Table of Contents

** **

 

** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**Form 10-Q**

 

**(MarkOne)**

 

| **x**                                                       | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|-------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                        |                                                                                                    |
| **For  the quarterly period ended September 30, 2009** |
|                                                        |                                                                                                    |
| **Or**                                                      |
|                                                        |                                                                                                    |
| **o**                                                       | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**      |

 

**Commission File Number: 001-32587**

 

----

 

**PHARMATHENE, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                     | ** ** | **20-2726770**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or  organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **One  Park Place, Suite 450, Annapolis, MD**               | ** ** | **21401**                             |
| (Address of  principal executive offices)                        |       | (Zip Code)                            |

 

**(410) 269-2600**

(Registrant’s telephone number, including area code)

 

----

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes x  No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data file required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405of this chapter) during the preceding 12 months (or for such shorter periodthat the registrant was required to submit and post such files). Yes o No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reportingcompany.  See the definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

| Large  Accelerated Filer o                     |   | Accelerated  Filer o         |
|------------------------------------------------|--------|------------------------------|
|                                           |   |                         |
| Non-Accelerated  Filer o                       |   | Smaller  Reporting Company x |
| (Do not check if  a smaller reporting company) |   |                         |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Act).  Yes o  No x

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:    The number ofshares of the registrant’s Common Stock, par value $0.0001 per share,outstanding as of November 11, 2009 was 28,435,598.

 

 

 

----

Table of Contents

 

**PHARMATHENE, INC.**

 

**TABLE OFCO****NTENTS**

 
| ** **                                                                                          | **Page**   |
|-----------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                          | ** ** |
| PART I — FINANCIAL INFORMATION                                                            | 1          |
|                                                                                                |       |
| Item 1.  Financial Statements                                                                       | 1          |
|                                                                                                |       |
| Item 2. Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 13         |
|                                                                                                |       |
| Item 3. Quantitative and  Qualitative Disclosures about Market Risk                                 | 21         |
|                                                                                                |       |
| Item 4.  Controls and Procedures                                                                    | 22         |
|                                                                                                |       |
| PART II  — OTHER INFORMATION                                                              | 22         |
|                                                                                                |       |
| Item 1.  Legal Proceedings                                                                          | 22         |
|                                                                                                |       |
| Item  1A. Risk Factors                                                                              | 24         |
|                                                                                                |       |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                | 37         |
|                                                                                                |       |
| Item  5. Other Information                                                                          | 38         |
|                                                                                                |       |
| Item  6. Exhibits                                                                                   | 38         |
|                                                                                                |       |
| Certifications                                                                                      |       |

 

----

Table of Contents

 

**PART I — FINANCIAL INFORMATION**

 

**Item1.  Financial Statements**

 

**PHARMATHENE, INC.**

**UNAUDITED CONDENSED CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                              | ** ** | **2009**               | ** ** | **2008**              | ** ** |
|                                                                                                                                    |       |                   |       |                  |       |
| **ASSETS**                                                                                                                              |       |                   |       |                  |       |
| Current  assets:                                                                                                                        |       |                   |       |                  |       |
| Cash  and cash equivalents                                                                                                              |       | $                      | 4,188,272  |                  | $          | 19,752,404 |   |
| Restricted  cash                                                                                                                        |       | —                 |       | 12,000,000            |       |
| Short-term  investments                                                                                                                 |       | 7,382,329              |       | 3,190,912             |       |
| Accounts  receivable                                                                                                                    |       | 5,055,107              |       | 8,890,077             |       |
| Other  receivables (including unbilled receivables)                                                                                     |       | 13,668,072             |       | 1,391,512             |       |
| Prepaid  expenses and other current assets                                                                                              |       | 1,765,758              |       | 917,125               |       |
| Total  current assets                                                                                                                   |       | 32,059,538             |       | 46,142,030            |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Long-term  restricted cash                                                                                                              |       | —                 |       | 1,250,000             |       |
| Property  and equipment, net                                                                                                            |       | 6,207,971              |       | 5,313,219             |       |
| Patents,  net                                                                                                                           |       | 930,350                |       | 925,489               |       |
| Other  long-term assets and deferred costs                                                                                              |       | 423,530                |       | 257,623               |       |
| Goodwill                                                                                                                                |       | 2,348,453              |       | 2,502,909             |       |
| Total  assets                                                                                                                           |       | $                      | 41,969,842 |                  | $          | 56,391,270 |   |
|                                                                                                                                    |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                 |       |                   |       |                  |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Current  liabilities:                                                                                                                   |       |                   |       |                  |       |
| Accounts  payable                                                                                                                       |       | $                      | 1,030,171  |                  | $          | 3,870,871 |   |
| Accrued  expenses and other current liabilities                                                                                         |       | 15,252,530             |       | 14,624,757            |       |
| Convertible  notes                                                                                                                      |       | —                 |       | 13,377,505            |       |
| Current  portion of derivative instruments                                                                                              |       | 47,431                 |       | —                |       |
| Current  portion of long-term debt                                                                                                      |       | —                 |       | 4,000,000             |       |
|                                                                                                                                    |       | 16,330,132             |       | 35,873,133            |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Other  long-term liabilities                                                                                                            |       | 446,390                |       | 626,581               |       |
| Derivative  instruments                                                                                                                 |       | 2,126,868              |       | —                |       |
| Convertible  notes and other long-term debt                                                                                             |       | 16,579,864             |       | 928,117               |       |
| Total  liabilities                                                                                                                      |       | 35,483,254             |       | 37,427,831            |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Stockholders’  equity:                                                                                                             |       |                   |       |                  |       |
| Common  stock, $0.0001 par value; 100,000,000 shares authorized; 28,091,635 and  25,890,143 shares issued and outstanding, respectively |       | 2,809                  |       | 2,589                 |       |
| Additional  paid-in-capital                                                                                                             |       | 156,242,571            |       | 142,392,163           |       |
| Accumulated  other comprehensive income                                                                                                 |       | 879,759                |       | 386,351               |       |
| Accumulated  deficit                                                                                                                    |       | (150,638,551           | )          | (123,817,664          | )          |
| Total  stockholders’ equity                                                                                                        |       | 6,486,588              |       | 18,963,439            |       |
| Total  liabilities and stockholders’ equity                                                                                        |       | $                      | 41,969,842 |                  | $          | 56,391,270 |   |

 

See the accompanyingnotes to the condensed consolidated financial statements.

 

1

----

Table ofContents

 

**PHARMATHENE, INC.**

**UNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
| ** **                                                                           | ** ** | **Three  months ended  September 30,** | ** ** | **Nine  months ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **2009**                                    | ** ** | **2008**                                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                                                                 |       |                                        |       |                                       |       |   |   |   |   |
| Contract  revenue                                                                    |       | $                                           | 6,830,399  |                                       | $          | 10,643,705 |   | $ | 20,423,513 |   | $ | 27,377,207 |   |
| Other  revenue                                                                       |       | —                                      |       | 32,461                                     |       | — |   | 53,612 |   |
|                                                                                 |       | 6,830,399                                   |       | 10,676,166                                 |       | 20,423,513 |   | 27,430,819 |   |
| Operating  expenses:                                                                 |       |                                        |       |                                       |       |   |   |   |   |
| Research  and development                                                            |       | 7,609,794                                   |       | 9,414,093                                  |       | 22,769,749 |   | 26,475,436 |   |
| General  and administrative                                                          |       | 6,224,868                                   |       | 4,803,190                                  |       | 15,787,115 |   | 14,655,971 |   |
| Acquired  in-process research and development                                        |       | —                                      |       | 225,000                                    |       | — |   | 16,131,002 |   |
| Depreciation  and amortization                                                       |       | 247,747                                     |       | 205,409                                    |       | 639,924 |   | 641,425 |   |
| Other  expenses                                                                      |       | 274,005                                     |       | —                                     |       | 1,158,566 |   | — |   |
| Total  operating expenses                                                            |       | 14,356,414                                  |       | 14,647,692                                 |       | 40,355,354 |   | 57,903,834 |   |
|                                                                                 |       |                                        |       |                                       |       |   |   |   |   |
| Loss  from operations                                                                |       | (7,526,015                                  | )          | (3,971,526                                 | )          | (19,931,841 | ) | (30,473,015 | ) |
| Other  income (expenses)                                                             |       |                                        |       |                                       |       |   |   |   |   |
| Interest  income                                                                     |       | 61,743                                      |       | 250,014                                    |       | 258,841 |   | 1,083,949 |   |
| Interest  expense                                                                    |       | (748,892                                    | )          | (628,470                                   | )          | (1,949,402 | ) | (1,947,245 | ) |
| Loss  on early extinguishment of debt                                                |       | (4,690,049                                  | )          | —                                     |       | (4,690,049 | ) | — |   |
| Change  in fair value of derivative instruments                                      |       | (1,059,509                                  | )          | 7,604                                      |       | (295,218 | ) | 123,148 |   |
| Total  other income (expenses)                                                       |       | (6,436,707                                  | )          | (370,852                                   | )          | (6,675,828 | ) | (740,148 | ) |
|                                                                                 |       |                                        |       |                                       |       |   |   |   |   |
| Net  loss                                                                            |       | (13,962,722                                 | )          | (4,342,378                                 | )          | (26,607,669 | ) | (31,213,163 | ) |
| Basic  and diluted net loss per share                                                |       | $                                           | (0.50      | )                                          | $          | (0.20 | ) | $ | (0.97 | ) | $ | (1.41 | ) |
| Weighted  average shares used in calculation of basic and diluted net loss per share |       | 28,077,348                                  |       | 22,095,545                                 |       | 27,388,761 |   | 22,089,949 |   |

 

See the accompanyingnotes to the condensed consolidated financial statements.

 

2

----

Table ofContents

 

**PHARMATHENE, INC.**

**UNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF CASHFLOWS**

 
| ** **                                                                   | ** ** | **Nine  months ended September 30,** | ** **  |
|------------------------------------------------------------------------------|------------|-------------------------------------------|-------------|
| ** **                                                                   | ** ** | **2009**                                  | ** **  | **2008** | ** ** |
| **Operating activities**                                                     |       |                                      |        |   |   |
| Net  loss                                                                    |       | $                                         | (26,607,669 | ) | $ | (31,213,163 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                                      |        |   |   |
| Acquired  in-process research and development                                |       | —                                    |        | 16,131,002 |   |
| Loss  on early extinguishment of debt                                        |       | 4,690,049                                 |        | — |   |
| Change  in fair value of derivative instruments                              |       | 295,218                                   |        | (123,148 | ) |
| Depreciation  and amortization                                               |       | 639,924                                   |        | 641,425 |   |
| Measurement  period changes in purchase accounting estimates                 |       | 154,456                                   |        | — |   |
| Share-based  compensation                                                    |       | 2,725,246                                 |        | 1,976,497 |   |
| Non-cash  interest expense on debt                                           |       | 605,265                                   |        | 1,292,598 |   |
| Changes  in operating assets and liabilities:                                |       |                                      |        |   |   |
| Accounts  receivable                                                         |       | 3,834,970                                 |        | (1,521,184 | ) |
| Prepaid  expenses and other assets                                           |       | (12,913,132                               | )           | (124,912 | ) |
| Accounts  payable                                                            |       | (2,840,700                                | )           | (1,446,808 | ) |
| Accrued  expenses and other liabilities                                      |       | 7,453,987                                 |        | 5,012,542 |   |
| Net  cash used in operating activities                                       |       | (21,962,386                               | )           | (9,375,151 | ) |
| **Investing activities**                                                     |       |                                      |        |   |   |
| Purchases  of property and equipment                                         |       | (1,539,537                                | )           | (455,242 | ) |
| Purchase  of letter of credit                                                |       | —                                    |        | (14,500,000 | ) |
| Purchases  of available-for-sale investments                                 |       | (8,800,640                                | )           | (11,577,455 | ) |
| Sales  of available-for-sale investments                                     |       | 4,600,000                                 |        | 20,624,293 |   |
| Payments  for purchase business combination                                  |       | (7,000,000                                | )           | (11,556,117 | ) |
| Net  cash used in investing activities                                       |       | (12,740,177                               | )           | (17,464,521 | ) |
| **Financing activities**                                                     |       |                                      |        |   |   |
| Issuance  of convertible notes                                               |       | 10,528,196                                |        | — |   |
| Payments  of long-term debt                                                  |       | (9,538,016                                | )           | (3,000,000 | ) |
| Decrease  in restricted cash requirements                                    |       | 13,250,000                                |        | — |   |
| Other  financing costs                                                       |       | (551,090                                  | )           | (206,154 | ) |
| Proceeds  from issuance of common stock                                      |       | 4,946,710                                 |        | — |   |
| Net  cash provided by (used in) financing activities                         |       | 18,635,800                                |        | (3,206,154 | ) |
|                                                                         |       |                                      |        |   |   |
| Effects  of exchange rates                                                   |       | 502,631                                   |        | (395,898 | ) |
| Decrease  in cash and cash equivalents                                       |       | (15,564,132                               | )           | (30,441,724 | ) |
| Cash  and cash equivalents, at beginning of period                           |       | 19,752,404                                |        | 40,582,643 |   |
| Cash  and cash equivalents, at end of period                                 |       | $                                         | 4,188,272   |   | $ | 10,140,919 |   |
|                                                                         |       |                                      |        |   |   |
| **Supplemental disclosure of non-cash financing  activities:**               |       |                                      |        |   |   |
| Exchange  of 8% convertible debt for 10% convertible debt and warrants       |       | $                                         | 8,767,606   |   | $ | — |   |

 

See the accompanyingnotes to the condensed consolidated financial statements.

 

3

----

Table of Contents

 

**PHARMATHENE, INC.**

**Notes to Condensed Consolidated Financial Statements**

**September 30, 2009**

**(unaudited)**

 

**Note 1 —Organization and Business**

 

Historically our operationswere conducted by our wholly-owned subsidiary PharmAthene US Corporation. In March 2008, PharmAthene Inc., through its wholly-owned subsidiaryPharmAthene UK Limited, acquired substantially all the assets and liabilitiesrelated to the biodefense vaccines business (the “Avecia Acquisition”) ofAvecia Biologics Limited (along with its affiliates, “Avecia”).  In February 2009,PharmAthene US Corporation was merged with and into PharmAthene, Inc.,with PharmAthene, Inc. being the surviving corporation.

 

We are abiopharmaceutical company focused on developing biodefense countermeasureapplications.  We are subject to those risks associated with anybiopharmaceutical company that has substantial expenditures for research anddevelopment.  There can be no assurance that our research and developmentprojects will be successful, that products developed will obtain necessaryregulatory approval, or that any approved product will be commerciallyviable.  In addition, we operate in an environment of rapid technologicalchange and are largely dependent on the services and expertise of ouremployees, consultants and other third parties.

 

**Note 2 —Summary of Significant Accounting Policies**

 

***Basis of Presentation***

 

The consolidatedfinancial statements include the accounts of PharmAthene, Inc. and itswholly-owned subsidiaries, PharmAthene U.S. Corporation, PharmAthene Canada, Inc.,and PharmAthene UK Limited, collectively referred to herein as “PharmAthene”, “we”,“us”, “our” or the “Company”.  All significant intercompany transactionsand balances have been eliminated in consolidation.  In the opinion of management, the accompanyingunaudited condensed consolidated financial statements include all adjustments,consisting of normal recurring adjustments, which are necessary to presentfairly our financial position, results of operations and cash flows. Theinterim results of operations are not necessarily indicative of the resultsthat may occur for the full fiscal year. The condensed consolidated balancesheet at December 31, 2008 has been derived from audited consolidatedfinancial statements at that date.  Thesecondensed statements should be read in conjunction with the ConsolidatedFinancial Statements and Notes included in our Annual Report on Form 10-Kfor the year ended December 31, 2008 filed with the Securities andExchange Commission.

 

We currently operate inone business segment.

 

***Use of Estimates***

 

The preparation offinancial statements in conformity with generally accepted accountingprinciples in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities,disclosure of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period.  Actual results could differ from those estimates.

 

***Comprehensive Loss***

 

Comprehensive lossincludes the total of our net loss and all other changes in equity other thantransactions with owners, including (i) changes in equity for cumulativetranslation adjustments resulting from the consolidation of foreignsubsidiaries as the financial statements of the subsidiaries located outside ofthe United States are accounted for using the local currency as the functionalcurrency, and (ii) unrealized gains

 

4

----

Table of Contents

 

and losses on short termavailable-for-sale investments.  Comprehensive loss for the three monthperiods ended September 30, 2009 and 2008 was approximately $12.7 millionand $4.5 million, respectively.  Comprehensive loss for the nine monthperiods ended September 30, 2009 and 2008 was approximately $26.1 millionand $31.6 million, respectively.

