##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

FORM 10-Q

---

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

|                                    |                            
|----------------------------------- | ---------------------------
|For the quarter ended June 30, 2001 | Commission File No. 0-18734

AVANIR Pharmaceuticals
(Exact name of registrant as specified in its charter)

|                                                                                                                                                                                                                                                                                                             |  |                                                                                                                             
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ----------------------------------------------------------------------------------------------------------------------------
|California
                                (State or other jurisdiction of
                                incorporation or organization)11388 Sorrento Valley Road, Suite 200
                                San Diego, California
                                (Address of principal executive office) |  | 33-0314804
                                (IRS Employer Identification No).92121
                                (Zip Code)

(858) 622-5200
(Registrants telephone number, including area code)

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 and Exchange Act
of 1934 during the preceding 12 months (or for such shorter periods 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 [   ]

The number of shares of Common Stock of the Registrant issued and outstanding
as of August 7, 2001:

|                                   |  |  |            | 
|---------------------------------- |  |  | ---------- | 
|Class A Common stock, no par value |  |  | 57,642,593 | 
|                                  
|                                  
|                                  
|                                  
|Class B Common stock, no par value |  |  | 36,500     | 



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TABLE OF CONTENTS



|                          |                                                                                               |                                            |  |  |  |  |  | 
|------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|                          |                                                                                               | CONSOLIDATED BALANCE SHEETS               
|                          |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                          |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                          |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                          | Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                          | Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                           
|PART II OTHER INFORMATION
|                          | Items 1-4. NOT APPLICABLE                                                                    
|                          | Item 6. EXHIBITS AND REPORTS ON FORM 8-K                                                     
|SIGNATURES               

AVANIR Pharmaceuticals

FORM 10-QFor the Quarter Ended June 30, 2001

INDEX

|         |  |                                                                            |  |  |    |      |  | 
|-------- |  | -------------------------------------------------------------------------- |  |  | -- | ---- |  | 
|         |  |                                                                            |  |  |    | Page
|         |  |                                                                            |  |  |    |     
|PART I.  |  | FINANCIAL INFORMATION                                                      |  |  |    |     
|        
|        
|        
|        
|Item 1.  |  | Financial Statements                                                       |  |  |    |     
|        
|        
|        
|        
|         |  | Consolidated Balance Sheets                                                |  |  | 3  |     
|        
|        
|        
|        
|         |  | Consolidated Statements of Operations                                      |  |  | 4  |     
|        
|        
|        
|        
|         |  | Consolidated Statements of Cash Flows                                      |  |  | 5  |     
|        
|        
|        
|        
|         |  | Notes to Consolidated Financial Statements                                 |  |  | 6  |     
|        
|        
|        
|        
|Item 2.  |  | Management's Discussion and Analysis of Financial Condition and Results of |  |  |    |     
|        
|        
|        
|        
|         |  | Operations                                                                 |  |  | 10 |     
|        
|        
|        
|        
|Item 3.  |  | Quantitative and Qualitative Disclosures about Market Risk                 |  |  | 21 |     
|        
|        
|        
|        
|PART II. |  | OTHER INFORMATION                                                          |  |  |    |     
|        
|        
|        
|        
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                        |  |  | 21 |     
|        
|        
|        
|        
|Item 6.  |  | Exhibits and Reports on Form 8-K                                           |  |  | 21 |     

2



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##### Table of Contents






AVANIR Pharmaceuticals

CONSOLIDATED BALANCE SHEETS (Unaudited)

---



|                                       |                                                              |                                                                                                                              |                           |                                  |            |            |         |               |            |            |         | 
|-------------------------------------- | ------------------------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------- | ------------------------- | -------------------------------- | ---------- | ---------- | ------- | ------------- | ---------- | ---------- | ------- | 
|                                       |                                                              |                                                                                                                              |                           |                                  |            | June 30,   |         | September 30,
|                                       |                                                              |                                                                                                                              |                           |                                  |            | 2001       |         | 2000         
|                                       |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|ASSETS                                 |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                      
|                                      
|                                      
|                                      
|Current assets:                        |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                      
|                                      
|                                      
|                                      
|                                       | Cash and cash equivalents                                    |                                                                                                                              | $                         | 13,476,478                       |            |            | $       | 19,699,768    |           
|                                      
|                                      
|                                      
|                                      
|                                       | Short-term investments                                       |                                                                                                                              |                           | 5,220,129                        |            |            |         | 868,474       |           
|                                      
|                                      
|                                      
|                                      
|                                       | Receivables, net                                             |                                                                                                                              |                           | 560,560                          |            |            |         | 95,429        |           
|                                      
|                                      
|                                      
|                                      
|                                       | Inventory                                                    |                                                                                                                              |                           | 222,585                          |            |            |         | 9,804         |           
|                                      
|                                      
|                                      
|                                      
|                                       | Prepaid and other                                            |                                                                                                                              |                           | 488,746                          |            |            |         | 411,999       |           
|                                       |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                       |                                                              |                                                                                                                              | Total current assets      |                                  |            | 19,968,498 |         |               |            | 21,085,474 |        
|                                      
|                                      
|                                      
|                                      
|                                       | Property and equipment, net                                  |                                                                                                                              |                           | 1,681,716                        |            |            |         | 1,050,703     |           
|                                      
|                                      
|                                      
|                                      
|                                       | Intangible costs, net                                        |                                                                                                                              |                           | 1,086,219                        |            |            |         | 614,816       |           
|                                      
|                                      
|                                      
|                                      
|                                       | Investments                                                  |                                                                                                                              |                           | 400,000                          |            |            |         | 700,000       |           
|                                      
|                                      
|                                      
|                                      
|                                       | Other assets                                                 |                                                                                                                              |                           | 63,587                           |            |            |         | 68,244        |           
|                                       |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                       |                                                              |                                                                                                                              | TOTAL ASSETS              |                                  | $          | 23,200,020 |         |               | $          | 23,519,237 |        
|                                       |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|LIABILITIES AND SHAREHOLDERS EQUITY   |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                      
|                                      
|                                      
|                                      
|Current liabilities:                   |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                      
|                                      
|                                      
|                                      
|                                       | Accounts payable                                             |                                                                                                                              | $                         | 591,283                          |            |            | $       | 965,636       |           
|                                      
|                                      
|                                      
|                                      
|                                       | Accrued expenses and other liabilities                       |                                                                                                                              |                           | 1,018,813                        |            |            |         | 537,027       |           
|                                      
|                                      
|                                      
|                                      
|                                       | Accrued compensation and payroll taxes                       |                                                                                                                              |                           | 279,020                          |            |            |         | 248,599       |           
|                                      
|                                      
|                                      
|                                      
|                                       | Notes payable                                                |                                                                                                                              |                           | 31,210                           |            |            |         | 171,667       |           
|                                       |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                       |                                                              |                                                                                                                              | Total current liabilities |                                  |            | 1,920,326  |         |               |            | 1,922,929  |        
|                                      
|                                      
|                                      
|                                      
|COMMITMENTS                            |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                      
|                                      
|                                      
|                                      
|REDEEMABLE CONVERTIBLE PREFERRED STOCK |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                      
|                                      
|                                      
|                                      
|                                       | Series D  no par value, 500 shares authorized;              |                                                                                                                              |                           |                                  |            |            |         |               |           
|                                      
|                                      
|                                      
|                                      
|                                       |                                                              |                                                                                                                              |                           | 50 shares issued and outstanding |            |            | 498,295 |               |            |            | 465,920 | 
|                                       |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|SHAREHOLDERS EQUITY                   |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                      
|                                      
|                                      
|                                      
|                                       | Preferred stock  no par value, 9,999,500 shares authorized: |                                                                                                                              |                           |                                  |            |            |         |               |           
|                                      
|                                      
|                                      
|                                      
|                                       |                                                              | Series C Junior Participating  1,000,000 shares
authorized, no shares issued or outstanding                                 |                           |                                  |           |            |         |               |           |           
|                                      
|                                      
|                                      
|                                      
|                                       | Common stock  no par value:                                 |                                                                                                                              |                           |                                  |            |            |         |               |           
|                                      
|                                      
|                                      
|                                      
|                                       |                                                              | Class A  99,288,000 shares authorized; 57,535,012 and
56,974,828 issued and outstanding                                     |                           |                                  | 85,349,626 |            |         |               | 84,695,590 |           
|                                      
|                                      
|                                      
|                                      
|                                       |                                                              | Class B  712,000 shares authorized; 36,500 and 65,000
shares issued and outstanding (convertible into Class A
Common Stock) |                           |                                  | 19,894     |            |         |               | 34,145     |           
|                                      
|                                      
|                                      
|                                      
|                                       | Receivable for Class A common stock                          |                                                                                                                              |                           |                                 |            |            |         | (649,431      | )         
|                                      
|                                      
|                                      
|                                      
|                                       | Accumulated deficit                                          |                                                                                                                              |                           | (64,556,877                      | )          |            |         | (62,949,916   | )         
|                                      
|                                      
|                                      
|                                      
|                                       | Accumulated other comprehensive loss                         |                                                                                                                              |                           | (31,244                          | )          |            |         |              |           
|                                       |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                       |                                                              | Total shareholders equity                                                                                                   |                           |                                  | 20,781,399 |            |         |               | 21,130,388 |           
|                                       |                                                              |                                                                                                                              |                           |                                  |            |            |         |              
|                                       |                                                              | TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                                                                   |                           | $                                | 23,200,020 |            |         | $             | 23,519,237 |           
|                                       |                                                              |                                                                                                                              |                           |                                  |            |            |         |              

See notes to consolidated financial statements.

