UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C.  20549





FORM
10-K/A


(Amendment
No. 2)





x
            ANNUAL REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For the
fiscal year ended December 31, 2009




or




 ̈
            TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For the
transition period from               
    to




Commission
file number 000-26422




DISCOVERY
LABORATORIES, INC.


(Exact
name of registrant as specified in its charter)





Delaware
              
              94-3171943(State
      or other jurisdiction of
                incorporation
      or organization)
              
              (I.R.S.
      Employer
                Identification
      Number)2600
      Kelly Road, Suite 100Warrington,
      Pennsylvania 18976-3622(Address
      of principal executive offices)





(215)
488-9300


(Registrant’s
telephone number, including area code)




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





Title of each class
                
                Name of each exchange on which
      registeredCommon
      Stock, $0.001 par value
                
                The
      Nasdaq Capital MarketPreferred
      Stock Purchase Rights




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




None


__________________





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  YES   ̈ 
  NO  x





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Exchange Act.  YES   ̈ 
  NO  x





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





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).  YES   ̈ 
  NO   ̈





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





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





Large
      accelerated filer
               ̈
              Accelerated
      filerxNon-accelerated
      filer
               ̈
              Smaller
      reporting company
              x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).


YES 
 ̈ 
  NO  x





The
aggregate market value of shares of voting and non-voting common equity held by
non-affiliates of the registrant computed using the closing price of common
equity as reported on The Nasdaq Global Market under the symbol DSCO on June 30,
2009, the last business day of the registrant’s most recently completed second
fiscal quarter, was approximately $126 million.  For the purposes of
determining this amount only, the registrant has defined affiliates to include:
(a) the executive officers named in Part III of this Annual Report on Form 10-K;
(b) all directors of the registrant; and (c) each shareholder, if any, that has
informed the registrant by March 1, 2009 that it is the beneficial owner of 10%
or more of the outstanding shares of common stock of the
registrant.





As of
November 12, 2010, 206,652,815 shares of the registrant’s common stock were
outstanding.





DOCUMENTS
INCORPORATED BY REFERENCE:









EXPLANATORY
NOTE





We are
filing this Amendment No. 2 on Form 10-K/A to our Annual Report on Form 10-K for
the year ended December 31, 2009, which was filed with the Securities and
Exchange Commission (“SEC”) on March 10, 2010 (“Annual Report on Form 10-K”),
(i) to amend Item 1A – “Risk Factors” to add to the risk factors previously
provided in our Annual Report on Form 10-K additional risk factors related to
the restatement of our financial statements, (ii) to amend Item 6 – “Selected
Financial Data” and Item 8 – “Financial Statements and Supplementary Data” to
restate our audited financial statements for the year ended December 31, 2009 to
reflect the reclassification of certain warrants from equity to liabilities, as
discussed below, (iii) to make corresponding amendments to Item 7 –
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” (“MD&A”) and to provide in MD&A additional disclosure with
respect to research and development expenses, (iv) to amend Item 9A – “Controls
and Procedures” to reflect a reassessment of  our disclosure controls
and procedures, and internal control over financial reporting, as of December
31, 2009 in light of the restatement of our audited financial statements for the
year ended December 31, 2009.


Other
than the foregoing, and the new certifications required by Rule 13a-14 under the
Securities and Exchange Act of 1934 (“Exchange Act”), our Annual Report on
Form 10-K is not being amended or updated in any respect.  This
Amendment No. 2 continues to describe the conditions as of the date of the
Annual Report on Form 10-K, and, except as contained herein, we have not
modified or updated the disclosures contained in the Annual Report on Form
10-K.  This Amendment No. 2 should be read in conjunction with our
filings made with the SEC subsequent to the filing of the Annual Report on Form
10-K, including any amendment to those filings.





Restatement
of Financial Statements





In
connection with a review of our Annual Report on Form 10-K among the Audit
Committee of our Board of Directors (the “Audit Committee”), and our management,
with the assistance of  Ernst & Young LLP (“Ernst & Young”), our
independent registered public accounting firm, and our outside legal advisors,
the Audit Committee has reassessed the accounting classification of certain
warrantsthat we
issued in May 2009 with respect to ASC 815 “Derivatives and Hedging — Contracts
in Entity’s Own Equity” (“ASC 815,” formerly known as Emerging Issues Task Force
Issue 00-19, “Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock”).  The review was conducted
to respond to certain comments raised by the Staff of the SEC following its
periodic review of our Annual Report on Form 10-K.





We have
historically accounted for warrants, which prior to May 2009 were issued in
private transactions, as equity instruments.  Our warrants generally
provide that, in the event the related registration statement or an exemption
from registration is not available for the issuance or resale of the warrant
shares, the holder  may exercise the warrant on a cashless basis. 
 However, notwithstanding the availability of cashless exercise and without
any evaluation of remoteness or probability, ASC 815, as interpreted,
establishes a presumption that, in the absence of express language to the
contrary, registered warrants may be subject to net cash settlement, as it is
not within our absolute control to provide freely-tradable shares in all
circumstances.





After
extensive discussion, the Audit Committee, together with our management and in
consultation with Ernst & Young and our outside legal advisors, determined
that, notwithstanding the highly–remote and theoretical possibility of net cash
settlement, the warrants identified above should have been recorded as
liabilities, measured at fair value calculated using the Black Scholes option
pricing model on the date of issue, with changes in the fair values recognized
in our quarterly statement of operations in our quarterly financial
reports.  Accordingly, the Audit Committee also concluded on
November 8, 2010 that our previously-filed consolidated financial statements for
the year ended December 31, 2009 on Form 10-K; Ernst & Young’s reports on
the financial statements and the effectiveness of internal control over
financial reporting for the year ended December 31, 2009; each of the
consolidated financial statements included in our Quarterly Reports on Form 10-Q
for the periods ended June 30, 2009 and September 30, 2009; and all related
earnings releases and similar communications that we issued with respect to the
foregoing, should no longer be relied upon.As
a result, we are restating our previously-filed consolidated financial
statements for the year ended December 31, 2009 on Form 10-K.  We do
not plan to amend our consolidated financial statements included in our
Quarterly Reports on Form 10-Q for the periods ended June 30, 2009 and September
30, 2009.


ii


The
restatements will have no impact on amounts previously reported for Assets;
Revenues; Operating Expenses; Cash Flows; Loans, Equipment Loan and Accounts
Payables; and Contractual Obligations.  The restatements will have no
effect on our development programs, including Surfaxin®, anticipated development
milestones, business strategy or operations. See, Item
7 – “Management’s Discussion and Analysis of Financial Condition and Results of
Operations,” in this Amendment No. 2.





In light
of the restatement, we have also determined that as of December 31, 2009 our
disclosure controls and procedures were not effective, and that we did not
maintain effective internal control over financial reporting due to a
material weakness related to the initial classification and subsequent
accounting of registered warrants as either liabilities or equity
instruments.  See, “Item 9A - Controls and
Procedures.”


Unless
the context otherwise requires, all references to “we,” “us,” “our,” and the
“Company” include Discovery Laboratories, Inc., and its wholly-owned, presently
inactive subsidiary, Acute Therapeutics, Inc.






FORWARD-LOOKING
STATEMENTS




This
Amendment No. 2 contains “forward-looking statements” within the meaning of
Section 27A of the Securities Act of 1933 (“Securities Act”) and Section 21E of
the Exchange Act.  The forward-looking statements include all matters that
are not historical facts.  Forward-looking statements are only predictions
and provide our current expectations or forecasts of future events and financial
performance and may be identified by the use of forward-looking terminology,
including the terms “believes,” “estimates,” “anticipates,” “expects,” “plans,”
“intends,” “may,” “will” or “should” or, in each case, their negative, or other
variations or comparable terminology, though the absence of these words does not
necessarily mean that a statement is not forward-looking.  We intend that
all forward-looking statements be subject to the safe-harbor provisions of the
Private Securities Litigation Reform Act of 1995.  The forward-looking
statements in this report are subject to certain risks and uncertainties that
could cause actual results to differ materially from historical results or
anticipated results, including those set forth under “Risk Factors” and
“Management's Discussion and Analysis of Financial Conditions and Results of
Operations” in the Annual Report on Form 10-K and elsewhere in, or incorporated
by reference into, the Annual Report on Form 10-K, as amended, including this
Amendment No. 2.





Except to
the extent required by applicable laws, rules or regulations, we do not
undertake any obligation to update any forward-looking statements or to publicly
announce revisions to any of the forward-looking statements, whether as a result
of new information, future events or otherwise.




iii




DISCOVERY
LABORATORIES, INC.




Table
of Contents to Annual Report on Form 10-K/A (Amendment No. 2)


For
the Year Ended December 31, 2009





PART
      IITEM
      1A.
              RISK
      FACTORS
              1PART
      IIITEM
      6.
              SELECTED
      FINANCIAL DATA
              3ITEM
      7.
              MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
              4ITEM
      8.
              FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA
              24ITEM
      9A.
              CONTROLS
      AND PROCEDURES
              24PART
      IVITEM
      15.
              EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES
              28SIGNATURES
              29




iv


ITEM
1A.       RISK FACTORS.




In addition to therisk factorsand other informationconcerning risksset forthin our Annual Report on Form
10-Kand in the
documents incorporated by reference inour Form 10-K and this Amendment
No. 2,you should carefully consider the
following risks before deciding toinvest in shares of our common
stock.If any of the following
risks actually occurs, our businessprospects, financial condition or results of
operationscould be
materially harmed.In such case, the market
price of our common stock would likely declinedue to the occurrence of any of
these risks, and youcouldlose all or part of your
investment.





Therestatement of our historical
financial statements has already consumeda significant amount of our time and
resources and may have a material adverse effect on our business and stock
price.




As
described earlier, we have restated our consolidated financial statements. The
restatement process was highly time and resource-intensive and involved
substantial attention from management and significant legal and accounting
costs. Although we have now completed the restatement, we cannot guarantee that
we will have no inquiries from the SEC or The NASDAQ Capital Market® (“Nasdaq
Capital Market”) regarding our restated financial statements or matters relating
thereto.




Any
future inquiries from the SEC as a result of the restatement of our historical
financial statements will, regardless of the outcome, likely consume a
significant amount of our resources in addition to those resources already
consumed in connection with the restatement itself.




Further,
many companies that have been required to restate their historical financial
statements have experienced a decline in stock price and stockholder lawsuits
related thereto.





Ifwe fail to maintain an effective
system of internal control over financial reporting, we may not be able to
accurately report our financial results, and current and potential stockholders
may lose confidence in our financial reporting.




We are
required by the SEC to establish and maintain adequate internal control over
financial reporting that provides reasonable assurance regarding the reliability
of our financial reporting and the preparation of financial statements in
accordance with generally accepted accounting principles. We are likewise
required, on a quarterly basis, to evaluate the effectiveness of our internal
controls and to disclose any changes and material weaknesses in those internal
controls.




As
described elsewhere in this Amendment No. 2, in connection with the restatement
process, we identified a material weakness with regard to accounting for warrant
instruments in our internal control over financial reporting, specifically with
regard to our prior interpretation of ASC 815, as it related to the initial
classification and subsequent accounting of registered warrants as either
liabilities or equity instruments dating back to May 2009.  Upon a
reassessment of those financial instruments, in light of GAAP as currently
interpreted, we determined that we should have accounted for certain warrant
instruments as liabilities instead of equity. Given this material weakness with
regard to warrants, management concluded that we did not maintain effective
internal control over financial reporting as of December 31,
2009.


1


Since the
determination regarding this material weakness, we plan to devote significant
effort and resources to the remediation and improvement of our internal control
over financial reporting.  While we have processes to identify and
intelligently apply developments in accounting, we plan to enhance these
processes to better evaluate our research and understanding of the nuances of
increasingly complex accounting standards.  Our plans include the
following: enhanced access to accounting literature, research materials and
documents; and increased communication among our legal and finance personnel and
third party professionals with whom to consult regarding complex accounting
applications.  The elements of our remediation plan can only be
accomplished over time and we can offer no assurance that these initiatives will
ultimately have the intended effects.  Any failure to maintain such
internal controls could adversely impact our ability to report our financial
results on a timely and accurate basis.  If our financial statements are
not accurate, investors may not have a complete understanding of our operations.
Likewise, if our financial statements are not filed on a timely basis as
required by the SEC and Nasdaq, we could face severe consequences from those
authorities.  In either case, there could result a material adverse affect
on our business.  Inferior internal controls could also cause investors to
lose confidence in our reported financial information, which could have a
negative effect on the trading price of our stock.  We can give no
assurance that the measures we have taken and plan to take in the future will
remediate the material weaknesses identified or that any additional material
weaknesses or restatements of financial results will not arise in the future due
to a failure to implement and maintain adequate internal control over financial
reporting or circumvention of these controls.  In addition, even if we are
successful in strengthening our controls and procedures, in the future those
controls and procedures may not be adequate to prevent or identify
irregularities or errors or to facilitate the fair presentation of our
consolidated financial statements.


2




PART
II




ITEM
6.          SELECTED FINANCIAL DATA




The
selected financial data set forth in this Item 6 give effect to the restatements
described in “Item 7 - Management’s Discussion and Analysis of Financial
Condition and Results of Operations,” and in Note 2 to our consolidated
financial statements and should be read in conjunction therewith.  The
consolidated statement of operations data for the years ended December 31, 2009
(as restated), 2008 and 2007 and consolidated balance sheet data as of December
31, 2009 (as restated) and 2008 have been derived from audited consolidated
financial statements included as part of this Amendment No. 2.  The
consolidated statement of operations data for the years ended December 31, 2006
and 2005 and consolidated balance sheet data as of December 31, 2007 and 2006
and 2005 are derived from audited financial statements not included in this
Amendment No. 2.




Consolidated Statement of Operations Data:
                              (inthousands,exceptpersharedata)For the year ended December 31,2009
                              (As Restated)
                            
                            
                            2008
                            
                            
                            2007
                            
                            
                            2006
                            
                            
                            2005Revenues
      from collaborative agreements
                            
                            $
                            -
                            
                            
                            $
                            4,600
                            
                            
                            $
                            -
                            
                            
                            $
                            -
                            
                            
                            $
                            134Operating
      Expenses:Research and
      development
                            
                            
                            19,077
                            
                            
                            
                            26,566
                            
                            
                            
                            26,200
                            
                            
                            
                            23,716
                            
                            
                            
                            24,137General and
      administrative
                            
                            
                            10,120
                            
                            
                            
                            16,428
                            
                            
                            
                            13,747
                            
                            
                            
                            18,386
                            
                            
                            
                            18,505Restructuring
    charges
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            4,805
                            
                            
                            
                            –In-process research and
      development
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            16,787Total
      expenses(1)
                            
                            
                            29,197
                            
                            
                            
                            42,994
                            
                            
                            
                            39,947
                            
                            
                            
                            46,907
                            
                            
                            
                            59,429(29,197
                            )
                            
                            
                            (38,394
                            )
                            
                            
                            (
      39,947
                            )
                            
                            
                            (46,907
                            )Change
      in fair value of common stock warrant liability
                            
                            
                            369
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –Other
      (expense) / income
                            
                            
                            (1,043
                            )
                            
                            
                            (712
                            )
                            
                            
                            (58
                            )
                            
                            
                            574
                            
                            
                            
                            391Net
      loss
                            
                            $
                            (29,871
                            )
                            
                            $
                            (
      39,106
                            )
                            
                            $
                            (
      40,005
                            )
                            
                            $
                            (46,333
                            )
                            
                            $
                            (58,904
                            )Net
      loss per common share - basic and diluted
                            
                            $
                            (0.26
                            )
                            
                            $
                            (
      0.40
                            )
                            
                            $
                            (0.49
                            )
                            
                            $
                            (0.74
                            )
                            
                            $
                            (1.09
                            )Weighted
      average number of common shares outstanding
                            
                            
                            115,200
                            
                            
                            
                            98,116
                            
                            
                            
                            81,731
                            
                            
                            
                            62,767
                            
                            
                            
                            54,094





(1)
              Included
      in the net loss for the years ended December 31, 2009, 2008, 2007 and 2006
      were non-cash charges for stock-based compensation for employees in
      accordance with ASC Topic 718 of $2.7 million, $4.6 million, $5.3 million
      and $5.5 million,
respectively.




Consolidated Balance Sheet Data:(in thousands)
                    
                    December 31,2009
                        (As Restated)
                    
                    
                    2008
                    
                    
                    2007
                    
                    
                    2006
                    
                    
                    2005Cash
      and investments
                    
                    $
                    15,741
                    
                    
                    $
                    24,792
                    
                    
                    $
                    53,007
                    
                    
                    $
                    26,402
                    
                    
                    $
                    50,908Working
      capital (before common stock warrant liability)
                    
                    
                    176
                    
                    
                    
                    15,551
                    
                    
                    
                    43,149
                    
                    
                    
                    18,999
                    
                    
                    
                    33,860Total
      assets
                    
                    
                    21,403
                    
                    
                    
                    32,889
                    
                    
                    
                    62,744
                    
                    
                    
                    34,400
                    
                    
                    
                    56,008Long-term
      obligations, less current potion
                    
                    
                    1,118
                    
                    
                    
                    12,090
                    
                    
                    
                    13,494
                    
                    
                    
                    12,110
                    
                    
                    
                    3,562Total
      stockholder’s equity
                    
                    $
                    1,296
                    
                    
                    $
                    10,933
                    
                    
                    $
                    38,781
                    
                    
                    $
                    14,322
                    
                    
                    $
                    34,838





3




ITEM
      7.
            MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS.





RESTATEMENT OF
PREVIOUSLY-ISSUED CONSOLIDATED FINANCIAL STATEMENTS





Inthis Amendment No. 2, wehave restated our
previously-issued
consolidated financial statements and related disclosures forthe year ended December 31,
2009and each of the
quarterly consolidated financial statements on Form 10-Q for the periods
endedJune 30, 2009 andSeptember 30, 2009 to
reclassifywarrantsthat we issued in May 2009,based on a reassessment of
the applicable accountingguidance.


In
accordance with our interpretation of applicable accounting guidance contained
in Accounting Standards Codification (ASC) Topic 815 “Derivatives and
Hedging — Contracts in Entity’s Own Equity” (ASC 815) (formerly known
as Emerging Issues Task Force Issue 00-19, “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”), we
have historically accounted for warrants as equity instruments.  Prior
to May 2009, we issued warrants in private transactions.  In May 2009, we
issued warrants in connection with a registered offering.  To respond
to certain comments raised by the Staff of the Securities and Exchange
Commission (“SEC”) following its periodic review of our 2009 Annual Report on
Form 10-K, the Audit Committee of our Board of Directors (the “Audit
Committee”), and our management, with the assistance of  Ernst &
Young LLP (“Ernst & Young”), our independent registered public accounting
firm, and our outside legal advisors,  reassessed the accounting
classification of the May 2009 registered warrantswith respect to
ASC 815.


The May
2009 warrants provide that, in the event the related registration statement or
an exemption from registration is not available for the issuance or resale of
the warrant shares, the holder  may exercise the warrant on a cashless
basis.  However, notwithstanding the availability of cashless exercise, ASC
815, as interpreted, establishes a presumption that, in the absence of express
language to the contrary, registered warrants may be subject to net cash
settlement, as it is not within our absolute control to provide freely-tradable
shares in all circumstances.  After extensive discussion, our
management, Ernst & Young, and our outside legal advisors concluded that,
although the interpretation and applicability of ASC 815 as it relates to
registered warrants is complex and subject to varying interpretations, it should
be applied based on a strict reading of the authoritative
literature.





Applying
such a strict reading, the Audit Committee, together with management and in
consultation with Ernst & Young and our outside legal advisors, determined
that, notwithstanding the highly-remote and theoretical possibility of net cash
settlement, the warrants that we issued in May 2009 in connection with a
registered offering should have been recorded as liabilities, measured at fair
value on the date of issue, with subsequent changes in the fair values
recognized in our quarterly statement of operations.  Accordingly, the
Audit Committee also concluded on November 8, 2010 that our
previously-filed consolidated financial statements for the year ended December
31, 2009 on Form 10-K; Ernst & Young’s reports on the financial statements
and the effectiveness of internal control over financial reporting for the year
ended December 31, 2009; each of the consolidated financial statements included
in our Quarterly Reports on Form 10-Q for the periods ended June 30, 2009 and
September 30, 2009; and all related earnings releases and similar communications
that we issued with respect to the foregoing, should no longer be relied
upon. As a result, we are amending and restating our previously-filed
consolidated financial statements for the year ended December 31, 2009 on Form
10-K.  We do not plan to amend our consolidated financial statements
included in our Quarterly Reports on Form 10-Q for the periods ended June 30,
2009 and September 30, 2009.


The
restatements reflect the reclassification of the warrants from equity to a
liability in the following amounts, which represents the fair value of the
warrants, as of the issuance dates, calculated using the Black-Scholes option
pricing model.


4


Issuance Date
                  
                  Number of Warrants
                    Issued
                  
                  
                  Exercise Price
                  
                  Expiration of
                    Warrants
                  
                  Fair Value of
                    Warrants at Issuance
                    Date(In
      thousands)May
      13, 2009
                  
                  
                  7,000,000
                  
                  
                  $
                  1.15
                  
                  May
      13, 2014
                  
                  $
                  3,560





The
revaluation of the fair value of warrants at each subsequent balance sheet date
results in a change in the carrying value of the liability, which change is
recorded as “Change in fair value of common stock warrant liability” in the
consolidated statement of operations. The net effect of these changes for year
ended December 31, 2009, and for each of the quarterly consolidated
financial statements on Form 10-Q for the periods ended June 30,
2009 and September 30, 2009 are as follows:


Reporting
      Period
                          
                          Income
      (Loss) Resulting from Change in Fair Value of Common Stock Warrant
      Liability (In
      thousands)
                          
                          
                          Net
      Effect on Loss Per ShareAnnualYear
      ended December 31, 2009
                          
                          $
                          369
                          
                          
                          $
                          –Interim
      (Unaudited)Quarter
      ended June 30, 2009
                          
                          
                          (1,323
                          )
                          
                          
                          (0.01
                          )Quarter
      ended September 30, 2009
                          
                          
                          (1,662
                          )
                          
                          
                          (0.01
                          )Quarter
      ended December 31, 2009
                          
                          
                          3,354
                          
                          
                          
                          0.03


We have
not amended our previously-filed Quarterly Reports on Form 10-Q for the periods
ended June 30, 2009 and September 30, 2009 to reflect the restatements
described in this Amendment No. 2, and thus the financial statements and related
financial statement information contained in those reports should no longer be
relied upon. Throughout this Amendment No. 2, all amounts presented from prior
periods and prior period comparisons that have been revised are labeled as
“restated” and reflect the balances and amounts on a restated
basis.




INTRODUCTION




Management’s
discussion and analysis of financial condition and results of operations
(MD&A) is provided as a supplement to the accompanying consolidated
financial statements and footnotes to help provide an understanding of our
financial condition, the changes in our financial condition and our results of
operations.  This item should be read in connection with our consolidated
financial statements.  See, “Item 15 – Exhibits and
Financial Statement Schedules.”





The
information below has been adjusted solely to reflect the impact of the
restatement of our financial results, which is more fully described above and in
Note 2 to the consolidated financial statements included in this Amendment
No. 2, and to provide in MD&A additional disclosure with respect to
research and development expenses, and does not reflect any subsequent
information or events occurring after the date of the filing of our Annual
Report on Form 10-K or update any disclosure herein to reflect the passage of
time since the date of such filings.





Our
discussion is organized as follows:





·
            Company Overview and Business
      Strategy:  this section provides a general description of our
      company and business plans.





·
            Critical Accounting
      Policies:  this section contains a discussion of the
      accounting policies that we believe are important to our financial
      condition and results of operations and that require the exercise of
      judgment and use of estimates on the part of management in their
      application.  In addition, all of our significant accounting
      policies, including the critical accounting policies and estimates, are
      discussed in Note 3 to the accompanying consolidated financial
      statements.




5




·
            Results of
      Operations:  this section provides an analysis of our results
      of operations presented in the accompanying consolidated statements of
      operations, including comparisons of the results for the years ended
      December 31, 2009, 2008 and
2007.





·
            Liquidity and Capital
      Resources:  this section provides a discussion on our capital
      resources, future capital requirements, cash flows, committed equity
      financing facilities, historical financing transactions, outstanding debt
      arrangements and commitments.






OVERVIEW




Discovery
Laboratories, Inc. (referred to as “we,” “us,” or the “Company”) is a
biotechnology company developing our novel KL4
proprietary technology, which produces a synthetic, peptide-containing
surfactant (KL4
surfactant) that is structurally similar to pulmonary surfactant, a substance
produced naturally in the lung and essential for survival and normal respiratory
function.  In addition, our proprietary capillary aerosol-generating
technology (capillary aerosolization technology) produces a dense aerosol with a
defined particle size, to potentially deliver our aerosolized KL4 surfactant
to the lung.  As many respiratory disorders are associated with surfactant
deficiency or surfactant degradation, we believe that our proprietary technology
platform makes it possible, for the first time, to develop a significant
pipeline of surfactant products targeted to treat a wide range of respiratory
problems.




We are
developing our lead products, Surfaxin®(lucinactant),
Surfaxin LSTM and Aerosurf®, to
address the most significant respiratory conditions affecting pediatric
populations.  Our research and development efforts are currently focused on
the management of RDS in premature infants.  We believe that the RDS market
represents a significant opportunity from both a medical and a business
perspective.  We further believe that Surfaxin, Surfaxin LS and Aerosurf,
have the potential to greatly improve the management of RDS and, collectively,
represent the opportunity, over time, to significantly expand the current RDS
worldwide annual market.





In
addition to our lead products, we plan over time to develop our KL4 surfactant
technology into a broad product pipeline that potentially will address a variety
of debilitating respiratory conditions for which there currently are no or few
approved therapies, in patient populations ranging from premature infants to
adults.  Our KL4 surfactant
is in clinical development to potentially address pediatric patients with Acute
Respiratory Failure (ARF) and patients with Cystic Fibrosis (CF). We are
conducting research and preclinical development with our KL4 surfactant
potentially to address Acute Lung Injury (ALI), and, potentially in the future,
other diseases associated with inflammation of the lung, such as Asthma and
Chronic Obstructive Pulmonary Disease (COPD).  We have also initiated
exploratory preclinical studies to assess the feasibility of using our KL4 surfactant
in combination with small and large molecule therapeutics to efficiently and
effectively deliver therapies to the lung to treat a range of pulmonary
conditions and disease.





An
important priority is to secure strategic and financial resources to potentially
maximize the inherent value in our KL4surfactant
technology.  We would prefer to accomplish our objectives through strategic
alliances.  With respect to our lead products, we are actively engaged in
discussions with potential strategic and/or financial partners, although there
can be no assurance that any strategic alliance or other financing transaction
will be successfully concluded.  With respect to our early stage
exploratory programs, our plans include potentially taking these initiatives
through a Phase 2 proof-of-concept phase and, if successful, thereafter
determining whether to seek strategic alliances or collaboration arrangements or
to utilize other financial alternatives to fund their further
development.





We have
focused our current resources on our lead products, primarily to address the
requirements to gain the potential approval of Surfaxin in the United
States.    Until such time as we secure sufficient strategic and
financial resources to support the continuing development of our KL4 surfactant
technology and support our operations, we will continue to conserve our
resources, predominantly by curtailing and pacing investments in our pipeline
programs.





6




The
reader is referred to, and encouraged to read in its entirety “Item 1 –
Business” of this Annual Report on Form 10-K, which contains a discussion of our
Business and Business Strategy, as well as information concerning our
proprietary technologies and our current and planned KL4 pipeline
programs.