 

***Basic and Diluted Net Loss Per Share***

 

Basic loss per share iscomputed by dividing consolidated net loss by the weighted average number ofcommon shares outstanding during the period, excluding unvested restrictedstock. For the periods presented in the accompanying condensed consolidatedstatements of operations, diluted loss per share is calculated similarlybecause the impact of all potentially dilutive securities is anti-dilutive dueto our net loss each period.  At September 30, 2009 and 2008 we hadtotal potential dilutive securities outstanding of approximately 19.3 millionshares and 16.2 million shares, respectively (related to outstanding stockoptions, outstanding stock purchase warrants, shares underlying our convertiblenotes, and unvested restricted stock) that we excluded from the calculation ofdiluted net loss per share since their inclusion would be anti-dilutive.

 

***Fair Value of Financial Instruments***

 

Our financial instrumentsprimarily include cash and cash equivalents, accounts receivable, short-terminvestments and other current assets, accounts payable, accrued and otherliabilities, convertible notes and long-term debt.  Due to the short-termnature of the cash and cash equivalents, accounts receivable, short-term investmentsand other current assets, accounts payable and accrued and other liabilities(including derivative instruments), the carrying amounts of these assets andliabilities approximate their fair value.  The carrying values of ourconvertible notes and other long term debt approximate their fair values, basedon our current incremental borrowing rates.

 

Short-term investmentsconsist of investment grade government agency and corporate debt securities duewithin one year.  All investments are classified as available-for-sale andare recorded at market value.  Unrealized gains and losses are reflectedin other comprehensive loss.  The estimated fair value of theavailable-for-sale securities is determined based on quoted market prices orrates.  Management reviews our investment portfolio on a regular basis andseeks guidance from our professional portfolio manager related to U.S. andglobal market conditions.  We assess the risk of impairment related tosecurities held in our investment portfolio on a regular basis and identifiedno permanent or “other-than-temporary” impairment during the quarter and ninemonths ended September 30, 2009.   Refer to Note 3.

 

***Concentration of Credit Risk***

 

Financial instrumentsthat potentially subject us to concentrations of credit risk are primarily cashand cash equivalents, investments and accounts receivable.  We maintainour cash and cash equivalents and investment balances in the form of moneymarket accounts, corporate and government debt securities and overnightdeposits with financial institutions that management believes arecreditworthy.  Our accounts receivables are primarily from agencies withinthe U.S. government, including the U.S. Department of Defense (the “DoD”), theNational Institute of Allergy and Infectious Diseases (“NIAID”), the BiomedicalAdvanced Research and Development Authority (“BARDA”), and the NationalInstitute of Health (“NIH”).

 

***Intangible Assets***

 

Patents are carried atcost less accumulated amortization which is calculated on a straight line basisover the estimated useful lives of the patents, currently estimated to be 11years.  Goodwill represents the excess of purchase price over the fairvalue of net identifiable assets associated with the Avecia Acquisition. We review the carrying value of our intangible assets for impairment annuallyduring the fourth quarter or more frequently if impairment indicatorsexist.  Evaluating for impairment requires management judgment, includingthe estimation of future cash flows, future growth rates and profitability andthe expected life over which cash flows will occur.  Changes in theCompany’s business strategy or adverse changes in

 

5

----

Table of Contents

 

market conditions couldimpact impairment analyses and require the recognition of an impairment chargeequal to the excess of the carrying value of the intangible asset over itsestimated fair value.  For the three and nine month periods ended September 30,2009, we determined that there was no impairment of our intangible assets.

 

***Revenue Recognition***

 

Our contracts may includemultiple elements, including one or more of up-front license fees, researchpayments, and milestone payments.  In these situations, we allocate thetotal contract price to the multiple elements based on their relative fairvalues and recognize revenue for each element according to its characteristics.  We generate our revenue from two different types ofcontractual arrangements:  cost-plus-fee contracts and cost reimbursablegrants.  Revenues on cost-plus-fee contracts are recognized to the extentof costs incurred plus an estimate of the applicable fees earned.  Weconsider fixed fees under cost-plus-fee contracts to be earned in proportion tothe allowable costs incurred in performance of the contract.  We analyzeeach cost reimbursable grant to determine whether we should report suchreimbursements as revenue or as an offset to our expenses incurred.  For thethree months ended September 30, 2009 and 2008, the Company recordedapproximately $0.2 million and $0.9 million, respectively, of costs reimbursedby the government as an offset to research and development expenses.  Forthe nine months ended September 30, 2009 and 2008, the Company recordedapproximately $1.4 million and $1.7 million, respectively, of costs reimbursedby the government as an offset to research and development expenses.

 

As revenue is recognizedin accordance with the terms of our contracts, related amounts are recorded asunbilled receivables, the primary component of “Other receivables (includingunbilled receivables)”.  As specific contract invoices are generated andsent to our government customer, invoiced amounts are transferred out of unbilledreceivables and into accounts receivable.

 

***Collaborative Arrangements***

 

We are an activeparticipant with exposure to significant risks and rewards of commercializationrelating to the development of several of our pipeline products.  Forcosts incurred and revenues generated from third parties where we are deemed tobe the principal participant, we recognize revenues and costs using the grossbasis of accounting; otherwise, we use the net basis of accounting.

 

***Research and Development***

 

Research and developmentcosts are expensed as incurred; advance payments are deferred and expensed asperformance occurs.  Research and development costs include salaries,facilities expense, overhead expenses, material and supplies, pre-clinicalexpense, clinical trials and related clinical manufacturing expenses,stock-based compensation expense, contract services and other outside services.

 

***Share-Based Compensation***

 

We expense the estimatedfair value of share-based awards granted to our employees under our stock-basedcompensation plans.  Share-based compensation cost is determined at thegrant date using an option pricing model.  The value of the award that isultimately expected to vest is recognized as expense on a straight line basisover the employee’s requisite service period.  We have estimated the fairvalue of each award using the Black-Scholes option pricing model.  TheBlack-Scholes model considers, among other factors, the expected life of theaward and the expected volatility of the Company’s stock price; we have notmade any significant changes to these factors during 2009.

 

Employee share-basedcompensation expense recognized for the three and nine months ended September 30,2009 and 2008  was calculated based on awards ultimately expected to vestand has been reduced for estimated forfeitures at a rate of approximately 17%for both stock options and restricted shares, based on our historicalforfeitures.  Share-based compensationexpense for the three and nine months ended September 30, 2009 and 2008,respectively, was:

 

6

----

Tableof Contents

 
| ** **                              | ** ** | **Three  months ended  September 30,** | ** ** | **Nine  months ended  September 30,** | ** ** |
|-----------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                              | ** ** | **2009**                                    | ** ** | **2008**                                   | ** ** | **2009** | ** ** | **2008** | ** ** |
| Research  and development               |       | $                                           | 179,559    |                                       | $          | 124,038 |   | $ | 646,028 |   | $ | 317,967 |   |
| General  and administrative             |       | 806,112                                     |       | 784,030                                    |       | 2,079,218 |   | 1,658,530 |   |
| Total  share-based compensation expense |       | $                                           | 985,671    |                                       | $          | 908,068 |   | $ | 2,725,246 |   | $ | 1,976,497 |   |

 

During the nine months ended September 30,2009, we granted 1,507,350 options to employees and non-employee directors, andmade restricted stock grants of 258,633. At September 30, 2009, we have total unrecognized stock basedcompensation expense related to unvested awards of approximately $6.7 millionthat we expect will be recognized over the next three years.

 

***Income Taxes***

 

We account forincome taxes using the asset and liability method. Under this method, deferredtax assets and liabilities are recorded for the estimated future taxconsequences attributable to differences between the financial statementcarrying amounts of assets and liabilities and their respective tax bases.Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. The effect of a tax ratechange on deferred tax assets and liabilities is recognized in income in theperiod that includes the enactment date. We record valuation allowances toreduce net deferred tax assets to the amount considered more likely than not tobe realized. Changes in estimates of future taxable income can materiallychange the amount of such valuation allowances.  As of September 30,2009, we had recognized a valuation allowance to the full extent of our netdeferred tax assets since the likelihood of realization of the benefit does notmeet the more likely than not threshold.  We believe that any uncertain tax position taken inthe past would not result in an adjustment to our effective income tax ratebecause adjustments to deferred tax assets and liabilities would be offset byadjustments to recorded valuation allowances.  We file a U.S. federalincome tax return as well as returns for various state and foreignjurisdictions.  The Company’s income taxes have not been examined by anytax jurisdiction since our inception.

 

***RecentAccounting Pronouncements***

 

In August 2009, theFinancial Accounting Standards Board issued Accounting Standards Update 2009-05,“Fair Value Measurements and Disclosures (Topic 820) Measuring Liabilities atFair Value (“ASU 2009-05”).  ASU 2009-05clarifies that in circumstances in which a quoted market price in an activemarket for the identical liability is not available, a reporting entity isrequired to measure fair value using one of several acceptable valuationtechniques.  ASU 2009-05 also clarifies (i) thatwhen estimating the fair value of a liability, a reporting entity is notrequired to include a separate input or adjustments to other inputs relatingthe existence of a restriction that prevents the transfer of the liability, and(ii) that both a “quoted price in an active market for the identicalliability at the measurement date” and the “quoted price for the identicalliability when traded as an asset in a active market when no adjustments to thequoted price of the asset are required” are Level 1 fair valuemeasurements.  ASU 2009-05 is effectivein the fourth quarter of 2009.  TheCompany has not yet determined the impact of the adoption of ASU 2009-05 on itsfinancial statements.

 

In October 2009, theFinancial Accounting Standards Board issued Accounting Standards Update2009-13, “Revenue Recognition (Topic 605) Multiple-Deliverable RevenueArrangements, a consensus of the FASB Emerging Issues Task Force (“ASU 2009-13”).    ASU 2009-13 amends existing accountingguidance for separating consideration in multiple-deliverablearrangements.  ASU 2009-13 establishes aselling price hierarchy for determining the selling price of adeliverable.  The selling price used foreach deliverable will be based on vendor-specific objective evidence ifavailable, third-party evidence if vendor-specific evidence is not available,or estimated selling price if neither vendor-specific evidence nor third-partyevidence is available.  ASU 2009-13eliminates residual method of allocation and requires that arrangementconsideration be allocated at the inception of the arrangement to alldeliverables using the “relative selling price method.”

 

7

----

Table of Contents

 

The relative sellingprice method allocates any discount in the arrangement proportionately to eachdeliverable on the basis of each deliverable’s selling price.  ASU 2009-13 requires that a vendor determineits best estimate of selling price in a manner that is consistent with thatused to determine the price to sell the deliverable on a stand-alone basis.  ASU 2009-13 is effective prospectively forrevenue arrangements entered into or materially modified in fiscal yearsbeginning on or after June 15, 2010, with earlier adoption permitted.  The Company has not yet determined the impactof the adoption of ASU 2009-13 on its financial statements.

 

**Note 3 —Fair Value Measurements**

 

We define fair value asthe exchange price that would be received for an asset or paid to transfer aliability (an exit price) in the principal or most advantageous market for theasset or liability in an orderly transaction between market participants at themeasurement date.  We report our assets and liabilities that are measuredat fair value using a three-level fair value hierarchy that prioritizes theinputs used to measure fair value.  This hierarchy maximizes the use ofobservable inputs and minimizes the use of unobservable inputs.  The threelevels of inputs used to measure fair value are as follows:

 

·                  Level 1 — Quoted prices in active markets foridentical assets or liabilities.

·                  Level 2 — Observable inputs other than quoted pricesincluded in Level 1, such as quoted prices for similar assets and liabilitiesin active markets; quoted prices for identical or similar assets andliabilities in markets that are not active; or other inputs that are observableor can be corroborated by observable market data.

·                  Level 3 — Unobservable inputs that are supported bylittle or no market activity and that are significant to the fair value of theassets or liabilities.  This includes certain pricing models, discountedcash flow methodologies and similar techniques that use significantunobservable inputs.

 

An asset’s or liability’slevel within the fair value hierarchy is based on the lowest level of any inputthat is significant to the fair value measurement. At each reporting period, weperform a detailed analysis of our assets and liabilities that are measured atfair value.  All assets and liabilities for which the fair valuemeasurement is based on significant unobservable inputs or instruments whichtrade infrequently and therefore have little or no price transparency areclassified as Level 3.

 

We have segregated ourfinancial assets and liabilities that are measured at fair value into the mostappropriate level within the fair value hierarchy based on the inputs used todetermine the fair value at the measurement date in the table below.  Wehave no non-financial assets and liabilities that are measured at fair value.

 
| ** **                     | ** ** | **as  of September 30, 2009** | ** ** |
|--------------------------------|------------|------------------------------------|------------|
| ** **                     | ** ** | **Level  1**                       | ** ** | **Level  2** | ** ** | **Level  3** | ** ** | **Balance** | ** ** |
| **Assets**                     |       |                               |       |   |   |   |   |   |   |
| Available-for-sale  securities |       | $                                  | 7,328,329  |   | $ | — |   | $ | — |   | $ | 7,382,329 |   |
|                           |       |                               |       |   |   |   |   |   |   |
| **Liabilities**                |       |                               |       |   |   |   |   |   |   |
| Stock  purchase warrants       |       | $                                  | —     |   | $ | — |   | $ | 2,174,299 |   | $ | 2,174,299 |   |

 

8

----

Table of Contents

 

The following table setsforth a summary of changes in the fair value of our Level 3 liabilities for thenine months ended September 30, 2009:

 
| ** **                  | ** ** | ** **              | ** ** | **Cumulative  Effect**        | ** ** | ** **               | ** ** | ** **          | ** ** | **Balance**                  | ** ** |
|-----------------------------|------------|-------------------------|------------|-------------------------------|------------|--------------------------|------------|---------------------|------------|------------------------------|------------|
| ** **                  | ** ** | **Balance  at**         | ** ** | **of  Adoption of**           | ** ** | **New**                  | ** ** | **Unrealized**      | ** ** | **as  of**                   | ** ** |
| **Description**             | ** ** | **Dec. 31,  2008** | ** ** | **New  Accounting  Guidance** | ** ** | **Liabilities  In 2009** | ** ** | **(Gains)  Losses** | ** ** | **September 30,  2009** | ** ** |
| Embedded  conversion option |       | $                       | 6,405      |                          | $          | —                   |       | $                   | —     |                         | $          | (6,405 | ) | $ | — |   |
| Stock  purchase warrants    |       | $                       | —     |                          | $          | 636,609                  |       | $                   | 1,236,067  |                         | $          | 301,623 |   | $ | 2,174,299 |   |

 

The unrealized losses onthe derivative instruments are classified in other expenses as the change inderivative instruments in our condensed consolidated statement of operations.The fair value of our stock purchase warrants and conversion option isdetermined based on the Black-Scholes option pricing model.

 

**Note 4 - Short-Term Investments — Available-for-SaleSecurities**

 

The amortized cost, grossunrealized gains, gross unrealized losses and estimated fair value ofavailable-for-sale short-term investments by security classification as of September 30,2009 were as follows:

 
| ** **                  | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | **Estimated** | ** ** |
|-----------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------|------------|
| ** **                  | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**      | ** ** |
| **September 30, 2009** | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Values**    | ** ** |
| Corporate  debt securities  |       | $             | 4,769,207  |           | $          | 8,591          |       | $             | (1,685     | ) | $ | 4,776,113 |   |
| Government  debt securities |       | $             | 2,605,661  |           | $          | 561            |       | $             | (6         | ) | $ | 2,606,216 |   |
| Total  securities           |       | $             | 7,374,868  |           | $          | 9,152          |       | $             | (1,691     | ) | $ | 7,382,329 |   |

 

During the nine monthsended September 30, 2009, we had no realized gains or losses on sales ofavailable-for-sale securities.  Gains and losses on available-for-salesecurities are based on the specific identification method.

 

**Note 5 —Debt**

 

***Convertible Notes***

 

Our 8% senior unsecuredconvertible notes accrued interest at an interest rate of 8% per annum and wereto mature on August 3, 2009 (the “Old Notes”).  The principal amountof the Old Notes and any accrued interest were convertible into shares ofPharmAthene common stock at the option of the holder at any time based upon aconversion rate of $10.00 per share.  In July 2009, we cancelled aportion of the Old Notes, and issued new convertible notes and stock purchasewarrants to holders of the cancelled notes as well as to certain new noteinvestors in a private placement (the “July 2009 Private Placement”). Specifically, in connection with the July 2009 Private Placement, we:

 

·                  exchanged a portion of our Old Notes in the aggregate principalamount plus accrued interest totaling $8.8 million for new two-year 10%unsecured senior convertible notes, convertible into common shares at aconversion price of approximately $2.54 per share (the “New Convertible Notes”)and cancelled the corresponding Old Notes;

·                  issued additional New Convertible Notes in theaggregate principal amount of $10.5 million to new note investors;

·                  issued to the recipients of the New Convertible Notesstock purchase warrants to purchase up to 2,572,775shares of common stock at $2.50 per share, whichwarrants are exercisable from January 28, 2010 through January 28,2015; and

·                  used the proceeds from the sale of the New ConvertibleNotes to repay $5.5 million of our Old Notes that were not exchanged for theNew Convertible Notes and warrants and repaid all outstanding amounts and feesunder our existing credit facility.

