The Company’s other comprehensive income (loss) consisted ofgains and losses on short-term investments and is reported in the statements ofstockholders’ equity.

 

### *New AccountingPronouncements*

###  

In December 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123 (revised 2004), *Share-BasedPayment* (SFAS 123R), which is a revision of Statement of FinancialAccounting Standards No. 123, *Accounting for Stock-BasedCompensation* (SFAS 123). SFAS 123R supersedes APB Opinion No. 25,*Accounting for Stock Issued to Employees*,and amends Statement of Financial Accounting Standards No. 95, *Statement of Cash Flows* (SFAS 95). Generally, the approachin SFAS 123R is similar to the approach described in SFAS 123. However, SFAS123R requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the income statement based on theirfair values. Pro forma disclosure is no longer an alternative. SFAS 123R mustbe adopted no later than January 1, 2006. Early adoption will be permittedin periods in which financial statements have not yet been issued. The Companywill adopt SFAS 123R on January 1, 2006.

 

Aspermitted by SFAS 123, the Company currently accounts for share-based paymentsto employees using Opinion 25’s intrinsic value method and, as such, generallyrecognizes no compensation cost for employee stock options. Accordingly, theadoption of SFAS 123R’s fair value method will have a significant impact on theCompany’s results of operations, although it will have no impact on the Company’soverall financial position. Determining the exact impact of adoption of SFAS123R cannot be predicted at this time because it will depend on levels ofshare-based payments granted in the future and the assumptions for thevariables which affect the computation. However, had the Company adopted SFAS123R in prior periods, the impact of that standard would have approximated theimpact of SFAS 123 as described in the disclosure of pro forma net loss and netloss per share in the *Stock Based Compensation*section of Note 1 above.

 

**2.**                                      STOCKHOLDERS’EQUITY

** **

*Authorized Shares*

 

The Company is authorized to issue up to 60,000,000shares of common stock and 15,000,000 shares of preferred stock.

 

F-11

----

 

*Public Offering of Shares of CommonStock*

 

On April 7,2004, the Company completed a public offering of 6,900,000 shares of commonstock, including the underwriters’ purchase of an additional 900,000 shares tocover over-allotments, at $11.50 per share resulting in proceeds ofapproximately $74.2 million, net of placement costs.

 

*ShelfRegistration*

 

On May 10, 2005, the Company filed a Form S-3with the Securities and Exchange Commission (“SEC”) to issue and sell up to atotal dollar amount of $100 million of the Company’s common stock to thepublic in a registered offering or offerings. The Form S-3 was declared effectiveby the SEC on July 6, 2005. As of December 31, 2005, no shares ofcommon stock had been issued pursuant to this shelf registration.

 

*Warrants*

 

In June 2005,upon execution of the license agreement with Organon, the Company issuedOrganon warrants to purchase 62,656 shares of common stock as a license fee. Thesewarrants, which have an exercise price of $15.96 per share and expire in June 2010,were valued at $615,000 using the Black-Scholes valuation model and recorded asa non-cash compensation charge, classified as research and developmentexpenses, during the second quarter of 2005 since the underlying technologystill requires substantial development effort.

 

In May 2004,the Company issued an outside consultant warrants to purchase 50,000 shares of commonstock as compensation for services provided. These warrants, which have anexercise price of $13.23 per share and expire in May 2007, were valued at$385,000 using the Black-Scholes valuation model and recorded as a non-cashcompensation charge during the second quarter of 2004.

 

*Private Placement of Common Stockand Warrants to Purchase Common Stock*

 

During April 2003, the Company completed aprivate placement of 4,029,342 shares of common stock and warrants to purchase1,007,333 shares of common stock for proceeds of approximately$9.5 million, net of placement costs and fees of approximately$0.8 million. The purchase price of each security, which is thecombination of one share of common stock and a warrant to purchase 25% of oneshare of the Company’s common stock, was priced at the market value of $2.56.Each warrant has an exercise price equal to $3.84 and expires in April 2008.In addition, in connection with the private placement, the Company issuedwarrants to purchase 380,908 shares of common stock to various placementagents. These warrants have an exercise price of $2.82 and expire in April 2008.One of the placement agents in the financing, who received warrants to purchase283,301 shares of common stock and cash commission of $508,000, is affiliatedwith a stockholder of the Company. As of December 31, 2005, none of thesewarrants remain outstanding.