As of
December 31, 2009, we had cash and cash equivalents of $15.7 million.  In
February 2010, we completed a public offering resulting in gross proceeds of
$16.5 million ($15.1 million net).  Also, as of December 31, 2009, our
$10.5 million loan with Quintiles is classified as a current liability, payable
in April 2010.  We are pursuing a potential strategic restructuring of this
loan: however, there can be no assurance that any such restructuring will occur.
Currently, under our two Committed Equity Financing Facilities (CEFFs), we may
potentially raise (subject to certain conditions, including minimum stock price
and volume limitations) up to an aggregate of $69.5 million.  However, as
of March 1, 2010, neither CEFF was available because the market price of our
common stock price was below the minimum price required to utilize the
facility.  During 2009, we raised aggregate gross proceeds of $22.0
million.  In May 2009, we completed a registered direct public offering in
resulting in gross proceeds of $11.3 million ($10.5 million net), and,
throughout 2009, we raised an aggregate of $10.7 million from 10 draw-downs
under our CEFFs.  See, ”– Committed Equity
Financing Facilities (CEFFs)”, and “– Financings Pursuant to Common Stock
Offerings.”





Our
future capital requirements depend upon many factors, including the success of
our efforts to secure one or more strategic alliances or other collaboration
arrangements to support our product development activities and, if approved,
commercialization plans.  We are currently focused on developing our lead
KL4
surfactant products, Surfaxin LS, Aerosurf and Surfaxin, to address the most
significant respiratory conditions affecting pediatric populations. 
However, there can be no assurance that we will be able to secure strategic
partners or collaborators to support and advise our activities, that our
research and development projects will be successful, that products developed
will obtain necessary regulatory approval, that any approved product will be
commercially viable, that any CEFF will be available for future financings, or
that we will be able to obtain additional capital when needed on acceptable
terms, if at all.  In addition to multiple strategic alternatives, we
continue to consider potential additional financings and other similar
opportunities to meet our capital requirements and continue our
operations.  Even if we succeed in securing strategic alliances, raising
additional capital and developing and subsequently commercializing product
candidates, we may never achieve sufficient sales revenue to achieve or maintain
profitability.




CRITICAL
ACCOUNTING POLICIES





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





We
believe the following accounting policies are the most critical for an
understanding of our financial condition and results of operations.  For
further discussion of our accounting policies, see “Note 3 – Summary of
Significant Accounting Policies” in the Notes to Consolidated Financial
Statements for the year ended December 31, 2009,  in Part IV to this Annual
Report on Form 10-K.





Revenue
recognition under strategic alliances and collaboration agreements





Revenue
under strategic alliances and our collaboration agreements is recognized based
on the performance requirements of the contract.  Grant revenue is recorded
upon receipt of funds.





Research
and development expenses





Research
and development costs consist primarily of expenses associated with our
personnel, facilities, manufacturing operations, formulation development,
research, clinical, regulatory, other preclinical and clinical activities and
medical affairs.  Research and development costs are charged to operations
as incurred.





7


Warrant
accounting




We
account for common stock warrants in accordance with applicable accounting
guidance provided in ASC 815 as either derivative liabilities or as equity
instruments depending on the specific terms of the warrant agreement.  In
compliance with applicable securities law, registered common stock warrants that
require the issuance of registered shares upon exercise and do not sufficiently
preclude an implied right to cash settlement are accounted for as derivative
liabilities.  We classify these derivative warrant liabilities on the
consolidated balance sheet as a current liability, which is revalued at each
balance sheet date subsequent to the initial issuance.   We use the
Black-Scholes pricing model to value the derivative warrant liability. Changes
in the fair value of the warrants are reflected in the consolidated statement of
operations as “Change in the fair value of common stock warrant
liability.”


RESULTS
OF OPERATIONS





The net
loss for the years ended December 31, 2009, 2008 and 2007 was $29.9 million
(or $0.26 per share), $39.1 million (or $0.40 per share), and
$40.0 million (or $0.49 per share), respectively.  Included in the net
loss for the years ended December 31, 2009, 2008 and 2007 were stock-based
compensation expenses of $2.7 million (or $0.02 per share), $4.6 million (or
$0.05 per share), and $5.3 million (or $0.06 per share), respectively.  In
addition, the net loss for the year ended December 31, 2009 includes $0.4
million of income from warrant obligations in connection with the restatement of
our previously reported financial statements.





Revenue





The
company did not record any revenues in 2009 and 2007.





In March
2008, we restructured our December 2005 strategic alliance with Philip Morris
USA Inc. (PMUSA), d/b/a Chrysalis Technologies (Chrysalis), and assumed full
responsibility from Chrysalis for the further development of the capillary
aerosolization technology.  As part of the restructuring, Chrysalis
completed a technology transfer to us, provided development support through June
30, 2008, and also paid us $4.5 million to support our future development
activities, which we recognized as revenue in 2008.  See,“Item 1 – Business
– Licensing, Patents and Other Proprietary Rights and Regulatory Designations –
Patents and Proprietary Rights – Philip Morris USA Inc. and Philip Morris
Products S.A.”





Research
and Development Expenses





Our
research and development expenses are charged to operations as incurred and we
track such costs by category rather than by project.  As many of our
research and development activities form a foundation for the development of our
KL4
surfactant technology platform, they benefit more than a single project. 
For that reason, we cannot reasonably estimate the costs or our research and
development activities on a project-by-project basis.  We believe that
tracking our expenses by category is a more accurate method of accounting for
these activities.  Our research and development costs consist primarily of
expenses associated with (a) manufacturing development, (b) development
operations, and (c) direct pre-clinical and clinical programs.  We
also track our research and development expenses by the following categories:
(i) salaries and benefits, (ii) contracted services, (iii) rents and utilities,
(iv) raw materials and supplies, (v) stock-based compensation and (vi)
other.




8




Research
and development expenses for the years ended December 31, 2009, 2008 and 2007
were $19.1 million, $26.6 million and $26.2 million, respectively. 
These costs are charged to operations as incurred and are tracked by category,
as follows:





(Dollars in thousands)
                                
                                Year Ended December 31,2009
                                
                                
                                2008
                                
                                
                                2007Research and Development Expenses:Manufacturing
      development
                                
                                $
                                9,118
                                
                                
                                $
                                14,165
                                
                                
                                $
                                11,888Development
      operations
                                
                                
                                7,100
                                
                                
                                
                                9,113
                                
                                
                                
                                10,196Direct
      pre-clinical and clinical programs
                                
                                
                                2,859
                                
                                
                                
                                3,288
                                
                                
                                
                                4,116Total
      Research and Development Expenses (1)
                                
                                $
                                19,077
                                
                                
                                $
                                26,566
                                
                                
                                $
                                26,200





For a
description of the clinical programs included in research and development, see “– Surfactant Replacement
Therapy for Respiratory Medicine.”





Manufacturing
Development





Manufacturing
development includes the cost of our manufacturing operations, quality assurance
and analytical chemistry capabilities to assure adequate production of clinical
and potential commercial drug supply for our KL4 surfactant
products, in conformance with current good manufacturing practices (cGMP). 
These costs include employee expenses, facility-related costs, depreciation,
costs of drug substances (including raw materials), supplies, quality control
and assurance activities and analytical services, etc.  Additionally, in
2008 costs included activities to address issues identified in an Approvable
Letter that we received from the FDA with respect to Surfaxin in May 2008 (May
2008 Approvable Letter).





The
decrease in manufacturing development expenses in 2009 as compared to 2008 is
primarily due to our efforts in 2009 to conserve financial resources following
receipt of the April 2009 Complete Response Letter.





The
increase in manufacturing development expenses in 2008 as compared to 2007 is
primarily due to: (i) expenditures in 2008 to support our quality assurance
and analytical chemistry capabilities, including implementation and validation
of analytical methods and quality testing of drug product for our development
programs; (ii) activities related to preparation of the Complete Response to the
May 2008 Approvable Letter; and (iii) purchases of active ingredients for the
production of Surfaxin.





Manufacturing
development expenses included charges of $0.4 million, $0.8 million and $0.7
million associated with stock-based employee compensation for the years ended
December 31, 2009, 2008, and 2007, respectively.





Development
Operations





Development
operations includes: (i) medical, scientific, clinical, regulatory, data
management and biostatistics activities in support of our KL4 surfactant
development programs; (ii) medical affairs activities to provide scientific
and medical education support in connection with our KL4 surfactant
technology pipeline programs; (iii) design and development for the
manufacture of our novel capillary aerosolization systems, including an aerosol
generating device, the disposable dose delivery packets and patient interface
system necessary to administer Aerosurf for our planned Phase 2 clinical trials
and; (iv) pharmaceutical development activities, including development of a
lyophilized (dry powder) formulation of our KL4
surfactant.  These costs include personnel, expert consultants, outside
services to support regulatory, data management and device development
activities, symposiums at key neonatal medical meetings, facilities-related
costs, and other costs for the management of clinical trials.





The
decrease in development operations expenses in 2009 as compared to 2008 is
primarily due to our efforts in 2009 to conserve financial resources and limit
investment in our KL4
respiratory pipeline programs following receipt of the April 2009 Complete
Response Letter.  The decrease in development operations expenses in 2008
as compared to 2007 is primarily due to cost reductions resulting from the
relocation of our analytical testing and pharmaceutical development activities
previously performed at our laboratories located in Doylestown, Pennsylvania,
and Mountain View, California, and consolidation of those activities into our
new laboratory space in Warrington, Pennsylvania, in the fourth quarter of
2007.  The decrease in 2008 from 2007 was partially offset by expenditures
in  2008 associated with our medical affairs capabilities, including
medical science liaisons and symposiums at key pediatric medical meetings in
anticipation of the potential approval and commercial launch of Surfaxin in May
2008.  Expenses associated with medical affairs activities were $0.6
million, $2.0 million and $0.8 million for the years ended December 31, 2009,
2008 and 2007, respectively.





9


Development
operations expenses included charges of $0.3 million, $0.7 million and $0.9
million associated with stock-based employee compensation for the years ended
December 31, 2009, 2008, and 2007, respectively.





Direct Pre-Clinical and
Clinical Programs





Direct
pre-clinical and clinical programs include: (i) pre-clinical activities,
including toxicology studies and other pre-clinical studies to obtain data to
support potential Investigational New Drug (IND) and NDA filings for our product
candidates; (ii) activities associated with conducting human clinical
trials, including patient enrollment costs, external site costs, clinical drug
supply and related external costs such as contract research consultant fees and
expenses; (iii) activities related to addressing the items identified in
the April 2009 Complete Response Letter; and (iv) activities related to
preparation of the Complete Responses (submitted in November 2007 and October
2008, respectively) to an Approvable Letter received from the FDA with respect
to Surfaxin in April 2006 (April 2006 Approvable Letter) and the May 2008
Approvable Letter.





Direct
pre-clinical and clinical programs expenses in 2009 included: (i) costs
associated with activities to address issues identified in the April 2009
Complete Response Letter; (ii) activities associated with the ongoing Phase
2 clinical trial evaluating the use of Surfaxin in children up to two years of
age suffering with ARF; and (iii) pre-clinical and preparatory activities
for anticipated Phase 2 clinical trials for Surfaxin LS and Aerosurf for RDS in
premature infants.





Direct
pre-clinical and clinical programs expenses in 2008 and 2007 included:
(i) costs associated with preparation of the Complete Responses to the May
2008 Approvable Letter and the April 2006 Approvable Letter;
(ii) activities associated with the ongoing Phase 2 clinical trial
evaluating the use of Surfaxin in children up to two years of age suffering with
ARF; and (iii) pre-clinical and preparatory activities for anticipated
Phase 2 clinical trials for Aerosurf for RDS in premature infants.  The
decrease in expenses in 2008 as compared to 2007 is primarily due to our efforts
to conserve financial resources following receipt of the May 2008 Approvable
Letter.





The
decrease in direct pre-clinical and clinical program expenses in 2009 compared
to 2008 and 2007 is primarily due to our efforts to conserve financial resources
and limit our investment in research and development programs in anticipation of
potentially securing a strategic or financial alternative to fund our research
and development activities.





Research and Development
Expenses by Category





We also
track our research and development expenses in major categories as shown in
the following table:





2009
                  
                  
                  2008
                  
                  
                  2007Salaries
      & Benefits
                  
                  $
                  8,693
                  
                  
                  $
                  11,651
                  
                  
                  $
                  9,808Contracted
      Services
                  
                  
                  4,832
                  
                  
                  
                  6,378
                  
                  
                  
                  8,522Rents
      & Utilities
                  
                  
                  1,310
                  
                  
                  
                  1,628
                  
                  
                  
                  2,105Depreciation
                  
                  
                  1,235
                  
                  
                  
                  1,511
                  
                  
                  
                  1,135Raw
      Materials & Supplies
                  
                  
                  1,466
                  
                  
                  
                  2,241
                  
                  
                  
                  1,091Stock-Based
      Compensation
                  
                  
                  694
                  
                  
                  
                  1,503
                  
                  
                  
                  1,681All
      Other
                  
                  
                  847
                  
                  
                  
                  1,654
                  
                  
                  
                  1,858Total
                  
                  $
                  19,077
                  
                  
                  $
                  26,566
                  
                  
                  $
                  26,200





Year-to-year
changes in salaries, benefits and stock-based compensation generally reflect
changes in the size and mix of our employee base over time.  In the second
half of 2007, we increased our workforce in anticipation of the potential
commercial launch of Surfaxin in 2008 and, with the prospect of generating
revenues, a potential acceleration of our investment in our pipeline
programs.  We maintained our employee base at approximately the same level
throughout 2008.  Following receipt of the April 2009 Complete Response
Letter for Surfaxin, we reduced our workforce and restructured certain functions
in research and development, primarily medical affairs. See, “– Results of Operations
– General and Administrative Expenses.”





10


Contracted
services include the cost of pre-clinical studies, clinical trial activities,
certain components our manufacturing operations, quality control and analytical
testing of our drug product, biological activity testing, consulting services,
aerosol device design and engineering services, etc.  Contracted services
decreased over the three-year period primarily due to limiting our investment in
our KL4 pipeline
programs to conserve financial resources following receipt of the May 2008
Approvable Letter.





Rents and
utilities are associated with our leased manufacturing, laboratory and related
facilities, including our manufacturing operations in Totowa, New Jersey. 
The decrease in rents and utilities over the three-year period is due to
termination of leases for office and analytical laboratory space in Doylestown,
Pennsylvania, and Mountain View, California, in mid-2008.  The activities
performed at these locations were consolidated in the fourth quarter of
2007 into our new analytical and development laboratory at corporate
headquarters at, in Warrington, Pennsylvania.





Depreciation
is associated with manufacturing and laboratory equipment, as well as leasehold
improvements at our manufacturing operations in Totowa and our laboratories and
related space at our headquarters in Warrington, Pennsylvania. The increase
in depreciation from 2007 to 2008 is associated with investments made to
complete the new analytical and development laboratory in Warrington,
Pennsylvania, at the end of 2007.  Approximately $300,000 of depreciation
in 2008 (and 2009) represents a full year of depreciation with respect to the
new laboratory.  The decline from 2008 to 2009 is due to our limiting
purchases of equipment during 2008 and 2009 to conserve financial resources.
 In addition, certain older assets became fully depreciated in this period,
resulting in a decrease in depreciation expense.





Raw
materials and supplies consist of purchases of our active pharmaceutical
ingredients for the manufacture of our KL4 product
candidates and supplies to support our manufacturing and laboratory operations,
including component parts for the disposable dose delivery packets and patient
interface system necessary to administer Aerosurf via our  novel capillary
aerosolization systems.





All other
includes the cost of employee travel, insurances, shipping and
taxes.





Research and Development
Projects





A
substantial portion of our cumulative losses to date, including approximately
$71.8 million in the three-year period ending December 31, 2009, relate to
investments in our research and development activities.  Due to the
significant risks and uncertainties inherent in the clinical development and
regulatory approval processes, the nature, timing and costs of the efforts
necessary to complete individual projects in development are not reasonably
estimable.  With every phase of a development project, there are
significant unknowns that may significantly impact cost projections and
timelines.  As a result of the number and nature of these factors, many of
which are outside our control, the success, timing of completion and ultimate
cost, of development of any of our product candidates is highly uncertain and
cannot be estimated with any degree of certainty.





Certain
of the risks and uncertainties affecting our ability to estimate projections and
timelines are discussed in “Item 1– Business – Government Regulation;” and in
“Item 1A – Risk Factors– The regulatory approval process for our products is
expensive and time-consuming and the outcome is uncertain.  We may not
obtain required regulatory approvals for the commercialization of our products;”
“– Our research and development activities involve significant risks and
uncertainties that are inherent in the clinical development and regulatory
approval processes;” “– Our ongoing  clinical trials may be delayed, or
fail, which will harm our business,” “– The manufacture of our drug products is
a highly exacting and complex process, and if we, our contract manufacturers or
any of our materials suppliers encounter problems manufacturing our products or
the drug substances used to make our products, this could potentially cause us
to delay development or clinical programs or, following approval, product
launch, or cause us to experience shortages of products inventories;” as well as
elsewhere in our Annual Report on Form 10-K.





11


Our lead
development projects are initially focused on the management of RDS in premature
infants and include Surfaxin, Surfaxin LS and Aerosurf.  We believe that
these neonatal programs have the potential to greatly improve the management
of  RDS and expand the current RDS market worldwide.  All of these
potential products are either in regulatory review or clinical or pre-clinical
development and none are available for commercial sale.  While we
anticipate that we will be in a position to file a complete response with the
FDA with respect to Surfaxin for the prevention of RDS in premature infants in
the first quarter 2011, which could lead to potential approval of Surfaxin in
2011, there can be no assurance that we will be successful in securing such
approval or that, if approved, we will be successful in commercializing Surfaxin
and realizing a profit in the foreseeable future.  We are preparing for
clinical programs for Surfaxin LS and Aerosurf; however, our ability to move
forward will depend upon the success of our efforts to secure appropriate
strategic alliances and capital to fund these activities.  Accordingly, we
are unable to project when we might implement these programs, the pace of such
implementation or the overall anticipated expense that we might
incur.





The
status of our lead projects and our other pipeline candidates, including the
potential timing and milestones for each, is discussed in “Item 1– Business –
Surfactant Replacement Therapy for Respiratory Medicine.” See also, “Item 1 –
Business – Business Strategy,” and “Item 1A – Risk Factors – We may not
successfully develop and market our products, and even if we do, we may not
become profitable,”  “– We will require significant additional capital to
continue our planned research and development activities and continue to operate
as a going concern.  Moreover, such additional financing could result in
equity dilution.”





In
addition to our lead products, we plan over time to develop our KL4 surfactant
technology into a broad product pipeline that potentially will address a variety
of debilitating respiratory conditions in patient populations ranging from
premature infants to adults.  After we have completed Phase 2
proof-of-concept studies for each potential indication, if successful, we plan
to assess the potential markets for these products and determine whether to seek
strategic alliances or collaboration arrangements, or utilize other financial
alternatives to fund their further development.  At the present time,
however, we continue to conserve our resources, predominantly by curtailing and
pacing investments in these pipeline programs.  See, “Item 1 – Business –
Business Operations,” and “ – Surfactant Replacement Therapy For Respiratory
Medicine.”





Our
ability to generate sufficient capital to support our product development
activities and, if approved, commercialization plans, depends upon many factors,
including the success of our efforts to secure one or more strategic alliances
or other collaboration arrangements.  We believe that our ability to
successfully enter into meaningful strategic alliances will likely improve with
advances, if any, that we are able to make in finalizing our development efforts
and filing the Complete Response for Surfaxin, and in our Surfaxin LS and
Aerosurf programs leading to initiation of clinical trials.  There can be
no assurance, however, that we will be able to secure strategic partners or
collaborators to support and provide expert advice to guide our activities, that
our research and development projects will be successful, or that we will be
able to obtain additional capital to support our activities when needed on
acceptable terms, if at all.





Ultimately,
if we do not successfully develop and gain marketing approval for our drug
product candidates, in the United States or elsewhere, we will not be able to
commercialize, or generate any revenues from the sale of, our products and the
value of our company and our financial condition and results of operations will
be substantially harmed.





General
and Administrative Expenses





General
and administrative expenses consist primarily of the costs of executive
management, business and commercial development, finance and accounting,
intellectual property and legal, human resources, information technology,
facility and other administrative costs.





General
and administrative expenses for the years ended December 31, 2009, 2008, and
2007 were $10.1 million, $16.4 million, and $13.7 million, respectively. 
General and administrative expenses included charges of $2.2 million, $3.1
million and $3.6 million associated with stock-based employee compensation for
the years ended December 31, 2009, 2008, and 2007, respectively.





12


Expenses
for pre-launch commercial activities for the years ended December 31, 2009, and
2008  and 2007 were $0.7, $5.0 million, and $2.2 million,
respectively.  A significant component of 2008 and 2007 general and
administrative expenses is associated with pre-launch commercial activities to
prepare for the potential approval and commercial launch of Surfaxin in May
2008.  These activities began in the second half of 2007 and were
accelerated in early 2008 up to receipt of the May 2008 Approvable Letter. 
Following receipt of the May 2008 Approvable Letter, we scaled back our
commercial activities.  Throughout the remainder of 2008 and into 2009, we
made limited investments in our commercial capabilities in anticipation of the
potential approval of Surfaxin in the United States.  Following receipt of
the April 2009 Complete Response Letter, we have reassessed our business
strategy and have curtailed investment in commercial capabilities.  We no
longer plan to establish our own specialty pulmonary commercial organization to
launch our KL4 surfactant
products in the Unites States and are now seeking to enter into strategic
alliances to support our research and development programs and, if approved, to
commercialize our products in all markets, including the United States. 
 Although we are actively engaged in discussions with potential strategic
and/or  financial partners, there can be no assurance that any strategic
alliance or other financing transaction will be successfully
concluded.





In
addition, following receipt in April 2009 Complete Response Letter, to conserve
our cash resources, we implemented cost containment measures and reduced our
workforce from 115 to 91 employees.  The workforce reduction was focused
primarily in our commercial and corporate administrative groups.  We
incurred a one-time charge of $0.6 million ($0.4 million in general and
administrative expenses and $0.2 million in research and development expenses)
in 2009 related to the workforce reduction. As of December 31, 2009, we had
77 full-time employees, the majority of which are devoted to research and
development.





We
believe our existing general and administrative resources, including legal,
finance, business development, information technologies, human resources and
general management capabilities, are sufficient to support our business
operations for the foreseeable future.  We may make additional investments
in the future to enhance these capabilities as and when required to meet the
needs of our business.





To
sustain and perfect our potential competitive position, we expect to invest in
maintaining our existing patent portfolio, trademarks, trade secrets and
regulatory exclusivity designations, including potential orphan drug and new
drug product exclusivities, and when appropriate, patent extensions, new
patents, new trademarks, and new regulatory exclusivity designations, when
available.  See, “Item 1 – Business –
Licensing, Patents and Other Proprietary Rights and Regulatory
Designations.”




Change
in Fair Value of Common Stock Warrant Liability
 
 We
account for common stock warrants in accordance with applicable accounting
guidance provided in ASC 815, as either derivative liabilities or as equity
instruments depending on the specific terms of the warrant agreement. Derivative
warrant liabilities are valued using the Black-Scholes pricing model at the date
of initial issuance and each subsequent balance sheet date.  Changes
in the fair value of the warrants are reflected in the consolidated statement of
operations as “Change in the fair value of common stock warrant
liability.”
 
 The
change in fair value of common stock warrant liability for the year ended
December 31, 2009 resulted in income of $0.4 million due primarily to a decrease
in the Company’s common stock share price during the period.




Other
Income / (Expense)




Other
income/(expense), net was ($1.0) million, ($0.7) million and ($0.1) million for
the years ended December 31, 2009, 2008 and 2007, respectively, as summarized in
the chart below:





(Dollars in thousands)
                    
                    Year Ended December 31,2009
                    
                    
                    2008
                    
                    
                    2007Interest
      income
                    
                    $
                    48
                    
                    
                    $
                    842
                    
                    
                    $
                    1,794Interest
      expense
                    
                    
                    (1,096
                    )
                    
                    
                    (1,614
                    )
                    
                    
                    (1,906
                    )Other
      income / (expense)
                    
                    
                    5
                    
                    
                    
                    60
                    
                    
                    
                    54Other
      income / (expense), net
                    
                    $
                    (1,043
                    )
                    
                    $
                    (712
                    )
                    
                    $
                    (58
                    )


Interest
income consists of interest earned on our cash and marketable securities. 
The decrease in interest income in 2009 and 2008 is due to a general decline in
market interest rates and in our average cash and marketable securities
balance.





Interest
expense consists of interest accrued on the outstanding balance of our loan with
Quintiles and under our equipment financing facilities.  In addition,
interest expense includes $0.5 million, $0.5 million and $0.5 million for the
years ended December 31, 2009, 2008 and 2007, respectively, associated with the
amortization of deferred financing costs for warrants issued to Quintiles in
October 2006 as consideration for restructuring our loan in 2006.  The
decrease in interest expense in 2009 and 2008 is due to a decline in the
variable interest rate on our Quintiles loan, which is equal to the U.S. prime
rate.




13




Other
income/(expenses) primarily consists of proceeds from the sale of our
Commonwealth of Pennsylvania research and development tax credits of $5,000,
$0.1 million, and $0.2 million for the years 2009, 2008 and 2007,
respectively.  The decrease in proceeds from the sale of these tax credits
is due to more credits being available for sale in 2007 and 2008 as
compared to 2009.




LIQUIDITY
AND CAPITAL RESOURCES





We have
incurred substantial losses since inception due to investments in research and
development, manufacturing and potential commercialization activities and we
expect to continue to incur substantial losses over the next several
years.  Historically, we have funded our business operations through
various sources, including public and private securities offerings, draw downs
under our CEFFs, capital equipment and debt facilities, and strategic
alliances.  We expect to continue to fund our business operations through a
combination of these sources, as well as sales revenue from our product
candidates, beginning with Surfaxin for the prevention of RDS, if
approved.





Following
receipt of the April 2009 Complete Response Letter for Surfaxin, we made
fundamental changes in our business strategy. We now believe that  it
is in our best interest financially to seek to develop and commercialize our
KL4
technology through strategic alliances or other collaboration
arrangements.  However, there can be no assurance that any strategic
alliance or other arrangement will be successfully concluded.





The
accompanying financial statements have been prepared assuming that we will
continue as a going concern, which contemplates the realization of assets and
satisfaction of liabilities in the normal course of business.  As a result
of our cash position as of December 31, 2009, the audit opinion we received from
our independent auditors, which is included in our financial statements in this
report, contains a notation related to our ability to continue as a going
concern.  Our ability to continue as a going concern is dependent on our
ability to raise additional capital, to fund our research and development and
commercial programs and meet our obligations on a timely basis.  If we are
unable to successfully raise sufficient additional capital, through strategic
and collaborative arrangements with potential partners and/or future debt
and equity financings, we will likely not have sufficient cash flows and
liquidity to fund our business operations, which could significantly limit our
ability to continue as a going concern.  In that event, we may be forced to
further limit development of many, if not all, of our programs and consider
other means of creating value for our stockholders, such as licensing the
development and/or commercialization of products that we consider valuable and
might otherwise plan to develop ourselves.  If we are unable to raise the
necessary capital, we may be forced to curtail all of our activities and,
ultimately, cease operations.  Even if we are able to raise additional
capital, such financings may only be available on unattractive terms, or could
result in significant dilution of stockholders’ interests and, in such event,
the market price of our common stock may decline.  Our December 31, 2009
financial statements do not include any adjustments relating to recoverability
and classification of recorded asset amounts or the amounts and classification
of liabilities that might be necessary should we be unable to continue in
existence.





Our
future capital requirements depend upon many factors, including the success of
our efforts to secure one or more strategic alliances to support our product
development activities and commercialization plans, and the ultimate success of
our product development and commercialization plans.  Currently, we are
focused on developing our lead KL4 surfactant
products to address the most significant respiratory conditions affecting
pediatric populations. However, there can be no assurance that we will be able
to secure strategic partners to support our activities, that our research and
development projects will be successful, that products developed will obtain
necessary regulatory approval, that any approved product will be commercially
viable, that any CEFF will be available for future financings, or that we will
be able to obtain additional capital when needed on acceptable terms, if at
all.  In addition to multiple strategic alternatives, we continue to
consider potential additional financings and other similar opportunities to meet
our capital requirements and continue our operations.  Even if we succeed
in raising additional capital and developing and subsequently commercializing
product candidates, we may never achieve sufficient sales revenue to achieve or
maintain profitability.