 

The New Convertible Notesissued in exchange for the Old Notes were accounted for as an earlyextinguishment of debt, resulting in a loss on extinguishment of the Old Notesof approximately $4.7 million.  Thisportion of the New Convertible Notes and the related stock purchase warrantswere recorded

 

9

----

Table of Contents

 

at their fair values,resulting in an increase to additional paid-in capital for the premiumassociated with the New Convertible Notes and the value attributed to thewarrants.

 

The New Convertible Notesand related stock purchase warrants issued to new note investors were initiallyrecorded at their relative fair values. As a result of this relative fair valueallocation, the total value allocated to the New Convertible Notes issued tonew note investors was $7.3 million. In combination with the $8.8 million ofNew Convertible Notes issued to the Old Note holders, the total initial valueascribed to the New Convertible Notes was approximately $16.1 million. Theinitial value of $16.1 million will be accreted up to the total aggregate principalamount of $19.3 million over the life of the notes by the recognition ofadditional interest expense. The total value of the New Convertible Notes,including accretion from additional interest expense, as of September 30,2009, was approximately $16.6 million.

 

Financing costs incurredin connection with the July 2009 Private Placement were allocated to thevarious components of consideration based on their relative fair values.

 

***Credit Facility***

 

In March 2007, weentered into a $10 million credit facility with Silicon Valley Bank and OxfordFinance Corporation (together, the “Lenders”).  In July 2009, werepaid all outstanding amounts due under the credit facility along with certainprepayment fees.  In connection with the credit facility, we issued to theLenders certain stock purchase warrants, which expire on March 30, 2017,to purchase an aggregate of 100,778 shares of the Company’s common stock at$3.97 per share.

 

**Note 6 —Avecia Acquisition**

 

***Avecia Settlement Agreement***

 

In June 2009,PharmAthene and Avecia entered into a settlement agreement (i) to resolvecertain issues related to the wind down and cancellation of work related to ourrPA vaccine program being conducted at Avecia pursuant to a master servicesagreement (“MSA”) between our two organizations, and (ii) to acceleratethe payment of certain deferred consideration related to the AveciaAcquisition.  Under the settlement agreement:

 

·                  we paid Avecia $7.0 million of theremaining deferred purchase price consideration under the Avecia Acquisition,and as a result our existing letter of credit that had supported the deferredconsideration (and the related requirement to maintain restricted cash ascollateral for the letter of credit) was terminated in June 2009;

·                  we agreed to pay Avecia approximately$1.8 million related to past performance and raw materials under the MSAsubject to certain remaining performance obligations by Avecia related to,among other things, the technology transfer effort to a new U.S.-based bulkdrug substance manufacturer; and

·                  we agreed to pay Avecia approximately$3.0 million in cancellation fees no later than January 5, 2010 (andearlier if certain other conditions are met).

 

In June 2009, theCompany expensed as allowable costs under its government contract the $1.8million payment for past contract performance and recognized related contractrevenues.  The Company also expensed the $3.0 million cancellation fee in June 2009.

 

***Contemplated Exit Activities***

 

In the second quarter2009, our existing research and development contract for SparVaxTM wastransferred from NIAID to BARDA.  In the third quarter 2009 BARDA andPharmAthene modified the existing statement of work to include, among otherthings, the completion of on-going stability studies and development of potencyassays along with certain manufacturing scale-up and technology transferactivities to a U.S.-based manufacturer for the bulk drug substance forSparVaxTM.****We then entered into a correspondingsubcontract with our U.S.-based manufacturer.

 

10

----

Table of Contents

 

As a result of thetransfer of the contract and modification of the statement of work, we havebeen transitioning development and manufacturing activities as well as othergeneral and administrative functions from the UK to the U.S.  Inconnection with this transition, we anticipate relocating our UK operations,including terminating our UK workforce, by June 30, 2010.  In the third quarter of 2009 we incurredexpenses associated with these exit activities of approximately $1.6 million.

 

***License Agreements***

 

In connection with theAvecia Acquisition, we acquired license agreements with The Defence Science andTechnology Laboratory of the United Kingdom Ministry of Defence (“DSTL”) forthe rights to certain technologies.  These agreements allow for thelicensing of specified patents and technology necessary to perform developmentof the rPA and rYP programs as required under our contracts with NIAID andBARDA.  Upon commercialization, the license agreements require us to makeroyalty payments equal to a specified percentage of future sales of productsfor both government procurement and commercial markets.  No payments onthese licenses have been incurred. In February 2009, both of theselicenses were amended and restated to broaden the scope of exclusivity andaddress other general business issues.

 

**Note 7 —Common Stock**

 

***Common Stock***

 

In March 2009, theCompany completed a public sale of 2,116,055 newly issued shares of its commonstock at $2.60 per share and warrants to purchase 705,354 shares of its commonstock at an exercise price of $3.00 per share, generating gross proceeds of$5.5 million.  The warrants became exercisable on September 27, 2009and will expire on September 27, 2014.

 

***Share-Based Awards***

 

Prior to 2007, we grantedshare-based awards pursuant to our 2002 Long-Term Incentive Plan (the “2002Plan”).  In connection with the merger between the subsidiary ofHealthcare Acquisition Corp. (“HAQ”) and PharmAthene, Inc. on August 3,2007 (the “Merger”), we assumed all outstanding awards that had been initiallygranted under the 2002 Plan.  No further grants are being made under the2002 Plan.  On August 3, 2007, ourstockholders approved the 2007 Long Term Incentive Plan (the “2007 Plan”) whichprovides for the granting of incentive and non-qualified stock options, stockappreciation rights, performance units, restricted common awards andperformance bonuses (collectively “awards”)  to our officers andemployees.  Additionally, the 2007 Plan authorizes the granting ofnon-qualified stock options and restricted stock awards to our directors and toindependent consultants.

 

At that time, we reserved3,500,000 shares of common stock in connection with awards to be granted underthe 2007 Plan, including those awards that had originally been made under the2002 Plan.  In 2008, our shareholders approved amendments to the 2007Plan, increasing from 3,500,000 shares to 4,600,000 shares the maximum numberof shares authorized for issuance under the plan and adding an evergreenprovision pursuant to which the number of shares authorized for issuance underthe plan will increase automatically in each year, beginning in 2009 andcontinuing through 2015, according to certain limits set forth in the 2007Plan.  The Board of Directors in conjunction with management determineswho receives awards, the vesting conditions, which are generally four years,and the exercise price.  Options may have a maximum term of ten years.

 

***Unit Purchase Option***

 

In connection with theinitial public offering of HAQ in 2005, the underwriters paid $100 for anoption to purchase up to a total of 225,000 units.  The units issuableupon exercise of this option are identical to those offered in the initialpublic offering (i.e. each unit consists of one share of common stock and onewarrant) except that the associated warrants have a higher exercise price (seebelow).  The unit purchase option became exercisable at $10.00 per unit onAugust 3, 2007, and expires on July 27, 2010 (except that the warrantincluded in such option expired unexercised on July 27, 2009).  Theexercise price and number

 

11

----

Table of Contents

 

of units issuable uponthe exercise of the option may be adjusted in certain circumstances includingin the event of a stock dividend, or recapitalization, reorganization, mergeror consolidation.  We are not obligated to pay cash or other considerationto the holders of the unit purchase option or “net-cash settle” the obligationof HAQ under the unit purchase option.

 

***Stock Purchase Warrants***

 

In connection with HAQ’sinitial public offering in 2005, HAQ sold warrants to acquire approximately 9.4million shares of common stock at an exercise price of $6.00 per share; thewarrants expired unexercised on July 27, 2009.  HAQ also issued tothe representative of the underwriters an option to purchase up to a total of225,000 units (as discussed above).  Underlying the units are 225,000shares of common stock and warrants to acquire 225,000 shares of common stockat an exercise price of $7.50 per share. All warrants expired unexercised on July 27, 2009.

 

Pursuant to the terms ofour credit facility (all outstanding amounts under which were repaid in full inJuly 2009), we issued to the Lenders 100,778 common stock warrants with anexercise price of $3.97 per share.  Thewarrants expire in 2017, and are classified in equity.

 

In connection with astock purchase by Kelisia Holdings Ltd. in 2008, we issued a warrant topurchase up to 2,745,098 additional shares of our common stock at an exerciseprice of $5.10 per share.  This warrant expired unexercised on October 10,2009.

 

Prior to our adoption on January 1,2009 of new accounting guidance related to the determination of derivativeliabilities, we classified our stock purchase warrants as equity in ourconsolidated balance sheets.  As a result of our adoption of the newaccounting guidance, we considered the warrant issued to Kelisia Holdings Ltd.to be a derivative liability and reclassified the warrant to reflect it as aliability in our consolidated balance sheets.  The impact of adopting thisnew guidance resulted in an increase in our retained deficit and a decrease toour additional paid in capital at January 1, 2009 of approximately$213,000 and $423,000, respectively, along with an increase in our reportedliabilities of approximately $637,000.

 

In connection with the March 27,2009 public offering of approximately 2.1 million shares, we issued warrants topurchase an aggregate of 705,354 shares of our common stock at an exerciseprice of $3.00 per share.  The warrants became exercisable on September 27,2009 and will expire on September 27, 2014.  We consider thesewarrants to be a derivative liability and as such reflect the liability at fairvalue in our condensed consolidated balance sheets.  The fair value ofthis derivative liability will be re-measured at the end of every reportingperiod and the change in fair value will be reported in the consolidatedstatement of operations as other income (expense).

 

In connection with the July 2009Private Placement, we issued warrants to purchase an aggregate of 2,572,775shares of our common stock at an exerciseprice of $2.50 per share.  The warrantswill be exercisable beginning January 28, 2010 and will expire on January 28,2015, and classified in equity.

 

**Note 8 —Commitments and Contingencies**

 

In December 2006,the Company filed a complaint against Siga Technologies, Inc. (“SIGA”) inthe Delaware Chancery Court.  The complaint alleges, among other things,that the Company has the right to license exclusively development and marketingrights for SIGA’s drug candidate, SIGA-246, pursuant to a merger agreementbetween the parties (the “Merger Agreement”) that was terminated in October 2006. The complaint also alleges that SIGA failed to negotiate in good faith theterms of such a license pursuant to the terminated merger agreement.

 

The Company is seekingalternatively a judgment requiring SIGA to enter into an exclusive licenseagreement with the Company for SIGA-246 in accordance with the terms of theterm sheet attached to the merger agreement or monetary damages.  In January 2008,the Delaware Chancery Court issued a ruling denying a motion by SIGA to dismissthe complaint.  SIGA has filed a counterclaim against the Company

 

12

----

Table of Contents

 

alleging that the Companybreached its duty to engage in good-faith negotiations by, among other things,presenting SIGA with a bad-faith initial proposal for a license agreement thatdid not contain all necessary terms, demanding SIGA prepare a complete draft ofa partnership agreement and then unreasonably rejecting that agreement, andunreasonably refusing to consider economic terms that differed from those setforth in the license agreement term sheet attached to the MergerAgreement.  SIGA is seeking recovery of its reliance damages from thisalleged breach.

 

Fact discovery in thecase is now complete, and the parties are engaged in expert witness discovery,which the Company believes will be complete in February 2010.  Following that, if neither party filesmotions for summary judgment, the Company believes the case could proceed totrial in March or April 2010, subject to the court’s docket andschedule.  If one or both of the partiesfiles motions for summary judgment, the Company believes a trial in the case isunlikely to occur before the end of the third quarter 2010, depending on thetiming and outcome of the court’s ruling on the motions for summary judgmentand the court’s docket and schedule at that time.

 

The Company entered intoa Registration Rights Agreement with the investors who participated in the July 2009Private Placement.  The Companysubsequently filed a registration statement on Form S-3 with theSecurities and Exchange Commission to register shares underlying the NewConvertible Notes and related warrants. This registration statement has not yet been declared effective.  The Registration Rights Agreement requiresthe Company to cause the registration statement to be declared effective by November 25,2009 and thereafter to continuously keep such registration statement effective.

 

Under the terms of the New Convertible Notes,if the registration statement is not declared effective by November 25,2009 (“Effectiveness Failure”), or after the effective date of the registrationstatement, after the 2nd consecutive business day (other than during anallowable blackout period) on which sales of all of the securities required tobe included on the registration statement cannot be made pursuant to theregistration statement (a “Maintenance Failure”), we will be required to pay toeach selling stockholder a one-time payment of 1.0% of the aggregate principalamount of the New Convertible Notes relating to the affected shares on: (i) theday of an Effectiveness Failure and (ii) the initial day of a MaintenanceFailure.

 

Following an Effectiveness Failure orMaintenance Failure, we will also be required to make to each sellingstockholder monthly payments of 1.0% of the aggregate principal amount of theNew Convertible Notes relating to the affected shares on each of the followingdates:  (i) on every 30th day afterthe initial day of an Effectiveness Failure and (ii) on every 30th dayafter the initial day of a Maintenance Failure, in each case prorated forshorter periods and until the failure is cured.

 

**Note 9 —Subsequent Events**

 

Management performed anevaluation of Company activity through November 11, 2009, the date theunaudited condensed consolidated financial statements were issued.  TheCompany concluded that there are no other significant subsequent eventsrequiring disclosure.

 

**Item2.  Management’s Discussion andAnalysis of Financial Condition and Results of Operations.**

 

*ThisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended.  This information mayinvolve known and unknown risks, uncertainties and other factors that aredifficult to predict and may cause our actual results, performance orachievements to be materially different from future results, performance orachievements expressed or implied by any forward-looking statements. These risks, uncertainties and other factors include, but are not limited to,risk associated with the reliability of the results of the studies relating tohuman safety and possible adverse effects resulting from the administration ofthe Company’s product candidates, unexpected funding delays and/or reductionsor elimination of U.S. government funding for one or more of the Company’sdevelopment programs, including without limitation our bid related to SparVaxTMunder the DHHS Request for Proposals for an Anthrax Recombinant ProtectiveAntigen (rPA) Vaccine for the Strategic National Stockpile, the award ofgovernment contracts to our competitors, unforeseen safety issues, challengesrelated to the development, technology transfer, scale-up, and/or processvalidation of manufacturing processes for our product candidates, unexpecteddeterminations that these product candidates prove not to be effective and/orcapable of being marketed as products, as well as risks detailed from time totime in PharmAthene’s Forms 10-K and 10-Q under the caption “Risk Factors” andin its other reports filed with the U.S. Securities and Exchange Commission(the “SEC”).  Forward-looking statements describe management’s currentexpectations regarding our future plans, strategies and objectives and aregenerally identifiable by use of the words “may,” “will,” “should,” “expect,” “anticipate,”“estimate,” “believe,” “intend,”  “project,” “potential” or “plan” or thenegative of these words or other variations on these words or comparableterminology.  Such statements include, but are not limited to, statementsabout potential future government contract or grant awards, potential paymentsunder government contracts or grants, potential regulatory approvals, futureproduct advancements, anticipated financial or operational results and expectedbenefits from our acquisition of Avecia’s biodefense vaccines business. Forward-*

 

13

----

Table of Contents

 

*lookingstatements are based on assumptions that may be incorrect, and we cannot assureyou that the projections included in the forward-looking statements will cometo pass.*

 

*We havebased the forward-looking statements included in this Quarterly Report on Form 10-Qon information available to us on the date of this Quarterly Report, and weassume no obligation to update any such forward-looking statements, other thanas required by law.  Although we undertake no obligation to revise orupdate any forward-looking statements, whether as a result of new information,future events or otherwise, you are advised to consult any additionaldisclosures that we may make directly to you or through reports that we, in thefuture, may file with the SEC, including Annual Reports on Form 10-K,Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.*

 

The following discussionshould be read in conjunction with the our condensed consolidated financialstatements which present our results of operations for the three and ninemonths ended September 30, 2009 and 2008 as well as our financialpositions at September 30, 2009 and December 31, 2008, containedelsewhere in this Quarterly Report on Form 10-Q.  The followingdiscussion should also be read in conjunction with the Annual Report on Form 10-Kfor the year ended December 31, 2008 filed on March 31, 2009 and asamended on April 30, 2009, including the consolidated financial statementscontained therein.