 

In March 2002, in connection with a privateplacement, the Company issued warrants to purchase 889,575 shares of commonstock to various placement agents. These warrants have exercise prices rangingfrom $2.72 to $2.96 and expire in March and April of 2007. As of December 31,2005, 8,936 of the warrants issued to various placement agents remain outstanding.

 

*Call forRedemption of Outstanding Warrants*

 

During October 2003, the Company called forredemption of the outstanding warrants to purchase common stock of the Companyissued in connection with the Company’s private placement in March 2002.As of October 1, 2003, there were warrants to purchase 2,167,962 shares ofcommon stock outstanding at an exercise price of $3.09 out of 3,435,726warrants originally issued. Pursuant to the terms of the warrant agreements,the Company had the right to call for redemption of the warrants if the closingprice of the Company’s common stock exceeded 200% of the warrant purchase pricefor 20 consecutive trading days, or $6.18, which occurred on September 26,2003. All outstanding warrants from the private placement in March 2002were exercised prior to the redemption date of October 20, 2003 resultingin gross proceeds to the Company of $6.7 million.

 

F-12

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**3.****                                      BENEFITPLANS**

 

*401(k) Plan*

 

The Company has a savings plan under Section 401(k)of the Internal Revenue Code under which all employees over the age oftwenty-one are eligible to participate on the first entry date (January 1,April 1, July 1 and October 1) following their hire date. Theplan allows for a matching contribution in the Company’s common stock (valuedas of the contribution date) equal to 100% of the amount of the salarycontributed for the preceding six- month period. Employees vest in the matchingcontribution made on the last day of June of the plan year provided theyare employed on the last day of December of the plan year and vest in thematching contribution made on the last day of December of the plan yearprovided that they are employed on the last day of June of the followingplan year. After five years of vesting service, the matching contribution is100% vested immediately. During the years ended December 31, 2005, 2004and 2003, the charge to operations for the matching contribution was $133,402,$123,763 and $65,500, respectively.

 

*Stock Options*

 

*2000 EQUITY INCENTIVE PLAN*  In May 2000, the Company adopted the2000 Equity Incentive Plan (the “2000 Plan”) providing for the grant toemployees, directors and consultants of the Company of incentive andnon-qualified stock options to purchase the Company’s common stock, as well asthe granting of stock bonuses and rights to purchase restricted stock. Theexercise price of all incentive stock options granted under the 2000 Plan shallnot be less than the fair market value of the Company’s common stock on thedate of grant. The exercise price of non-qualified stock options granted underthe 2000 Plan shall not be less than 85% of the fair market value of theCompany’s common stock on the date of grant. Options granted under the 2000Plan have a term of up to ten years and generally vest over four years. In February 2001,the shareholders of the Company approved a provision to amend the 2000 Plan,whereby the total number of shares reserved for issuance under the 2000 Planand the 1996 Equity Incentive Plan, in the aggregate, may be increasedquarterly such that the number equals 21.1% of the number of shares of theCompany’s common stock issued and outstanding as of the end of that day.Additionally, in September 2003, the shareholders of the Company approvedan amendment to the 2000 Plan to increase the number of shares of common stockavailable for issuance as incentive stock options from 875,000 shares to5,600,000 shares. This amendment does not alter the total number of sharesavailable for issuance under the 2000 Plan; it only increases the total numberof shares that may be issued under the 2000 Plan as incentive stock options.As of December 31, 2005, 3,399,190 shares of the Company’s common stockare available for future grant under the 2000 Plan.

 

*1996 EQUITY INCENTIVE PLAN*  In January 1996, the Company adopted the1996 Equity Incentive Plan (the “1996 Plan”) providing for the grant toemployees, directors and consultants of the Company of incentive andnon-qualified stock options to purchase the Company’s common stock, as well asthe granting of stock bonuses and rights to purchase restricted stock. Theexercise price of all incentive stock options granted under the 1996 Plan shallnot be less than the fair market value of the Company’s common stock on thedate of grant. The exercise price of non-qualified stock options granted underthe 1996 Plan shall not be less than 85% of the fair market value of theCompany’s common stock on the date of grant. Options granted under the 1996Plan have a term of up to ten years and vest as determined by the Board but inno event less than twenty percent per year. As of December 31, 2005,16,873 shares of the Company’s common stock are available for future grantunder the 1996 Plan.