14


As of
December 31, 2009, we had cash and cash equivalents of $15.7 million.  In
February 2010, we completed a public offering resulting in gross proceeds of
$16.5 million ($15.1 million net).  Also, as of December 31, 2009, our
$10.5 million loan with Quintiles is classified as a current liability, payable
in April 2010. We are pursuing a potential strategic restructuring of this
loan: however, there can be no assurance that any such restructuring will occur.
Currently, under our two CEFFs, we may potentially raise (subject to certain
conditions, including minimum stock price and volume limitations) up to an
aggregate of $69.5 million.  However, as of March 5, 2010, neither the May
2008 CEFF nor the December 2008 CEFF was available because the market price of
our common stock was below the minimum price required ($1.15 and $0.60,
respectively) to utilize the facility.  During 2009, we raised aggregate
gross proceeds of $22.0 million.  In May 2009, we completed a registered
direct public offering in resulting in gross proceeds of $11.3 million ($10.5
million net), and, throughout 2009, we raised an aggregate of $10.7
million from 10 draw-downs under our CEFFs.  See, “– Committed Equity
Financing Facilities (CEFFs),” and “– Financings Pursuant to Common Stock
Offerings.”




To meet
our capital requirements, we continue to consider multiple strategic
alternatives, including, but not limited to potential business alliances,
commercial and development partnerships, additional financings and other
similar opportunities, although there can be no assurance that we will take any
further specific actions or enter into any transactions.  Until such
time as we secure the necessary capital, we plan to continue conserving our
financial resources, predominantly by limiting investments in our pipeline
programs.  See, “Item 1A – Risk Factors
–  We will require significant additional capital to continue our planned
research and development activities and continue to operate as a going
concern.  Moreover, such additional financing could result in equity
dilution,” and “– The terms of our indebtedness may impair our ability to
conduct our business,” “– Future sales and issuances of our common stock or
rights to purchase our common stock, including pursuant to our CEFFs, stock
incentive plans and upon the exercise of outstanding securities exercisable for
shares of our common stock, could result in substantial additional dilution of
our stockholders, cause our stock price to fall and adversely affect our ability
to raise capital.”





Cash
Flows





We had
cash, cash equivalents and marketable securities of $15.7 million, $24.8 million
and $53.0 million as of December 31, 2009, 2008 and 2007, respectively. 
The decrease of $9.1 million in 2009 is primarily due to $30.0 million used in
operating activities, capital expenditures and principal payments on equipment
loans, partially offset by proceeds of $10.4 million from financings under our
CEFFs and $10.5 million from our May 2009 Registered Direct Offering. See, “– Committed Equity
Financing Facilities (CEFFs)”, and “– Financings Pursuant to Common Stock
Offerings.”





Cash
Flows Used in Operating Activities





Cash
flows used in operating activities were $27.4 million, $31.8 million and $29.4
million for the years ended December 31, 2009, 2008 and 2007,
respectively.





Our cash
flows used in operating activities are a result of our net operating losses
adjusted for non-cash items associated with stock-based compensation, fair value
adjustment of common stock warrants, depreciation and changes in our accounts
payable and accrued liabilities.  See, “– Results of
Operations.”  Cash flows from operating activities in 2008 also include
$4.5 million received from Chrysalis to support development of our
capillary aerosolization technology.





Cash
Flows From / (Used in) Investing Activities





Cash
flows from / (used in) investing activities include capital expenditures of $0.1
million, $0.6 million and $3.8 million for the years ended December 31, 2009,
2008 and 2007, respectively.  Capital expenditures were primarily for
laboratory and manufacturing equipment to support analytical, quality,
manufacturing and development activities.  In 2007, we completed
construction of a new analytical and development laboratory in our headquarters
in Warrington, Pennsylvania, for a total cost of approximately $3.0 million and
consolidated at this location the analytical, quality and development activities
previously conducted at locations in Doylestown, Pennsylvania, and Mountain
View, California.  The new laboratory expanded our capabilities by
providing additional capacity to conduct analytical testing as well as
opportunities to exploit our internal professional expertise across a broad
range of projects, improving both operational efficiency and financial
economics.  The leases for our Doylestown, Pennsylvania, and Mountain View,
California, locations either expired or terminated in 2008.  See, “– Contractual
Obligations.”





15




Cash
flows from / (used in) investing activities also include cash used to purchase
short-term marketable securities and cash received from the sale and/or maturity
of short-term marketable securities.  When assessing our cash position and
managing our liquidity and capital resources, we do not consider cash flows
between cash and marketable securities to be meaningful.  Cash used to
purchase marketable securities is subject to an investment policy that is
approved by the Board of Directors and provides for the purchase of high-quality
marketable securities, while ensuring preservation of capital and fulfillment of
liquidity needs.  As of December 31, 2009, the company did not have any
available-for-sale marketable securities.





Cash
Flows from Financing Activities





Cash
flows from financing activities were $18.3 million, $4.2 million and $59.7
million for the years ended December 31, 2009, 2008 and 2007, respectively, as
summarized in the chart below:





(In millions)
                        
                        Year Ended December 31,2009
                        
                        
                        2008
                        
                        
                        2007Financings
      under CEFFs
                        
                        $
                        10.3
                        
                        
                        $
                        6.3
                        
                        
                        $
                        7.0Financings
      pursuant to common stock offerings
                        
                        
                        10.5
                        
                        
                        
                        –
                        
                        
                        
                        51.7Proceeds
      from equipment financing facilities
                        
                        
                        –
                        
                        
                        
                        0.9
                        
                        
                        
                        2.9Debt
      service payments
                        
                        
                        (2.5
                        )
                        
                        
                        (3.0
                        )
                        
                        
                        (1.9
                        )Cash
      flows from financing activities, net
                        
                        $
                        18.3
                        
                        
                        $
                        4.2
                        
                        
                        $
                        59.7




The
following sections provide a more detailed discussion of our cash flows from
financing activities.




Committed
Equity Financing Facilities (CEFFs)





We have
entered into four Committed Equity Financing Facilities (CEFFs) with Kingsbridge
Capital Limited (Kingsbridge), a private investment group, under which
Kingsbridge is committed to purchase, subject to certain conditions,
newly-issued shares of our common stock.  The CEFFs allow us, at our
discretion, to raise capital at the time and in amounts deemed suitable to us,
to support our business plans.  We are not obligated to utilize any of the
funds available under the CEFFs.  Each CEFF is available for a period of
two or three years from inception.  Should we choose to utilize any of the
CEFFs, our ability to access the funds available under the CEFFs is subject to
certain conditions, including stock price and volume limitations.





As of
December 31, 2009, we had two CEFFs available for future financings as
follows: the CEFF dated December 12, 2008 (December 2008 CEFF) and the CEFF
dated May 22, 2008 (May 2008 CEFF).  A third CEFF entered in April 2006
expired on May 12, 2009 and is no longer available.  The following table
sets forth an overview of the “draw down” requirements and availability under
each CEFF:




16




(in millions, except per
                      share data and trading days)
                    
                    Minimum
                      Price
                    
                    Minimum
                    
                    # of Trading
                      Days
                    
                    
                    Amount per
                      Contract
                    
                    
                    Potential Availability
                      at
                      December 31, 2009CEFF
                    Expiration
                    
                    to Initiate
                      Draw
                      Down(1)
                    
                    VWAP for Daily
                      Pricing(2)
                    
                    In Each
                      Draw
                      Down(2)
                    
                    
                    Shares
                    
                    
                    Maximum
                      Proceeds
                    
                    
                    Shares
                    
                    
                    Maximum
                      ProceedsMay
      2008
                    June
      18, 2011
                    
                    $
                    1.15
                    
                    90%
      of the
                      closing
      market
                      price
      on the
                    
                    
                    8
                    
                    
                    
                    19.3
                    
                    
                    
                    $  
       60.0
                    
                    
                    
                    12.8
                    
                    
                    
                    $ 
        51.8Dec.
      2008
                    Feb.
      6, 2011
                    
                    $
                    0.60
                    
                    day
      preceding
                      the
      first day of
                      draw
      down
                    
                    
                    6
                    
                    
                    
                    15.0
                    
                    
                    
                    $  
       25.0
                    
                    
                    
                    7.1
                    
                    
                    
                    $   
      17.7




(1)
            To
      initiate a draw down, the closing price of our common stock on the trading
      day immediately preceding the first trading day of the draw down period
      must be at least equal to the minimum price set forth
    above.


(2)
              If
      on any trading day, the daily volume-weighted average of our common stock
      (VWAP) is less than the minimum VWAP set forth above, no shares are
      purchased on that trading day and the aggregate amount that we originally
      designated for the overall draw down is reduced for each such day by
      1/8th in
      the case of the December 2008 CEFF, and  1/6th in
      the case of the May 2008 CEFF, respectively .  Unless we and
      Kingsbridge agree otherwise, a minimum of three trading days must elapse
      between the expiration of any draw-down pricing period and the beginning
      of the next draw-down pricing
period.





Each draw
down is limited in amount as follows:





·
            May
      2008 CEFF – the lesser of 3.0 percent of the closing price market value of
      the outstanding shares of our common stock at the time of the draw down or
      $10 million; and


·
            December
      2008 CEFF – the lesser of 1.5 percent of the closing price market value of
      the outstanding shares of our common stock at the time of the draw down or
      $3 million.





The
purchase price of shares sold to Kingsbridge under the CEFFs is at a discount to
the VWAP (as defined in the applicable agreement) for each of the trading days
following our initiation of a “draw down” under the CEFF, as
follows:





DailyVWAP
                  
                  %ofVWAP
                  
                  
                  ApplicableDiscountMay
      2008 CEFFGreater
      than $7.25 per share
                  
                  
                  94
                  %
                  
                  
                  6
                  %Less
      than or equal to $7.25 but greater than $3.85 per share
                  
                  
                  92
                  %
                  
                  
                  8
                  %Less
      than or equal to $3.85 but greater than $1.75 per share
                  
                  
                  90
                  %
                  
                  
                  10
                  %Less
      than or equal to $1.75 but greater than or equal to $1.15 per
      share
                  
                  
                  88
                  %
                  
                  
                  12
                  %December
      2008 CEFFGreater
      than $7.25 per share
                  
                  
                  94
                  %
                  
                  
                  6
                  %Less
      than or equal to $7.25 but greater than $3.85 per share
                  
                  
                  92
                  %
                  
                  
                  8
                  %Less
      than or equal to $3.85 but greater than $1.75 per share
                  
                  
                  90
                  %
                  
                  
                  10
                  %Less
      than or equal to $1.75 but greater than or equal to $1.10 per
      share
                  
                  
                  88
                  %
                  
                  
                  12
                  %Less
      than or equal to $1.10 but greater than or equal to $.60
                  
                  
                  85
                  %
                  
                  
                  15
                  %





In
addition, Kingsbridge may terminate the CEFFs under certain circumstances,
including if a material adverse event relating to our business continues for 10
trading days after notice of the material adverse event.




In
connection with the December 2008 CEFF, we issued a warrant to Kingsbridge on
December 22, 2008 to purchase up to 675,000 shares of our common stock at an
exercise price of $1.5132 per share.  The warrant expires in May 2014 and
is exercisable, in whole or in part, for cash, except in limited circumstances,
with expected total proceeds to us, if exercised, of approximately $1.0
million.  As of December 31, 2009, this warrant had not been
exercised.





17


In
connection with the May 2008 CEFF, we issued a warrant to Kingsbridge on May 22,
2008 to purchase up to 825,000 shares of our common stock at an exercise price
of $2.506 per share.  The warrant expires in November 2013 and is
exercisable, in whole or in part, for cash, except in limited circumstances,
with expected total proceeds to us, if exercised, of approximately $2.1
million.  As of December 31, 2009, this warrant had not been
exercised.





In
connection with the 2006 CEFF, we issued a Class C Investor Warrant to
Kingsbridge on April 17, 2006 to purchase up to 490,000 shares of our common
stock at an exercise price equal to $5.6186 per share.  The warrant expires
in October 2011 and is exercisable, in whole or in part, for cash, except in
limited circumstances, with expected total proceeds to us, if exercised, of
approximately $2.8 million.  As of December 31, 2009, this Class C Investor
Warrant had not been exercised.





In
connection with a CEFF that we entered in 2004, we issued a Class B Investor
Warrant to Kingsbridge to purchase up to 375,000 shares of our common stock at
an exercise price equal to $12.0744 per share.  The warrant expired
unexercised in January 2010.





CEFF
Financings





The financings that wecompleted under theDecember2008 CEFF are:





(in thousands, except per share
data)


CompletionDate
                    
                    SharesIssued
                    
                    
                    GrossProceeds
                    
                    
                    Discounted
                      AveragePrice
                      PerShareApril
      8, 2009
                    
                    
                    806
                    
                    
                    
                    $  
       1,000
                    
                    
                    
                    $
         1.24May
      7, 2009
                    
                    
                    1,273
                    
                    
                    
                    1,000
                    
                    
                    
                    0.79September
      23, 2009
                    
                    
                    1,793
                    
                    
                    
                    1,583
                    
                    
                    
                    0.88October
      13, 2009
                    
                    
                    1,909
                    
                    
                    
                    1,800
                    
                    
                    
                    0.94October
      21, 2009
                    
                    
                    2,101
                    
                    
                    
                    1,900
                    
                    
                    
                    0.90





The
financings that we completed under the May 2008 CEFF are:





(in thousands, except per share
data)


CompletionDate
                    
                    SharesIssued
                    
                    
                    GrossProceeds
                    
                    
                    Discounted
                      AveragePrice
                      PerShareJuly
      11, 2008
                    
                    
                    1,105
                    
                    
                    
                    $ 
        1,563
                    
                    
                    
                    $   
      1.41July
      31, 2008
                    
                    
                    992
                    
                    
                    
                    1,500
                    
                    
                    
                    1.51October
      17, 2008
                    
                    
                    914
                    
                    
                    
                    1,313
                    
                    
                    
                    1.44November
      20, 2008
                    
                    
                    221
                    
                    
                    
                    250
                    
                    
                    
                    1.13January
      2, 2009
                    
                    
                    479
                    
                    
                    
                    500
                    
                    
                    
                    1.04January
      16, 2009
                    
                    
                    419
                    
                    
                    
                    438
                    
                    
                    
                    1.04February
      18, 2009
                    
                    
                    857
                    
                    
                    
                    1,000
                    
                    
                    
                    1.17March
      31, 2009
                    
                    
                    1,015
                    
                    
                    
                    1,094
                    
                    
                    
                    1.08October
      13, 2009
                    
                    
                    559
                    
                    
                    
                    606
                    
                    
                    
                    1.09





18


The
financings that we completed under the now expired 2006 CEFF are:





(in thousands, except per share
data)


CompletionDate
                    
                    SharesIssued
                    
                    
                    GrossProceeds
                    
                    
                    Discounted
                      AveragePrice
                      PerShareMay
      29, 2006
                    
                    
                    1,079
                    
                    
                    
                    $ 
        2,188
                    
                    
                    
                    $
         2.03October
      11, 2006
                    
                    
                    1,205
                    
                    
                    
                    2,300
                    
                    
                    
                    1.91November
      10, 2006
                    
                    
                    1,372
                    
                    
                    
                    3,000
                    
                    
                    
                    2.19February
      22, 2007
                    
                    
                    943
                    
                    
                    
                    2,000
                    
                    
                    
                    2.12October
      12, 2007
                    
                    
                    1,909
                    
                    
                    
                    5,000
                    
                    
                    
                    2.62September
      9, 2008
                    
                    
                    676
                    
                    
                    
                    1,250
                    
                    
                    
                    1.85





Financings
Pursuant to Common Stock Offerings





Historically,
we have funded, and expect to continue to fund, our business operations through
various sources, including financings pursuant to common stock
offerings.





2008
Universal Shelf





In June
2008, we filed a universal shelf registration statement on Form S-3 (No.
333-151654) (“2008 Universal Shelf”) with the SEC for the proposed offering from
time to time of up to $150 million of our securities, including common stock,
preferred stock, varying forms of debt and warrant securities, or any
combination of the foregoing, on terms and conditions that will be determined at
that time.





In
February 2010, we completed a public offering of 27,500,000 shares of our common
stock and warrants to purchase 13,750,000 shares of our common stock, sold as
units, with each unit consisting of one share of common stock and a warrant to
purchase 0.50 of a share of common stock, at a public offering price of $0.60
per unit, resulting in gross and net proceeds to us of $16.5 million and
approximately $15.1 million, respectively.  The warrants expire in February
2015 and are exercisable, subject to an aggregate share ownership limitation, at
a price per share of $0.85, for cash or, in the event that the related
registration statement or an exemption from registration is not available for
the resale of the warrant shares, on a cashless basis.





In May
2009, we completed a registered direct offering of 14,000,000 shares of our
common stock and warrants to purchase 7,000,000 shares of our common stock, sold
as units to select institutional investors, with each unit consisting of one
share of common stock and a warrant to purchase 0.50 of a share of common stock,
at an offering price of $0.81 per unit, resulting in gross and net proceeds to
us of $11.3 million and $10.5 million, respectively.  The warrants expire
in May 2014 and are exercisable, subject to an aggregate share ownership
limitation, at a price per share of $1.15, for cash or, in the event that the
related registration statement or an exemption from registration is not
available for the resale of the warrant shares, on a cashless
basis.





As of
December 31, 2009 and March 1, 2010, respectively, up to $138.7 million and
$122.2 million of our securities are potentially available for issuance pursuant
to the 2008 Universal Shelf.





2005
Universal Shelf





In
October 2005, we filed a universal shelf registration statement on Form S-3
(File No. 333-128929) (2005 Universal Shelf) with the SEC for the proposed
offering, from time to time, of up to $100 million of our debt or equity
securities.





In
December 2007, we completed a registered direct offering of 10,000,000 shares of
our common stock to select institutional investors.  The shares were priced
at $2.50 per share resulting in gross and net proceeds to us of $25.0 million
and $23.6 million, respectively.





19


In April
2007, we completed a registered direct offering of 14,050,000 shares of our
common stock to select institutional investors.  The shares were priced at
$2.15 per share resulting in gross and net proceeds to us of $30.2 million and
$28.1 million, respectively.





The
October 2005 universal shelf registration statement expired in December 2008 and
is no longer available.





Debt





Historically,
we have funded, and expect to continue to fund, our business operations through
various sources, including debt arrangements such as credit facilities and
equipment financing facilities.





Loan
with Quintiles





Quintiles
extended to us a secured, revolving credit facility, which we restructured in
October 2006.  The outstanding principal balance of the loan, $8.5 million,
is due and payable on April 30, 2010, together with all unpaid interest accrued
since July 1, 2006.  Since October 2006, interest is calculated at the
prime rate, compounded annually.  We may repay the loan, in whole or in
part, at any time without prepayment penalty or premium.  In addition, our
obligations to Quintiles under the loan agreement are secured by a security
interest in substantially all of our assets, subject to limited exceptions set
forth in the related security agreement.





Also in
October 2006, in consideration of Quintiles’s agreement to restructure the loan,
we entered into a Warrant Agreement with Quintiles, pursuant to which Quintiles
has the right to purchase 1.5 million shares of our common stock at an exercise
price of $3.5813 per share.  The warrants have a seven-year term and are
exercisable, in whole or in part, for cash, cancellation of a portion of our
indebtedness under the Quintiles loan agreement, or a combination of the
foregoing, in an amount equal to the aggregate purchase price for the shares
being purchased upon any exercise.





As of
December 31, 2009, the outstanding balance under the loan was $10.5 million
($8.5 million principal and $2.0 million accrued interest) and was classified as
a current liability on the Consolidated Balance Sheets as of such
date.





For the
years ended December 31, 2009, 2008 and 2007, we incurred interest expense
associated with the Quintiles loan of $0.3 million, $0.5 million and $0.7
million, respectively.  The decrease in interest expense in 2009 and 2008
is due to declines in the prime rate during 2008 ranging from 7.25% to
3.25%.  During 2009, the prime rate remained at 3.25%.  In addition,
for the years ended December 31, 2009, 2008 and 2007, we incurred interest
expense associated with the amortization of deferred financing costs in
connection with warrants issued to Quintiles in October 2006 of $0.5 million,
$0.5 million and $0.5 million, respectively.





Equipment
Financing Facilities





Historically,
we have funded our purchases of capital expenditures through the use of
equipment financing facilities, although we currently do not have a facility
available.  The outstanding principal balance of these facilities as of
December 31, 2009 and 2008 was as follows:




20




(in
      thousands)
                  
                  2009
                  
                  
                  2008GE
      Business Financial Services, Inc.Short-term
                  
                  $
                  538
                  
                  
                  $
                  2,385Long-term
                  
                  
                  65
                  
                  
                  
                  664Total
                  
                  
                  603
                  
                  
                  
                  3,049Pennsylvania
      Machinery and Equipment LoanShort-term
                  
                  
                  59
                  
                  
                  
                  57Long-term
                  
                  
                  363
                  
                  
                  
                  428Total
                  
                  
                  422
                  
                  
                  
                  485Total
      Short-term
                  
                  
                  597
                  
                  
                  
                  2,442Total
      Long-term
                  
                  
                  428
                  
                  
                  
                  1,092Total
                  
                  $
                  1,025
                  
                  
                  $
                  3,534





GE Business Financial Services Inc.





In May
2007, we entered into a Credit and Security Agreement (Credit Agreement) with GE
Business Financial Services Inc. (formerly Merrill Lynch Business Financial
Services Inc.) (GE), as Lender, pursuant to which GE agreed to provide us a
$12.5 million facility (Facility) to fund our capital programs.  The right
to draw under this Facility expired on November 30, 2008.  Over the term of
the Facility, we received $7.2 million, $4.0 million of which was applied
to prepayment of a prior facility and $2.3 million of which was associated
with construction and equipment for the analytical and development laboratory
that we built in our Warrington, Pennsylvania headquarters in 2007.





Proceeds
received under the Facility were $0.0 million, $0.4 million and $6.8 million for
the years ended December 31, 2009, 2008 and 2007, respectively.  Advances
under the Facility to finance the acquisition of property and equipment are
amortized over a period of 36 months and all other equipment and related
costs are amortized over a period of 24 months.  The advance to prepay our
prior facility is amortized over a period of 27 months.  Interest on each
advance accrues at a fixed rate per annum equal to one-month LIBOR plus 6.25%,
determined on the funding date of such advance.  Principal and interest on
all advances are payable in equal installments on the first business day of each
month.  We may prepay advances, in whole or in part, at any time, subject
to a prepayment penalty, which, depending on the period of time elapsed from the
closing of the Facility, will range from 4% to 1%.





Principal
payments under the Facility were $2.4 million, $3.0 million and $1.2 million for
the years ended December 31, 2009, 2008 and 2007, respectively.  Interest
expense under the Facility was $0.2 million, $0.5 million and $0.7 million for
the years ended December 31, 2009, 2008 and 2007, respectively.  The
remaining outstanding loan balance under the Facility was $0.6 million as of
December 31, 2009, which will be paid over the next 21 months, with the final
payment in September 2011.





Our
obligations under the Facility are secured by a security interest in (i) the
financed property and equipment, and (ii) all of our intellectual property
(Supplemental Collateral), subject to limited exceptions set forth in the Loan
Agreement.  The Supplemental Collateral will be released on the earlier to
occur of (a) receipt by us of FDA approval of our NDA for Surfaxinfor
the prevention of RDS in premature infants, or (b) the date on which we shall
have maintained over a continuous 12-month period ending on or after March 31,
2008, measured at the end of each calendar quarter, a minimum cash balance equal
to our projected cash requirements for the following 12-month period.  In
addition, we, GE and Quintiles entered into an Intercreditor Agreement under
which GE agreed to subordinate its security interest in the Supplemental
Collateral (which does not include financed property and equipment) to the
security interest in the same collateral that we previously granted to Quintiles
(as discussed above).





21


Pennsylvania – Department of Community and Economic Development –
Machinery and Equipment Loan Fund





We
entered into a Loan Agreement and Security Agreement with the Commonwealth of
Pennsylvania, Department of Community and Economic Development (Department) in
September 2008, pursuant to which the Department made a loan to us from the
Machinery and Equipment Loan Fund in the amount of $500,000 (MELF Loan) to fund
the purchase and installation of new machinery and equipment and the upgrade of
existing machinery and equipment at our analytical and development laboratory in
Warrington, Pennsylvania.  Principal and interest on the MELF Loan is
payable in equal monthly installments over a period of seven years. 
Interest on the principal amount accrues at a fixed rate of five percent (5.0%)
per annum.  We may prepay the MELF Loan at any time without
penalty.





In
addition to customary terms and conditions, the MELF Agreement provides that we
must meet certain criteria regarding retention and creation of new jobs within a
three-year period.  In the event that we fail to comply with this
requirement, the interest rate on the Promissory Note, except in limited
circumstances, will be adjusted to a fixed rate equal to two percentage points
above the current prime rate for the remainder of the term.





Off-Balance
Sheet Arrangements





We did
not have any material off-balance sheet arrangements at December 31, 2009, 2008
or 2007, or for the periods then ended.





Contractual
Obligations





Payments
due under contractual debt obligations at December 31, 2009, including principal
and interest, are as follows:





(in thousands)
                            
                            2010
                            
                            
                            2011
                            
                            
                            2012
                            
                            
                            2013
                            
                            
                            2014
                            
                            
                            There-
                              after
                            
                            
                            TotalLoan
      payable(1)
                            
                            $
                            10,573
                            
                            
                            $
                            –
                            
                            
                            $
                            –
                            
                            
                            $
                            –
                            
                            
                            $
                            –
                            
                            
                            $
                            –
                            
                            
                            $
                            10,573Equipment
      loan obligations(1)
                            
                            
                            722
                            
                            
                            
                            152
                            
                            
                            
                            85
                            
                            
                            
                            85
                            
                            
                            
                            85
                            
                            
                            
                            70
                            
                            
                            
                            1,199Operating
      lease obligations
                            
                            
                            1,127
                            
                            
                            
                            1,146
                            
                            
                            
                            1,166
                            
                            
                            
                            320
                            
                            
                            
                            150
                            
                            
                            
                            –
                            
                            
                            
                            3,909CEO
      severance obligations
                            
                            
                            1,211
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            1,211Total
                            
                            $
                            13,633
                            
                            
                            $
                            1,298
                            
                            
                            $
                            1,251
                            
                            
                            $
                            405
                            
                            
                            $
                            235
                            
                            
                            $
                            70
                            
                            
                            $
                            16,892





(1) See, “– Liquidity and Capital
Resources - Debt.”  For the purposes of this table, we have assumed that
the Quintiles Loan will accrue interest through maturity at an average rate that
is equal to the current prime rate of 3.25%.





Operating
Lease Agreements





Our
operating leases consist primarily of facility leases for our operations in
Pennsylvania and New Jersey. We maintain our headquarters in Warrington,
Pennsylvania.  The facility is 39,594 square feet and serves as the main
operating facility for clinical development, regulatory, analytical technical
services, research and development,  and administration.  In April
2007, the lease, which originally expired in February 2010 with total aggregate
payments of $4.6 million, was extended an additional three years through
February 2013 with additional payments of $3.0 million over the extension
period.





We lease
approximately 21,000 square feet of space for our manufacturing facility in
Totowa, New Jersey, at an annual rent of $150,000.  This space is
specifically designed for the manufacture and filling of sterile pharmaceuticals
in compliance with cGMP and is our only manufacturing facility.  The lease
expires in December 2014, subject to the landlord’s right, upon two years’ prior
notice, to terminate the lease early.  This early termination right is
subject to certain conditions, including that the master tenant, a related party
of the landlord, must have ceased all activities at the premises, and, depending
upon the timing of the notice, if we satisfy certain financial conditions, the
landlord would be obligated to make early termination payments to us.  At
the present time, we understand that the master tenant continues to be active in
the premises. The total aggregate payments over the term of the lease are
$1.4 million.  In connection with our manufacturing operations in Totowa,
New Jersey, we have 15 employees subject to a collective bargaining arrangement
which expires on December 3, 2010. See,“Item 1 – Business –
Business Operations – Manufacturing and Distribution,” and “Item 2 –
Properties.”





22


Our lease
for 5,600 square feet of office and analytical laboratory space in Doylestown,
Pennsylvania was terminated effective July 31, 2008 and all activities at this
location have been consolidated into our laboratory space in Warrington,
Pennsylvania.  Our lease for 16,800 square feet of office and laboratory
space at our facility in Mountain View, California, expired without renewal or
extension on June 30, 2008.  In December 2007, we consolidated these
activities into our laboratory space in Warrington, Pennsylvania.




