**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

**(Mark one)**

**x****            AnnualReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

**For the fiscal year ended December 31, 2006**

**OR**

**o****              TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

**For thetransition periodfrom:                              to**

**CommissionFile Number: 000-23267**

**DEPOMED, INC.**

(Exact Name of Registrant as Specified in its Charter)

| **California**                                                  |   | **94-3229046**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
| **1360 O’Brien Drive, Menlo Park, California**             |   | **94025**                             |
| (Address of  principal executive offices)                       |   | (Zip Code)                            |

 

Registrant’s telephone number, including area code:  **(650) 462-5900**

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

Common Stock, no par value

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

None

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.

Yes  o   No  x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act.

Yes  o   No  x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

Yes  x   No  o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer, as defined in Rule 12b-2 of the Exchange Act.

| Large accelerated filer  o |   | Accelerated  filer  x |   | Non-accelerated  filer  o |
|--------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

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

Yes  o   No  x

The aggregate market valueof the voting and non-voting common equity held by non-affiliates of theregistrant based upon the closing price of Common Stock on the Nasdaq StockMarket on June 30, 2006 was approximately $209,545,000. Shares of CommonStock held by each officer and director and by each person who owns 10% or moreof the outstanding Common Stock have been excluded in that such persons may bedeemed to be affiliates. This determination of affiliate status is notnecessarily a conclusive determination for other purposes.

The number of sharesoutstanding of the registrant’s Common Stock, no par value, as of March 6,2007 was 42,091,255.

**Documents Incorporated by Reference**

Portions of the registrant’sProxy Statement, which will be filed with the Securities and ExchangeCommission pursuant to Regulation 14A in connection with the registrant’s 2007Annual Meeting of Shareholders, expected to be held on or about May 31,2007, are incorporated by reference in Part III of this Form 10-K.

 

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**DEPOMED, INC.2006 FORM 10-K REPORTTABLE OF CONTENTS**
|            | ** ** | ** **                                                                                                                      | ** ** | **PAGE** |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| ** ** | ** ** | **PART I**                                                                                                                 |       |     |
| Item 1.    |       | Business                                                                                                                        |       | 4        |
| Item 1A.   |       | Risk  Factors                                                                                                                   |       | 22       |
| Item 1B.   |       | Unresolved Staff Comments                                                                                                       |       | 34       |
| Item 2.    |       | Properties                                                                                                                      |       | 34       |
| Item 3.    |       | Legal  Proceedings                                                                                                              |       | 34       |
| Item 4.    |       | Submission of Matters to a Vote of Security Holders                                                                             |       | 34       |
| ** ** | ** ** | **PART II**                                                                                                                |       |     |
| Item 5.    |       | Market for the Registrant’s Common Equity, Related  Shareholder Matters and Issuer Purchases of Equity Securities          |       | 37       |
| Item 6.    |       | Selected  Financial Data                                                                                                        |       | 39       |
| Item 7.    |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |       | 40       |
| Item 7A.   |       | Quantitative and Qualitative Disclosures about Market  Risk                                                                     |       | 52       |
| Item 8.    |       | Financial Statements and Supplementary Data                                                                                     |       | 53       |
| Item 9.    |       | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                  |       | 53       |
| Item 9A.   |       | Controls and  Procedures                                                                                                        |       | 53       |
| Item 9B.   |       | Other  Information                                                                                                              |       | 55       |
|       | ** ** | **PART III**                                                                                                               |       |     |
| Item 10.   |       | Directors,  Executive Officers and Corporate Governance                                                                         |       | 55       |
| Item 11.   |       | Executive  Compensation                                                                                                         |       | 55       |
| Item 12.   |       | Security Ownership of Certain Beneficial Owners and  Management and Related Shareholder Matters                  |       | 55       |
| Item 13.   |       | Certain  Relationships and Related Transactions, and Director’s Independence                                               |       | 55       |
| Item 14.   |       | Principal Accountant Fees  and Services                                                                                         |       | 55       |
|       | ** ** | **PART IV**                                                                                                                |       |     |
| Item 15.   |       | Exhibits and Financial Statement Schedules                                                                                      |       | 56       |
|       |       | Signatures                                                                                                                      |       | 59       |

 

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**NOTE REGARDING FORWARD-LOOKING STATEMENT**

Statementsmade in this Annual Report on Form 10-K that are not statements ofhistorical fact are forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended (the Securities Act), and Section 21Eof the Securities Exchange Act of 1934, as amended. We have based theseforward-looking statements on our current expectations and projections aboutfuture events. Our actual results could differ materially from those discussedin, or implied by, these forward-looking statements. Forward-looking statementsare identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,”“will,” “may” and other similar expressions. In addition, any statements thatrefer to expectations, projections or other characterizations of future eventsor circumstances are forward-looking statements. Forward-looking statementsinclude, but are not necessarily limited to, those relating to:

·       thecommercial success and market acceptance of GLUMETZATM (metformin hydrochlorideextended release tablets) in the United States;

·       thesuccess of our collaborative arrangement with King Pharmaceuticals, Inc.with respect to GLUMETZA;

·       resultsand timing of our clinical trials, including the results of our Gabapentin GRTMtrials;

·       acceptanceand approval of regulatory filings;

·       theresults of our internal research and development efforts;

·       ourongoing patent litigation against IVAX;

·       ourneed for, and ability to raise, additional capital;

·       marketacceptance of ProQuin® XR (ciprofloxacin hydrochloride extendedrelease tablets);

·       theefforts of Esprit Pharma, Inc. with respect to the commercialization ofProQuin XR;

·       ourcollaborative partners’ compliance or non-compliance with their obligationsunder our agreements with them;

·       ourability to obtain commercialization partners for our products and productcandidates;

·       theefforts of our foreign collaborative partners with respect to the marketing ofGLUMETZA in Canada and Korea;

·       ourability to obtain other commercialization partners for our products and productcandidates; and

·       ourplans to develop other product candidates.

Factors that could causeactual results or conditions to differ from those anticipated by these andother forward-looking statements include those more fully described in “**ITEM 1A.****RISK FACTORS**” andelsewhere in this Annual Report on Form 10-K. We disclaim any intentto update or revise these forward-looking statements to reflect new events orcircumstances.

**CORPORATE INFORMATION**

The address of ourInternet website is *http://www.depomedinc.com*.We make available, free of charge through our website or upon written request,our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K and other periodic SEC reports, alongwith amendments to all of those reports, as soon as reasonably practicableafter we file the reports with the SEC.

Unless the contextindicates otherwise, “Depomed”, “the Company”, “we”, “our” and “us” refer toDepomed, Inc. Depomed was incorporated in the State of California on August 7,1995. Our headquarters are located in Menlo Park, California.

Depomed® and ProQuin® areregistered trademarks of Depomed. Gabapentin GRTM and AcuFormTM are trademarks ofDepomed. GLUMETZATM****is a trademarkof Biovail Laboratories International, s.r.l. exclusively licensed in theUnited States to Depomed. All other trademarks and trade names referenced inthis Annual Report on Form 10-K are the property of their respectiveowners.

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**PART I**

**ITEM 1.**                BUSINESS

**COMPANY OVERVIEW**

Depomed is a specialty pharmaceutical company focusedon the development and commercialization of differentiated products thataddress large and growing markets and are based on proprietary oral drugdelivery technologies. We have developed two commercial products. GLUMETZATM(metformin hydrochloride extended release tablets) is a once-daily treatmentfor adults with type 2 diabetes that we jointly commercialize in the UnitedStates with King Pharmaceuticals, Inc. ProQuin XR (ciprofloxacinhydrochloride extended release tablets) is a once-daily treatment foruncomplicated urinary tract infections that Esprit Pharma, Inc. markets inthe United States.

We have a three-pronged approach to productdevelopment designed to optimize the use and value of our drug deliverytechnologies, while managing the costs and risks associated with developing andcommercializing pharmaceutical products. We develop products for our ownaccount that are designed to compete in large growing markets and that can behighly differentiated from immediate release versions of the compounds uponwhich they are based. Second, we selectively enter into collaborativepartnerships with other companies where the unique capabilities of ourtechnology can provide superior value to a partner’s compound, resulting in significantlygreater value for Depomed than a traditional fee-for-service arrangement. Third,we enter into arrangements that enable our technology to be applied by othercompanies to a greater number of compounds than our infrastructure can support,so as to derive additional value from our technology. In the future, we plan tocommercialize our proprietary products, relying on partners to cover the largeprimary care audiences, while maintaining co-promotion and distribution rightsin order to be in a position to create our own sales force when appropriate,thereby increasing the value to us of our products, and our control over them.

Our most advanced product candidate in development isGabapentin GRTM, an extended release form of gabapentin. With respect toGabapentin GR, we have completed enrollment of a Phase 3 clinical trialfor the treatment of postherpetic neuralgia, completed and announced positiveresults of a Phase 2 clinical trial for the treatment of diabeticperipheral neuropathy, and submitted an investigational new drug application,or IND, for a Phase 2 clinical trial for the treatment of menopausal hotflashes. Additionally, we have other product candidates in earlier stages of development,including a treatment for gastroesophageal reflux disease.

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The following table summarizes our marketed products,and our product pipeline.
|                       | **Marketed Products**                 | ** **                                                                                                                                                     |
|-----------------------|---------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Product**           | **Indication**                        | **Status****(1)**                                                                                                                                              |
| GLUMETZATM        | Type 2 diabetes                       | Currently sold in  the United States, Canada and Korea.

*Canadian  rights held by Biovail.  Korean rights held by LG Life Sciences.*                          |
| ProQuin® XR | Uncomplicated urinary tract infection | Currently sold in  the United States.*US rights held by Esprit Pharma, Inc.*

Regulatory  application pending in Sweden.*European rights held by Madaus.* |
| ** **            | **Product Pipeline**                  | ** **                                                                                                                                                     |
| Gabapentin GRTM   | Postherpetic neuralgia                | Phase 3 enrollment complete.                                                                                                                              |
|                  | Diabetic peripheral neuropathy        | Phase 2 trial complete.                                                                                                                                   |
|                  | Menopausal hot flashes                | IND for Phase 2 trial submitted to FDA. *Rights to a patent covering gabapentin for this  indication sublicensed from PharmaNova, Inc.*              |
| Undisclosed compound  | Gastroesophageal reflux disease       | Phase 2a proof of concept studies underway.                                                                                                               |
| Undisclosed compound  | Confidential(2)                       | Preclinical studies.*Partnered with Supernus  Pharmaceuticals, Inc.*                                                                                      |
| Undisclosed compound  | Confidential(2)                       | *Partnered with New River  Pharmaceuticals, Inc.*                                                                                                         |
|                       |                                       |                                                                                                                                                                |  |  |  |  |

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(1)          Thesection below entitled “Government Regulation” for additional information regardingthe phases of drug development.

(2)          Thecompound and indication may not be disclosed pursuant to the collaborationagreement.

**SIGNIFICANT DEVELOPMENTS DURING 2006**

During2006, among other things, we:

·       Jointlylaunched GLUMETZA in the United States with King Pharmaceuticals;

·       Completeda Phase 2 study and initiated a Phase 3 study with Gabapentin GR forthe treatment of postherpetic neuralgia;

·       Completeda Phase 2 study with Gabapentin GR for the treatment of diabeticperipheral neuropathy;

·       Exclusivelysublicensed rights to the use of gabapentin for the treatment of menopausal hotflashes under a University of Rochester patent;

·       Initiatedan internal development program for a gastroesophageal reflux diseasetreatment;

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·       Establisheda collaboration arrangement with Patheon, Inc. designed to expand thebreadth of our collaboration programs;

·       Enteredinto a collaboration arrangement with Supernus Pharmaceuticals (formerly ShireLaboratories) for a new product candidate;

·       Retainedco-promotion rights on GLUMETZA under our promotion arrangement with KingPharmaceuticals, and obtained co-promotion rights on ProQuin XR from EspritPharma;

·       Receiveda $10 million license fee payment from Esprit Pharma for ProQuin XR; and

·       Established a $30 million equityline of credit.

**MARKETED PRODUCTS**

***GLUMETZA***TM

***General***

The 500mg strength ofGLUMETZA is our internally developed once-daily metformin product for type 2diabetes. The FDA approved GLUMETZA for marketing in the United States in June 2005.At that time, a subsidiary of Biovail Corporation, or Biovail, held US andCanadian marketing rights to GLUMETZA pursuant to a license agreement weentered into with the Biovail subsidiary in 2002. We reacquired the US rightsto GLUMETZA from Biovail in December 2005. In June 2006, we enteredinto a promotion arrangement with King Pharmaceuticals related to GLUMETZAunder which we and King jointly commercialize GLUMETZA in the United States.GLUMETZA was launched in the United States in September 2006. In February 2007,we obtained a waiver from the FDA of a Phase 4 pediatric study onGLUMETZA.

In connection with therestructuring of our GLUMETZA agreements with Biovail in December 2005, wealso acquired an exclusive US license to a 1000mg strength of GLUMETZAutilizing proprietary Biovail drug delivery technology that is a reformulatedversion of the 1000mg GLUMETZA initially approved by the FDA for marketing inthe United States along with the 500mg GLUMETZA. Biovail has completed thereformulation of the 1000mg GLUMETZA. We expect to submit to the FDA before theend of the first quarter of 2007, a supplemental New Drug Application to theFDA covering the 1000mg GLUMETZA seeking approval to market the product in theUnited States. If approved, we expect the 1000mg GLUMETZA to be available latein 2007, or in the first quarter of 2008.

Our issued US patentscovering the 500mg GLUMETZA expire between 2016 and 2020.

The 500mg GLUMETZA hasalso been approved for marketing in Canada, where it is marketed by Biovail,and in Korea, where it is marketed by LG Life Sciences under the trade nameNovamet GR.

***Diabetes***

Diabetes is a disease inwhich levels of glucose, a type of sugar found in the blood, are above normal. Diabeticpatients do not produce insulin, a hormone produced in the pancreas, or do notproperly use insulin, making it difficult for the body to convert food intoenergy. Type 2 diabetes is the most common form of diabetes, accounting for 90to 95 percent of all diabetes cases, according to the National Institute ofDiabetes and Digestive and Kidney Diseases of the National Institutes ofHealth, or the NIDDK.

The body breaks down foodinto glucose, and delivers glucose to cells through the bloodstream. Cells useinsulin to help process blood glucose into energy. In the case of type 2diabetes, cells fail to use insulin properly or the pancreas cannot make asmuch insulin as the body requires. That causes the amount of glucose in theblood to increase, while starving cells of energy. Over time, high bloodglucose levels damage 

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nervesand blood vessels, which can lead to complications such as heart disease,stroke, blindness, kidney disease, nerve problems, gum infections, andamputation.

***Target Market***

According to the NIDDK,20.8 million people in the United States, or seven percent of the USpopulation, have diabetes. Of those, 14.6 million are diagnosed, and all but200,000 are at least 20 years old. The NIDDK estimates that in 2005 1.5 millionnew cases of diabetes were diagnosed in the United States in people aged 20years or older. Among adults with diagnosed diabetes, 57 percent take oralmedication only, and 12 percent take both insulin and oral medication,according to the 2001-2003 National Health Interview Survey of theCenters for Disease Control and Prevention. In 2006, the metformin market inthe United States was approximately $1.4 billion in retail sales.

***GLUMETZA Collaborationand Licensing Arrangements***

*King Pharmaceuticals.*   InJune 2006, we entered into a promotion agreement with King Pharmaceuticalspursuant to which we granted King the co-exclusive right to promote GLUMETZA inthe United States. Under the agreement, King is required to promote GLUMETZA tophysicians in the United States through its sales force, to deliver a minimumnumber of annual detail calls to potential GLUMETZA prescribers, and tomaintain a sales force of a minimum size. In consideration for its promotion ofGLUMETZA, King receives a promotion fee equal to fifty percent of gross margin,which is defined in the agreement as sales of GLUMETZA, net of returns,discounts, rebates and chargebacks, minus cost of goods sold and certainadjustments (including the one percent royalty due to Biovail with respect tothe 500mg GLUMETZA tablet). We share out-of-pocket marketing expenses with Kingat an agreed-upon ratio, in which Depomed’s share is lower than King’s.

We have the right underthe contract to promote GLUMETZA to physicians to whom King does not make detailcalls, or does not make detail calls with sufficient regularity. Incrementalsales generated by physicians called upon by us, over a baseline establishedprior to our promotion, are excluded from net sales for purposes of calculatingthe promotion fee payable to King.

The 1000mg formulation ofGLUMETZA to which we have rights to in the United States from Biovail will alsobe subject to the agreement, if that formulation is approved for marketing. Theterm of the promotion agreement with King is five years, with additional oneyear renewal periods if agreed upon by the parties. In September 2006, welaunched the 500mg GLUMETZA in the United States.

The agreement provided fora six-month option in favor of King to negotiate with us the terms of anexclusive license in the United States to our AcuForm drug deliverytechnology in combination with metformin hydrochloride and any other activepharmaceutical ingredient. King did not exercise that option and the optionexpired in December 2006.

*Biovail.*   Welicensed US and Canadian rights to GLUMETZA to Biovail in 2002. We received a$25 million license fee payment from Biovail under our original licenseagreement following FDA approval of GLUMETZA. In December 2005, we andBiovail entered into an Amended and Restated License Agreement relating toGLUMETZA. The Amended and Restated License Agreement supersedes our April 27,2004 Amended License and Development Agreement with Biovail.

Pursuant to the Amendedand Restated License Agreement, Biovail has an exclusive license in Canada tomanufacture and market the 500mg GLUMETZA, and we receive royalties of sixpercent of Canadian net sales of the 500mg GLUMETZA. We will also receivepayments from Biovail equal to one percent of Canadian net sales of the 1000mgGLUMETZA if that formulation is approved and marketed in Canada. The royaltypayable by Biovail on net sales of the 500mg GLUMETZA may be increased to tenpercent if regulatory approval in the United States of the 1000mg newformulation of GLUMETZA is not obtained by June 30, 2007, provided that wehave complied with our obligations related to obtaining such regulatoryapproval.

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In December 2005, wealso entered into a Manufacturing Transfer Agreement and a Supply Agreementwith Biovail related to the 1000mg GLUMETZA with Biovail. Under thoseagreements, we received an exclusive license to market the 1000mg GLUMETZA inthe United States, and an exclusive license to the “GLUMETZA” trademark in theUnited States for the purpose of marketing GLUMETZA. We will purchase 1000mgGLUMETZA exclusively from Biovail under the Supply Agreement, subject toback-up manufacturing rights in our favor. If we exercise our back-upmanufacturing rights, compensation to Biovail will change from a supply-basedarrangement to royalties of six percent of net sales of the 1000mg GLUMETZA inthe United States (or, if less, thirty percent of royalties and other similarpayments from our licensees) under the Manufacturing Transfer Agreement. Also,we will pay Biovail royalties of one percent of net sales of the 500mg GLUMETZAin the United States (or, if less, five percent of royalties and other similarpayments from our licensees). The Supply Agreement also includes provisions forthe continued development of the 1000mg GLUMETZA in the event that the FDA doesnot approve the sNDA covering the 1000mg GLUMETZA.

*LG Life Sciences.*   InAugust 2004, we entered into a license and distribution agreement grantingLG Life Sciences an exclusive license to the 500mg GLUMETZA in the Republic ofKorea. LG Life Sciences launched the product, known as Novamet GR, in Korea in2006.

We received a $600,000upfront license fee from LG in connection with entering into the agreement. In November 2006,we amended the agreement to provide for a $500,000 milestone payment from LGwith respect to LG’s approval to market GLUMETZA in the Republic of Korea,rather than a $700,000 payment, as reflected in the original agreement. Wereceived the $500,000 payment in November 2006, net of applicable Koreanwithholding taxes, and commenced negotiations to further amend the agreement toformally grant LG a license to manufacture the 500mg GLUMETZA in exchange forroyalties on net sales of GLUMETZA in Korea, and to remove the provisions ofthe original agreement providing for the supply of 500mg GLUMETZA tablets bythe Company to LG. In January 2007, we completed our negotiations with LG,and entered into an amended license agreement implementing the provisions.

***ProQuin***® XR

***General***

ProQuin XR is a once-dailyformulation of the antibiotic ciprofloxacin for uncomplicated urinary tractinfections. We developed ProQuin XR, and the FDA approved it for marketing inthe United States in May 2005. Esprit Pharma licensed marketing rights toProQuin XR in the United States in July 2005, and launched the product inthe United States in November 2005.

Our issued US patentscovering ProQuin XR expire between 2016 and 2020. We have additional US patentapplications covering ProQuin XR pending.

***UncomplicatedUrinary Tract Infection***

A urinary tract infection,or UTI, is an infection in the urinary bladder. An uncomplicated UTI is a UTIthat does not spread from the bladder to the kidney or the prostate. Commonsymptoms associated with UTIs include a frequent urge to urinate and a painful,burning feeling in the area of the bladder or urethra during urination, and anoverall ill-feeling of malaise.

Uncomplicated UTIs arevery common in women between 20 and 50. The NIDDK reports that infections ofthe urinary tract are the second most common type of infection in the body,account for approximately 8.3 million doctor visits each year, with one womanin five developing a UTI during her lifetime. According to the NIDDK, nearly20% of women who experience a UTI will experience another. 30% of women who experiencea second UTI will have a third UTI, and 80% of women who have at least threeUTIs, or approximately one woman in one hundred, will have recurrences.

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***Target Market***

Ciprofloxacin is a memberof the family of drug compounds known as quinolones, which also includeslevaquin. In 2006, there were approximately 8 million prescriptions forquinolones filled in the United States.

***ProQuin XRCollaboration and Licensing Arrangements***

*Esprit Pharma.*   InJuly 2005, we entered into an exclusive license and marketing agreementwith Esprit Pharma, Inc. pursuant to which we granted Esprit exclusive USmarketing and distribution rights to ProQuin XR. The agreement obligates Espritto pay us $50 million in license fees, of which $40 million has been paid. Theremaining $10 million is due in July 2007. The agreement also provides forroyalty payments to us of 15 percent to 25 percent of ProQuin XR net sales, basedon escalating net sales, subject to minimum royalty obligations of $4.6 millionin 2006, $5.0 million in 2007 and in subsequent years remains at $5.0 million,subject to annual increases in the consumer price index beginning in 2008. Wealso have a supply agreement with Esprit under which we provide Esprit withcommercial quantities of ProQuin XR.

In July 2006, we amended the license agreement withEsprit to, among other matters, extend to December 2006 the due date on the $10million license fee payment to Depomed that had been due in July 2006, tocredit royalties paid to us for sales made in the fourth quarter of 2005 ofProQuin XR against Esprit’s $4.6 million minimum royalty obligation in 2006,and to establish a joint marketing team to periodically review and discuss allaspects of the commercialization of ProQuin XR.

Also in July 2006, we entered into a co-promotionagreement with Esprit in which we obtained co-promotion rights to marketProQuin XR. Under the terms of the co-promotion agreement, we have the right,but not the obligation, to promote ProQuin XR in the United States to up to40,000 physicians, other than urologists and obstetricians/gynecologists, notcalled upon by Esprit. The agreement permits us to co-promote ProQuin XRdirectly or through third parties agreed upon by Esprit. If we exercise ourco-promotion rights, we will receive a co-promotion fee of 18% on net salesgenerated by physicians called upon by us. The co-promotion agreement has afour-year term.

In December 2006, wedelivered a notice to Esprit regarding alleged breaches by Esprit of thelicense agreement. The alleged breaches related to Esprit’s failure to make a$10 million license fee payment due to the Company in December 2006, andto use commercially reasonable efforts to market ProQuin XR. In connection withthe notice, we filed a demand for binding arbitration. Subsequent to thedelivery of the notice and demand for arbitration, Esprit paid us the $10million license fee payment in December 2006 and we withdrew withoutprejudice the notice and demand for arbitration. We also agreed to commence, inJanuary 2007, discussions with Esprit toward a mutually agreeable,long-term restructuring of the license agreement. Those discussions began in January 2007and are continuing. The agreement will remain in effect unless and until we andEsprit agree to any modifications to it.

*Madaus.*   InNovember 2005, we entered into a distribution and supply agreement forProQuin XR in Europe with a privately owned specialty pharmaceutical company,Madaus S.r.l. Under the terms of the agreement, we granted an exclusive rightto Madaus for the commercialization of ProQuin XR in Europe and agreed tosupply Madaus with commercial quantities of ProQuin XR tablets in bulk form. InMarch 2006, Madaus filed a Marketing Authorization Application for ProQuinXR with the Medical Products Agency in Sweden, which is pending.

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**PRODUCT CANDIDATES**

***Gabapentin GR forNeuropathic Pain***

***General***

Gabapentin GR is ourinternally developed, extended release formulation of the compound gabapentin.Gabapentin is marketed by Pfizer Inc. for adjunctive therapy for epilepticseizures and postherpetic pain under the trade name Neurontin. It is alsomarketed by a number of other companies as a generic, immediate release drug.

*Postherpetic Neuralgia.*   Postherpeticneuralgia, or PHN, is a persistent pain condition caused by nerve damage duringa shingles, or herpes zoster, viral infection. There are an estimated 600,000to one million cases of shingles each year, according to the Centers forDisease Control and Prevention. The incidence of PHN increases in elderlyshingles patients, in whom the incidence of PHN in shingles patients 50 to 69years old is 50 percent and increases to 75 percent in patients over 70 yearsold, according to WWMR, Inc., a pharmaceutical market research firm. Painassociated with PHN reportedly can be so severe that patients are unable toresume normal activities for months. Since there is no cure for PHN, treatmentsare focused on relieving pain.

*Diabetic PeripheralNeuropathy.*   Diabetic peripheral neuropathy, orDPN, is a peripheral nerve disorder caused by diabetes. Approximately 60 to 70percent of the more than 20 million diabetics in the United States have mild tosevere forms of nervous system damage, according to the National Institutes ofHealth. After a period of inadequate glycemic control, nerve damage may occurand may lead to a number of health problems, including indigestion, diarrhea orconstipation, dizziness, bladder infections and impotence. DPN is oftenassociated with numbness, pain, or tingling in the feet or legs and may lead toweakness in the muscles of the feet. Current treatment approaches for DPNinvolve providing options for pain relief and implementing glycemic controlmeasures, including diet, exercise and medication, to prevent further tissuedamage by bringing blood sugar levels under control.

***Target Market***

Approximately 2.6 millionpeople are estimated to have suffered from moderate to severe neuropathic painin 2004. The overall neuropathic pain market is expected to reach$3.5 billion in 2014, with an expected patient population of over threemillion, according to WWMR, Inc., a pharmaceutical market research firm.

***Clinical Program***

*Phase 2 PostherpeticNeuralgia Study.*   We conducted a randomized,double-blind, placebo-controlled Phase 2 trial of 158 PHN patients. Wereported the results of the study in January 2006. Patients wererandomized into three treatment groups for four weeks of treatment:  placebo, an 1800mg total daily dose ofGabapentin GR given once daily, and an 1800mg total daily dose of Gabapentin GRgiven twice daily. The primary objective of the study was to assess therelative efficacy of Gabapentin GR once-daily, twice-daily, and placebo inreducing PHN patients’ average daily pain scores from baseline to the end of afour-week treatment period on the basis of the Likert pain scale, and 11-pointnumerical rating scale used to assess pain intensity. Secondary objectivesincluded assessments of changes from baseline in sleep interference, andadditional patient and clinician assessments of pain.

Reductions in averagedaily pain scores were statistically significant with twice-daily Gabapentin GRfrom week two to the end of treatment based on the Likert pain scale. Clinicallysignificant improvements in the score were observed with mean change frombaseline to study end of -2.24 compared to -1.29 for placebo (p=0.014). The secondary endpoint of sleep interference was also statisticallysignificantly different, with sleep interference scores reduced by -2.28 withGabapentin GR compared to -1.16 with placebo (p=0.006).

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For once-daily GabapentinGR, there was an improvement in pain that did not reach statisticalsignificance, with a reduction in mean daily pain score of -1.93 withGabapentin GR compared to -1.29 with placebo (p= 0.089). SleepInterference Scores were reduced by -1.94 compared to -1.16 withplacebo (p=0.048).

There were no seriousadverse events associated with Gabapentin GR. The most common side effectsobserved were dizziness (22% in the once-daily arm, 11% in the twice-daily arm,and 10% in the placebo arm), and somnolence (9% in the once-daily arm, 8% inthe twice-daily arm, and 8% in the placebo arm).

*Phase 3 PostherpeticNeuralgia Study.*   In May 2006, we initiateda Phase 3 clinical trial for Gabapentin GR for the treatment of PHN. Thestudy is a randomized, double-blind, placebo-controlled study of approximately 400PHN patients. The study was fully enrolled in early March 2007. Patientsin the study are randomized into three treatment arms:  placebo, a total daily dose of 1800mg ofGabapentin GR dosed once daily, and a total daily dose of 1800mg of GabapentinGR dosed twice daily.

The primary objective ofthe study is to assess the efficacy of Gabapentin GR in reducing the painassociated with PHN, measured from baseline pain scores to the end of aten-week treatment period on the basis of the Likert pain scale. Secondaryobjectives include an assessment of changes from baseline in sleepinterference, and additional patient and clinician assessments of pain andquality of life.

We expect to report theresults of the study in mid-2007. If the results of the study arepositive, we expect to file an NDA for Gabapentin GR for PHN in the fourthquarter of 2007.