 

**Overview**

 

We are a biodefensecompany engaged in the development and commercialization of medicalcountermeasures against biological and chemical weapons.  We currentlyhave five product candidates in various stages of development:

 

·                  SparVaxTM, a second generation recombinant protectiveantigen (“rPA”) anthrax vaccine,

·                  Valortim®, a fully human monoclonal antibody (anidentical population of highly specific antibodies produced from a singleclone) for the prevention and treatment of anthrax infection,

·                  Protexia®, which mimics a natural bioscavenger for thetreatment or prevention of nerve agent poisoning by organophosphate compounds,including nerve gases and pesticides,

·                  a third generation rPA anthrax vaccine, and

·                  RypVaxTM, a recombinant dual antigen vaccine forpneumonic and bubonic plague (“rYP”).

 

In August 2009 webegan a Phase I clinical trial of our Valortim® anthrax anti-toxin fully humanmonoclonal antibody in combination with the antibiotic ciprofloxacin. Duringthe course of the study, there were two adverse reactions in the four subjectsdosed, one of which was characterized by the clinical investigators as aserious adverse event.  While bothadverse reactions resolved after cessation of the administration of Valortim® andappropriate medical treatment, and neither of the subjects appears to haveexperienced any further or lasting adverse consequences, we temporarily haltedthe trial per the requirements of the clinical trial protocol and informed theU.S Food and Drug Administration (“FDA”) and the National Institute of Allergyand Infectious Diseases (NIAID) of these developments.  The FDA has placed theValortim®/ciprofloxacin study on partial clinical hold pending the outcome ofan investigation.  This clinical hold doesnot pertain to other Valortim® related development efforts under the existinginvestigational new drug (IND) application, and adverse reactions like thoseseen in this trial have been observed before with the administration of othermarketed monoclonal antibodies.

 

The Biomedical AdvancedResearch and Development Authority (“BARDA”) has also informed us that theywill

 

14

----

Tableof Contents

 

not make an award withrespect to our submission for additional advanced development funding for Valortim®under BAA-BARDA-09-34 until satisfactory resolution of this issue and theclinical hold is lifted, at which point we expect they will promptlyre-commence the negotiation process.  Theantibiotic interaction study is not on the critical development path for FDAlicensure for the product, and at this point the Company does not believe thedelay to this trial will impact the overall Valortim® developmenttimeline.  However, it is unclear at thistime how long it will take us to complete our investigation, if and when wewill be in a position to recommence negotiations with BARDA with respect to apotential award under the BAA, and how any delay in potential future funding ofthe program could affect the overall Valortim® development timeline.

 

**CriticalAccounting Policies**

 

***Estimates***

 

The preparation offinancial statements in conformity with generally accepted accountingprinciples in the U.S. requires us to make estimates and assumptions thataffect the reported amounts of assets and liabilities, disclosure of contingentassets and liabilities at the date of the financial statements, and thereported amounts of revenues and expenses during the reporting period.  Webase our estimates and assumptions on historical experience and various otherfactors that are believed to be reasonable under the circumstances. Actual results could differ from our estimates and assumptions.  We believe the following are our criticalaccounting policies, i.e., they affect our more significant estimates andassumptions and require the use of difficult, subjective and complex judgmentin their application.

 

***Share-Based Payments***

 

We expense allshare-based awards to employees, including grants of employee stock options,based on their estimated fair value at date of grant.  Costs of allshare-based payments are recognized over the requisite service period that anemployee must provide to earn the award (i.e. usually the vesting period) andcharged to the functional operating expense associated with that employee.

 

***Revenue Recognition***

 

Our revenue-generatingcontracts may include multiple elements, including one or more of up-frontlicense fees, research payments, and milestone payments.  In thesesituations, we allocate the total contract price to the multiple elements basedon their relative fair values and recognize revenue for each element accordingto its characteristics.  We generate our revenue from twodifferent types of contractual arrangements:  cost-plus-fee contracts andcost reimbursable grants.  Revenues on cost-plus-fee contracts arerecognized to the extent of costs incurred plus an estimate of the applicablefees earned.  We consider fixed fees under cost-plus-fee contracts to beearned in proportion to the allowable costs incurred in performance of thecontract.  We analyze each cost reimbursable grant to determine whether weshould report such reimbursements as revenue or as an offset to our expensesincurred.  As revenue is recognized inaccordance with the terms of our contracts, related amounts are recorded asunbilled receivables, the primary component of “Other receivables (includingunbilled receivables)”.  As specific contract invoices are generated andsent to our government customer, invoiced amounts are transferred out ofunbilled receivables and into accounts receivable.

 

***Research and Development Expenses***

 

Research and developmentcosts are expensed as incurred; advance payments are deferred and expensed asperformance occurs.  Research and development costs include salaries,facilities expense, overhead expenses, material and supplies, pre-clinicalexpense, clinical trials and related clinical manufacturing expenses,stock-based compensation expense, contract services and other outside services.

 

***Intangible Assets***

 

Because of the nature ofpharmaceutical research, and particularly because of the difficultiesassociated with efficacy studies in humans related to the bioterrorist productswith which we work and the government’s related funding provisions, factorsthat affect the estimate of the life of an asset are often more uncertain thanwith respect to other non-bioterrorist pharmaceutical research.  On anannual basis, we assess recoverability of intangible assets from futureoperations, using undiscounted future cash flows

 

15

----

Tableof Contents

 

derived from theintangible assets.  Any impairment would be recognized in operatingresults to the extent the carrying value exceeds the fair value, which isdetermined based on the net present value of estimated future cash flows; incertain situations, where the carrying value is dependent upon the outcome of asingle study and that study is unsuccessful, that impairment may be significantin amount and immediate in timing.

 

**Resultsof Operations for the Three and Nine Months ended September 30, 2009 and2008**

 

***Revenue***

 

We recognized revenue of$6.8 million and $10.7 million during the three months ended September 30,2009 and 2008, respectively.  We recognized revenue of $20.4 million and$27.4 million during the nine months ended September 30, 2009 and 2008,respectively.

 

Our revenue consistedprimarily of contract funding from the U.S. government for the development ofProtexia®, SparVaxTM and Valortim®.  Our revenue in each of the three and ninemonths ended September 30, 2009 changed from the comparable periods of2008 due to the following:

 

·                  Under the September 2006 contract with the U.S. Department ofDefense (“DoD”) for the advanced development of Protexia®, we recognized $1.5 million and $4.9 million ofrevenue for the three months ended September 30, 2009 and 2008,respectively.  We recognized $6.8 million and $17.6 million of revenue forthe nine months ended September 30, 2009 and 2008, respectively.  Thesignificant decline in revenue in 2009 is primarily attributable to the shiftof our Protexia® program from broad pre-clinical developmentefforts, including manufacturing, to a focus on clinical evaluation as well asthe completion, during the third quarter of 2009, of all work and relatedfunding under the initial phase of the contract with the DoD.  We believe that the DoD will make a decisionregarding funding for the next phase of the development work for Protexia® during thefirst quarter of 2010.  Consequently,during the fourth quarter of 2009 and until a funding decision is made, we donot expect to recognize revenues under this contract during that period.

 

·                  Under our contract for the development of SparVaxTM, acquired as part ofthe Avecia Acquisition in April 2008, we recognized approximately $2.4million and $3.8 million of revenue for the three months ended September 30,2009 and 2008, respectively.  We recognized $7.3 million and $6.0 millionof revenue for the nine months ended September 30, 2009 and 2008,respectively.  The nine month period in 2008 only includes revenuerecognized from and after April 2, 2008, the closing date of the AveciaAcquisition.  The rate of revenues (andcorresponding costs) recognized in the 2009 periods associated with work onthis development contract declined as compared to the same periods in 2008 aswe stopped our development work at Avecia, revised our development plan, andcommenced our efforts to transfer technology from Avecia to a US-based bulkdrug substance manufacturer.  For thenine month period, this decline was partially offset by revenue attributable toour June 2009 settlement agreement with Avecia, which included $1.8million related to past performance and raw materials under our master servicesagreement with Avecia.

 

·                  Under the September 2007 contract for theadvanced development of Valortim®,we recognized $2.0 million and $0.5 million of revenue for the three monthsended September 30, 2009 and 2008, respectively.  We recognized $4.2million and $1.0 million of revenue for the nine months ended September 30,2009 and 2008, respectively.  The increase in revenue for both the threeand nine month periods is primarily attributable to the reimbursement of highercosts related to pre-clinical studies as well other development work in the2009 periods as we prepared for and commenced human clinical trials.  For reasons discussed previously, we expectthat revenues for the rest of 2009 and into 2010 will not continue to increaseat this rate.

 

·                  Under our contract for the advanced development of ourplague vaccine, RypVaxTM, acquired as part of the Avecia Acquisition in April 2008,we recognized approximately $0.7 million and $1.6 million of revenue for thethree months ended September 30, 2009 and 2008, respectively.

 

16

----

Table of Contents

 

We recognized $1.5 millionand $2.9 million of revenue for the nine months ended September 30, 2009and 2008, respectively. ****We and theU.S. government have agreed to a reduction to the scope of work under ourcurrent contract that will result in early wind down of all activities underthat contract, likely no later than the end of the first half of 2010.  As such, we expect revenues and related costsunder that contract will decline over the wind down period.

 

·                  Under our September 2008 contract award for theadditional development work on our third generation rPA anthrax vaccine, werecognized approximately $0.2 million and $0.6 million of revenue for the threeand nine months ended September 30, 2009, respectively, and none in thecorresponding periods of 2008, as we began work under this contract in 2009.

 

***Research and Development Expenses***

 

Our research anddevelopment expenses were $7.6 million and $9.4 million for the three monthsended September 30, 2009 and 2008, respectively, and were $22.8 millionand $26.5 million for the nine months ended September 30, 2009 and 2008,respectively. These expenses resulted from research and development activitiesrelated to programs for Valortim® and Protexia®,as well as from activities related to the SparVaxTM, RypVaxTM and thirdgeneration anthrax vaccine programs.  Our research and development expensesare primarily funded through U.S. government contracts and grant awards. We incurred both direct expenses, which included salaries and other costs ofpersonnel, raw materials and supplies, and an allocation of indirectexpenses.  We also incurred third-party costs, such as contract research,consulting and clinical development costs for individual projects. Research and development expenses for the three and nine months ended September 30,2009 were net of cost reimbursements under certain of our government grants of$0.2 million and $1.4 million, respectively.  Research and developmentexpenses for the three and nine months ended September 30, 2008 were netof cost reimbursements under certain of our government grants of $0.9 millionand $1.7 million, respectively.

 

Research and developmentexpenses for the three and nine months ended September 30, 2009 and 2008were attributable to research programs as follows:

 
| ** **                               | ** ** | **Three**                    | ** ** | **Nine**                     | ** ** |
|------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | **months  ended**            | ** ** | **months  ended**            | ** ** |
| **($’s in millions)**               | ** ** | **September 30,  2009** | ** ** | **September 30,  2008** | ** ** | **September 30,  2009** | ** ** | **September 30,  2008** | ** ** |
| Anthrax  therapeutic and vaccines        |       | $                            | 5.3        |                         | $          | 4.1 |   | $ | 15.0 |   | $ | 11.5 |   |
| Chemical  nerve agent protectants        |       | 1.7                          |       | 3.1                          |       | 6.1 |   | 10.4 |   |
| Recombinant  dual antigen plague vaccine |       | .6                           |       | 2.0                          |       | 1.5 |   | 4.1 |   |
| Internal  research and development       |       | —                       |       | 0.2                          |       | 0.2 |   | 0.5 |   |
| Total  research and development expenses |       | $                            | 7.6        |                         | $          | 9.4 |   | $ | 22.8 |   | $ | 26.5 |   |

 

For the three and ninemonths ended September 30, 2009 and 2008, research and developmentexpenses decreased $1.8 million and $3.7 million, respectively, primarilyattributable to a reduction in pre-clinical development costs for our chemicalnerve agent protectants program as we progress in our clinical evaluationphase, and a reduction in development costs for our plague vaccine program,partially offset by increased pre-clinical development associated with ouranthrax-related therapeutics and vaccines programs.  The decrease indevelopment expenses related to the clinical nerve agent protectants programresulted from reduced process development and manufacturing activities as theprogram moved from the development stage to the Phase I clinical trial. Expenses in connection with the anthrax therapeutics and vaccines programsincreased primarily as a result of increased pre-clinical development activityin 2009 as we prepared for and started Phase I human clinical trials, alongwith increased costs incurred in connection with our June 2009 settlementagreement with Avecia.** **As we note above,****we and the U.S. government have agreed to a reduction tothe scope of work under our current contract for RypVaxTM and expectrevenues and related costs under that contract will decline over the wind downperiod.  We also anticipate that costsunder our chemical nerve agent protectants program will increase in futureperiods as that program progresses through human clinical trials.

 

17

----

Table of Contents

 

***General and Administrative Expenses***

 

General andadministrative functions include executive management, finance andadministration, government affairs and regulations, corporate development,human resources, legal, and compliance.  For each function, we may incurdirect expenses such as salaries, supplies and third-party consulting and otherexternal costs and non-cash expenditures such as expense related to stockoption and restricted share awards.  An allocation of indirect costs suchas facilities, utilities and other administrative overhead is also included ingeneral and administrative expenses.

 

Expenses associated withgeneral and administrative functions were $6.2 million and $4.8 million for thethree months ended September 30, 2009 and 2008, and were $15.8 million and$14.7 million for the nine months ended September 30, 2009 and 2008,respectively.

 

General andadministrative expenses increased $1.4 million and $1.1 million for the threeand nine months ended September 30, 2009, respectively, as compared to thecomparable 2008 periods.  The increases were primarily due to the costsassociated with the transitioning of our development and manufacturingactivities as well as other general and administrative functions from the UK tothe U.S., and with preparing and submitting various bids and proposals, alongwith increased stock-based compensation costs during the nine-month period.

 

***Depreciation and Intangible Amortization***

 

Depreciation andamortization expenses were $0.2 million for both the three months ended September 30,2009 and 2008, respectively, and were $0.6 million for both the nine monthperiods.  These expenses relate primarily to the depreciation andamortization of farm building improvements, leasehold improvements andlaboratory equipment, and patents acquired as part of a 2005 businesscombination.

 

***Other Income and Expenses***

 

Other income and expensesprimarily consists of income on our investments, interest expense on our debtand other financial obligations, changes in market value of our derivativefinancial instruments, loss on early extinguishment of debt, and foreigncurrency transaction gains or losses.  For the three months ended September 30,2009 and 2008, we recognized interest income of $0.1 million and $0.3 million,respectively.  For the nine months ended September 30, 2009 and 2008,we recognized interest income of $0.3 million and $1.1 million,respectively.  The decrease in interest income during the periods isprimarily attributable to the reduced average balances of our investments andcash balances as we continue to use cash to support our operations, along withlower prevailing interest rates.

 

We incurred interestexpense of $0.7 million and $0.6 million for the three months ended September 30,2009 and 2008, respectively, and $1.9 million in both nine month periods. Interest expense relates primarily to our outstanding convertible notes(including the amortization of debt discount related to the (i) allocationof fair value to the stock purchase warrants and (ii) beneficialconversion feature) and our senior secured credit facility, which facility werepaid in full in July 2009.

 

The change in the fairvalue of our derivative instruments (various stock purchase warrants and theembedded conversion option in the Old Notes) was $1.1 million and $0.3 millionfor the three and nine months ended September 30, 2009,respectively.  We measure the fair value of these derivative instrumentsusing the Black-Scholes option pricing model.  As discussed in Note 7 toour condensed consolidated financial statements, we adopted new accountingguidance in the first quarter of 2009 related to the accounting for warrants weissued in October 2008 (which expired unexercised in October 2009).  The new guidance was adopted using thecumulative catch-up method.  Accordingly,there was no change in the fair value of the warrants in 2008 prior toadoption.

 

18

----

Table of Contents

 

**Liquidityand Capital Resources**

 

***Overview***

 

Our primary cashrequirements through the end of 2010 are to fund our research and developmentprograms and support our general and administrative activities.  Ourfuture capital requirements will depend on many factors, including, but notlimited to, the progress of our research and development programs; the progressof pre-clinical and clinical testing; the time and cost involved in obtainingregulatory approval; the cost of filing, prosecuting, defending and enforcingany patent claims and other intellectual property rights; changes in ourexisting research relationships, competing technological and marketingdevelopments; our ability to establish collaborative arrangements and to enterinto licensing agreements and contractual arrangements with others; and anyfuture change in our business strategy.  These cash requirements couldchange materially as a result of shifts in our business and strategy.