3



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##### Table of Contents






AVANIR Pharmaceuticals

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

---



|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |           |            |  
|----------------------------------------------------------------------- | -------------- | ------- | ---------- | ------------------ | ---------- | ----------------- | ---------- | --------- | ---------- | ---- | ---------- | --------- | ---------- | - | ---------- | --------- | ---------- | -
|                                                                        |                |         |            | Three months ended |            | Nine months ended
|                                                                        |                |         |            | June 30,           |            | June 30,         
|                                                                        |                |         |            |                    |            |                  
|                                                                        |                |         |            | 2001               |            | 2000              |            | 2001      |            | 2000
|                                                                        |                |         |            |                    |            |                   |            |           |            |     
|REVENUES:                                                               |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Contract and license revenues                                           |                | $       | 5,000      |                    |            |                   |           |           |            | $    | 5,017,350  |           |            | $ | 1,000,000  |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Royalty revenues                                                        |                |         | 508,739    |                    |            |                   |           |           |            |      | 1,761,790  |           |            |   |           |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Grant revenue                                                           |                |         |           |                    |            |                   |           |           |            |      | 72,535     |           |            |   |           |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Interest and other                                                      |                |         | 284,975    |                    |            | $                 | 162,631    |           |            |      | 960,474    |           |            |   | 213,646    |          
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|                                                                        | Total revenues |         |            | 798,714            |            |                   |            | 162,631   |            |      |            | 7,812,149 |            |   |            | 1,213,646 |           
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|EXPENSES:                                                               |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Product launch expenses                                                 |                |         | 235,919    |                    |            |                   |           |           |            |      | 728,148    |           |            |   |           |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Research and development                                                |                |         | 1,394,732  |                    |            |                   | 638,616    |           |            |      | 5,165,822  |           |            |   | 1,581,351  |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Sales and marketing                                                     |                |         | 360,550    |                    |            |                   | 214,336    |           |            |      | 866,844    |           |            |   | 465,834    |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|General and administrative                                              |                |         | 799,002    |                    |            |                   | 758,742    |           |            |      | 2,620,613  |           |            |   | 2,684,547  |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Litigation settlement                                                   |                |         |           |                    |            |                   |           |           |            |      |           |           |            |   | 4,097,504  |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Interest                                                                |                |         | 870        |                    |            |                   | 874        |           |            |      | 5,308      |           |            |   | 346,220    |          
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|                                                                        | Total expenses |         |            | 2,791,073          |            |                   |            | 1,612,568 |            |      |            | 9,386,735 |            |   |            | 9,175,456 |           
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|NET LOSS                                                                |                | $       | (1,992,359 | )                  |            | $                 | (1,449,937 | )         |            | $    | (1,574,586 | )         |            | $ | (7,961,810 | )        
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|NET LOSS ATTRIBUTABLE TO
COMMON SHAREHOLDERS:                           |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Net loss                                                                |                | $       | (1,992,359 | )                  |            | $                 | (1,449,937 | )         |            | $    | (1,574,586 | )         |            | $ | (7,961,810 | )        
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Dividends on redeemable
convertible preferred stock                     |                |         | (6,233     | )                  |            |                   | (155,613   | )         |            |      | (18,698    | )         |            |   | (155,613   | )        
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Accretion of discount
related to redeemable
convertible preferred stock |                |         | (4,559     | )                  |            |                   |           |           |            |      | (13,677    | )         |            |   |           |          
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|NET LOSS ATTRIBUTABLE TO
COMMON SHAREHOLDERS                            |                | $       | (2,003,151 | )                  |            | $                 | (1,605,550 | )         |            | $    | (1,606,961 | )         |            | $ | (8,117,423 | )        
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|NET LOSS PER SHARE:                                                     |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|                                                                        |                | BASIC   |            | $                  | (0.03      | )                 |            | $         | (0.03      | )    |            | $         | (0.03      | ) |            | $         | (0.16      | )
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|                                                                        |                | DILUTED |            | $                  | (0.03      | )                 |            | $         | (0.03      | )    |            | $         | (0.03      | ) |            | $         | (0.16      | )
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|WEIGHTED AVERAGE NUMBER OF
COMMON SHARES OUTSTANDING:                   |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|                                                                        |                | BASIC   |            |                    | 57,542,291 |                   |            |           | 55,181,700 |      |            |           | 57,368,194 |   |            |           | 50,417,191 |  
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          
|                                                                        |                | DILUTED |            |                    | 57,542,291 |                   |            |           | 55,181,700 |      |            |           | 57,368,194 |   |            |           | 50,417,191 |  
|                                                                        |                |         |            |                    |            |                   |            |           |            |      |            |           |            |   |            |          

See notes to consolidated financial statements.

4



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##### Table of Contents






AVANIR Pharmaceuticals

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

---



|                                                                               |                                                      |                                           |            |                   |            |      |            |            |            |  
|------------------------------------------------------------------------------ | ---------------------------------------------------- | ----------------------------------------- | ---------- | ----------------- | ---------- | ---- | ---------- | ---------- | ---------- | -
|                                                                               |                                                      |                                           |            | Nine Months Ended
|                                                                               |                                                      |                                           |            | June 30,         
|                                                                               |                                                      |                                           |            |                  
|                                                                               |                                                      |                                           |            | 2001              |            | 2000
|                                                                               |                                                      |                                           |            |                   |            |     
|OPERATING ACTIVITIES:                                                          |                                                      |                                           |            |                   |            |      |            |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Net loss                                                                       |                                                      | $                                         | (1,574,586 | )                 |            | $    | (7,961,810 | )         
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Adjustments to reconcile net income to net cash used for
operating activities: |                                                      |                                           |            |                   |            |      |            |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Depreciation and amortization                                                  |                                                      |                                           | 516,770    |                   |            |      | 103,486    |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Non-cash interest expense                                                      |                                                      |                                           |           |                   |            |      | 402,990    |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Compensation paid with common stock and stock options                          |                                                      |                                           | 95,271     |                   |            |      | 573,170    |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Litigation settlements paid with common stock                                  |                                                      |                                           |           |                   |            |      | 4,097,504  |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Loss on disposal of assets                                                     |                                                      |                                           | 16,482     |                   |            |      | 5,224      |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Patents abandoned                                                              |                                                      |                                           |           |                   |            |      | 87,325     |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Changes in assets and liabilities:                                             |                                                      |                                           |            |                   |            |      |            |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Accounts receivable                                  |                                           |            | (465,131          | )          |      |            | 76,499     |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Inventory                                            |                                           |            | (212,781          | )          |      |            | (1,551     | )         
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Prepaid and other                                    |                                           |            | (72,090           | )          |      |            | 120,200    |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Deferred costs                                       |                                           |            | (256,175          | )          |      |            | 100,000    |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Accounts payable                                     |                                           |            | (374,353          | )          |      |            | (1,005,379 | )         
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Accrued expenses and other liabilities               |                                           |            | 366,320           |            |      |            | (17,003    | )         
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Accrued compensation and payroll taxes               |                                           |            | 30,421            |            |      |            | 50,766     |           
|                                                                               |                                                      |                                           |            |                   |            |      |            |           
|                                                                               |                                                      | Net cash used for operating activities:   |            |                   | (1,929,852 | )    |            |            | (3,368,579 | )
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|INVESTING ACTIVITIES:                                                          |                                                      |                                           |            |                   |            |      |            |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Investments in securities                            |                                           |            | (4,450,000        | )          |      |            | (388,122   | )         
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Proceeds from investments                            |                                           |            | 67,101            |            |      |            |           |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Patent costs                                         |                                           |            | (386,059          | )          |      |            | (83,530    | )         
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Capital expenditures                                 |                                           |            | (882,278          | )          |      |            | (105,072   | )         
|                                                                               |                                                      |                                           |            |                   |            |      |            |           
|                                                                               |                                                      | Net cash used for investing activities    |            |                   | (5,351,236 | )    |            |            | (576,724   | )
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|FINANCING ACTIVITIES:                                                          |                                                      |                                           |            |                   |            |      |            |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Proceeds from issuance of common and preferred stock |                                           |            | 1,198,255         |            |      |            | 14,398,748 |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Proceeds from issuance of convertible notes payable  |                                           |            |                  |            |      |            | 1,500,000  |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Debt issue costs                                     |                                           |            |                  |            |      |            | (155,015   | )         
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Repayment of convertible notes payable               |                                           |            |                  |            |      |            | (1,500,000 | )         
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Proceeds from issuance of subordinated notes payable |                                           |            | 27,648            |            |      |            | 36,277     |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|                                                                               | Repayment of subordinated notes payable              |                                           |            | (168,105          | )          |      |            | (189,356   | )         
|                                                                               |                                                      |                                           |            |                   |            |      |            |           
|                                                                               |                                                      | Net cash provided by financing activities |            |                   | 1,057,798  |      |            |            | 14,090,654 |  
|                                                                               |                                                      |                                           |            |                   |            |      |            |           
|NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                           |                                                      |                                           | (6,223,290 | )                 |            |      | 10,145,351 |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                               |                                                      |                                           | 19,699,768 |                   |            |      | 122,674    |           
|                                                                               |                                                      |                                           |            |                   |            |      |            |           
|CASH AND CASH EQUIVALENTS AT END OF PERIOD                                     |                                                      | $                                         | 13,476,478 |                   |            | $    | 10,268,025 |           
|                                                                               |                                                      |                                           |            |                   |            |      |            |           
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                             |                                                      |                                           |            |                   |            |      |            |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Interest paid                                                                  |                                                      | $                                         | 5,308      |                   |            | $    | 343,340    |           
|                                                                               |                                                      |                                           |            |                   |            |      |            |           
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND
FINANCING ACTIVITIES:       |                                                      |                                           |            |                   |            |      |            |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Accrued leasehold improvements                                                 |                                                      |                                           |           |                   |            | $    | 245,700    |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Value of conversion discount  convertible preferred stock                     |                                                      |                                           |           |                   |            | $    | 140,000    |           
|                                                                              
|                                                                              
|                                                                              
|                                                                              
|Patent purchased with common stock                                             |                                                      | $                                         | 111,158    |                   |            |      |           |           