Rent
expense under all leases for the years ended December 31, 2009, 2008, and 2007
was $1.1 million, $1.2 million and $1.5 million respectively.




Former
CEO Commitment





Effective
August 13, 2009, Dr. Robert J. Capetola resigned his positions as our President
and Chief Executive Officer and as a member of our Board.  The Board
elected Mr. W. Thomas Amick, Chairman of the Board, to serve as Chief Executive
Officer on an interim basis.  We entered into a separation agreement and
general release (Separation Agreement) with Dr. Capetola providing for (i) an
upfront severance payment of $250,000, and (ii) periodic payments in an amount
equal to his base salary (calculated at a rate of $490,000 per annum), in
accordance with our payroll practices and less required withholdings.  The
periodic payments will end the earlier of (x) May 3, 2010 or (y) the date, if
ever, that a Corporate Transaction (as defined below) occurs.  In addition,
Dr. Capetola will be entitled to (A) continuation of medical benefits and
insurance coverage for a period of 24 or 27 months, depending upon
circumstances, and (B) accelerated vesting of all outstanding restricted shares
and options, which shall remain exercisable to the end of their stated
terms.





The
Separation Agreement provides further that, upon the occurrence of a Corporate
Transaction prior to May 4, 2010, Dr. Capetola will receive a payment of up to
$1,580,000 (the “Additional Severance”) or, if any such Corporate Transaction
also constitutes a Change of Control (as such term is defined in the Separation
Agreement), a payment of up to $1,777,500; provided, however, that, in each
case, any such payment will be reduced by the sum of the amounts described in
clauses (i) and (ii) of this paragraph that theretofore have been paid.  A
“Corporate Transaction” is defined in the Separation Agreement as (1) one or
more corporate partnering or strategic alliance transactions, Business
Combinations or public or private financings that (A) are completed during the
Severance Period (as defined in the Separation Agreement) and (B) result in cash
proceeds (net of transaction costs) to the Company of at least $20 million
received during the Severance Period or within 90 calendar days thereafter, or
(2) an acquisition of the Company, by business combination or other similar
transaction, that occurs during the Severance Period and the consideration paid
to stockholders of the Company, in cash or securities, is at least
$20 million.  For this purpose, net proceeds will be calculated
without taking into account any amounts received by the Company as reimbursement
for costs of development and research activities to be performed in connection
with any such transaction.





Since
August 13, 2009, we have raised approximately $5.89 million in gross proceeds
utilizing our CEFFs (see, “– Committed Equity
Financing Facilities (CEFFs)”).  In addition, on February 23, 2010, we
completed a public offering that resulted in net proceeds to us of approximately
$15.1 million (see, “– Financings
Pursuant to Common Stock Offerings.”).  As the receipt from financings of
more than $20 million qualifies as a Corporate Transaction, our obligation under
the Separation Agreement to make payment to Dr. Capetola of the Additional
Severance has matured.  Therefore, in accordance with the Separation
Agreement, on March 5, 2010, we issued a payment to Dr. Capetola in the amount
of approximately $1.06 million (less withholding), representing his Additional
Severance payment, reduced by the payments previously made to him under the
Severance Agreement, which total approximately $0.52 million.  Our
obligation to make periodic payments under the Separation Agreement has been
satisfied and no further payments are due at this time.





Future
Milestone Commitment





In
addition to the contractual obligations above, we have certain milestone and
royalty payment obligations to Johnson & Johnson related to our product
licenses.  To date, of the $2,500,000 aggregate potential milestone
payments, we have paid $450,000 for milestones that have been
achieved.





23


ITEM
      8.
            FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA.





See, Index to Consolidated
Financial Statements on Page F-1 attached hereto.




ITEM
      9A.
            CONTROLS
      AND PROCEDURES.




(a)
Evaluation of disclosure controls and procedures




Our
management, including our Chief Executive Officer and Chief Financial Officer,
does not expect that our disclosure controls or our internal control over
financial reporting will prevent all error and all fraud.  A control
system, no matter how well designed and operated, can provide only reasonable,
not absolute, assurance that the control system’s objectives will be
met.  Further, the design of a control system must reflect the fact
that there are resource constraints, and the benefits of controls must be
considered relative to their costs.  Because of the inherent
limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within the company have been detected.  These inherent limitations
include the realities that judgments in decision-making can be faulty and that
breakdowns can occur because of simple error or mistake.  Controls can
also be circumvented by the individual acts of some persons, by collusion of two
or more people, or by management override of the controls.  The design
of any system of controls is based in part on certain assumptions about the
likelihood of future events, and there can be no assurance that any design will
succeed in achieving its stated goals under all potential future
conditions.  Over time, controls may become inadequate because of
changes in conditions or deterioration in the degree of compliance with policies
or procedures.  Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur and
not be detected.  In designing and evaluating the disclosure controls
and procedures, our management recognized that any controls and procedures, no
matter how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives and our management necessarily was
required to apply its judgment in evaluating the cost-benefit relationship of
possible controls and procedures.


In
connection with the preparation of this Amendment No. 2, our Chief
Executive Officer and our Chief Financial Officer evaluated the effectiveness of
the design and operation of our disclosure controls and procedures as of
December 31, 2009.  In making this evaluation, they considered the
material weakness related to the initial classification and subsequent
accounting for warrants discussed below.  Solely as a result of
the material weakness, our Chief Executive Officer and Chief Financial Officer
have concluded that our disclosure controls and procedures were not effective as
of December 31, 2009.


(b)
Management’s Report on our Internal Control over Financial
Reporting




Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Rule 13a-15(f)
promulgated under the Exchange Act.  Our internal control system is
designed to provide reasonable assurance to our management and board of
directors regarding the preparation and fair presentation of published financial
statements.  All internal control systems, no matter how well designed,
have inherent limitations.  Therefore, even those systems determined to be
effective can provide only reasonable assurance with respect to financial
statement preparation and presentation.




In
connection with this Amendment No. 2, management, including our Chief Executive
Officer and Chief Financial Officer, reassessed the effectiveness of our
internal control over financial reporting as of December 31, 2009.  In
making this assessment, our management used the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in
Internal Control-Integrated Framework.  This evaluation identified a
material weakness in our internal control regarding our process and procedures
related to the initial classification and subsequent accounting of registered
warrants as liabilities or equity instruments.  This material weakness in
our internal controls resulted in the restatement of our 2009 financial
statements.  As a result, management has revised its assessment to conclude
that our internal control over financial reporting was not effective as of
December 31, 2009, based on the COSO criteria.




24




The
effectiveness of our internal control over financial reporting as of
December 31, 2009 has been audited by Ernst & Young LLP, an
independent registered public accounting firm, as stated in their report which
is included herein.





(c)
            Changes
      in internal controls





There
were no changes in our internal control over financial reporting identified
in connection with the evaluation described above that occurred during the
quarter ended December 31, 2009 that has materially affected, or is reasonably
likely to materially affect, our internal control over financial
reporting.


25


Report of
Independent Registered Public Accounting Firm




The Board
of Directors and Stockholders


Discovery
Laboratories, Inc. and Subsidiary




We have
audited Discovery Laboratories, Inc. and subsidiary’s internal control over
financial reporting as of December 31, 2009, based on criteria established in
Internal Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the COSO criteria). Discovery
Laboratories, Inc. and subsidiary’s management is responsible for maintaining
effective internal control over financial reporting, and for its assessment of
the effectiveness of internal control over financial reporting included in the
accompanying Management’s Report on our Internal Control over Financial
Reporting. Our responsibility is to express an opinion on the company’s internal
control over financial reporting based on our audit.
 
 We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, testing
and evaluating the design and operating effectiveness of internal control based
on the assessed risk, and performing such other procedures as we considered
necessary in the circumstances. We believe that our audit provides a reasonable
basis for our opinion.
 
 A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.
 
 Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
 
 In our report dated March 10, 2010, we
expressed an unqualified opinion that the Company maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2009, based on the COSO criteria.  Management has subsequently
determined that a deficiency in controls relating to the accounting for
registered warrants existed as of the previous assessment date, and has further
concluded that such deficiency represented a material weakness as of December
31, 2009.  As a result, management has revised its assessment, as
presented in the accompanying Management’s Report on Internal Control over
Financial Reporting, to conclude that the Company’s internal control over
financial reporting was not effective as of December 31,
2009.  Accordingly, our present opinion on the effectiveness of the
Company’s internal control over financial reporting as of December 31, 2009, as
expressed herein, is different from that expressed in our previous
report.
 
 A material weakness is a deficiency, or
combination of deficiencies, in internal control over financial reporting, such
that there is a reasonable possibility that a material misstatement of the
company’s annual or interim financial statements will not be prevented or
detected on a timely basis.  Management has identified a material
weakness in internal controls over theclassification of and subsequent
accounting for registered warrants.  Specifically, the process
and procedures for the classification and subsequent accounting of registered
warrants as liabilities or equity instruments were not
effective.  This material weakness in internal controls over
registered warrants resulted in the restatement of the 2009 financial
statements.  We also have audited, in accordance with the standards of
the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of
Discovery Laboratories, Inc. and subsidiary as of December 31, 2009 and 2008,
and the related consolidated statements of operations, stockholders’ equity, and
cash flows for each of the three years in the period ended December 31, 2009.
This material weakness was considered in determining the nature, timing, and
extent of audit tests applied in our audit of the 2009 consolidated financial
statements, and this report does not affect our report dated March 10, 2010,
except for Note 2, Note 4 and Note 5, as to which the date is November 12, 2010,
on those consolidated financial statements (as restated).
 
 In our
opinion, because of the effect of the material weakness described above on the
achievement of the objectives of the control criteria, the Company has not
maintained effective internal control over financial reporting as of December
31, 2009, based on the COSO criteria.






/s/
      Ernst & Young LLP





Philadelphia,
Pennsylvania
 March 10,
2010, except for
 the
effects of the material weakness described in the
 sixth
paragraph above, as to which the date is November 12, 2010


26




PART
IV




ITEM
      15.
            EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES.





The
consolidated financial statements required to be filed in this Annual Report on
Form 10-K are listed on the Index to Consolidated Financial Statements on page
F-1 hereof.





Exhibits
are listed on the Index to Exhibits at the end of this Annual Report on Form
10-K.  The exhibits required to be filed pursuant to Item 601 of Regulation
S-K, which are listed on the Index in response to this Item, are incorporated
herein by reference.


27


SIGNATURES




Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.





DISCOVERY
      LABORATORIES, INC.





Date:
      November 12, 2010
                By:
                /s/W. Thomas AmickW.
      Thomas Amick, Chairman of the Boardand
      Chief Executive Officer (Principal Executive
  Officer)




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





Signature
                          
                          Name & Title
                          
                          Date/s/
      W. Thomas Amick
                          
                          W.
      Thomas Amick
                            Chairman
      of the Board and Chief Executive Officer (Principal Executive
      Officer)
                          
                          November
      12, 2010/s/
      John G. Cooper
                          
                          John
      G. Cooper
                            President
      and Chief Financial Officer
                          
                          November
      12, 2010/s/
      John Tattory
                          
                          John
      Tattory
                            Vice
      President, Finance, and Controller
                            (Principal
      Accounting Officer)
                          
                          November
      12, 2010/s/
      Antonio Esteve
                          
                          Antonio
      Esteve, Ph.D.
                            Director
                          
                          November
      12, 2010/s/
      Max E. Link
                          
                          Max
      E. Link, Ph.D.
                            Director
                          
                          November
      12, 2010/s/
      Herbert H. McDade, Jr.
                          
                          Herbert
      H. McDade, Jr.
                            Director
                          
                          November
      12, 2010/s/
      Bruce A. Peacock
                          
                          Bruce
      A. Peacock
                            Director
                          
                          November
      12, 2010/s/
      Marvin E. Rosenthale
                          
                          Marvin
      E. Rosenthale, Ph.D.
                            Director
                          
                          November
      12, 2010


28





INDEX
TO EXHIBITS




The
following exhibits are included with this Annual Report on Form
10-K/A.





ExhibitNo.
              
              Description
              
              MethodofFiling3.1
              
              Amended
      and Restated Certificate of Incorporation of Discovery Laboratories, Inc.
      (Discovery), dated December 9, 2009.
              
              Incorporated
      by reference to Exhibit 3.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 9, 2009.3.2
              
              Certificate
      of Designations, Preferences and Rights of Series A Junior Participating
      Cumulative Preferred Stock of Discovery, dated February 6,
      2004.
              
              Incorporated
      by reference to Exhibit 2.2 to Discovery’s Form 8-A, as filed with the SEC
      on February 6, 2004.3.3
              
              Amended
      and Restated By-Laws of Discovery, as amended effective September 3,
      2009.
              
              Incorporated
      by reference to Exhibit 3.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on September 4, 20094.1
              
              Shareholder
      Rights Agreement, dated as of February 6, 2004, by and between Discovery
      and Continental Stock Transfer & Trust Company.
              
              Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on February 6, 2004.4.2
              
              Form
      of Class A Investor Warrant.
              
              Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on June 20, 2003.4.3
              
              Class
      B Investor Warrant dated July 7, 2004, issued to Kingsbridge Capital
      Limited.
              
              Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K as
      filed with the SEC on July 9, 2004.4.4
              
              Warrant
      Agreement, dated as of November 3, 2004, by and between Discovery and
      QFinance, Inc.
              
              Incorporated
      by reference to Exhibit 4.1 of Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended September 30, 2004, as filed with the SEC on
      November 9, 2004.4.5
              
              Class
      C Investor Warrant, dated April 17, 2006, issued to Kingsbridge Capital
      Limited
              
              Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on April 21, 2006.4.6
              
              Second
      Amended and Restated Promissory Note, dated as of October 25, 2006, issued
      to PharmaBio Development Inc. (“PharmaBio”)
              
              Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on October 26, 2006.4.7
              
              Warrant
      Agreement, dated as of October 25, 2006, by and between Discovery and
      PharmaBio
              
              Incorporated
      by reference to Exhibit 4.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on October 26, 2006.4.8
              
              Warrant
      Agreement, dated November 22, 2006
              
              Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on November 22,
2006.




29




ExhibitNo.
                
                Description
                
                MethodofFiling4.9
                
                Warrant
      Agreement dated May 22, 2008 by and between Kingsbridge Capital Limited
      and Discovery.
                
                Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K as
      filed with the SEC on May 28, 2008.4.10
                
                Warrant
      Agreement dated December 12, 2008 by and between Kingsbridge Capital
      Limited and Discovery.
                
                Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 15, 2008.4.11
                
                Form
      of Stock Purchase Warrant issued in May 2009
                
                Incorporated
      by reference to Exhibit 10.3 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on May 8, 2009.4.12
                
                Form
      of Stock Purchase Warrant issued in February 2010
                
                Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on February 18, 2010.4.13
                
                Warrant
      Agreement, dated as of April 30, 2010, by and between Discovery and
      PharmaBio
                
                Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on April 28, 2010.10.1+
                
                Sublicense
      Agreement, dated as of October 28, 1996, between Johnson & Johnson,
      Ortho Pharmaceutical Corporation and Acute Therapeutics,
    Inc.
                
                Incorporated
      by reference to Exhibit 10.6 to Discovery’s Registration Statement on Form
      SB-2/A, as filed with the SEC on April 18, 1997 (File No.
      333-19375).10.2
                
                Registration
      Rights Agreement, dated June 16, 1998, among Discovery, Johnson &
      Johnson Development Corporation and The Scripps Research
      Institute.
                
                Incorporated
      by reference to Exhibit 10.28 to Discovery’s Annual Report on Form 10-KSB
      for the year ended December 31, 1998, as filed with the SEC on April 9,
      1999.10.3*
                
                Restated
      1993 Stock Option Plan of Discovery.
                
                Incorporated
      by reference to Discovery’s Registration Statement on Form SB-2 (File No.
      33-92-886).10.4*
                
                1995
      Stock Option Plan of Discovery.
                
                Incorporated
      by reference to Discovery’s Registration Statement on Form SB-2 (File No.
      33-92-886).10.5*
                
                Amended
      and Restated 1998 Stock Incentive Plan of Discovery (amended as of May 13,
      2005).
                
                Incorporated
      by reference to Exhibit 4.1 to Discovery’s Registration Statement on Form
      S-8, as filed with the SEC on August 23, 2005 (File No.
      333-116268).10.6*
                
                Form
      of Notice of Grant of Stock Option under the 1998 Stock Incentive
      Plan.
                
                Incorporated
      by reference to Exhibit 10.2 to Discovery’s Quarterly Report on Form
      10-QSB for the quarter ended September 30, 1999, as filed with the SEC on
      November 17, 1999.10.7*
                
                Discovery’s
      2007 Long Term Incentive Plan
                
                Incorporated
      by reference to Exhibit 1.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on June 28,
2007.




30






ExhibitNo.
                
                Description
                
                MethodofFiling10.8*
                
                Form
      of 2007 Long-Term Incentive Plan Stock Option Agreement
                
                Incorporated
      by reference to Exhibit 10.3 to Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended June 30, 2007, as filed with the SEC on August 9,
      2007.10.9*
                
                Form
      of Stock Issuance Agreement, dated as of October 30, 2007, between the
      Discovery and the Grantees
                
                Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on November 5, 2007.10.10+
                
                Amended
      and Restated Sublicense and Collaboration Agreement made as of December 3,
      2004, between Discovery and Laboratorios del Dr. Esteve,
    S.A.
                
                Incorporated
      by reference to Exhibit 10.28 to Discovery’s Annual Report on Form 10-K
      for the year ended December 31, 2004, as filed with the SEC on March 16,
      2005.10.11+
                
                Amended
      and Restated Supply Agreement, dated as of December 3, 2004, by and
      between Discovery and Laboratorios del Dr. Esteve, S.A.
                
                Incorporated
      by reference to Exhibit 10.29 to Discovery’s Annual Report on Form 10-K
      for the year ended December 31, 2004, as filed with the SEC on March 16,
      2005.10.12
                
                Assignment
      of Lease and Termination and Option Agreement, dated as of December 30,
      2005, between Laureate Pharma, Inc. and Discovery.
                
                Incorporated
      by reference to Exhibit 10.1 to Discovery’s Annual Report on Form 10-K for
      the year ended December 31, 2005, as filed with the SEC on March 16,
      2006.10.13
                
                Common
      Stock Purchase Agreement, dated April 17, 2006, by and between Discovery
      and Kingsbridge Capital Limited.
                
                Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on April 21, 2006.10.14
                
                Second
      Amended and Restated Loan Agreement, dated as of December 10, 2001,
      amended and restated as of October 25, 2006, by and between Discovery and
      PharmaBio
                
                Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on October 26, 2006.10.15*
                
                Amended
      and Restated Employment Agreement, dated as of May 4, 2006, by and between
      Discovery and Robert J. Capetola, Ph.D.
                
                Incorporated
      by reference to Exhibit 10.1 to Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended March 31, 2006, as filed with the SEC on May 10,
      2006.10.16*
                
                Amendment
      to the Amended and Restated Employment Agreement dated as of May 4, 2006
      between Robert J. Capetola and Discovery Laboratories,
Inc.
                
                Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on January 3, 200810.17*
                
                Amended
      and Restated Employment Agreement, dated as of May 4, 2006, by and between
      Discovery and John G. Cooper.
                
                Incorporated
      by reference to Exhibit 10.2 to Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended March 31, 2006, as filed with the SEC on May 10,
      2006.10.18*
                
                Amendment
      to the Amended and Restated Employment Agreement dated as of May 4, 2006
      between John G. Cooper and Discovery Laboratories, Inc.
                
                Incorporated
      by reference to Exhibit 10.3 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on January 3,
2008




31




ExhibitNo.
                
                Description
                
                MethodofFiling10.19*
                
                Amended
      and Restated Employment Agreement, dated as of May 4, 2006, by and between
      Discovery and  David L. Lopez, Esq., CPA
                
                Incorporated
      by reference to Exhibit 10.3 to Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended March 31, 2006, as filed with the SEC on May 10,
      2006.10.20*
                
                Amendment
      to the Amended and Restated Employment Agreement dated as of May 4, 2006
      between David L. Lopez and Discovery Laboratories, Inc.
                
                Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on January 3, 2008.10.21*
                
                Amended
      and Restated Employment Agreement, dated as of May 4, 2006, by and between
      Discovery and Robert Segal, M.D.
                
                Incorporated
      by reference to Exhibit 10.4 to Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended March 31, 2006, as filed with the SEC on May 10,
      2006.10.22*
                
                Amendment
      to the Amended and Restated Employment Agreement dated as of May 4, 2006
      between Robert Segal, M.D., F.A.C.P., and Discovery
                
                Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on July 15, 2008.10.23*
                
                Amendment
      dated December 12, 2008 to the Amended and Restated Employment Agreement
      dated as of May 4, 2006 between Robert Segal, M.D., F.A.C.P., and
      Discovery
                
                Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 18, 2008.10.24*
                
                Amended
      and Restated Employment Agreement, dated as of May 4, 2006, by and between
      Discovery and Charles Katzer.
                
                Incorporated
      by reference to Exhibit 10.31 to Discovery’s Annual Report on Form 10-K
      for the year ended December 31, 2006, as filed with the SEC on March 16,
      2007.10.25*
                
                Amendment
      to the Amended and Restated Employment Agreement dated as of May 4, 2006
      between Charles F. Katzer and Discovery
                
                Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on July 15, 2008.10.26*
                
                Amendment
      dated December 12, 2008 to the Amended and Restated Employment Agreement
      dated as of May 4, 2006 between Charles F. Katzer and Discovery
      Laboratories, Inc.
                
                Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 18, 2008.10.27
                
                Lease
      Agreement dated May 26, 2004, and First Amendment to Lease Agreement,
      dated April 2, 2007, by and between TR Stone Manor Corp. and Discovery
      Laboratories, Inc.
                
                Incorporated
      by reference to Exhibits 10.1 and 10.2 to Discovery’s Current Report on
      Form 8-K, as filed with the SEC on April 6, 2007.10.28
                
                Credit
      and Security Agreement, dated as of May 21, 2007, by and between Discovery
      and Merrill Lynch Capital, a division of Merrill Lynch Business Financial
      Services, Inc.
                
                Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on May 24,
2007.




32




ExhibitNo.
                  
                  Description
                  
                  MethodofFiling10.29
                  
                  First
      Amendment to Credit and Security Agreement (the “Amendment”) dated May 30,
      2008, between the Company and GE Business Financial Services Inc.
      (formerly Merrill Lynch Business Financial Services, Inc.)
                  
                  Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on June 2, 2008.10.30
      +
                  
                  Amended
      and Restate License Agreement by and between Discovery and Philip Morris
      USA Inc., d/b/a/ Chrysalis Technologies, dated March 28,
    2008
                  
                  Incorporated
      by reference to Exhibit 10.4 to Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended March 31, 2008, as filed with the SEC on May 9,
      2008.10.31
      +
                  
                  License
      Agreement by and between and Philip Morris Products S.A., dated March 28,
      2008
                  
                  Incorporated
      by reference to Exhibit 10.5 to Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended March 31, 2008, as filed with the SEC on May 9,
      2008.10.32
                  
                  Common
      Stock Purchase Agreement, dated as of May 22, 2008, by and between
      Kingsbridge Capital and Discovery
                  
                  Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on May 27, 2008.10.33
                  
                  Registration
      Rights Agreement, dated as of December 12, 2008, by and between
      Kingsbridge Capital and Discovery
                  
                  Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on May 27, 2008.10.34
                  
                  Common
      Stock Purchase Agreement, dated December 12, 2008, by and between
      Discovery and Kingsbridge Capital Limited.
                  
                  Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 15, 2008.10.35
                  
                  Registration
      Rights Agreement, dated as of December 12, 2008, by and between
      Kingsbridge Capital and Discovery
                  
                  Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 15, 2008.10.36*
                  
                  Agreement,
      dated as of August 13, 2009, by and between Discovery and W. Thomas Amick
      Regarding Service as Chief Executive Officer on a Part-Time, Interim
      Basis
                  
                  Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on September 4,2009.10.37*
                  
                  Separation
      of Employment Agreement and General Release, dated as of August 13, 2009,
      by and between Discovery and Robert J. Capetola
                  
                  Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on September 4, 2009.10.38
                  
                  Payment
      Agreement and Loan Amendment (amending the Second Amended and Restated
      Loan Agreement, dated as of December 10, 2001, amended and restated as of
      October 25, 2006) dated April 27, 2010, by and between Discovery and
      PharmaBio
                  
                  Incorporated
      by reference to Exhibit 1.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on April 28, 2010.10.39
                  
                  Third
      Amended Promissory Note dated April 27, 2010 (amending and restating the
      Second Amended Promissory Note dated as of October 25, 2006), payable to
      PharmaBio
                  
                  Incorporated
      by reference to Exhibit 1.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on April 28,
2010.




33






ExhibitNo.
                        
                        Description
                        
                        MethodofFiling10.40
                        
                        Securities
      Purchase Agreement dated April 27, 2010, by and between Discovery and
      PharmaBio
                        
                        Incorporated
      by reference to Exhibit 1.3 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on April 28, 2010.21.1
                        
                        Subsidiaries
      of Discovery.
                        
                        Incorporated
      by reference to Exhibit 21.1 to Discovery’s Annual Report on Form 10-KSB
      for the year ended December 31, 1997, as filed with the SEC on March 31,
      1998.23.1
                        
                        Consent
      of Ernst & Young LLP, independent registered public accounting
      firm.
                        
                        Incorporated
      by reference to Exhibit 23.1 to Discovery’s Annual Report on Form 10-K for
      the year ended December 31, 2009, as filed with the SEC on March 10,
      2010.23.2
                        
                        Consent
      of Ernst & Young LLP, independent registered public accounting
      firm.
                        
                        Filed
      herewith.31.1
                        
                        Certification
      of Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange
      Act.
                        
                        Incorporated
      by reference to Exhibit 31.1 to Discovery’s Annual Report on Form 10-K for
      the year ended December 31, 2009, as filed with the SEC on March 10,
      2010.31.2
                        
                        Certification
      of Chief Financial Officer and Principal Accounting Officer pursuant to
      Rule 13a-14(a) of the Exchange Act.
                        
                        Incorporated
      by reference to Exhibit 31.2 to Discovery’s Annual Report on Form 10-K for
      the year ended December 31, 2009, as filed with the SEC on March 10,
      2010.31.3
                        
                        Certification
      of Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange
      Act.
                        
                        Incorporated
      by reference to Exhibit 31.3 to Discovery’s Annual Report on Form 10-K/A
      for the year ended December 31, 2009, as filed with the SEC on April 30,
      2010.31.4
                        
                        Certification
      of Chief Financial Officer and Principal Accounting Officer pursuant to
      Rule 13a-14(a) of the Exchange Act.
                        
                        Incorporated
      by reference to Exhibit 31.4 to Discovery’s Annual Report on Form 10-K/A
      for the year ended December 31, 2009, as filed with the SEC on April 30,
      2010.31.5
                        
                        Certification
      of Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange
      Act.
                        
                        Filed
      herewith.31.6
                        
                        Certification
      of Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange
      Act.
                        
                        Filed
      herewith.32.1
                        
                        Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.
                        
                        Incorporated
      by reference to Exhibit 32.1 to Discovery’s Annual Report on Form 10-K for
      the year ended December 31, 2009, as filed with the SEC on March 10,
      2010.




34






ExhibitNo.
                
                Description
                
                MethodofFiling32.2
                
                Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.
                
                Incorporated
      by reference to Exhibit 31.4 to Discovery’s Annual Report on Form 10-K/A
      for the year ended December 31, 2009, as filed with the SEC on April 30,
      2010.32.3
                
                Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.
                
                Filed
      herewith.





+           Confidential
treatment requested as to certain portions of these exhibits.  Such
portions have been redacted and filed separately with the
Commission.





*           A
management contract or compensatory plan or arrangement required to be filed as
an exhibit to this annual report pursuant to Item 15(b) of Form
10-K.