 

Since our inception, wehave not generated positive cash flows from operations.  To bridge the gapbetween payments made to us under our government contracts and grants and ouroperating and capital needs, we have had to rely on a variety of financingsources, including the issuance of equity securities and convertible notes,proceeds from loans and other borrowings, and the trust funds obtained in theMerger.  For the foreseeable future, we will continue to need these typesof financing vehicles and potentially others to help fund our future operatingand capital requirements.  We believe that the funds obtained from the July 2009Private Placement, existing cash resources, along with cash receipts fromcontract receivables (a substantial portion of which was unbilled at September 30,2009) generated under our contracts, will be sufficient to enable us to fundour existing research and development programs and support our currentlyanticipated general and administrative activities at least through the end of2010.  We have based this projection on our current and anticipatedoperations, which do not take into account any potential future governmentcontracts that may be awarded to the Company, merger and acquisition orcorporate partnering activities, or unexpected financial obligations.

 

The continuing turmoilaffecting the banking system and financial markets and the possibility thatfinancial institutions may consolidate or cease operations has resulted in atightening in the credit markets, a low level of liquidity in many financialmarkets, and extreme volatility in fixed income, credit, currency and equitymarkets.  As a result, there can be no assurance that future funding willbe available to us on reasonably acceptable terms, or at all.  Inaddition, due to the United States government’s substantial efforts tostabilize the economy, the U.S. government may be forced or choose to reduce ordelay spending in the biodefense field, which could decrease thelikelihood of future government contract awards, the likelihood that thegovernment will exercise its right to extend any of its existing contracts withus and/or the likelihood that the government would procure products fromus.  Finally, the note and warrant purchase agreement entered into inconnection with the July 2009 Private Placement limits us from incurringsenior indebtedness (other than trade payables) in excess of $10 millionwithout the prior written approval of no less than a majority of the aggregateprincipal amount of the debt then outstanding.

 

We have incurredcumulative net losses and expect to incur additional losses in conducting furtherresearch and development activities.  We do not have commercial productsand, given the substantial costs relating to the development of pharmaceuticalproducts, have relatively limited existing capital resources.  Our planswith regard to these matters include continued development of our products aswell as seeking additional funds to support our research and developmentefforts.  Although we continue to pursue these plans, there is noassurance that we will be successful in obtaining sufficient future financingon commercially reasonable terms or at all or that we will be able to secureadditional funding through government contracts and grants. Our condensedconsolidated financial statements have been prepared on a basis which assumesthat we will continue as a going concern and which contemplates the realizationof assets and the satisfaction of liabilities and commitments in the normalcourse of business and do not include any adjustments that might result if thecarrying amount of recorded assets and liabilities are not realized.

 

19

----

Table of Contents

 

***Sources and Uses of Cash***

 

Cash, cash equivalentsand short-term available-for-sale investments were $11.6 million and $22.9million at September 30, 2009 and December 31, 2008,respectively.  The $11.3 million decrease in the first nine months of 2009primarily was attributable to the funding of our operations and capitalexpenditures (of approximately $23.5 million) and the payment of deferredconsideration related to the Avecia Acquisition (of $7.0 million), offset inpart by the March 2009 public sale of common stock (for net proceeds ofapproximately $4.9 million) and the July 2009 Private Placement (for netproceeds after repayment of debt, of approximately $2.5 million), along withthe associated reduction in our requirement to maintain restricted cash of$13.3 million.

 

In March 2009, weclosed on the public sale of 2,116,055 newly issued shares of our common stockat $2.60 per share and warrants to purchase 705,354 shares of our common stockat an exercise price of $3.00 per share, resulting in net proceeds ofapproximately $4.9 million.  The warrants became exercisable on September 27,2009 and will expire on September 27, 2014.  We intend to use the netproceeds for general corporate purposes, including the satisfaction of existingobligations.

 

Upon the closing of theAvecia Acquisition, in addition to certain initial consideration paid at thattime, we also provided a letter of credit in the amount of $7 million assecurity for deferred consideration in that same amount.  Pursuant to thesettlement agreement with Avecia entered into as of June 17, 2009, we paidthe $7 million deferred consideration to Avecia during the second quarter 2009(in connection with which the letter of credit securing such amount wasterminated and the required cash restrictions eliminated).

 

In July 2009, weclosed on the private sale of approximately $19.3 million of newly issuedtwo-year 10 % unsecured senior convertible notes, convertible immediately intocommon shares at a conversion price of approximately $2.54 per share (the “NewConvertible Notes”), and warrants to purchase 2,572,775 shares of common stock at $2.50 per share. Thewarrants become exercisable beginning on January 28, 2010 and will expireon January 28, 2015**. **As part of this sale we exchangeda portion of our then-outstanding 8% unsecured senior convertible notes,originally issued on August 3, 2007 and due August 3, 2009 (the “OldNotes”), in the aggregate principal amount plus accrued interest of $8.8million for New Convertible Notes, cancelled the corresponding Old Notes,issued additional New Convertible Notes in the aggregate principal amount of$10.5 million to new note investors, and issued to the recipients of the NewConvertible Notes the stock purchase warrants described above.  In connection with the exchange, werecognized a loss on the early extinguishment of the Old Notes of approximately$4.7 million.  We used the proceeds fromthe sale of the New Convertible Notes to repay $5.5 million of our Old Notesthat were not exchanged for the New Convertible Notes and warrants and repaidall outstanding amounts and fees under our existing senior secured creditfacility.

 

***Operating Activities***

 

Net cash used inoperating activities was $22.0 million and $9.4 million for the nine monthsended September 30, 2009 and 2008, respectively.  Net cash used inoperations during the nine months ended September 30, 2009 reflects ournet loss of $26.6 million, adjusted for certain non-cash items, includingshare-based compensation (of $2.7 million), non-cash interest expense (of $0.6million), a decrease in accounts receivable (of $3.8 million), an increase inother assets (the increase in other assets of $12.9 million primarily relatesto an increase in unbilled receivables related to government contracts), and anincrease in accrued expenses and accounts payable (of $4.6 million).

 

Net cash used inoperations during the nine months ended September 30, 2008 reflects ournet loss of $31.2 million, adjusted for certain non-cash items, includingacquired in-process research and development related to the Avecia Acquisition(of $16.1 million), share-based compensation (of $2.0 million), non-cashinterest expense (of $1.3 million), an increase in accounts receivable (of $1.5million), and an increase in accrued expenses and accounts payable (of $3.6million).

 

20

----

Table of Contents

 

***Investing Activities***

 

Net cash used ininvesting activities was $12.7 million for the nine months ended September 30,2009, compared to $17.5 million for the nine months ended September 30,2008.  Investing activities for the first nine months of 2009 relatedprimarily to the payment in June of $7.0 million of deferred purchaseconsideration to Avecia, purchases, net of sales, of available for sale securitiesof $4.2 million and approximately $1.5 million of capital expenditures.

 

In the first nine monthsof 2008 and in connection with the Avecia Acquisition, we paid $10.0 million toAvecia and funded a $7.0 million letter of credit. In order to fund thetransaction and the restricted cash obligations pursuant to the loanmodification agreement under our senior secured credit facility, approximately$20.6 million of available-for-sale securities were sold. Additionally, duringthe first nine months of 2008, the Company incurred approximately $1.6 millionrelated to transactions costs incurred as a result of the Avecia Acquisition.

 

***Financing Activities***

 

Net cash provided byfinancing activities was $18.6 million for the nine months ended September 30,2009 as compared to net cash used by financing activities of $3.2 million forthe nine months ended September 30, 2008.  In March 2009, weraised net proceeds of approximately $4.9 million as a result of the publicsale of shares of our common stock and warrants.  We raised $10.5 million in the July 2009Private Placement, and used $9.5 million of those proceeds to repay ourexisting convertible notes and all amounts outstanding under our creditfacility.  We exchanged and cancelled$8.8 million of our then-outstanding 8% convertible notes for our newly issued10% convertible notes and stock purchase warrants.  Additionally, pursuant to the payment toAvecia of the deferred purchase consideration and the repayment of all amountsdue under our credit facility, we eliminated all of our restricted cashobligations (approximately $13.3 million).

 

Net cash used byfinancing activities was $3.2 million for the nine month period ended September 30,2008. We made principal repayments of $3.0 million under outstanding creditfacilities for the nine months ended September 30, 2008.

 

**Off-BalanceSheet Arrangements**

 

We do not have anyoff-balance sheet arrangements.

 

**ContractualObligations**

 

The following arecontractual commitments at September 30, 2009 associated with leases,research and development arrangements, collaborative development obligationsand long term debt:

 
| **Contractual Obligations ($ in thousands) (1)** | ** ** | **Total** | ** ** | **Less  than 1  Year** | ** ** | **1-3  Years** | ** ** | **3-5  Years** | ** ** | **More  than  5 years** | ** ** |
|-------------------------------------------------------|------------|-----------|------------|------------------------|------------|----------------|------------|----------------|------------|-------------------------|------------|
| Operating  facility leases                            |       | $         | 6,301      |                   | $          | 993            |       | $              | 2,263      |                    | $          | 2,434 |   | $ | 611 |   |
| Research  and development agreements                  |       | 12,594    |       | 9,294                  |       | 3,300          |       | —         |       | —                  |       |
| Notes  payable, including interest                    |       | 23,209    |       | —                 |       | 23,209         |       | —         |       | —                  |       |
| Total  contractual obligations                        |       | $         | 42,104     |                   | $          | 10,287         |       | $              | 28,772     |                    | $          | 2,434 |   | $ | 611 |   |

 

----

(1) Thistable does not include any royalty payments of future sales of products subjectto license agreements the Company has entered into in relation to itsin-licensed technology, as the timing and likelihood of such payments are notknown.

 

**Item3.  Quantitative and QualitativeDisclosures about Market Risk.**

 

Not applicable.

 

21

----

Table of Contents

 

**Item4.  Controls and Procedures.**

 

***Evaluation of Disclosure Controls and Procedures***

 

Under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer, we conducted an evaluation of ourdisclosure controls and procedures, as such term is defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of theend of the period covered by this report.  Based on this evaluation, ourprincipal executive officer and our principal financial officer concluded thatour disclosure controls and procedures were effective to provide reasonableassurance that information required to be disclosed by us in reports we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms, and isaccumulated and communicated to our management, including our principalexecutive officer and principal financial officer, as appropriate to allowtimely decisions regarding required disclosures.

 

***Changes in Internal Control Over Financial Reporting***

 

Management has identifiedseveral changes in our internal controls over financial reporting (as definedin Exchange Act Rules 13a-15(f) and 15d-15(f)) that occurred during2009 that have materially affected, or are reasonably likely to materiallyaffect, our internal controls over financial reporting, including (i) theresignation of our financial reporting manager during the second quarter 2009, (ii) ourreliance on external financial consultants to provide a significant portion ofour internal accounting and financial reporting functions; and (iii) ourimplementation of a new financial accounting system.  We are in theprocess of completing but have not yet completed our internal documentation ofall the changes in our internal controls over financial reporting.

 

To specifically addressthe changes identified in our internal controls over financial reporting, wedeveloped and performed additional analytical and substantive procedures duringour quarter closing process. Management believes that these additionalprocedures provide reasonable assurance that our condensed consolidatedfinancial statements as of and for the three and nine months ended September 30,2009, are fairly stated in all material respects in accordance with generallyaccepted accounting principles in the United States.

 

***Inherent Limitations on Disclosure Controls and Procedures***

 

In designing andevaluating the disclosure controls and procedures, management recognized thatany controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving the desired controlobjectives.  In addition, the design of disclosure controls and proceduresmust reflect the fact that there are resource constraints and that managementis required to apply its judgment in evaluating the benefits of possiblecontrols and procedures relative to their costs.

 

**PART II — OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

In December 2006,the Company filed a complaint against Siga Technologies, Inc. (“SIGA”) inthe Delaware Chancery Court.  The complaint alleges, among other things,that the Company has the right to license exclusively development and marketingrights for SIGA’s drug candidate, SIGA-246, pursuant to a merger agreementbetween the parties (the “Merger Agreement”) that was terminated in October 2006. The complaint also alleges that SIGA failed to negotiate in good faith theterms of such a license pursuant to the terminated merger agreement.

 

22

----

Table of Contents

 

The Company is seekingalternatively a judgment requiring SIGA to enter into an exclusive licenseagreement with the Company for SIGA-246 in accordance with the terms of theterm sheet attached to the merger agreement or monetary damages.  In January 2008,the Delaware Chancery Court issued a ruling denying a motion by SIGA to dismissthe complaint.  SIGA has filed a counterclaim against the Company allegingthat the Company breached its duty to engage in good-faith negotiations by,among other things, presenting SIGA with a bad-faith initial proposal for alicense agreement that did not contain all necessary terms, demanding SIGAprepare a complete draft of a partnership agreement and then unreasonablyrejecting that agreement, and unreasonably refusing to consider economic termsthat differed from those set forth in the license agreement term sheet attachedto the Merger Agreement.  SIGA is seeking recovery of its reliance damagesfrom this alleged breach.

 

Fact discovery in thecase is now complete, and the parties are engaged in expert witness discovery,which the Company believes will be complete in February 2010.  Following that, if neither party filesmotions for summary judgment, the Company believes the case could proceed totrial in March or April 2010, subject to the court’s docket andschedule.  If one or both of the partiesfiles motions for summary judgment, the Company believes a trial in the case isunlikely to occur before the end of the third quarter 2010, depending on thetiming and outcome of the court’s ruling on the motions for summary judgmentand the court’s docket and schedule at that time.

 

23

----

Table of Contents

 

**Item 1A.  Risk Factors**

 

*Investing in our securities involves risks.  Inaddition to the other information in this quarterly report on Form 10-Q,stockholders and potential investors should carefully consider the risksdescribed below relating to investment in our common stock.  The risks anduncertainties described below are not the only ones we face.  Additionalrisks and uncertainties not presently known to us or that we currently considerimmaterial may also impair our business operations.  If any of thefollowing risks actually occur, our business, financial condition and/orresults of operations could be materially adversely affected, the trading priceof our common stock could decline and a stockholder could lose all or part ofhis or her investment*.

 

***Risk Related to Request for ProposalRFP-BARDA-08-15***

 

***If we do not receive the award bythe U.S. Department of Health and Human Services (the “DHHS”) for an rPA anthraxvaccine, we likely will need to curtail our operations significantly and we maybe placed at a competitive disadvantage in the biodefense industry.***

 

OnFebruary 29, 2008, the DHHS issued a formal Request for Proposal(RFP-BARDA-08-15) for an “Anthrax Recombinant Protective Antigen (rPA) Vaccinefor the Strategic National Stockpile,” which includes a requisition for 25million doses of an rPA anthrax vaccine.  We submitted a response to thissolicitation on July 31, 2008.  While the original solicitationindicated that an award would be made by September 26, 2008, which waslater extended to December 31, 2008, DHHS subsequently delayed the awarddate further because, among other things, of a protest filed by a bidder thathad been eliminated from further consideration under the solicitation. The U.S. General Accounting Office (the “GAO”) subsequently denied thatprotest.  On April 15, 2009, DHHS issued an amendment to the RFPrequiring that each bidder submit by April 30, 2009 a comprehensive planto the FDA outlining the bidder’s regulatory strategy for the rPA anthraxvaccine to be developed under a contract should one be awarded under thesolicitation.  Pursuant to an amendment dated April 22, 2009, DHHSfurther extended the submission deadline to June 15, 2009.  On July 9,2009, the Company announced that the FDA completed its review of the Company’sproposed development plan for SparVaxTM, and the Company hasshared the FDA’s feedback with BARDA as required by these two amendments. Timing for an award under this solicitation remains uncertain.  There canbe no assurance that DHHS will not again extend the timeline for issuing anaward, add other requirements, or that the Company will be awarded a contractunder that solicitation.

 

Weare currently aware of at least one other bidder for the award withsubstantially greater financial and other resources, manufacturing capabilitiesand commercialization capabilities than we have.  Because the U.S.government is currently the only customer for our product candidates, if wefail to receive the award for the rPA anthrax vaccine, we could be forced toabandon or severely curtail our efforts with respect to our lead productcandidate, SparVaxTM, which, in turn, could place us at a competitivedisadvantage.  We have been engaged in discussions with DHHS with respectto our ability to satisfy the requirements of the RFP.  DHHS has requestedadditional information that, if not determined by them to be satisfactory,could result in our elimination from consideration for procurement.  Noassurances can be given that DHHS will make an award to us or that if made, itwill not include substantial conditions, that we can satisfy all of theseconditions or that we can begin to receive any proceeds from any such awardwithin any specific period of time.  In any event, we still have notcompleted development of SparVaxTM and our ability to recognize any meaningfulproceeds from the sale of SparVaxTM will still depend upon our completing thedevelopment and testing of such product.