See notes to consolidated financial statements

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##### Table of Contents






AVANIR Pharmaceuticals

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

---

1.      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation.We have prepared the unaudited consolidated financial
statements in this quarterly report in accordance with the instructions to Form
10-Q adopted under the Securities Exchange Act of 1934. These statements
should be read with our audited consolidated financial statements and the
accompanying notes included in our Annual Report on Form 10-K for the fiscal
year ended September 30, 2000. These statements include all adjustments,
consisting only of normal recurring accruals, necessary to present fairly our
financial position as of June 30, 2001, and the results of operations for the
three and nine-month periods ended June 30, 2001. The results of operations
for the three and nine months ended June 30, 2001 may not be indicative of the
results that may be expected for the fiscal year ending September 30, 2001.

Estimates.The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires that we make estimates and assumptions that affect the reported
amounts of our assets and liabilities and disclosure of contingent assets and
liabilities as of 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.

Reclassifications.Certain amounts in the prior years consolidated financial
statements have been reclassified to conform to current period presentation.

2.      BALANCE SHEET DETAIL

The following tables provide details of selected balance sheet items.

|                             |                                                 |                             |           |           |           |               |           |          |           | 
|---------------------------- | ----------------------------------------------- | --------------------------- | --------- | --------- | --------- | ------------- | --------- | -------- | --------- | 
|                             |                                                 |                             |           | June 30,  |           | September 30,
|                             |                                                 |                             |           | 2001      |           | 2000         
|                             |                                                 |                             |           |           |           |              
|Receivables, net:            |                                                 |                             |           |           |           |               |           |         
|                            
|                            
|                            
|                            
|                             | Total receivables                               |                             | $         | 575,101   |           |               | $         | 109,970  |          
|                            
|                            
|                            
|                            
|                             | Allowance for doubtful accounts                 |                             |           | (14,541   | )         |               |           | (14,541  | )        
|                             |                                                 |                             |           |           |           |               |           |         
|                             |                                                 | Receivables, net            |           | $         | 560,560   |               |           | $        | 95,429    | 
|                             |                                                 |                             |           |           |           |               |           |         
|Property and Equipment, Net: |                                                 |                             |           |           |           |               |           |         
|                            
|                            
|                            
|                            
|                             | Leasehold improvements                          |                             | $         | 483,311   |           |               | $         | 416,523  |          
|                            
|                            
|                            
|                            
|                             | Computer equipment and related software         |                             |           | 290,105   |           |               |           | 233,200  |          
|                            
|                            
|                            
|                            
|                             | Research and development equipment              |                             |           | 1,494,712 |           |               |           | 781,677  |          
|                            
|                            
|                            
|                            
|                             | Office equipment, furniture, and fixtures       |                             |           | 208,147   |           |               |           | 193,808  |          
|                             |                                                 |                             |           |           |           |               |           |         
|                             |                                                 |                             | 2,476,275 |           |           |               | 1,625,208 |         
|                            
|                            
|                            
|                            
|                             | Less, accumulated depreciation and amortization |                             |           | (794,559  | )         |               |           | (574,505 | )        
|                             |                                                 |                             |           |           |           |               |           |         
|                             |                                                 | Property and equipment, net |           | $         | 1,681,716 |               |           | $        | 1,050,703 | 
|                             |                                                 |                             |           |           |           |               |           |         
|Intangible costs, net:       |                                                 |                             |           |           |           |               |           |         
|                            
|                            
|                            
|                            
|                             | Intangible costs                                |                             | $         | 1,212,438 |           |               | $         | 715,222  |          
|                            
|                            
|                            
|                            
|                             | Less, accumulated amortization                  |                             |           | (126,219  | )         |               |           | (100,406 | )        
|                             |                                                 |                             |           |           |           |               |           |         
|                             |                                                 | Intangible costs, net       |           | $         | 1,086,219 |               |           | $        | 614,816   | 
|                             |                                                 |                             |           |           |           |               |           |         

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##### Table of Contents



3.      INVENTORY

Inventories are stated at the lower of cost (first-in, first-out) or
market price. Inventories consist of the raw material, docosanol, which is the
active ingredient in docosanol 10% cream.

4.      INVESTMENTS

The following tables summarize the Companys investments in securities,
which are either held to maturity or available for sale. Available-for-sale
securities are those investments that the Company does not intend to sell in
the near term nor hold to maturity. The available-for-sale investments are
carried at fair value with unrealized gains or losses reported in shareholders
equity as a component of comprehensive income. Investments classified as held
to maturity are recorded at amortized cost.