35




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Contents


PageConsolidated
      Financial StatementsReport
      of Independent Registered Public Accounting Firm
              F-2Balance
      Sheets as of December 31, 2009 and December 31, 2008
              F-3Statements
      of Operations for the years ended December 31, 2009, 2008 and
      2007
              F-4Statements
      of Changes in Stockholders’ Equity for the years ended December 31,
      2009, 2008 and 2007
              F-5Statements
      of Cash Flows for the years ended December 31, 2009, 2008 and
      2007
              F-6Notes
      to consolidated financial statements
              F-7




F-1




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Report of
Independent Registered Public Accounting Firm





The Board
of Directors and Stockholders
 Discovery
Laboratories, Inc.
 
 We have
audited the accompanying consolidated balance sheets of Discovery Laboratories,
Inc. and subsidiary (the “Company”) as of December 31, 2009 and 2008, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for each of the three years in the period ended December 31,
2009.  These financial statements are the responsibility of the
Company's management.  Our responsibility is to express an opinion on
these financial statements based on our audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
 
 In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Discovery
Laboratories, Inc. and subsidiary at December 31, 2009 and 2008, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2009, in conformity with U.S.
generally accepted accounting principles.
 
 The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. As more fully described in Note 3, the Company
has incurred recurring operating losses and has generated negative cash flows
from operations since inception and expects such results to continue for the
foreseeable future.  In addition, there is uncertainty as to the
Company’s ability to raise additional capital sufficient to meet its obligations
on a timely basis.  These conditions raise substantial doubt about the
Company’s ability to continue as a going concern. Management’s plans in regard
to these matters also are described in Note 3.  The December 31, 2009
consolidated financial statements do not include any adjustments to reflect the
possible future effects on the recoverability and classification of assets or
the amounts and classification of liabilities that may result from the outcome
of this uncertainty.
 
 As
discussed in Note 2 to the consolidated financial statements, the 2009
consolidated financial statements have been restated to correct an error related
to the accounting for registered warrants.
 We also have audited, in accordance with
the standards of the Public Company Accounting Oversight Board (United States),
the Company’s internal control over financial reporting as of December 31, 2009,
based on criteria established in Internal Control-Integrated Framework issued by
the Committee of Sponsoring Organizations of the Treadway Commission and our
report dated March 10, 2010, except for the effects of the material weakness
described in the sixth paragraph of that report, as to which the date is
November 12, 2010, expressed an adverse opinion thereon.
 
 /s/ Ernst & Young LLP
 Philadelphia,
PA
 March 10,
2010, except for Note 2, Note 4, and
 Note 5,
as to which the date is November 12, 2010


F-2




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Consolidated
Balance Sheets





(In
thousands, except per share data)





December 31,
                      
                      
                      December 31,2009
                      
                      
                      2008(As
      Restated)ASSETSCurrent
      Assets:Cash
      and cash equivalents
                      
                      $
                      15,741
                      
                      
                      $
                      22,744Available-for-sale
      marketable securities
                      
                      
                      –
                      
                      
                      
                      2,048Prepaid
      expenses and other current assets
                      
                      
                      233
                      
                      
                      
                      625Total
      current assets
                      
                      
                      15,974
                      
                      
                      
                      25,417Property
      and equipment, net
                      
                      
                      4,668
                      
                      
                      
                      5,965Restricted
      cash
                      
                      
                      400
                      
                      
                      
                      600Other
      assets
                      
                      
                      361
                      
                      
                      
                      907Total
      assets
                      
                      $
                      21,403
                      
                      
                      $
                      32,889LIABILITIES
      & STOCKHOLDERS’ EQUITYCurrent
      Liabilities:Accounts
      payable
                      
                      $
                      1,294
                      
                      
                      $
                      2,111Accrued
      expenses
                      
                      
                      3,446
                      
                      
                      
                      5,313Common
      stock warrant liability
                      
                      
                      3,191
                      
                      
                      
                      -Loan
      payable, including accrued interest
                      
                      
                      10,461
                      
                      
                      
                      –Equipment
      loan, current portion
                      
                      
                      597
                      
                      
                      
                      2,442Total
      current liabilities
                      
                      
                      18,989
                      
                      
                      
                      9,866Loan
      payable, including accrued interest
                      
                      
                      –
                      
                      
                      
                      10,128Equipment
      loan, non-current portion
                      
                      
                      428
                      
                      
                      
                      1,092Other
      liabilities
                      
                      
                      690
                      
                      
                      
                      870Total
      liabilities
                      
                      
                      20,107
                      
                      
                      
                      21,956Stockholders’
      Equity:Preferred
      stock, $0.001 par value; 5,000 shares authorized; no shares issued or
      outstanding
                      
                      
                      –
                      
                      
                      
                      –Common
      stock, $0.001 par value; 380,000 and 180,000 shares authorized; 126,689
      and 101,588 shares issued, 126,376 and 101,275 shares outstanding at
      December 31, 2009 and December 31, 2008, respectively
                      
                      
                      127
                      
                      
                      
                      102Additional
      paid-in capital
                      
                      
                      361,503
                      
                      
                      
                      341,293Accumulated
      deficit
                      
                      
                      (357,280
                      )
                      
                      
                      (327,409
                      )Treasury
      stock (at cost); 313 shares
                      
                      
                      (3,054
                      )
                      
                      
                      (3,054
                      )Accumulated
      other comprehensive income
                      
                      
                      –
                      
                      
                      
                      1Total
      stockholders’ equity
                      
                      
                      1,296
                      
                      
                      
                      10,933Total
      liabilities & stockholders’ equity
                      
                      $
                      21,403
                      
                      
                      $
                      32,889




See notes to consolidated financial
statements




F-3




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Consolidated
Statements of Operations





(In
thousands, except per share data)





Year Ended December 31,2009
                        
                        
                        2008
                        
                        
                        2007(As
      Restated)Revenue
      from collaborative arrangement and grants:
                        
                        $
                        –
                        
                        
                        $
                        4,600
                        
                        
                        $
                        –Expenses:Research
      & development
                        
                        
                        19,077
                        
                        
                        
                        26,566
                        
                        
                        
                        26,200General
      & administrative
                        
                        
                        10,120
                        
                        
                        
                        16,428
                        
                        
                        
                        13,747Total
      expenses
                        
                        
                        29,197
                        
                        
                        
                        42,994
                        
                        
                        
                        39,947Operating
      loss
                        
                        
                        (29,197
                        )
                        
                        
                        (38,394
                        )
                        
                        
                        (39,947
                        )Change
      in fair value of common stock warrant liability
                        
                        
                        369
                        
                        
                        
                        -
                        
                        
                        
                        -Other
      income / (expense):Interest
      and other income
                        
                        
                        39
                        
                        
                        
                        902
                        
                        
                        
                        2,029Interest
      and other expense
                        
                        
                        (1,082
                        )
                        
                        
                        (1,614
                        )
                        
                        
                        (2,087
                        )Other
      income / (expense), net
                        
                        
                        (1,043
                        )
                        
                        
                        (712
                        )
                        
                        
                        (58
                        )Net
      loss
                        
                        $
                        (29,871
                        )
                        
                        $
                        (39,106
                        )
                        
                        $
                        (40,005
                        )Net
      loss per common share - basic and diluted
                        
                        $
                        (0.26
                        )
                        
                        $
                        (0.40
                        )
                        
                        $
                        (0.49
                        )Weighted
      average number of common shares outstanding - basic and
      diluted
                        
                        
                        115,200
                        
                        
                        
                        98,116
                        
                        
                        
                        81,731




See notes to consolidated financial
statements


F-4




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Consolidated
Statements of Changes in Stockholders’ Equity


For
Years Ended December 31, 2009, 2008 and 2007





Unearned
                    
                    
                    
                    
                    
                    
                    
                    
                    Accumulated(In thousands)
                    
                    
                    
                    
                    Additional
                    
                    
                    Portion of
                    
                    
                    
                    
                    
                    
                    
                    
                    Other Com-Common Stock
                    
                    
                    Paid-in
                    
                    
                    Compensatory
                    
                    
                    Accumulated
                    
                    
                    Treasury Stock
                    
                    
                    prehensiveShares
                    
                    
                    Amount
                    
                    
                    Capital
                    
                    
                    Stock Options
                    
                    
                    Deficit
                    
                    
                    Shares
                    
                    
                    Amount
                    
                    
                    Income/(Loss)
                    
                    
                    Total(As Restated)
                    
                    
                    
                    
                    
                    (As Restated)
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (As Restated)Balance
      – January 1, 2007
                    
                    
                    69,871
                    
                    
                    $
                    70
                    
                    
                    $
                    265,604
                    
                    
                    $
                    –
                    
                    
                    $
                    (248,298
                    )
                    
                    
                    (313
                    )
                    
                    $
                    (3,054
                    )
                    
                    $
                    –
                    
                    
                    $
                    14,322Comprehensive
      loss:Net
      loss
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (40,005
                    )
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (40,005
                    )Other
      comprehensive loss – unrealized gains on investments
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    42
                    
                    
                    
                    42Total
      comprehensive loss
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (39,963
                    )Issuance
      of common stock, stock option exercises
                    
                    
                    62
                    
                    
                    
                    –
                    
                    
                    
                    106
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    106Issuance
      of common stock, 401(k) employer match
                    
                    
                    118
                    
                    
                    
                    –
                    
                    
                    
                    294
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    294Issuance
      of common stock, April 2007 financing
                    
                    
                    14,050
                    
                    
                    
                    14
                    
                    
                    
                    28,131
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    28,145Issuance
      of common stock, December 2007 financing
                    
                    
                    10,000
                    
                    
                    
                    10
                    
                    
                    
                    23,550
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    23,560Issuance
      of common stock, CEFF financings
                    
                    
                    2,852
                    
                    
                    
                    3
                    
                    
                    
                    6,997
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    7,000Stock–based
      compensation expense
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    5,317
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    5,317Balance
      – December 31, 2007
                    
                    
                    96,953
                    
                    
                    $
                    97
                    
                    
                    $
                    329,999
                    
                    
                    $
                    –
                    
                    
                    $
                    (288,303
                    )
                    
                    
                    (313
                    )
                    
                    $
                    (3,054
                    )
                    
                    $
                    42
                    
                    
                    $
                    38,781Comprehensive
      loss:Net
      loss
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (39,106
                    )
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (39,106
                    )Other
      comprehensive loss – unrealized gains on investments
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (41
                    )
                    
                    
                    (41
                    )Total
      comprehensive loss
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (39,147
                    )Issuance
      of common stock, stock option exercises
                    
                    
                    18
                    
                    
                    
                    –
                    
                    
                    
                    21
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    21Issuance
      of common stock, 401(k) employer match
                    
                    
                    231
                    
                    
                    
                    –
                    
                    
                    
                    380
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    380Issuance
      of common stock, CEFF financings
                    
                    
                    4,387
                    
                    
                    
                    5
                    
                    
                    
                    6,266
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    6,271Stock-based
      compensation expense
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    4,627
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    4,627Balance
      – December 31, 2008
                    
                    
                    101,589
                    
                    
                    $
                    102
                    
                    
                    $
                    341,293
                    
                    
                    $
                    –
                    
                    
                    $
                    (327,409
                    )
                    
                    
                    (313
                    )
                    
                    $
                    (3,054
                    )
                    
                    $
                    1
                    
                    
                    $
                    10,933Comprehensive
      loss:Net
      loss
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (29,871
                    )
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (29,871
                    )Other
      comprehensive loss – unrealized gains on investments
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (1
                    )
                    
                    
                    (1
                    )Total
      comprehensive loss
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    (29,872
                    )Issuance
      of common stock, restricted stock awards
                    
                    
                    21
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –Issuance
      of common stock, 401(k) employer match
                    
                    
                    347
                    
                    
                    
                    –
                    
                    
                    
                    290
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    290Issuance
      of common stock, May 2009 financing
                    
                    
                    14,000
                    
                    
                    
                    14
                    
                    
                    
                    6,891
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    6,905Issuance
      of common stock, CEFF financings
                    
                    
                    10,732
                    
                    
                    
                    11
                    
                    
                    
                    10,346
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    10,357Stock-based
      compensation expense
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    2,683
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    2,683Balance
      – December 31, 2009
                    
                    
                    126,689
                    
                    
                    $
                    127
                    
                    
                    $
                    361,503
                    
                    
                    $
                    –
                    
                    
                    $
                    (357,280
                    )
                    
                    
                    (313
                    )
                    
                    $
                    (3,054
                    )
                    
                    $
                    –
                    
                    
                    $
                    1,296




See notes to consolidated financial
statements




F-5




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Consolidated
Statements of Cash Flows





(In
thousands)





Year
      Ended December 31,2009
                            
                            
                            2008
                            
                            
                            2007(As
      Restated)Cash
      flow from operating activities:Net
      loss
                            
                            $
                            (29,871
                            )
                            
                            $
                            (39,106
                            )
                            
                            $
                            (40,005
                            )Adjustments
      to reconcile net loss to net cash used in  operating
      activities:Depreciation
      and amortization
                            
                            
                            1,992
                            
                            
                            
                            2,215
                            
                            
                            
                            2,062Stock–based
      compensation and 401(k) match
                            
                            
                            2,973
                            
                            
                            
                            5,007
                            
                            
                            
                            5,613Fair
      value adjustment of common stock warrants
                            
                            
                            (369
                            )Loss
      on disposal of property and equipment
                            
                            
                            –
                            
                            
                            
                            110
                            
                            
                            
                            18Changes
      in:Prepaid
      expenses and other current assets
                            
                            
                            392
                            
                            
                            
                            (56
                            )
                            
                            
                            (89
                            )Accounts
      payable
                            
                            
                            (817
                            )
                            
                            
                            1,353
                            
                            
                            
                            (871
                            )Accrued
      expenses
                            
                            
                            (1,867
                            )
                            
                            
                            (1,773
                            )
                            
                            
                            2,762Other
      assets
                            
                            
                            (1
                            )
                            
                            
                            3
                            
                            
                            
                            35Other
      liabilities and accrued interest on loan payable
                            
                            
                            153
                            
                            
                            
                            495
                            
                            
                            
                            1,080Net
      cash used in operating activities
                            
                            
                            (27,415
                            )
                            
                            
                            (31,752
                            )
                            
                            
                            (29,395
                            )Cash
      flow from investing activities:Purchase
      of property and equipment
                            
                            
                            (147
                            )
                            
                            
                            (632
                            )
                            
                            
                            (3,765
                            )Restricted
      cash
                            
                            
                            200
                            
                            
                            
                            -
                            
                            
                            
                            -Purchase
      of marketable securities
                            
                            
                            –
                            
                            
                            
                            (25,765
                            )
                            
                            
                            (38,355
                            )Proceeds
      from sale or maturity of marketable securities
                            
                            
                            2,047
                            
                            
                            
                            39,754
                            
                            
                            
                            22,319Net
      cash provided by / (used in) investing activities
                            
                            
                            2,100
                            
                            
                            
                            13,357
                            
                            
                            
                            (19,801
                            )Cash
      flow from financing activities:Proceeds
      from issuance of securities, net of expenses
                            
                            
                            20,820
                            
                            
                            
                            6,292
                            
                            
                            
                            58,809Proceeds
      from equipment loans
                            
                            
                            –
                            
                            
                            
                            896
                            
                            
                            
                            2,862Principal
      payments under equipment loan obligations
                            
                            
                            (2,508
                            )
                            
                            
                            (2,978
                            )
                            
                            
                            (1,948
                            )Net
      cash provided by financing activities
                            
                            
                            18,312
                            
                            
                            
                            4,210
                            
                            
                            
                            59,723Net (decrease) / increase in cash and cash
      equivalents
                            
                            
                            (7,003
                            )
                            
                            
                            (14,185
                            )
                            
                            
                            10,527Cash
      and cash equivalents – beginning of year
                            
                            
                            22,744
                            
                            
                            
                            36,929
                            
                            
                            
                            26,402Cash and cash equivalents – end of
      year
                            
                            $
                            15,741
                            
                            
                            $
                            22,744
                            
                            
                            $
                            36,929Supplementary
      disclosure of cash flows information:Interest
      paid
                            
                            $
                            208
                            
                            
                            $
                            529
                            
                            
                            $
                            676Non-cash
      transactions:Unrealized
      gain / (loss) on marketable securities
                            
                            
                            (1
                            )
                            
                            
                            (41
                            )
                            
                            
                            42Exchange
      of equipment loan obligation
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            3,968




See notes to consolidated financial
statements




F-6


DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Restatement
of Historical Financial Statements





The
accompanying Consolidated Balance Sheet as of December 31, 2009 and the
Consolidated Statement of Operations, Equity, and Cash Flows for the year ended
December 31, 2009, have been restated in this report to reclassify certain
warrants based on a reassessment of the applicable accounting guidance,
as  discussed in Note 2.


Note
1 –  The Company and Description of Business





Discovery
Laboratories, Inc. (referred to as “we,” “us,” or the “Company”) is a
biotechnology company developing surfactant therapies to treat respiratory
disorders and diseases for which there frequently are few or no approved
therapies.  Our novel KL4
proprietary technology produces a synthetic, peptide-containing surfactant
(KL4
surfactant) that is structurally similar to pulmonary surfactant, a substance
produced naturally in the lung and essential for survival and normal respiratory
function.  In addition, our proprietary capillary aerosol-generating
technology (capillary aerosolization technology) produces a dense aerosol with a
defined particle size, to potentially deliver our aerosolized KL4 surfactant
to the lung.  As many respiratory disorders are associated with
surfactant deficiency or surfactant degradation, we believe that our proprietary
technology platform makes it possible, for the first time, to develop a
significant pipeline of surfactant products targeted to treat a wide range of
previously unaddressed respiratory problems.





We are
developing our lead products, Surfaxin®(lucinactant),
Surfaxin LSTM and Aerosurf®, to
address the most significant respiratory conditions affecting pediatric
populations.  In April 2009, we received a Complete Response Letter
from the U.S. Food and Drug Administration (FDA) with respect to our New Drug
Application (NDA) for Surfaxin for the prevention of Respiratory Distress
Syndrome (RDS) in premature infants, our first product based on our novel
KL4
surfactant technology.  The letter focused primarily on certain
aspects of our fetal rabbit biological activity test (BAT, a quality control and
stability release test for Surfaxin and our other KL4 pipeline
products), specifically whether analysis of preclinical data from both the BAT
and a well-established preterm lamb model of RDS demonstrates the degree of
comparability that the FDA requires and whether the BAT can adequately
distinguish change in Surfaxin biological activity over time.  We met
with the FDA at an end-of-review meeting in June 2009 and by teleconference in
September 2009 to discuss specific proposals to resolve this sole remaining
Chemistry, Manufacturing & Control (CMC) issue, which must be addressed to
obtain approval of Surfaxin.  Based on these and other interactions
with the FDA, we are currently implementing a protocol intended to optimize and
revalidate the BAT.  This effort is ongoing and, although not
necessarily indicative of the final results, the BAT is presently meeting all
pre-specified acceptance criteria.  Once the BAT is optimized and
revalidated, we plan to initiate a comprehensive preclinical program that will
consist of a series of a series of side-by-side studies comparing the results of
the BAT with those of the well-established preterm lamb model of RDS in order to
satisfy the FDA’s requirements with respect to the BAT.  If these
studies are successful, we believe that we could be in a position to file a
Complete Response to the April 2009 Complete Response Letter in the first
quarter of 2011, which could lead to approval of Surfaxin for the prevention of
Respiratory Distress Syndrome (RDS) in premature infants in 2011.  If
approved, Surfaxin would be the first synthetic, peptide-containing surfactant
for use in pediatric medicine.





Surfaxin
LS, our lyophilized KL4
surfactant, is a dry powder formulation that is resuspended as a liquid prior to
use and is intended to improve ease of use for healthcare practitioners,
eliminate the need for cold-chain storage, and potentially further improve
clinical performance.  Aerosurf is our proprietary KL4 surfactant
in aerosolized form, which we are developing using our capillary aerosolization
technology, initially to treat premature infants at risk for
RDS.  Premature infants with RDS are treated with surfactants that are
administered by means of invasive endotracheal intubation and mechanical
ventilation, procedures that frequently result in serious respiratory conditions
and complications.  If approved, we believe that Aerosurf will make it
possible to administer surfactant into the lung without subjecting patients to
such invasive procedures.  We believe that Aerosurf has the potential
to enable a significant increase in the use of surfactant therapy in pediatric
medicine.




F-7




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


In
addition to our lead products, we plan over time to develop our KL4 surfactant
technology into a broad product pipeline that potentially will address a variety
of debilitating respiratory conditions for which there currently are no or few
approved therapies, in patient populations ranging from premature infants to
adults.  Our plans include potentially taking these initiatives
through a Phase 2 proof-of-concept phase and, if successful, thereafter
determining whether to seek strategic alliances or collaboration arrangements or
to utilize other financial alternatives to fund their further
development.  We have an ongoing Phase 2 clinical trial of Surfaxin to
potentially address Acute Respiratory Failure (ARF) and our KL4 surfactant
is the subject of an investigator-initiated Phase 2a clinical trial assessing
the safety, tolerability and short-term effectiveness (via improvement in
mucociliary clearance) of aerosolized KL4 surfactant
in patients with Cystic Fibrosis (CF).  We are conducting research and
preclinical development with our KL4 surfactant
potentially to address Acute Lung Injury (ALI), and, potentially in the future,
other diseases associated with inflammation of the lung, such as Asthma and
Chronic Obstructive Pulmonary Disease (COPD).  We have also initiated
exploratory preclinical studies to assess the feasibility of using our KL4 surfactant
in combination with small and large molecule therapeutics to efficiently and
effectively deliver therapies to the lung to treat a range of pulmonary
conditions and disease.





We are
actively assessing various strategic and financial alternatives to secure the
necessary capital to advance our KL4respiratory pipeline programs to maximize stockholder value, although we
prefer to accomplish our objectives through strategic alliances.  We
are actively engaged in current discussions with potential strategic and/or
financial partners, but there can be no assurance that any strategic alliance or
other financing alternatives will be successfully
concluded.   Until we secure an alliance or other financing
alternative, we will continue to focus our financial resources on the potential
approval of Surfaxin, while minimizing investments in our other pipeline
programs.





Note
2 – Restatement of Financial Statements





We have
restated our previously issued consolidated financial statements and related
disclosures for the year ended December 31, 2009 to correct errors in the
accounting for certain warrants.  Specifically, we previously
classified as equity instruments warrants that should have been classified as
derivative liability instruments based on the terms of the warrants and the
applicable accounting guidance.
  
 We have
historically accounted for warrants, which prior to May 2009 were issued in
private transactions, as equity instruments.  Certain warrants issued
in registered transactions in May 2009 generally provide that, in the event the
related registration statement or an exemption from registration is not
available for the issuance or resale of the warrant shares, the holder may
exercise the warrant on a cashless basis.   However,
notwithstanding the availability of cashless exercise, generally accepted
accounting principles establishes that, in the absence of express agreement of
the parties to the contrary, registered warrants may be subject to net cash
settlement, as it is not within the absolute control of the issuer to provide
freely-tradable shares in all circumstances.  The applicable
accounting principles expressly do not allow for an evaluation of the likelihood
that an event would trigger cash settlement.
  
 The
accompanying 2009 financial statements have been restated to report the
warrants issued in May 2009 as derivative liabilities measured at estimated fair
value, calculated using the Black-Scholes option pricing
model:


F-8


DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Issuance Date
                  
                  Number of Warrants
                    Issued
                  
                  
                  Exercise Price
                  
                  Expiration of
                    Warrants
                  
                  Fair Value of
                    Warrants at Issuance
                    Date(In thousands)May
      13, 2009
                  
                  
                  7,000,000
                  
                  
                  $
                  1.15
                  
                  May
      13, 2014
                  
                  $
                  3,560





The
revaluation of the fair value of warrants at each subsequent balance sheet date
results in a change in the carrying value of the liability, which is recorded as
“Change in fair value of common stock warrant liability” in the consolidated
statement of operations. The net effect of these changes for the year ended
December 31, 2009, and for each of the quarterly consolidated financial
statements for the periods ended June 30, 2009 and September 30, 2009 are
as follows:


Reporting Period
                      
                      Income (Loss) Resulting from Change
                        in Fair Value of Common Stock
                        Warrant Liability(In thousands)
                      
                      
                      Net Effect on Loss
                        Per ShareAnnualYear
      ended December 31, 2009
                      
                      $
                      369
                      
                      
                      $
                      –Interim
      (Unaudited)Quarter
      ended June 30, 2009
                      
                      
                      (1,323
                      )
                      
                      
                      (0.01
                      )Quarter
      ended September 30, 2009
                      
                      
                      (1,662
                      )
                      
                      
                      (0.01
                      )Quarter
      ended December 31, 2009
                      
                      
                      3,354
                      
                      
                      
                      0.03





We have
not amended our previously-filed Quarterly Reports on Form 10-Q for the periods
ended June 30, 2009 and September 30, 2009 to correct these misstatements,
and thus the financial statements and related financial statement information
contained in those reports should no longer be relied upon.
 
 The
following tables summarize the effects of the restatement on each affected
caption in the accompanying financial statements as of and for the year ended
December 31, 2009:


Consolidated
      Balance Sheet
                                  
                                  December
      31, 2009
                                  
                                  
                                  December
      31, 2009(in
      thousands)
                                  
                                  (As
      previously reported)
                                  
                                  
                                  (As
      restated)Current
      Liabilities:Common
      stock warrant liability
                                  
                                  $
                                  --
                                  
                                  
                                  $
                                  3,191Total
      Current Liabilities
                                  
                                  
                                  15,798
                                  
                                  
                                  
                                  18,989Total
      Liabilities
                                  
                                  
                                  16,916
                                  
                                  
                                  
                                  20,107Stockholders’
      Equity:Additional
      paid-in-capital
                                  
                                  
                                  365,063
                                  
                                  
                                  
                                  361,503Accumulated
      deficit
                                  
                                  
                                  (357,649
                                  )
                                  
                                  
                                  (357,280
                                  )Total
      stockholders’ equity
                                  
                                  
                                  4,487
                                  
                                  
                                  
                                  1,296





Consolidated  Statement of Operations
                    
                    Year Ended
                      December 31, 2009
                    
                    
                    Year Ended
                      December 31, 2009(in thousands)
                    
                    (As previously reported)
                    
                    
                    (As restated)Change
      in fair value of common stock warrant liability
                    
                    $
                    —
                    
                    
                    $
                    369Net
      Loss
                    
                    
                    (30,240
                    )
                    
                    
                    (29,871
                    )Loss Per Share
                    
                    
                    (0.26
                    )
                    
                    
                    (0.26
                    )


Consolidated  Statement
      of Cash Flows
                        
                        Year
      Ended
                          December
      31, 2009
                        
                        
                        Year
      Ended
                          December
      31, 2009(in
      thousands)
                        
                        (As
      previously reported)
                        
                        
                        (As
      restated)Net
      Loss
                        
                        $
                        (30,240
                        )
                        
                        $
                        (29,871
                        )Fair
      value adjustment of common stock warrants
                        
                        
                        --
                        
                        
                        
                        (369
                        )
 F-9




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Note
3 –  Liquidity Risks and Management’s Plans





We have
incurred substantial losses since inception, due to investments in research and
development, manufacturing and potential commercialization activities and we
expect to continue to incur substantial losses over the next several
years.  Historically, we have funded our business operations through
various sources, including public and private securities offerings, draw downs
under our CEFFs, capital equipment and debt facilities, and strategic
alliances.  We expect to continue to fund our business operations
through a combination of these sources, as well as sales revenue from our
product candidates, beginning with Surfaxin for the prevention of RDS, if
approved.




Following
receipt of the April 2009 FDA Complete Response Letter for Surfaxin, we made
fundamental changes in our business strategy.  We now believe
that  it is in our best interest financially to seek to develop and
commercialize our KL4 technology
through strategic alliances or other collaboration
arrangements.  However, there can be no assurance that any strategic
alliance or other arrangement will be successfully concluded.