*Phase 2 DiabeticPeripheral Neuropathy Study.*   In December 2006,we reported results of a Phase 2 randomized, double-blind,placebo-controlled study of Gabapentin GR that involved 147 patients withdiabetic peripheral neuropathy. Patients in the study were randomized into oneof three treatment groups:  placebo,3000mg of Gabapentin GR dosed once daily, or 3000mg of Gabapentin GR dosedtwice daily. The primary objective of the study was to assess the efficacy ofGabapentin GR in treating the pain associated with DPN, as measured by theLikert pain scale. Secondary objectives include an assessment of changes frombaseline in sleep interference, and additional patient and clinicianassessments of pain and quality of life.

Reductions in averagedaily pain scores from baseline to the end of treatment based on the Likertpain scale were statistically significant with once-daily Gabapentin GR. Clinicallysignificant improvements in the pain score were observed with a mean changefrom baseline to study end of -2.45 compared to -1.26 for placebo(p= 0.002). Although not statistically significantly different for twice-dailyGabapentin GR, there was pain improvement with a reduction in mean daily painscore of -1.75 with Gabapentin GR compared to -1.26 with placebo(p= 0.190).

The assessment of “responders”,defined as patients with at least a 50 percent reduction in pain at endpointcompared to baseline, showed that both Gabapentin GR arms reached statisticalsignificance. The proportion of responders was 35 percent for once-dailyGabapentin GR (p= 0.001), 26 percent for twice-daily Gabapentin GR (p= 0.015)and 8 percent for placebo.

Sleep interferencedecreased with both once and twice-daily Gabapentin GR, with once-dailyGabapentin GR reaching statistical significance. In the once-daily arm, SleepInterference Scores were reduced by -2.70 compared to -1.65 withplacebo (p=0.01).

There were no seriousadverse events associated with Gabapentin GR in the trial. The most common sideeffects observed were dizziness and somnolence, which are commonly associatedwith gabapentin. The reported incidences were 17.0 percent and 12.8 percent fordizziness and somnolence respectively for once-daily Gabapentin GR and 12.2percent and 4.1 percent, respectively for twice-daily Gabapentin GR.

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***Gabapentin GR forMenopausal Hot Flashes***

***General***

**We planto use our existing Gabapentin GR formulation to study its safety and efficacyin the treatment of hot flashes associated with menopause. We have an exclusivesublicense from PharmaNova, under United States Patent No. 6,310,098, heldby the University of Rochester, to develop and commercialize in the UnitedStates a product that contains gabapentin as its active pharmaceuticalingredient, and is indicated for the treatment of menopausal hot flashes. Webelieve that Gabapentin GR is an excellent non-hormonal product candidate forthis indication, because numerous academic studies have demonstrated thatgabapentin may be effective in treating hot flashes, and gabapentin has a longhistory of use in other indications.**

The patent we have sublicensedexpires in 2020.

***Hot Flashes***

A hot flash is a suddenflushing and sensation of heat caused by dilation of skin capillaries. Hotflashes are normally associated with menopausal endocrine imbalance. Theoccurrence and frequency of hot flashes are unpredictable. Symptoms oftenassociated with hot flashes include sweating, irritatability and frustration.

Hot flashes can beginearly in menopause and are most common during the first few years aftermenopause begins. There are over 40 million postmenopausal women more than 55years old and about 2 million women enter menopause every year in the UnitedStates. Approximately 80% of those women suffer from hot flashes.

***Current Treatments;Target Market***

Currently, the leadingprescription drug product for the treatment of hot flashes associated withmenopause is hormone replacement therapy, or HRT, which involves theadministration of hormone estrogen, either alone or in combination with thehormone progestin. In 2001, the HRT market represented more than $2 billion andin excess of 90 million prescriptions. In 2003, the Women’s Health Initiativereleased the results of a clinical study that revealed an increased risk ofblood clots, stroke, and breast cancer associated with HRT. Subsequently, in2003, the HRT market decreased by more than $850 million and 34 millionprescriptions relative to 2001. HRT prescriptions declined to 44 millionprescriptions in 2006.

Existing non-hormonalpharmaceutical alternatives to HRT for the treatment of hot flashes includeoff-label administration of anti-depressants. There is also a considerablemarket for dietary and herbal supplements for the treatment of hot flashes,although we are not aware of any clinical study demonstrating the safety andefficacy of any such treatment.

***Clinical Program***

We participated in a pre-INDmeeting with the FDA in February 2007 to discuss our proposed clinicalprogram for Gabapentin GR for the treatment of menopausal hot flashes. Based oninput we received from the FDA at that meeting, we have submitted to the FDA anIND for a Phase 2 study of Gabapentin GR for the treatment of menopausalhot flashes. If the FDA does not raise an objection to the IND application, weexpect to commence a Phase 2 study assessing the safety and efficacy ofGabapentin GR for the treatment of menopausal hot flashes in the second quarterof 2007.

***PharmaNova LicenseArrangement***

In October 2006, weentered into a sublicense agreement with PharmaNova, Inc. Pursuant to theagreement, PharmaNova has granted us an exclusive sublicense, under UnitedStates Patent No. 6,310,098, held by the University of Rochester, todevelop and commercialize in the United States a product that 

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containsgabapentin as its active pharmaceutical ingredient, and is indicated for thetreatment of hot flashes associated with menopause.

We paid PharmaNova anupfront license fee of $500,000 upon signing of the agreement and are requiredto pay PharmaNova an additional $500,000 upon dosing of the first patient inany Phase 3 trial for the product, $1,000,000 upon submission to the FDAof a New Drug Application, or NDA, for the product, and $2,000,000 upon FDAapproval of an NDA. The agreement provides for royalty payments to PharmaNovaon net sales of the product, and for milestone payments upon achievement ofannual net sales in excess of certain thresholds. We are also required to payPharmaNova consultancy fees of $300,000 over approximately ten months beginningin November 2006.

***GastroesophagealReflux Disease Program***

***General***

Gastroesophageal refluxdisease, or GERD, is a disorder of the digestive system caused by the failureof the lower esophageal sphincter muscle, or LES, to close properly, whichpermits stomach contents to leak back into the esophagus. When stomach contentspass through the LES into the esophagus, stomach acid causes the burningsensation in the chest or throat known as heartburn. Heartburn that occurs morethan twice a week may be GERD. Other symptoms of GERD can include acidindigestion, bad breath, chest pain, hoarseness in the morning, and troubleswallowing. According to the NIDDK, 20% of the US population suffers from GERD.

***GERD Treatments;Target Market***

Treatments for GERDinclude:  antacids designed to neutralizestomach acid, such as Alka-Seltzer, Mylanta and Rolaids, among others; foamingagents, such as Gaviscon, that cover stomach contents with foam in order toprevent reflux; H2 blockers, such as cimetidine (Tagamet HB),famotidine (Pepcid AC) and ranitidine (Zantac), among others; proton pumpinhibitors, or PPIs, such as omeprazole (Prilosec), lansoprazole (Prevacid),and esomperzole (Nexium), among others; and drugs known as prokinetics that aredesigned to strengthen the LES and accelerate stomach emptying. GERD treatmentsare often taken in combination.

The US market for GERDtreatment was in excess of $13 billion in 2006, according to IMS Health,Inc., a pharmaceutical market research firm.

***Clinical Program***

In 2006, we conducted aPhase 1 GERD study designed to provide us with insight into ourformulation strategy for our GERD program. We are now conducting Phase 2aproof-of-concept GERD studies designed to assess the safety and efficacy of theactive compound in our formulation. We expect to complete these studies in thesecond quarter of 2007. Depending on those results, and interest in the projectfrom potential collaborative partners, we may proceed with a Phase 2 GERDstudy.

**OTHER RESEARCH AND DEVELOPMENT AND COLLABORATIVEPROGRAMS**

*New River.*   InJune 2005, we entered into a development and license agreement with NewRiver Pharmaceuticals Inc. to develop through the feasibility phase up to threeproprietary New River compounds in combination with our AcuForm technology.Pursuant to the agreement, New River will fund research and development underthe agreement, and New River may acquire worldwide rights to use our AcuForm technologyin the product candidates for agreed-upon milestone payments and royalties. NewRiver has proposed three product candidates for development, though we areawaiting further information from New River related to the proposed productcandidates.****The acquisition of New River byShire Pharmaceuticals, Inc. is pending. We do not know whether theacquisition may impact our arrangement with New River.

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*Supernus.*   InSeptember 2006, we entered into a collaboration agreement with SupernusPharmaceuticals, Inc. to develop through a Phase 1 study a productcandidate leveraging our AcuForm drug delivery technology. The cost andownership of the program will be shared between the parties equally. Thecollaboration agreement includes provisions pursuant to which the parties maynegotiate and enter into a definitive agreement for the further development andfor commercialization, by either or both parties, of the product candidate.

*Patheon.*   InAugust 2006, we entered into a collaboration agreement with Patheon, Inc.,or Patheon, related to our proprietary AcuForm drug delivery technology. Underthe agreement, we have granted Patheon access to our AcuForm drug deliverytechnology for the purpose of formulating, developing and improvingpharmaceutical products outside of our own internal programs for Patheon’sclients and collaborative partners. A joint committee with representatives fromDepomed and Patheon will review compounds prior to initiating work to ensurethere are no conflicts with our own internal programs. Patheon will assumeprimary responsibility for initial feasibility work with technical assistancefrom us. For product candidates that advance beyond feasibility, Depomed,Patheon and any third party will negotiate a license agreement, and Depomed andPatheon would share any license fees, milestone payments and royalties.

*Biovail.*   InFebruary 2007, we entered into a license and development agreement withBiovail granting Biovail an option to license our AcuForm drug deliverytechnology to develop and commercialize up to two pharmaceutical products.Pursuant to the agreement, Biovail paid us an upfront fee of $500,000 in February 2007,and is contingently obligated to pay us additional fees related to the exerciseof the license option, the initiation of the first Phase 3 trial for eachproduct and upon receipt of U.S. regulatory approval for each product.  The agreement also stipulates that Biovailmake royalty payments to us on net commercial sales of any product developedunder the agreement.

Also in February 2007,we amended our stock purchase agreement with Biovail, which was originallyentered into in May 2002. The amended stock purchase agreement removedBiovail’s observer rights on the Company’s board of directors and removed theright of first negotiation in favor of Biovail with respect to any acquisitiontransactions of the Company.

**RESEARCH AND DEVELOPMENT EXPENSES**

Our research anddevelopment expenses were $26.9 million in 2006, $18.4 million in 2005, and$21.4 million in 2004.

**OUR DRUG DELIVERY TECHNOLOGIES**

The AcuForm technologyis based on our proprietary oral drug delivery technologies and is designed toinclude formulations of drug-containing polymeric tablets that allow multi-hourdelivery of an incorporated drug. Although our formulations are proprietary,the polymers utilized in the AcuForm technology are commonly used in thefood and drug industries and are included in the list of inert substancesapproved by the FDA for use in oral pharmaceuticals. By using differentformulations of the polymers, we believe that the AcuForm technology isable to provide continuous, controlled delivery of drugs of varying molecularcomplexity and solubility. With the use of different polymers and polymers ofvarying molecular weight, our AcuForm tablet technology can deliver drugsby diffusion, tablet erosion, or from a bi-layer matrix. In addition, ourtechnology allows for the delivery of more than one drug from a single tablet. Iftaken with a meal, these polymeric tablets remain in the stomach for anextended period of time to provide continuous, controlled delivery of anincorporated drug.

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The AcuForm technology’s design is based in parton principles of human gastric emptying and gastrointestinal transit. Followinga meal, liquids and small particles flow continuously from the stomach into theintestine, leaving behind the larger undigested particles until the digestiveprocess is complete. As a result, drugs in liquid or dissolved form or thoseconsisting of small particles tend to empty rapidly from the stomach andcontinue into the small intestine and on into the large intestine, often beforethe drug has time to act locally or to be absorbed in the stomach and/or uppersmall intestine. The drug-containing polymeric tablets of theAcuForm technology are formulated into easily swallowed shapes and aredesigned to swell upon ingestion. The tablets attain a size after ingestionsufficient to be retained in the stomach for multiple hours during thedigestive process while delivering the drug content at a controlled rate. Afterdrug delivery is complete, the polymeric tablet dissolves and becomes a waterygel, which is safely eliminated through the intestine sight unseen.

The following graphicdemonstrates the operation of the AcuForm technology.

****

The AcuForm technology is designed to addresscertain limitations of drug delivery and to provide for orally-administered,conveniently-dosed, cost-effective drug therapy that provides continuous,controlled-delivery of a drug over a multi-hour period. We believe that the AcuForm technologycan provide one or more of the following advantages over conventional methodsof drug administration:

·       *Greater Patient and Caregiver Convenience*.   We believethat the AcuForm technology may offer once-daily or reduced frequencydosing for certain drugs that are currently required to be administered severaltimes daily. Such less frequent dosing promotes compliance with dosingregimens. Patient noncompliance with dosing regimens has been associated withincreased costs of medical therapies by prolonging treatment duration,increasing the likelihood of secondary or tertiary disease manifestation andcontributing to over-utilization of medical personnel and facilities. Byimproving patient compliance, providers and third-party payors may reduceunnecessary expenditures and improve therapeutic outcomes.

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·       *Enhanced Safety and Efficacy through Controlled Delivery*.   Webelieve that the AcuForm technology may improve the ratio of therapeuticeffect to toxicity by decreasing the initial peak concentrations of a drugassociated with toxicity, while maintaining levels of the drug at therapeutic,subtoxic concentrations for an extended period of time. Many drugs demonstrateoptimal efficacy when concentrations are maintained at therapeutic levels overan extended period of time. When a drug is administered intermittently, thetherapeutic concentration is often exceeded for some period after whichconcentrations fall below therapeutic levels. Excessively high concentrationsare a major cause of side effects and subtherapeutic concentrations areineffective.

·       *Proprietary Reformulation of Generic Products.*   Webelieve that the AcuForm technology may offer the potential to produceimproved formulations of off-patent drugs. These proprietary formulations maybe differentiated from existing generic products by virtue of reduced dosingrequirements, improved efficacy, decreased toxicity or additional indications.

·       *More Efficient Gastrointestinal Drug Absorption*.   Webelieve that the AcuForm technology can be used for improved oraladministration of drugs that are inadequately absorbed when delivered asconventional tablets or capsules. Many drugs are primarily absorbed in thestomach, duodenum or upper small intestine regions, through which drugs administeredin conventional oral dosage forms transit quickly. In contrast, the AcuForm technologyis designed to be retained in the stomach, allowing for constant multi-hourflow of drugs to these regions of the gastrointestinal tract. Accordingly, forsuch drugs, we believe that the AcuForm technology offers a significantlyenhanced opportunity for increased absorption. Unlike some insoluble drugdelivery systems, the polymer comprising the AcuForm technology dissolvesat the end of its useful life and is passed through the gastrointestinal tractand eliminated.

·       *Gastric Delivery for Local Therapy and Absorption*.   Webelieve that the AcuForm technology can be used to deliver drugs which canefficiently eradicate gastrointestinal-dwelling microorganisms, such as *H. pylori*, the bacterium which is a cause of mostpeptic ulcers.

·       *RationalDrug Combinations*.   We believe that the AcuForm technologymay allow for rational combinations of drugs with different biologicalhalf-lives. Physicians frequently prescribe multiple drugs for treatment of asingle medical condition. Single product combinations have not been consideredfeasible because the different biological half-lives of these combination drugswould result in an overdosage of one drug and/or an underdosage of the other.By appropriately incorporating different drugs into a AcuForm technologywe believe that we can provide for the release of each incorporated drugcontinuously at a rate and duration (dose) appropriately adjusted for thespecific biological half-lives of the drugs. We believe that future rationaldrug combination products using the AcuForm technology have the potentialto simplify drug administration, increase patient compliance, and reducemedical costs.

**COMPETITION**

*GLUMETZA.*   GLUMETZAcompetes against immediate release metformin, which is marketed primarily bygeneric manufacturers. GLUMETZA also competes against both branded and genericextended-release versions of metformin, such as Bristol-Myers Squibb’sGlucophage XR and Sciele Pharma’s Fortamet. Generic extended-releasemetformin manufacturers include Barr Pharmaceuticals, Inc., ANDRXCorporation, Mylan Laboratories, Inc. and Teva Pharmaceutical Industries,Ltd., among others.

GLUMETZA also competes against oral type 2 diabetesmedications other than metformin, such as Takeda’s Actos (pioglitazonehydrochloride), GlaxoSmithKline’s Avandia (risiglitazon), Pfizer’s Glucotrol(sulfonylurea) and Merck’s Januvia (sitagliptin), among others.

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*ProQuinXR.*   ProQuin XR competes against Cipro XR, aonce-daily ciprofloxacin product for the treatment of urinary tract infectionsthat is marketed by Schering-Plough Corporation. ProQuin XR also competesagainst immediate release ciprofloxacin, which is marketed primarily by genericmanufacturers. We believe that one or more generic versions of Cipro XR mayenter the market in 2007, though we are not currently aware of any.

*GabapentinGR for Neuropathic Pain.*   Gabapentin is currentlymarketed by Pfizer as Neurontin and by several generic manufacturers foradjunctive therapy for epileptic seizures and for postherpetic pain. Inaddition, Pfizer has developed a new product, LyricaTM (pregabalin), which hasbeen approved for marketing in the United States and the European Union for thetreatment of postherpetic neuralgia, diabetic neuropathy and partial seizures.

If approved, Gabapentin GR will compete against otherneuropathic pain treatments, such as anti-depressants, other anti-convulsants,local anesthetics used as regional nerve blockers, anti-arrythmics and opiods. Weare also aware of at least one company that is developing a prodrug ofgabapentin for the neuropathic pain market. To our knowledge, we are the onlycompany currently in clinical trials with a sustained release formulation ofgabapentin for the United States market.

*GabapentinGR for Menopausal Hot Flashes.*   If approved,Gabapentin GR for hot flashes will compete against HRT, such as WyethPharmaceuticals’ Premarin (estrogens) and Prempro (a combination of estrogensand a progestin) products, and anti-depressant medications prescribedoff-label. Wyeth’s anti-depressant drug candidate, Prestiq, is inpre-registration for treatment of hot flashes. We are aware that Pfizer hasnon-exclusively licensed from the University of Rochester rights to develop ahot flash product containing pregablin under the same patent we havesublicensed exclusive rights to develop a menopausal hot flash productcontaining gabapentin. Accordingly, Pfizer may develop a competing hot flashproduct.

*GERD.*   AnyGERD product we develop will compete against the antacids, foaming agents, H2 blockers, proton pump inhibitors andprokinetics described above under “***GERD Treatments; TargetMarket***”.

*DrugDelivery Technologies.*   Other companies that haveoral drug delivery technologies competitive with the AcuForm technologyinclude Bristol-Myers Squibb, IVAX Corporation (a subsidiary of TevaPharmaceutical Industries, Ltd.), ALZA Corporation (a subsidiary of Johnson &Johnson), SkyePharma plc, Biovail Corporation, Flamel Technologies S.A.,Ranbaxy Laboratories, Ltd., Kos Pharmaceuticals, Inc., Intec Pharma andAlpharma, Inc., all of which develop oral tablet products designed torelease the incorporated drugs over time. Each of these companies has patentedtechnologies with attributes different from ours, and in some cases withdifferent sites of delivery to the gastrointestinal tract.

*General.*   Webelieve that we compete favorably in the markets described above on the basisof the safety and efficacy of our products and product candidates, and, in somecases, on the basis of the price of our products. However, competition inpharmaceutical products and drug delivery technologies is intense, and weexpect competition to increase. There may be other companies developingproducts competitive with ours of which we are unaware. Competing product ortechnologies developed in the future may prove superior to our products ortechnologies, either generally or in particular market segments. Thesedevelopments could make our products or technologies noncompetitive orobsolete.

Most of our principalcompetitors have substantially greater financial, sales, marketing, personneland research and development resources than we do. In addition, many of ourpotential collaborative partners have devoted, and continue to devote,significant resources to the development of their own products and drugdelivery technologies.

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**PATENTS ANDPROPRIETARY RIGHTS**

Our success will depend in part on our ability toobtain and maintain patent protection for our technologies and to preserve ourtrade secrets. Our policy is to seek to protect our proprietary rights, byamong other methods, filing patent applications in the United States andforeign jurisdictions to cover certain aspects of our technology. We currentlyhold nine issued patents, and have seventeen patent applications pending in theUnited States. In addition, we are preparing patent applications relating toour expanding technology for filing in the United States and abroad. We havealso applied for patents in numerous foreign countries. Some of those countrieshave granted our applications and other applications are still pending. Ourpending patent applications may lack priority over others’ applications or maynot result in the issuance of patents. Even if issued, our patents may not besufficiently broad to provide protection against competitors with similartechnologies and may be challenged, invalidated or circumvented, which couldlimit our ability to stop competitors from marketing related products or maynot provide us with competitive advantages against competing products.

We also rely on trade secrets and proprietaryknow-how, which are difficult to protect. We seek to protect such information,in part, through entering into confidentiality agreements with employees,consultants, collaborative partners and others before such persons or entitieshave access to our proprietary trade secrets and know-how. Theseconfidentiality agreements may not be effective in certain cases, due to, amongother things, the lack of an adequate remedy for breach of an agreement or afinding that an agreement is unenforceable. In addition, our trade secrets mayotherwise become known or be independently developed by competitors.

Our ability to develop our technologies and to makecommercial sales of products using our technologies also depends on notinfringing others’ patents or other intellectual property rights. We are notaware of any intellectual property claims against us. However, the pharmaceuticalindustry has experienced extensive litigation regarding patents and otherintellectual property rights. For example, Pfizer initiated several lawsuitsagainst companies marketing generic gabapentin products, claiming that theseproducts infringe Pfizer’s patents. The results of this litigation couldadversely impact the commercialization of any gabapentin product.****Also, we are awarethat patents issued to third parties relating to sustained release drugformulations or particular pharmaceutical compounds could in the future beasserted against us, although we believe that we do not infringe any validclaim of any patents. If claims concerning any of our products were to ariseand it was determined that these products infringe a third party’s proprietaryrights, we could be subject to substantial damages for past infringement or beforced to stop or delay our activities with respect to any infringing product,unless we can obtain a license, or we may have to redesign our product so thatit does not infringe upon others’ patent rights, which may not be possible orcould require substantial funds or time. Such a license may not be available onacceptable terms, or at all. Even if we, our collaborators or our licensorswere able to obtain a license, the rights may be nonexclusive, which would giveour competitors access to the same intellectual property. In addition, anypublic announcements related to litigation or interference proceedingsinitiated or threatened against us, even if such claims are without merit,could cause our stock price to decline.

From time to time, we may become aware of activitiesby third parties that may infringe our patents. Infringement by others of ourpatents may reduce our market shares (if a related product is approved) and,consequently, our potential future revenues and adversely affect our patentrights if we do not take appropriate enforcement action. We may need to engagein litigation in the future to enforce any patents issued or licensed to us orto determine the scope and validity of third-party proprietary rights. Ourissued or licensed patents may not be held valid by a court of competentjurisdiction. Whether or not the outcome of litigation is favorable to us,defending a lawsuit takes significant time, may be expensive and may divertmanagement attention from other business concerns. We may also be required toparticipate in interference proceedings declared by the United States Patentand Trademark Office for the purpose of determining the priority of inventions inconnection with our patent applications or other parties’ patent 

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applications. Adversedeterminations in litigation or interference proceedings could require us toseek licenses which may not be available on commercially reasonable terms, orat all, or subject us to significant liabilities to third parties. If we needbut cannot obtain a license, we may be prevented from marketing the affectedproduct.

InJanuary 2006, we filed a complaint against IVAX Corporation in federalcourt for infringement of two of our U.S. patents related to the AcuForm deliverytechnology. The complaint alleges infringement of our patents by IVAX’sextended release metformin hydrochloride tablet. Although we intend tovigorously enforce our intellectual property rights, there can be no assurancethat we will be successful in our litigation against IVAX.

**MANUFACTURING**

We have established internal manufacturing facilitiesthat are in compliance with current good manufacturing practices, tomanufacture supplies for our Phase 1 and Phase 2 clinical trials.

We are responsible for the supply and distribution ofGLUMETZA. In 2006, we transferred the manufacturing of the 500mg GLUMETZA fromBiovail to MOVA Pharmaceuticals, a subsidiary of Patheon, Inc. and oursole supplier of GLUMETZA 500mg tablets. In December 2006, we entered intoa manufacturing agreement with MOVA Pharmaceuticals related to the 500mgGLUMETZA. Farmhispania, S.A. is a sole supplier to us for the activepharmaceutical ingredient in GLUMETZA. We obtain the active pharmaceuticalingredient to GLUMETZA on a purchase order basis only. If the new formulationof 1000mg GLUMETZA is approved, we will rely on Biovail as our sole supplier.

We are also responsible for supplying commercialquantities of ProQuin XR to Esprit, and we will be responsible for supplyingbulk ProQuin XR tablets to Madaus upon any approval in Europe. For themanufacture of ProQuin XR tablets, we have entered into an agreement with MOVAPharmaceuticals, as our sole supplier. Uquifa Mexico, S.A., our supplier of theactive pharmaceutical ingredient to ProQuin XR, is also a sole supplier to us.We obtain the active pharmaceutical ingredient to ProQuin XR on a purchaseorder basis only.

We have obtained active pharmaceutical ingredient andPhase 3 clinical batches of Gabapentin GR from contract manufacturers on apurchase order basis. We currently have no long-term supply arrangement withrespect to Gabapentin GR.

We do not have, and we do not intend to establish inthe foreseeable future, internal commercial scale manufacturing capabilities.Rather, we intend to use the facilities of third parties to manufactureproducts for Phase 3 clinical trials and commercialization. Our dependenceon third parties for the manufacture of products using the AcuForm technologymay adversely affect our ability to deliver such products on a timely orcompetitive basis. The manufacturing processes of our third party manufacturersmay be found to violate the proprietary rights of others. If we are unable tocontract for a sufficient supply of required products on acceptable terms, orif we encounter delays and difficulties in our relationships withmanufacturers, the market introduction and commercial sales of our productswill be delayed, and our future revenue will suffer.

Applicable current GoodManufacturing Practices (cGMP) requirements and other rules andregulations prescribed by foreign regulatory authorities will apply to themanufacture of products using the AcuForm technology. We will depend onthe manufacturers of products using the AcuForm technology to comply withcGMP and applicable foreign standards. Any failure by a manufacturer ofproducts using the AcuForm technology to maintain cGMP or comply withapplicable foreign standards could delay or prevent the initial or continuedcommercial sale of our products.

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**MARKETING AND SALES**

In 2004, we announced our determination to evolve froma solely product development focused company to an integrated specialtypharmaceutical company, with sales and marketing of our own products.Preliminary staffing for these activities began in 2005. In 2006, we enhancedour internal sales and marketing capabilities through the hiring of additionalsales and marketing employees and the engagement of consultants. We anticipatethe build-up of our commercial infrastructure will continue over the nextseveral years.

In 2006, our commercial organization implementeddistribution arrangements for GLUMETZA, developed and oversaw the launch ofGLUMETZA in September 2006, and is involved in all aspects of thecommercialization of GLUMETZA. Our sales and marketing personnel are alsoengaged in preparation for the potential launch of Gabapentin GR, andcommercial and marketing assessments of existing and potential productcandidates.

All marketing activitiesassociated with GLUMETZA and ProQuin XR, as well as marketing activitiesrelated to any other products for which we obtain regulatory approval, will besubject to numerous federal and state laws governing the marketing and promotionof pharmaceutical products. The FDA regulates post-approval promotionallabeling and advertising to ensure that they conform with statutory andregulatory requirements. In addition to FDA restrictions, the marketing ofprescription drugs is subject to laws and regulations prohibiting fraud andabuse under government healthcare programs. For example, the federal healthcareprogram antikickback statute prohibits giving things of value to induce theprescribing or purchase of products that are reimbursed by federal healthcareprograms, such as Medicare and Medicaid. In addition, federal false claims lawsprohibit any person from knowingly presenting, or causing to be presented, afalse claim for payment to the federal government. Under this law, the federalgovernment in recent years has brought claims against drug manufacturersalleging that certain marketing activities caused false claims for prescriptiondrugs to be submitted to federal programs. Many states have similar statutes orregulations, which apply to items and services reimbursed under Medicaid andother state programs, or, in some states, regardless of the payer. If we, orour collaborative partners, fail to comply with applicable FDA regulations orother laws or regulations relating to the marketing of our products, we couldbe subject to criminal prosecution, civil penalties, seizure of products,injunction, exclusion of our products from reimbursement under governmentprograms, as well as other regulatory actions against our product candidates, ourcollaborative partners or us.

**GOVERNMENTREGULATION**

Numerous governmental authorities in the United Statesand other countries regulate our research and development activities and thoseof our collaborative partners. Governmental approval is required of allpotential pharmaceutical products using the AcuForm technology and themanufacture and marketing of products using the AcuForm technology priorto the commercial use of those products. The regulatory process takes severalyears and requires substantial funds. If new products using theAcuForm technology do not receive the required regulatory approvals or ifsuch approvals are delayed, our business would be materially adverselyaffected. There can be no assurance that the requisite regulatory approvalswill be obtained without lengthy delays, if at all.

In the United States, the FDA rigorously regulatespharmaceutical products, including any drugs using the AcuForm technology.If a company fails to comply with applicable requirements, the FDA or the courtsmay impose sanctions. These sanctions may include civil penalties, criminalprosecution of the company or its officers and employees, injunctions, productseizure or detention, product recalls and total or partial suspension ofproduction. The FDA may withdraw approved applications or refuse to approvepending new drug applications, premarket approval applications, or supplementsto approved applications.