|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |   |           |   |           | 
|------------------------- | ----------------------- | -------------------------------- | ---------------------- | ------- | --------- | --------- | --------- | ---------- | ------ | ---------- | ------ | ----- | ------ | - | ------ | - | --------- | - | --------- | 
|                          |                         |                                  |                        |         |           |           |           |            |        | Gross      |        | Gross |        |   |        |  
|                          |                         |                                  |                        |         |           | Amortized |           | Unrealized |        | Unrealized |        | Fair 
|                          |                         |                                  |                        |         |           | Cost      |           | Gain       |        | Loss       |        | Value
|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |      
|As of June 30, 2001:      |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|                         
|                         
|                         
|                         
|                          |                         | Certificates of deposit          |                        | $       | 501,373   |           |           | $          | 10,787 |            |        |       |       |   |        | $ | 512,160   |  
|                         
|                         
|                         
|                         
|                          |                         | Government securities            |                        |         | 4,950,000 |           |           |            |       |            |        | $     | 31,152 |   |        |   | 4,918,848 |  
|                         
|                         
|                         
|                         
|                          |                         | Commercial paper                 |                        |         | 200,000   |           |           |            |       |            |        |       | 1,374  |   |        |   | 198,626   |  
|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|                          |                         |                                  |                        | Total   |           | $         | 5,651,373 |            |        | $          | 10,787 |       |        | $ | 32,526 |   |           | $ | 5,629,634 | 
|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|Reported as:              |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|                         
|                         
|                         
|                         
|                          | Short-term investments: |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |   |          
|                         
|                         
|                         
|                         
|                          |                         | Classified as available for sale |                        | $       | 4,418,756 |           |           |            |        |            |        |       |        |   |        |   |           |  
|                         
|                         
|                         
|                         
|                          |                         | Classified as held to maturity   |                        |         | 801,373   |           |           |            |        |            |        |       |        |   |        |   |           |  
|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|                          |                         |                                  | Short-term investments |         |           | 5,220,129 |           |            |        |            |        |       |        |   |        |   |           |   |          
|                         
|                         
|                         
|                         
|                          | Long-term investments   |                                  |                        | 400,000 |           |           |           |            |        |            |        |       |        |   |        |   |          
|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|                          |                         |                                  |                        | Total   |           | $         | 5,620,129 |            |        |            |        |       |        |   |        |   |           |   |           | 
|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|As of September 30, 2000: |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|                         
|                         
|                         
|                         
|                          |                         | Certificates of deposit          |                        | $       | 588,122   |           |           |            |       |            |        |       |       |   |        | $ | 588,122   |  
|                         
|                         
|                         
|                         
|                          |                         | Government securities            |                        |         | 780,352   |           |           |            |       |            |        | $     | 1,517  |   |        |   | 778,835   |  
|                         
|                         
|                         
|                         
|                          |                         | Commercial paper                 |                        |         | 200,000   |           |           |            |       |            |        |       | 336    |   |        |   | 199,664   |  
|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|                          |                         |                                  |                        | Total   |           | $         | 1,568,474 |            |        |            |       |       |        | $ | 1,853  |   |           | $ | 1,566,621 | 
|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|Reported as:              |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|                         
|                         
|                         
|                         
|                          |                         | Short-term investments           |                        | $       | 868,474   |           |           |            |        |            |        |       |        |   |        |   |           |  
|                         
|                         
|                         
|                         
|                          |                         | Investments                      |                        |         | 700,000   |           |           |            |        |            |        |       |        |   |        |   |           |  
|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  
|                          |                         |                                  |                        | Total   |           | $         | 1,568,474 |            |        |            |        |       |        |   |        |   |           |   |           | 
|                          |                         |                                  |                        |         |           |           |           |            |        |            |        |       |        |   |        |  

5.      ROYALTY REVENUES FROM LICENSE AGREEMENTS

Our policy is to recognize royalty revenues from our licensed products
when earned. Net sales figures used for calculating royalties due the Company
can often include deductions for costs of unsaleable returns, managed care
chargebacks, cash discounts, freight and warehousing, and miscellaneous
write-offs, which may vary over the course of the license agreement. Sales of
Abreva, if publicly reported by our licensee, GlaxoSmithKline, could differ
from net sales used for calculating royalties and in determining the royalties
earned according the license agreement.

7



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##### Table of Contents



6.      PRODUCT LAUNCH COSTS

AVANIR has incurred certain costs related to the product launch phase for
Abreva through June 30, 2001. Our obligation to share product launch costs
with GlaxoSmithKline ceased after June 30, 2001.

7.      NET INCOME (LOSS) PER SHARE

Computation of Net
Income and Net Loss per Common Share. Basic income and
basic loss per share is computed by dividing the net income and net loss by the
weighted average number of common shares outstanding during the period (basic
EPS method). Diluted earnings (loss) per common share is computed using the
weighted-average number of common and dilutive common equivalent shares
outstanding during the period (diluted EPS method). Dilutive common
equivalent shares consist of shares issuable upon exercise of stock options and
warrants and conversion of preferred stock. In the accompanying consolidated
statements of operations, diluted net loss per share is the same as basic net loss per share
for both the three and nine months ended June 30,
2001, because the inclusion of 6,936,816 and 7,362,746 dilutive common
equivalent shares, respectively, would be anti-dilutive.

8.      COMPREHENSIVE LOSS

Comprehensive income for the Company includes unrealized gains and losses
on available-for-sale securities. The components of comprehensive income
(loss) are as follows:

|                         |                                                                 |   |                             |            |                            |   |            |            |      |   |            |            |   |   |            |            |  
|------------------------ | --------------------------------------------------------------- | - | --------------------------- | ---------- | -------------------------- | - | ---------- | ---------- | ---- | - | ---------- | ---------- | - | - | ---------- | ---------- | -
|                         |                                                                 |   | Three Months Ended June 30, |            | Nine Months Ended June 30,
|                         |                                                                 |   |                             |            |                           
|                         |                                                                 |   | 2001                        |            | 2000                       |   | 2001       |            | 2000
|                         |                                                                 |   |                             |            |                            |   |            |            |     
|Comprehensive loss:      |                                                                 |   |                             |            |                            |   |            |            |      |   |            |            |   |   |            |           
|                        
|                        
|                        
|                        
|                         | Net loss                                                        |   | $                           | (1,992,359 | )                          |   | $          | (1,449,937 | )    |   | $          | (1,574,586 | ) |   | $          | (7,961,810 | )
|                        
|                        
|                        
|                        
|                         | Net change in
unrealized loss on
available-for-sale
investments |   |                             | (31,244    | )                          |   |            |           |      |   |            | (31,244    | ) |   |            |           |  
|                         |                                                                 |   |                             |            |                            |   |            |            |      |   |            |            |   |   |            |           
|Total comprehensive loss |                                                                 | $ | (2,023,603                  | )          |                            | $ | (1,449,937 | )          |      | $ | (1,605,830 | )          |   | $ | (7,961,810 | )         
|                         |                                                                 |   |                             |            |                            |   |            |            |      |   |            |            |   |   |            |           

9.      MINORITY INTEREST IN SUBSIDIARY

At June 30, 2001, IDEC Pharmaceuticals held an ownership interest in our
subsidiary, Xenerex Biosciences, of approximately 5% on a fully diluted basis.
We consider the cost basis of the minority interest held by IDEC to be
immaterial for separate financial statement disclosure at this time.

10.      SHAREHOLDERS EQUITY

Preferred Stock

Preferred stock consists of Series C Junior Participating Preferred Stock
and Series D Redeemable Convertible Preferred Stock.

Series C Junior Participating Preferred Stock.None of the Series C Junior
Participating Preferred Stock is outstanding.

Series D Redeemable Convertible Preferred Stock.At June 30, 2001 and
September 30, 2000, 50 shares of Series D redeemable convertible preferred
stock (Series D Shares) remained outstanding in connection with a securities
purchase agreement made with certain investors on March 22, 1999. The Series
D holders may convert any or all of the remaining Series D Shares into shares
of Class A common stock at a conversion rate equal to $10,000 divided by a
conversion price equal to the lesser of:

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| |  |  | the Fixed Conversion Price an amount equal to $2.715 per share
of Class A common stock; or                                    
| | - |  | -------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the Variable Conversion Price an amount equal to 86% of the
market price of our Class A common stock, defined as the lower of:
|

| |  |  | the average of the five lowest trading prices per share of
Class A common stock on The American Stock Exchange during the 25
trading days immediately preceding a given date of determination,
where trading price is determined as the average of the high and
low trading prices of our Class A common stock on a particular
trading day; or
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the average of the high and low trading price per share of
Class A common stock on The American Stock Exchange on the date of
determination.                                                                                                                                                                                                  

Common Stock

Class A Common Stock.For the three months ended June 30, 2001, we issued an
aggregate of 97,518 shares of Class A common stock in exchange for $136,831
received in connection with the exercise of employee stock options. The
average exercise price per share for the three-month period was $1.403. For
the nine months ended June 30, 2001, we issued an aggregate of 384,549 shares
of Class A common stock in exchange for $382,262 received in connection with
the exercise of employee stock options. The average exercise price for the
common stock for the nine-month period was $0.99 per share.

Class B Common Stock Conversion.On June 27, 2001, 12,500 shares of Class B
common stock converted to 12,500 shares of Class A common stock.

11.      RECENT ACCOUNTING PRONOUNCEMENTS

In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS 133). SFAS No. 133, as amended,
establishes accounting and reporting standards for derivative instruments and
for hedging activities. It requires an entity to recognize all derivatives as
either assets or liabilities on the balance sheet and measure those instruments
at fair value. We currently do not have any derivative instruments or any
embedded derivative instruments that require bifurcation and we are not
conducting any hedging activity; therefore, there is no material impact on our
financial statements.