 

24

----

Tableof Contents

 

**Risks Related to Our Financial Condition**

 

***We have a history of losses andnegative cash flow, anticipate future losses and negative cash flow, and cannotprovide assurances that we will achieve profitability.***

 

Wehave incurred significant losses since we commenced operations.  For thethree and nine months ended September 30, 2009, we incurred operatinglosses of approximately $14.0 million and $26.6 million respectively and had anaccumulated deficit of approximately $150.6 million at September 30,2009.  Our losses to date have resulted principally from research anddevelopment costs related to the development of our product candidates, generaland administrative costs related to operations, and costs related to the AveciaAcquisition.

 

Ourlikelihood for achieving profitability will depend on numerous factors,including success in:

 

·      developingour existing products and developing and testing new product candidates;

·      receiving regulatory approvals;

·      carrying out our intellectual propertystrategy;

·      establishing our competitive position;

·      pursuing third-party collaborations;

·      acquiring or in-licensing products;

·      manufacturing and marketing products; and

·      continuing to receive government funding andidentifying new government funding opportunities.

 

Manyof these factors will depend on circumstances beyond our control.  Wecannot guarantee that we will achieve sufficient revenues forprofitability.  Even if we do achieve profitability, we cannot guaranteethat we can sustain or increase profitability on a quarterly or annual basis inthe future.  If revenues grow more slowly than we anticipate, or ifoperating expenses exceed our expectations or cannot be adjusted accordingly,then our business, results of operations, financial condition and cash flowswill be materially and adversely affected.  Because our strategy mightinclude acquisitions of other businesses, acquisition expenses and any cashused to make these acquisitions will reduce our available cash.  While webelieve that our existing cash resources, along with cash receipts fromcontract receivables (some of which were unbilled at September 30, 2009)generated under our contracts, will be sufficient to enable us to fund ourexisting research and development programs and support our currentlyanticipated general and administrative activities at least through the end of2010, there can be no assurance that unexpected financial obligations or otheractivities that increase our use of cash will not result in our depleting ourcash resources quicker than presently anticipated.  Furthermore, if wereceive the award from DHHS for advanced development and procurement ofSparVaxTM, we would be obligated to make $10 million in milestone payments toAvecia within 90 days of the receipt of such award.

 

Thecontinuing turmoil affecting the banking system and financial markets and thepossibility that financial institutions may consolidate or cease operations hasresulted in a tightening in the credit markets, a low level of liquidity inmany financial markets and extreme volatility in fixed income, credit, currencyand equity markets.  As a result, there can be no assurances that we willbe successful in obtaining sufficient financing on commercially reasonableterms or at all.  Our requirements for additional capital may besubstantial and will be dependent on many factors, including the success of ourresearch and development efforts, our ability to commercialize and marketproducts, our ability to successfully pursue our licensing and collaborationstrategy, the receipt of continued government funding, competing technologicaland marketing developments, costs associated with the protection of ourintellectual property and any future change in our business strategy.

 

Tothe extent that we raise additional capital through the sale of securities, aswe did recently with the July 2009 Private Placement, the issuance of thosesecurities or shares underlying such securities would result in dilution thatcould be substantial to our stockholders.  In addition, if we incuradditional debt financing, a

 

25

----

Table of Contents

 

substantialportion of our operating cash flow may be dedicated to the payment of principaland interest on such indebtedness, thus limiting funds available for ourbusiness activities.

 

Ifadequate funds are not available, we may be required to curtail significantlyour development and commercialization activities.  This would have amaterial adverse effect on our business, financial condition and/or results ofoperations.

 

**Risks Related to Product Development and Commercialization**

 

***We have not commercialized anyproducts or recognized any revenues from sales.  All of our productcandidates are still under development, and there can be no assurance ofsuccessful commercialization of any of our products.***

 

Wehave not commercialized any products or recognized any revenues from productsales.  In general, our research and development programs are at earlystages.  There can be no assurances that one or more of our future productcandidates will not fail to meet safety standards in human testing, even ifthose product candidates are found to be effective in animal studies.  Todevelop and commercialize biodefense treatment and prophylactic productcandidates, we must provide the U.S. Food and Drug Administration (the “FDA”)and foreign regulatory authorities with human clinical and non-clinical animaldata that demonstrate adequate safety and effectiveness.  To generatethese data, we will have to subject our product candidates to significant additionalresearch and development efforts, including extensive non-clinical studies andclinical testing.  We cannot be sure that our approach to drug discoverywill be effective or will result in the development of any drug.  Even ifour product candidates are successful when tested in animals, such successwould not be a guarantee of the safety or effectiveness of such productcandidates in humans.

 

Researchand development efforts in the biodefense industry are time-consuming andsubject to delays.  Even if we initially receive positive early-stagepre-clinical or clinical results, such results may not be indicative of resultsthat could be anticipated in the later stages of drug development.  Delaysin obtaining results in our non-clinical studies and clinical testing can occurfor a variety of reasons, such as slower than anticipated enrollment byvolunteers in the trials, adverse events related to the products, failure tocomply with Good Clinical Practices, unforeseen safety issues, unsatisfactory resultsin trials, perceived defects in the design of clinical trials, changes inregulatory policy as well as for reasons detailed in “*Risk Factors—Necessary Reliance on the Animal Rule inConducting Trials is Time-Consuming and Expensive*.”

 

Anydelay or adverse clinical event arising during any of our clinical trials couldforce us to conduct additional clinical trials in order to obtain approval fromthe FDA and other regulatory bodies.  Our development costs will increasesubstantially if we experience material delays in any clinical trials or if weneed to conduct more or larger trials than planned.

 

Ifdelays are significant, or if any of our products do not prove to be safe,pure, and potent (including efficacy) or do not receive required regulatoryapprovals, we may have to abandon the product altogether and will be unable torecognize revenues from the sale of that product.  In addition, ourcollaborative partners may not be able to conduct clinical testing or obtainnecessary approvals from the FDA or other regulatory authorities for anyproduct candidates jointly developed by us and our partners.  If we failto obtain required governmental approvals, we and our collaborative partnerswill experience delays in, or be precluded from, marketing products developedthrough them or, as applicable, their research.

 

***Necessary Reliance on the Animal Rule inConducting Trials is Time-Consuming and Expensive.***

 

Asdescribed in “*Business—U.S. GovernmentRegulatory Pathway—General*”, to obtain FDA approval for our biologicalwarfare defense products under current FDA regulations, we are required toutilize animal model studies for efficacy and provide animal and human safetydata under the “Animal Rule.”  For many of the biological and chemicalthreats, animal models are not yet available, and as such we are developing, orwill have to develop, appropriate animal models, which is a time-consuming andexpensive research effort.  Further, we may not be able to sufficientlydemonstrate the animal correlation to the satisfaction of the FDA, as thesecorollaries are difficult to establish and are often unclear.  The FDA maydecide that our

 

26

----

Table of Contents

 

dataare insufficient for approval and require additional preclinical, clinical orother studies, refuse to approve our products, or place restrictions on ourability to commercialize those products.  Further, other countries do not,at this time, have established criteria for review and approval of these typesof products outside their normal review process; i.e., there is no “Animal Rule”equivalent, and consequently there can be no assurance that we will be able tomake a submission for marketing approval in foreign countries based on suchanimal data.

 

Additionally,few facilities in the U.S. and internationally have the capability to testanimals with anthrax, plague, nerve agents, or other lethal biotoxins orchemical agents or otherwise assist us in qualifying the requisite animalmodels.  We have to compete with other biodefense companies for access tothis limited pool of highly specialized resources.  We therefore may notbe able to secure contracts to conduct the testing in a predictable timeframeor at all.

 

***Even if we succeed incommercializing our product candidates, they may not become profitable andmanufacturing problems or side effects discovered at later stages can furtherincrease costs of commercialization.***

 

Wecannot assure you that any drugs resulting from our research and developmentefforts will become commercially available.  Even if we succeed indeveloping and commercializing our product candidates, we may never generatesufficient or sustainable revenues to enable us to be profitable.  Even ifeffective, a product that reaches market may be subject to additional clinicaltrials, changes to or re-approvals of our manufacturing facilities or a changein labeling if we or others identify side effects or manufacturing problems aftera product is on the market.  This could harm sales of the affectedproducts and could increase the cost and expenses of commercializing andmarketing them.  It could also lead to the suspension or revocation ofregulatory approval for the products.

 

Weand our contract manufacturers (“CMOs”) will also be required to comply withthe applicable FDA current Good Manufacturing Practice (“cGMP”)regulations.  These regulations include requirements relating to qualitycontrol and quality assurance as well as the corresponding maintenance ofrecords and documentation.  Manufacturing facilities are subject toinspection by the FDA.  These facilities must be approved to supplylicensed products to the commercial marketplace.  We and our contract manufacturersmay not be able to comply with the applicable cGMP requirements and other FDAregulatory requirements.  Should we or our contract manufacturers fail tocomply, we could be subject to fines or other sanctions or could be precludedfrom marketing our products.

 

Inparticular, as part of the transfer of our existing contract with NIAID for thedevelopment of SparVaxTM to BARDA on April 1, 2009, the terms of thatcontract were modified to provide for the transfer of the manufacturing processfor the bulk drug substance for SparVaxTM from Avecia Biologics in the U.K. to aU.S.-based contract manufacturing organization.  We believe that if we areawarded a contract under RFP-BARDA-08-15 for the advanced development andprocurement of 25 million doses of SparVaxTM, the U.S. government will requirethat such new CMO manufacture the bulk drug substance for SparVaxTM.  Thiscontract manufacturer has not manufactured that bulk drug substance before, andthere can be no assurance we will be successful in our technology transfer effortsor that this new contract manufacturer will ever be able to manufacturesufficient amounts of cGMP quality bulk drug substance necessary for us to meetour obligations under any such advanced development and procurement contract.

 

Wemay fail to fully realize the potential of Valortim® and of our co-development arrangement withMedarex, our partner in the development of Valortim®,which would have an adverse effect upon our business.  We have completedonly one Phase I clinical trial for Valortim® with our development partner, Medarex, at thispoint.  As discussed in “—*Risks Related to Our Dependence on U.S. Government Contracts—Most ofour immediately foreseeable future revenues are contingent upon grants andcontracts from the U.S. government and we may not achieve sufficient revenuesfrom these agreements to attain profitability*”, in the fourthquarter of 2009, the FDA placed our Phase I clinical trial of Valortim® and ciprofloxacin on clinical hold, pendingthe results of our investigation of the potential causes for adverse reactionsobserved in two subjects dosed in the trial. BARDA has advised us that untilsatisfactory resolution of this issue and the clinical hold is lifted it willnot act on our request for additional advanced development funding for Valortim® under BAA-BARDA-09-34.

 

Beforewe may begin selling any doses of Valortim®,we will need to conduct more comprehensive safety trials in a significantlylarger group of human subjects.  We willbe required to expend a significant amount to finalize manufacturing capabilitythrough a contract manufacturer to provide material to conduct the pivotalsafety and efficacy trials.  If our contract manufacturer is unable toproduce sufficient quantities at a reasonable cost, or has any other obstaclesto production, such as volatile manufacturing, then we will be unable tocommence these required clinical trials and studies.  Even after we expendsufficient funds to complete the development of Valortim® and if and when we enter into an

 

27

----

Table of Contents

 

agreementto supply Valortim® to theU.S. government, we will be required to share any and all profits from the saleof products with our partner in accordance with a pre-determined formula.

 

*****If we cannot maintain successful licensingarrangements and collaborations, enter into new licensing arrangements andcollaborations, or effectively accomplish strategic acquisitions, our abilityto develop and commercialize a diverse product portfolio could be limited andour ability to compete may be harmed.*****

 

Akey component of our business strategy is the in-licensing of compounds andproducts developed by other pharmaceutical and biotechnology companies oracademic research laboratories.

 

Forexample, we have an agreement with Medarex to develop Valortim®, a fully human monoclonal antibody product designed to protect againstand treat inhalation anthrax.  Under the agreement with Medarex, we willbe entitled to a variable percentage of profits derived from sales of Valortim®, if any, depending, in part, on the amount of our investment.  Inaddition, we have entered into licensing and research and developmentagreements with a number of other parties and collaborators.  There can beno assurances that the research and development conducted pursuant to theseagreements will result in revenue generating product candidates.  If oursuppliers, vendors, licensors, or other collaboration partners experiencefinancial difficulties as a result of the continuing credit crisis and furtherweakening of the global economy, or if they are acquired as part of thecurrent wave of consolidations in the pharmaceutical industry (such as, forexample, with the recent acquisition of Medarex by Bristol Myers Squibb), theirpriorities or our working relationship with them might change.  As aresult, they might shift resources away from the research,development and/or manufacturing efforts intended to benefit our products,which could lead to significant delays in our development programs andpotential future sales.  Finally, our current licensing, research anddevelopment, and supply agreements may expire and may not be renewable or couldbe terminated if we do not meet our obligations.  For example, our license agreement from DSTLfor certain technology related to RypVaxTM requires that we diligently pursue developmentof this product candidate to maintain exclusive rights to the technology.  Upon termination of our existing contractwith the U.S. government for the development of RypVaxTM,which is on an accelerated wind-down schedule, we may decide not to continuewith development efforts at a level necessary to meet this requirement.

 

Ifwe are not able to identify new licensing opportunities or enter into otherlicensing arrangements on acceptable terms, we may be unable to develop adiverse portfolio of products.  For our future collaboration efforts to besuccessful, we must first identify partners whose capabilities complement andintegrate well with ours.  We face, and will continue to face, significantcompetition in seeking appropriate collaborators.  Collaborationarrangements are complex and time consuming to negotiate, document andimplement.  We may not be successful in our efforts to establish andimplement collaborations or other similar arrangements.  The terms of anycollaboration or other arrangements that we establish may not be favorable tous.  Furthermore, technologies to which we gain access may proveineffective or unsafe or our partners may prove difficult to work with or lessskilled than we originally expected.  In addition, any past collaborativesuccesses are no indication of potential future success.

 

Wemay also pursue strategic acquisitions to further our development andcommercialization efforts.  To achieve the anticipated benefits of anacquisition, we must integrate the acquired company’s business, technology andemployees in an efficient and effective manner.  The successfulcombination of companies in a rapidly changing biodefense industry may be moredifficult to accomplish than in other industries.  The combination of twocompanies requires, among other things, integration of the companies’respective technologies and research and development efforts.  We cannotassure you that any integration will be accomplished smoothly orsuccessfully.  The difficulties of integration are increased by the needto coordinate geographically separated organizations and address possibledifferences in corporate cultures and management philosophies.  Theintegration of certain operations will require the dedication of managementresources that may temporarily distract attention from the day-to-dayoperations of the combined companies.  The business of the combinedcompanies may also be disrupted by employee retention uncertainty and lack offocus during integration.  The inability of management to integratesuccessfully the operations of the two companies, in particular, to integrateand retain key scientific

 

28

----

Table of Contents

 

personnel,or the inability to integrate successfully two technology platforms, could havea material adverse effect on our business, results of operations and financialcondition.

 

***We may become subject to productliability claims, which could reduce demand for our product candidates orresult in damages that exceed our insurance coverage.***

 

Weface an inherent risk of exposure to product liability suits in connection withour product candidates being tested in human clinical trials or soldcommercially.  We may become subject to a product liability suit if anyproduct we develop causes injury, or if treated individuals subsequently becomeinfected or suffer adverse effects from our products.  Regardless of meritor eventual outcome, product liability claims may result in decreased demandfor a product, injury to our reputation, withdrawal of clinical trialvolunteers, and loss of revenues.

 

Inaddition, if a product liability claim is brought against us, the cost ofdefending the claim could be significant and any adverse determination mayresult in liabilities in excess of our insurance coverage.  Although ouranthrax countermeasures are covered under the general immunity provisions ofthe U.S. Public Readiness and Emergency Preparedness Act (the “Public ReadinessAct”), there can be no assurance that the U.S. Secretary of Health and HumanServices will make other declarations in the future that cover any of our otherproduct candidates or that the U.S. Congress will not act in the future toreduce coverage under the Public Readiness Act or to repeal italtogether.  For further discussion of that act, see “Risk Factors - *Legislation limiting or restricting liability formedical products used to fight bioterrorism is new, and we cannot be certainthat any such protection will apply to our products or if applied what thescope of any such coverage will be*” below.  Additionally, weare considering applying for indemnification under the U.S. SupportAnti-terrorism by Fostering Effective Technologies (SAFETY) Act of 2002 whichpreempts and modifies tort laws so as to limit the claims and damagespotentially faced by companies who provide certain “qualified” anti-terrorismproducts.  However, we cannot be certain that we will be able to obtain ormaintain coverage under the SAFETY Act or adequate insurance coverage onacceptable terms, if at all.