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We generally must conduct preclinical testing onlaboratory animals of new pharmaceutical products prior to commencement ofclinical studies involving human beings. These studies evaluate the potentialefficacy and safety of the product. We then submit the results of these studiesto the FDA as part of an Investigational New Drug application, which mustbecome effective before beginning clinical testing in humans.

Typically, humanclinical evaluation involves a time-consuming and costly three-phase process:

·       InPhase 1, we conduct clinical trials with a small number of subjects todetermine a drug’s early safety profile and its pharmacokinetic pattern.

·       InPhase 2, we conduct limited clinical trials with groups of patientsafflicted with a specific disease in order to determine preliminary efficacy,optimal dosages and further evidence of safety.

·       InPhase 3, we conduct large-scale, multi-center, comparative trials withpatients afflicted with a target disease in order to provide enough data todemonstrate the efficacy and safety required by the FDA prior tocommercialization.

The FDA closely monitors the progress of each phase ofclinical testing. The FDA may, at its discretion, re-evaluate, alter, suspendor terminate testing based upon the data accumulated to that point and the FDA’sassessment of the risk/benefit ratio to patients. The FDA may also requireadditional clinical trials after approval, which are known as Phase 4trials.

The results of the preclinical and clinical testingare submitted to the FDA in the form of a New Drug Application, or NDA, forapproval prior to commercialization. An NDA requires that our products arecompliant with cGMP. Failure to achieve or maintain cGMP standards for productsusing the AcuForm technology would adversely impact their marketability.In responding to an NDA, the FDA may grant marketing approval, requestadditional information or deny the application. Failure to receive approval forany products using the AcuForm technology would have a material adverseeffect on the Company.

The FDA regulatesnot only prescription and over-the-counter drugs approved by NDAs, but alsoover-the-counter products that comply with monographs issued by the FDA. Theseregulations include:

·       cGMPrequirements;

·       generaland specific over-the-counter labeling requirements (including warningstatements);

·       advertisingrestrictions; and

·       requirementsregarding the safety and suitability of inactive ingredients.

In addition, the FDA may inspect over-the-counterproducts and manufacturing facilities. A failure to comply with applicableregulatory requirements may lead to administrative or judicially imposedpenalties. If an over-the-counter product differs from the terms of amonograph, it will, in most cases, require FDA approval of an NDA for theproduct to be marketed.

Foreign regulatoryapproval of a product must also be obtained prior to marketing the productinternationally. Foreign approval procedures vary from country to country. Thetime required for approval may delay or prevent marketing in certain countries.In certain instances we or our collaborative partners may seek approval tomarket and sell certain products outside of the United States before submittingan application for United States approval to the FDA. The clinical testingrequirements and the time required to obtain foreign regulatory approvals maydiffer from that required for FDA approval. Although there is now a centralizedEuropean Union (EU) approval mechanism in place, each EU country maynonetheless impose its own procedures and requirements. Many of theseprocedures and requirements are time-consuming and expensive. Some EU countriesrequire price approval as part of the regulatory process. 

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Theseconstraints can cause substantial delays in obtaining required approval fromboth the FDA and foreign regulatory authorities after the relevant applicationsare filed, and approval in any single country may not meaningfully indicatethat another country will approve the product.

**PRODUCT LIABILITY**

Our businessinvolves exposure to potential product liability risks that are inherent in theproduction and manufacture of pharmaceutical products. We have obtained productliability insurance for clinical trials currently underway and forecasted 2007sales of our products, but:

·       wemay be unable to obtain product liability insurance for future trials;

·       wemay be unable to obtain product liability insurance for future products;

·       wemay be unable to maintain product liability insurance on acceptable terms;

·       wemay be unable to secure increased coverage as the commercialization of the AcuForm technologyproceeds; or

·       ourinsurance may not provide adequate protection against potential liabilities.

Our inability to obtainadequate insurance coverage at an acceptable cost could prevent or inhibit thecommercialization of our products. Defending a lawsuit would be costly andsignificantly divert management’s attention from conducting our business. Ifthird parties were to bring a successful product liability claim or series ofclaims against us for uninsured liabilities or in excess of insured liabilitylimits, our business, financial condition and results of operations could bematerially harmed.

**EMPLOYEES**

As of December 31, 2006, we had 105 full-timeemployees. None of our employees is represented by a collective bargainingagreement, nor have we experienced any work stoppage. We believe that ourrelations with our employees are good.

Oursuccess is dependent in large part upon the continued services of JohnW. Fara, Ph.D., our Chairman, President and Chief Executive Officer, Carl A.Pelzel, our Executive Vice President and Chief Operating Officer, and othermembers of our executive management team, and on our ability to attract andretain key management and operating personnel. We do not have agreements with Dr. Fara,Mr. Pelzel or any of our other executive officers that provide for theircontinued employment with us. Management, scientific and operating personnelare in high demand in our industry and are often subject to competing offers.The loss of the services of one or more members of management or key employeesor the inability to hire additional personnel as needed could result in delaysin the research, development and commercialization of our products andpotential product candidates.

**ITEM 1A.**        RISKFACTORS

In addition to otherinformation in this report, the following factors should be consideredcarefully in evaluating an investment in our securities. We believe thefollowing risks and uncertainties, along with the risks and uncertaintiesdescribed elsewhere in this Form 10-K, including those describedabove under “**BUSINESS—Competition,—Patentsand Proprietary Rights,—Manufacturing,—Marketing and Sales,—GovernmentRegulation,—Product Liability,—Employees**” and under “**MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS—Liquidity and Capital Resources”** are the materialrisks and uncertainties we face at the present time. If any of the risks oruncertainties described in this Form 10-K actually occurs, ourbusiness, results of operations or financial condition could be materiallyadversely affected. The risks and uncertainties described in this Form 10-Kare not the only ones facing the Company. Additional risks and uncertainties 

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of whichwe are unaware or currently deem immaterial may also become important factorsthat may harm our business.

**We depend heavily on King Pharmaceuticals for thesuccessful commercialization of GLUMETZA in the United States.**

In June 2006,we entered into a promotion agreement with King Pharmaceuticals pursuant towhich King promotes GLUMETZA in the United States through its sales force. Underthe agreement, in exchange for promotion fees, King is required to promoteGLUMETZA to physicians in the United States, to deliver a minimum number ofannual detail calls to potential GLUMETZA prescribers, and to maintain a salesforce of a minimum size. Although we have retained rights to promote GLUMETZAto certain physicians and to retain revenues from incremental sales generated byphysicians we call upon, we have not yet established a sales force, orcontracted with a third party to act as our sales force, and we do not haveimmediate plans to do so. Accordingly, the success of the initialcommercialization of GLUMETZA will depend in large part on the efforts of King’ssales force in the promotion of the product. Factors that may affect thesuccess of our promotion arrangement with King include the following:

·       Kingmay acquire or develop alternative products;

·       Kingmay pursue higher-priority programs, or change the focus of its marketingprograms;

·       Kingmay in the future choose to devote fewer resources to GLUMETZA;

·       GLUMETZAmay fail to achieve market acceptance; and

·       Kingmay fail to comply with its obligations under our promotion agreement.

Any of the precedingfactors could affect King’s commitment to the collaboration, which, in turn,could adversely affect the commercial success of GLUMETZA. Any failure tosuccessfully commercialize GLUMETZA could have a material adverse effect on ourbusiness, financial conditions, results of operations and cash flows.

**We are responsible for the distribution of GLUMETZA,and we have limited experience with distribution of pharmaceutical products.**

We are responsible for thedistribution of GLUMETZA, which is the first product that we have distributedourselves. Although we have enhanced our in-house commercial operations anddistribution capabilities in connection with the commercial launch of GLUMETZA,our internal resources remain limited. In addition, we have entered intodistribution arrangements with third parties related to GLUMETZA, includingCardinal Health, AmeriSource Bergen and McKesson, and we will depend on them toensure that GLUMETZA is widely available to support its commercial availability.To continue to support our commercialization effort related to GLUMETZA and anyother product we choose to market and distribute, we must continue to enhanceour internal commercial infrastructure, and continue to contract with capablethird parties to assist us in our commercialization efforts. The development ofthat infrastructure will also require substantial resources, whichmay divert the attention of our management and key personnel. The effortsof third parties with whom we contract for distribution of our productsmay not be successful. Any failure on our part to successfully developdistribution capabilities could cause delays in product sales and incurincreased costs.

**We have limited in-house sales and marketingresources, which we will require in order to successfully co-promote GLUMETZAand ProQuin XR through our own sales force.**

Although we have the rightto co-promote GLUMETZA and ProQuin XR through our own sales force, or throughthird parties, we have no sales force and limited marketing and sales staff. Thesuccess of 

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our ownpromotion efforts for GLUMETZA, ProQuin XR and any other product candidatesthat receive regulatory approval that we choose to market or co-market willrequire that we substantially enhance our in-house marketing and sales forcewith technical expertise, or make arrangements with third parties toperform these services for us. The development of the infrastructureassociated with these activities involves substantial resources, andconsiderable attention of our management and key personnel. To the extent thatwe enter into marketing and sales arrangements with other companies, ourrevenues will depend on the efforts of others. These efforts may not besuccessful. If we fail to fully develop marketing and sales capabilities, orenter into arrangements with third parties, our revenues may suffer.

**We depend on EspritPharma for the successful commercialization of ProQuin XR in the United States.**

Esprit has exclusive marketing rights to ProQuin XR inthe United States. Esprit launched ProQuin XR in November 2005. In July 2006,we agreed to extend to December 2006 the due date on the $10 millionlicense fee payment to Depomed that had been due in July 2006. In December 2006,we did not receive the license fee payment on its due date, and we initiatedarbitration proceedings related to alleged breaches by Esprit of our licenseagreement with Esprit. Later in December 2006, Esprit paid us the $10million license fee payment and we withdrew without prejudice the notice anddemand for arbitration. We also agreed to commence, in January 2007,discussions with Esprit toward a mutually agreeable, long-term restructuring ofthe license agreement. Those discussions began in January 2007 and arecontinuing. The result of those discussions is uncertain, and we may not beable to negotiate mutually agreeable modifications to the license agreement.

Esprit is a private company with a limited operatinghistory and has not yet established a proven track record of successfullycommercializing its products. In addition, Esprit has limited financialresources relative to many other pharmaceutical companies. Any financialdifficulties experienced by Esprit, or complications in the promotion ofProQuin XR or Esprit’s other products, or execution of its business plan,may adversely affect the ProQuin XR commercialization effort and Esprit’sability to comply with its obligations to us under our license agreement.

If Esprit fails tosuccessfully commercialize ProQuin XR, or to comply with its obligations underour license agreement, including its future license fee and minimum royaltyobligations, our business, financial condition and results of operations may bematerially and adversely affected.

**We depend on our marketing partners for the successfulcommercialization of GLUMETZA in Canada and Korea, and of ProQuin XR in Europe.**

We have licensed exclusivemarketing rights to the 500mg GLUMETZA in Canada to Biovail, and in Korea to LGLife Sciences. Biovail launched the 500mg GLUMETZA in Canada in November 2005,and LG launched the 500mg GLUMETZA in Korea in 2006 under the trade nameNovamet GR. We have also entered into a supply and distribution agreement withMadaus related to the commercialization of ProQuin XR in Europe. If Biovail orLG fails to successfully commercialize GLUMETZA in Canada, our business andfuture revenues may be adversely affected.

**Our product candidates are at early stages ofdevelopment and may not be successful or achieve market acceptance.**

We have completedenrollment of a Phase 3 clinical trial of Gabapentin GR for the treatmentof postherpetic neuralgia, and we have completed a Phase 2 trial ofGabapentin GR for diabetic neuropathy. In 2007, we expect to initiate aclinical development program for Gabapentin GR for the treatment of hot flashesassociated with menopause, and to advance the clinical development program ofour gastroesophageal reflux disease product candidate. In addition, we expectto submit before the end of the first quarter of 2007 a supplemental NDA filingfor the new 1000mg formulation of GLUMETZA for 

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which wehave an exclusive license in the United States. We have other productcandidates in earlier stages of development. Our own product candidates andthose of our collaborative partners are subject to the risk that any or all ofthem are found to be ineffective or unsafe, or otherwise may fail toreceive necessary regulatory clearances. We are unable to predict whether anyof these other product candidates will receive regulatory clearances or besuccessfully manufactured or marketed. Further, due to the extended testing andregulatory review process required before marketing clearance can be obtained,the time frames for commercialization of any products are long and uncertain. Evenif these other product candidates receive regulatory clearance, our productsmay not achieve or maintain market acceptance. Also, substantially all ofour product candidates, other than the 1000mg formulation of GLUMETZA, use theAcuForm technology. If it is discovered that the AcuForm technologycould have adverse effects or other characteristics that indicate it isunlikely to be effective as a delivery system for drugs or therapeutics, ourproduct development efforts and our business would be significantly harmed.

**We are expectingoperating losses in the future.**

To date, we have hadlimited revenues from license fees, product sales, royalties, collaborativeresearch and development arrangements and feasibility studies. For the yearended December 31, 2006, we had total revenues of $9.6 million and for theyears ended December 31, 2005 and 2004, we had total revenues of $4.4million and $200,000, respectively. For the year ended December 31, 2006,we incurred net losses of $39.7 million and for the years ended December 31,2005 and 2004, we incurred net losses of $24.5 million and $26.9 million,respectively. As we incur increasing expenses related to the commercializationof GLUMETZA, continue our research and development efforts, preclinical testingand clinical trial activities, and expand our sales and marketing organization,we anticipate that we will continue to incur substantial operating losses forat least the next year. Therefore, we expect our cumulative losses to increase.These losses, among other things, have had, and we expect that they willcontinue to have, an adverse impact on our total assets, shareholders’ equityand working capital.

**Our operating resultsmay fluctuate and affect our stock price.**

The followingfactors will affect our operating results and may result in a material adverseeffect on our stock price:

·       thedegree of commercial success of GLUMETZA and ProQuin XR;

·       ourcollaborative partners’ compliance or non-compliance with their obligationsunder our agreements with them;

·       resultsof clinical trials for our product candidates;

·       regulatoryactions;

·       resultsof litigation, including our pending litigation against IVAX Corporation;

·       developmentsconcerning proprietary rights, including patents, infringement allegations andlitigation matters;

·       variationsin revenues obtained from collaborative agreements, including milestonepayments, royalties, license fees and other contract revenues;

·       decisionsby collaborative partners to proceed or not to proceed with subsequent phasesof a collaboration or program;

·       marketacceptance of the AcuForm technology;

·       adoptionof new technologies by us or our competitors;

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·       theintroduction of new products by our competitors;

·       manufacturingcosts and difficulties;

·       changesin government funding;

·       third-partyreimbursement policies; and

·       the status of ourcompliance with the provisions of the Sarbanes-Oxley Act of 2002.

**Our collaborative arrangements may give rise todisputes over commercial terms, contract interpretation and ownership of ourintellectual property and may adversely affect the commercial success ofour products.**

We currently have a collaboration agreement fordevelopment of product candidates through the feasibility phase with New RiverPharmaceuticals, and we have a collaboration arrangement with Patheon, Inc.related to the potential development of product candidates for third parties. Wealso have a collaboration agreement with Supernus, Inc. providing for thedevelopment of a product candidate through feasibility, with the possibility toenter into a definitive agreement providing for the further development of theproduct candidate, by either or both parties. In addition, we have in the pastand may in the future enter into other collaborative arrangements, some ofwhich have been based on less definitive agreements, such as memoranda ofunderstanding, material transfer agreements, options or feasibility agreements.We may not execute definitive agreements formalizing these arrangements. Collaborativerelationships are generally complex and may give rise to disputesregarding the relative rights, obligations and revenues of the parties,including the ownership of intellectual property and associated rights andobligations, especially when the applicable collaborative provisions have notbeen fully negotiated and documented. Such disputes can delay collaborativeresearch, development or commercialization of potential products, and can leadto lengthy, expensive litigation or arbitration. The terms of collaborativearrangements may also limit or preclude us from developing products ortechnologies developed pursuant to such collaborations. Additionally, thecollaborators under these arrangements might breach the terms of theirrespective agreements or fail to prevent infringement of the licensed patentsby third parties. Moreover, negotiating collaborative arrangements often takesconsiderably longer to conclude than the parties initially anticipate, whichcould cause us to agree to less favorable agreement terms that delay or deferrecovery of our development costs and reduce the funding available to supportkey programs.

We may beunable to enter into future collaborative arrangements on acceptable terms,which would harm our ability to develop and commercialize our current andpotential future products. Further, even if we do enter into collaborationarrangements, it is possible that our collaborative partners may notchoose to develop and commercialize products using the AcuForm technology.Other factors relating to collaborations that may adversely affect thecommercial success of our products include:

·       anyparallel development by a collaborative partner of competitive technologies orproducts;

·       arrangementswith collaborative partners that limit or preclude us from developing productsor technologies;

·       prematuretermination of a collaboration agreement; or

·       failureby a collaborative partner to devote sufficient resources to the developmentand commercial sales of products using the AcuForm technology.

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Generally, ourcollaborative arrangements do not restrict our collaborative partners fromcompeting with us or restrict their ability to market or sell competitiveproducts. Our current and any future collaborative partners may pursueexisting or other development-stage products or alternative technologies inpreference to those being developed in collaboration with us. Our collaborativepartners may also terminate their collaborative relationships with us orotherwise decide not to proceed with development and commercialization of ourproducts.

**Our licensed patent covering the use of gabapentin totreat hot flashes associated with menopause is a method-of-use patent, whichincreases the risk that prescriptions for gabapentin to treat hot flashes inmenopausal women could be written for, or filled with, generic gabapentin.**

We have an exclusive sublicense from PharmaNova, Inc.to a patent held by the University of Rochester to develop and commercialize inthe United States a gabapentin product for the treatment of hot flashesassociated with menopause in women. Because a method-of-use patent, such as thepatent we have sublicensed from PharmaNova, covers only a specified use of aparticular compound, not a particular composition of matter, we cannot preventothers from commercializing gabapentin. Accordingly, physicians could prescribeanother manufacturer’s gabapentin to treat hot flashes in menopausal womenrather than Gabapentin GR, or pharmacists could seek to fill prescriptions forGabapentin GR with another manufacturer’s gabapentin. Although any such “off-label”use would violate our licensed patent, effectively monitoring compliance withour licensed patent may be difficult and costly.

**It is difficult to develop a successful product. If wedo not develop a successful product we may be unable to raise additional funds.**

The drugdevelopment process is costly, time-consuming and subject to unpredictabledelays and failures. Before we or others make commercial sales of productsusing the AcuForm technology, other than GLUMETZA and ProQuin XR, we, ourcurrent and any future collaborative partners will need to:

·       conductpreclinical and clinical tests showing that these products are safe andeffective; and

·       obtainregulatory approval from the FDA or foreign regulatory authorities.

We will have tocurtail, redirect or eliminate our product development programs if we or ourcollaborative partners find that:

·       ourdrug delivery technology has unintended or undesirable side effects; or

·       productcandidates that appear promising in preclinical or early-stage clinical studiesdo not demonstrate efficacy in later-stage, larger scale clinical trials.

Even when or if ourproducts obtain regulatory approval, successful commercialization requires:

·       marketacceptance;

·       cost-effectivecommercial scale production; and

·       reimbursementunder private or governmental health plans.

Any material delay orfailure in the governmental approval process and/or the commercialization ofour potential products would adversely impact our financial position andliquidity and would make it difficult for us to raise financing on favorableterms, if at all.

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**If we do not achieve our projected development andcommercialization goals in the timeframes we announce and expect, thecommercialization of our product candidates may be delayed and our businesswill be harmed and our stock price may decline.**

For planningpurposes, we estimate the timing of the accomplishment of various scientific,clinical, regulatory and other product development and commercialization goals.These milestones may include our expectations regarding the commercial launchof our products by us or our licensees, and the commencement or completion ofscientific studies and clinical trials and the submission of regulatory filings.From time to time, we may publicly announce the expected timing of some ofthese milestones, such as the completion of our ongoing Phase 3 clinicaltrial of Gabapentin GR, or the submission of the supplemental NDA covering the1000mg formulation of GLUMETZA. All of these milestones are based on a variety ofassumptions. The actual timing of these milestones can vary considerably fromour estimates depending on numerous factors, some of which are beyond ourcontrol, including:

·       ouravailable capital resources;

·       theefforts of our marketing partners with respect to the commercialization of ourproducts;

·       therate of progress, costs and results of our clinical trial and research anddevelopment activities, including the extent of scheduling conflicts withparticipating clinicians and clinical institutions and our ability to identifyand enroll patients who meet clinical trial eligibility criteria;

·       ourreceipt of approvals by the FDA and other regulatory agencies and the timingthereof;

·       otheractions by regulators;

·       ourability to access sufficient, reliable and affordable supplies of componentsused in the manufacture of our product candidates, including insulin andmaterials for our AcuForm technology; and

·       thecosts of ramping up and maintaining manufacturing operations, as necessary.

If we fail to achieve ourannounced milestones in the timeframes we announce and expect, our business andresults of operations may be harmed and the price of our stock may decline.

**We depend on clinical investigators and clinical sitesto enroll patients in our clinical trials and other third parties to manage thetrials and to perform related data collection and analysis, and, as a result,we may face costs and delays outside of our control.**

We rely on clinical investigators and clinical sitesto enroll patients and other third parties to manage our trials and to performrelated data collection and analysis. However, we may be unable to control theamount and timing of resources that the clinical sites that conduct theclinical testing may devote to our clinical trials. If our clinicalinvestigators and clinical sites fail to enroll a sufficient number of patientsin our clinical trials or fail to enroll them on our planned schedule, we willbe unable to complete these trials or to complete them as planned, which coulddelay or prevent us from obtaining regulatory approvals for our productcandidates.

Our agreements withclinical investigators and clinical sites for clinical testing and for trialmanagement services place substantial responsibilities on these parties, whichcould result in delays in, or termination of, our clinical trials if theseparties fail to perform as expected. For example, if any of our clinical trialsites fail to comply with FDA-approved good clinical practices, we may beunable to use the data gathered at those sites. If these clinicalinvestigators, clinical sites or other third parties do not carry out theircontractual duties or obligations or fail to meet expected deadlines, or if thequality or accuracy of the clinical data they obtain is compromised due totheir failure to adhere to our clinical protocols or for 

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otherreasons, our clinical trials may be extended, delayed or terminated, and we maybe unable to obtain regulatory approval for, or successfully commercialize, ourproduct candidates.

**If we are unable to obtain or maintain regulatoryapproval, we will be limited in our ability to commercialize our products, andour business will be harmed.**

The regulatory process is expensive and timeconsuming. Even after investing significant time and expenditures on clinicaltrials, we may not obtain regulatory approval of our product candidates. Dataobtained from clinical trials are susceptible to varying interpretations, whichcould delay, limit or prevent regulatory approval, and the FDA may not agreewith our methods of clinical data analysis or our conclusions regarding safetyand/or efficacy. Significant clinical trial delays would impair our ability tocommercialize our products and could allow our competitors to bring products tomarket before we do. In addition, changes in regulatory policy for productapproval during the period of product development and regulatory agency reviewof each submitted new application may cause delays or rejections. Even if wereceive regulatory approval, this approval may entail limitations on theindicated uses for which we can market a product.

Further, with respect toour approved products, once regulatory approval is obtained, a marketed productand its manufacturer are subject to continual review. The discovery ofpreviously unknown problems with a product or manufacturer may result inrestrictions on the product, manufacturer or manufacturing facility, includingwithdrawal of the product from the market. Manufacturers of approved productsare also subject to ongoing regulation, including compliance with FDAregulations governing current Good Manufacturing Practices (cGMP). Failure tocomply with manufacturing regulations can result in, among other things,warning letters, fines, injunctions, civil penalties, recall or seizure ofproducts, total or partial suspension of production, refusal of the governmentto renew marketing applications and criminal prosecution.

**Pharmaceuticalmarketing is subject to substantial regulation in the United States.**

All marketing activitiesassociated with ProQuin XR and GLUMETZA, as well as marketing activitiesrelated to any other products for which we obtain regulatory approval, will besubject to numerous federal and state laws governing the marketing andpromotion of pharmaceutical products. The FDA regulates post-approvalpromotional labeling and advertising to ensure that they conform tostatutory and regulatory requirements. In addition to FDA restrictions, themarketing of prescription drugs is subject to laws and regulations prohibitingfraud and abuse under government healthcare programs. For example, the federalhealthcare program antikickback statute prohibits giving things of value toinduce the prescribing or purchase of products that are reimbursed by federalhealthcare programs, such as Medicare and Medicaid. In addition, federal falseclaims laws prohibit any person from knowingly presenting, or causing to bepresented, a false claim for payment to the federal government. Under this law,the federal government in recent years has brought claims against drugmanufacturers alleging that certain marketing activities caused false claimsfor prescription drugs to be submitted to federal programs. Many states havesimilar statutes or regulations, which apply to items and services reimbursedunder Medicaid and other state programs, or, in some states, regardless of thepayer. If we, or our collaborative partners, fail to comply with applicable FDAregulations or other laws or regulations relating to the marketing of our products,we could be subject to criminal prosecution, civil penalties, seizure ofproducts, injunction, and exclusion of our products from reimbursement undergovernment programs, as well as other regulatory actions against our productcandidates, our collaborative partners or us.

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**The approval process outside the United States isuncertain and may limit our ability to develop, manufacture and sell ourproducts internationally.**

To market any of ourproducts outside of the United States, we and our collaborative partners,including Madaus, are subject to numerous and varying foreign regulatoryrequirements, implemented by foreign health authorities, governing the designand conduct of human clinical trials and marketing approval for drug products.The approval procedure varies among countries and can involve additionaltesting, and the time required to obtain approval may differ from that requiredto obtain FDA approval. The foreign regulatory approval process includes all ofthe risks associated with obtaining FDA approval set forth above, and approvalby the FDA does not ensure approval by the health authorities of any othercountry, nor does the approval by foreign health authorities ensure approval bythe FDA.

**If we or our marketing partners are unable to obtain acceptableprices or adequate reimbursement for our products from third-party payers, wewill be unable to generate significant revenues.**

In both domesticand foreign markets, sales of our product candidates will depend in part on theavailability of adequate reimbursement from third-party payers such as:

·       governmenthealth administration authorities;

·       privatehealth insurers;

·       healthmaintenance organizations;

·       pharmacybenefit management companies; and

·       otherhealthcare-related organizations.

If reimbursement is not available for our products orproduct candidates, demand for these products may be limited. Further, anydelay in receiving approval for reimbursement from third-party payers wouldhave an adverse effect on our future revenues. Third-party payers areincreasingly challenging the price and cost-effectiveness of medical productsand services. Significant uncertainty exists as to the reimbursement status ofnewly approved healthcare products, including pharmaceuticals. Our products maynot be considered cost effective, and adequate third-party reimbursement may beunavailable to enable us to maintain price levels sufficient to realize anacceptable return on our investment.

Federal and stategovernments in the United States and foreign governments continue to proposeand pass new legislation designed to contain or reduce the cost of healthcare.Existing regulations affecting pricing may also change before many of ourproduct candidates are approved for marketing. Cost control initiatives could decreasethe price that we receive for any product we may develop.

**We may be unable to compete successfully in thepharmaceutical product and drug delivery system industries.**

Other companies that have oral drug deliverytechnologies competitive with the AcuForm technology include Bristol-MyersSquibb, IVAX Corporation (a subsidiary of TEVA Pharmaceutical Industries, Ltd.),ALZA Corporation (a subsidiary of Johnson & Johnson), SkyePharma plc,Biovail Corporation, Flamel Technologies S.A., Ranbaxy Laboratories, Ltd., KosPharmaceuticals, Inc., Intec Pharma and Alpharma, Inc., all of whichdevelop oral tablet products designed to release the incorporated drugs overtime. Each of these companies has patented technologies with attributesdifferent from ours, and in some cases with different sites of delivery to thegastrointestinal tract.

Bristol-Myers Squibb is currently marketing asustained release formulation of metformin, Glucophage XR, with whichGLUMETZA competes. The limited license that Bristol-Myers Squibb obtained fromus under our November 2002 settlement agreement extends to certain currentand 

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internally-developedfuture compounds, which may increase the likelihood that we will facecompetition from Bristol-Myers Squibb in the future on products in addition toGLUMETZA. Several other companies, including Barr Pharmaceuticals, Inc.,Mylan Laboratories, Inc. and Teva Pharmaceutical Industries, Ltd. havereceived FDA approval for and are selling a controlled-release metforminproduct. Flamel Technologies has a controlled-release microparticle-basedformulation of metformin product in Phase 2 clinical trials.

Bayer Corporation developed a once-daily ciprofloxacinproduct for the treatment of urinary tract infections, which is currentlymarketed by Schering-Plough Corporation. There may be other companiesdeveloping products competitive with GLUMETZA and ProQuin XR of which we areunaware.

Gabapentin is currently marketed by Pfizer asNeurontin for adjunctive therapy for epileptic seizures and for postherpetic pain.Pfizer’s basic U.S. patents relating to Neurontin have expired, and at leastseven companies have received approval to market generic versions of theimmediate release product. In addition, Pfizer has developed a new product,LyricaTM (pregabalin), which has been approved for marketing in the U.S. and theEuropean Union.

Competition in pharmaceutical products and drugdelivery systems is intense. We expect competition to increase. Competingtechnologies or products developed in the future may prove superior to theAcuForm technology or products using the AcuForm technology, eithergenerally or in particular market segments. These developments could make theAcuForm technology or products using the AcuForm technologynoncompetitive or obsolete.