In December 1999, the Securities and Exchange Commission (SEC) issued
Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
Statements (SAB). SAB 101, as amended, summarizes certain of the SECs
views in applying accounting principles generally accepted in the United States
of America to revenue recognition in financial statements, including revenues
earned from collaborations between companies. On April 1, 2001, we adopted SAB
101, which did not change the accounting of the Company for revenue
recognition. At June 30, 2001, we were involved in two research collaborations
that contained payments that are tied to the achievement of future milestones.
We intend to recognize the revenues associated with those milestone payments as
the services contemplated by the agreements have been achieved.

In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 141, Business
Combinations.SFAS No. 141 establishes new standards for accounting and
reporting requirements for business combinations, requires that the purchase
method of accounting be used for all business combinations initiated after June
30, 2001 and eliminates the pooling-of-interests method. Management does not
believe that SFAS No. 141 will have a material impact on the Companys
consolidated financial statements.

9



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In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets, which supersedes APB Opinion No. 17, Intangible Assets. SFAS No. 142
establishes new standards for goodwill acquired in a business combination and
eliminates amortization of goodwill and other intangible assets with indefinite
lives and instead sets forth methods to periodically evaluate goodwill for
impairment. The Company expects to adopt this statement during the first
quarter of fiscal 2002. Management does not believe that SFAS No. 142 will
have a material impact on the Companys financial statements.




Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This report contains forward-looking statements concerning our future
events or performance. You should not rely excessively on these
forward-looking statements, because they are only predictions based on our
current expectations and assumptions. Forward-looking statements often contain
words like estimate, anticipate, intend, believe or expect. Many
known and unknown risks and uncertainties could cause our actual results to
differ materially from those indicated in these forward-looking statements.
You should review carefully the risks and uncertainties identified in this
report, including those explained below and in our annual report on Form 10-K
filed with the Securities and Exchange Commission. We have no obligation to
update or announce revisions to any forward-looking statements to reflect
actual events or developments.

Overview

AVANIR Pharmaceuticals, based in San Diego, is an emerging diversified
biopharmaceutical company with an FDA-approved drug currently on the market.
AVANIR is engaged in research, development, commercialization, licensing and
sales of innovative drug products and antibody generation services. Our
current clinical development programs are centered around a novel approach to
using a known drug, dextromethorphan, for the treatment of several central
nervous system disorders. Longer-term, our emphasis in drug discovery has been
directed towards evaluation of a compound that appears capable of reducing
Immunoglobulin Epsilon (IgE), known to be a primary cause of allergies and
asthma. To capitalize on our pharmaceutical development expertise and expand
our product development pipeline, we seek other drug development opportunities
for acquisition or in-licensing. Our subsidiary, Xenerex Biosciences, provides
a contract service to other companies, with its patented human antibody
generating platform now being offered to those companies seeking human
antibodies as possible solutions to their own product development programs.
Xenerex is also working on research related to finding fully human antibodies
for our own selected disease targets.

Licensed Products and Future Licensing

Marketed in North America by the worlds largest pharmaceutical company,
GlaxoSmithKline, Abreva (docosanol 10% cream) first became available in the
United States in late 2000. By March 2001, Abreva had become the largest
selling consumer healthcare product for the treatment of cold sores. Under the
license agreement with GlaxoSmithKline for North America, AVANIR expects to
earn $25 million in license fees, of which $15 million has been paid to date,
plus royalties on sales of Abreva in future years. Through license fees and
royalties being earned under the existing license agreement with
GlaxoSmithKline and anticipated licensing of the product to other companies in
the rest of the world, our first product should provide a significant source of
funds for AVANIR to continue developing other drugs currently in the product
development pipeline or in the drug discovery stage.

We are exploring several opportunities to license the rights to market
docosanol 10% cream to other companies in the rest of the world and we want to
make sure that we select the best candidate in

10



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each major market. After making
initial visits to current and prospective licensees in Japan, Korea, Israel and
Western Europe in early 2001, we are now working to narrow our list of
prospects who we believe could best fit the criteria we see as being the most
important for licensing our product. Aside from important terms involving
license fees and royalties, other criteria for evaluation of potential
licensees include such intangibles as expertise with regulatory approvals in
the respective territories, marketing prowess in the over the counter market
place, strength of marketing program and commitment to our products success,
to name a few. We continue to hold discussions with those companies who have
come the closest to our criteria and that have expressed interest in licensing
docosanol. We intend to narrow the field of potential licensees and enter into
additional license agreements for docosanol before the end of this calendar
year.

Product Development

AVANIR has the rights to develop at least four potential indications for
Neurodex (dextromethorphan)  as treatments for emotional lability, neuropathic
pain, weaning from narcotics, and chronic cough. Currently, we are engaged in
clinical development for two of the indications. The most advanced of which is
a Phase II/III clinical trial for the treatment of emotional lability, a
neurodegenerative disease for which no FDA approved drug exists for
approximately one million sufferers. AVANIR intends to follow with a second
Phase III clinical trial for emotional lability in 2002 provided the results of
the existing trial meet our expectations. Also, we expect to begin enrolling
patients in a Phase II clinical trial for diabetic neuropathic pain by the end
of the calendar year.

Drug Discovery Programs

Our drug discovery programs are currently in the areas of developing novel
treatments for allergy and asthma, inflammation, and lipid lowering. However,
our largest and most advanced efforts are focused on evaluating our lead
compound as a potential novel oral treatment for allergy and asthma. We have
discovered compounds that reduce IgE levels in both in-vitro and ex-vivo assays
and in-vivo allergy models. We intend to evaluate the results of current
toxicology studies now under way to determine whether our lead compound could
be acceptable for filing with the FDA for an Investigational New Drug (IND)
application at the end of this calendar year or early next year.

Antibody Generation Services and Xenerex Biosciences

Through our subsidiary, Xenerex Biosciences, we recently began providing
antibody generation services through research collaborations with two
companies. In early May 2001, Xenerex announced its first research
collaboration agreement with Eos Biotechnology, a privately funded
biotechnology company located in South San Francisco. The research
collaboration provides for Xenerex to generate fully human monoclonal
antibodies to three cancer-target antigens provided by Eos. Eos will evaluate
the antibodies generated by Xenerex for potential development of therapeutic
treatments for the selected cancers. In June 2001, Xenerex entered into an
agreement with Peregrine Pharmaceuticals, Inc. (NASDAQ: PPHM) for the purposes
of collaboration to discover, develop and potentially commercialize fully human
monoclonal antibody therapies for the treatment of solid tumor cancers. The
agreement provides for the transfer of three antigen targets from Peregrine to
Xenerex for antibody generation and screening.

We believe that these two recent collaboration agreements represent
important steps forward in validating the unique technology that Xenerex offers
to the biopharmaceutical marketplace. In partnering with Eos and Peregrine, we
have expanded the number and types of proteins to which we can apply our
antibody generation capabilities. Our strategy is to continue to build our
client base with partners who are also focused on novel treatments and
technologies. Our objective in establishing fee arrangements under these
collaboration agreements is to cover our direct research costs incurred on

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behalf of our clients. However, if any of our antibody products are accepted
by our partners for further development and our partners are able to move
forward successfully with clinical trials on drugs using our technology, then
Xenerex has the opportunity to earn milestone payments as drug development
progresses and possibly royalties on sales if a drug reaches the market.

In addition to providing antibody generation services for others, Xenerex
is also engaged in research for the purposes of identifying antigen targets for
its own development and generating antibodies to those targets. Recently,
Xenerex initiated this effort for two targets. If Xenerex is successful in
characterizing the antibody product candidates that emerge from this effort and
if the candidates look promising, Xenerex intends to offer to other companies
the opportunity to either license or co-development those antibodies.

Intellectual Property

We continue making progress in enhancing our intellectual property
portfolios. In June 2001, our subsidiary, Xenerex Biosciences, announced that
it had licensed the rights to a patent for grafting adult human stem cells into
severe combined immunodeficient (SCID) mice. The ability to engraft adult
human stem cells, which may respond to unique antigens with unique antibodies,
broadens the Companys technological resources with yet another important
option in generating fully human monoclonal antibodies.

RESULTS OF OPERATIONS 
THREE MONTHS ENDED JUNE 30, 2001

Net Losses

The Companys third fiscal quarter net loss of $2 million reflects an
increase of $542,000 over the net loss in the same period a year ago. The net
loss per share was $0.03, which was the same as the net loss per share for the
same period a year ago, after rounding to the nearest cent in each of the
periods.

Revenues

Revenues for the third fiscal quarter ended June 30, 2001 were $799,000,
an increase of 391% over revenues of $163,000 in the same period a year ago.
Third fiscal quarter 2001 revenues include $509,000 in royalties earned on
sales of Abreva by GlaxoSmithKline. Sales of Abreva were lower in the third
fiscal quarter as the cold and flu season passed and in-store inventory levels
heading into the summer months were reduced. Thus, the spring months making up
most of the third fiscal quarter brought lower wholesale sales of cold sore products
than the winter months in the prior quarter. The balance of the third fiscal
quarter revenues came from interest income. For the same period a year ago,
the Company earned $163,000 in interest income.