 

**Risks Related to Our Dependence on U.S. Government Contracts**

 

***Most of our immediately foreseeablefuture revenues are contingent upon grants and contracts from the U.S.government and we may not achieve sufficient revenues from these agreements toattain profitability.***

 

Forthe foreseeable future, we believe our main customer will be nationalgovernments, primarily the U.S. government.  Substantially all of ourrevenues to date have been derived from grants and U.S. governmentcontracts.  There can be no assurances that existing government contractswill be renewed or that we can enter into new contracts or receive new grants. The process of obtaining government contracts is lengthy and uncertain and wewill have to compete with other companies for each contract.  For example,while RFP-BARDA-08-15 for an rPA vaccine for the SNS initially indicated thatthe government would make an award by September 26, 2008 (later extendedmultiple times), as of the date this quarterly report on Form 10-Q isfiled, the government has still not issued an award under thatsolicitation.  There can be no assurances that we will be awarded anycontracts to supply the U.S. or other governments with our products as suchawards may be made, in whole or in part, to our competitors.  If the U.S.government makes significant future contract awards for the supply to the U.S.emergency stockpile of a competing product, our business will be harmed and itis unlikely that we will ultimately be able to supply that particular treatmentor product to foreign governments or other third parties.  Further,changes in government budgets and agendas, ****cost overruns in our programs,****oradvances by our competitors, may result in a decreased and de-prioritizedemphasis ****on, or termination of, government contracts that support the development****and/orprocurement of the biodefense products we aredeveloping  For example, the U.S. government has selected a plague vaccineproduct candidate from a competitor for advanced development funding, and we donot anticipate that the U.S. government will provide additional funding in thefuture for or procure RypVaxTM. Furthermore, given the limited future prospectsfor RypVaxTM at this time, we and the U.S. government have agreed to a reductionto the scope of work that will result in early wind down of all activitiesunder that contract, likely no later than the end of the first half of2010.  Previously, the contract was expected to expire in the second halfof 2011.

 

29

----

Table of Contents

 

Underthe terms of our 2006 contract with the U.S. Department of Defense regardingProtexia®, the Department of Defense may elect not tocontinue development assistance of this nerve agent countermeasure after thefinal payment under the initial funding of $41 million has been received (whichdecision we anticipate may occur in the first quarter of 2010), or, if theDepartment of Defense does so elect to continue funding and we meet alldevelopment milestones, it may nevertheless choose not to procure any doses ofProtexia®.

 

Inthe fourth quarter of 2009, the FDA placed our phase I clinical trial ofValortim® and ciprofloxacin on clinical hold, pending the results of our investigationof the potential causes for adverse reactions observed in two subjects dosed inthe trial. BARDA has advised us that until satisfactory resolution of thisissue and the clinical hold is lifted it will not act on our request foradditional advanced development funding for Valortim® underBAA-BARDA-09-34.  It is unclear at thistime how long it will take us to complete our investigation, if and when wewill be in a position to recommence negotiations with BARDA with respect to apotential award under the BAA, and how any delay in potential future funding ofthe program could affect the overall Valortim® development timeline.

 

Dueto the current economic downturn, the accompanying fall in tax revenues and theU.S. government’s efforts to stabilize the economy, the U.S. government may beforced or choose to reduce or delay spending in the biodefense field, whichcould decrease the likelihood of future government contract awards or that thegovernment would procure products from us.

 

***U.S. government agencies havespecial contracting requirements that give them the ability to unilaterallycontrol our contracts.***

 

U.S.government contracts typically contain unfavorable termination provisions andare subject to audit and modification by the government at its sole discretion,which will subject us to additional risks.  These risks include theability of the U.S. government unilaterally to:

 

·                  suspend or prevent us for a set period oftime from receiving new contracts or extending existing contracts based onviolations or suspected violations of laws or regulations;

·                  terminate our contracts, including if fundsbecome unavailable to the applicable governmental agency;

·                  reduce the scope and value of our contracts;

·                  audit and object to our contract-relatedcosts and fees, including allocated indirect costs;

·                  control and potentially prohibit the exportof our products; and

·                  change certain terms and conditions in ourcontracts.

 

TheU.S. government will be able to terminate any of its contracts with us eitherfor its convenience or if we default by failing to perform in accordance withthe contract schedule and terms.  Termination-for-convenience provisionsgenerally enable us to recover only our costs incurred or committed, settlementexpenses, and profit on the work completed prior to termination. Termination-for-default provisions do not permit these recoveries and wouldmake us liable for excess costs incurred by the U.S. government in procuringundelivered items from another source.

 

Dueto the current economic downturn, the accompanying fall in tax revenues, andthe U.S. government’s efforts to stabilize the economy, the U.S. government maybe forced or choose to reduce or delay spending in the biodefense field, whichcould decrease the likelihood of future government contract awards, thelikelihood that the government will exercise its right to extend any of itsexisting contracts with us and/or the likelihood that the government wouldprocure products from us.

 

***The U.S. government’s determinationto award any contracts may be challenged by an interested party, such asanother bidder, at the GAO or in federal court.  If such a challenge is successful,a contract may be terminated.***

 

Thelaws and regulations governing the procurement of goods and services by theU.S. government provide procedures by which other bidders and other interestedparties may challenge the award of a government

 

30

----

Table of Contents

 

contract. If we are awarded a government contract, such challenges or protests could befiled even if there are not any valid legal grounds on which to base theprotest.  If any such protests are filed, the government agency may decideto suspend our performance under the contract while such protests are beingconsidered by the GAO or the applicable federal court, thus potentiallydelaying delivery of goods and services and payment.  In addition, wecould be forced to expend considerable funds to defend any potentialaward.  If a protest is successful, the government may be ordered toterminate our contract and reselect bids.  The government could even bedirected to award a potential contract to one of the other bidders.  Anexample is the protest filed by a third-party bidder with the GAO challengingthe decision of the DHHS to eliminate that bidder from further considerationunder the solicitation for an rPA vaccine for the Strategic National Stockpile(RFP-BARDA-08-15), a result of which was a delay to the contract award dateunder this solicitation.

 

***Our business is subject to audit bythe U.S. government and a negative audit could adversely affect our business.***

 

U.S.government agencies such as the Defense Contract Audit Agency, or the DCAA,routinely audit and investigate government contractors.  These agenciesreview a contractor’s performance under its contracts, cost structure andcompliance with applicable laws, regulations and standards.

 

TheDCAA also reviews the adequacy of, and a contractor’s compliance with, itsinternal control systems and policies, including the contractor’s purchasing,property, estimating, compensation and management information systems. Any costs found to be improperly allocated to a specific contract will not bereimbursed, while such costs already reimbursed must be refunded.  If anaudit uncovers improper or illegal activities, we may be subject to civil andcriminal penalties and administrative sanctions, including:

 

·                  termination of contracts;

·                  forfeiture of profits;

·                  suspension of payments;

·                  fines; and

·                  suspension or prohibition from conductingbusiness with the U.S. government.

 

Inaddition, we could suffer serious reputational harm if allegations ofimpropriety were made against us.

 

***Laws and regulations affectinggovernment contracts make it more costly and difficult for us to successfullyconduct our business.***

 

Wemust comply with numerous laws and regulations relating to the formation,administration and performance of government contracts, which can make it moredifficult for us to retain our rights under these contracts.  These lawsand regulations affect how we conduct business with government agencies. Among the most significant government contracting regulations that affect ourbusiness are:

 

·                  the Federal Acquisition Regulations, or FAR,and agency-specific regulations supplemental to the Federal AcquisitionRegulations, which comprehensively regulate the procurement, formation,administration and performance of government contracts;

·                  the business ethics and public integrityobligations, which govern conflicts of interest and the hiring of formergovernment employees, restrict the granting of gratuities and funding oflobbying activities and incorporate other requirements such as theAnti-Kickback Act and Foreign Corrupt Practices Act;

·                  export and import control laws andregulations; and

·                  laws, regulations and executive ordersrestricting the use and dissemination of information classified for nationalsecurity purposes and the exportation of certain products and technical data.

 

Foreigngovernments typically also have laws and regulations governing contracts withtheir respective agencies.  These foreign laws and regulations affect howwe and our customers conduct business and, in

 

31

----

Table of Contents

 

someinstances, impose added costs on our business.  Any changes in applicablelaws and regulations could restrict our ability to maintain our existingcontracts and obtain new contracts, which could limit our ability to conductour business and materially adversely affect our revenues and results ofoperations.

 

**Risks Related to Dependence on or Competition From ThirdParties**

 

***Because we depend on clinicalresearch centers and other contractors for clinical and non-clinical testing,including testing under the Animal Rule, and for certain research anddevelopment activities, the results of our clinical trial, non-clinical animalefficacy studies, and research and development activities are largely beyondour control.***

 

Thenature of clinical trials and our business strategy of outsourcingsubstantially all of our research and development and manufacturing workrequire that we rely on clinical research centers and other contractors toassist us with research and development, clinical and non-clinical testing(including animal efficacy studies under the Animal Rule), patient enrollmentand other activities.  As a result, our success depends largely on thesuccess of these third parties in performing their responsibilities. Although we prequalify our contractors and believe that they are fully capableof performing their contractual obligations, we cannot directly control theadequacy and timeliness of the resources and expertise that they apply to theseactivities.  Furthermore, we have to compete with other biodefensecompanies for access to this limited pool of highly specializedresources.  If our contractors do not perform their obligations in anadequate and timely manner or we are unable to enter into contracts with thembecause of prior commitments to our competitors, the pace of clinical ornon-clinical development, regulatory approval and commercialization of ourproduct candidates could be significantly delayed and our prospects could beadversely affected.

 

***We depend on third parties tomanufacture, package and distribute compounds for our product candidates andkey components for our product candidates.  The failure of these thirdparties to perform successfully could harm our business.***

 

Wedo not have any of our own manufacturing facilities.  We have thereforeutilized, and intend to continue utilizing, third parties to manufacture,package and distribute our product candidates and key components of our productcandidates.  Any material disruption in manufacturing could cause a delayin our development programs and potential future sales.  Furthermore,certain compounds, media, or other raw materials used to manufacture our drugcandidates are available from any one or a limited number of sources.  Anydelays or difficulties in obtaining key components for our product candidatesor in manufacturing, packaging or distributing our product candidates coulddelay clinical trials and further development of these potentialproducts.  Additionally, the third parties we rely on for manufacturingand packaging are subject to regulatory review, and any regulatory complianceproblems with these third parties could significantly delay or disrupt ourcommercialization activities.

 

Wewere notified by the contract manufacturer who supplies the pegylation reagentfor our Protexia® product candidate that it intends to cease itscontract manufacturing operations to focus exclusively on developing its ownproprietary product candidates.  We are now in the process of searchingfor an alternative supplier.  As part of this process, we will need tonegotiate and execute a license to certain intellectual property from ourcurrent supplier related to the pegylation process and to engage in atechnology transfer process to a new supplier.  If we are not successfulin these endeavors, our Protexia® development program will be adverselyaffected.

 

Finally,third-party manufacturers, suppliers and distributors, like most companies,have been adversely affected by the current credit crisis and weakening of theglobal economy and as such may be more susceptible to being acquired as part ofthe current wave of consolidations in the pharmaceutical industry.  Ithas, for example, become increasingly challenging for companies to secure debtcapital to fund their

 

32

----

Table of Contents

 

operationsas financial institutions have significantly curtailed their lendingactivities.  If our third-party suppliers continue to experience financialdifficulties as a result of weakening demand for their products or for otherreasons and are unable to obtain the capital necessary to continue their presentlevel of operations or are acquired by others, they may have to reduce theiractivities and/or their priorities or our working relationship with themmight change.  A material deterioration in their ability orwillingness to meet their obligations to us could cause a delay in ourdevelopment programs and potential future sales and jeopardize our ability tomeet our obligations under our contracts with the government or other thirdparties.

 

***We face, and likely will continue toface, competition from companies with greater financial, personnel and researchand development resources.  Our commercial opportunities will be reducedor eliminated if our competitors are more successful in the development andmarketing of their products.***

 

Thebiopharmaceutical industry is characterized by rapid and significanttechnological change.  Our success will depend on our ability to developand apply our technologies in the design and development of our productcandidates and to establish and maintain a market for our product candidates. There are many organizations, both public and private, including majorpharmaceutical and chemical companies, specialized biotechnology firms,universities and other research institutions engaged in developingpharmaceutical and biotechnology products.  Many of these organizationshave substantially greater financial, technical, intellectual property,research and development, and human resources than we have.  Competitorsmay develop products or other technologies that are more effective than anythat we are developing or may obtain FDA approval for products morerapidly.  As noted above in “- *Most ofour immediately foreseeable future revenues are contingent upon grants andcontracts from the U.S. government and we may not achieve sufficient revenuesfrom these agreements to attain profitability,”* the U.S. governmenthas selected a plague vaccine product candidate from a competitor for advanceddevelopment funding.   We and the U.S. government have agreed to areduction to the scope of work that will result in early wind down of allactivities under that contract, likely no later than the end of the first halfof 2010.

 

Ifwe commence commercial sales of products, we still must compete in themanufacturing and marketing of such products, areas in which we have limitedexperience.  Many of these organizations also have manufacturingfacilities and established marketing capabilities that would enable suchcompanies to market competing products through existing channels ofdistribution.  Our commercial opportunities will be reduced or eliminatedif our competitors develop and market products that:

 

·                  are more effective;

·                  have fewer or less severe adverse sideeffects;

·                  are more adaptable to various modes ofdosing;

·                  obtain orphan drug exclusivity that blocksthe approval of our application for seven years;

·                  are easier to administer; or

·                  are less expensive than the products orproduct candidates that we are, or in the future will be, developing.

 

Whilethe regulatory climate for generic versions of biological products approvedunder a Biologics License Application (or a BLA) in the United States remainsuncertain, and currently there is no formalized mechanism by which the FDA canapprove a generic version of an approved biological product, Federallegislation has been introduced to establish a legal pathway for the approvalof generic versions of approved biological products.  If enacted, thelegislation will impact the revenue projections for our products.

 

Evenif we are successful in developing effective products, and obtain FDA and otherregulatory approvals necessary for commercializing them, our products may notcompete effectively with other successful products.  Our competitors maysucceed in developing and marketing products either that are more effectivethan those that we may develop, alone or with our collaborators, making ourproducts obsolete, or that are marketed before any products that we develop aremarketed.

 

33

----

Table ofContents

 

**RisksRelated to Political and Social Factors**

 

***Political or social factors may delay or impair our abilityto market our products and our business may be materially adversely affected.***

 

Products developed totreat diseases caused by, or to combat the threat of, bioterrorism will besubject to changing political and social environments.  The political andsocial responses to bioterrorism have been unpredictable.  Political orsocial pressures may delay or cause resistance to bringing our products tomarket or limit pricing of our products, which would harm our business.

 

**RisksRelated to Intellectual Property**

 

***Our commercial success will be affected significantly by ourability (i) to obtain and maintain protection for our proprietarytechnology and that of our licensors and collaborators and (ii) not toinfringe on patents and proprietary rights of third parties****.*

 

The patent position ofbiotechnology firms generally is highly uncertain and involves complex legaland factual questions, and, therefore, validity and enforceability cannot bepredicted with certainty.  To date, no consistent policy has emergedregarding the breadth of claims allowed in biotechnology patents.  Wecurrently hold two U.S. patents, have five pending U.S. patent applications,and have a limited number of foreign patents and pending international andforeign patents applications.  In addition, we have rights under numerousother patents and patent applications pursuant to exclusive and non-exclusivelicense arrangements with licensors and collaborators.  However, there canbe no assurance that patent applications owned or licensed by us will result inpatents being issued or that the patents, whether existing or issued in thefuture, will afford protection against competitors with similartechnology.  Any conflicts resulting from third-party patent applicationsand patents could significantly reduce the coverage of the patents owned,optioned by or licensed to us or our collaborators and limit our ability orthat of our collaborators to obtain meaningful patent protection.

 

Further, our commercialsuccess will depend significantly on our ability to operate without infringingthe patents and proprietary rights of third parties.  We are aware of oneU.S. patent covering recombinant production of an antibody and a license may berequired under such patent with respect to Valortim®,which is a monoclonal antibody and uses recombinant reproduction of antibodies. Although the patent owner has granted licenses under such patent, we cannotprovide any assurances that we will be able to obtain such a license or thatthe terms thereof will be reasonable.  If we do not obtain such a licenseand if a legal action based on such patent was to be brought against us or ourdistributors, licensees or collaborators, we cannot provide any assurances thatwe or our distributors, licensees or collaborators would prevail or that wehave sufficient funds or resources to defend such claims.