Most of our principalcompetitors have substantially greater financial, sales, marketing, personneland research and development resources than we do. In addition, many of ourpotential collaborative partners have devoted, and continue to devote,significant resources to the development of their own drug delivery systems andtechnologies.

**We depend on third parties who are single sourcesuppliers to manufacture ProQuin XR, GLUMETZA and our later stage productcandidates. If these suppliers are unable to manufacture ProQuin XR, GLUMETZAor our product candidates, our business will be harmed.**

We are responsible for the supply and distribution ofGLUMETZA, and MOVA Pharmaceuticals, a subsidiary of Patheon, Inc., is oursole supplier for tablets of the 500mg strength of GLUMETZA pursuant to asupply agreement we entered into with MOVA Pharmaceuticals in December 2006.We purchase the active ingredient for the 500mg GLUMETZA from Farmhispania,S.A., a sole supplier to us, on a purchase order basis. If the new formulationof 1000mg GLUMETZA is approved, we will rely on Biovail as our sole supplier. Wewill be unable to manufacture GLUMETZA in a timely manner if we are unable toobtain GLUMETZA 500mg tablets from our contract manufacturer or activepharmaceutical ingredient from suppliers, or GLUMETZA 1000mg tablets fromBiovail.

We are also responsible for supplying commercialquantities of ProQuin XR to Esprit. For the manufacture of ProQuin XR tablets,we have entered into an agreement with MOVA Pharmaceuticals, as our solesupplier. Uquifa Mexico, S.A., our supplier of the active pharmaceuticalingredient to ProQuin XR, is also a sole supplier to us. We obtain the activepharmaceutical ingredient to ProQuin XR on a purchase order basis only. We willalso be responsible for the manufacture of bulk ProQuin XR tablets to Madausfor the European market, if the product is approved for marketing in Europeanjurisdictions. We intend to purchase ProQuin XR tablets from MOVAPharmaceuticals for that purpose  If weare unable, for whatever reason, to obtain the active pharmaceutical ingredientor ProQuin XR tablets from our contract manufacturers, we may be unable tomanufacture ProQuin XR in a timely manner, if at all.

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Although we have obtainedclinical batches of Gabapentin GR from a contract manufacturer, we currentlyhave no long-term supply arrangement with respect to Gabapentin GR. Any failureto obtain clinical supplies of Gabapentin GR could adversely affect ourGabapentin clinical development programs.

**We could become subject to product liabilitylitigation and may not have adequate insurance to cover product liabilityclaims.**

Our businessinvolves exposure to potential product liability risks that are inherent in theproduction and manufacture of pharmaceutical products. We have obtained productliability insurance for clinical trials currently underway and forecasted 2007sales of our products, but:

·       wemay be unable to obtain product liability insurance for future trials;

·       wemay be unable to obtain product liability insurance for future products;

·       wemay be unable to maintain product liability insurance on acceptable terms;

·       wemay be unable to secure increased coverage as the commercialization of theAcuForm technology proceeds; or

·       ourinsurance may not provide adequate protection against potentialliabilities.

Our inability to obtainadequate insurance coverage at an acceptable cost could prevent or inhibit thecommercialization of our products. Defending a lawsuit would be costly andsignificantly divert management’s attention from conducting our business. Ifthird parties were to bring a successful product liability claim orseries of claims against us for uninsured liabilities or in excess ofinsured liability limits, our business, financial condition and results ofoperations could be materially harmed.

**If we choose to acquire new and complementarybusinesses, products or technologies, we may be unable to complete theseacquisitions or to successfully integrate them in a cost effective andnon-disruptive manner.**

Our success depends on ourability to continually enhance and broaden our product offerings in response tochanging customer demands, competitive pressures and technologies. Accordingly,we may in the future pursue the acquisition of complementary businesses,products or technologies instead of developing them ourselves. We have nocurrent commitments with respect to any acquisition or such investment. We donot know if we would be able to successfully complete any acquisitions, orwhether we would be able to successfully integrate any acquired business,product or technology or retain any key employees. Integrating any business,product or technology we acquire could be expensive and time consuming, disruptour ongoing business and distract our management. If we were to be unable tointegrate any acquired businesses, products or technologies effectively, ourbusiness would suffer. In addition, any amortization or charges resulting fromthe costs of acquisitions could harm our operating results.

**We have implementedcertain anti-takeover provisions.**

Certain provisions of our articles of incorporationand the California General Corporation Law could discourage a third party fromacquiring, or make it more difficult for a third party to acquire control ofour company without approval of our board of directors. These provisions couldalso limit the price that certain investors might be willing to pay in thefuture for shares of our common stock. Certain provisions allow the board ofdirectors to authorize the issuance of preferred stock with rights superior tothose of the common stock. We are also subject to the provisions of Section 1203of the California General Corporation Law which requires a fairness opinion tobe provided to our shareholders in connection with their consideration of anyproposed “interested party” reorganization transaction.

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We have adopted ashareholder rights plan, commonly known as a “poison pill”. The provisionsdescribed above, our poison pill and provisions of the California GeneralCorporation Law may discourage, delay or prevent a third party from acquiringus.

**Increasedcosts associated with corporate governance compliance may significantly impactour results of operations.**

Changing laws, regulationsand standards relating to corporate governance, public disclosure andcompliance practices, including the Sarbanes-Oxley Act of 2002, new SECregulations and Nasdaq Global Market rules, are creating uncertainty forcompanies such as ours in understanding and complying with these laws,regulations and standards. As a result of this uncertainty and other factors,devoting the necessary resources to comply with evolving corporate governanceand public disclosure standards has resulted in and may in the future result inincreased general and administrative expenses and a diversion of managementtime and attention to compliance activities. We also expect these developmentsto increase our legal compliance and financial reporting costs. In addition,these developments may make it more difficult and more expensive for us toobtain director and officer liability insurance, and we may be required toaccept reduced coverage or incur substantially higher costs to obtain coverage.Moreover, we may be unable to comply with these new rules and regulationson a timely basis.

These developments couldmake it more difficult for us to attract and retain qualified members of ourboard of directors, or qualified executive officers. We are presentlyevaluating and monitoring regulatory developments and cannot estimate thetiming or magnitude of additional costs we may incur as a result. To the extentthese costs are significant, our general and administrative expenses are likelyto increase.

**If wesell shares of our common stock under our equity line of credit arrangement orin other future financings, existing common shareholders will experience immediatedilution and, as a result, our stock price may go down.**

We may from time to timeissue additional shares of common stock at a discount from the current tradingprice of our common stock. As a result, our existing common shareholders willexperience immediate dilution upon the purchase of any shares of our commonstock sold at such discount. For example, in December 2006, we enteredinto a common stock purchase agreement with Azimuth Opportunity Ltd., pursuantto which we may sell shares of common stock at a discount to the prevailingmarket price ranging from 3.775% to 6.375%, excluding an additional placementagent fee of 1.125% payable by us on the gross offering proceeds. In addition,as other capital raising opportunities present themselves, we may enter intofinancing or similar arrangements in the future, including the issuance of debtsecurities, preferred stock or common stock. If we issue common stock orsecurities convertible into common stock, our common shareholders willexperience dilution and this dilution will be greater if we find it necessaryto sell securities at a discount to prevailing market prices.

**If weare unable to satisfy regulatory requirements relating to internal controls,our stock price could suffer.**

Section 404 of the Sarbanes-OxleyAct of 2002 requires companies to conduct a comprehensive evaluation of theirinternal control over financialreporting. At the end of each fiscal year, we must perform an evaluation of ourinternal control over financial reporting, include in our annual report theresults of the evaluation, and have our external auditors publicly attest tosuch evaluation. If material weaknesses were found in our internal controls inthe future, if we fail to complete future evaluations on time, or if our externalauditors cannot attest to our future evaluations, we could fail to meet ourregulatory reporting requirements and be subject to regulatory scrutiny and aloss of public confidence in our internal controls, which could have an adverseeffect on our stock price.

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**Business interruptions could limit our ability tooperate our business.**

Our operations arevulnerable to damage or interruption from computer viruses, human error,natural disasters, telecommunications failures, intentional acts of vandalismand similar events. In particular, our corporate headquarters are located in the San Francisco Bayarea, which has a history of seismic activity. We have not established a formaldisaster recovery plan, and our back-up operations and our businessinterruption insurance may not be adequate to compensate us for losses thatoccur. A significant business interruption could result in losses or damagesincurred by us and require us to cease or curtail our operations.

**ITEM1B.**       UNRESOLVED STAFF COMMENTS

None.

**ITEM2.**                PROPERTIES

We currently leaseapproximately 55,000 square feet of laboratory and office facilities in MenloPark, California. The lease terms are through June 2009 with options toextend the lease terms for an additional five years. We expect that these facilitieswill accommodate our growth for the next one to two years.

**ITEM3.**                LEGAL PROCEEDINGS

We are involved in legalproceedings relating to some of our intellectual property rights. In January 2006,Depomed filed a complaint against IVAX Corporation in the U.S. District Courtfor the Northern District of California for infringement of U.S. Patent Nos.6,340,475 and 6,635,280, both of which are owned by Depomed. The patents relateto our AcuForm delivery technology. The complaint alleges infringement ofour patents by IVAX’s extended release metformin hydrochloride tablet. In April2006, IVAX filed an answer and counterclaim, in which it alleged that thepatents in suit are not infringed by IVAX and are invalid and unenforceable. InDecember 2006, the court issued an order construing certain of the claimterms appearing in the patents. Discovery in the case is ongoing, and the courthas not yet set a deadline for the close of discovery.

**ITEM4.**                SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submittedto a vote of security holders during the fourth quarter of the fiscal yearended December 31, 2006.

**EXECUTIVE AND OTHER OFFICERS OF THE REGISTRANT**

Our executive and otherofficers of the company and their ages as of December 31, 2006 are as follows:
| Name                    | ** ** | **Age** | ** ** | **Position**                                          |
|-------------------------|------------|---------|------------|-------------------------------------------------------|
| **Executive  Officers** |       |    |       |                                                  |
| John W. Fara, Ph.D.     |       | 64      |       | Chairman, President and  Chief Executive Officer      |
| Carl A. Pelzel          |       | 56      |       | Executive Vice President  and Chief Operating Officer |
| John F. Hamilton        |       | 62      |       | Vice President, Finance  and Chief Financial Officer  |
| John N. Shell           |       | 53      |       | Vice President,  Operations                           |
| Matthew M. Gosling      |       | 36      |       | Vice President and  General Counsel                   |
| **Other  Officers**     |       |    |       |                                                  |
| Jeff P. Miller          |       | 54      |       | Vice President,  Regulatory and Quality Assurance     |
| Thadd M. Vargas         |       | 41      |       | Vice President, Business Development                  |

 

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*John W. Fara, Ph.D.* hasserved as a director of the company since November 1995 and as itsPresident and Chief Executive Officer since December 1996. In April 2000,he became Chairman of the Board of Directors of the company succeeding Dr. JohnW. Shell, the founder of the company. From February 1990 to June 1996Dr. Fara was President and Chief Executive Officer of Anergen, Inc.,a biotechnology company. Prior to February 1990 he was President ofPrototek, Inc., a biotechnology company. Prior to Prototek, he wasDirector of Biomedical Research and then Vice President of Business Developmentduring ten years with ALZA. Dr. Fara received a B.S. degree from theUniversity of Wisconsin and a Ph.D. degree from the University of California,Los Angeles. He is also a member of the board of directors of AVI BioPharma, Inc.and Iomed, Inc., both of which are publicly held companies.

*Carl A. Pelzel* joined Depomedin June 2005 as Vice President, Marketing and Commercial Development; hewas appointed to the position of Executive Vice President and Chief OperatingOfficer in September 2005. Before joining Depomed, Mr. Pelzel was SeniorVice President, Global Commercial Operations at Chiron Corporation from June 2003to September 2004. Prior to joining Chiron, Mr. Pelzel was Presidentand Chief Executive Officer of Invenux Inc., a privately-held biopharmaceuticalcompany from March 2001 to November 2002. Mr. Pelzel also spent11 years with GlaxoSmithKline in senior-level sales, marketing andinternational operational positions, including Country Manager of Hong Kong andChina. He spent 13 years with American Home Products, focused primarily ontheir antibiotics business. During his career, he directed the launch of five majorpharmaceutical products, many on a global basis. Mr. Pelzel has a B.A.degree from Hartwick College of Oneonta, New York.

*John F. Hamilton* has servedas the company’s Vice President of Finance and Chief Financial Officer since January 1997.Prior to joining the company, Mr. Hamilton was Vice President and ChiefFinancial Officer of Glyko, Inc. and Glyko Biomedical Ltd., a carbohydrateinstrument and reagents company from May 1992 to September 1996. Hewas President and Chief Financial Officer of Protos Corporation, a drug designsubsidiary of Chiron Corporation, from June 1988 to May 1992 and heldvarious positions with Chiron Corporation, including Treasurer, from September 1987to May 1992. Mr. Hamilton received a B.A. degree from the Universityof Pennsylvania and an M.B.A. degree from the University of Chicago.

*John N. Shell* served asDirector of Operations for the company from its inception in August 1995until December 1996, when he was named Vice President of Operations. From May 1994to August 1995, Mr. Shell served in a similar capacity at the DepomedDivision of M6. Mr. Shell served as a director of the company from itsinception until November 2003. Prior to 1994, Mr. Shell served asMaterials Manager for Ebara International Corporation, a multi-nationalsemiconductor equipment manufacturer, and as Materials Manager for ILCTechnology, an electro-optics and electronics manufacturer. Mr. Shellreceived his B.A. degree from the University of California, Berkeley.

*Matthew M. Gosling**has served as Vice President andGeneral Counsel since June 2006.*Before joining Depomed,Mr. Gosling was a partner at Heller Ehrman LLP, a national law firm, wherehe served a nine-year tenure as a corporate transactional attorney. Mr. Goslingreceived his law degree from the University of Chicago and holds a B.A. degreefrom Trinity University, San Antonio.

*Jeff P. Miller* has served asVice President of Regulatory Affairs and Quality Assurance for Depomed sinceNovember, 2005. Before joining Depomed, he was Vice President, RegulatoryAffairs and Quality for the Drug Development Division of ICON (formerly,GloboMax), a worldwide clinical and regulatory consulting firm. From 2001 to2003, Mr. Miller was Executive Director, Regulatory Affairs and Compliancefor DURECT Corporation, a drug delivery technology company. His career alsoincludes several senior level positions at biotechnology companies, includingClingenix/Research Services Inc., from 1999 to 2001, CV Therapeutics, Inc.,from 1997 to 1999 and, from 1993 to 1997, Matrix Pharmaceutical, Inc.Earlier in his career, Mr. Miller spent 17 years at Syntex Research, Inc.in basic research and Human Pharmaceutical Regulatory Affairs and Compliance.Mr. Miller holds a B.A. degree in Biological Sciences from the Universityof California, Santa Barbara.

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*Thadd M. Vargas* has served asthe company’s Vice President of Business Development since December 2002.Before joining the company, Mr. Vargas was Vice President of Finance atWorldres.com, Inc., Director of Finance at Kosan Biosciences, Inc.and Director of Business Development at Anergen, Inc. Prior to Anergen, Mr. Vargaswas a member of Ernst & Young’s life sciences audit practice. Mr. Vargasholds a B.A. degree in Business Economics from the University of California atSanta Barbara.

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**PART II**

**ITEM 5.**                MARKETFOR THE REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

**Market Information**

Our common stock trades the Nasdaq Global Market(Nasdaq) under the symbol “DEPO”. The following table sets forth, for theperiods indicated, the intraday high and low prices of our common stock asreported by the Nasdaq from January 1, 2005 to December 31, 2006.

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2005**       |       |     |       |    |       |
| First Quarter  |       | $        | 5.65       |    | $          | 3.77 |   |
| Second Quarter |       | $        | 4.75       |    | $          | 3.13 |   |
| Third Quarter  |       | $        | 6.83       |    | $          | 4.32 |   |
| Fourth Quarter |       | $        | 6.85       |    | $          | 4.58 |   |
| **2006**       |       |     |       |    |       |
| First Quarter  |       | $        | 7.19       |    | $          | 5.57 |   |
| Second Quarter |       | $        | 6.99       |    | $          | 5.65 |   |
| Third Quarter  |       | $        | 6.08       |    | $          | 3.75 |   |
| Fourth Quarter |       | $        | 4.82       |    | $          | 2.74 |   |

 

On March 6, 2007, theclosing price of our common stock was $3.35. As of March 6, 2007, therewere approximately 70 shareholders of record of our common stock, one of whichis Cede & Co., a nominee for Depository Trust Company, or DTC. All ofthe shares of common stock held by brokerage firms, banks and other financialinstitutions as nominees for beneficial owners are deposited into participantaccounts at DTC, and are therefore considered to be held of record by Cede &Co. as one shareholder.

**Dividends**

We have never declared orpaid any cash dividends on our common stock. We currently intend to retain anyfuture earnings to finance the growth and development of our business andtherefore, do not anticipate paying any cash dividends in the foreseeablefuture.

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**Stock PricePerformance Graph**

The following graph compares total shareholder returnsof Depomed for the past five years to two indices: the Nasdaq Center forResearch in Security Prices Total Return Index for the Nasdaq Stock Market(U.S. Companies) and the Nasdaq Biotechnology Index. The total return forDepomed’s common stock and for each index assumes the reinvestment of alldividends, although cash dividends have never been declared on Depomed’s commonstock.

**COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN***

Among Depomed, Inc., the Nasdaq Composite Indexand the NASDAQ Biotechnology Index

*                    $100 investedon 12/31/01 in stock or index-including reinvestment of dividends. Fiscal yearending December 31.

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**ITEM 6.**                SELECTEDFINANCIAL DATA

| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Consolidated  Statement of Operations Data:**                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Total revenues                                                                    |       | $                                          | 9,551,218  |   | $ | 4,405,329 |   | $ | 202,569 |   | $ | 981,990 |   | $ | 1,661,186 |   |
| Total costs and expenses                                                          |       | 51,158,680                                 |       | 30,916,856 |   | 26,537,341 |   | 30,380,445 |   | 30,088,624 |   |
| Loss from operations                                                              |       | (41,607,462                                | )          | (26,511,527 | ) | (26,334,772 | ) | (29,398,455 | ) | (28,427,438 | ) |
| Equity in loss of joint venture                                                   |       | —                                     |       | — |   | — |   | (5,359 | ) | (2,435,667 | ) |
| Gain from Bristol-Myers Squibb legal settlement                                   |       | —                                     |       | — |   | — |   | — |   | 18,000,000 |   |
| Gain from extinguishment of debt                                                  |       | —                                     |       | 1,058,935 |   | — |   | — |   | — |   |
| Net loss before income taxes                                                      |       | (39,576,788                                | )          | (24,467,272 | ) | (26,774,637 | ) | (30,015,098 | ) | (13,494,565 | ) |
| Provision for income taxes                                                        |       | (82,500                                    | )          | — |   | (99,000 | ) | — |   | — |   |
| Net loss (1)                                                                      |       | (39,659,288                                | )          | (24,467,272 | ) | (26,873,637 | ) | (30,015,098 | ) | (13,494,565 | ) |
| Deemed dividend on preferred stock                                                |       | (665,258                                   | )          | (842,202 | ) | — |   | — |   | — |   |
| Net loss applicable to common stock shareholders (1)                              |       | (40,324,546                                | )          | (25,309,474 | ) | (26,873,637 | ) | (30,015,098 | ) | (13,494,565 | ) |
| Basic and diluted net loss per share applicable to  common stock shareholders (1) |       | $                                          | (0.97      | ) | $ | (0.64 | ) | $ | (0.78 | ) | $ | (1.23 | ) | $ | (0.92 | ) |
| Shares used in  computing basic and diluted net loss per share                    |       | 41,517,661                                 |       | 39,821,182 |   | 34,628,825 |   | 24,458,259 |   | 14,642,745 |   |

 

| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Consolidated Balance Sheet Data**              |       |                  |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and marketable securities |       | $                     | 33,557,373 |   | $ | 59,073,065 |   | $ | 18,104,839 |   | $ | 44,255,260 |   | $ | 20,217,973 |   |
| Total assets                                     |       | 52,617,184            |       | 66,414,076 |   | 22,868,583 |   | 47,692,649 |   | 23,179,277 |   |
| Deferred revenue, non-current portion            |       | 57,483,045            |       | 51,421,263 |   | 493,750 |   | — |   | — |   |
| Long-term obligations, non-current portion       |       | —                |       | — |   | 10,280,591 |   | 9,497,845 |   | 9,003,937 |   |
| Series A convertible preferred stock        |       | 12,015,000            |       | 12,015,000 |   | 12,015,000 |   | 12,015,000 |   | 12,015,000 |   |
| Accumulated deficit                              |       | (184,111,185          | )          | (144,451,897 | ) | (119,984,625 | ) | (93,110,988 | ) | (63,095,890 | ) |
| Total  shareholders’ (deficit) equity       |       | (27,288,460           | )          | 6,760,999 |   | 8,403,298 |   | 34,576,154 |   | (6,413,866 | ) |
|                                                  |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)           Net loss, net loss applicable to common stockshareholders and net loss per share in 2002 include a $18.0 million gainrelated to the settlement of the patent infringement lawsuit we filed againstBristol-Myers Squibb.

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**OVERVIEW**

Depomed is a specialty pharmaceutical company focusedon the development and commercialization of differentiated products thataddress large and growing markets and are based on proprietary oral drugdelivery technologies. We have developed two commercial products. GLUMETZATM(metformin hydrochloride extended release tablets) is a once-daily treatmentfor adults with type 2 diabetes that we jointly commercialize in the UnitedStates with King Pharmaceuticals, Inc. ProQuin XR (ciprofloxacinhydrochloride extended release tablets) is a once-daily treatment foruncomplicated urinary tract infections that Esprit Pharma, Inc. markets inthe United States.

We have a three-pronged approach to productdevelopment designed to optimize the use and value of our drug deliverytechnologies, while managing the costs and risks associated with developing andcommercializing pharmaceutical products. We develop products for our ownaccount that are designed to compete in large growing markets and that can behighly differentiated from immediate release versions of the compounds uponwhich they are based. Second, we selectively enter into collaborativepartnerships with other companies where the unique capabilities of ourtechnology can provide superior value to a partner’s compound, resulting in significantlygreater value for Depomed than a traditional fee-for-service arrangement.Third, we enter into arrangements that enable our technology to be applied byother companies to a greater number of compounds than our infrastructure cansupport, so as to derive additional value from our technology. We plan tocommercialize our proprietary products, relying on partners to cover the largeprimary care audiences, while maintaining co-promotion and distribution rightsin order to be in a position to create our own sales force when appropriate,thereby increasing the value to us of our products, and our control over them.

Our most advanced productcandidate is Gabapentin GRTM, an extended release form of gabapentin we aredeveloping. With respect to Gabapentin GR, we have completed enrollment of aPhase 3 clinical trial for the treatment of postherpetic neuralgia,completed and announced positive results of a Phase 2 clinical trial forthe treatment of diabetic peripheral neuropathy, and submitted aninvestigational new drug application for a Phase 2 clinical trial for thetreatment of menopausal hot flashes. We have other product candidates inearlier stages of development, including a treatment for gastroesophagealreflux disease.

**CRITICAL ACCOUNTINGPOLICIES AND ESTIMATES**

A detailed discussion of our significant accountingpolicies can be found in Note 1 of the Notes to Consolidated FinancialStatements, and the impact and risks associated with our accounting policiesare discussed throughout this Annual Report on Form 10-K and in thefootnotes to the consolidated financial statements. Critical accountingpolicies are those that require significant judgment and/or estimates bymanagement at the time that financial statements are prepared such thatmaterially different results might have been reported if other assumptions hadbeen made. We consider certain accounting policies related to revenuerecognition and use of estimates to be critical policies. These estimates formthe basis for making judgments about the carrying values of assets andliabilities. We base our estimates and judgments on historical experience andon various other assumptions that we believe to be reasonable under thecircumstances. Actual results could differ materially from these estimates.

We believe the followingpolicies to be the most critical to an understanding of our financial conditionand results of operations because they require us to make estimates,assumptions and judgments about matters that are inherently uncertain.

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***Revenue Recognition***

Revenue arrangements with multiple elements aredivided into separate units of accounting if certain criteria are met,including whether the delivered element has stand-alone value to the customerand whether there is objective and reliable evidence of the fair value of theundelivered items. The consideration received is allocated among the separateunits based on their respective fair values, and the applicable revenuerecognition criteria are applied to each of the separate units. Revenue isrecognized when there is persuasive evidence that an arrangement exists,delivery has occurred and title has passed, the price is fixed or determinableand we are reasonably assured of collecting the resulting receivable.

The GLUMETZA product that we sell to wholesalers andretail pharmacies is subject to rights of return up to twelve months afterproduct expiration. Given the limited sales history of GLUMETZA, we currently cannotreliably estimate expected returns of the product at the time of shipment.Accordingly, we defer recognition of revenue on product shipments of GLUMETZAuntil the right of return no longer exists, which occurs at the earlier of thetime GLUMETZA units are dispensed through patient prescriptions or expirationof the right of return. We estimate patient prescriptions dispensed using ananalysis of third-party information, including third-party market researchdata, information obtained from certain wholesalers with respect to inventorylevels and out-movement and retail pharmacy re-stocking activity. GLUMETZA waslaunched in September 2006 and accordingly, the Company has not hadsignificant history estimating the number of patient prescriptions dispensed.If we underestimate or overestimate patient prescriptions dispensed for a givenperiod, adjustments to revenue may be necessary in future periods. As a resultof this policy, we recognized $526,000 in GLUMETZA product revenue in 2006,which is net of estimated patient support program discounts, wholesaler fees,stocking allowances, prompt payment discounts and chargebacks. We have adeferred revenue balance of $4.8 million at December 31, 2006 for GLUMETZAproduct shipments, net of estimated patient support program discounts,wholesaler fees, stocking allowances, prompt payment discounts and chargebacks.In addition, the costs of manufacturing GLUMETZA associated with the deferredrevenue are recorded as deferred costs, which are included in inventory, untilsuch time the deferred revenue is recognized.

In the fourth quarter of 2006, we commenced a patientsupport program for GLUMETZA which has two components. Patients who participatein the GLUMETZA loyalty card program receive discounts of up to $20 off theirrequired co-pay for a GLUMETZA prescription. In addition to the loyalty cardprogram, a separate voucher program provides patients with a supply of 35tablets at no cost to the patient when the voucher is redeemed at a pharmacy.Our costs associated with actual patient support program discounts redeemed arerecorded as a reduction of revenue and were minimal in 2006. We have madeestimates of our costs associated with loyalty cards and vouchers that havebeen dispensed to patients and yet to be redeemed in 2006, and have includedthese estimates as a reduction to deferred revenue.

Product sales revenue related to our supply agreementwith Esprit for ProQuin XR is recognized after the expiration of a 30-dayperiod in which Esprit may reject product that does not meet agreed-uponspecifications.

Royalties are recognized as earned in accordance withapplicable contract terms when royalties from licensees can be reliablymeasured and collectibility is reasonably assured. We recognize royalties underour agreement with Esprit based on Esprit’s sales, net of any estimatedreturns, discounts, rebates and chargebacks.

Royalties received under our agreement with Espritthat are greater than the minimum royalty due are recognized based on Esprit’ssales, net of any estimated returns, discounts, rebates and chargebacks. Totalroyalty revenue recognized by the Company through December 31, 2006 wasequal to Esprit’s 2006 minimum royalty obligation. Royalties received under ouragreement with Biovail related to the marketing of GLUMETZA in Canada arerecognized when the royalty payments are received as the amounts are not 

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estimable. Royaltypayments received in excess of amounts earned are classified as royaltyadvances until earned.

Collaborative revenue recognized relates to servicesrendered in connection with collaborative arrangements and the achievement ofmilestones under such arrangements. Revenue related to collaborative agreementswith corporate partners is recognized as the expenses are incurred under eachcontract. We are required to perform services as specified in eachrespective agreement on a best or commercially reasonable efforts basis, and weare reimbursed based on the costs incurred on each specific contract.Nonrefundable substantive milestone payments are recognized pursuant tocollaborative agreements upon the achievement of specified milestones where nofurther obligation to perform exists under that milestone provision of thearrangement and when collectibility is reasonably assured.

Revenue from licensearrangements, including license fees creditable against future royaltyobligations (if any), of the licensee, is recognized when an arrangement isentered into if we have substantially completed our obligations under the termsof the arrangement and our remaining involvement is inconsequential andperfunctory. If we have significant continuing involvement under such anarrangement, license fees are deferred and recognized over the estimatedperformance period. License fee payments received in excess of amounts earnedare classified as deferred revenue until earned.

***Research and Development Expense and Accruals***

Research and developmentexpenses include related salaries, contractor fees, clinical trial costs,facilities costs, administrative expenses and allocations of corporate costs.All such costs are charged to research and development expense as incurred.These expenses result from our independent research and development efforts aswell as efforts associated with collaborations. Our expense accruals forclinical trials are based on estimates of the services received from clinicaltrial centers and clinical research organizations. If possible, we obtaininformation regarding unbilled services directly from service providers.However, we may be required to estimate these services based on informationavailable to our product development or administrative staff. If weunderestimate or overstimate the activity associated with a study or service ata given point in time, adjustments to research and development expenses may benecessary in future periods. Historically, our estimated accrued liabilitieshave approximated actual expense incurred.