 

*STOCK OPTION CANCEL AND RE-GRANTPROGRAM*  In June 2001,the Company implemented an option cancel and re-grant program. Pursuant to theprogram, the exercise price of certain options held by certain of the Company’sexecutive officers and directors were exchanged for options with an exerciseprice of $2.50, the fair market value of the Company’s common stock on June 27,2001, the date the option cancel and re-grant program was effected. As acondition to participating in the option cancel and re-grant program, optioneeswho elected to surrender their old options for the replacement options had toexercise at least twenty percent of the replacement options on June 27,2001. In addition, the replacement options expire no later than the earlier ofthe expiration date of the original option grant or June 27, 2006. TheCompany’s chief executive officer exercised his options to purchase 101,319shares of common stock pursuant to a promissory note that was issued by the Companyand was secured by his stock. The outstanding principal amount of thepromissory note was due on June 27, 2006, with interest payable annually.The principal

 

F-13

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amount of the loan was $189,973 and the interest rate was variable,adjusted monthly and was two points above the federal funds rate. In January 2004,the principal amount of the loan and related interest was paid in full.

 

As a result of the program, the Company grantedoptions to purchase 618,738 shares of its common stock. In accordance with FASBInterpretation No. 44, *Accounting forCertain Transactions Involving Stock Compensation—An Interpretation of APBOpinion No. 25*, the shares underlying the options are accountedfor as variable, and the intrinsic value of the options to purchase commonstock are re-measured at the end of each period for the term of the option andamortized over the vesting period. During the years ended December 31,2005 and 2004, the Company recorded a compensation benefit of $1,749,135 and$699,033, respectively, as the intrinsic value of the common stock underlyingthe options declined due to a decline in the Company’s stock price. The Companyrecorded stock compensation expense of $5,879,277 for the year ended December 31,2003 to reflect in an increase in the intrinsic value of the common stockunderlying the options due to an increase in the Company’s stock price duringthis period.

 

The following table summarizes the activity of theCompany’s stock options and warrants for the periods presented:

 
| ** **                     | ** ** | **NUMBER OF WARRANTS/OPTIONS** | ** ** |
|--------------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **Warrants**                   | ** ** | **2000  Equity  Incentive  Plan Options** | ** ** | **1996  Equity  Incentive  Plan Options** | ** ** | **Non-Qualified  Stock Options** | ** ** | **Other  Options** | ** ** |
| Balance December 31, 2002 |       | 4,358,882                      |       | 922,214 |   | 765,715 |   | 10,000 |   | 3,125 |   |
| Granted                        |       | 1,688,241                      |       | 1,783,345 |   | 19,397 |   | — |   | — |   |
| Exercised                      |       | (4,008,811                     | )          | (136,553 | ) | (12,155 | ) | — |   | — |   |
| Canceled                       |       | (12,500                        | )          | (12,500 | ) | (16,873 | ) | — |   | — |   |
| Expired                        |       | —                         |       | — |   | (10,205 | ) | (10,000 | ) | — |   |
| Balance December 31, 2003 |       | 2,025,812                      |       | 2,556,506 |   | 745,879 |   | — |   | 3,125 |   |
| Granted                        |       | 50,000                         |       | 459,863 |   | — |   | — |   | — |   |
| Exercised                      |       | (403,681                       | )          | (536,502 | ) | (374,723 | ) | — |   | — |   |
| Canceled                       |       | —                         |       | — |   | — |   | — |   | — |   |
| Expired                        |       | (21,081                        | )          | — |   | — |   | — |   | (3,125 | ) |
| Balance December 31, 2004 |       | 1,651,050                      |       | 2,479,867 |   | 371,156 |   | — |   | — |   |
| Granted                        |       | 62,656                         |       | 830,125 |   | — |   | — |   | — |   |
| Exercised                      |       | (1,292,114                     | )          | (270,003 | ) | (91,955 | ) | — |   | — |   |
| Canceled                       |       | —                         |       | — |   | — |   | — |   | — |   |
| Expired                        |       | —                         |       | — |   | — |   | — |   | — |   |
| Balance December 31, 2005 |       | 421,592                        |       | 3,039,989 |   | 279,201 |   | — |   | — |   |

 