The
accompanying financial statements have been prepared assuming that we will
continue as a going concern, which contemplates the realization of assets and
satisfaction of liabilities in the normal course of business.  As a
result of our cash position as of December 31, 2009, the audit opinion we
received from our independent auditors, which is included in our financial
statements in this report, contains a notation related to our ability to
continue as a going concern.  Our ability to continue as a going
concern is dependent on our ability to raise additional capital, to fund our
research and development and commercial programs and meet our obligations on a
timely basis.  If we are unable to successfully raise sufficient
additional capital, through strategic and collaborative arrangements with
potential partners and/or future debt and equity financings, we will likely
not have sufficient cash flows and liquidity to fund our business operations,
which could significantly limit our ability to continue as a going
concern.  In that event, we may be forced to further limit development
of many, if not all, of our programs and consider other means of creating value
for our stockholders, such as licensing the development and/or commercialization
of products that we consider valuable and might otherwise plan to develop
ourselves.  If we are unable to raise the necessary capital, we may be
forced to curtail all of our activities and, ultimately, cease
operations.  Even if we are able to raise additional capital, such
financings may only be available on unattractive terms, or could result in
significant dilution of stockholders’ interests and, in such event, the market
price of our common stock may decline.  Our December 31, 2009
financial statements do not include any adjustments relating to recoverability
and classification of recorded asset amounts or the amounts and classification
of liabilities that might be necessary should we be unable to continue in
existence.




Our
future capital requirements will depend upon many factors, including our efforts
to secure one or more strategic alliances to support our product development
activities and commercialization plans, and the ultimate success of our product
development and commercialization plans.  Currently, we are focused on
developing our lead KL4 surfactant
products to address the most significant respiratory conditions affecting
pediatric populations.  However, there can be no assurance that our
research and development projects will be successful, that products developed
will obtain necessary regulatory approval, that any approved product will be
commercially viable, that any CEFF will be available for future financings, or
that we will be able to secure strategic alliances or obtain additional capital
when needed on acceptable terms, if at all.  Even if we succeed in
securing strategic alliances, raising additional capital and developing and
subsequently commercializing product candidates, we may never achieve sufficient
sales revenue to achieve or maintain profitability.




As of
December 31, 2009, we had cash and cash equivalents of $15.7
million.  In February 2010, we completed a public offering resulting
in gross proceeds of $16.5 million ($15.1 million net).  Also, as of
December 31, 2009, our $10.5 million loan with Quintiles (formerly PharmaBio
Development Inc. and NovaQuestTM), a strategic investment group of Quintiles
Transnational Corp., is classified as a current liability, payable in April
2010.  We are pursuing a potential strategic restructuring of this
loan; however, there can be no assurance that any such restructuring will occur.
Currently, under our two CEFFs, we may potentially raise (subject to certain
conditions, including minimum stock price and volume limitations) up to an
aggregate of $69.5 million.  However, as of March 5, 2010, neither the
May 2008 CEFF nor the December 2008 CEFF was available because the market price
of our common stock price was below the minimum price required ($1.15 and $0.60,
respectively) to utilize the facility.  See, Note 10 – Stockholders’
Equity, for details about our CEFFs. During 2009, we raised  aggregate
gross proceeds of $22.0 million.  In May 2009, we completed a public
offering of or common stock, resulting in gross proceeds of $11.3 million ($10.5
million net), and, throughout 2009, we raised an aggregate of $10.7 million from
10 draw-downs under our CEFFs.  See,“Item 7 – Management’s
Discussion and Analysis of Financial Condition and Results of Operations –
Liquidity and Capital Resources – Committed Equity Financing Facilities
(CEFFs),” and “– Financings Pursuant to Common Stock Offerings.”




F-10




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Note
4 –  Summary of Significant Accounting Policies and Recent Accounting
Pronouncements





The
consolidated financial statements and accompanying notes are prepared in
accordance with accounting principles generally accepted in the United
States.




Consolidation





The
consolidated financial statements include all of the accounts of Discovery
Laboratories, Inc. and its inactive subsidiary, Acute Therapeutics,
Inc.  All intercompany transactions and balances have been eliminated
in consolidation.





Use
of estimates





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





Cash,
cash equivalents and marketable securities





We
consider all highly liquid marketable securities purchased with a maturity of
three months or less to be cash equivalents.





Marketable
securities are classified as available-for-sale and carried at fair market
value, based on quoted market prices for these or similar
instruments.  Realized gains and losses are computed using the average
cost of securities sold.  Any appreciation/depreciation on these
marketable securities is recorded as other comprehensive income (loss) in the
statements of changes in stockholders’ equity until
realized.  Realized gains (losses) on disposition of marketable
securities are recorded in the statement of operations when
disposed.





Marketable
securities are purchased pursuant to an investment policy approved by our Board
of Directors (the Board) that provides for the purchase of high-quality
marketable securities, while ensuring preservation of capital and fulfillment of
liquidity needs.





Fair
Value of Financial Instruments





Our
financial instruments consist principally of cash and cash equivalents,
marketable securities and restricted cash.   The fair values of
the Company’s cash equivalents and marketable securities are based on quoted
market prices.  The carrying amount of cash equivalents and marketable
securities is equal to their respective fair values at December 31, 2009 and
December 31, 2008.





Other
financial instruments, including accounts payable and accrued expenses, are
carried at cost, which the Company believes approximates fair
value.





Property
and equipment





Property
and equipment are recorded at cost and depreciated using the straight-line
method over the estimated useful lives of the assets (generally three to ten
years).  Leasehold improvements are amortized over the shorter of the
estimated useful lives or the remaining term of the lease.  Repairs
and maintenance costs are charged to expense as incurred.


F-11




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Long-lived
assets





Our
long-lived assets, primarily consisting of equipment, are reviewed for
impairment when events or changes in circumstances indicate the carrying amount
of an asset may not be recoverable, or its estimated useful life has changed
significantly.  When an asset’s undiscounted cash flows are less than
its carrying value, an impairment is recorded and the asset is written down to
its estimated value.  No impairment was recorded during the years
ended December 31, 2009, 2008 and 2007, as management believes there are no
circumstances that indicate the carrying amount of the assets will not be
recoverable.





Revenue
recognition under strategic alliances and collaboration agreements





Revenue
under strategic alliances and our collaboration agreements is recognized based
on the performance requirements of the contract.  Upfront,
non-refundable license fees received in connection with collaboration agreements
are deferred and recognized as revenue over the life of the agreement or period
of performance obligations.  Revenues derived from the achievement of
milestones are recognized when the milestone is achieved, as long as there are
no further performance obligations.  Deferred revenue results from
cash received or amounts receivable in advance of revenue recognition based upon
the performance requirements of the contract.  Grant revenue is
recorded upon receipt of funds.




Research
and development





Research
and development costs consist primarily of expenses associated with our
personnel, facilities, manufacturing operations, formulation development,
research, clinical, regulatory, other preclinical and clinical activities and
medical affairs.  Research and development costs are charged to
operations as incurred.





Stock-based
compensation





Effective
January 1, 2006, we adopted the fair value recognition provisions of Accounting
Standards Codification (ASC) Topic 718 “Stock Compensation,” using
the modified-prospective-transition method.  See, Note 11 – Stock Options
and Stock-based Employee Compensation, for a detailed description of our
recognition of stock-based compensation expense.





Warrant
accounting




We
account for common stock warrants in accordance with applicable accounting
guidance provided in ASC 815 as either derivative liabilities or as equity
instruments depending on the specific terms of the warrant agreement.  In
compliance with applicable securities law, registered common stock warrants that
require the issuance of registered shares upon exercise and do not sufficiently
preclude an implied right to cash settlement are accounted for as derivative
liabilities.  We classify these derivative warrant liabilities on the
consolidated balance sheet as a current liability, which is revalued at each
balance sheet date subsequent to the initial issuance.  We use the
Black-Scholes pricing model to value the derivative warrant liability. Changes
in the fair value of the warrants are reflected in the consolidated statement of
operations as “Change in the fair value of common stock warrant
liability.”




Income
taxes





We
provide for income taxes in accordance with Accounting Standards Codification
(ASC) Topic 740, “Accounting
for Income Taxes”.  ASC Topic 740 requires the recognition of
deferred tax liabilities and assets for the expected future tax consequences of
temporary differences between financial statement


carrying
amounts and the tax basis of assets and liabilities.





We use a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return.  The adoption of ASC 740 on January 1, 2007 did not have a
material impact on the consolidated financial statements.  Due to the
fact that we have never realized a profit, management has fully reserved the net
deferred tax asset since realization is not assured.


F-12




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Comprehensive
Loss





Comprehensive
loss consists of net loss plus the changes in unrealized gains and losses on
available-for-sale securities.  Comprehensive loss for the years ended
December 31, 2009, 2008 and 2007 are as follows:





(in thousands)
                  
                  December 31,2009
                  
                  
                  2008
                  
                  
                  2007(As Restated)Net
      loss
                  
                  $
                  (29,871
                  )
                  
                  $
                  (39,106
                  )
                  
                  $
                  (40,005
                  )Change
      in unrealized (losses)/gains on marketable securities
                  
                  
                  (1
                  )
                  
                  
                  (41
                  )
                  
                  
                  42Comprehensive
      loss
                  
                  $
                  (29,872
                  )
                  
                  $
                  (39,147
                  )
                  
                  $
                  (39,963
                  )





Net
loss per common share





Basic net
loss per common share is computed by dividing the net loss by the weighted
average number of common shares outstanding for the periods.  For the
years ended December 31, 2009, 2008 and 2007, 30.9 million,
25.1 million and 20.3 million shares of common stock, respectively, were
potentially issuable upon the exercise of certain stock options and warrants and
vesting of restricted stock awards.  Due to our net loss, these
potentially issuable shares were not included in the calculation of diluted net
loss per share as the effect would be anti-dilutive, therefore basic and
dilutive net loss per share are the same.





Business
segments





We
currently operate in one business segment, which is the research and development
of products focused on surfactant replacement therapies for respiratory
disorders and diseases. We are managed and operated as one business. A single
management team that reports to the Chief Executive Officer comprehensively
manages the entire business. We do not operate separate lines of business with
respect to our product candidates.





Recent Accounting
Pronouncements





In
June 2009, the Financial Accounting Standards Board (FASB) issued the Accounting Standards
CodificationTM(the Codification).  The Codification now is the
single source of authoritative accounting principles recognized by FASB to be
applied by nongovernmental entities in the preparation of financial statements
in conformity with Generally Accepted Accounting Principles (GAAP), in the
United States.  The Codification became effective for interim and
annual periods ending after September 15, 2009.  All other
accounting literature not included in the Codification will be nonauthoritative,
except for additional authoritative rules and interpretive releases issued by
the United States Securities Exchange Commission (SEC).  The
Codification is not intended to change GAAP; instead, it reorganizes the
thousands of US GAAP pronouncements into approximately 90 Accounting
Topics.  Adoption of the Codification did not have an impact on our
consolidated financial statements.





In May
2009, FASB issued new guidance for accounting for subsequent
events.  The new guidance, which is now part of Accounting Standards
Codification (ASC) Topic 855, Subsequent Events, is
consistent with existing auditing standards in its definition of subsequent
events, but requires disclosure of the date through which an entity has
evaluated subsequent events and the basis for that date.  There are
two types of subsequent events: (1) events that provide additional evidence
about conditions that existed at the balance sheet date, and are recognized in
the financial statements, and (2) events that provide evidence about
conditions that did not exist at the balance sheet date, but arose before the
financial statements are issued or are available to be issued, and are not
recognized at the balance sheet date.  The adoption of the new
guidance had no impact on our consolidated financial statements.  We
evaluated all events or transactions that occurred after December 31, 1009 up
through March 10, 2010, the date these financial statements were issued and
filed with the SEC.  During this period we had three material
nonrecognized subsequent events, which are described in Note
18.


F-13




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY




In
December 2007, FASB issued new guidance for accounting for collaborative
arrangements.  The new guidance, which is now part of ASC Topic 808,
Collaborative
Arrangements, is effective for fiscal years beginning after December 15,
2008.  The scope of the new guidance is limited to collaborative
arrangements where no separate legal entity exists and in which the parties are
active participants and are exposed to significant risks and rewards that depend
on the success of the activity.  The new guidance requires certain
income statement presentation of transactions with third parties and of payments
between parties to the arrangement, along with disclosure about the nature and
purpose of the arrangement.  The adoption of the new guidance on
January 1, 2009 did not have a material impact on our consolidated financial
statements.





In
December 2007, FASB issued new guidance for accounting for business
combinations.  The new guidance, which is now part of ASC topic 805,
Business Combinations,
is effective for financial statements issued for fiscal years beginning on or
after December 15, 2008.  The new guidance establishes principles
and requirements for how an acquirer recognizes and measures in its financial
statements the identifiable assets acquired, the liabilities assumed, any
noncontrolling interest in the acquiree, and the goodwill acquired in the
business combination.  ASC Topic 805 also establishes disclosure
requirements to enable the evaluation of the nature and financial effects of the
business combination. We adopted the new guidance on January 1, 2009, which had
no immediate impact on our financial statements; however, it may have an impact
on the accounting for any potential future business combinations.





Note
5 –  Fair Value Measurements





ASC Topic
820, Fair Value Measurements and Disclosures establishes a framework for
measuring fair value under GAAP and enhances disclosures about fair value
measurements.





Fair
value is defined as the exchange price that would be received for an asset or
paid to transfer a liability in the principal or most advantageous market for
the asset or liability in an orderly transaction between market participants on
the measurement date.





Valuation
techniques used to measure fair value must maximize the use of observable inputs
and minimize the use of unobservable inputs.  The fair value hierarchy
is based on three levels of inputs, of which the first two are considered
observable and the last unobservable, as follows:





·
            Level
      1 – Quoted prices in active markets for identical assets and
      liabilities.  Level 1 is generally considered the most reliable
      measurement of fair value under ASC
820.


·
            Level
      2 – Inputs other than Level 1 that are observable, either directly or
      indirectly, such as quoted prices for similar assets or liabilities,
      quoted prices in markets that are not active, or other inputs that are
      observable or can be corroborated by observable market data for
      substantially the full term of the assets or
  liabilities.


·
            Level
      3 – Unobservable inputs that are supported by little or no market activity
      and that are significant to the fair value of the assets or
      liabilities.




F-14




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Fair
Value on a Recurring Basis




Assets
and liabilities measured at fair value on a recurring basis are categorized in
the table below as of December 31, 2009:





Fair Value
                  
                  
                  Fair value measurement using(in thousands)
                  
                  December 31,
                    2009
                  
                  
                  Level 1
                  
                  
                  Level 2
                  
                  
                  Level 3Assets:Money
      markets (1)
                  
                  $
                  14,690
                  
                  
                  $
                  14,690
                  
                  
                  $
                  –
                  
                  
                  $
                  –Certificate
      of deposit
                  
                  
                  600
                  
                  
                  
                  600
                  
                  
                  
                  –
                  
                  
                  
                  –Total
      Assets
                  
                  $
                  15,290
                  
                  
                  $
                  15,290
                  
                  
                  $
                  –
                  
                  
                  $
                  –LiabilitiesCommon
      stock warrant liability
                  
                  $
                  3,191
                  
                  
                  $
                  $ –
                  
                  
                  $
                  –
                  
                  
                  $
                  3,191


(1)
Dreyfus Treasury & Agency Cash Management Fund.





The
following table summarizes the activity of Level 3 inputs measured on a
recurring basis for the year ended December 31, 2009:





(in thousands)
                  
                  Fair Value Measurements of Common
                    Stock Warrants Using Significant
                    Unobservable Inputs
                    (Level 3)Balance
      at December 31, 2008
                  
                  $
                  -Issuance
      of common stock warrants
                  
                  
                  3,560Change
      in fair value of common stock warrant liability
                  
                  
                  (369
                  )Balance
      at December 31, 2009
                  
                  $
                  3,191





Note
6 –  Marketable Securities





We did
not hold any available-for-sale marketable securities as of December 31,
2009.  The following is a summary of available-for-sale marketable
securities as of December 31, 2008 and 2007:





(in thousands)
                      
                      Amortized
                        CostBasis
                      
                      
                      Gross
                        Unrealized
                        Holding
                        Gains
                      
                      
                      Gross
                        Unrealized
                        Holding
                        Losses
                      
                      
                      Aggregate
                        FairValueDecember 31, 2008U.S.
      treasury notes
                      
                      $
                      2,047
                      
                      
                      $
                      1
                      
                      
                      $
                      –
                      
                      
                      $
                      2,048Total
                      
                      $
                      2,047
                      
                      
                      $
                      1
                      
                      
                      $
                      –
                      
                      
                      $
                      2,048December 31, 2007Commercial
      paper
                      
                      $
                      16,010
                      
                      
                      $
                      42
                      
                      
                      $
                      –
                      
                      
                      $
                      16,052Certificates
      of deposit
                      
                      
                      26
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      26Total
                      
                      $
                      16,036
                      
                      
                      $
                      42
                      
                      
                      $
                      –
                      
                      
                      $
                      16,078




F-15




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Available-for-sale
marketable securities consist of United States treasury notes, certificates of
deposits, and high-quality commercial paper with a maturity of greater than
three months.  All available-for-sale marketable securities have a
maturity period of less than one year.  These assets are measured at
fair market value at each reporting period.  The fair market value is
recorded using quoted prices from active markets.





Marketable
securities are purchased pursuant to an investment policy approved by our Board
that provides for the purchase of high-quality marketable securities, while
ensuring preservation of capital and fulfillment of liquidity
needs.





Note
7 –  Restricted Cash





Restricted
cash consists of a security deposit held by our bank in the amount of $600,000
to secure a letter of credit in the same notional amount held by our landlord to
secure our obligations under our Lease Agreement dated May 26, 2004 for our
headquarters location in Warrington, Pennsylvania (See, Note 14 – Commitments,
for further discussion on our leases).  Under the terms of our Lease,
beginning in March 2010, the letter of credit (and the related security deposit)
will be reduced to $400,000 and will remain in effect at that level through the
remainder of the lease term.  Subject to certain conditions, upon
expiration of the lease in February 2013, the letter of credit will expire and
the security deposit will be released.




Note
8 – Property and Equipment





Property and equipment as of December
31, 2009 and 2008 was comprised of the following:





December 31,(in thousands)
                  
                  2009
                  
                  
                  2008Equipment
                  
                  $
                  7,265
                  
                  
                  $
                  7,143Furniture
                  
                  
                  791
                  
                  
                  
                  791Leasehold
      improvements
                  
                  
                  2,838
                  
                  
                  
                  2,813Subtotal
                  
                  
                  10,894
                  
                  
                  
                  10,747Accumulated
      depreciation and amortization
                  
                  
                  (6,226
                  )
                  
                  
                  (4,782
                  )Property
      and equipment, net
                  
                  $
                  4,668
                  
                  
                  $
                  5,965





Equipment
primarily consists of: (i) manufacturing equipment to produce our KL4 surfactant
products, including Surfaxin and Aerosurf, for use in our preclinical studies,
clinical trials and  potential commercial needs; (ii) laboratory
equipment for manufacturing, analytical, research and development activities;
and (iii) computers and office equipment to support our overall business
activities.





Leasehold
improvements primarily consists of construction of a new analytical and
development laboratory in our Warrington, Pennsylvania headquarters, which was
completed in 2007 and where we consolidated the analytical, quality and
development activities previously located in Doylestown, Pennsylvania, and
Mountain View, California.  The activities conducted in our laboratory
include release and stability testing of raw materials as well as preclinical,
clinical and, if approved, commercial drug product supply.  We also
perform development work with respect to our aerosolized KL4 surfactant
and novel formulations of our KL4 surfactant
technology.  The laboratory will be amortized through the end of the
lease term for our Warrington, Pennsylvania headquarters in 2013.  In
addition, in 2007, we built a microbiology laboratory at our manufacturing
facility in Totowa, New Jersey, to support production of our drug product
candidates.  The microbiology laboratory will be amortized through the
end of the lease term for our Totowa, New Jersey facility in 2014.




Depreciation
and amortization expense on property and equipment for the years ended December
31, 2009, 2008, and 2007 was $1.4 million, $1.6 million, and $1.5 million,
respectively.


F-16




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Note
9 – Accrued Expenses





Accrued
expenses as of December 31, 2009 and 2008 were comprised of the
following:





December 31,(in thousands)
                  
                  2009
                  
                  
                  2008Accrued
      compensation(1)
                  
                  $
                  1,763
                  
                  
                  $
                  2,390Accrued
      manufacturing
                  
                  
                  568
                  
                  
                  
                  1,174Accrued
      research and development
                  
                  
                  332
                  
                  
                  
                  374All
      other accrued expenses
                  
                  
                  783
                  
                  
                  
                  1,375Total
      accounts payable and accrued expenses
                  
                  $
                  3,446
                  
                  
                  $
                  5,313


Accrued
compensation consists of potential employee incentive arrangements (pursuant to
plans approved by our Board), contractual future severance arrangements for our
former President and Chief Executive Officer (see, Note 14 – Commitments,
for further discussion of this arrangement)  and existing union
employees at our manufacturing operations, and employees’ unused earned
vacation.





Note
10 Debt





Loan Payable –
Quintiles





Quintiles
(formerly PharmaBio Development, Inc. and NovaQuestTM) in 2001 extended to us a
secured, revolving credit facility, which we restructured in October
2006.  The outstanding principal balance of the loan, $8.5 million, is
due and payable on April 30, 2010, together with all unpaid interest accrued
since July 1, 2006.  Since October 2006, interest is calculated at the
prime rate, compounded annually.  We may repay the loan, in whole or
in part, at any time without prepayment penalty or premium.  In
addition, our obligations to Quintiles under the loan agreement are secured by a
security interest in substantially all of our assets, subject to limited
exceptions set forth in the related security agreement.





Also in
October 2006, in consideration of Quintiles’s agreement to restructure the loan,
we entered into a Warrant Agreement with Quintiles, pursuant to which Quintiles
has the right to purchase 1.5 million shares of our common stock at an exercise
price of $3.5813 per share.  The warrants have a seven-year term and
are exercisable, in whole or in part, for cash, cancellation of a portion of our
indebtedness under the Quintiles loan agreement, or a combination of the
foregoing, in an amount equal to the aggregate purchase price for the shares
being purchased upon any exercise.





As of
December 31, 2009, the outstanding balance under the loan was $10.5 million
($8.5 million principal and $2.0 million accrued interest) and was classified as
a current liability on the Consolidated Balance Sheet as of such
date.





For the
years ended December 31, 2009, 2008 and 2007, we incurred interest expense
associated with the Quintiles loan of $0.3 million, $0.5 million and $0.7
million, respectively.  The decrease in interest expense in 2009 and
2008 is due to declines in the prime rate during 2008 ranging from 7.25% to
3.25%.  During 2009, the prime rate remained at 3.25%.  In
addition, for the years ended December 31, 2009, 2008 and 2007, we incurred
interest expense associated with the amortization of deferred financing costs in
connection with warrants issued to Quintiles in October 2006 of $0.5 million,
$0.5 million and $0.5 million, respectively.


F-17




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Equipment
Loans





Our
equipment loan liabilities as of December 31, 2009 and 2008 are as
follows:





(in
      thousands)
                  
                  2009
                  
                  
                  2008GE
      Business Financial Services, Inc.Short-term
                  
                  $
                  538
                  
                  
                  $
                  2,385Long-term
                  
                  
                  65
                  
                  
                  
                  664Total
                  
                  
                  603
                  
                  
                  
                  3,049Pennsylvania
      Machinery and Equipment LoanShort-term
                  
                  
                  59
                  
                  
                  
                  57Long-term
                  
                  
                  363
                  
                  
                  
                  428Total
                  
                  
                  422
                  
                  
                  
                  485Total
      Short-term
                  
                  
                  597
                  
                  
                  
                  2,442Total
      Long-term
                  
                  
                  428
                  
                  
                  
                  1,092Total
                  
                  $
                  1,025
                  
                  
                  $
                  3,534





For the
years ended December 31, 2009, 2008 and 2007, we incurred interest expense
associated with our equipment loans of $0.2 million, $0.6 million and $0.6
million, respectively.





Equipment
Financing Facility with GE Business Financial Services Inc.





In May
2007, we entered into a Credit and Security Agreement (Credit Agreement) with GE
Business Financial Services Inc. (formerly Merrill Lynch Business Financial
Services Inc.) (GE), as Lender, pursuant to which GE agreed to provide a $12.5
million facility (Facility) to fund our capital programs.  The right
to draw under this Facility expired on November 30, 2008.  Over the
term of the Facility, we received $7.2 million, $4.0 million of which was
applied to prepayment of a prior facility and $2.3 million of which was
associated with construction and equipment for the analytical and development
laboratory that we built in our Warrington, Pennsylvania headquarters in
2007.





Advances
under the Facility to finance the acquisition of property and equipment are
amortized over a period of 36 months and all other equipment and related
costs are amortized over a period of 24 months.  The advance to prepay
our prior facility is amortized over a period of 27 months.  Interest
on each advance accrues at a fixed rate per annum equal to one-month LIBOR plus
6.25%, determined on the funding date of such advance.  Principal and
interest on all advances are payable in equal installments on the first business
day of each month.  We may prepay advances, in whole or in part, at
any time, subject to a prepayment penalty, which, depending on the period of
time elapsed from the closing of the Facility, will range from 4% to
1%.





Our
obligations under the Facility are secured by a security interest in (i) the
financed property and equipment, and (ii) all of our intellectual property
(Supplemental Collateral), subject to limited exceptions set forth in the Loan
Agreement.  The Supplemental Collateral will be released on the
earlier to occur of (a) receipt by us of FDA approval of our NDA for
Surfaxinfor
the prevention of RDS in premature infants, or (b) the date on which we shall
have maintained over a continuous 12-month period ending on or after March 31,
2008, measured at the end of each calendar quarter, a minimum cash balance equal
to our projected cash requirements for the following 12-month
period.  In addition, we, GE and Quintiles entered into an
Intercreditor Agreement under which GE agreed to subordinate its security
interest in the Supplemental Collateral (which does not include financed
property and equipment) to the security interest in the same collateral that we
previously granted to Quintiles as discussed above.


F-18




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY


Pennsylvania
Machinery and Equipment Loan Fund (MELF)





We
entered into a Loan Agreement and Security Agreement with the Commonwealth of
Pennsylvania, Department of Community and Economic Development (Department),
effective September 8, 2008, pursuant to which the Department made a loan to us
from the Machinery and Equipment Loan Fund in the amount of $500,000 (MELF Loan)
to fund the purchase and installation of new machinery and equipment and the
upgrade of existing machinery and equipment at our analytical and development
laboratory in Warrington, Pennsylvania.  Principal and interest on the
MELF Loan is payable in equal monthly installments over a period of seven
years.  Interest on the principal amount accrues at a fixed rate of
five percent (5.0%) per annum.  We may prepay the MELF Loan at any
time without penalty.





In
addition to customary terms and conditions, the MELF Agreement provides that we
must meet certain criteria regarding retention and creation of new jobs within a
three-year period.  In the event that we fail to comply with this
requirement, the interest rate on the Promissory Note, except in limited
circumstances, will be adjusted to a fixed rate equal to two percentage points
above the current prime rate for the remainder of the term.





Note
11 – Stockholders’ Equity





Registered Public Offerings
and Private Placements




In
February 2010, we completed a public offering of 27,500,000 shares of our common
stock and warrants to purchase 13,750,000 shares of our common stock, sold as
units, with each unit consisting of one share of common stock and a warrant to
purchase 0.50 of a share of common stock, at a public offering price of $0.60
per unit, resulting in gross and net proceeds to us of $16.5 million and $15.1
million, respectively.  The warrants expire in February 2015 and are
exercisable, subject to an aggregate share ownership limitation, at a price per
share of $0.85, for cash or, in the event that the related registration
statement or an exemption from registration is not available for the resale of
the warrant shares, on a cashless basis.  This offering was made
pursuant to the 2008 Universal Shelf (see,Universal Shelf
Registration Statements of this Note).





In May
2009, we completed a registered direct offering of 14,000,000 shares of our
common stock and warrants to purchase 7,000,000 shares of our common stock, sold
as units to select institutional investors, with each unit consisting of one
share of common stock and a warrant to purchase 0.50 of a share of common stock,
at an offering price of $0.81 per unit, resulting in gross and net proceeds to
us of $11.3 million and $10.5 million, respectively.


The
warrants expire in May 2014 and are exercisable, subject to an aggregate share
ownership limitation, at a price per share of $1.15, for cash or, in the event
that the related registration statement or an exemption from registration is not
available for the resale of the warrant shares, on a cashless
basis.  This offering was made pursuant to our 2008 Universal
Shelf.