***Stock-Based Compensation***

As of January 1, 2006, we began accounting forstock-based compensation in accordance with Statement of Financial AccountingStandards No. 123 (revised 2004), *Share-Based Payment*(FAS123(R)), using the modified prospective transition method. We use theBlack-Scholes option valuation model to estimate the fair value of stockoptions and Employee Stock Purchase Plan (ESPP) shares. The Black-Scholes modelrequires the input of highly subjective assumptions. The most significantassumptions are our estimates of the expected volatility and the expected termof the award. For our volatility assumption, we use the historical volatilityof our common stock over the expected term of the options. We have concludedthat our historical share option exercise experience does not provide areasonable basis upon which to estimate expected term and therefore, as of January 1,2006, we estimate the expected term of options granted by taking the average ofthe vesting term and the contractual term of the option, as illustrated in SECStaff Accounting Bulletin No. 107 (SAB 107). As required, we review ourvaluation assumptions at each grant date and, as a result, we are likely tochange our valuation assumptions used to value employee stock-based awardsgranted in future periods. FAS 123(R) requires that employee and directorstock-based compensation costs be recognized over the vesting period of theaward, and we have elected to use the straight-line attribution method.Stock-based compensation expense recognized under FAS 123(R) in theconsolidated statements of operations for the year ended December 31, 2006related to stock options and the ESPP was $2,572,000, which consisted of  $976,000 in research and development 

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expense, $1,584,000 inselling, general and administrative expense and $12,000 in cost of sales. As aresult of adopting FAS 123(R), our net loss for the year ended December 31,2006 was $2,342,000 higher than if we continued to account for stock-basedcompensation under APB 25 as we did in comparable prior year periods.Accordingly, basic and diluted net loss applicable to common stock shareholdersper share for the year ended December 31, 2006 was $0.06 higher than if wecontinued to account for stock-based compensation under APB 25. Theimplementation of FAS 123(R) did not have an impact on our cash flowsfor the year ended December 31, 2006.

Prior to January 1, 2006, we measuredcompensation expense for our employee stock-based compensation plans using theintrinsic value method under APB No. 25. Under APB No. 25,no stock-based compensation was recognized for the ESPP or for option grantswhen the exercise price of the options granted was equal to or greater than thefair value market price of the stock on the grant date. In accordance with theprovisions of FAS 123(R), we eliminated the balance of the deferredcompensation calculated under APB No. 25 to the common stock accounton January 1, 2006. For the years ended December 31, 2005 and 2004 werecognized approximately $386,000 and $258,000, respectively, of stock-basedcompensation expense for employees under APB No. 25.

FAS 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. Weestimated forfeitures based on historical experience. Prior to the adoption ofFAS 123(R), pro forma information required under FAS 123 includedforfeitures as they occurred.

**RESULTS OFOPERATIONS**

***Revenues***

Total revenues are summarized in the following table:

| ** **            | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|-----------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Product sales:        |       |      |       |      |       |      |       |
| ProQuin XR            |       | $         | 1,265,000  |      | $          | 930,000   |       | $ | — |   |
| GLUMETZA              |       | 526,000   |       | —    |       | —    |       |
| Total product sales   |       | 1,791,000 |       | 930,000   |       | —    |       |
| Royalties:            |       |      |       |      |       |      |       |
| ProQuin XR            |       | 3,931,000 |       | 669,000   |       | —    |       |
| GLUMETZA              |       | 109,000   |       | —    |       | —    |       |
| Total royalties       |       | 4,040,000 |       | 669,000   |       | —    |       |
| License revenue:      |       |      |       |      |       |      |       |
| ProQuin XR            |       | 2,068,000 |       | 424,000   |       | —    |       |
| GLUMETZA              |       | 1,542,000 |       | 151,000   |       | 31,000    |       |
| Total license revenue |       | 3,610,000 |       | 575,000   |       | 31,000    |       |
| Collaborative revenue |       | 110,000   |       | 2,231,000 |       | 172,000   |       |
| Total revenues        |       | $         | 9,551,000  |      | $          | 4,405,000 |       | $ | 203,000 |   |

 

**Product sales**

We began selling GLUMETZA in September 2006 towholesalers and retail pharmacies that is subject to rights of return up totwelve months after product expiration. Given the limited sales history ofGLUMETZA and return privileges, the Company currently cannot reliably estimateexpected returns of the product at the time of shipment. We defer recognitionof revenue on product shipments of GLUMETZA to our customers until such timeGLUMETZA units are dispensed through patient 

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prescriptions. We estimatethe volume of prescription units dispensed by pharmacies based on data providedby external, independent sources. In 2006, we recognized $526,000 of productsales of GLUMETZA, which is net of estimated patient support program discounts,wholesaler fees, stocking allowances, prompt payment discounts and chargebacks.We have deferred recognition of revenue on GLUMETZA product shipments tocustomers in which we estimate have not been dispensed through patientprescriptions. At December 31, 2006, we have a deferred revenue balance,which is classified as a liability on the consolidated balance sheet, of $4.8million associated with the deferral of revenue on GLUMETZA product shipments,which is net of estimated patient support program discounts, wholesaler fees,stocking allowances, prompt payment discounts and chargebacks.

ProQuin XR product salesrelate to our supply agreement with Esprit. We began supplying Esprit withcommercial quantities of ProQuin XR in the fourth quarter of 2005. All revenuerecognized related to ProQuin XR product sales in 2006 was recorded in thefirst half of the year. As a result of their existing inventory levels anddemand forecast for ProQuin XR product, Esprit did not make any purchases fromus in the second half of 2006.

**Royalties**

Our agreement with Esprit provides for royaltypayments by Esprit to us of 15 percent to 25 percent of ProQuin XR net sales inthe United States, based on escalating net sales and subject to certain minimumroyalty amounts. Esprit’s minimum royalty amount for 2006 was $4.6 million andunder our amended license agreement entered into in July 2006, amountspaid by Esprit for 2005 royalties were creditable against the 2006 minimumroyalty obligation. Net sales of ProQuin XR by Esprit for 2005 and 2006 did notreach levels that would obligate Esprit to pay an amount greater than theminimum royalty obligation, and accordingly, through January 2007, Esprithas paid us $4.6 million in total royalties for 2005 and 2006. We recognized$3.9 million in royalty revenue under this agreement in 2006, which representsthe $4.6 million minimum royalty obligation less $0.7 million of royaltyrevenue recognized in 2005. Esprit’s minimum royalty obligation for 2007 is$5.0 million, and in subsequent years is $5.0 million per year, subject toannual increases in the consumer price index beginning in 2008. Should Espritnot pay us the minimum royalty due under the agreement in future years, itcould result in a material adverse effect on our financial condition.

In 2006, we receivedroyalties of $109,000 from Biovail based on net sales of the 500mg GLUMETZA inCanada.

**License revenue**

As of December 31, 2006, we have received $40.0million in license fees under our license agreement with Esprit for ProQuin XR.We received $30.0 million in license fees in July 2005 and an additional$10.0 million in December 2006. The license fees received are beingrecognized as revenue ratably commencing on our receipt of the fees throughJune 2020, which represents the length of time we are obligated tomanufacture ProQuin XR under our ProQuin XR supply agreement with Esprit.Accordingly, license revenue increased in 2006 over 2005 as a result of a fullyear of amortization rather than a partial year of amortization in 2005. Espritis obligated to pay us an additional $10.0 million in July 2007. ShouldEsprit not pay us the final $10.0 million license fee installment, it couldresult in a material adverse effect on our financial condition.

We also received $25.0 million in license fees fromBiovail in July 2005. We are recognizing the $25.0 million license feepayment as revenue ratably until February 2023, which represents theestimated length of time our obligations exist under the arrangement related toroyalties we are obligated to pay Biovail on net sales of GLUMETZA in theUnited States and for our obligation to use Biovail as our sole supplier of the1000mg GLUMETZA, should the 1000mg GLUMETZA obtain approval in the UnitedStates.

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**Collaborativerevenue**

Collaborative revenuedecreased in 2006 from 2005 and increased in 2005 from 2004 as a result ofservices performed in 2005 under our agreement with Boehringer IngelheimPharmaceuticals, which were completed in December 2005. We are not awareof any additional work that we will be requested to perform on thispharmaceutical compound.

***Cost of Sales***

| ** **    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------|------------|----------|------------|----------|------------|----------|------------|
| Cost of sales |       | $        | 1,601,000  |     | $          | 909,000  |       |   | $ | — |   |   |
|               |            |          |            |          |            |          |            |  |  |  |  |  |

 

Cost of sales consists ofcosts of the active pharmaceutical ingredient, contract manufacturing andpackaging costs, product quality testing, internal employee costs related tothe manufacturing process, distribution costs and shipping costs related toProQuin XR and GLUMETZA product sales. Cost of sales increased in 2006 as aresult of the GLUMETZA launch in September 2006. The costs ofmanufacturing associated with deferred revenue on GLUMETZA product shipmentsare recorded as deferred costs, which are included in inventory, until suchtime the deferred revenue is recognized. We expect cost of sales to continue toincrease in 2007, as we expect product sales of GLUMETZA to increase over 2006levels.

***Research and Development Expense***

Our research and development expenses currentlyinclude costs for scientific personnel, supplies, equipment, outsourcedclinical and other research activities, consultants, depreciation, facilitiesand utilities. The scope and magnitude of future research and developmentexpenses cannot be predicted at this time for our product candidates in the earlyphases of research and development, as it is not possible to determine thenature, timing and extent of clinical trials and studies, the FDA’srequirements for a particular drug and the requirements and level ofparticipation, if any, by potential partners. As potential products proceedthrough the development process, each step is typically more extensive, andtherefore more expensive, than the previous step. Success in developmenttherefore, generally results in increasing expenditures until actual productlaunch. Furthermore, our business strategy involves licensing certain of ourdrug candidates to collaborative partners. Depending upon when suchcollaborative arrangements are executed, the amount of costs incurred solely byus will be impacted. Total research and development expense, as compared to theprior year, was as follows:

| ** **                         | ** ** | **2006**  | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------|------------|-----------|------------|------------|------------|------------|------------|
| Research and  development expense  |       | $         | 26,891,000 |       | $          | 18,369,000 |       | $ | 21,359,000 |   |
| Dollar change  from prior year     |       | 8,522,000 |       | (2,990,000 | )          |       |       |
| Percentage change from  prior year |       | 46        | %          | (14        | %)         |       |       |
|                                    |            |           |            |            |            |            |            |  |  |  |

 

In 2006, the majority of our research and developmentexpense was related to Gabapentin GR. The increase in research and developmentexpense in 2006 from 2005 was primarily due to completion of our Phase 2and commencement of our Phase 3 clinical trials for Gabapentin GR for thetreatment of postherpetic neuralgia and completion of our Phase 2 clinicaltrial for Gabapentin GR for the treatment of diabetic peripheral neuropathy. Weexpect to complete our Phase 3 clinical trial for Gabapentin GR for thetreatment of postherpetic neuralgia in 2007. We also incurred an increase instock compensation expense of $1.0 million in research and development expenseas a result of the adoption of FAS 123(R) on January 1, 2006.

The decrease in research and development expense in2005 from 2004 was primarily due to reductions in research and developmentexpense for ProQuin XR, which received FDA approval in the second quarter of2005. This decrease was partially offset by an increase in research anddevelopment expense for 

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Gabapentin GR, which beganPhase 2 clinical trials for the treatment of postherpetic neuralgia in January 2005.

We categorize our research and development expense byproject. The table below shows research and development costs for our majorclinical development programs, as well as other expenses associated with allother projects in our product pipeline.

| ** **                               | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004**   | ** ** |
|------------------------------------------|------------|-----------|------------|-----------|------------|------------|------------|
| Gabapentin GR                            |       | $         | 23,995,000 |      | $          | 12,336,000 |       | $ | 4,982,000 |   |
| ProQuin XR                               |       | —    |       | 2,250,000 |       | 11,171,000 |       |
| Other projects                           |       | 2,896,000 |       | 3,783,000 |       | 5,206,000  |       |
| Total research and  development expenses |       | $         | 26,891,000 |      | $          | 18,369,000 |       | $ | 21,359,000 |   |

 

The following table summarizes our principal productdevelopment initiatives as of March 2007. In addition to the productslisted in the table below, from time to time we may enter into feasibilitystudies with collaborative partners that, if successful, may be followed bydefinitive agreements to advance development of the product candidate.

| **Program**               | ** ** | **Potential  Indications**               | ** ** | **Development  Status**                                                  |
|---------------------------|------------|------------------------------------------|------------|--------------------------------------------------------------------------|
| Gabapentin GR             |       | Postherpetic neuralgia                   |       | Phase 3 enrollment  complete.                                       |
|                      |       | Diabetic peripheral neuropathy |       | Phase 2 trial  complete.                                            |
|                      |       | Menopausal hot flashes                   |       | IND for Phase 2  trial submitted to FDA.                            |
| Undisclosed compound |       | Gastroesophageal reflux  disease (GERD)  |       | Phase 2a proof of  concept studies underway.                        |
| Undisclosed  compound     |       | Confidential(1)                          | * *   | Preclinical studies.*Partnered with Supernus Pharmaceuticals, Inc.* |
| Undisclosed  compound     |       | Confidential(1)                          | * *   | *Partnered with New River  Pharmaceuticals, Inc.*                   |

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(1)          The compound andindication may not be disclosed pursuant to the terms of the applicablecollaboration agreement.

We expect that the pharmaceutical products that wedevelop internally will take, on average, from four to eight years to research,develop and obtain FDA approval in the United States, assuming that we aresuccessful. We generally must conduct preclinical testing on laboratory animalsof new pharmaceutical products prior to commencement of clinical studiesinvolving human beings. These studies evaluate the potential efficacy andsafety of the product. We then submit the results of these studies to the FDAas part of an Investigational New Drug Application, or IND, which, ifsuccessful, allows the opportunity for clinical study of the potential newmedicine.

Typically, humanclinical evaluation involves a time-consuming and costly three-phase process:

•     In Phase 1, we conductclinical trials with a small number of subjects to determine a drug’s earlysafety profile and its blood concentration profile over time. A Phase 1trial for our average potential product may take 6 to 12 months to plan andcomplete.

•     In Phase 2, we conductlimited clinical trials with groups of patients afflicted with a specificdisease in order to determine preliminary efficacy, optimal dosages and furtherevidence of safety. A Phase 2 trial for our average potential product maytake 9 to 18 months to plan and complete.

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•     In Phase 3, we conductlarge-scale, multi-center, comparative trials with patients afflicted with atarget disease in order to provide enough data to demonstrate the efficacy andsafety required by the FDA prior to commercialization of the product. APhase 3 trial for our average potential product may take 1 to 3 years toplan and complete.

The most significant expenses associated with clinicaldevelopment derive from the Phase 3 trials as they tend to be the longestand largest studies conducted during the drug development process. We began aPhase 3 trial for Gabapentin GR for the treatment of postherpeticneuralgia in May 2006 and we expect to report the results of the study mid-2007.If the results of the study are positive, we expect to file an NDA forGabapentin GR for postherpetic neuralgia in the fourth quarter of 2007.

We anticipate our research and development expense toincrease slightly in 2007 as we expect to complete our Phase 3 trial forGabapentin GR for postherpetic neuralgia, commence a Phase 2 trial forGabapentin GR for the treatment of menopausal hot flashes, and conduct aPhase 2a proof of concept study for an undisclosed compound for thetreatment of GERD.

The successful developmentof pharmaceutical products is highly uncertain. The FDA closely monitors theprogress of each phase of clinical testing. The FDA may, at its discretion,re-evaluate, alter, suspend or terminate testing based upon the dataaccumulated to that point and the FDA’s assessment of the risk/benefit ratio topatients. The FDA may also require additional clinical trials after approval,which are known as Phase 4 trials. Various statutes and regulations alsogovern or influence the manufacturing, safety, labeling, storage and recordkeeping for each product. The lengthy process of seeking FDA approvals, and thesubsequent compliance with applicable statutes and regulation, require theexpenditure of substantial resources.

***Selling, General and Administrative Expense***

Selling, general and administrative expenses primarilyconsist of personnel expenses to support our operating activities, marketingand promotion expenses associated with GLUMETZA, facility costs andprofessional expenses, such as legal and accounting fees. Total selling,general and administrative expenses, as compared to the prior year, were asfollows:

| ** **                                    | ** ** | **2006**   | ** ** | **2005**  | ** ** | **2004**   | ** ** |
|-----------------------------------------------|------------|------------|------------|-----------|------------|------------|------------|
| Selling, general  and administrative expenses |       | $          | 22,667,000 |      | $          | 11,639,000 |       | $ | 5,179,000 |   |
| Dollar change  from prior year                |       | 11,028,000 |       | 6,460,000 |       |       |       |
| Percentage change from  prior year            |       | 95         | %          | 125       | %          |       |       |
|                                               |            |            |            |           |            |            |            |  |  |  |

 

In 2004, we announced our determination to evolve froma solely product development focused company to an integrated specialtypharmaceutical company with sales and marketing of our own products. Preliminarystaffing for these activities began in 2005. In 2006, we enhanced our internalsales and marketing capabilities through the hiring of additional sales andmarketing employees and the engagement of consultants. We anticipate thebuild-up of our commercial infrastructure will continue over the next severalyears.

The increase in selling, general and administrativeexpense in 2006 from 2005 was primarily due to approximately $3.0 million inexpense related to marketing costs associated with GLUMETZA, which was launchedin September 2006, $2.4 million in related promotion fees due to Kingunder the promotion agreement related to GLUMETZA, an increase of $1.7 millionin legal fees due to our patent infringement case against IVAX, and an increasein stock compensation expense of $1.2 million as a result of the adoption ofFAS 123(R) on January 1, 2006.

The increase in selling, general and administrativeexpense in 2005 from 2004 was primarily due to approximately $3.5 million inexpense related to the planning and organization of commercial manufacturingactivities at our contract manufacturer for ProQuin XR, increased salaryexpense of 

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$1.3 million relatedto bonuses accrued under the bonus plan approved by the Compensation Committeeof the Board of Directors in July 2005 and marketing expense of $0.8million primarily related to ProQuin XR marketing incurred prior to thelicensing of ProQuin XR and during the transition of marketing activities toEsprit.

We expect that selling,general and administrative expense will continue to increase as we build asales force and incur increased expenses associated with the promotion andmarketing of GLUMETZA.

***Interest Income and Expense***

| ** **                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004**  | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Interest income                |       | $        | 2,031,000  |     | $          | 1,445,000 |       | $ | 489,000 |   |
| Interest expense               |       | —   |       | (460,000 | )          | (929,000  | )          |
| Net interest income  (expense) |       | $        | 2,031,000  |     | $          | 985,000   |       | $ | (440,000 | ) |

 

Interest income increased in 2006 over 2005 due tohigher investment balances in 2006 resulting from of our receipt of licensefees from Esprit and Biovail in 2005 and also due to higher interest ratesearned on our investment portfolio.

Interest expense in 2005and 2004 was mainly due to interest on a promissory note, issued to ElanCorporation plc, or Elan. The note was fully repaid in June 2005.

***Gain from Extinguishment of Debt***

In connection with theformation of DDL, an Elan joint venture, Elan made a loan facility available tous for up to $8,010,000 in principal to support our 80.1% share of the jointventure’s research and development costs pursuant to a convertible promissorynote issued by us to Elan. The funding term of the loan expired in November 2002.The note had a six-year term, was due in January 2006, and bore interestat 9% per annum, compounded semi-annually, on any amounts borrowed under thefacility. However, in June 2005, we repurchased the promissory note withan outstanding balance of $10,724,000, including $2,927,000 of accruedinterest, for $9,665,000 including commissions paid to a financial consultantand legal fees. A gain on the extinguishment of the debt of $1,059,000 wasrecorded in other income in 2005.

***Series A Preferred Stock and Deemed Dividends***

In January 2000, we issued 12,015 shares of Series APreferred Stock at a price of $1,000 per share. The Series A PreferredStock accrued a dividend of 7% per annum, compounded semi-annually and payablein shares of Series A Preferred Stock. The Series A Preferred Stockwas convertible at anytime between January 2002 and January 2006 intoour common stock. The original conversion price of the Series A PreferredStock was $12.00. However, as a result of our March 2002 and October 2003financings, the conversion price was adjusted to $9.51 per share. In December 2004,we entered into an agreement with the Series A Preferred shareholder toresolve a misunderstanding between us and the shareholder relating primarily toprior adjustments to the conversion price of the Series A Preferred Stock(the December 2004 Agreement). Pursuant to the December 2004Agreement, among other matters, we agreed to adjust the conversion price to$7.50 per share. We and the shareholder also agreed to binding interpretationsof certain other terms related to the Series A conversion price.

Prior to December 2004, the amounts calculated asSeries A Preferred stock dividends were accounted for as an adjustment tothe conversion price following EITF Issue No. 98-5, *Accounting for Convertible Securities with BeneficialConversion Features or Contingently Adjustable Conversion Ratios*(IssueNo. 98-5).**As a resultof the December 2004 Agreement, we determined that a significantmodification of the preferred stock agreement had occurred, and, therefore, anew commitment date was established for the Series A Preferred Stock.Further, we determined that the fair value of the modified preferred stock 

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was below the carryingvalue of such securities as of the date of the modification, therefore, nodeemed dividend resulted from this modification. Also, we determined thatalthough a new commitment date had been established, this change did not resultin a beneficial conversion feature subject to recognition pursuant to EmergingIssues Task Force Issue No. 00-27, *Applicationof Issue No. 98-5 to Certain Convertible Instruments*.However, an anti-dilution provision of the Series A Preferred Stock wastriggered by our January 2005 financing, which adjusted the conversionprice of the Series A Preferred Stock to $7.12. As a result of theadjusted conversion price and an increase in the amount of common stockissuable upon conversion of the Series A Preferred Stock due to additionalaccumulated dividends, the Series A Preferred Stock now contains a “beneficialconversion feature” subject to recognition pursuant to Issue No. 98-5.

In conjunction with the modification of the agreement,we issued a warrant to the Series A Preferred shareholder. The value ofthe warrant was considered in determining the value of the modified security.The warrant is convertible into shares of our common stock during the periodbetween January 2006 and January 2009. The conversion price of thewarrant initially was $7.12, which was equal to the Series A PreferredStock conversion price in effect as of January 20, 2006. The conversionprice of the warrant decreases by approximately 4.8% per year during theconversion period, such that the number of shares of our common stock issuableupon conversion of the warrant will increase by approximately 5.1% per year.The conversion of the warrant may be satisfied only by surrender of theoutstanding shares of Series A Preferred Stock.

The Series A Preferred Stock accrued dividendsthrough January 20, 2006, the date the warrant initially becameexercisable. As a result of the issuance of the warrant, the preferred stockmay be surrendered in exchange for common stock for an additional three yearsthrough January 20, 2009. As long as the Series A Preferred Stockremains outstanding, the number of shares into which the warrant can beconverted increases as the conversion price of the warrant decreases resultingin additional deemed dividends on the Series A Preferred Stock. For theyears ended December 31, 2006, 2005 and 2004 we recognized Series APreferred Stock deemed dividends of approximately $665,000, $842,000 and zero,respectively, attributable to the beneficial conversion feature from theaccrued dividends and decreasing warrant price. We will continue to recognizeSeries A Preferred Stock deemed dividends until the earlier of the timethe Series A Preferred Stock is surrendered or January 2009.

As of December 31,2006, there were 18,158 shares of Series A Preferred Stock outstandingwith an aggregate liquidation preference of approximately $18,159,000. Thewarrant was convertible into 2,672,423 shares of our common stock at aconversion price of $6.79 as of December 31, 2006.

**LIQUIDITY ANDCAPITAL RESOURCES**

| ** **                                        | ** ** | **As of December 31,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                        | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Cash, cash  equivalents and marketable securities |       | $                                     | 33,557,000 |   | $ | 59,073,000 |   |
|                                                   |            |                                       |            |  |  |  |  |

 

Since inception through December 31, 2006, wehave financed our product development and operations primarily from private andpublic sales of equity securities and receipts of upfront license fees fromcollaborative and license partners. InJanuary 2005, we completed a registered direct public offering of5,036,000 shares of our common stock at $4.50 per share with net proceeds of$21,019,000. In July 2005, we received $25.0 million under our licenseagreement with Biovail and $30.0 million under our license agreement withEsprit. In December 2006, we received an additional $10.0 million fromEsprit. Esprit is obligated to pay us an additional $10.0 million inJuly 2007.

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In December 2006, weentered into a common stock purchase agreement with Azimuth Opportunity, Ltd.,pursuant to which Azimuth is committed to purchase, from time to time and atour sole discretion, up to the lesser of (a) $30,000,000 of our commonstock, or (b) 8,399,654 shares of common stock. Sales to Azimuth under theagreement, if any, will occur over a 24-month term and will be made at aprice equal to the average closing price of our common stock over a givenpricing period, minus a discount ranging from 3.775% to 6.375%, which variesbased on a threshold price set by us. Upon each sale of the our common stock toAzimuth under the agreement, we have also agreed to pay Reedland CapitalPartners a placement fee equal to 1.125% of the aggregate dollar amount ofcommon stock purchased by Azimuth. Azimuth is not required to purchase ourcommon stock when the price of our common stock is below $2 per share. As ofDecember 31, 2006, we have not sold any common stock to Azimuth under thiscommon stock purchase agreement.

As of December 31,2006, we have accumulated net losses of $184.1 million. We expect to continueto incur operating losses for at least the next year. We anticipate that ourexisting capital resources and contractual amounts due to us will permit us tomeet our capital and operational requirements through at least the endof 2007. We base this expectation on our current operating plan, whichmay change as a result of many factors.

Ourcash needs may also vary materially from our current expectations becauseof numerous factors, including:

·       expenditures related to ourcommercialization efforts;

·       results of research anddevelopment efforts;

·       financial terms ofdefinitive license agreements or other commercial agreements we enter into, ifany;

·       receipt of payments due tous under our contracts with collaborative partners;

·       results of our litigationagainst IVAX Corporation;

·       changes in the focus anddirection of our research and development programs;

·       technological advances;

·       results of clinicaltesting, requirements of the FDA and comparable foreign regulatory agencies;and

·       acquisitions or investmentin complimentary businesses, products or technologies.

Wewill need substantial funds of our own or from third parties to:

·       conduct research anddevelopment programs;

·       conduct preclinical andclinical testing; and

·       manufacture (or havemanufactured) and market (or have marketed) potential products using the AcuForm technology.

Ourexisting capital resources may not be sufficient to fund our operationsuntil such time as we may be able to generate sufficient revenues tosupport our operations. We have limited credit facilities and except for thecommon stock purchase agreement with Azimuth, we have no other committedsources of capital. To the extent that our capital resources are insufficientto meet our future capital requirements, we will have to raise additional fundsthrough the sale of our equity securities or from development and licensingarrangements to continue our development programs. We may be unable toraise such additional capital on favorable terms, or at all. If we raiseadditional capital by selling our equity or convertible debt securities, theissuance of such securities could result in dilution of our shareholders’equity positions. If adequate funds are not available we may have to:

·       delay, postpone orterminate clinical trials;

·       curtail other operationssignificantly; and/or

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·       obtain funds throughentering into collaboration agreements on unattractive terms.

The inability to raiseadditional capital would have a material adverse effect on our company.

The following tablesummarizes our cash flow activities:

| ** **                                       | ** ** | **2006**   | ** **  | **2005**    | ** ** | **2004**   | ** ** |
|--------------------------------------------------|------------|------------|-------------|-------------|------------|------------|------------|
| Cash provided by (used  in) operating activities |       | $          | (27,700,000 | )           | $          | 28,817,000 |       | $ | (23,268,000 | ) |
| Cash provided by  (used in) investing activities |       | 31,764,000 |        | (34,822,000 | )          | 4,086,000  |       |
| Cash provided by  financing activities           |       | 2,945,000  |        | 12,618,000  |       | 91,000     |       |
|                                                  |            |            |             |             |            |            |            |  |  |  |

 

In 2006, cash used inoperating activities was primarily our net loss for the year adjusted forstock-based compensation, depreciation expense and movements in workingcapital. In 2005, cash provided from operations was due primarily to increasesin deferred revenue related to license payments received under our agreementswith Esprit and Biovail, partially offset by our net loss for the year. In2004, cash used in operations was primarily our net loss for the year adjustedfor depreciation and movements in working capital.

Cash provided by investingactivities in 2006 was due to a $32,539,000 net decrease in marketablesecurities partially offset by $774,000 in purchases of laboratory and officeequipment. Cash used in investing activities in 2005 consisted of a netincrease in marketable securities of $34,031,000 resulting from investment oflicense fees received under our agreements with Esprit and Biovail and $791,000in purchases of lab and office equipment. Cash provided by investing activitiesin 2004 consisted primarily of a net decrease in marketable securities of $6,758,000partially offset by $2,673,000 in purchases of capital equipment and leaseholdimprovements, including approximately $1,936,000 of improvements related toadditional space we leased.

Cash provided fromfinancing activities in 2006 consisted of $2,945,000 of proceeds from exercisesof stock options, warrants and purchases of common stock under our employeestock purchase plan. Cash provided from financing activities in 2005 consistedprimarily of net proceeds of $21,019,000 from our registered direct public offeringof 5,036,000 shares of common stock for $4.50 per share in January 2005and $1,370,000 in proceeds from the exercise of stock options, warrants andpurchases of common stock under our employee stock purchase plan, which werepartially offset by the repayment of the Elan promissory note of $9,665,000 and$106,000 in payments on equipment loans and capital lease obligations. Cashprovided from financing activities in 2004 was $91,000 and consisted primarilyof $419,000 of proceeds from exercises of stock options and warrants partiallyoffset by $328,000 in payments on equipment loans and capital leases.