F-14

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The following table summarizes information regardingstock options outstanding at December 31, 2005:

 
| **Range of  Exercise Prices** | ** **     | **Options  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual Life  in Years** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Options  Exercisable** | ** ** | **Weighted  Average  Exercise Price of  Options  Exercisable** | ** ** |
|-------------------------------|----------------|--------------------------|------------|--------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------|------------|----------------------------------------------------------------|------------|
| $                             | 0.00 - $2.00   |                     | 8,872      |                                                         | 5.7        |                                  | $          | 1.30                     |       | 7,302                                                          |       | $ | 1.33 |   |
| $                             | 2.01 - $3.00   |                     | 812,999    | ** **                                                   | 5.4        |                                  | $          | 2.51                     |       | 652,647                                                        |       | $ | 2.51 |   |
| $                             | 3.01 - $4.00   |                     | 555,257    |                                                         | 6.3        |                                  | $          | 3.29                     |       | 504,701                                                        |       | $ | 3.29 |   |
| $                             | 4.01 - $6.00   |                     | 620,154    |                                                         | 7.5        |                                  | $          | 4.62                     |       | 362,873                                                        |       | $ | 4.60 |   |
| $                             | 6.01 - $11.00  |                     | 74,267     |                                                         | 8.5        |                                  | $          | 9.97                     |       | 52,699                                                         |       | $ | 9.86 |   |
| $                             | 11.01 - $15.00 |                     | 1,138,754  |                                                         | 8.8        |                                  | $          | 13.11                    |       | 481,052                                                        |       | $ | 13.00 |   |
| $                             | 15.01 - $20.00 |                     | 108,575    |                                                         | 8.0        |                                  | $          | 15.03                    |       | 88,270                                                         |       | $ | 15.04 |   |
| $                             | 20.01 - $25.00 |                     | 312        |                                                         | 2.5        |                                  | $          | 22.25                    |       | 312                                                            |       | $ | 22.25 |   |
|                          |           | 3,319,190                |       | 7.3                                                          |       | $                                     | 7.25       |                     | 2,149,856  |                                                           | $          | 6.09 |   |

 

The weighted average exercise prices for stock optionactivity are as follows:

 
| ** **                     | ** ** | **Number of Stock  Options Under All Plans** | ** ** | **Weighted Average  Exercise Prices** | ** ** |
|--------------------------------|------------|----------------------------------------------|------------|---------------------------------------|------------|
|                           |       |                                         |       |                                  |       |
| Balance December 31, 2002 |       | 1,701,054                                    |       | $                                     | 3.03       |   |
| Granted                        |       | 1,802,742                                    |       | $                                     | 3.48       |   |
| Exercised                      |       | (148,708                                     | )          | $                                     | 2.04       |   |
| Cancelled                      |       | (29,373                                      | )          | $                                     | 9.06       |   |
| Expired                        |       | (20,205                                      | )          | $                                     | 16.50      |   |
| Balance December 31, 2003 |       | 3,305,510                                    |       | $                                     | 3.18       |   |
| Granted                        |       | 459,863                                      |       | $                                     | 12.61      |   |
| Exercised                      |       | (911,225                                     | )          | $                                     | 2.40       |   |
| Cancelled                      |       | —                                       |       | $                                     | —     |   |
| Expired                        |       | (3,125                                       | )          | $                                     | 18.00      |   |
| Balance December 31, 2004 |       | 2,851,023                                    |       | $                                     | 4.93       |   |
| Granted                        |       | 830,125                                      |       | $                                     | 13.35      |   |
| Exercised                      |       | (361,958                                     | )          | $                                     | 3.03       |   |
| Cancelled                      |       | —                                       |       | $                                     | —     |   |
| Expired                        |       | —                                       |       | $                                     | —     |   |
| Balance December 31, 2005 |       | 3,319,190                                    |       | $                                     | 7.25       |   |

** **

**4.****                                     ****SIGNIFICANT LICENSING ANDCOLLABORATION AGREEMENTS**

 

*Licenseand Collaboration Agreement with Organon*

 

In June 2005, the Company entered into a license agreement with Organon in connection with the initiation of its second development program, wherein the Company is evaluating potential pharmaceutical treatments for OSA. The Company entered into three licensing agreements to support and facilitate the program. Specifically, the Company licensed mirtazapine-related patents from Organon and patents from two other parties that provide the opportunity to combine mirtazapine with a second approved agent with the goal of potentially augmenting efficacy and improving tolerability. The series of licenses will allow the Company to evaluate a number of potential OSA treatment modalities in proof of concept trials.

 

F-15

 

Upon execution of the license agreement with Organon, the Company issued to Organon as a license fee a warrant to purchase 62,656 shares of common stock. These warrants, which have an exercise price of $15.96 per share and expire in June 2010, were valued at $615,000 and recorded as a non-cash compensation charge, classified as research and development expenses, during the second quarter of 2005 since the underlying technology still requires substantial development effort. Under the agreement with Organon, the Company and Organon will jointly fund development activities in the event a candidate from the proof of concept trials has been selected for continued development. If the Company is able to select a development candidate, the following is the structure of the agreement with Organon. The Company will have operational control of the development activities and, depending on the candidate selected, will fund 40% or 50% of the development-related expenses. If the FDA approves this product, Organon will have operational control of sales and marketing activities, with the Company having the opportunity to co-promote up to 25% of the physician promotion and details using its own sales force in the United States, Mexico and Canada. Expenses and revenue in the United States, Mexico and Canada are to be shared between the Company and Organon based on the level of promotional effort each party contributes, with the Company having the ability to share up to 40% or 50% depending on the candidate selected. Organon will be solely responsible for commercialization in the rest of the world and will pay the Company a royalty on net sales (as defined in the agreement).