 

We are also aware ofpending applications directed to pegylated butyrylcholinesterase. Protexia® incorporates butyrylcholinesterase.  Ifpatents are issued to third parties that cover Protexia® or otherproducts, we may be required to obtain a license under such patents or obtainalternative technology.  We cannot provide any assurances that suchlicenses will be available or that the terms thereof will be reasonable or thatwe will be able to develop alternative technologies.  If we do not obtainsuch a license and if a legal action based on such patent was to be broughtagainst us or our distributors, licensees or collaborators, we cannot provideany assurances that we or our distributors, licensees or collaborators wouldprevail or that we have sufficient funds or resources to defend such claims.

 

The costs associated withestablishing the validity of patents, of defending against patent infringementclaims of others and of asserting infringement claims against others isexpensive and time consuming, even if the ultimate outcome is favorable. An outcome of any patent prosecution or litigation that is unfavorable to us orone of our licensees or collaborators may have a material adverse effect onus.  The expense of a protracted infringement suit, even if ultimatelyfavorable, would also have a material adverse effect on us.

 

We furthermore rely upontrade secrets protection for our confidential and proprietaryinformation.  We have taken measures to protect our proprietaryinformation; however, these measures may not provide 

 

34

----

Table of Contents

 

adequate protection tous.  We have sought to protect our proprietary information by enteringinto confidentiality agreements with employees, collaborators andconsultants.  Nevertheless, employees, collaborators or consultants maystill disclose our proprietary information, and we may not be able tomeaningfully protect our trade secrets.  In addition, others mayindependently develop substantially equivalent proprietary information ortechniques or otherwise gain access to our trade secrets.

 

**RisksRelated to Regulatory Approvals and Legislation**

 

***Our use of hazardous materials and chemicals requires us tocomply with regulatory requirements which may result in significant costs andexpose us to potential liabilities.***

 

Our research anddevelopment involves the controlled use of hazardous materials andchemicals.  We are subject to federal, state, local and foreign lawsgoverning the use, manufacture, storage, handling and disposal of suchmaterials.  We will not be able to eliminate the risk of accidentalcontamination or injury from these materials.  In the event of such anaccident, we could be forced to pay significant damages or fines, and thesedamages could exceed our resources and any applicable insurance coverage. In addition, we may be required to incur significant costs to comply withregulatory requirements in the future.

 

***Legislation limiting or restricting liability for medicalproducts used to fight bioterrorism is new, and we cannot be certain that anysuch protection will apply to our products or if applied what the scope of anysuch coverage will be.***

 

The U.S. Public ReadinessAct was signed into law in December 2005 and creates general immunity formanufacturers of countermeasures, including security countermeasures (asdefined in Section 319F-2(c)(1)(B) of that act), when the U.S.Secretary of Health and Human Services issues a declaration for theirmanufacture, administration or use.  The declaration is meant to providegeneral immunity from all claims under state or federal law for loss arisingout of the administration or use of a covered countermeasure. Manufacturers are excluded from this protection in cases of willfulmisconduct.  Although our anthrax countermeasures have been covered underthe general immunity provisions of the Public Readiness Act since October 1,2008, there can be no assurance that the Secretary of Health and Human Serviceswill make other declarations in the future that would cover any of our otherproduct candidates or that the U.S. Congress will not act in the future toreduce coverage under the Public Readiness Act or to repeal it altogether.

 

Upon a declaration by theSecretary of Health and Human Services, a compensation fund would be created toprovide “timely, uniform, and adequate compensation to eligible individuals forcovered injuries directly caused by the administration or use of a coveredcountermeasure.”  The “covered injuries” to which the program applies aredefined as serious physical injuries or death.  Individuals are permittedto bring a willful misconduct action against a manufacturer only after theyhave exhausted their remedies under the compensation program.  A willfulmisconduct action could be brought against us if an individual(s) hasexhausted their remedies under the compensation program which thereby couldexpose us to liability.  Furthermore, there is no assurance that theSecretary of Health and Human Services will issue under this act a declarationto establish a compensation fund.  We may also become subject to standardproduct liability suits and other third party claims if products we developwhich fall outside of the Public Readiness Act cause injury or if treatedindividuals subsequently become infected or otherwise suffer adverse effectsfrom such products.

 

***We are required to comply with certain export control laws,which may limit our ability to sell our products to non-U.S. persons and maysubject us to regulatory requirements that may delay or limit our ability todevelop and commercialize our products.***

 

Our product candidatesare subject to the Export Administration Regulations (“EAR”) administered bythe U.S. Department of Commerce and are, in certain instances (such asregarding aspects of our Protexia® product candidate) subject to theInternational Traffic in Arms Regulations (“ITAR”) administered by the U.S.Department of State.  EAR restricts the export of dual-use products andtechnical data to certain 

 

35

----

Tableof Contents

 

countries, while ITARrestricts the export of defense products, technical data and defenseservices.  The U.S. government agencies responsible for administering EARand ITAR have significant discretion in the interpretation and enforcement ofthese regulations.  Failure to comply with these regulations can result incriminal and civil penalties and may harm our ability to enter into contractswith the U.S. government.  It is also possible that these regulationscould adversely affect our ability to sell our products to non-U.S. customers.

 

**Risks Relatedto Personnel**

 

***We depend on our key technical and management personnel, andthe loss of these personnel could impair the development of our products.***

 

We rely, and willcontinue to rely, on our key management and scientific staff, all of whom areemployed at-will.  The loss of key personnel or the failure to recruitnecessary additional qualified personnel could have a material adverse effecton our business and results of operations.  There is intense competitionfrom other companies, research and academic institutions and otherorganizations for qualified personnel.  We may not be able to continue toattract and retain the qualified personnel necessary for the development of ourbusiness.  If we do not succeed in retaining and recruiting necessary personnelor developing this expertise, our business could suffer significantly.

 

In particular, as notedabove in “*Even if we succeed incommercializing our product candidates, they may not become profitable andmanufacturing problems or side effects discovered at later stages can furtherincrease costs of commercialization,*” we are transferring themanufacturing process for the bulk rPA drug substance from Avecia in the UnitedKingdom to a U.S.-based contract manufacturer.  In connection with thattransfer, we also anticipate moving our U.K.-based operations to the UnitedStates by June 30, 2010.  There can be no assurance that we will beable to recruit and hire the necessary staff in the U.S. to complete thetransfer of activities in a timely and cost effective manner.

 

***Biotechnology companies often become subject to claims thatthey or their employees wrongfully used or disclosed alleged trade secrets ofthe employees’ former employers.  Such litigation could result insubstantial costs and be a distraction to our management.***

 

As is commonplace in thebiotechnology industry, we employ individuals who were previously employed atother biotechnology or pharmaceutical companies, including at competitors orpotential competitors.  Although no claims against us are currentlypending, we may be subject to claims that we or our employees haveinadvertently or otherwise used or disclosed trade secrets or other proprietaryinformation of their former employers.  Litigation may be necessary todefend against these claims.  Even if we are successful in defendingagainst these claims, litigation could result in substantial costs and distractmanagement.

 

**RisksRelated to our Common Stock**

 

***Shares that we may issue in the future in connection withcertain capital-raising transactions and shares available for future issuanceupon conversion and exercise of convertible notes, warrants and options coulddilute our shareholders and depress the market price of our common stock.***

 

We will likely seek toraise additional capital and may do so at any time through various financingalternatives, including potentially selling shares of common or preferredstock, notes and/or warrants convertible into, or exercisable for, shares ofcommon or preferred stock.  We could again rely upon the shelfregistration statement on Form S-3, which was declared effective on February 12,2009, in connection with a sale from time to time of common stock, preferredstock or warrants or any combination of those securities, either individuallyor in units, in one or more offerings for up to $50,000,000 (inclusive of thegross proceeds from our recent public offering of $5.5 million and the $2.1million we would receive if all of the warrants issued in that offering wereexercised).  Raising capital in this manner or any other manner maydepress the market price of our stock, and any such financing(s) willdilute our existing shareholders.

 

36

----

Table ofContents

 

In addition, as of September 30,2009, we had outstanding options to purchase approximately 5.2 million sharesof common stock.  Additional shares are reserved for issuance under our2007 Long-Term Incentive Compensation Plan.  Our stock options aregenerally exercisable for ten years, with a significant portion exercisableeither immediately or beginning one year after the date of the grant. Furthermore, the senior unsecured convertible notes in the aggregate principalamount of $19.3 million issued in July 2009 are convertible atapproximately $2.54 per share into approximately 7.6 million shares of ourcommon stock, and the accompanying warrants are exercisable beginning on January 28,2010 for up to approximately 2.6 million shares of common stock at $2.50 pershare.  Finally, as of November 6, 2009, the Company had issued andoutstanding additional warrants to purchase up to an additional approximately3.5 million shares of common stock.  The issuance or even the expectedissuance of a large number of shares of our common stock upon conversion orexercise of the securities described above could depress the market price ofour stock and the issuance of such shares will dilute the stock ownership ofour existing shareholders.

 

***If we are unable to continue to satisfy the listingrequirements of NYSE Amex, our securities could be delisted from trading whichcould limit investors’ ability to make transactions in our securities andsubject us to additional trading restrictions.***

 

Our common stock andcertain warrants are listed on the NYSE Amex (formerly the NYSE Alternext US orAmerican Stock Exchange), a national securities exchange, which imposescontinued listing requirements with respect to listed shares.  If we failto satisfy one or more of the requirements, such as the policy that issuersthat have had losses in their five most recent fiscal years have stockholders’equity of at least $6,000,000, that issuers have more than 300 publicshareholders, or that the aggregate market value of shares publicly held bemore than $1,000,000, the NYSE Amex may decide to delist our commonstock.  If the NYSE Amex delists our securities from trading on itsexchange and we are not able to list our securities on another exchange or tohave them quoted on Nasdaq, our securities could be quoted on the OTC BulletinBoard or on the “pink sheets”.  As a result, we could face significantadverse consequences including:

 

·     a limited availabilityof market quotations for our securities;

·     adetermination that our common stock is a “penny stock” which will requirebrokers trading in our common stock to adhere to more stringent rules andpossibly result in a reduced level of trading activity in the secondary tradingmarket for our securities;

·     a limited amount of newsand analyst coverage for us; and

·     a decreased ability toissue additional securities or obtain additional financing in the future.

 

***We can make no assurances that we will ever pay dividends.***

 

We have not paid anydividends on our common stock in 2007, 2008, and the first nine months of 2009and do not intend to declare any dividends in the foreseeable future. While subject to periodic review, our current policy is to retain all earnings,if any, primarily to finance our future growth.  We make no assurancesthat we will ever pay dividends, cash or otherwise.  Whether we pay anydividends in the future will depend on our financial condition, results ofoperations, and other factors that we will consider.

 

**Item 2. Unregistered Sales of Equity Securities and Use of Proceeds**

 

On July 28, 2009, weclosed on the private sale of approximately $19.3 million of newly issuedtwo-year 10% unsecured senior convertible notes, convertible immediately intocommon shares at a conversion price of approximately $2.54 per share (the “NewConvertible Notes”), and warrants to purchase 2,572,775shares of common stock at $2.50 pershare.  The warrants become exercisablebeginning on January 28, 2010 and will expire on January 28,2015.  The conversion price of the NewConvertible Notes and the exercise price of the warrants are subject tocustomary anti-dilution adjustments, including in the event of a stockdividend, stock split or stock combination, recapitalization or reorganization,merger or consolidation, sale of all or substantially all of our assets,distribution of debt or assets to our stockholders and in connection withcertain other dilutive equity issuances.

 

37

----

Table ofContents

 

An aggregate of up to11,704,010 shares of our common stock is issuable upon conversion of the NewConvertible Notes and exercise of the related warrants, including (i) upto 9,131,235 shares of common stock issuable upon conversion of all of the NewConvertible Notes and (ii) 2,572,775 shares of our common stock issuableupon exercise of all of the related warrants. Of the 9,131,235 shares of common stock issuable upon conversion of the NewConvertible Notes, up to 7,591,790 shares are issuable in respect of theaggregate principal amount of the notes and up to 1,539,455 shares are issuablein respect of interest that accrues on the notes, assuming conversion of all ofthe notes on the date of maturity.

 

As part of this sale weexchanged a portion of our then-outstanding 8% unsecured senior convertiblenotes, originally issued on August 3, 2007 and due August 3, 2009(the “Old Notes”), in the aggregate principal amount plus accrued interest of$8.8 million for New Convertible Notes, cancelled the corresponding Old Notes,issued additional New Convertible Notes in the aggregate principal amount of$10.5 million to new note investors, and issued to the recipients of the NewConvertible Notes the stock purchase warrants described above.  We used the proceeds from the sale of the NewConvertible Notes to repay $5.5 million of our Old Notes that were notexchanged for the New Convertible Notes and warrants and repay all outstandingamounts and fees under our existing senior secured credit facility.

 

The New Convertible Notesand related warrants were issued in reliance on the exemption from registrationprovided by 4(2) of the Securities Act of 1933, as amended, as they wereissued in a transaction by us not involving a public offering.  We are currently in the process ofregistering with the Securities and Exchange Commission for resale the sharesof common stock underlying the New Convertible Notes and related warrants.

 

**Item 5. Other Information**

 

The descriptionscontained in Item 3.03 “Material Modification to Rights of Security Holders” inour Current Report on Form 8-K, filed on November 4, 2009, and in “Proposal2” in our Definitive Proxy Statement on Schedule 14A, filed on September 29,2009, are incorporated herein by reference.

 

**Item 6.  Exhibits.**

 
| **No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                               |
|---------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1     |       | Amended and Restated  Certificate of Incorporation of the Company, as amended on October 29, 2009  *                                                                                                                                                                                                                                                                     |
| 4.9     |       | Form of 10%  Unsecured Senior Convertible Note**                                                                                                                                                                                                                                                                                                                         |
| 4.10    |       | Form of Warrant to  Purchase Common Stock**                                                                                                                                                                                                                                                                                                                              |
| 10.45.1 |       | Modification  (Amendment) 16 to the Contract with the National Institutes of Health for the  Production and Testing of Anthrax Recombinant Protective Antigen (rPA)  Vaccine (#N01-AI-30052) ***                                                                                                                                                                              |
| 10.50   |       | Form of  Note and Warrant Purchase Agreement, dated as of July 24, 2009, by and  among PharmAthene, Inc. and the investors signatories thereto, as  amended by Amendment No. 1 to Note and Warrant Purchase Agreement, dated  as of July 26, 2009 and Amendment No. 2 to Note and Warrant  Purchase Agreement, dated as of July 28, 2009** |
| 10.51   |       | Form of  Registration Rights Agreement, dated as of July 28**,**  2009 by and among PharmAthene, Inc. and the investors signatories  thereto**                                                                                                                                                                                                                 |
| 10.52   | ** ** | Technology  Transfer and Development Services Subcontract, dated as of September 17,  2009, by and between Diosynth RTP Inc. and PharmAthene, Inc. ***                                                                                                                                                                                                              |
| 31.1    |       | Certification of  Principal Executive Officer Pursuant to SEC Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                                                                   |
| 31.2    |       | Certification of  Principal Financial Officer Pursuant to SEC Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                                                                   |
| 32.1    |       | Certification of  Principal Executive Officer Pursuant to 18 U.S.C. Section 1350                                                                                                                                                                                                                                                                                         |
| 32.2    |       | Certification of  Principal Financial Officer Pursuant to 18 U.S.C. Section 1350                                                                                                                                                                                                                                                                                         |

 

----

*  Incorporated by reference to thecorresponding exhibit to the Company’s current report on Form 8-K filed on*November 4,****2009.*

 

38

----

Table of Contents

 

******Incorporated by reference to thecorresponding exhibit to amendment no. 1 to the Company’s current report on Form 8-Kfiled on *August 3, 2009*.

*** Certain confidentialportions of this exhibit have been omitted and filed separately with theSecurities and Exchange Commission pursuant to a request for confidentialtreatment under Rule 24b-2 of the Securities Exchange Act of 1934.

 

39

----

Table ofContents

 

**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused the report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
| ** **                     | **PHARMATHENE,  INC.** |
|--------------------------------|------------------------|
|                           |                   |   |
|                           |                   |   |
| Dated: November 13,  2009 | By:                    | /s/ David P. Wright |
|                           |                   | **David  P. Wright** |
|                           |                   | **Chief  Executive Officer** |
|                           |                   |   |
|                           |                   |   |
| Dated: November 13,  2009 | By:                    | /s/ Charles A. Reinhart  III |
|                           |                   | **Charles  A. Reinhart III** |
|                           |                   | **Chief  Financial Officer** |

 

40

----