***ContractualObligations***

As of December 31,2006, our contractual obligations are shown in the following table:

| ** **            | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **Total** | ** ** |
|-----------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|-----------|------------|
| Operating leases      |       | $                               | 1,230,000  |               | $          | 2,191,000          |       | $         | 19,000     |   | $ | 3,440,000 |   |
| Purchase  commitments |       | 2,752,000                       |       | —             |       | —             |       | 2,752,000 |       |
|                  |       | $                               | 3,982,000  |               | $          | 2,191,000          |       | $         | 19,000     |   | $ | 6,192,000 |   |

 

At December 31, 2006, we had non-cancelablepurchase orders and minimum purchase obligations for 2007 of $2,542,000 underour manufacturing agreement with MOVA Pharmaceuticals for the manufacture ofGLUMETZA. The amounts disclosed only represent minimum purchase requirements.Actual purchases are expected to exceed these amounts. We are alsocontractually obligated to pay PharmaNova consultancy fees of $210,000 in 2007under a consulting agreement related to our Gabapentin GR product candidate forthe treatment of menopausal hot flashes.

The contractual obligationsreflected in this table exclude $3.5 million of contingent milestone paymentswe may be obligated to pay in the future under our sublicense agreement withPharmaNova. 

51

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Thesepayments relate to various milestones for the product candidate under thesublicense agreement, including dosing of the first patient in any Phase 3trial, submission to the FDA of an NDA, and FDA approval of an NDA. The abovetable also excludes any future royalty payments we may be required to pay onproducts we have licensed or any promotion fees associated with our promotionagreement with King.

**OFF-BALANCE SHEETARRANGEMENTS**

We do not have anyoff-balance sheet arrangements that are reasonably likely to have a current orfuture material effect on our financial condition, results of operations,liquidity, capital expenditures or capital resources.

**RECENTLY ISSUEDACCOUNTING STANDARDS**

In July 2006, theFinancial Accounting Standards Board (FASB) issued FASB Interpretation No. 48,*Accounting for Uncertainty in Income Taxes, aninterpretation of FASB Statement No. 109* (FIN 48).FIN 48 clarifies the accounting for uncertainty in income taxes byprescribing the recognition threshold a tax position is required to meet beforebeing recognized in the financial statements. It also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006 and is required to be adopted by us on January 1,2007. We are currently evaluating the effect that the adoption of FIN 48will have on our consolidated results of operations and financial condition andare not yet in a position to determine such effects.

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

***InterestRate Risk***

We consider all highlyliquid investments with an original maturity (at date of purchase) of threemonths or less to be cash equivalents. At December 31, 2006, ourmarketable securities available for sale consisted of U.S. corporate debt andU.S. mortgage-backed debt securities with maturity dates of less than twoyears. Our investments in U.S. corporate debt securities consist primarily ofinvestments in investment grade corporate bonds and notes. Our investments inU.S. government debt securities consist of low risk government agency bondstypically with a rating of A or higher. Our operating results have not beensensitive to changes in the general level of interest rates in the UnitedStates, particularly because most of our marketable securities are invested inshort-term debt instruments.

As of December 31, 2006, the principal amounts,fair values and related weighted-average interest rates of our investments indebt securities classified as marketable securities available-for-sale were asfollows:

| ** **            | ** ** | **Duration**                        | ** ** |
|-----------------------|------------|-------------------------------------|------------|
| ** **            | ** ** | **Less than 1 year** | ** ** | **1 to 2 years** | ** ** | **Total** | ** ** |
| Principal amount      |       |                                | $          | 16,006,000 |   |   | $ | 3,000,000 |   | $ | 19,006,000 |   |
| Fair value            |       |                                | $          | 15,989,000 |   |   | $ | 2,994,000 |   | $ | 18,983,000 |   |
| Average interest rate |       |                                | 5.24       | % |   | 5.03 | % | 5.21 | % |

 

***Foreign Currency Risk***

We have not had anysignificant transactions in foreign currencies, nor did we have any significantbalances that were due or payable in foreign currencies at December 31,2006. Accordingly, significant changes in foreign currency rates would not havea material impact on our financial position and results of operations.

52

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**ITEM 8.**             FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

The financial statements required by this item are setforth beginning on page 60 of this report and are incorporated herein byreference.

**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTINGAND FINANCIAL DISCLOSURE

None.

**ITEM9A.**        CONTROLS AND PROCEDURES

**(a) Conclusion Regarding the Effectiveness of DisclosureControls and Procedures**

At the end of the periodcovered by this report, we carried out an evaluation, under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer, of the effectiveness of the design andoperation of our disclosure controls and procedures, as such term is definedunder Rule 13a-15(e) promulgated under the Securities ExchangeAct of 1934, as amended (the Exchange Act). Based on this evaluation, ourprincipal executive officer and our principal financial officer concluded thatour disclosure controls and procedures were effective as of December 31,2006 to ensure that information to be disclosed by us in this Annual Report on Form 10-Kwas recorded, processed summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and Form 10-K.

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our Exchange Act reports is recorded, processed, summarizedand reported within the time periods specified in the Securities and ExchangeCommission’s rules and forms and that such information is accumulated andcommunicated to our management, including our chief executive officer and chieffinancial officer, as appropriate, to allow for timely decisions regardingrequired disclosure. There were no changes in our internal controls overfinancial reporting during the quarter ended December 31, 2006 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

We intend to review andevaluate the design and effectiveness of our disclosure controls and procedureson an ongoing basis and to correct any material deficiencies that we maydiscover. Our goal is to ensure that our management has timely access tomaterial information that could affect our business. While we believe thepresent design of our disclosure controls and procedures is effective toachieve our goal, future events affecting our business may cause us to modifyour disclosure controls and procedures. In designing and evaluating thedisclosure controls and procedures, management recognizes that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement is required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

**(b) Management’s Report on Internal Control OverFinancial Reporting**

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rules 13a-15(f).Under the supervision and with the participation of our management, includingour principal executive officer and principal financial officer, we conductedan evaluation of the effectiveness of our internal control over financialreporting based on the framework in*InternalControl - Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission. Based on our evaluation under theframework in*Internal Control - IntegratedFramework*, our management concluded that our internal control overfinancial reporting was effective as of December 31, 2006.

Our management’sassessment of the effectiveness of our internal control over financialreporting as of December 31, 2006 has been audited by Ernst &Young LLP, an independent registered public accounting firm, as stated in theirreport which is included herein.

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**Reportof Independent Registered Public Accounting Firm**

The Board of Directors andShareholdersDepomed, Inc.

We have audited management’sassessment, included above in the accompanying Management’s Report on InternalControl Over Financial Reporting, that Depomed, Inc. maintained effectiveinternal control over financial reporting as of December 31, 2006, basedon criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria). DepomedInc.’s management is responsible for maintaining effective internal controlover financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of thecompany’s internal control over financial reporting based on our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design andoperating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinion.

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

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

In our opinion, management’sassessment that Depomed, Inc. maintained effective internal control overfinancial reporting as of December 31, 2006, is fairly stated, in allmaterial respects, based on the COSO criteria. Also, in our opinion, Depomed, Inc.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2006, based on****the COSO criteria**.**

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Depomed, Inc. as of December 31,2006 and 2005, and the related consolidated statements of operations, shareholders’equity (deficit), and cash flows for each of the three years in the period endedDecember 31, 2006 of Depomed, Inc. and our report dated March 15,2007 expressed an unqualified opinionthereon.
|                                       | /s/ Ernst &  Young LLP |   |   |
|---------------------------------------|---------------------------------|--------|--------|
| Palo Alto, California  March 15, 2007 |                            |

 

54

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**ITEM 9B.**       OTHERINFORMATION

None.

**PART III**

**ITEM 10.**         DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by this Item with respect toexecutive officers is set forth in Part I of this report and theinformation with respect to directors and corporate governance matters isincorporated by reference to the information set forth under the caption “Electionof Directors” in the company’s Proxy Statement for the 2007 Annual Meeting ofShareholders.

The section entitled “Compliance Under Section 16(a) ofthe Securities Exchange Act of 1934” appearing in the Proxy Statement for the2007 Annual Meeting of Shareholders sets forth the information concerningcompliance by officers, directors and 10% shareholders of the company with Section 16of the Exchange Act of 1934 and is incorporated herein by reference.

**ITEM 11.**         EXECUTIVECOMPENSATION

The information required by this Item is incorporatedherein by reference to the information set forth under the caption “ExecutiveCompensation” in the Proxy Statement for the 2007 Annual Meeting ofShareholders.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDERMATTERS

The information required by this Item is incorporatedherein by reference to the information set forth under the caption “SecurityOwnership of Certain Beneficial Owners and Management and Related ShareholderMatters” in the Proxy Statement for the 2007 Annual Meeting of Shareholders.

**ITEM  13.**      CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, ANDDIRECTOR INDEPENDENCE

The information required by this Item is incorporatedherein by reference to the information set forth under the captions “Directors”and “Certain Relationships and Related Transactions” in the Proxy Statement forthe 2007 Annual Meeting of Shareholders.

**ITEM 14.**         PRINCIPALACCOUNTANT FEES AND SERVICES

The information required by this Item is incorporatedherein by reference to the information set forth under the caption “PrincipalAccountant Fees and Services” in the Proxy Statement for the 2007 AnnualMeeting of Shareholders.

55

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**PART IV**

**ITEM15.**         EXHIBITS AND FINANCIALSTATEMENT SCHEDULES

**(a)**

**1.****                 FinancialStatements**

Reportof Independent Registered Public Accounting Firm

ConsolidatedBalance Sheets

ConsolidatedStatements of Operations

ConsolidatedStatements of Cash Flows

ConsolidatedStatements of Shareholders’ Equity (Deficit)

Notesto Consolidated Financial Statements

**2.****                 FinancialStatement Schedules**

Schedule II isincluded on page 92 of this report. All other schedules are omittedbecause they are not required or the required information is included in thefinancial statements or notes thereto.

**3.****                 Exhibits:**
| Exhibit | ** ** | **Footnote** | ** ** | **Description of Document**                                                                                                                                                                                             |
|---------|------------|--------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1     |       | (1)          |       | Amended and Restated  Articles of Incorporation                                                                                                                                                                         |
| 3.2     |       | (2)          |       | Certificate of Amendment  to Amended and Restated Articles of Incorporation                                                                                                                                             |
| 3.3     |       | (3)          |       | Certificate of  Determination of Rights and Preferences of Series A Preferred Stock  filed with the State of California on January 14, 2000                                                                   |
| 3.4     |       | (4)          |       | Certificate of  Determination of Series RP Preferred Stock of the company                                                                                                                                          |
| 3.5     |       | (5)          |       | Bylaws, as amended                                                                                                                                                                                                      |
| 4.1     |       | (6)          |       | Form of  Subscription Agreement dated as of May 2, 2001                                                                                                                                                       |
| 4.2     |       | (6)          |       | Supplement to  Form of Subscription Agreement dated as of May 29, 2001                                                                                                                                        |
| 4.3     |       | (6)          |       | Form of Warrant  dated as of June 13, 2001                                                                                                                                                                    |
| 4.4     |       | (7)          |       | Form of  Subscription Agreement dated as of March 14, 2002                                                                                                                                                    |
| 4.5     |       | (7)          |       | Placement Agent Warrant  dated as of March 14, 2002                                                                                                                                                                |
| 4.6     |       | (8)          |       | Stock Purchase  Agreement, dated as of May 28, 2002, between the Company and Biovail  Laboratories International SRL                                                                                               |
| 4.7     |       |         |       | Amendment No. 1 to  Stock Purchase Agreement, dated as February 7, 2007, between the Company  and Biovail Laboratories International SRL                                                                      |
| 4.8     |       | (9)          |       | Form of Warrant  dated as of April 21, 2003                                                                                                                                                                   |
| 4.9     |       | (9)          |       | Depomed, Inc.  Securities Purchase Agreement, dated as of April 21, 2003                                                                                                                                      |
| 4.10    |       | (10)         |       | Form of Warrant to  purchase common stock dated December 10, 2004 (see Exhibit A of  Exhibit 10.13 below)                                                                                           |
| 4.11    |       | (11)         |       | Rights Agreement, dated  as of April 21, 2005, between the company and Continental Stock Transfer  and Trust Company as Rights Agent                                                                               |
| 10.1**  |       | (12)         |       | 1995 Stock Option Plan,  as amended                                                                                                                                                                                     |
| 10.2    |       |         |       | Form of Incentive  Stock Option Agreement under 1995 Stock Option Plan                                                                                                                                             |
| 10.3    |       |         |       | Form of  Nonstatutory Stock Option Agreement under 1995 Stock Option Plan                                                                                                                                          |
| 10.4    |       |         |       | Form of Exercise  Notice under 1995 Stock Option Plan                                                                                                                                                              |
| 10.5    |       | (1)          |       | Agreement re: Settlement  of Lawsuit, Conveyance of Assets and Assumption of Liabilities dated  August 28, 1995 by and among Depomed Systems, Inc., Dr. John  W. Shell and M6 Pharmaceuticals, Inc. |
| 10.6**  |       | (13)         |       | Form of  Indemnification Agreement between the Company and its directors and executive  officers                                                                                                                   |
| 10.7    |       | (14)         |       | Settlement and Release  Agreement, dated as of November 22, 2002, between the Company and  Bristol-Myers Squibb Company                                                                                            |

56

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| 10.8    |   | (15)   |   | Lease extension  agreement dated April 30, 2003 between the Company and Menlo Business  Park LLC                                                                        |
|---------|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.9    |   | (15)   |   | Lease agreement dated  April 30, 2003 between the Company and Menlo Park Business Park LLC                                                                              |
| 10.10   |   | (16)   |   | Termination Agreement,  dated as of September 16, 2003 among the Company, Elan Corporation, plc,  Elan Pharma International Limited, Ltd. And Depomed Development, Ltd. |
| 10.11** |   |   |   | 2004 Equity Incentive  Plan                                                                                                                                                  |
| 10.12** |   | (17)   |   | 2004 Employee Stock  Purchase Plan                                                                                                                                           |
| 10.13   |   | (10)   |   | Agreement, dated as of  December 10, 2004, between the Company and Kings Road Investments, Ltd.                                                                         |
| 10.14** |   | (18)   |   | Offer Letter, dated  June 14, 2005, between the Company and Carl Pelzel                                                                                                 |
| 10.15   |   | (19)   |   | Convertible  Note Repurchase Agreement, dated as of June 24, 2005, between the  Company and Elan Pharma International Limited                                      |
| 10.16+  |   | (20)   |   | Exclusive License and  Marketing Agreement dated July 21, 2005 between the Company and Esprit  Pharma, Inc.                                                        |
| 10.17*  |   | (13)   |   | Amendment No. 1 to  Exclusive License and Marketing Agreement between the Company and Esprit  Pharma, Inc., dated as of July 24, 2006                         |
| 10.18*  |   | (21)   |   | Technology Transfer and  Commercial Manufacturing Agreement dated October 18, 2005 between the  Company and MOVA Pharmaceutical Corporation                             |
| 10.19+  |   | (21)   |   | Amended and Restated  License Agreement dated December 13, 2005 between the Company and  Biovail Laboratories International SRL                                         |
| 10.20+  |   | (21)   |   | Supply Agreement dated  December 13, 2005 between the Company and Biovail Laboratories International  SRL                                                               |
| 10.21+  |   | (21)   |   | Manufacturing Transfer  Agreement dated December 13, 2005 between the Company and Biovail  Laboratories International SRL                                               |
| 10.22** |   | (22)   |   | Description of  Non-employee Director Compensation Policy, as amended                                                                                                        |
| 10.23** |   | (23)   |   | Bonus Plan of the  Company, as amended                                                                                                                                       |
| 10.24** |   | (24)   |   | Form of Management  Continuity Agreement between the Company and certain officers of the Company                                                                        |
| 10.25   |   | (25)   |   | Offer Letter, dated  June 14, 2006, between the Company and Matthew Gosling                                                                                             |
| 10.26*  |   | (26)   |   | Promotion Agreement,  dated as of June 27, 2006, between the Company and King  Pharmaceuticals, Inc.                                                               |
| 10.27*  |   | (13)   |   | Co-Promotion Agreement  dated July 24, 2006 between the Company and Esprit Pharma, Inc.                                                                            |
| 10.28   |   | (13)   |   | Lease Agreement dated  July 28, 2006 between the Company and Menlo Business Park, LLC                                                                                   |
| 10.29   |   | (13)   |   | Lease Extension  Agreement dated July 28, 2006 between the Company and Menlo Business  Park, LLC                                                                        |
| 10.30   |   | (13)   |   | Second Lease Extension  Agreement dated July 28, 2006 between the Company and Menlo Business  Park, LLC                                                                 |
| 10.31*  |   |   |   | Sublicense Agreement  dated October 13, 2006 between the Company and PharmaNova, Inc.                                                                              |
| 10.32   |   | (27)   |   | Common Stock Purchase  Agreement dated December 11, 2006 between the Company and Azimuth  Opportunity Ltd. dated December 11, 2006.                                |
| 10.33*  |   |   |   | Commercial Manufacturing  Agreement dated December 19, 2006 between the Company and MOVA  Pharmaceutical Corporation                                                    |
| 23.1    |   |   |   | Consent of Independent  Registered Public Accounting Firm                                                                                                                    |
| 24.1    |   |   |   | Power of Attorney (See  Page 59)                                                                                                                                        |

57

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| 31.1 |   |   |   | Certification pursuant  to Rule 13a-14(a) under the Securities Exchange Act of 1934  of John W. Fara, Ph.D. |
|------|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------|
| 31.2 |   |   |   | Certification pursuant  to Rule 13a-14(a) under the Securities Exchange Act of John  F. Hamilton            |
| 32.1 |   |   |   | Certification pursuant  to 18 U.S.C. Section 1350 of John W. Fara, Ph.D.                                         |
| 32.2 |   |   |   | Certification pursuant  to 18 U.S.C. Section 1350 of John F. Hamilton                                            |

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       (1) Incorporatedby reference to the Company’s registration statement on Form SB-2(File No. 333-25445)

       (2) Incorporatedby reference to the Company’s Form 10-K filed on March 31, 2003

       (3) Incorporatedby reference to the Company’s Form 8-K filed on February 18,2000

       (4) Incorporated by reference to the Company’sForm 10-Q filed on May 10, 2005

       (5) Incorporatedby reference to the Company’s Form 8-K filed on April 19, 2005

       (6) Incorporatedby reference to the Company’s registration statement on Form S-3(File No. 333-66688) filed on August 3, 2001

       (7) Incorporatedby reference to the Company’s registration statement on Form S-3(File No. 333-86542) filed on April 18, 2002

       (8) Incorporatedby reference to the Company’s Form 8-K/A dated May 28, 2002 andfiled on December 23, 2002

       (9) Incorporatedby reference to the Company’s Form 8-K filed on April 25, 2003

(10) Incorporatedby reference to the Company’s Form 8-K filed on December 14,2004

(11) Incorporatedby reference to the Company’s Form 8-A filed on April 22, 2005

(12) Incorporatedby reference to the Company’s registration statement on Form S-8(File No. 333-101796) filed on December 12, 2002

(13) Incorporated by reference to the Company’sForm 10-Q filed on November 9, 2006

(14) Incorporatedby reference to the Company’s Form 8-K/A dated November 22,2002 and filed on December 23, 2002

(15) Incorporatedby reference to the Company’s Form 10-Q filed on August 14,2003

(16) Incorporatedby reference to the Company’s Form 10-Q filed on November 14,2003

(17) Incorporatedby reference to the Company’s Form S-8 filed on June 21, 2004

(18) Incorporated by reference to the Company’sForm 8-K filed on June 17, 2005

(19) Incorporated by reference to the Company’sForm 8-K filed on June 29, 2005

(20) Incorporated by reference to the Company’sForm 10-Q filed on November 9, 2005

(21) Incorporated by reference to the Company’sForm 10-K filed on March 16, 2006

(22) Incorporated by reference to the Company’sForm 8-K filed on March 29, 2006 and the Company’s Form 8-Kfiled on December 12, 2006

(23) Incorporated by reference to the Company’sForm 8-K filed on April 12, 2006

(24) Incorporated by reference to the Company’sForm 8-K filed on May 19, 2006

(25) Incorporated by reference to the Company’sForm 8-K filed on June 30, 2006

(26) Incorporated by reference to the Company’sForm 10-Q filed on August 7, 2006

(27) Incorporated by reference to the Company’sForm 8-K filed on December 12, 2006

+                Confidentialtreatment granted

*                    Confidentialtreatment requested

**    Managementcontract, compensation plan or arrangement

58

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the issuer, a corporation organized andexisting under the laws of the State of California, has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized, in theCity of Menlo Park, State of California, on the 15th day of March 2007.

|            | DEPOMED, INC. |
|------------|--------------------|
|            | By                 | **/s/ John W. Fara, Ph.D.** |
| ** ** | ** **         | **John W. Fara, Ph.D. *Chairman, President and Chief Executive Officer*** |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below hereby constitutes and appoints John W. Fara andJohn F. Hamilton, and each of them acting individually, as his true and lawfulattorneys-in-fact and agents, each with full power of substitution, for him inany and all capacities, to sign any and all amendments to this report on Form 10-Kand to file the same, with exhibits thereto and other documents in connectiontherewith, with the Securities and Exchange Commission, granting unto saidattorneys-in-fact and agents, with full power of each to act alone, full powerand authority to do and perform each and every act and thing requisite andnecessary to be done in connection therewith, as fully for all intents andpurposes as he might or could do in person, hereby ratifying and confirming allthat said attorneys-in-fact and agents, or his or their substitute orsubstitutes, may lawfully do or cause to be done by virtue hereof.

**Pursuant to therequirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-Khas been signed by the following persons in the capacities and on the datesindicated.**
|                              | **Signature** | ** **                                       | ** ** | ** **           | ** ** | ** ** |
|------------------------------|---------------|--------------------------------------------------|------------|----------------------|------------|------------|
| **/s/ John W. Fara, Ph.D.**  |          | Chairman,  President and Chief Executive         |       | March 15,  2007 |
| **John W. Fara, Ph.D.**      |          | Officer (Principal  Executive Officer)           |       |                 |
| **/s/ John F. Hamilton**     |          | Vice President,  Finance and Chief               |       | March 15,  2007 |
| **John F. Hamilton**         |          | Financial Officer (Principal  Financial Officer) |       |                 |
| **/s/ G. Steven Burrill**    |          | Director                                         |       | March 15,  2007 |
| **G. Steven Burrill**        |          |                                             |       |                 |
| **/s/ John W. Shell, Ph.D.** |          | Director                                         |       | March 15,  2007 |
| **John W. Shell, Ph.D.**     |          |                                             |       |                 |
| **/s/ Craig R. Smith, M.D.** |          | Director                                         |       | March 15,  2007 |
| **Craig R. Smith, M.D.**     |          |                                             |       |                 |
| **/s/ Peter D. Staple**      |          | Director                                         |       | March 15,  2007 |
| **Peter D. Staple**          |          |                                             |       |                 |
| **/s/ Julian N. Stern**      |          | Director and  Secretary                          |       | March 15,  2007 |
| **Julian  N. Stern**         |          |                                             |       |                 |

 

59

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**DEPOMED, INC.INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

**DEPOMED, INC.CONSOLIDATED FINANCIAL STATEMENTS**
| Report of Independent  Registered Public Accounting Firm        |   | 61 |   |
|-----------------------------------------------------------------|--------|----|--------|
| Consolidated Balance Sheets                                     |   | 62 |   |
| Consolidated Statements of Operations                           |   | 63 |   |
| Consolidated Statements of Shareholders’ Equity  (Deficit) |   | 64 |   |
| Consolidated Statements of Cash Flows                           |   | 65 |   |
| Notes to  Consolidated Financial Statements                     |   | 66 |   |

 

60

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and ShareholdersDepomed, Inc.

We have audited the accompanying consolidated balancesheets of Depomed, Inc. as of December 31, 2006 and 2005, and therelated consolidated statements of operations, shareholders’ equity (deficit),and cash flows for each of the three years in the period ended December 31,2006. Our audits also included the financial statement schedule listed in theIndex at Item 15(a). These financial statements and schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and schedule based on our audits.

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

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Depomed, Inc. at December 31, 2006 and 2005, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2006, in conformity with U.S.generally accepted accounting principles. Also, in our opinion, the related financialstatement schedule, when considered in relation to the basic financialstatements taken as a whole, presents fairly in all material respects theinformation set forth therein.

As discussed in Note 1 to the consolidatedfinancial statements, the Company adopted Statement of Financial AccountingStandards No. 123 (revised 2004), *Share-Based Payment*,effective January 1, 2006.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Depomed, Inc.’s internal controlover financial reporting as of December 31, 2006, based on criteriaestablished in Internal Control-Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission and our report dated March 15**,** 2007 expressed an unqualified opinion thereon.
|                                            | /s/ Ernst &  Young LLP |   |   |
|--------------------------------------------|---------------------------------|--------|--------|
| Palo Alto, California  March 15, 2007 |

 

61

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**DEPOMED, INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                                                                                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                     | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                                                                                                                                |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                                                                      |       | $                     | 14,574,110 |   | $ | 7,565,556 |   |
| Marketable securities                                                                                                                                                                                                                                                                          |       | 16,984,503            |       | 51,507,509 |   |
| Accounts receivable                                                                                                                                                                                                                                                                            |       | 7,126,895             |       | 1,094,840 |   |
| Unbilled accounts receivable                                                                                                                                                                                                                                                                   |       | 1,954,904             |       | 861,576 |   |
| Inventories                                                                                                                                                                                                                                                                                    |       | 4,483,157             |       | 901,348 |   |
| Prepaid and other current assets                                                                                                                                                                                                                                                               |       | 2,756,174             |       | 1,107,710 |   |
| Total current assets                                                                                                                                                                                                                                                                           |       | 47,879,743            |       | 63,038,539 |   |
| Marketable  securities                                                                                                                                                                                                                                                                         |       | 1,998,760             |       | — |   |
| Property and  equipment, net                                                                                                                                                                                                                                                                   |       | 2,541,463             |       | 3,146,611 |   |
| Other assets                                                                                                                                                                                                                                                                                   |       | 197,218               |       | 228,926 |   |
|                                                                                                                                                                                                                                                                                           |       | $                     | 52,617,184 |   | $ | 66,414,076 |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                                                                                                       |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                                                                                                                           |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                                                                                                               |       | $                     | 4,886,222  |   | $ | 1,588,999 |   |
| Accrued compensation                                                                                                                                                                                                                                                                           |       | 1,817,418             |       | 1,989,606 |   |
| Accrued clinical trial expense                                                                                                                                                                                                                                                                 |       | 726,379               |       | 63,005 |   |
| Accrued promotion fee expense                                                                                                                                                                                                                                                                  |       | 2,339,925             |       | — |   |
| Other accrued liabilities                                                                                                                                                                                                                                                                      |       | 3,087,998             |       | 718,788 |   |
| Deferred product sales                                                                                                                                                                                                                                                                         |       | 4,825,099             |       | 82,048 |   |
| Deferred license revenue                                                                                                                                                                                                                                                                       |       | 4,599,947             |       | 3,572,196 |   |
| Other current liabilities                                                                                                                                                                                                                                                                      |       | 55,845                |       | 93,073 |   |
| Total current liabilities                                                                                                                                                                                                                                                                      |       | 22,338,833            |       | 8,107,715 |   |
| Deferred license  revenue, non-current portion                                                                                                                                                                                                                                                 |       | 57,483,045            |       | 51,421,263 |   |
| Other long-term  liabilities                                                                                                                                                                                                                                                                   |       | 83,766                |       | 124,099 |   |
| Commitments                                                                                                                                                                                                                                                                                    |       |                  |       |   |   |
| Shareholders’ equity  (deficit):                                                                                                                                                                                                                                                          |       |                  |       |   |   |
| Preferred stock, no par value, 5,000,000 shares  authorized; Series A convertible preferred stock, 25,000 shares  designated, 18,158 and 17,543 shares issued and outstanding at  December 31, 2006 and 2005, respectively, with an aggregate liquidation  preference of $18,158,848 |       | 12,015,000            |       | 12,015,000 |   |
| Common stock, no par value, 100,000,000 shares  authorized; 42,029,411 and 40,689,369 shares issued and outstanding at  December 31, 2006 and 2005, respectively                                                                                                                          |       | 144,820,534           |       | 139,640,599 |   |
| Deferred compensation                                                                                                                                                                                                                                                                          |       | —                |       | (337,049 | ) |
| Accumulated deficit                                                                                                                                                                                                                                                                            |       | (184,111,185          | )          | (144,451,897 | ) |
| Accumulated other comprehensive (loss)                                                                                                                                                                                                                                                         |       | (12,809               | )          | (105,654 | ) |
| Total shareholders’ equity (deficit)                                                                                                                                                                                                                                                      |       | (27,288,460           | )          | 6,760,999 |   |
|                                                                                                                                                                                                                                                                                           |       | $                     | 52,617,184 |   | $ | 66,414,076 |   |

 

See accompanying notes to Consolidated Financial Statements.