 

Assuming the decision is made by the Company and Organon to proceed with the commencement of the first Phase III clinical trial, at any time thereafter, either the Company or Organon may elect to change the structure of the financial agreement to provide that the party that makes such election will no longer share in expenses and revenue, and instead will have the potential right to receive potential milestone and royalty payments in the event a product is commercialized.

 

In connection with the Company’s related licensing transactionswith the two other parties (one of which is a related party as discussed inNote 6), the Company paid the parties aggregate license payments totaling $2.5million, included in research and development expenses, with the potential foradditional milestone payments of up to $25.3 million related to the Company’sOSA program, as development progresses. The parties will also participate inroyalties from any marketed products that may be developed under therespective agreements.

 

*Licenseand Collaboration Agreement with Forest Laboratories*

 

In January 2004, the Company entered into acollaboration agreement with Forest Laboratories for the development and marketingof milnacipran. Under the agreement with Forest Laboratories, the Companysublicensed its exclusive rights to develop and commercialize milnacipran toForest Laboratories for the United States, with an option to extend theterritory to include Canada. In addition, Forest Laboratories has an option toacquire an exclusive license from the Company in the United States, andpotentially Canada, to any compounds developed under the Company’s agreementwith Collegium Pharmaceutical, Inc. Forest Laboratories assumedresponsibility for funding all continuing development of milnacipran, includingthe funding of clinical trials and regulatory approvals, as well as a certainnumber of the Company’s employees. However, in light of the increased expenseand risk associated with running two parallel trials, the Company has agreedupon an alternative cost sharing arrangement with Forest Laboratories for thesecond Phase III trial only. In connection with this arrangement, the amount offunding that the Company receives from Forest Laboratories for certain of itsemployees has been eliminated as of the fourth quarter in 2004 for the secondPhase III trial only, and the Company will pay for a majority of the externalcosts of the second Phase III trial only, with Forest reimbursing the Companyunder specific scenarios where the second Phase III trial is used as one of thetwo required pivotal trials in the New Drug Application (NDA) submission to theFDA. Forest Laboratories is funding the third Phase III trial, including aspecified number of our employees that are assisting with the conduct of thattrial. Forest Laboratories will also be responsible for sales and marketingactivities related to any product developed under the agreement, and theCompany will have the option to co-promote using its own sales force up to 25%of the total physician details and would be reimbursed by Forest Laboratoriesin an amount equal to Forest Laboratories’ cost of providing the equivalentdetailing calls.

 

Under the agreement with Forest Laboratories, theCompany received an upfront, non-refundable payment of $25.0 million, ofwhich $1.25 million, classified as research and development expenses, waspaid to Pierre Fabre as a sublicense fee. The total upfront and milestonepayments to the Company under the agreement could total approximately$205.0 million related to the development of milnacipran for the treatmentof FMS, a large portion of which will depend upon achieving certain sales ofmilnacipran and an additional $45.0 million in the event that the

 

F-16

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Company and Forest Laboratories develop other indications formilnacipran. In addition, the Company has the potential to receive royaltypayments based on sales of licensed product under this agreement. ForestLaboratories also assumed the future royalty payments due to Pierre Fabre andthe transfer price for the active ingredient used in milnacipran. The agreementwith Forest Laboratories extends until the later of (i) the expiration ofthe last to expire of the applicable patents, (ii) 10 years after thefirst commercial sale of a product under the agreement or (iii) the lastcommercial sale of a generic product, unless terminated earlier. Each party hasthe right to terminate the agreement upon prior written notice of thebankruptcy or dissolution of the other party, or a breach of any materialprovision of the agreement if such breach has not been cured within therequired time period following such written notice. Forest Laboratories may alsoterminate the agreement upon an agreed notice period in the event ForestLaboratories reasonably determines that the development program indicatesissues of safety or efficacy that are likely to prevent or significantly delaythe filing or approval of a new drug application or to result in labeling orindications that would have a significant adverse affect on the marketing ofany product developed under the agreement.