Expenses

Operating Expenses- Operating expenses for the third fiscal quarter ended June
30, 2001 were $2.8 million compared to $1.6 million as reported for the same
period a year ago. The $1.2 million increase in operating expenses over the
same period a year ago reflect a $756,000 increase in research and development
expenses primarily for the Companys Phase II/III clinical trial for a
potential treatment of emotional lability in Lou Gehrigs disease (ALS),
$236,000 in expenses related to the launch of Abreva and slightly higher sales
and marketing and administrative expenses as the Company explored potential
product license arrangements. A comparison of operating expenses for the third
fiscal quarter

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ended June 30, 2001, with that of the same period in the prior
year is described below in the discussions of research and development, general
and administrative, sales and marketing and interest expenses.

Research and Development Expenses During the third fiscal quarter ended June
30, 2001, research and development expenses amounted to $1.4 million,
accounting for 50% of total operating expenses, compared to $639,000, or 40% of
total operating expenses for the same period a year ago. The increased
expenses in the third fiscal quarter ended June 30, 2001 related to increased
staff size and outside contract research to support primarily the Companys
clinical development programs initiated in fiscal year 2001 and toxicology and
other preclinical research related to the Companys allergy and asthma research
program.

In November 2000, the Company initiated Phase II/III clinical trials of
Neurodex in the first of a series of studies intended to examine the effect of
the drug in the treatment of emotional lability in neurodegenerative diseases.
Patient enrollments continue as approximately one-third of the one-month
patient studies have been completed with plans to complete the balance of
patient enrollments during the remainder of the calendar year.

In addition to the Companys Phase II/III clinical trial for a potential
treatment of emotional lability in neurodegenerative diseases, the Company
currently has several research programs underway including a preclinical
research program focused on developing a novel treatment for allergy and
asthma. We plan to continue our preclinical research in this area and intend
to file an investigational new drug application (IND) with the U.S. Food and
Drug Administration (FDA) by the end of this calendar year. Xenerex
Biosciences continues its research for the development of fully human
monoclonal antibodies to selected targets.

General and Administrative Expenses For the third fiscal quarter ended June
30, 2001, general and administrative expenses were $799,000, compared to
$759,000 as reported for the same period in fiscal year 2000. Slightly higher
general and administrative expenses are related primarily to the higher cost of
operating and maintaining the Companys new facility, higher utility rates, and
an increase in staff size to support the Companys growing programs related to
research and development and expanded marketing efforts for outlicensing
docosanol 10% cream outside of North America.

Sales and Marketing Expenses For the third fiscal quarter ended June 30,
2001, sales, marketing and business development expenses were $361,000 compared
with $214,000 in the comparable period a year earlier. Higher expenses were
incurred in the current fiscal year primarily due to added costs associated
with exploring opportunities to outlicense docosanol 10% cream in the
international market place and evaluation of other opportunities to inlicense
drug candidates owned by others that are available for development.

Interest Expense- Interest expense decreased slightly to $870 in the third
fiscal quarter ended June 30, 2001, compared to $874 for the same period in
fiscal year 2000. Interest expense remained relatively low for the third
fiscal quarters ended June 30 for both fiscal years as the Company financed its
operations primarily by means other than debt.

RESULTS OF OPERATIONS 
NINE MONTHS ENDED JUNE 30, 2001

Net Loss

For the nine months ended June 30, 2001, the Company incurred a net loss
of $1.6 million or $0.03 per share, an improvement of 80% compared with a net
loss of $8 million or $0.16 per share for

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the same period in fiscal 2000.
Excluding litigation settlement costs of $4.1 million in the prior fiscal year
and product launch expenses of $728,000 in the current fiscal year, the Company
reduced its losses by $3 million fiscal year-to-date. The $3 million
improvement reflects primarily a $6.6 million or 544% increase in revenues,
partially offset by a $3.6 million or 227% increase in research and development
expenses, compared with the same period a year ago.

Revenues

Revenues for the nine months ended June 30, 2001 increased to $7.8 million
from $1.2 million in the same period in fiscal year 2000. A $5 million
milestone payment from GlaxoSmithKline in October 2000, $1.8 million in
royalties on product sales of Abreva and $960,000 in interest income accounted
for most of the revenues for the current nine-month period, compared to the $1
million milestone payment from GlaxoSmithKline and $214,000 in interest income
for the same period in fiscal year 2000.

Expenses

Operating Expenses For the nine months ended June 30, 2001, total operating
expenses increased to $9.4 million compared to $9.2 million in the same period
in fiscal year 2000. Excluding product launch costs in the current year and
litigation settlement costs in the prior year, operating expenses were higher
by $3.6 million. A comparison of operating expenses for the first nine months
of fiscal year 2001 with the same period in fiscal year 2000 is described below
in the discussions of research and development, general and administrative,
sales and marketing, litigation settlement and interest expenses.

Research and Development During the first nine months of fiscal year 2001,
research and development expenses amounted to $5.2 million, compared to $1.6
million in the same period in fiscal year 2000. Expenses for the first nine
months of fiscal year 2001 include a $1.4 million increase related to clinical
trials for Neurodex, a $556,000 increase for occupancy costs related to the
cost of operating the Companys new laboratory facilities, a $421,000 increase
for preclinical research in our allergy and asthma program, and a $820,000
increase to research and development related to the monoclonal antibodies
development program at the Companys subsidiary, Xenerex Biosciences.

General and Administrative Expenses For the nine months ended June 30, 2001,
general and administrative expenses of $2.6 million were slightly less than as
the same period in 2000.

Sales and Marketing Expenses During the first nine months of fiscal year
2001, sales and marketing expenses were $867,000 compared to $466,000 in the
comparable period a year earlier. Sales, marketing and business development
expenses for fiscal year 2001 have increased because of the expansion of
commercial development activity in both AVANIR and Xenerex. Sales and
marketing activity for the same period in fiscal year 2000 was relatively low
while the Company was still awaiting approval by the FDA for Abreva and
because of the decision to outlicense to GlaxoSmithKline the rights to market
and sell Abreva.

Litigation Settlement Expense The Company did not incur any litigation
settlement expense for the first nine months of fiscal year 2001. Litigation
settlement expense for the first nine months of fiscal year 2000 was $4.1
million, which the Company paid by issuing Class A common stock.

Interest Expense- Interest expense decreased to $5,300 in the first nine
months of fiscal year 2001 compared to $346,000 for the same period in fiscal
year 2000. The higher level of interest expense in fiscal year 2000 was due
primarily to the issuance of $1.5 million in 11% convertible debentures, which
were repaid in the second quarter of fiscal year 2000.

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LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2001, we had cash, cash equivalents and investments of $19.1
million, net working capital of $18 million, and shareholders equity of $20.8
million. At September 30, 2000, we had cash, cash equivalents and investments
of $21.3 million, net working capital of $19.2 million, and shareholders
equity of $21.1 million. The $1.2 million decrease in working capital during
the first nine months of fiscal year 2001 was primarily due to using cash to
fund operating losses. The Company believes that it has adequate cash
resources to fund operations through at least the next twelve months.

Operating Activities. Net cash used for operating activities amounted to $1.9
million in the first nine months of fiscal 2001, compared to net cash used in
operating activities of $3.4 million during the comparable period in fiscal
year 2000. The improvement in net cash used for operating activities is
primarily the result of lower losses through the first nine months of fiscal
year 2001 compared with the same period a year ago.

Investing Activities. Net cash used for investing activities totaled $5.4
million during the first nine months of fiscal year 2001, including capital
expenditures of $882,000 and patent costs of $386,000. Net cash used for
investing activities during the first nine months of fiscal year 2000 amounted
to $577,000, including capital expenditures of $105,000.

Financing Activities. During the first nine months of fiscal year 2001, we
received $1.2 million from financing activities and repaid $168,000 in
short-term notes payable. The amount received from financing activities is
primarily from sales of common stock related to exercises of stock options and
stock purchase warrants. During the first nine months of fiscal 2000, we
received $14.4 million from the issuance of common stock related to a $6
million private financing transaction and exercises of employee stock options
and stock purchase warrants. Also during fiscal year 2000, we issued $1.5
million in convertible notes, which we repaid in the same year.