In
December 2007, we completed a registered direct offering of 10,000,000 shares of
our common stock to select institutional investors.  The shares were
priced at $2.50 per share resulting in gross and net proceeds to us of $25.0
million and $23.6 million, respectively.  This offering was made
pursuant to the 2005 Universal Shelf (see,Universal Shelf
Registration Statements of this Note).





In April
2007, we completed a registered direct offering of 14,050,000 shares of our
common stock to select institutional investors.  The shares were
priced at $2.15 per share resulting in gross and net proceeds to us of $30.2
million and $28.1 million, respectively.  This offering was made
pursuant to our 2005 Universal Shelf.





Committed Equity Financing
Facilities (CEFFs)





We have
entered into four Committed Equity Financing Facilities (CEFFs) with Kingsbridge
Capital Limited (Kingsbridge), a private investment group, under which
Kingsbridge is committed to purchase, subject to certain conditions,
newly-issued shares of our common stock.  The CEFFs allow us, at our
discretion, to raise capital at the time and in amounts deemed suitable to us,
to support our business plans.  We are not obligated to utilize any of
the funds available under the CEFFs.  Each CEFF is available for a
period of 2 to 3 years from inception.  Should we choose to utilize
any of the CEFFs, our ability to access the funds available under the CEFFs is
subject to certain conditions, including stock price and volume
limitations.


F-19




DISCOVERY
LABORATORIES, INC.  AND SUBSIDIARY




As of
December 31, 2009, we had two CEFFs available for future financings as follows:
the CEFF dated December 12, 2008 (December 2008 CEFF) and the CEFF dated May 22,
2008 (May 2008 CEFF).  A third CEFF entered in April 2006 expired on
May 12, 2009 and is no longer available.  The following table sets
forth an overview of the “draw down” requirements and availability under each
CEFF:




(in
      millions, except per
                          share
      data and trading
                          days)
                        
                        Minimum
                          Price
                          to
      Initiate
                        
                        Minimum
                          VWAP
      for
                        
                        #
      of
                          Trading
                          Days
                          In
      Each
                        
                        
                        Amount
      per
                          Contract
                        
                        
                        Potential
      Availability
                          at
                          December
      31, 2009Expiration
                        
                        Draw
                          Down(1)
                        
                        Daily
                          Pricing(2)
                        
                        Draw
                          Down(2)
                        
                        
                        Shares
                        
                        
                        Maximum
                          Proceeds
                        
                        
                        Shares
                        
                        
                        Maximum
                          ProceedsMay
      2008
                          CEFF
                        June
      18, 2011
                        
                        $
                        1.15
                        
                        90%
      of the closing market price on the
                        
                        
                        8
                        
                        
                        
                        19.3
                        
                        
                        $
                        60.0
                        
                        
                        
                        12.8
                        
                        
                        $
                        51.8Dec.
      2008
                          CEFF
                        Feb.
      6, 2011
                        
                        $
                        0.60
                        
                        day
      preceding the first day of
                          draw
      down
                        
                        
                        6
                        
                        
                        
                        15.0
                        
                        
                        $
                        25.0
                        
                        
                        
                        7.1
                        
                        
                        $
                        17.7




(1)
              To
      initiate a draw down, the closing price of our common stock on the trading
      day immediately preceding the firsttrading day of the draw down period
      must be at least equal to the minimum price set forth
    above.


(2)
              If
      on any trading day, the daily volume-weighted average of our common stock
      (VWAP) is less than the minimum VWAP set forth above, no shares are
      purchased on that trading day and the aggregate amount that we originally
      designated for the overall draw down is reduced for each such day by
      1/8th
      in the case of the December 2008 CEFF, and  1/6th
      in the case of the May 2008 CEFF, respectively .  Unless we and
      Kingsbridge agree otherwise, a minimum of three trading days must elapse
      between the expiration of any draw-down pricing period and the beginning
      of the next draw-down pricing
period.





Each draw
down is limited in amount as follows:





·
            May
      2008 CEFF – the lesser of 3.0 percent of the closing price market value of
      the outstanding shares of our common stock at the time of the draw down or
      $10 million; and


·
            December
      2008 CEFF – the lesser of 1.5 percent of the closing price market value of
      the outstanding shares of our common stock at the time of the draw down or
      $3 million.





The
purchase price of shares sold to Kingsbridge under the CEFFs is at a discount to
the VWAP (as defined in the applicable agreement) for each of the trading days
following our initiation of a “draw down” under the CEFF, as
follows:





Daily VWAP
                  
                  % of VWAP
                  
                  
                  Applicable DiscountMay
      2008 CEFFGreater
      than $7.25 per share
                  
                  
                  94
                  %
                  
                  
                  6
                  %Less
      than or equal to $7.25 but greater than $3.85 per share
                  
                  
                  92
                  %
                  
                  
                  8
                  %Less
      than or equal to $3.85 but greater than $1.75 per share
                  
                  
                  90
                  %
                  
                  
                  10
                  %Less
      than or equal to $1.75 but greater than or equal to $1.15 per
      share
                  
                  
                  88
                  %
                  
                  
                  12
                  %December
      2008 CEFFGreater
      than $7.25 per share
                  
                  
                  94
                  %
                  
                  
                  6
                  %Less
      than or equal to $7.25 but greater than $3.85 per share
                  
                  
                  92
                  %
                  
                  
                  8
                  %Less
      than or equal to $3.85 but greater than $1.75 per share
                  
                  
                  90
                  %
                  
                  
                  10
                  %Less
      than or equal to $1.75 but greater than or equal to $1.10 per
      share
                  
                  
                  88
                  %
                  
                  
                  12
                  %Less
      than or equal to $1.10 but greater than or equal to $.60
                  
                  
                  85
                  %
                  
                  
                  15
                  %





In
addition, Kingsbridge may terminate the CEFFs under certain circumstances,
including if a material adverse event relating to our business continues for 10
trading days after notice of the material adverse event.


F-20





DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





In
connection with the December 2008 CEFF, we issued a warrant to Kingsbridge on
December 22, 2008 to purchase up to 675,000 shares of our common stock at an
exercise price of $1.5132 per share.  The warrant expires in May 2014
and is exercisable, in whole or in part, for cash, except in limited
circumstances, with expected total proceeds to us, if exercised, of
approximately $1.0 million.  As of December 31, 2009, this warrant had
not been exercised.





In
connection with the May 2008 CEFF, we issued a warrant to Kingsbridge on May 22,
2008 to purchase up to 825,000 shares of our common stock at an exercise price
of $2.506 per share.  The warrant expires in November 2013 and is
exercisable, in whole or in part, for cash, except in limited circumstances,
with expected total proceeds to us, if exercised, of approximately $2.1
million.  As of December 31, 2009, this warrant had not been
exercised.





In
connection with the 2006 CEFF, we issued a Class C Investor Warrant to
Kingsbridge on April 17, 2006 to purchase up to 490,000 shares of our common
stock at an exercise price equal to $5.6186 per share.  The warrant
expires in October 2011 and is exercisable, in whole or in part, for cash,
except in limited circumstances, with expected total proceeds to us, if
exercised, of approximately $2.8 million.  As of December 31, 2009,
this Class C Investor Warrant had not been exercised.





In
connection with a CEFF that we entered in 2004, we issued a Class B Investor
Warrant to Kingsbridge to purchase up to 375,000 shares of our common stock at
an exercise price equal to $12.0744 per share.  The warrant expired
unexercised in January 2010.





CEFF
Financings





The financings that we completed under
the December 2008 CEFF are:




(in thousands, except per share
data)


Completion Date
                      
                      Shares Issued
                      
                      
                      Gross Proceeds
                      
                      
                      Discounted
                        Average Price
                        Per ShareApril
      8, 2009
                      
                      
                      806
                      
                      
                      $
                      1,000
                      
                      
                      $
                      1.24May
      7, 2009
                      
                      
                      1,273
                      
                      
                      
                      1,000
                      
                      
                      
                      0.79September
      23, 2009
                      
                      
                      1,793
                      
                      
                      
                      1,583
                      
                      
                      
                      0.88October
      13, 2009
                      
                      
                      1,909
                      
                      
                      
                      1,800
                      
                      
                      
                      0.94October
      21, 2009
                      
                      
                      2,101
                      
                      
                      
                      1,900
                      
                      
                      
                      0.90




F-21




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





The
financings that we completed under the May 2008 CEFF are:





(in thousands, except per share
data)


Completion Date
                      
                      Shares Issued
                      
                      
                      Gross Proceeds
                      
                      
                      Discounted
                        Average Price
                        Per ShareJuly
      11, 2008
                      
                      
                      1,105
                      
                      
                      $
                      1,563
                      
                      
                      $
                      1.41July
      31, 2008
                      
                      
                      992
                      
                      
                      
                      1,500
                      
                      
                      
                      1.51October
      17, 2008
                      
                      
                      914
                      
                      
                      
                      1,313
                      
                      
                      
                      1.44November
      20, 2008
                      
                      
                      221
                      
                      
                      
                      250
                      
                      
                      
                      1.13January
      2, 2009
                      
                      
                      479
                      
                      
                      
                      500
                      
                      
                      
                      1.04January
      16, 2009
                      
                      
                      419
                      
                      
                      
                      438
                      
                      
                      
                      1.04February
      18, 2009
                      
                      
                      857
                      
                      
                      
                      1,000
                      
                      
                      
                      1.17March
      31, 2009
                      
                      
                      1,015
                      
                      
                      
                      1,094
                      
                      
                      
                      1.08October
      13, 2009
                      
                      
                      559
                      
                      
                      
                      606
                      
                      
                      
                      1.09





The
financings that we completed under the now expired 2006 CEFF are:





(in thousands, except per share
data)


Completion Date
                      
                      Shares Issued
                      
                      
                      Gross Proceeds
                      
                      
                      Discounted
                        Average Price
                        Per ShareMay
      29, 2006
                      
                      
                      1,079
                      
                      
                      $
                      2,188
                      
                      
                      $
                      2.03October
      11, 2006
                      
                      
                      1,205
                      
                      
                      
                      2,300
                      
                      
                      
                      1.91November
      10, 2006
                      
                      
                      1,372
                      
                      
                      
                      3,000
                      
                      
                      
                      2.19February
      22, 2007
                      
                      
                      943
                      
                      
                      
                      2,000
                      
                      
                      
                      2.12October
      12, 2007
                      
                      
                      1,909
                      
                      
                      
                      5,000
                      
                      
                      
                      2.62September
      9, 2008
                      
                      
                      676
                      
                      
                      
                      1,250
                      
                      
                      
                      1.85





401(k) Employer
Match





We have a
voluntary 401(k) savings plan covering eligible employees that allows for
periodic discretionary matches as a percentage of each participant’s
contributions (up to the maximum deduction allowed, excluding “catch up”
amounts) in newly issued shares of common stock.  For the years ended
December 31, 2009, 2008 and 2007, the match resulted in the issuance of 346,904,
231,287, and 118,330 shares of common stock, respectively.


F-22




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





Common Shares Reserved for
Future Issuance





Common shares reserved for potential
future issuance upon exercise of warrants




The chart
below summarizes shares of our common stock reserved for future issuance upon
the exercise of warrants.




(in thousands, except  price per share data)December 31,
                    
                    
                    Exercise
                    
                    Expiration2009
                    
                    
                    2008
                    
                    
                    Price
                    
                    DateInvestor
      Warrants – May 2009 Financing (1)
                    
                    
                    7,000
                    
                    
                    
                    -
                    
                    
                    $
                    1.15
                    
                    5/13/2014Kingsbridge
      – December 2008 CEFF(2)
                    
                    
                    675
                    
                    
                    
                    675
                    
                    
                    $
                    1.51
                    
                    6/12/2014Kingsbridge
      – May 2008 CEFF(2)
                    
                    
                    825
                    
                    
                    
                    825
                    
                    
                    $
                    2.51
                    
                    11/22/2013Private
      Placement – 2006 (3)
                    
                    
                    2,315
                    
                    
                    
                    2,315
                    
                    
                    $
                    3.18
                    
                    11/22/2011Quintiles
      - 2006 Loan Restructuring (4)
                    
                    
                    1,500
                    
                    
                    
                    1,500
                    
                    
                    $
                    3.58
                    
                    10/26/2013Class
      C Investor Warrants - 2006 CEFF (2)
                    
                    
                    490
                    
                    
                    
                    490
                    
                    
                    $
                    5.62
                    
                    10/17/2011Quintiles
      - 2004 Partnership Restructuring (5)
                    
                    
                    850
                    
                    
                    
                    850
                    
                    
                    $
                    7.19
                    
                    11/3/2014Class
      B Investor Warrants - 2004 CEFF (2)
                    
                    
                    375
                    
                    
                    
                    375
                    
                    
                    $
                    12.07
                    
                    1/6/2010Class
      A Investor Warrants – 2003
                    
                    
                    809
                    
                    
                    
                    809
                    
                    
                    $
                    6.88
                    
                    9/19/2010Total
                    
                    
                    14,839
                    
                    
                    
                    7,839




(1)
            Refer
      to the Registered Public Offerings and Private Placements section of this
      Note.


(2)
            Refer
      to the Registered Public Offerings and Private Placements section of this
      Note.


(3)
            In
      Nov. 2006, in connection with a sale of 4.6 million shares of our common
      stock, we issued warrants to purchase common stock at an exercise price
      equal to $3.18 per share. The warrants expire in Nov. 2011 and, subject to
      an aggregate share ownership limitation, are exercisable, in whole or in
      part, for cash, except in limited circumstances, with expected proceeds to
      us of $7.4 million. As of December 31, 2009, the warrants had not been
      exercised


(4)
            Refer
      to Note 9 – Debt


(5)
            Issued
      in connection with a restructuring of a 2003 arrangement with Quintiles
      Transnational Corp that resulted in cancellation of a 2001
      commercialization agreement and extension of the Quintiles Loan. Refer to
      Note 9 – Debt.






Common
shares reserved for potential future issuance upon exercise of stock
options




In June
2007, our stockholders approved the adoption of the 2007 Long-Term Incentive
Plan (the “2007 Plan”). The 2007 Plan provides for the grant of long-term equity
and cash incentive compensation awards and replaced the Amended and Restated
1998 Stock Incentive Plan (the “1998 Plan”) whose ten-year term was to expire in
March 2008. The 2007 Plan continues many of the features of the 1998 Plan, but
is updated to reflect changes to Nasdaq rules regarding equity compensation,
other regulatory changes and market and corporate governance developments.
Awards outstanding under the 1998 Plan will continue to be governed by the terms
of the 1998 Plan and the agreements under which they were
granted.


F-23




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





Stock
options outstanding and available for future issuance as of December 31, 2009
and 2008 are as follows:





(in thousands)
                  
                  As of December 31,2009
                  
                  
                  20082007
      PlanOutstanding
                  
                  
                  6,688
                  
                  
                  
                  7,296Available
      for Future Grants
                  
                  
                  1,812
                  
                  
                  
                  1,204Total
                  
                  
                  8,500
                  
                  
                  
                  8,5001998
      PlanOutstanding
                  
                  
                  9,298
                  
                  
                  
                  9,916Available
      for Future Grants
                  
                  
                  –
                  
                  
                  
                  –Total
                  
                  
                  9,298
                  
                  
                  
                  9,916Total
      Outstanding
                  
                  
                  15,986
                  
                  
                  
                  17,212Total
      Available for Future Grants
                  
                  
                  1,812
                  
                  
                  
                  1,204Total
                  
                  
                  17,798
                  
                  
                  
                  18,416





The 1998
Plan was suspended upon approval of the 2007 Plan in June 2007; therefore, no
shares were available for future grants under the 1998 Plan. See, Note 11 – Stock Options
and Stock-based Employee Compensation.





Universal Shelf Registration
Statements





2008 Universal Shelf





In June
2008, we filed a universal shelf registration statement on Form S-3 (No.
333-151654) (“2008 Universal Shelf”) with the SEC for the proposed offering from
time to time of up to $150 million of our securities, including common stock,
preferred stock, varying forms of debt and warrant securities, or any
combination of the foregoing, on terms and conditions that will be determined at
that time. As of December 31, 2009 and March 1, 2010, respectively, up to $138.7
million and $122.2 million of our securities are potentially available for
issuance pursuant to the 2009 Universal Shelf. See, Registered Public
Offering and Private Placements in this Note for offerings made pursuant to the
2008 Universal Shelf.





2005
Universal Shelf




In
October 2005, we filed a universal shelf registration statement on Form S-3
(File No. 333-128929) (2005 Universal Shelf) with the SEC for the proposed
offering, from time to time, of up to $100 million of our debt or equity
securities. See,
Registered Public Offering and Private Placements in this Note for a discussion
of offerings pursuant to the 2008 Universal Shelf. The October 2005 Universal
Shelf expired in December 2008.




Common
shares reserved for potential future issuance under CEFF
arrangements


As of
December 31, 2009, the Company had two CEFFs available for future financings, as
follows:




(in thousands)
                    
                    Potential future issuance
                      as of December 31,Expiration
                    
                    2009
                    
                    
                    2008May
      2008 CEFF
                    June
      18, 2011
                    
                    
                    12,768
                    
                    
                    
                    15,618December
      2008 CEFF
                    February 6, 2011
                    
                    
                    7,118
                    
                    
                    
                    15,000




F-24




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





Common
shares reserved for potential future issuance under our 401(k)
Plan





In
September 2009 and December 2008, our Board approved an increase of 160,000 and
350,000 shares, respectively, to the reserve for issuance under the 401(k) Plan.
As of December 31, 2009 and 2008, we had 137,435 and 324,339 shares,
respectively, reserved for potential future issuance under the 401(k)
Plan.




Note
12 –  Stock Options and Stock-based Employee Compensation




Long-Term
Incentive Plans




In June
2007, our stockholders approved the 2007 Plan, which replaced the 1998 Plan,
which by its terms would have expired in March 2008. See, Note 10 – Common shares
reserved for potential future issuance upon exercise of stock options. The
purposes of the 2007 Plan are to (i) encourage eligible participants to acquire
a proprietary interest in our company, (ii) provide employees incentives to
contribute to our future success, thereby enhancing stockholder value, and
(iii) attract and retain exceptionally qualified individuals upon whom, in
large measure, our sustained progress, growth and profitability
depend.





Under the
2007 Plan, we may grant awards for up to 8,500,000 shares of our common stock.
An administrative committee (the Committee – currently the Compensation
Committee of the Board) or Committee delegates may determine the types, the
number of shares covered by, and the terms and conditions of, such awards.
Eligible participants may include any of our employees, directors, advisors or
consultants.




The 2007
Plan continues many of the features of the 1998 Plan, but is updated to reflect
changes to Nasdaq rules regarding equity compensation, other regulatory changes
and market and corporate governance developments. Awards outstanding under the
1998 Plan continue to be governed by the terms of that plan and the applicable
award agreements.





Award
under the two plans may include:





Stock
Options and Stock Appreciation Rights (SARs)





The
Committee may award nonqualified stock options, incentive stock options, or SARs
with a term of not more than ten years and a purchase price not be less than
100% of the fair market value on the date of grant. The Committee will establish
the vesting schedule for stock options and the method of payment for the
exercise price, which may include cash, shares, or other awards. Although
individual grants may vary, option awards generally are exercisable upon
vesting, vest based upon three years of continuous service and have a 10-year
term. In addition, the 2007 Plan provides for limits on the number of options
and SARs granted to any one participant and the terms of any incentive stock
option must comply with the provisions of Section 162(m) of the Internal Revenue
Code.





Restricted
Stock and Restricted Stock Units





The
Committee may grant restricted stock awards (RSAs) and restricted stock units
and, among other things, establish the applicable restrictions, including any
limitation on voting rights or the receipt of dividends, and will establish the
manner and timing under which restrictions may lapse. If employment is
terminated during the applicable restriction period (other than as a result of
death or disability), shares of restricted stock and restricted stock units
still subject to restriction will be forfeited, except as determined otherwise
by the Committee.





Performance
Awards and Other Stock-Based Awards




The
Committee may grant performance awards, which may be denominated in cash,
shares, other securities or other awards and payable to, or exercisable by, the
participant upon the achievement of performance goals during performance
periods, as established by the Committee. The Committee may grant other
stock-based awards that are denominated or payable in shares, under the terms
and conditions as the Committee will determine. The Committee may decide to
include dividends or dividend equivalents as part of a performance or other
stock-based award, and may accrue dividends, with or without interest, until the
award is paid.


F-25




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





Automatic
Grant of Non-Employee Director Options





Each
non-employee directors is entitled to automatic option grants on specified dates
as follows: (i) options to purchase 40,000 shares on the date of first election
or appointment to the board and (ii) options to purchase 30,000 shares on the
date of each subsequent annual stockholders meeting if such director continues
to, and has served as a director for at least six months. Non-employee director
options vest on the first anniversary of the date of grant (subject to continued
service through such date) and will otherwise vest in full upon the termination
of service as a result of death or disability. Non-employee director options
have a term of ten years (subject to earlier termination twelve months after any
termination of service).





No SARs
or Performance Awards have been granted under either plan. No RSAs have been
granted under the 2007 Plan. Under the 1998 Plan, in 2007, 56,660 RSAs were
granted to certain employees for no cash consideration. These RSAs initially
were to vest on the date that Surfaxin for RDS first becomes widely commercially
available; however, the Committee amended the vesting provisions in 2009 to
provide for vesting on the third anniversary of the grant date. As of December
31, 2009, there were 27,500 unvested restricted stock awards outstanding, which
vested on January 3, 2010.





Under the
2007 Plan, as of December 31, 2009, options to purchase 6,687,719 shares of
common stock were outstanding and 1,812,281 shares were available for potential
future grants. As of December 31, 2008, options to purchase 7,295,667 shares of
common stock were outstanding and 1,204,333 shares were available for potential
future grants. Under the 1998 Plan, options to purchase 9,297,792 and 9,916,644
shares of common stock were outstanding as of December 31, 2009 and December 31,
2008, respectively. No shares are available for future grants under the 1998
Plan.




A summary
of option activity under the 2007 Plan and 1998 Plan as of December 31, 2009 and
changes during the periods ended December 31, 2007, 2008 and 2009, respectively,
is presented below:




(in thousands, except for weighted-average data)
                                          
                                          Stock Options
                                        
                                        Price Per Share
                                        
                                        Shares
                                        
                                        Weighted-Average
                                          Exercise
                                          Price
                                        
                                        Weighted-Average
                                          Remaining
                                          Contractual
                                          Term(In Yrs)Outstanding
      at December 31, 2006
                                        
                                        $0.19
      – $10.60
                                        
                                        10,690
                                        
                                        $
                                        4.89Granted
                                        
                                        2.08
      – 3.58
                                        
                                        3,907
                                        
                                        
                                        2.94Exercised
                                        
                                        0.19
      – 2.46
                                        
                                        (61)
                                        
                                        
                                        1.72Forfeited
      or expired
                                        
                                        0.19
      – 9.80
                                        
                                        (606)
                                        
                                        
                                        5.07Outstanding
      at December 31, 2007
                                        
                                        $0.19
      – $10.60
                                        
                                        13,930
                                        
                                        $
                                        4.35Granted
                                        
                                        1.21
      – 2.90
                                        
                                        3,950
                                        
                                        
                                        1.78Exercised
                                        
                                        0.32
      – 1.62
                                        
                                        (18)
                                        
                                        
                                        1.21Forfeited
      or expired
                                        
                                        0.19
      – 10.60
                                        
                                        (650)
                                        
                                        
                                        5.17Outstanding
      at December 31, 2008
                                        
                                        $0.81
      – $10.43
                                        
                                        17,212
                                        
                                        $
                                        3.72Granted
                                        
                                        0.49
      – 1.18
                                        
                                        297
                                        
                                        
                                        0.78Exercised
                                        
                                        —
                                        
                                        —
                                        
                                        
                                        —Forfeited
      or expired
                                        
                                        0.81
      – 9.17
                                        
                                        (1,523)
                                        
                                        
                                        2.63Outstanding
      at December 31, 2009
                                        
                                        $0.49
      – $10.43
                                        
                                        15,986
                                        
                                        $
                                        3.76
                                        
                                        
                                        6.1Exercisable
      at December 31, 2009
                                        
                                        $1.15
      – $10.43
                                        
                                        13,608
                                        
                                        $
                                        4.09
                                        
                                        
                                        5.7


F-26




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





Based
upon application of the Black-Scholes option-pricing formula described below,
the weighted-average grant-date fair value of options granted during the years
ended December 31, 2009, 2008 and 2007 was $0.56, $0.88 and $2.05, respectively.
The total intrinsic value of options exercised during the years ended December
31, 2009, 2008 and 2007 was $0, $13,000 and $57,000, respectively. The total
intrinsic value of options outstanding, vested and exercisable as of December
31, 2009 is $13,000, $0 and $0, respectively.




A summary
of the status of our nonvested shares issuable upon exercise of outstanding
options and changes during 2009 is presented below:




(shares in thousands)
                            
                            Option
                              Shares
                            
                            Weighted-Average Grant-Date Fair ValueNon-vested
      at December 31, 2008
                            
                            6,607
                            
                            $
                            1.40Granted
                            
                            297
                            
                            
                            .56Vested
                            
                            (3,636)
                            
                            
                            1.55Forfeited
                            
                            (891)
                            
                            
                            1.33Non-vested
      at December 31, 2009
                            
                            2,377
                            
                            $
                            1.11





The
following table provides detail with regard to options outstanding, vested and
exercisable at December 31, 2009:




(shares in thousands)
                              
                              Outstanding
                              
                              Vested and ExercisablePrice per share
                              
                              Shares
                              
                              
                              Weighted-
                                Average
                                Price
                                per Share
                              
                              Weighted-
                                Average
                                Remaining
                                Contractual
                                Life
                              
                              Shares
                              
                              
                              Weighted-
                                Average
                                Price
                                per Share
                              
                              Weighted-
                                Average
                                Remaining
                                Contractual
                                Life$0.49
      – $2.00
                              
                              
                              4,148
                              
                              
                              $
                              1.63
                              
                              7.86
      Years
                              
                              
                              2,404
                              
                              
                              $
                              1.69
                              
                              7.23
      years$2.01
      – $4.00
                              
                              
                              7,463
                              
                              
                              $
                              2.66
                              
                              6.41
      Years
                              
                              
                              6,829
                              
                              
                              $
                              2.65
                              
                              6.44
      years$4.01
      – $6.00
                              
                              
                              657
                              
                              
                              $
                              4.75
                              
                              0.88
      Years
                              
                              
                              657
                              
                              
                              $
                              4.75
                              
                              0.88
      years$6.01
      – $8.00
                              
                              
                              1,350
                              
                              
                              $
                              6.87
                              
                              5.26
      Years
                              
                              
                              1,350
                              
                              
                              $
                              6.87
                              
                              5.26
      years$8.01
      – $10.00
                              
                              
                              2,343
                              
                              
                              $
                              8.93
                              
                              4.24
      Years
                              
                              
                              2,343
                              
                              
                              $
                              8.93
                              
                              4.24
      years$10.01
      – $10.43
                              
                              
                              25
                              
                              
                              $
                              10.43
                              
                              4.22
      Years
                              
                              
                              25
                              
                              
                              $
                              10.43
                              
                              4.22
      years15,986
                              
                              
                              
                              
                              
                              
                              
                              
                              13,608





Stock-Based
Compensation





As a
result of adopting Accounting Standards Codification (ASC) Topic 718 “Stock Compensation,” on
January 1, 2006, we recognized compensation expense for the years ended December
31, 2009, 2008 and 2007 of $2.7 million, $4.6 million and $5.3 million,
respectively.


F-27


DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





Stock-based
compensation expenses was classified as follows:




Years Ended December 31,(in thousands)
                                
                                2009
                                
                                
                                2008
                                
                                
                                2007Research
      and development
                                
                                $
                                649
                                
                                
                                $
                                1,501
                                
                                
                                $
                                1,706General
      and administrative
                                
                                
                                2,035
                                
                                
                                
                                3,127
                                
                                
                                
                                3,613Total
                                
                                $
                                2,684
                                
                                
                                $
                                4,628
                                
                                
                                $
                                5,319





The fair
value of each option award is estimated on the date of grant using the
Black-Scholes option-pricing formula that uses assumptions noted in the
following table. Expected volatilities are based upon the historical volatility
of our common stock and other factors. We also use historical data and other
factors to estimate option exercises, employee terminations and forfeiture rates
within the valuation model. The risk-free interest rates are based upon the U.S.
Treasury yield curve in effect at the time of the grant.