 

For the years ended December 31, 2005 and 2004,the Company recognized revenues of $8.4 million and $14.4 million,respectively, under its collaboration agreement with Forest Laboratories,consisting of the recognition of the upfront payment of $25.0 million fromForest Laboratories on a straight-line basis over a period of 8 years, sponsoreddevelopment reimbursements and funding received from Forest Laboratories during2004 for certain of the Company’s employees devoted to the development ofmilnacipran.

 

*LicensingAgreement with Pierre Fabre*

 

In August 2001, the Company entered into alicense agreement and a trademark agreement with Pierre Fabre. Pursuant to theterms of the license agreement, the Company paid Pierre Fabre $1.5 millionupon execution of the agreement and a $1.0 million milestone payment in September 2003.The upfront payment of $1.5 million and $1.0 million milestonepayment have been expensed pursuant to SFAS No. 2, *Accountingfor Research and Development Costs*, as the ultimatecommercialization of the related products is uncertain and the technology hasno alternative uses. Additional payments of up to $4.5 million will be dueto Pierre Fabre based on meeting certain clinical and regulatory milestones.

 

The license agreement was amended and restated in November 2001and subsequently in May 2003. In connection with the second amended andrestated agreement in May 2003, the Company issued Pierre Fabre 1,000,000shares of common stock and warrants to purchase 300,000 shares of common stock.These warrants have an exercise price of $4.91 per share and expire in June 2008.Pursuant to SFAS No. 2, the additional license consideration in the form ofthe equity instruments has been expensed as the ultimate commercialization ofthe related product is uncertain and the technology has no alternative uses.Accordingly, during the second quarter of 2003, the Company recognized anon-cash charge of $5.0 million classified as research and developmentexpense based on the fair value of the stock and warrants issued to PierreFabre.

 

In January 2004, in connection with the Company’stransaction with Forest Laboratories, the Company’s license agreement andtrademark agreement with Pierre Fabre were further amended. The third amendedand restated license agreement with Pierre Fabre provides the Company with anexclusive license to develop and sell any products with the compoundmilnacipran as an active ingredient for any indication in the United States andCanada. Simultaneous to the third amended and restated license agreement, theCompany also entered into a purchase and supply agreement with Pierre Fabre forthe active pharmaceutical ingredient in milnacipran. If any product iscommercialized, Pierre Fabre will have the exclusive right to manufacture theactive ingredients used in the commercial product for a specified time period(subject to compliance with certain provisions in the agreement), and PierreFabre will be paid a transfer price for each product manufactured and royaltiesbased on net sales, both obligations which have been assumed by ForestLaboratories. Additionally, the Company is obligated to pay Pierre Fabre a 5%sublicense fee on upfront and milestone payments received from ForestLaboratories. Once a total of $7.5 million has been paid to Pierre Fabre,such additional sublicense payments due to Pierre Fabre shall be creditedagainst any royalties or milestones owed by the Company to Pierre Fabre, whichshall be carried forward to any subsequent years as applicable. Pierre Fabrealso retains the right to sell products in indications developed by the Companyoutside the United States and Canada and will pay the Company a royalty basedon net sales for such products. The license agreement also provides PierreFabre with certain rights to obtain a license outside the United States andCanada for new formulations and new salts developed by the Company. Theagreement is effective until the later of the expiration of the last-to-expireof certain patents held by Pierre Fabre relating to the development of

 

F-17

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milnacipran or ten years after the first commercial sale of a licensedproduct, unless terminated earlier. Each party has the right to terminate theagreement upon 90 days’ prior written notice of the bankruptcy ordissolution of the other party or a breach of any material provision of theagreement if the breach is not cured within 90 days following the writtennotice. Additionally, Pierre Fabre has the right to terminate the agreementupon 90 days’ prior notice to the Company if the Company takes certainactions.

 

*Reformulationand New Product Agreement*

 

In August 2002, the Company entered into aReformulation and New Product Agreement (“Agreement”) with CollegiumPharmaceutical, Inc., or Collegium, pursuant to which Collegium isattempting to develop new formulations of milnacipran and new products that areanalogs of milnacipran. In January 2004, the Company exercised its optionto acquire an exclusive license to technology developed under this agreement.In the event the Company commercializes any of the reformulations or newproducts developed under the agreement with Collegium, the Company will beobligated to pay Collegium milestone payments, which amount to $5.4 million inthe aggregate, as well as potential royalty payments based on the net sales ofreformulated or new products. Additionally, in October 2002, the Companyentered into a Common Stock Issuance Agreement with Collegium, pursuant towhich Collegium may elect to be issued shares of the Company’s commonstock, subject to certain conditions, in lieu of cash, for milestone payments.The Company has authorized the issuance of up to 1,800,000 shares of commonstock as milestone payments. The agreement with Collegium is effective untilthe expiration of the last-to-expire of the issued patents, if any, unlessterminated earlier. Each party has the right to terminate the agreement upon60 days’ prior written notice of the bankruptcy or dissolution of theother party or a breach of any material provision of the agreement if thebreach has not been cured within the 60-day period following the writtennotice.