62

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**DEPOMED, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**
|                                                                               | ** ** | **Year Ended December 31,** | ** **  |
|-------------------------------------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                                                    | ** ** | **2006**                                   | ** **  | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                                     |       |                                       |        |   |   |   |   |
| Product sales                                                                 |       | $                                          | 1,790,834   |   | $ | 930,624 |   | $ | — |   |
| Royalties                                                                     |       | 4,039,948                                  |        | 668,789 |   | — |   |
| License revenue                                                               |       | 3,610,468                                  |        | 575,291 |   | 31,250 |   |
| Collaborative revenue                                                         |       | 109,968                                    |        | 2,230,625 |   | 171,319 |   |
| Total revenues                                                                |       | 9,551,218                                  |        | 4,405,329 |   | 202,569 |   |
| Costs and  expenses:                                                          |       |                                       |        |   |   |   |   |
| Cost of sales                                                                 |       | 1,600,744                                  |        | 908,521 |   | — |   |
| Research and development                                                      |       | 26,891,139                                 |        | 18,369,217 |   | 21,358,802 |   |
| Selling, general and administrative                                           |       | 22,666,797                                 |        | 11,639,118 |   | 5,178,539 |   |
| Total costs and expenses                                                      |       | 51,158,680                                 |        | 30,916,856 |   | 26,537,341 |   |
| Loss from operations                                                          |       | (41,607,462                                | )           | (26,511,527 | ) | (26,334,772 | ) |
| Other income  (expenses):                                                     |       |                                       |        |   |   |   |   |
| Gain from extinguishment of debt                                              |       | —                                     |        | 1,058,935 |   | — |   |
| Interest and other income                                                     |       | 2,030,674                                  |        | 1,445,057 |   | 489,013 |   |
| Interest expense                                                              |       | —                                     |        | (459,737 | ) | (928,878 | ) |
| Total other  income (expenses)                                                |       | 2,030,674                                  |        | 2,044,255 |   | (439,865 | ) |
| Net loss before income taxes                                                  |       | (39,576,788                                | )           | (24,467,272 | ) | (26,774,637 | ) |
| Provision for income taxes                                                    |       | (82,500                                    | )           | — |   | (99,000 | ) |
| Net loss                                                                      |       | (39,659,288                                | )           | (24,467,272 | ) | (26,873,637 | ) |
| Deemed dividend on preferred stock                                            |       | (665,258                                   | )           | (842,202 | ) | — |   |
| Net loss applicable to common stock shareholders                              |       | $                                          | (40,324,546 | ) | $ | (25,309,474 | ) | $ | (26,873,637 | ) |
| Basic and diluted net loss applicable to common  stock shareholders per share |       | $                                          | (0.97       | ) | $ | (0.64 | ) | $ | (0.78 | ) |
| Shares used in  computing basic and diluted net loss per share                |       | 41,517,661                                 |        | 39,821,182 |   | 34,628,825 |   |

 

See accompanying notes to Consolidated Financial Statements.

63

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**DEPOMED, INC.CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIT)**

| ** **                                                   | ** ** | ** **               | ** ** | ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | **Accumulated**   | ** ** | ** **             | ** ** |
|--------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|-----------------|------------|-----------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                   | ** ** | ** **               | ** ** | ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | **Other**         | ** ** | ** **             | ** ** |
| ** **                                                   | ** ** | ** **               | ** ** | ** **            | ** ** | **Deferred**    | ** ** | ** **      | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** ** |
| ** **                                                   | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Stock-Based** | ** ** | **Accumulated** | ** ** | **Income**        | ** ** | **Equity**             | ** ** |
| ** **                                                   | ** ** | ** **               | ** ** | ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | ** **        | ** ** | ** **             | ** ** |
| ** **                                                   | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**      | ** ** | **Amount**      | ** ** | **Compensation**  | ** ** | **Deficit**            | ** ** | **(Loss)** | ** ** | **(Deficit)** | ** ** |
| Balances at Dec. 31, 2003                               |       |                     | 12,015     |                  |       | $               | 12,015,000 |            | 34,569,212 |              | $          | 116,540,841            |       |   | $ | (863,872 | ) |   | $ | (93,110,988 | ) |   | $ | (4,827 | ) |   |   | $ | 34,576,154 |   |   |
| Common stock issuance costs                                  |       |                     | —     |                  |       | —          |       | —          |       | (935              | )          |                   | —     |   |   | — |   |   | — |   |   |   | (935 | ) |   |
| Issuance of common stock upon exercise of options            |       |                     | —     |                  |       | —          |       | 35,902          |       | 92,496            |       |                   | —     |   |   | — |   |   | — |   |   |   | 92,496 |   |   |
| Issuance of common stock upon exercise of warrants           |       |                     | —     |                  |       | —          |       | 38,544          |       | 139,523           |       |                   | —     |   |   | — |   |   | — |   |   |   | 139,523 |   |   |
| Issuance of common stock under employee stock  purchase plan |       |                     | —     |                  |       | —          |       | 47,532          |       | 188,227           |       |                   | —     |   |   | — |   |   | — |   |   |   | 188,227 |   |   |
| Stock-based compensation                                     |       |                     | —     |                  |       | —          |       | —          |       | 110,794           |       |                   | (15,629    | ) |   | — |   |   | — |   |   |   | 95,165 |   |   |
| Amortization of deferred stock-based compensation            |       |                     | —     |                  |       | —          |       | —          |       | —            |       |                   | 257,521    |   |   | — |   |   | — |   |   |   | 257,521 |   |   |
| Issuance of preferred stock                                  |       |                     | 3,806      |                  |       | —          |       | —          |       | —            |       |                   | —     |   |   | — |   |   | — |   |   |   | — |   |   |
| Comprehensive loss:                                          |       |                     |       |                  |       |            |       |            |       |              |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                     |       |                     | —     |                  |       | —          |       | —          |       | —            |       |                   | —     |   |   | (26,873,637 | ) |   | — |   |   |   | (26,873,637 | ) |   |
| Unrealized gain (loss) on available-for-sale  securities     |       |                     | —     |                  |       | —          |       | —          |       | —            |       |                   | —     |   |   | — |   |   | (71,216 | ) |   |   | (71,216 | ) |   |
| Comprehensive loss                                           |       |                     |       |                  |       |            |       |            |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | (26,944,853 | ) |   |
| Balances at Dec. 31, 2004                               |       |                     | 15,821     |                  |       | 12,015,000      |       | 34,691,190      |       | 117,070,946       |       |                   | (621,980   | ) |   | (119,984,625 | ) |   | (76,043 | ) |   |   | 8,403,298 |   |   |
| Issuance of common stock, net of issuance costs              |       |                     | —     |                  |       | —          |       | 5,036,000       |       | 21,019,267        |       |                   | —     |   |   | — |   |   | — |   |   |   | 21,019,267 |   |   |
| Issuance of common stock upon exercise of options            |       |                     | —     |                  |       | —          |       | 234,468         |       | 709,059           |       |                   | —     |   |   | — |   |   | — |   |   |   | 709,059 |   |   |
| Issuance of common stock upon exercise of warrants           |       |                     | —     |                  |       | —          |       | 625,152         |       | 279,732           |       |                   | —     |   |   | — |   |   | — |   |   |   | 279,732 |   |   |
| Issuance of common stock under employee stock  purchase plan |       |                     | —     |                  |       | —          |       | 102,559         |       | 381,005           |       |                   | —     |   |   | — |   |   | — |   |   |   | 381,005 |   |   |
| Stock-based compensation                                     |       |                     | —     |                  |       | —          |       | —          |       | 214,585           |       |                   | —     |   |   | — |   |   | — |   |   |   | 214,585 |   |   |
| Amortization of deferred stock-based compensation            |       |                     | —     |                  |       | —          |       | —          |       | (33,995           | )          |                   | 284,931    |   |   | — |   |   | — |   |   |   | 250,936 |   |   |
| Issuance of preferred stock                                  |       |                     | 1,722      |                  |       | —          |       | —          |       | —            |       |                   | —     |   |   | — |   |   | — |   |   |   | — |   |   |
| Comprehensive loss:                                          |       |                     |       |                  |       |            |       |            |       |              |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                     |       |                     | —     |                  |       | —          |       | —          |       | —            |       |                   | —     |   |   | (24,467,272 | ) |   | — |   |   |   | (24,467,272 | ) |   |
| Unrealized gain (loss) on available-for-sale  securities     |       |                     | —     |                  |       | —          |       | —          |       | —            |       |                   | —     |   |   | — |   |   | (29,611 | ) |   |   | (29,611 | ) |   |
| Comprehensive loss                                           |       |                     |       |                  |       |            |       |            |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | (24,496,883 | ) |   |
| Balances at Dec. 31, 2005                               |       |                     | 17,543     |                  |       | 12,015,000      |       | 40,689,369      |       | 139,640,599       |       |                   | (337,049   | ) |   | (144,451,897 | ) |   | (105,654 | ) |   |   | 6,760,999 |   |   |
| Change in classification upon adoption of  FAS 123R     |       |                     | —     |                  |       | —          |       | —          |       | (337,049          | )          |                   | 337,049    |   |   | — |   |   | — |   |   |   | — |   |   |
| Issuance of common stock upon exercise of options            |       |                     | —     |                  |       | —          |       | 228,006         |       | 476,736           |       |                   | —     |   |   | — |   |   | — |   |   |   | 476,736 |   |   |
| Issuance of common stock upon exercise of warrants           |       |                     | —     |                  |       | —          |       | 980,813         |       | 2,041,735         |       |                   | —     |   |   | — |   |   | — |   |   |   | 2,041,735 |   |   |
| Issuance of common stock under employee stock  purchase plan |       |                     | —     |                  |       | —          |       | 131,223         |       | 426,083           |       |                   | —     |   |   | — |   |   | — |   |   |   | 426,083 |   |   |
| Stock-based compensation                                     |       |                     | —     |                  |       | —          |       | —          |       | 2,572,430         |       |                   | —     |   |   | — |   |   | — |   |   |   | 2,572,430 |   |   |
| Issuance of preferred stock                                  |       |                     | 615        |                  |       | —          |       | —          |       | —            |       |                   | —     |   |   | — |   |   | — |   |   |   | — |   |   |
| Comprehensive loss:                                          |       |                     |       |                  |       |            |       |            |       |              |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                     |       |                     | —     |                  |       | —          |       | —          |       | —            |       |                   | —     |   |   | (39,659,288 | ) |   | — |   |   |   | (39,659,288 | ) |   |
| Unrealized gain (loss) on available-for-sale  securities     |       |                     | —     |                  |       | —          |       | —          |       | —            |       |                   | —     |   |   | — |   |   | 92,845 |   |   |   | 92,845 |   |   |
| Comprehensive loss                                           |       |                     |       |                  |       |            |       |            |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | (39,566,443 | ) |   |
| Balances at  Dec. 31, 2006                              |       |                     | 18,158     |                  |       | $               | 12,015,000 |            | 42,029,411 |              | $          | 144,820,534            |       |   | $ | — |   |   | $ | (184,111,185 | ) |   | $ | (12,809 | ) |   |   | $ | (27,288,460 | ) |   |

 

64

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**DEPOMED, INCCONSOLIDATED STATEMENTS OF CASH FLOWS**
|                                                                                            | ** ** | **Year Ended December 31,** | ** **  |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                                                                 | ** ** | **2006**                                   | ** **  | **2005** | ** ** | **2004** | ** ** |
| **Operating Activities**                                                                   |       |                                       |        |   |   |   |   |
| Net loss                                                                                   |       | $                                          | (39,659,288 | ) | $ | (24,467,272 | ) | $ | (26,873,637 | ) |
| Adjustments to reconcile  net loss to net cash (used in) provided by operating activities: |       |                                       |        |   |   |   |   |
| Depreciation and amortization                                                              |       | 1,380,466                                  |        | 1,138,912 |   | 1,443,749 |   |
| Gain on extinguishment of debt                                                             |       | —                                     |        | (1,058,935 | ) | — |   |
| Accrued interest expense on shareholder notes                                              |       | —                                     |        | 443,344 |   | 868,566 |   |
| Employee and director stock-based compensation                                             |       | 2,558,541                                  |        | 385,960 |   | 257,521 |   |
| Stock-based compensation issued to consultants                                             |       | 13,889                                     |        | 79,560 |   | 95,165 |   |
| Changes  in assets and liabilities:                                                        |       |                                       |        |   |   |   |   |
| Accounts receivable                                                                        |       | (7,125,383                                 | )           | (1,956,416 | ) | 278,452 |   |
| Inventories                                                                                |       | (3,581,809                                 | )           | (901,348 | ) | — |   |
| Other current assets                                                                       |       | (1,648,464                                 | )           | (665,361 | ) | 249,842 |   |
| Other assets                                                                               |       | 31,708                                     |        | 151,342 |   | (54,132 | ) |
| Accounts payable and other accrued liabilities                                             |       | 8,669,732                                  |        | 81,234 |   | (203,644 | ) |
| Accrued compensation                                                                       |       | (172,188                                   | )           | 1,078,883 |   | 101,214 |   |
| Deferred revenue                                                                           |       | 11,832,584                                 |        | 54,506,757 |   | 568,750 |   |
| Net cash (used in) provided by operating activities                                        |       | (27,700,212                                | )           | 28,816,660 |   | (23,268,154 | ) |
| **Investing Activities**                                                                   |       |                                       |        |   |   |   |   |
| Expenditures for property and equipment                                                    |       | (774,224                                   | )           | (791,247 | ) | (2,672,635 | ) |
| Purchases of marketable securities                                                         |       | (20,072,113                                | )           | (64,197,066 | ) | (21,557,673 | ) |
| Maturities of marketable securities                                                        |       | 48,810,291                                 |        | 26,069,548 |   | 12,061,752 |   |
| Sales of marketable securities                                                             |       | 3,800,258                                  |        | 4,096,496 |   | 16,254,096 |   |
| Net cash provided by (used in) investing activities                                        |       | 31,764,212                                 |        | (34,822,269 | ) | 4,085,540 |   |
| **Financing Activities**                                                                   |       |                                       |        |   |   |   |   |
| Payments on capital lease obligations                                                      |       | —                                     |        | (33,186 | ) | (38,541 | ) |
| Payments on equipment loans                                                                |       | —                                     |        | (73,008 | ) | (289,559 | ) |
| Payment of promissory note from related party                                              |       | —                                     |        | (9,665,000 | ) | — |   |
| Proceeds from issuance of common stock                                                     |       | 2,944,554                                  |        | 22,389,064 |   | 419,311 |   |
| Net cash provided by financing activities                                                  |       | 2,944,554                                  |        | 12,617,870 |   | 91,211 |   |
| Net increase (decrease) in cash and cash equivalents                                       |       | 7,008,554                                  |        | 6,612,261 |   | (19,091,403 | ) |
| Cash and cash equivalents at beginning of year                                             |       | 7,565,556                                  |        | 953,295 |   | 20,044,698 |   |
| Cash and cash equivalents at end of year                                                   |       | $                                          | 14,574,110  |   | $ | 7,565,556 |   | $ | 953,295 |   |
| **Supplemental  Schedule of Non-Cash Financing and Investing Activities**                  |       |                                       |        |   |   |   |   |
| Value of leasehold improvement allowance                                                   |       | $                                          | —      |   | $ | — |   | $ | 356,780 |   |
| Deferred compensation related to stock options  granted to employees and consultants       |       | —                                     |        | — |   | 31,500 |   |
| Acquisition of property and equipment under capital  leases                                |       | —                                     |        | 774 |   | 31,761 |   |
| **Supplemental  Disclosure of Cash Flow Information**                                      |       |                                       |        |   |   |   |   |
| Cash paid during the  period for:                                                          |       |                                       |        |   |   |   |   |
| Interest                                                                                   |       | $                                          | —      |   | $ | 459,737 |   | $ | 928,878 |   |
| Taxes                                                                                      |       | 82,500                                     |        | — |   | 99,000 |   |

 

See accompanying notes to Consolidated Financial Statements.

65

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1. ORGANIZATION AND SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

***Organization***

Depomed is a specialtypharmaceutical company focused on the development and commercialization ofdifferentiated products that address large and growing markets and are based onproprietary oral drug delivery technologies. The Company has developed twocommercial products. GLUMETZATM (metformin hydrochloride extended releasetablets) is a once-daily treatment for adults with type 2 diabetes that theCompany jointly commercializes in the United States with King Pharmaceuticals, Inc.ProQuin® XR (ciprofloxacin hydrochloride extended releasetablets) is a once-daily treatment for uncomplicated urinary tract infectionsthat Esprit Pharma, Inc. markets in the United States. The Company has aproduct candidate, Gabapentin GRTM,an extended release form of gabapentin, currently in a Phase 3 trial forthe treatment of postherpetic neuralgia. The Company has also completed aPhase 2 trial for Gabapentin GR for the treatment of diabetic peripheralneuralgia and has submitted an investigational new drug application for aPhase 2 trial for Gabapentin GR for the treatment of menopausal hotflashes.

***Reclassifications***

Certain reclassificationshave been made to the December 31, 2005 balance sheet in order to conformto the Company’s current presentation. The Company has removed the line itempreviously titled “deferred margin” which was associated with the net balanceof deferred revenue and deferred costs on product sales and classified thoseamounts separately within deferred product sales and inventory, respectively.

***Principles ofConsolidation***

The consolidated financialstatements include the accounts of the Company and Depomed Development, Ltd.,DDL, formerly a joint venture with Elan Corporation, plc, Elan PharmaInternational, Ltd. and Elan International Services, Ltd. (together, Elan),which became a wholly-owned subsidiary of the Company in the second quarter of2004. For the years ended December 31, 2006, 2005 and 2004, the Companyconsolidated selling, general and administrative expense of approximately$7,000, $7,000 and $6,000, respectively, related to DDL. DDL does not have anyfixed assets, liabilities or employees and will not perform any furtherproduct development on behalf of Depomed or any other entity. Materialintercompany accounts and transactions have been eliminated. In the fourth quarterof 2005, the Company’s Board of Directors approved the dissolution of DDL,which the Company believes will be completed in 2007.

***Use of Estimates***

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the financial statements and accompanying notes. Actualresults could differ from those estimates.

***Revenue Recognition***

Revenue arrangements withmultiple elements are divided into separate units of accounting if certaincriteria are met, including whether the delivered element has stand-alone valueto the customer and whether there is objective and reliable evidence of thefair value of the undelivered items. The consideration received is allocatedamong the separate units based on their respective fair values, and theapplicable revenue recognition criteria are applied to each of the separateunits.

66

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Revenue is recognized when there is persuasiveevidence that an arrangement exists, delivery has occurred and title haspassed, the price is fixed or determinable and the Company is reasonablyassured of collecting the resulting receivable.

The Company sells GLUMETZA product to wholesalers andretail pharmacies that is subject to rights of return up to twelve months afterproduct expiration. Given the limited sales history of GLUMETZA, the Companycurrently cannot reliably estimate expected returns of the product at the timeof shipment. Accordingly, the Company defers recognition of revenue on productshipments of GLUMETZA until the right of return no longer exists, which occursat the earlier of the time GLUMETZA units are dispensed through patientprescriptions or expiration of the right of return. The Company estimates patientprescriptions dispensed using an analysis of third-party information, includingthird-party market research data, information obtained from certain wholesalerswith respect to inventory levels and out-movement and retail pharmacyre-stocking activity. As a result of this policy, the Company has a deferredrevenue balance of $4.8 million at December 31, 2006 related to GLUMETZAproduct shipments that have not been recognized as revenue, which is net ofestimated patient support program discounts, wholesaler fees, stockingallowances, prompt payment discounts and chargebacks. The Company willrecognize revenue upon the earlier of prescription units dispensed orexpiration of the right of return until it can reliably estimate productreturns, at which time the Company will record a one-time increase in netrevenue related to the recognition of revenue previously deferred. In addition,the costs of manufacturing GLUMETZA associated with the deferred revenue arerecorded as deferred costs, which are included in inventory, until such timethe deferred revenue is recognized.

Product sales revenue related to the Company’s supplyagreement with Esprit is recognized after the expiration of a 30-dayperiod in which Esprit may reject product that does not meet agreed-uponspecifications.

Royalties are recognized as earned in accordance withthe contract terms when royalties from licensees can be reliably measured andcollectibility is reasonably assured. The Company recognizes royalties underits agreement with Esprit based on Esprit’s sales, net of any estimatedreturns, discounts, rebates and chargebacks. Esprit is obligated to pay theCompany annual minimum royalties. Total royalty revenue recognized by theCompany to date has been equal to Esprit’s minimum royalty obligation under theagreement. Royalties received under the Company’s agreement with Biovail arerecognized when the royalty payments are received as they are not estimable.Royalty payments received in excess of amounts earned are classified as royaltyadvances until earned.

Revenue from license arrangements, including licensefees creditable against future royalty obligations (if any), of the licensee,is recognized when an arrangement is entered into if the Company hassubstantially completed its obligations under the terms of the arrangement andthe Company’s remaining involvement is inconsequential and perfunctory. If theCompany has significant continuing involvement under such an arrangement,license fees are deferred and recognized over the estimated performance period.License fee payments received in excess of amounts earned are classified asdeferred revenue until earned.

Collaborative revenuerecognized relates to services rendered in connection with collaborativearrangements and the achievements of milestones under such arrangements.Revenue related to collaborative agreements with corporate partners isrecognized as the expenses are incurred under each contract. The Company isrequired to perform services as specified in each respective agreement andthe Company is reimbursed based on the costs incurred on each specificcontract. Nonrefundable substantive 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

milestonepayments are recognized pursuant to collaborative agreements upon theachievement of specified milestones where no further obligation toperform exists under that milestone provision of the arrangement and whencollectibility is reasonably assured.

***Stock-Based Compensation***

Effective January 1, 2006, Depomed implementedthe provisions of Statement of Financial Accounting Standards No. 123(revised 2004), *Share-Based Payment*(FAS 123(R)), as interpreted by SEC Staff Accounting Bulletin No. 107(SAB 107), using the modified prospective transition method. FAS 123(R) isa revision of Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation*(FAS 123), andsupercedes APB Opinion No. 25, *Accounting for StockIssued to Employees* (APB No. 25).**FAS 123(R) requirescompanies to recognize the cost of employee and director services received inexchange for awards of equity instruments, based on the grant-date fair valueof those awards, in the statement of operations as pro forma disclosure is nolonger an alternative. Using the modified prospective transition method ofFAS 123(R), Depomed began recognizing fair-value compensation expense forstock-based awards, including stock options granted and purchase rights issuedunder its employee purchase plan after January 1, 2006. Compensationexpense for stock-based awards granted prior to implementation that wereunvested and outstanding as of January 1, 2006 will be recognized over therequisite service period based on the grant-date fair value of those optionsand awards as previously calculated under FAS 123. The compensationexpense for stock-based compensation is based on the single-option approach,includes an estimate for forfeitures and is recognized over the vesting term ofthe options using the straight-line method. FAS 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. Depomedestimates forfeitures based on historical experience. Prior to the adoption ofFAS 123(R), pro forma disclosures required under FAS 123 includedforfeitures as they occurred. Under the modified prospective transition methodof implementation, no restatement of prior periods has been made. See Note 8of the Notes to Consolidated Financial Statements for further informationregarding Depomed’s stock-based compensation assumptions and expenses,including pro forma disclosures for prior periods.

In November 2005, theFASB issued Staff Position (FSP) No. FAS 123(R)-3, *Transition Election Related to Accounting for Tax Effects ofShare-Based Payment Awards (*FSP 123(R)-3). The Company haselected to adopt the alternative transition method provided in the FSP 123(R)-3for calculating the tax effects of stock-based compensation pursuant toFAS 123(R). The alternative transition method includes simplified methodsto establish the beginning balance of the APIC pool related to the tax effectsof employee stock-based compensation, and to determine the subsequent impact onthe APIC pool and Consolidated Statements of Cash Flows of the tax effects ofemployee stock-based compensation awards that are outstanding upon adoption ofFAS 123(R).

***Research andDevelopment Expense and Accruals***

Research and developmentexpenses include related salaries, contractor fees, clinical trial costs,facilities costs, administrative expenses and allocations of corporate costs.All such costs are charged to research and development expense as incurred.These expenses result from the Company’s independent research and developmentefforts as well as efforts associated with collaborations. The Company reviewsand accrues clinical trial expenses based on work performed, which relies onestimates of total costs incurred based on patient enrollment, completion ofpatient studies and other events. The Company follows this method sincereasonably dependable estimates of the costs applicable to various stages of aresearch agreement or clinical trial can be made. Accrued clinical costs aresubject to revisions as trials 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

progressto completion. Revisions are charged to expense in the period in which thefacts that give rise to the revision become known.

***Shipping andHandling Costs***

Shipping and handlingcosts incurred for inventory purchases and product shipments are recorded incost of sales in the consolidated statements of operations.

***Advertising Costs***

All costs associated withadvertising are expensed in the year incurred. Advertising expense for the yearended December 31, 2006 was $1.3 million. There was no advertising expensefor the years ended December 31, 2005 and 2004.

***ComprehensiveIncome***

Comprehensive income(loss) is comprised of net loss and other comprehensive income (loss). Othercomprehensive income (loss) includes certain changes in equity of the Companythat are excluded from net loss. Specifically, FAS No. 130, *Reporting Comprehensive Income*, requiresunrealized holding gains and losses on the Company’s available-for-salesecurities, which were reported separately in shareholders’ equity, to be includedin accumulated other comprehensive income (loss). Comprehensive income (loss)for the years ended December 31, 2006, 2005 and 2004 has been reflected inthe Consolidated Statements of Shareholders’ Equity (Deficit).

***Cash, CashEquivalents and Marketable Securities***

The Company considers allhighly liquid investments with an original maturity (at date of purchase) ofthree months or less to be cash equivalents. Cash and cash equivalents consistof cash on deposit with banks, money market instruments and commercial paper.The Company places its cash, cash equivalents and marketable securities withhigh quality, U.S. financial institutions and, to date, has not experiencedmaterial losses on any of its balances. The Company records cash and cashequivalents at amortized cost, which approximates the fair value. Allmarketable securities are classified as available-for-sale since theseinstruments are readily marketable. These securities are carried at fair value,which is based on readily available market information, with unrealized gainsand losses included in accumulated other comprehensive income (loss) withinshareholders’ equity. The Company uses the specific identification method todetermine the amount of realized gains or losses on sales of marketablesecurities. Realized gains or losses have been insignificant and are includedin “interest and other income” in the condensed consolidated statement ofoperations.

***Accounts Receivable***

Trade accounts receivableare recorded net of allowances for cash discounts for prompt payment. To datethe Company has not recorded a bad debt allowance due to the fact that themajority of its product revenue comes from sales to a limited number offinancially sound companies. The need for bad debt allowance is evaluated eachreporting period based on our assessment of the credit worthiness of ourcustomers.

***Inventories***

Inventories are stated atthe lower of cost or market with cost determined by specific manufactured lot.Inventories consist of costs of the active pharmaceutical ingredient, contractmanufacturing and 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

packagingcosts. The Company writes-off the value of inventory for potentially excess,dated or obsolete inventories based on an analysis of inventory on hand and onfirm purchase commitments. There were no such write-offs recorded as of December 31,2006.

***Property andEquipment***

Property and equipment arestated at cost, less accumulated depreciation and amortization (See Note 5of the Notes to Consolidated Financial Statements). Depreciation is providedusing the straight-line method over the estimated useful lives of therespective assets, generally three to five years. Leasehold improvements areamortized over the lesser of the lease term or the estimated useful lives of therelated assets.

***Long-Lived Assets***

In accordance withFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*, the Company identifiesand records impairment losses, as circumstances dictate, on long-lived assetsused in operations when events and circumstances indicate that the assets mightbe impaired and the discounted cash flows estimated to be generated by thoseassets are less than the carrying amounts of those assets. No such impairmentshave been identified with respect to the Company’s long-lived assets, whichconsist primarily of property and equipment.

***Net Loss Per CommonShare***

Netloss per share is computed using the weighted-average number of shares ofcommon stock outstanding. Common stock equivalent shares from outstanding stockoptions, warrants and other convertible securities and loans are not includedas their effect is antidilutive. As of December 31, the followingpotentially dilutive securities were excluded from the computation of dilutedearnings per share:

| ** **                                          | ** ** | **2006**                       | ** ** | **2005**                                | ** ** | **2004**                       | ** ** |
|-----------------------------------------------------|------------|--------------------------------|------------|-----------------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **Common  Equivalent  Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Common  Equivalent  Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Common  Equivalent  Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Stock options                                       |       | 5,195,595                      |       |                                    | $          | 4.80                           |       |   | 4,371,964 |   |   | $ | 4.44 |   |   | 4,346,620 |   |   | $ | 4.37 |   |   |
| Warrants                                            |       | 500,173                        |       |                                    | $          | 2.16                           |       |   | 2,010,071 |   |   | $ | 3.16 |   |   | 2,942,404 |   |   | $ | 2.89 |   |   |
| Convertible  preferred shares and accrued dividends |       | 2,672,423                      |       |                                    | —     |                           |       | 2,540,949 |   |   | — |   |   | 2,251,822 |   |   |   |   |   |
| Convertible  promissory note and accrued interest   |       | —                         |       |                                    | —     |                           |       | — |   |   | — |   |   | 1,338,620 |   |   |   |   |   |
| Biovail  Purchaser’s Option                    |       | —                         |       |                                    | —     |                           |       | — |   |   | — |   |   | 3,901,961 |   |   | $ | 8.21 |   |   |
|                                                |       | 8,368,191                      |       |                                    |       |                           |       | 8,922,984 |   |   |   |   |   | 14,781,427 |   |   |   |   |   |

 

***Income Taxes***

Income taxes are computedin accordance with FAS No. 109, *Accountingfor Income Taxes*, which requires the use of the liability method inaccounting for income taxes. Under FAS No. 109, deferred tax assetsand liabilities are measured based on differences between the financialreporting and tax basis of assets and liabilities using enacted rates and lawsthat are expected to be in effect when the differences are expected to reverse.