Our sources of cash flows from operations for the next several quarters
will depend substantially on license fees and royalties earned on sales of
Abreva by GlaxoSmithKline under our existing license agreement. We expect to
receive one-half of the remaining $10 million in license fees due under our
license agreement with GlaxoSmithKline during the fiscal quarter ending
September 30, 2001, with the balance of the license fees coming before the end
of December 2001. Royalties on sales of Abreva may vary substantially from
quarter to quarter, depending on the season and level of marketing and
advertising of the product by GlaxoSmithKline.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS 133). SFAS No. 133, as amended,
establishes accounting and reporting standards for derivative instruments and
for hedging activities. It requires an entity to recognize all derivatives as
either assets or liabilities on the balance sheet and measure those instruments
at fair value. We currently do not have any derivative instruments or any
embedded derivative instruments that require bifurcation and we are not
conducting any hedging activity; therefore, there is no material impact on our
financial statements.

In December 1999, the Securities and Exchange Commission (SEC) issued
Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
Statements (SAB). SAB 101, as amended, summarizes certain of the SECs
views in applying accounting principles generally accepted in the United States
of America to revenue recognition in financial statements, including revenues
earned from collaborations between companies. On April 1, 2001 we adopted SAB
101, which did not change the

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accounting of the Company for revenue
recognition. At June 30, 2001, we were involved in two research collaborations
that contained payments that are tied to the achievement of future milestones.
We intend to recognize the revenues associated with those milestone payments as
the services contemplated by the agreements have been achieved.

In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 141, Business
Combinations. SFAS No. 141 establishes new standards for accounting and
reporting requirements for business combinations, requires that the purchase
method of accounting be used for all business combinations initiated after June
30, 2001 and eliminates the pooling-of-interests method. Management does not
believe that SFAS No. 141 will have a material impact on the Companys
consolidated financial statements.

In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets, which supersedes APB Opinion No. 17, Intangible Assets. SFAS No. 142
establishes new standards for goodwill acquired in a business combination and
eliminates amortization of goodwill and other intangible assets with indefinite
lives and instead sets forth methods to periodically evaluate goodwill for
impairment. The Company expects to adopt this statement during the first
quarter of fiscal 2002. Management does not believe that SFAS No. 142 will
have a material impact on the Companys financial statements.

RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATIONS

If GlaxoSmithKline experiences any delays in the manufacture, distribution or
promotion of docosanol 10% cream, then our business will be materially and
adversely affected.

We have signed an exclusive license agreement with GlaxoSmithKline for
manufacturing and sales of docosanol 10% cream in North America. Docosanol 10%
cream, which is being marketed under the trade name of Abreva in the United
States, is approved for sale only in the United States at this time.
Therefore, our royalty revenues from sales of the product for the next year
will depend solely upon GlaxoSmithKlines marketing efforts. Any problem or
delays in manufacturing, promotion and distribution of Abreva could affect
materially and adversely our business operations and financial condition.

AVANIR and its licensees may not be successful in obtaining regulatory approval
of docosanol 10% cream immediately as an OTC product in the rest of the world
or in marketing and selling the product in foreign countries.

AVANIR and its licensees could face the following risks in our efforts to
obtain regulatory approval as an OTC product and to market and sell docosanol
10% cream in foreign countries:



| |  |  | Regulatory approval requirements differ by country, and
obtaining approvals to market the drug in foreign countries may be
difficult to obtain or may require prescription status first before
obtaining sufficient experience to warrant approval as an OTC
product;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | building product awareness of a new drug, whether
prescription or OTC, among customers or retail store decision makers
may require a substantial amount of product promotion, which does
not guarantee success;                                                      
|
| |  |  | consumers may not perceive that docosanol 10% cream is
superior to existing and potentially new OTC products for oral
herpes;                                                                                                                                        
|
| |  |  | acceptance of docosanol 10% cream in the OTC consumer market
may not be widespread; and                                                                                                                                                                              

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| |  |  | potential price erosion could occur due to competitive
reactions to our products introduction.
| | - |  | -----------------------------------------------------------------------------------------------

Docosanol 10% cream will face intense competition from a number of existing and
well-established products and the companies that market their products.

Docosanol 10% cream competes with several other products for oral-facial
herpes currently on the market in the U.S., as well as other products or
potential products that are or may be under development or undergoing FDA
review. Most of our competitors, including Blistex, Inc., Bayer Corp. and
Schering Plough, have substantial financial resources, research and development
facilities and manufacturing and marketing experience. Even with docosanol 10%
cream being marketed by one of the worlds largest consumer healthcare
companies, our licensee may not achieve commercial success in this intensely
competitive environment, which would severely impact our revenues.

Foreign sales of docosanol 10% cream and other potential products are subject
to various foreign trade risks.

Our license agreement with GlaxoSmithKline is for the United States and
Canada only. We also have exclusive license agreements for docosanol 10% cream
for Israel and Korea. We are holding discussions with other potential
licensees for marketing and selling docosanol 10% cream in other countries not
already licensed. However, we may not finalize any license or distributorship
arrangements for territories on a timely basis or on favorable terms, if at
all. Further, we are exposed to various foreign trade risks relating to the
continued development and marketing of docosanol 10% cream by our foreign
licensees. Further, we may arrange for contracts in the future for the
manufacture, marketing and distribution of docosanol 10% cream overseas by
foreign licensees, which will be substantially outside our control. Even if we
are able to obtain experienced licensees in foreign markets, specific risks
that could impact significantly our ability to deliver products abroad include:



| |  |  | difficulties in obtaining regulatory approval of
docosanol 10% cream in Canada, Israel, Korea and other foreign
countries;
| | - |  | --------------------------------------------------------------------------------------------------------------------------
|
| |  |  | changes in the regulatory and competitive environments in foreign countries;                                              
|
| |  |  | changes in a specific countrys or regions political or economic conditions;                                             
|
| |  |  | difficulty in finding foreign partners with sufficient
capital to effectively launch, market and promote the product;     
|
| |  |  | shipping delays;                                                                                                          
|
| |  |  | difficulties in managing operations across disparate geographic areas;                                                    
|
| |  |  | fluctuations in foreign currency exchange rates;                                                                          
|
| |  |  | prices of competitive products;                                                                                           
|
| |  |  | difficulties associated with enforcing agreements through foreign legal systems; and                                      
|
| |  |  | trade protection measures, including customs duties and export quotas.                                                    

Our failure or inability to comply with government regulations regarding the
development, production, testing, manufacturing and marketing of our other
products may adversely affect our operations.

Governmental authorities in the U.S., including the FDA, and other
countries regulate significantly the development, production, testing,
manufacturing and marketing of pharmaceutical products. The clinical testing
and regulatory approval process can take a number of years and require the
expenditure of substantial resources. Failure to obtain, or delays in
obtaining, these approvals will adversely affect our business operations,
including our ability to commence marketing of any proposed products. We may
find it necessary to use a significant portion of our financial resources for
research and development and the clinical trials necessary to obtain these
approvals for our proposed products. We will continue to incur costs of
development without any assurance that we will ever obtain regulatory

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approvals
for any of our products under development. In addition, we cannot predict the
extent to which adverse governmental regulation might arise from future U.S. or
foreign legislative or administrative action. Moreover, we cannot predict with
accuracy the effect of unspecified, but possible, future changes in the
regulatory approval process and in the domestic health care system for which we
develop our products. Future changes could affect adversely the time frame
required for regulatory review, our financial resources, and the sale prices of
our proposed products, if approved for sale.

Unsuccessful or lengthy research and development programs for proposed new
products could negatively affect our business.

We face substantial risks of failing to complete the development of our
research programs for the treatment of central nervous system disorders,
allergy and asthma, and other areas. Our Phase II/III clinical trials of
Neurodex for the treatment of emotional lability in ALS and MS patients may
experience setbacks or failures for reasons we have not anticipated. Although
we have observed activity of our allergy/asthma drug in our preclinical
research in several in-vitro and ex-vivo assays and in-vivo allergy models,
they may not be relevant to the development of, indicate the efficacy of, or
have the safety profile necessary for a proposed product for human use.
Unsuccessful clinical trial results for our proposed products could affect
materially and adversely our future business operations and financial
condition. The development process for medical products is lengthy and capital
intensive. Our drug development programs are exposed to all of the risks
inherent in product development based on innovative technologies, including
unanticipated development problems and the possible lack of funding or
collaborative partners, which could result in the abandonment or substantial
change in the development of a specific product.

We expect to incur increased energy costs and frequent power outages as a
result of the energy crisis currently being experienced in California.