Years Ended December 31,2009
                  
                  
                  2008
                  
                  
                  2007Weighted
      average expected volatility
                  
                  
                  99
                  %
                  
                  
                  81
                  %
                  
                  
                  88
                  %Weighted
      average expected term
                  
                  4.7
      years
                  
                  
                  4.6
      years
                  
                  
                  4.8
      yearsWeighted
      average risk-free interest rate
                  
                  
                  1.7
                  %
                  
                  
                  2.1
                  %
                  
                  
                  4.8
                  %Expected
      dividends
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –




The total
fair value of the underlying shares of the options vested during 2009, 2008, and
2007 equals $5.6 million, $4.7 million and $4.9 million, respectively. As of
December 31, 2009, there was $2.2 million of total unrecognized compensation
cost related to non-vested share-based compensation arrangements granted under
the Plan. That cost is expected to be recognized over a weighted-average vesting
period of 1.37 years.





On August
13, 2009, Dr. Robert J. Capetola, our former President and Chief Executive
Officer, resigned his position and with us and as a member of our Board. Under
the terms of a Separation of Employment Agreement and General Release dated
August 13, 2009 between Dr. Capetola and ourselves, all of Dr. Capetola’s
outstanding RSAs and options immediately vested and all such RSAs and options
shall remain exercisable to the end of their stated terms. During 2009, the
company recognized $0.3 million in stock option modification costs related to
these items.





Note
13 – Corporate Partnership, Licensing and Research Funding
Agreements





Laboratorios
del Dr. Esteve, S.A.




We have a
strategic alliance with Laboratorios del Dr. Esteve, S.A. (Esteve) for the
development, marketing and sales of a broad portfolio of potential surfactant
products in Andorra, Greece, Italy, Portugal, and Spain. Esteve will pay us a
transfer price on sales of Surfaxin and other KL4 surfactant
products. We will be responsible for the manufacture and supply of all of the
covered products and Esteve will be responsible for all sales and marketing in
the territory. Esteve is obligated to make stipulated cash payments to us upon
our achievement of certain milestones, primarily upon receipt of marketing
regulatory approvals for the covered products. In addition, Esteve has agreed to
contribute to Phase 3 clinical trials for the covered products by conducting and
funding development performed in the territory. As part of a restructuring of
this alliance in December 2004, we regained full commercialization rights to our
KL4
surfactant technology in portions of the original territory licensed to Esteve,
including key European markets, Central America, and South America (Former
Esteve Territories) and agreed to pay to Esteve 10% of any cash up-front and
milestone fees (not to exceed $20 million in the aggregate) that we may receive
in connection with any strategic collaborations for the development and
commercialization of certain of our KL4 surfactant
products, including Surfaxin and Aerosurf in the Former Esteve
Territories.


F-28




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





Licensing
and Research Funding Agreements





Philip
Morris USA Inc. and Philip Morris Products S.A.





In March
2008, we restructured our December 2005 strategic alliance with Philip Morris
USA Inc. (PMUSA), d/b/a Chrysalis Technologies (Chrysalis), and assumed full
responsibility from Chrysalis for the further development of the capillary
aerosolization technology, including finalizing design development for the
initial prototype aerosolization device platform and disposable dose packets. In
connection with the restructuring, we restated our prior agreement as of March
28, 2008 and entered into an Amended and Restated License Agreement with PMUSA
with respect to the United States (U.S. License Agreement), and, as PMUSA had
assigned to Philip Morris Products S.A. (PMPSA) all rights in and to the
capillary aerosolization technology outside of the United States (International
Rights), effective on the same date, we entered into a License Agreement with
PMPSA with respect to the International Rights (International License Agreement)
on substantially the same terms and conditions as the U.S. License Agreement. We
currently hold exclusive licenses to the capillary aerosolization technology
both in and outside of the United States for use with pulmonary surfactants
(alone or in combination with any other pharmaceutical compound(s)) for all
respiratory diseases and conditions (the foregoing uses in each territory, the
Exclusive Field). In addition, under the U.S. License Agreement, our license to
use the capillary aerosolization technology includes other (non-surfactant)
drugs to treat a wide range of pediatric and adult respiratory indications in
hospitals and other health care institutions.





As part
of the restructuring, Chrysalis completed a technology transfer, provided
development support to us through June 30, 2008, and also paid us
$4.5 million to support our future development activities. We are obligated
to pay royalties at a rate equal to a low single-digit percent of sales of
products sold in the Exclusive Field in the territories. In connection with
exclusive undertakings of PMUSA and PMPSA not to exploit the capillary
aerosolization technology for all licensed uses, we are obligated to pay
royalties on all product sales, including sales of aerosol devices and related
components that are not based on the capillary aerosolization technology;
provided, however, that no royalties are payable to the extent that we exercise
our right to terminate the license with respect to a specific indication. We
also agreed in the future to pay minimum royalties, but are entitled to a
reduction of future royalties in an amount equal to the excess of any minimum
royalty paid over royalties actually earned in prior periods.





Johnson
& Johnson and Ortho Pharmaceutical Corporation





We,
Johnson & Johnson and its wholly-owned subsidiary, Ortho Pharmaceutical
Corporation, are parties to an agreement granting to us an exclusive worldwide
license to the proprietary KL4 surfactant
technology, including Surfaxin, in exchange for certain license fees, milestone
payments aggregating up to $2,500,000 and royalties. To date, we have paid
$450,000 of such amount for milestones that have been achieved.




Note
14 – Commercial Strategy and Cost Containment Measures





Following
receipt of the April 2009 Complete Response Letter for Surfaxin for the
prevention of RDS in premature infants, we reviewed all aspects of our business
with a view to conserving our cash and implemented a fundamental change in our
business strategy. We no longer are planning to establish our own specialty
pulmonary organization to commercialize our potential pediatric products in the
United States. Rather, to secure capital and advance our KL4 surfactant
pipeline programs, we are now seeking strategic alliances in all markets,
including the United States, to support our research and development programs
and, if approved, to commercialize our products.




In
addition, in April 2009, we implemented cost containment measures and reduced
our workforce from 115 to 91 employees, focusing primarily on our commercial and
corporate administrative groups. We continue to maintain our core capabilities
to support development of our KL4 surfactant
technology, including quality, manufacturing and research and development
resources. We incurred a charge of $0.6 million in the second quarter of 2009
associated with staff reductions and the close-out of certain contractual
arrangements, which is included within the appropriate line items on the
Statements of Operations ($0.4 million in general and administrative expenses
and $0.2 million in research and development expenses). As of December 31, 2009,
payments totaling $0.6 million had been made related to these items and $29,000
was unpaid, as follows:


F-29




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





(in thousands)
                  
                  Severance
                    and Benefits
                    Related
                  
                  
                  Termination
                    of
                    Commercial
                    Programs
                  
                  
                  TotalQ2
      2009 Charge
                  
                  $
                  554
                  
                  
                  $
                  74
                  
                  
                  $
                  628Payments
      / Adjustments
                  
                  
                  (450
                  )
                  
                  
                  —
                  
                  
                  
                  (450
                  )Liability
      as of June 30, 2009
                  
                  $
                  104
                  
                  
                  $
                  74
                  
                  
                  $
                  178Payments
      / Adjustments
                  
                  
                  (97
                  )
                  
                  
                  (4
                  )
                  
                  
                  (101
                  )Liability
      as of September 30, 2009
                  
                  $
                  7
                  
                  
                  $
                  70
                  
                  
                  $
                  77Payments
      / Adjustments
                  
                  
                  (7
                  )
                  
                  
                  (41
                  )
                  
                  
                  (48
                  )Liability
      as of December 31, 2009
                  
                  $
                  -
                  
                  
                  $
                  29
                  
                  
                  $
                  29





Note
15 – Commitments




Future
payments due under contractual obligations at December 31, 2009 are as
follows:




(in thousands)
                      
                      2010
                      
                      
                      2011
                      
                      
                      2012
                      
                      
                      2013
                      
                      
                      2014
                      
                      
                      There-after
                      
                      
                      TotalLoan
      payable(1)
                      
                      $
                      10,573
                      
                      
                      $
                      –
                      
                      
                      $
                      –
                      
                      
                      $
                      –
                      
                      
                      $
                      –
                      
                      
                      $
                      –
                      
                      
                      $
                      10,573Equipment
      loan obligations(1)
                      
                      
                      722
                      
                      
                      
                      152
                      
                      
                      
                      85
                      
                      
                      
                      85
                      
                      
                      
                      85
                      
                      
                      
                      70
                      
                      
                      
                      1,199Operating
      lease obligations
                      
                      
                      1,127
                      
                      
                      
                      1,146
                      
                      
                      
                      1,166
                      
                      
                      
                      320
                      
                      
                      
                      150
                      
                      
                      
                      –
                      
                      
                      
                      3,909CEO
      Severance obligations
                      
                      
                      1,211
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      1,211Total
                      
                      $
                      13,633
                      
                      
                      $
                      1,298
                      
                      
                      $
                      1,251
                      
                      
                      $
                      405
                      
                      
                      $
                      235
                      
                      
                      $
                      70
                      
                      
                      $
                      16,892




(1)See, Note 9: “Debt”




Our
operating leases consist primarily of facility leases for our operations in
Pennsylvania and New Jersey.




We
maintain our headquarters in Warrington, Pennsylvania. The facility is 39,594
square feet and serves as the main operating facility for clinical development,
regulatory, analytical technical services, research and development, and
administration. In April 2007, the lease, which originally expired in February
2010 with total aggregate payments of $4.6 million, was extended an additional
three years through February 2013 with additional payments of $3.0 million over
the extension period.




We lease
approximately 21,000 square feet of space for our manufacturing facility in
Totowa, New Jersey, at an annual rent of $150,000. This space is specifically
designed for the manufacture and filling of sterile pharmaceuticals in
compliance with cGMP and is our only manufacturing facility. The lease expires
in December 2014, subject to the landlord’s right, upon two years’ prior notice,
to terminate the lease early. This early termination right is subject to certain
conditions, including that the master tenant, a related party of the landlord,
must have ceased all activities at the premises, and, depending upon the timing
of the notice, if we satisfy certain financial conditions, the landlord would be
obligated to make early termination payments to us. At the present time, we
understand that the master tenant continues to be active in the
premises. The total aggregate payments over the term of the lease are $1.4
million. In connection with our manufacturing operations in Totowa, New Jersey,
we have 15 employees subject to a collective bargaining arrangement which
expires on December 3, 2010. For a discussion of our manufacturing strategy,
see, “Item 1 – Business
– Business Operations – Manufacturing and Distribution,” in our Annual Report on
Form 10-K.


F-30


DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





Our lease
for 5,600 square feet of office and analytical laboratory space in Doylestown,
Pennsylvania was terminated effective July 31, 2008 and all activities at this
location have been consolidated into our laboratory space in Warrington,
Pennsylvania. Our lease for 16,800 square feet of office and laboratory space at
our facility in Mountain View, California, expired without renewal or extension
on June 30, 2008. In December 2007, we consolidated these activities into our
laboratory space in Warrington, Pennsylvania.




Rent
expense under all of these leases for the years ended December 31, 2009, 2008,
and 2007 was $1.1 million, $1.2 million and $1.5 million,
respectively.





In
addition to the contractual obligations above, we have certain milestone and
royalty payment obligations to Johnson & Johnson related to our product
licenses. To date, of the $2,500,000 aggregate potential amount of such
milestone payments, we have paid $450,000 for milestones that have been
achieved.




Former
CEO Commitment




Effective
August 13, 2009, Dr. Robert J. Capetola resigned his positions as our President
and Chief Executive Officer and as a member of our Board. We entered into a
separation agreement and general release (Separation Agreement) with Dr.
Capetola providing for (i) an upfront severance payment of $250,000, and (ii)
periodic payments in an amount equal to his base salary (calculated at a rate of
$490,000 per annum), in accordance with our payroll practices and less required
withholdings. The periodic payments will end the earlier of (x) May 3, 2010 or
(y) the date, if ever, that a Corporate Transaction (as defined below)
occurs.  In addition, Dr. Capetola will be entitled to (A)
continuation of medical benefits and insurance coverage for a period of 24 or 27
months, depending upon circumstances, and (B) accelerated vesting of all
outstanding restricted shares and options, which shall remain exercisable to the
end of their stated terms.





The
Separation Agreement provides further that, upon the occurrence of a Corporate
Transaction prior to May 4, 2010, Dr. Capetola will receive a payment of up to
$1,580,000 (Additional Severance) or, if any such Corporate Transaction also
constitutes a Change of Control (as such term is defined in the Separation
Agreement), a payment of up to $1,777,500; provided, however, that, in each
case, any such payment will be reduced by the sum of the amounts described in
clauses (i) and (ii) of this paragraph that theretofore have been paid. A
“Corporate Transaction” is defined in the Separation Agreement as (1) one or
more corporate partnering or strategic alliance transactions, Business
Combinations or public or private financings that (A) are completed during the
Severance Period (as defined in the Separation Agreement) and (B) result in cash
proceeds (net of transaction costs) to the Company of at least $20 million
received during the Severance Period or within 90 calendar days thereafter, or
(2) an acquisition of the Company, by business combination or other similar
transaction, that occurs during the Severance Period and the consideration paid
to stockholders of the Company, in cash or securities, is at least
$20 million.  For this purpose, net proceeds will be calculated
without taking into account any amounts received by the Company as reimbursement
for costs of development and research activities to be performed in connection
with any such transaction. See
also, Note 18 – Subsequent Events.





Note
16 – Litigation





We are
not aware of any pending or threatened legal actions that would, if determined
adversely to us, have a material adverse effect on our business and
operations.




We have
from time to time been involved in disputes and proceedings arising in the
ordinary course of business, including in connection with the conduct of our
clinical trials. In addition, as a public company, we are also potentially
susceptible to litigation, such as claims asserting violations of securities
laws. Any such claims, with or without merit, if not resolved, could be
time-consuming and result in costly litigation. There can be no assurance that
an adverse result in any future proceeding would not have a potentially material
adverse effect on our business, results of operations and financial
condition.




F-31




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





Note
17 – Income Taxes




Since our
inception, we have never recorded a provision or benefit for Federal and state
income taxes.





The
reconciliation of the income tax benefit computed at the Federal statutory rates
to our recorded tax benefit for the years ended December 31, 2009, 2008 and 2007
is as follows:





(in thousands)
                        
                        December 31,2009
                        
                        
                        2008
                        
                        
                        2007(As Restated)Income
      tax benefit, statutory rates
                        
                        $
                        10,156
                        
                        
                        $
                        13,296
                        
                        
                        $
                        13,601State
      taxes on income, net of Federal benefit
                        
                        
                        423
                        
                        
                        
                        2,102
                        
                        
                        
                        2,363Research
      and development tax credit
                        
                        
                        756
                        
                        
                        
                        1,026
                        
                        
                        
                        960Employee
      Related
                        
                        
                        (1,471
                        )
                        
                        
                        (1,306
                        )
                        
                        
                        (1,118
                        )Other
                        
                        
                        107
                        
                        
                        
                        (32
                        )
                        
                        
                        (24
                        )Income
      tax benefit
                        
                        
                        9,971
                        
                        
                        
                        15,086
                        
                        
                        
                        15,782Valuation
      allowance
                        
                        
                        (9,971
                        )
                        
                        
                        (15,086
                        )
                        
                        
                        (15,782
                        )Income
      tax benefit
                        
                        $
                        –
                        
                        
                        $
                        –
                        
                        
                        $
                        –





The tax
effects of temporary differences that give rise to deferred tax assets and
deferred tax liabilities, at December 31, 2009 and 2008, are as
follows:




(in thousands)
                          
                          December 31,2009
                          
                          
                          2008Long-term
      deferred tax assets:Net
      operating loss carryforwards (Federal and state)
                          
                          $
                          126,291
                          
                          
                          $
                          115,401Research
      and development tax credits
                          
                          
                          7,893
                          
                          
                          
                          7,137Compensation
      expense on stock
                          
                          
                          4,730
                          
                          
                          
                          4,334Charitable
      contribution carryforward
                          
                          
                          6
                          
                          
                          
                          6Other
      accrued
                          
                          
                          1,635
                          
                          
                          
                          2,073Depreciation
                          
                          
                          2,341
                          
                          
                          
                          2,494Capitalized
      research and development
                          
                          
                          2,069
                          
                          
                          
                          2,411Total
      long-term deferred tax assets
                          
                          
                          144,965
                          
                          
                          
                          133,857Long-term
      deferred tax liabilities
                          
                          
                          –
                          
                          
                          
                          –Net
      deferred tax assets
                          
                          
                          144,632
                          
                          
                          
                          133,857Less:
      valuation allowance
                          
                          
                          (144,965
                          )
                          
                          
                          (133,857
                          )Deferred
      tax assets, net of valuation allowance
                          
                          $
                          –
                          
                          
                          $
                          –




We are in
a net deferred tax asset position at December 31, 2009 and 2008 before the
consideration of a valuation allowance. Due to the fact that we have never
realized a profit, management has fully reserved the net deferred tax asset
since realization is not assured.





At
December 31, 2009 and 2008, we had available carryforward net operating losses
for Federal tax purposes of $315.5 million and $292.6 million, respectively, and
a research and development tax credit carryforward of $7.9 million and $7.1
million, respectively. The Federal net operating loss and research and
development tax credit carryforwards began to expire in 2008 and will continue
through 2028. Approximately $11.9 million of the $315.5 net operating loss
carryforwards expire prior to 2013.




F-32




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





At
December 31, 2009, we had available carryforward Federal and state net operating
losses of $1.8 million and $16,000, respectively, related to stock based
compensation. Additionally, at December 31, 2008 and 2007, we had available
carryforward losses of approximately $271.1 million and $250.2 million,
respectively, for state tax purposes. Of the $271.1 state tax carryforward
losses, $246.7 million is associated with the state of Pennsylvania, with the
remainder associated with New Jersey, California and Florida.




Utilization
of net operating loss (NOL) and research and development (R&D) credit
carryforwards may be subject to a substantial annual limitation under Section
382 of the Internal Revenue Code of 1986 due to ownership change limitations
that have occurred previously or that could occur in the future. These ownership
changes may limit the amount of NOL and R&D credit carryforwards that can be
utilized annually to offset future taxable income and tax, respectively. There
also could be additional ownership changes in the future which may result in
additional limitations in the utilization of the carryforward NOLs and
credits.





A full valuation allowance has been
provided against our research and development credits and, if a future
assessment requires an adjustment, an adjustment would be offset by an
adjustment to the valuation allowance. Thus, there would be no impact to the
consolidated balance sheet or statement of operations if an adjustment were
required.





Federal
and state net operating losses, $1.8 million and $16,000, respectively, relate
to stock-based compensation, the tax effect of which will result in a credit to
equity as opposed to income tax expense, to the extent these losses are utilized
in the future.




On
January 1, 2007, we adopted the provisions of Accounting Standards Codification
(ASC) Topic 740, “Accounting
for Income Taxes”. Topic 740 creates a single model to address
uncertainty in tax positions and clarifies the accounting for income taxesby prescribing the
minimum recognition threshold a tax position is required to meet before being
recognized in the financial statements. The provisions ofTopic 740 apply to all
material tax positions in all taxing jurisdictions for all open tax years.The adoption of Topic
740 did not have a material effect on the Company’s financial condition or
results of operations for the year ended December 31, 2009.





Note
18 – Selected Quarterly Financial Data (Unaudited)





The
following table contains unaudited statement of operations information for each
quarter of 2009 and 2008.  The operating results for any quarter are
not necessarily indicative of results for any future period.  The
quarterly financial information as of and for the quarters ended June 30, 2009,
September 30, 2009 and December 31, 2009 have been restated to give effect to
the matter discussed in Note 2.




F-33




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





2009 Quarters Ended:(in thousands, except per share data)
                    
                    Mar. 31
                    
                    
                    June 30
                    
                    
                    Sept. 30
                    
                    
                    Dec.31
                    
                    
                    Total Year(As Restated)
                    
                    
                    (As Restated)
                    
                    
                    (As Restated)
                    
                    
                    (As Restated)Revenues
                    
                    $
                    –
                    
                    
                    $
                    –
                    
                    
                    $
                    –
                    
                    
                    $
                    –
                    
                    
                    $
                    –Expenses:Research
      and development
                    
                    
                    5,607
                    
                    
                    
                    5,052
                    
                    
                    
                    4,530
                    
                    
                    
                    3,888
                    
                    
                    
                    19,077General
      and administrative
                    
                    
                    3,096
                    
                    
                    
                    2,592
                    
                    
                    
                    2,417
                    
                    
                    
                    2,015
                    
                    
                    
                    10,120Total
      expenses
                    
                    
                    8,703
                    
                    
                    
                    7,644
                    
                    
                    
                    6,947
                    
                    
                    
                    5,903
                    
                    
                    
                    29,197Operating
      loss
                    
                    
                    (8,703
                    )
                    
                    
                    (7,644
                    )
                    
                    
                    (6,947
                    )
                    
                    
                    (5,903
                    )
                    
                    
                    (29,197
                    )Change
      in fair value of common stock warrant liability
                    
                    
                    -
                    
                    
                    
                    (1,323
                    )
                    
                    
                    (1,662
                    )
                    
                    
                    3,354
                    
                    
                    
                    369Other
      expense, net
                    
                    
                    (297
                    )
                    
                    
                    (264
                    )
                    
                    
                    (244
                    )
                    
                    
                    (238
                    )
                    
                    
                    (1,043
                    )Net
      loss
                    
                    $
                    (9,000
                    )
                    
                    $
                    (9,231
                    )
                    
                    $
                    (8,853
                    )
                    
                    $
                    (2,787
                    )
                    
                    $
                    (29,871
                    )Net
      loss per common share - basic and diluted
                    
                    $
                    (0.09
                    )
                    
                    $
                    (0.08
                    )
                    
                    $
                    (0.07
                    )
                    
                    $
                    (0.02
                    )
                    
                    $
                    (0.26
                    )Weighted
      average number of common shares outstanding
                    
                    
                    102,093
                    
                    
                    
                    112,712
                    
                    
                    
                    119,993
                    
                    
                    
                    125,638
                    
                    
                    
                    115,200





2009 Quarters Ended:(in thousands)
                          
                          Mar. 31
                          
                          
                          June 30
                          
                          
                          Sept. 30
                          
                          
                          Dec.31(As Restated)
                          
                          
                          (As Restated)
                          
                          
                          (As Restated)Total
      Assets
                          
                          $
                          26,271
                          
                          
                          $
                          29,940
                          
                          
                          $
                          23,809
                          
                          
                          $
                          21,403Current
      Liabilities
                          
                          $
                          8,844
                          
                          
                          $
                          22,437
                          
                          
                          $
                          23,488
                          
                          
                          $
                          18,989Total
      Liabilities
                          
                          $
                          20,832
                          
                          
                          $
                          23,864
                          
                          
                          $
                          24,730
                          
                          
                          $
                          20,107Stockholders’
      Equity
                          
                          $
                          5,439
                          
                          
                          $
                          6,076
                          
                          
                          $
                          (921
                          )
                          
                          $
                          1,296





2008 Quarters Ended:(in thousands, except per share data)
                    
                    Mar. 31
                    
                    
                    June 30
                    
                    
                    Sept. 30
                    
                    
                    Dec.31
                    
                    
                    Total YearRevenues
                    
                    $
                    2,050
                    
                    
                    $
                    2,500
                    
                    
                    $
                    50
                    
                    
                    $
                    –
                    
                    
                    $
                    4,600Expenses:Research
      and development
                    
                    
                    7,232
                    
                    
                    
                    7,439
                    
                    
                    
                    6,724
                    
                    
                    
                    5,170
                    
                    
                    
                    26,566General
      and administrative
                    
                    
                    4,505
                    
                    
                    
                    5,076
                    
                    
                    
                    3,726
                    
                    
                    
                    3,121
                    
                    
                    
                    16,428Total
      expenses
                    
                    
                    11,737
                    
                    
                    
                    12,515
                    
                    
                    
                    10,450
                    
                    
                    
                    8,291
                    
                    
                    
                    42,994Operating
      loss
                    
                    
                    (9,687
                    )
                    
                    
                    (10,015
                    )
                    
                    
                    (10,400
                    )
                    
                    
                    (8,291
                    )
                    
                    
                    (38,394
                    )Other
      expense, net
                    
                    
                    (27
                    )
                    
                    
                    (200
                    )
                    
                    
                    (239
                    )
                    
                    
                    (246
                    )
                    
                    
                    (712
                    )Net
      loss
                    
                    $
                    (9,714
                    )
                    
                    $
                    (10,215
                    )
                    
                    $
                    (10,639
                    )
                    
                    $
                    (8,537
                    )
                    
                    $
                    (39,106
                    )Net
      loss per common share - basic and diluted
                    
                    $
                    (0.10
                    )
                    
                    $
                    (0.11
                    )
                    
                    $
                    (0.11
                    )
                    
                    $
                    (0.08
                    )
                    
                    $
                    (0.40
                    )Weighted
      average number of common shares outstanding
                    
                    
                    96,649
                    
                    
                    
                    96,691
                    
                    
                    
                    98,619
                    
                    
                    
                    100,474
                    
                    
                    
                    98,116




F-34




DISCOVERY
LABORATORIES, INC. AND SUBSIDIARY





Note
19 – Subsequent Events




We
evaluated all events or transactions that occurred after December 31, 2009 up
through the date we issued these financial statements. During this period we did
not have any material recognized subsequent events, however, there were three
nonrecognized subsequent events described below:




In
February 2010, we completed a public offering of 27,500,000 shares of our common
stock and warrants to purchase 13,750,000 shares of our common stock, sold as
units, with each unit consisting of one share of common stock and a warrant to
purchase 0.50 of a share of common stock, at a public offering price of $0.60
per unit, resulting in gross and net proceeds to us of $16.5 million and $15.1
million, respectively. See, Note 10 – Stockholders’
Equity – Registered Public Offerings and Private Placements, for a further
discussion of this offering.




With
respect to our Former CEO Commitment (see, Note 14 – Commitments –
Former CEO Commitment), since August 13, 2009, we have raised approximately
$5.89 million in gross proceeds utilizing our CEFFs (see, Note 10 – Stockholders’
Equity – Committed Equity Financing Facilities – CEFF Financings). In addition,
on February 23, 2010, we completed a public offering that resulted in net
proceeds to us of approximately $15.1 million (see, Note 10 – Stockholders’
Equity – Registered Public Offerings and Private Placements). As the receipt
from financings of more than $20 million qualifies as a Corporate Transaction,
our obligation under the Separation Agreement to make payment to Dr. Capetola of
the Additional Severance has matured. Therefore, in accordance with the
Separation Agreement, on March 5, 2010, we made a payment to Dr. Capetola in the
amount of approximately $1.06 million (less withholding), representing his
Additional Severance payment, reduced by the payments previously made to him
under the Severance Agreement, which total approximately $0.52 million. Our
obligation to make periodic payments under the Separation Agreement has been
satisfied and no further payments are due at this time.






On
February 16, 2010, we announced that we had received written guidance from the
FDA advising us that, since an acceptable animal model (preterm lamb) of RDS
already exists, a PD clinical trial approach would not be appropriate. We had
previously expected, based on prior guidance received from the FDA, that a
limited, pharmacodynamic-based (PD) clinical trial in preterm infants would be
required to address the sole remaining CMC issue relating to the BAT that must
be addressed to obtain approval of Surfaxin for the prevention of RDS in
premature infants. As a result, instead of pursuing a limited clinical trial, we
are now focused on completing the optimization and revalidation of the BAT and
developing a comprehensive preclinical plan intended to meet the FDA’s
requirements. If these studies are successful, we believe that we could be in a
position to file a Complete Response to the April 2009 Complete Response Letter
in the first quarter of 2011, which could lead to approval of Surfaxin for the
prevention of Respiratory Distress Syndrome (RDS) in premature infants in
2011.