 

**5.**                                      INCOMETAXES

** **

Significant components of the Company’s net deferredincome tax assets as of December 31, 2005 and 2004 are shown below. Avaluation allowance has been established to offset the net deferred tax assetas of December 31, 2005 and 2004, respectively, as the realization of suchassets is uncertain.

 
| ** **                           | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|--------------------------------------|------------|-------------|------------|-------------|------------|
|                                 |       |        |       |        |       |
| Net operating loss carryforwards     |       | $           | 29,705,000 |        | $          | 31,965,000 |   |
| Deferred revenue                     |       | 7,640,000   |       | —      |       |
| Capitalized research and development |       | 6,035,000   |       | 5,925,000   |       |
| Capitalized intangibles              |       | 4,426,000   |       | 3,165,000   |       |
| Tax credits                          |       | 2,273,000   |       | 2,301,000   |       |
| Other                                |       | 276,000     |       | 195,000     |       |
|                                 |       | 50,355,000  |       | 43,551,000  |       |
| Valuation allowance                  |       | (50,355,000 | )          | (43,551,000 | )          |
|                                 |       | $           | —     |        | $          | — |   |

 

As of December 31, 2005, the Company hasaccumulated federal and California net operating loss carryforwards ofapproximately $81,200,000 and $22,600,000, respectively. The federal tax losscarryforwards will begin to expire in 2008, and the California tax losscarryforwards will begin to expire in 2007. Additionally, the Company hasfederal and California research and development tax credit carryforwards ofapproximately $1,899,000 and $549,000, respectively, which will begin expiringin 2006 unless previously utilized.

 

The Company has determined that “ownership changes”within the meaning of Internal Revenue Code Section 382 have occurred inprior years. However, the Company has determined based on an analysis completedin 2004 that those limitations on the future utilization of net operating losscarryforwards will not have a material impact on such utilization. Futurefinancings may cause additional changes in ownership and cause furtherlimitation on the use of net operating loss carryforwards.

 

F-18

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**6.****                                      RELATEDPARTY TRANSACTIONS**

 

A member of the Company’s board of directors acceptedthe position of Chief Executive Officer of a biotechnology company in April 2005.The Company entered into an agreement with this company in January 2005with respect to the in-license of certain patents. Under this agreement, the Companypaid an aggregate of $1.5 million, included in research and developmentexpenses, to such biotechnology company. In the event the Company moves forwardwith development of a product or products under this agreement, the Companywould be obligated to pay certain milestone and royalty payments.

 

In conjunction with the signing of the collaborationagreement with Forest Laboratories in the first quarter of 2004, options topurchase 200,000 shares of common stock at $2.51 per share became fully vested.Such options were previously granted to outside consultants and two formerboard members for services provided in connection with corporate partnernegotiations and were to become fully vested upon the execution of asignificant strategic collaboration within two years of the date of grant. TheCompany recorded a non-cash compensation charge of $2.4 million, determinedusing the Black-Scholes valuation model, in the first quarter of 2004 inconnection with this transaction.

 

During March 2004, the Company entered intoconsulting agreements with certain board members in connection with theirresignation from the Company’s board of directors to roles as consultants. Pursuantto such consulting agreements, the Company is committed to pay each consultanta fee of $50,000 per year for services provided over a two-year term. Additionally,each consultant will vest in all unvested shares under outstanding optiongrants in equal monthly installments over a period of two years from theeffective date of the agreements. In connection with the consulting agreements,the Company recorded a non-cash compensation charge of $2.8 million during thefirst quarter of 2004 related to the accounting for the stock optionspreviously granted to such former board members.

 

The Company employs the services of a consultant,whose husband is an officer of the Company. Such consultant provided consultingservices to the Company in the amount of approximately $147,000, $144,000 and$70,000 for the years ended December 31, 2005, 2004 and 2003,respectively.