The State of California has experienced and continues to experience a
deterioration in the ability of major utilities to provide energy for the
States needs. Throughout California, the crisis has resulted in rolling
blackouts where certain areas are not provided with any electricity for
periods of up to two hours. The immediate impact has been a significant
increase in power rates for most users, including us. Additionally, the loss
of electrical power or blackouts for any significant periods of time could
harm either our vendors or our ability to conduct our experiments or to provide
antibody research services for others. Further, we could lose valuable
progress made to date in experiments currently underway. We have attempted to
mitigate the severity of such losses by installing emergency power equipment,
which we intend to use for those electrical needs that we consider to be the
most critical to operating our business. However, the emergency power unit
does not cover all of our electrical needs.

Difficulties in acquiring inlicensed technologies that we believe are necessary
to fill our product development pipeline may negatively affect the price of our
common stock and restrict our growth.

Our business strategy for growth is not only through internal development,
but also through inlicensing of products, potential products and/or
technologies at various stages in the drug development pipeline. We will face
intense competition in attempting to inlicense other products and technologies.
In addition, we may not be able to locate suitable products and technologies
to fit our strengths, be able to obtain them on acceptable terms, or have the
financial resources to develop products from the inlicensed technology. If we
are unable to add to our product development pipeline, our growth may be
limited and it may affect our business and stock price negatively. Also, we
must have the financial resources to acquire and/or inlicense new products and
technologies and develop and market the products, if approved. We can provide
no assurance that we will be successful in our inlicensing strategy or that it
will have the desired effect on our future growth or stock price.

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Our failure to retain key management and scientific personnel could negatively
affect our business.

Our success depends on the performance of a small core staff of key
management and scientific employees with biotech experience. Given our small
staff size and programs currently under development, we depend substantially on
our ability to hire, train, retain and motivate high quality personnel,
especially our scientists and management team in this field. If we were to
lose one or more of our key scientists, then we would lose the history and
knowledge that they have which could substantially delay one or more of our
development programs until adequate replacement personnel could be hired and
trained.

Our future success also depends on our continuing ability to identify,
hire, train and retain highly qualified, technical, sales, marketing and
customer service personnel. We presently employ approximately 40 people in
AVANIR and our subsidiary, Xenerex Biosciences, and we expect to hire
additional people throughout the year. While we have employment and employee
retention agreements with certain key executives, they are limited in scope and
provide no real assurance that any of these people will continue their
employment with us. We do not have key person life insurance policies. The
industry in which we compete has a high level of employee mobility and
aggressive recruiting of skilled personnel, which creates intense competition
for qualified personnel, particularly in product research, development, sales
and marketing.

Our patents may be challenged and our pending patents may be denied. Either
result would seriously jeopardize our ability to compete in the intended
markets for our proposed products.

We rely substantially on the protection of our intellectual property for
docosanol, with 17 U.S. and foreign docosanol patents and 24 additional
docosanol-related patent applications pending. We also have seven U.S. and
foreign patents issued, one Notice of Allowance of a patent and 62 applications
pending on other products and technologies, and have inlicensed the rights to
market a potential product that treats multiple central nervous system
disorders that has six issued patents. Because of the competitive nature of
the bio-pharmaceutical industry, we cannot assure you that:



| |  |  | the claims in the pending patent applications will be
allowed or that we will even be issued additional patents;                                                                     
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | present and future competitors will not develop similar
or superior technologies independently, duplicate our
technologies or design around the patented aspects of our
technologies;
|
| |  |  | our proposed technologies will not infringe other
patents or rights owned by others, including licenses which may
not be available to us;                                            
|
| |  |  | any issued patents will provide us with significant
competitive advantages; or                                                                                                       
|
| |  |  | challenges will not be instituted against the validity
or enforceability of any patent that we own or, if instituted,
that these challenges will not be successful.                  

Our inability to obtain or maintain patent protections for our products in
foreign markets may negatively affect our financial condition.

The process for the approval of patent applications in foreign countries
may differ significantly from the process in the U.S. These differences may
delay our plans to market and sell docosanol 10% cream and other products in
the international marketplace. Approval in one country does not necessarily
indicate that approval can be obtained in other countries. The patent
authorities in each country administer that countrys laws and regulations
relating to patents independently of the laws and regulations of any other
country and we must seek and obtain the patents separately. Our inability to
obtain or maintain patent protections for docosanol 10% cream and other
products in foreign markets

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would severely hamper our ability to generate
international sales from our first product and other products still under
development.

If we do not protect our technical innovations, then our business may be
negatively affected.

We rely substantially on confidentiality agreements to protect our
innovations. We cannot assure you that secrecy obligations will be honored, or
that others will not develop independently similar or superior technology. In
addition, if our consultants, key employees or other third parties apply
technological information independently developed by them or by others to our
projects, then disputes may arise as to the proprietary rights to this
information in which we may not receive a favorable resolution.

Developing new pharmaceutical products for human use involves product liability
risks, for which we currently have limited insurance coverage.

The testing, marketing, and sale of pharmaceutical products involves the
risk of product liability claims by consumers and other third parties. We
maintain product liability insurance coverage for our clinical trials in the
amount of $2 million per incident and $2 million in the aggregate. However,
product liability claims can be high in the pharmaceutical industry and our
insurance may not cover sufficiently all of the possible liabilities. If a
suit against our business or proposed products is successful, then the lack or
insufficiency of insurance coverage could affect materially and adversely our
business and financial condition. Furthermore, various distributors of
pharmaceutical products require minimum product liability insurance coverage
before their purchase or acceptance of products for distribution. Failure to
satisfy these insurance requirements could impede our ability to achieve broad
distribution of our proposed products.

We may issue additional shares of our Class A common stock. These issuances may
dilute the value of our Class A common stock to current shareholders and may
adversely affect the market price of our Class A common stock.

If we raise additional capital by issuing additional shares of Class A
common stock at a price or a value per share less than the then-current price
per share of Class A common stock, then the value of the shares of Class A
common stock outstanding will be diluted or reduced. Further, even if we were
to sell shares of common stock at prices higher than todays price, sales of
such shares, over which we have no control, may depress our market price and
dilute earnings per share.

The conversion or exercise of currently outstanding stock purchase warrants and
stock options, or conversion of redeemable convertible preferred stock
currently outstanding will have a dilutive effect on our Class A common stock.

As of August 7, 2001, the Company had outstanding stock options to
purchase an aggregate of 5,366,429 shares of Class A common stock at exercise
prices ranging from $0.30 to $6.44 per share and warrants to acquire up to
1,264,550 shares of Class A common stock at exercise prices ranging from
$0.9144 to $2.715 per share. The Company has or may have other securities that
have a dilutive effect, including 50 shares of Series D redeemable convertible
preferred stock, which at recent market prices may be converted into
approximately 184,000 shares of Class A common stock at a fixed conversion
price of $2.715 per share.

Sales in the public market of shares of Class A common stock acquired upon
exercise of stock options and warrants may affect adversely the prevailing
market prices for Class A common stock. Negative price movements in the shares
of Class A common stock likely would affect adversely our ability to obtain
additional equity capital on favorable terms, if at all.

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We do not intend to declare or pay cash dividends in the foreseeable future.

We do not intend to declare or pay cash dividends in the foreseeable
future. We expect to retain any earnings, if and when achieved, to finance our
business.




Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Companys market risk exposures are related to both its short and
long-term investments. Our excess cash is currently invested in commercial
paper primarily rated A-1 or P-1 by Standard & Poors or Moodys with
maturities of 90 days or less and government securities with maturities ranging
from one to five years. Our cash and cash equivalents are represented by
highly liquid institutional money market funds, which we believe do not have
significant market risk. We do not enter into derivative or other financial
instruments for trading or speculative purposes. We expect that our sales
transactions for the foreseeable future will be denominated in U.S. dollars and
thus will not be subject to risk due to currency exchange fluctuations.




PART II OTHER INFORMATION




Items 1-4. NOT APPLICABLE




Item 6. EXHIBITS AND REPORTS ON FORM 8-K

None.




SIGNATURES

Pursuant to the requirements 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.

|                                       |  |                                                                                                  |  |                
|-------------------------------------- |  | ------------------------------------------------------------------------------------------------ |  | ---------------
|Signature                              |  | Title                                                                                            |  | Date           
|                                       |  |                                                                                                  |  |                
|                                       |  |                                                                                                  |  |                
|/s/GERALD J. YAKATAN
Gerald J. Yakatan |  | President and Chief
Executive Officer
(Principal Executive Officer)                              |  | August 13, 2001
|                                       |  |                                                                                                  |  |                
|/s/GREGORY P. HANSON
Gregory P. Hanson |  | Vice President, Finance and Chief
Financial Officer
(Principal Financial and Accounting Officer) |  | August 13, 2001

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