 

**7.****                                      COMMITMENTSAND CONTINGENCIES**

 

The Company currently occupies approximately 5,200square feet of leased office space in San Diego, California. The San Diegofacility houses the Company’s executive and administrative offices. The leasefor this facility expires in July 2007.

 

Future annual minimum lease payments due undernoncancelable capital and operating leases consists of the following at December 31,2005:

 
| **Years Ending December 31,** | ** ** | **Operating  Leases** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| 2006                               |       | $                     | 184,804    |   |
| 2007                               |       | 110,270               |       |
| Total minimum lease  payments      |       | $                     | 295,074    |   |

 

Total rent expense was approximately $176,000,$191,000 and $171,000 for the years ended December 31, 2005, 2004 and 2003,respectively.

 

F-19

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**8.****                                     ****QUARTERLY INFORMATION(UNAUDITED)**

 

The following quarterly information includes alladjustments which management considers necessary for a fair statement of suchinformation.

 
| ** **                                                             | ** ** | **2005**           | ** ** |
|------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                             | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|                                                                   |       |               |       |   |   |   |   |   |   |
| Revenues                                                               |       | $                  | 3,210,590  |   | $ | 2,332,863 |   | $ | 1,575,000 |   | $ | 1,266,183 |   |
| Total costs and  expenses                                              |       | $                  | 5,511,289  |   | $ | 7,892,330 |   | $ | 2,462,103 |   | $ | 3,673,040 |   |
| Other income                                                           |       | $                  | 551,419    |   | $ | 694,164 |   | $ | 671,752 |   | $ | 609,796 |   |
| Net loss **(1)**                                                       |       | $                  | (1,749,280 | ) | $ | (4,865,303 | ) | $ | (215,351 | ) | $ | (1,797,061 | ) |
| Net loss per share –  basic and diluted                           |       | $                  | (0.06      | ) | $ | (0.16 | ) | $ | (0.01 | ) | $ | (0.06 | ) |
| Shares used in  calculating per share amounts – basic and diluted |       | 30,391,504         |       | 30,481,785 |   | 31,627,157 |   | 31,901,659 |   |

 

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**(1)**                                 Duringthe first, second, third and fourth quarters, the Company recognized non-cashcompensation expense (benefit) for variable stock options of $(1,392,060),$1,148,732, $(1,580,894) and $75,087, respectively, related to the variableaccounting treatment for options issued pursuant to the cancel and re-grantprogram in June 2001.

 
| ** **                                                   | ** ** | **2004**              | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                   | ** ** | **First  Quarter(2)** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|                                                         |       |                  |       |   |   |   |   |   |   |
| Revenues                                                     |       | $                     | 3,392,618  |   | $ | 3,465,823 |   | $ | 4,259,010 |   | $ | 3,297,168 |   |
| Total costs and expenses                                     |       | $                     | 10,745,200 |   | $ | 5,422,385 |   | $ | 4,315,142 |   | $ | 6,231,381 |   |
| Other income                                                 |       | $                     | 69,735     |   | $ | 196,670 |   | $ | 432,557 |   | $ | 385,521 |   |
| Net income (loss) **(1)**                                    |       | $                     | (7,282,847 | ) | $ | (1,759,892 | ) | $ | 376,425 |   | $ | (2,548,692 | ) |
| Net income (loss) per share - basic                          |       | $                     | (0.33      | ) | $ | (0.06 | ) | $ | 0.01 |   | $ | (0.08 | ) |
| Net income (loss) per share - diluted                        |       | $                     | (0.33      | ) | $ | (0.06 | ) | $ | 0.01 |   | $ | (0.08 | ) |
| Shares used in calculating per share amounts – basic    |       | 22,361,079            |       | 28,989,249 |   | 29,624,813 |   | 30,039,328 |   |
| Shares used in calculating per share amounts –  diluted |       | 22,361,079            |       | 28,989,249 |   | 32,890,482 |   | 30,039,328 |   |

 

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**(1)**                                 Duringthe first, second, third and fourth quarters, the Company recognized non-cashcompensation expense (benefit) for variable stock options of $(1,442,933),$847,025, $(782,454) and $679,329, respectively, related to the variableaccounting treatment for options issued pursuant to the cancel and re-grantprogram in June 2001.

 

**(2)**                                 Duringthe first quarter, the Company recognized non-cash charges of $2.4 millionrelated to stock options that vested upon the execution of the collaborationagreement with Forest Laboratories and $2.8 million in connection with theaccounting treatment for stock options related to the resignation of certainboard members during the first quarter of 2004.

 

F-20

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