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

***SegmentInformation***

The Company followsFAS No. 131, *Disclosures aboutSegments of an Enterprise and Related Information*.FAS No. 131 establishes standards for reporting financial informationabout operating segments in financial statements, as well as additionaldisclosures about products and services, geographic areas, and major customers.The Company operates in one operating segment and has operations solely in theUnited States. To date, all of the Company’s revenues from product sales arerelated to sales of GLUMETZA and ProQuin XR in the United States. The Companyhas recognized license and royalty revenue from license agreements in theterritories of the United States, Canada and Korea.

***Concentrationof Risk***

The Company is subject to credit risk from itsaccounts receivable related to product sales. The majority of the Company’strade accounts receivable arises from product sales in the United States. Twowholesale distributors represented 44% and 39% of GLUMETZA shipments for theyear ended December 31, 2006. These two customers individually comprised75% and 8%, respectively, of GLUMETZA accounts receivable as ofDecember 31, 2006. To date, the Company has not experienced any losseswith respect to the collection of its accounts receivable and believes that allof its past due accounts receivable are collectible.

The Company relies on asingle third-party manufacturer in Puerto Rico to manufacture GLUMETZA andProQuin XR. The Company also relies on a single third-party supplier for thesupply of metformin hydrochloride, the active pharmaceutical ingredient inGLUMETZA and a single third-party supplier for the supply of ciprofloxacinhydrochloride, the active pharmaceutical ingredient  in ProQuin XR.

***Fair Value of Financial Instruments***

The Company’s financialinstruments include cash and cash equivalents, marketable securities, accountsreceivable and accounts payable. Cash and cash equivalents are carried atamortized cost and accounts receivable and accounts payable are carried atcost, which the Company believes approximate fair value due to the relativeshort maturities of these instruments.

***Recently Issued Accounting Standards***

In July 2006, theFinancial Accounting Standards Board issued FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes, an interpretation of FASBStatement No. 109* (FIN 48). FIN 48 clarifies theaccounting for uncertainty in income taxes by prescribing the recognitionthreshold a tax position is required to meet before being recognized in thefinancial statements. It also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition. FIN 48 is effective for fiscal years beginningafter December 15, 2006 and is required to be adopted by the Company in2007. The Company is currently evaluating the effect that the adoption ofFIN 48 will have on its consolidated results of operations and financialcondition and is not yet in a position to determine such effects.

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 2.**          LICENSEAND COLLABORATIVE ARRANGEMENTS

***King Pharmaceuticals, Inc.***

In June 2006, theCompany entered into a promotion agreement with King Pharmaceuticals, Inc.(King), pursuant to which King was granted the co-exclusive right to promoteGLUMETZA in the United States. Under the agreement, King is required topromote GLUMETZA to physicians in the United States through its sales force, todeliver a minimum number of annual detail calls to potential GLUMETZAprescribers, and to maintain a sales force of a minimum size. In considerationfor King’s promotion of GLUMETZA, the Company is required to pay King apromotion fee equal to fifty percent of gross margin, which is defined in theagreement as sales of GLUMETZA, net of actual returns, estimated discounts,estimated rebates and estimated chargebacks, minus cost of goods sold andcertain adjustments, including the one percent royalty due to BiovailLaboratories International with respect to sales of the 500mg GLUMETZA tabletin the United States. In September 2006, the Company launched the500mg GLUMETZA in the United States. For the year ended December 31, 2006,the Company recognized $2.4 million in promotion fee expense under theagreement, which is classified in selling, general and administrative expense.

***Esprit Pharma, Inc.***

In July 2005, the Company entered into anexclusive license and marketing agreement with Esprit Pharma, Inc.(Esprit) to market and distribute ProQuin XR in the United States, which wassubsequently amended in July 2006. The agreement obligates Esprit to paythe Company $50 million in license fees, of which $30.0 million was paid in July 2005and $10.0 million was paid in December 2006. The remaining $10 million isdue in July 2007. The license fee payments received are recognized asrevenue ratably until June 2020, which represents the length of time thatthe Company is obligated to manufacture ProQuin XR for Esprit or its licensees.The Company recognized $2,068,000 and $424,000 of license revenue related tothe amortization of these upfront fees for the years ended December 31,2006 and 2005, respectively.

The agreement also provides for royalty payments byEsprit to the Company of 15 percent to 25 percent of ProQuin XR net sales,based on escalating net sales and subject to certain minimum royalty amounts. Esprit’sminimum royalty amount for 2006 was $4.6 million. Royalties paid by Esprit onsales made in the fourth quarter of 2005 were creditable against Esprit’s 2006minimum royalty obligation. Esprit’s minimum royalty obligation for 2007 is$5.0 million, and in subsequent years remains at $5.0 million per year, subjectto annual increases in the consumer price index in 2008. The Company recognized $3,931,000 and$669,000 of royalty revenue under the agreement for the years ended December 31,2006 and 2005, respectively.

In connection with thelicense agreement, the Company also entered into a related supply agreementwith Esprit, pursuant to which the Company will supply commercial quantities ofProQuin XR to Esprit. The Company recognized $1,265,000 and $930,000 of productrevenue related to the supply of ProQuin XR to Esprit for the years ended December 31,2006 and 2005, respectively.

***Biovail Laboratories International***

In May 2002, the Company entered into adevelopment and license agreement granting Biovail Laboratories Incorporated(Biovail) an exclusive license in the United States and Canada to manufactureand market GLUMETZA. Under the terms of the agreement, the Company wasresponsible for completing the clinical development program in support of the500mg GLUMETZA. In April 2003, 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Biovail submitted a NewDrug Application to the U.S. Food and Drug Administration (FDA) for approval andin July 2005, Biovail received FDA approval to market GLUMETZA in theUnited States. In accordance with the license agreement, Biovail paid a $25.0million license fee payment to the Company.

In April 2004, the Company and Biovail amendedthe GLUMETZA license agreement. Under the amended agreement, the Company wouldreceive royalties on sales of Biovail’s 1000mg metformin HCl tablet in theUnited States and Canada in exchange for allowing Biovail to use the Company’sclinical data for its Metformin GR, a 500mg metformin HCl tablet, to supportand accelerate regulatory submissions for Biovail’s 1000mg tablet and toestablish equivalence between the two dosage forms. In May 2005, Biovailreceived a Notice of Compliance for the 500mg and 1000mg strengths of GLUMETZAfrom the Therapeutic Products Directorate of Canada to market the products inCanada.

In October 2005, the Company delivered a noticeof breach to Biovail and subsequently filed suit in respect of its licenseagreement with Biovail, related to the failure of Biovail to make the firstcommercial sale of the 500mg strength GLUMETZA within 120 days of approval ineach of Canada and the United States as required in the license agreement. In December 2005,the Company settled its dispute with Biovail and entered into an amendedlicense agreement whereby the Company granted to Biovail an exclusive licensein Canada to manufacture and market the 500mg formulation of GLUMETZA and theCompany established its right to manufacture and market the 500mg GLUMETZA inthe United States and internationally with the exception of Canada. The Companywill recognize the $25.0 million license fee payment as revenue ratably until February 2023,which represents the estimated length of time the Company’s obligations existunder the arrangement related to royalties it is obligated to pay Biovail onnet sales of the 500mg GLUMETZA in the United States and to use Biovail as theCompany’s sole supplier of the 1000mg of GLUMETZA, should the 1000mg obtainapproval in the United States. The Company recognized $1,454,000 and $76,000 of license revenuerelated to the amortization of this upfront fee for the years ended December 31,2006 and 2005, respectively.

Under the agreement, Biovail will pay the Companyroyalties of six percent on net sales of the 500mg GLUMETZA and one percent on netsales of the 1000mg GLUMETZA in Canada. The Company recognized royalty revenue under the agreement of $109,000and zero for the years ended December 31, 2006 and 2005, respectively.

The Company will pay Biovail royalties of one percenton net sales of the 500mg GLUMETZA in the United States. The Company recognizedroyalty expense under the agreement of $62,000 and zero for the years endedDecember 31, 2006 and 2005, respectively.

As part of the samesettlement, Biovail granted the Company an exclusive license to market the1000mg GLUMETZA in the United States. The Company is obligated to purchase the1000mg GLUMETZA exclusively from Biovail, subject to back-up manufacturing rightsin the Company’s favor. If the Company exercises its back-up rights,compensation to Biovail will change from a supply-based arrangement toroyalties of six percent on net sales of the 1000mg GLUMETZA.

***LG Life Sciences,Ltd***.

In August 2004, the Company entered into alicense and distribution agreement granting LG Life Sciences an exclusivelicense to the 500mg GLUMETZA in the Republic of Korea. LG launched the productin Korea, known as Novamet GR in 2006.

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Upon signing of theagreement, LG paid the Company a $600,000 upfront license fee. In November 2006,both parties amended the agreement and LG paid the Company a $500,000 milestonepayment in respect of LG’s approval to market GLUMETZA in the Republic ofKorea, rather than a $700,000 payment, as reflected in the original agreement.As of December 31, 2006, the upfront license fee and milestone payment isbeing amortized over a period of eight years, which represents the estimatedlength of time the Company is obligated to provide assistance in developmentand manufacturing. The Company recognized license revenue of $89,000, $75,000and $31,000 in 2006, 2005 and 2004, respectively, related to the amortizationof the upfront license and milestone payments.

***Madaus S.r.l.***

In November 2005, theCompany entered into a distribution and supply agreement for ProQuin XR inEurope with a privately owned specialty pharmaceutical company, Madaus S.r.l.Under the terms of the agreement, the Company granted an exclusive right toMadaus for the commercialization of ProQuin XR in Europe and agreed to supplyMadaus with commercial quantities of ProQuin XR tablets in bulk form. Madauswill pay the Company at a pre-specified percent of Madaus’ wholesale ex-factoryprice, net of packaging costs. In January 2006, Madaus paid the Company a$200,000 license fee. An advance payment against future product sales of$300,000 will be due within 30 days of the first European regulatory approval. InMarch 2006, Madaus filed a Marketing Authorization Application (MAA) forProQuin XR with the Medical Products Agency in Sweden, which is currentlypending. No revenue has been recognized under the agreement.

***PharmaNova, Inc.***

In October 2006, Depomed entered into asublicense agreement with PharmaNova, Inc. Pursuant to the agreement,PharmaNova has granted the Company an exclusive sublicense, under a United Statespatent held by the University of Rochester, to develop and commercialize aproduct in the United States containing the compound gabapentin as its activepharmaceutical ingredient which is indicated for the treatment of hot flashesassociated with menopause in women.

The Company paidPharmaNova an upfront license fee of $500,000 upon signing of the agreement andis required to pay PharmaNova an additional $500,000 upon dosing of the firstpatient in any Phase 3 trial for the product, $1,000,000 upon submissionto the FDA of a New Drug Application for the product, and $2,000,000 upon FDAapproval of an NDA. The agreement also provides for royalty payments toPharmaNova on net sales of the product, and for milestone payments uponachievement of annual net sales in excess of certain thresholds. The Company isalso required to pay PharmaNova consultancy fees of $300,000 over approximatelyten months beginning in November 2006. The Company has recognized $597,000of research and development expense under the agreement in 2006, including the$500,000 upfront license fee paid upon signing of the agreement.

***Patheon, Inc.***

In August 2006,Depomed entered into a collaboration agreement with Patheon, Inc. relatedto the Company’s proprietary AcuForm drug delivery technology. Under theagreement, Depomed granted Patheon access to the Company’s AcuForm drugdelivery technology for the purpose of formulating, developing and improvingpharmaceutical products outside of our own internal programs for Patheon’sclients and collaborative partners. A joint committee with representatives fromDepomed and Patheon will review compounds prior to initiating work to ensurethere are no conflicts with our own internal programs. 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Patheonwill assume primary responsibility for initial feasibility work with technicalassistance from us. For product candidates that advance beyond feasibility,Depomed, Patheon and any third party will negotiate a license agreement, andDepomed and Patheon would share any license fees, milestone payments and royalties.

***Supernus Pharmaceuticals, Inc.***

In September 2006,Depomed entered into a collaboration agreement with Supernus Pharmaceuticals, Inc.to develop through a Phase 1 study a product candidate leveraging theCompany’s AcuForm drug delivery technology. The cost and ownership of theprogram will be shared between the parties equally. The collaboration agreementincludes provisions pursuant to which the parties may negotiate and enter intoa definitive agreement for the further development and for commercialization,by either or both parties, of the product candidate. The Company recognized $56,000of research and development expense under the agreement in 2006.

***Boehringer Ingelheim Pharmaceuticals, Inc.***

In April 2005,Depomed entered into an agreement with Boehringer Ingelheim Pharmaceuticals, Inc.to conduct feasibility studies with an undisclosed pharmaceutical compound andin December 2005, the Company completed the studies and delivered theagreed feasibility results. Under the agreement, all research and developmentwork with the partner’s pharmaceutical compound was funded by the partner. TheCompany recognized collaborative revenue of $2,231,000 in 2005, whichapproximated the costs recognized under the agreement.

***New River Pharmaceuticals, Inc.***

In June 2005, Depomed entered into a developmentand license agreement with New River Pharmaceuticals Inc. to develop throughthe feasibility phase up to three proprietary New River compounds incombination with the AcuForm technology. Pursuant to the agreement, NewRiver will fund research and development under the agreement, and New River mayacquire worldwide rights to use the AcuForm technology in the productcandidates for agreed-upon milestone payments and royalties. New River hasproposed three product candidates for development, though the Company isawaiting further information from New River related to the proposed productcandidates. No revenue has been recognized under the agreement.

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 3.**          MARKETABLESECURITIES

Securitiesclassified as available-for-sale as of December 31, 2006 and 2005 aresummarized below. Estimated fair value is based on quoted market prices forthese investments.
| December 31, 2006                                                  | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------|------------|
| U.S. debt securities:                                                        | ** ** | ** **          | ** ** |                         | ** ** | ** **                    |       | ** **          | ** ** | ** ** | ** ** |
| Total included in cash and cash equivalents                                  |       | $                   | 11,399,459 |                         |       | $                             | —     | ** **          |       | $ | — |   | $ | 11,399,459 |   |
| Total maturing  within 1 year and included in marketable securities:         | ** ** | ** **          | ** ** |                         | ** ** | ** **                    |       | ** **          | ** ** | ** ** | ** ** |
| U.S. corporate debt securities                                               |       | 9,212,842           |       |                         | —     | ** **                    |       | (3,197              | )          | 9,209,645 |   |
| U.S. government debt securities                                              |       | 6,789,077           |       |                         | —     | ** **                    |       | (9,529              | )          | 6,779,548 |   |
| Total maturing  between 1 and 2 years and included in marketable securities: |       |                |       |                         |       | ** **                    |       |                |       |   |   |
| U.S. corporate debt securities                                               |       | 2,994,153           |       |                         | 1,157      | ** **                    |       | (1,240              | )          | 2,994,070 |   |
| Total  available-for-sale                                                    |       | $                   | 30,395,531 |                         |       | $                             | 1,157      | ** **          |       | $ | (13,966 | ) | $ | 30,382,722 |   |

 
| December 31, 2005                                                  | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------|------------|
| U.S. debt securities:                                                        |       |                |       |                         |       | ** **                    |       |                |       |   |   |
| Total included in cash and cash equivalents                                  |       | $                   | 4,488,518  |                         |       | $                             | —     | ** **          |       | $ | — |   | $ | 4,488,518 |   |
| Total maturing  within 1 year and included in marketable securities:         |       |                |       |                         |       | ** **                    |       |                |       |   |   |
| U.S. corporate debt securities                                               |       | 25,152,443          |       |                         | —     | ** **                    |       | —              |       | 25,152,443 |   |
| U.S. government debt securities                                              |       | 21,996,005          |       |                         | 744        | ** **                    |       | (90,696             | )          | 21,906,053 |   |
| Total maturing  between 1 and 2 years and included in marketable securities: |       |                |       |                         |       | ** **                    |       |                |       |   |   |
| U.S. corporate debt securities                                               |       | 2,464,715           |       |                         | —     | ** **                    |       | —              |       | 2,464,715 |   |
| U.S. government debt securities                                              |       | 2,000,000           |       |                         | —     | ** **                    |       | (15,702             | )          | 1,984,298 |   |
| Total available-for-sale                                                     |       | $                   | 56,101,681 |                         |       | $                             | 744        | ** **          |       | $ | (106,398 | ) | $ | 55,996,027 |   |

 

At December 31,2006, the Company held nine securities in an unrealized loss position.

The following table shows the gross unrealized lossesand fair value of the Company’s investments with unrealized losses that are notdeemed to be other-than-temporarily impaired, aggregated by investment categoryand length of time that individual securities have been in a continuousunrealized loss position, at December 31, 2006:
|                                    | ** ** | **Less than 12 months** | ** ** | **12 months or greater** | ** ** | **Total**           | ** ** |
|------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|---------------------|------------|
| **U.S. Debt Securities** | ** ** | **Fair Value**                    | ** ** | **Gross  Unrealized  Losses**           | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** |
| U.S. corporate  debt securities    |       | $                                      | 6,759,743  |                                    |       | $                   | (1,920     | ) |   | $ | 2,449,902 |   |   | $ | (1,277 | ) |   | $ | 9,209,645 |   |   | $ | (3,197 | ) |   |
| U.S. government  debt securities   |       | 6,782,888                              |       |                                    | (6,189     | )                   |       | 1,995,420 |   |   | (4,580 | ) |   | 8,778,308 |   |   | (10,769 | ) |   |
| Total available-for-sale           |       | $                                      | 13,542,631 |                                    |       | $                   | (8,109     | ) |   | $ | 4,445,322 |   |   | $ | (5,857 | ) |   | $ | 17,987,953 |   |   | $ | (13,966 | ) |   |

 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

The gross unrealizedlosses above were caused by interest rate increases. No significant facts orcircumstances have arisen to indicate that there has been any deterioration inthe creditworthiness of the issuers of the Company’s securities. Based on theCompany’s review of these securities, including the assessment of the durationand severity of the related unrealized losses and the Company’s ability andintent to hold the investments until maturity, there were noother-than-temporary impairments for these securities as of December 31,2006.

**NOTE 4.**             INVENTORIES

Inventoriesrelate to the manufacture of the Company’s GLUMETZA and ProQuin XR products.Inventories are stated at the lower of cost or market and consist of thefollowing:

| ** **      | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------|------------|---------------------------------|------------|---------------------------------|------------|
| Raw materials   |       |                            | $          | 1,343,421                       |       |   |   | $ | 446,397 |   |   |
| Work-in-process |       |                            | 1,387,359  |                            |       |   | 418,389 |   |   |
| Finished goods  |       |                            | 969,619    |                            |       |   | — |   |   |
| Deferred costs  |       |                            | 782,758    |                            |       |   | 36,562 |   |   |
| Total           |       |                            | $          | 4,483,157                       |       |   |   | $ | 901,348 |   |   |

 

Deferred costs representthe costs of product shipped for which recognition of revenue has beendeferred.

**NOTE 5.**          PROPERTYAND EQUIPMENT

Propertyand equipment consists of the following:

| ** **                      | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| Furniture and  office equipment |       |                            | $          | 1,441,936                       |       |   |   | $ | 1,334,230 |   |   |
| Laboratory  equipment           |       |                            | 4,400,151  |                            |       |   | 4,071,695 |   |   |
| Leasehold  improvements         |       |                            | 2,919,440  |                            |       |   | 2,874,972 |   |   |
|                            |       |                            | 8,761,527  |                            |       |   | 8,280,897 |   |   |
| Less accumulated  depreciation  |       |                            | (6,220,064 | )                               |       |   | (5,134,286 | ) |   |
| Property and equipment,  net    |       |                            | $          | 2,541,463                       |       |   |   | $ | 3,146,611 |   |   |

 

There was no property andequipment included under capitalized leases as of December 31, 2006 and December 31,2005. Depreciation expense was $1,291,000, $1,475,000 and $1,184,000 for 2006,2005 and 2004, respectively.

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 6.**          DEFERREDREVENUE

Deferred revenue consistsof the following:

| ** **                                     | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| Deferred revenue, current portion              |       |                            |       |                            |       |   |   |   |   |
| Deferred product  sales                        |       |                            | $          | 4,825,099                       |       |   |   | $ | 82,048 |   |   |
| Deferred license  revenue                      |       |                            | 4,599,947  |                            |       |   | 3,572,196 |   |   |
|                                           |       |                            | 9,425,046  |                            |       |   | 3,654,244 |   |   |
| Deferred license  revenue, non-current portion |       |                            | 57,483,045 |                            |       |   | 51,421,263 |   |   |
| Total deferred revenue                         |       |                            | $          | 66,908,091                      |       |   |   | $ | 55,075,507 |   |   |

 

Deferred product sales as of December 31, 2006relate to the Company’s GLUMETZA product shipments that have not beenrecognized as revenue in accordance with the Company’s revenue recognitionpolicy. Deferred product sales as of December 31, 2005 relate to ProQuinproduct shipped to Esprit under the parties’ supply agreement that was stillsubject to a 30-day period in which Esprit could reject product that didnot meet agreed-upon specifications.

Deferred license revenuerelates to upfront payments received by the Company under license and marketingagreements with its partners. In July 2005, the Company received $30million from Esprit and additional $10 million in December 2006. The final$10 million installment under the agreement is due July 2007. The license fees payments received fromEsprit are recognized as revenue ratably until June 2020, which representsthe length of time that the Company is obligated to manufacture ProQuin XR forEsprit or its licensees. In December 2004, the Company received a $25million license fee payment under its agreement with Biovail. The $25million license fee is being recognized as revenue ratably until February 2023,which represents the estimated length of time the Company’s obligations existunder the arrangement related to royalties it is obligated to pay Biovail onnet sales of GLUMETZA in the United States and to use Biovail as the Company’ssole supplier of the 1000mg of GLUMETZA, should the 1000mg obtain approval inthe United States. The Company also received a $600,000 upfront license fee in August 2005and a $500,000 milestone payment in November 2006 under its agreement withLG Life Sciences. As of December 31, 2006, the upfront license fee andmilestone payment received from LG Life Sciences are being amortized through August 2012,which represents the estimated length of time the Company is obligated toprovide assistance in development and manufacturing.

**NOTE 7.**          COMMITMENTSAND CONTINGENCIES

***Leases***

The Company leases its facilities under non-cancelableoperating leases that expire in June 2009 with options to extend the leaseterms for an additional five years. The leases are subject to annual increaseson the anniversary of the commencement dates. Rent expense was $1,206,000,$1,058,000 and $1,057,000 for the years ended December 31, 2006, 2005, and2004, respectively.

In 2004, the Company received a leasehold improvementallowance from the landlord of approximately $357,000 which was used toreimburse costs of remodeling the Company’s facility. The Company recorded thecosts of improvements in property, plant and equipment and the allowance as adeferred rent credit. The Company amortizes the leasehold improvement assetover the shorter of the life 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

of the improvements or thelife of the lease. The Company amortizes the deferred rent credit as areduction of rent expense on a straight-line basis over the life of the lease.

As of December 31,2006, future minimum payments under operating leases for facilities andequipment were as follows:

| 2007   |   | $         | 1,230,102 |   |
|--------|--------|-----------|-----------|--------|
| 2008   |   | 1,420,307 |      |
| 2009   |   | 770,832   |      |
| 2010   |   | 12,298    |      |
| 2011   |   | 6,149     |      |
|   |   | $         | 3,439,688 |   |

 

***Manufacturing Agreements***

The Company has entered intoa manufacturing arrangement with MOVA Pharmaceuticals (MOVA), a subsidiary ofPatheon, Inc. pursuant to which MOVA will manufacture commercialquantities of GLUMETZA for the Company. As of December 31, 2006, theCompany has non-cancelable purchase orders and minimum purchase obligations for2007 totaling $2,542,000 under this arrangement.

***Convertible Promissory Note***

In connection with theformation of DDL, Elan made a loan facility available to the Company for up to$8,010,000 in principal to support the Company’s 80.1% share of the jointventure’s research and development costs pursuant to a convertible promissorynote issued by the Company to Elan. The funding term of the loan expired in November 2002.The note had a six-year term, was due in January 2006, and bore interestat 9% per annum, compounded semi-annually, on any amounts borrowed under thefacility. However, in June 2005, the Company repurchased the promissorynote with an outstanding balance of $10,724,000, including $2,927,000 ofaccrued interest, for $9,665,000 including commissions paid to a financialconsultant and legal fees. A gain on the extinguishment of the debt of$1,059,000 was recorded in other income for the year ended December 31,2005.

***Long-Term Debt***

In March 2001, theCompany entered into a secured equipment financing credit facility. The creditfacility allowed the Company to finance up to $2,000,000 of equipment andleasehold improvements purchased from August 2000 through December 31,2001. The interest rate was recalculated with each draw at 7.5% above the thencurrent 36 month US Treasury Note rate. At the end of December 2001,the Company had utilized approximately $1,347,000 of the credit facility. Theunused portion of the credit facility of $653,000 expired on December 31,2001. All amounts outstanding under the facility were repaid by July 2005.

**NOTE 8.**          STOCK-BASEDCOMPENSATION

TheCompany adopted FAS 123(R) on January 1, 2006 as described inNote 1 of the Notes to Consolidated Financial Statements. The Company usesthe Black-Scholes option valuation model to determine the fair value of stockoptions and employee stock purchase plan (ESPP) shares. The determination ofthe fair value of stock-based payment awards on the date of grant using anoption 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

valuation model is affected by the Company’s stockprice as well as assumptions which include the Company’s expected term of theaward, the expected stock price volatility, risk-free interest rate andexpected dividends over the expected term of the award.

TheCompany has concluded that its historical share option exercise experience doesnot provide a reasonable basis upon which to estimate expected term andtherefore, as of January 1, 2006, estimates the expected term of optionsgranted by taking the average of the vesting term and the contractual term ofthe option, as illustrated in SAB 107. The Company estimates the volatility ofits common stock price by using the historical volatility over the expectedterm of the options. The Company bases the risk-free interest rate on U.S.Treasury zero-coupon issues with terms similar to the expected term of theoptions as of the date of grant. The Company does not anticipate paying anycash dividends in the foreseeable future and therefore uses an expecteddividend yield of zero in the option valuation model.

The Company used thefollowing assumptions to calculate the fair value of option grants for the yearended December 31, 2006:

| ** **                               | ** ** | **2006**   | ** ** |
|------------------------------------------|------------|------------|------------|
| **Employee and Director Stock  Options** | ** ** | ** ** | ** ** |
| Risk-free  interest rate                 |       | 4.44-5.23% |       |
| Dividend yield                           |       | None       |       |
| Expected option  term (in years)         |       | 5.25-6.06  |       |
| Expected stock price  volatility         |       | 53.8-62.2% |       |

 

The Company used thefollowing assumptions to calculate the fair value of purchase rights grantedunder the ESPP for the year ended December 31, 2006:

| ** **                       | ** ** | **2006**   | ** ** |
|----------------------------------|------------|------------|------------|
| **Employee Stock Purchase Plan** | ** ** | ** ** | ** ** |
| Risk-free  interest rate         |       | 4.52-5.06% |       |
| Dividend yield                   |       | None       |       |
| Expected option  term (in years) |       | 0.5-2.0    |       |
| Expected stock price  volatility |       | 33.5-56.1% |       |

 

Stock-basedcompensation expense recognized under FAS 123(R) in the consolidatedstatements of operations for the year ended December 31, 2006 related tostock options and the ESPP was $2,572,000, which consisted of  $976,000 in research and development expense,$1,584,000 in selling, general and administrative expense and $12,000 in costof sales. As a result of adopting FAS 123(R), Depomed’s net loss for theyear ended December 31, 2006 was $2,342,000 higher, respectively, than ifthe Company continued to account for stock-based compensation under APB 25as it did in comparable prior year periods. Accordingly, basic and diluted netloss applicable to common stock shareholders per share for the year ended December 31,2006 was $0.06 higher than if the Company continued to account for stock-basedcompensation under APB 25. The implementation of FAS 123(R) didnot have an impact on the Company’s cash flows for the year ended December 31,2006.

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

The weighted-average grant date fair value of optionsgranted during the year ended December 31, 2006 was $3.50. Theweighted-average grant date fair value of purchase rights granted under theESPP during the year ended December 31, 2006 was $1.55. The totalintrinsic value of options exercised during the year ended December 31,2006 was $498,000. The total fair value of options that vested during the yearended December 31, 2006 was $2.3 million. At December 31, 2006,Depomed had $4.9 million of total unrecognized compensation expense, net ofestimated forfeitures, related to stock option plans that will be recognizedover an average vesting period of 2.5 years. Cash received from stock optionexercises was $477,000 during the year ended December 31, 2006.

Prior to January 1,2006, the Company measured compensation expense for its employee stock-basedcompensation plans using the intrinsic value method under APB No. 25.Under APB No. 25, no stock-based compensation was recognized for theESPP or for option grants when the exercise price of the options granted wasequal to or greater than the fair value market price of the stock on the grantdate. In accordance with the provisions of FAS 123(R), we eliminated thebalance of the deferred compensation calculated under APB No. 25 tothe common stock account on January 1, 2006. For the years endedDecember 31, 2005 and 2004 the Company recognized approximately $386,000and $258,000, respectively, of stock-based compensation expense under APB No. 25.

***Pro Forma Information under FAS 123 for PeriodsPrior to Fiscal 2006***

Priorto January 1, 2006, Depomed followed the disclosure provisions ofFAS 123. The following table illustrates the effect on net loss and netloss per share for the years ended December 31, 2005 and 2004 if the fairvalue recognition provisions of FAS 123 had been applied to optionsgranted and ESPP shares purchased under Depomed’s equity-based compensationplans. For purposes of this pro forma disclosure, the estimated value of theawards is recognized over the vesting periods.

| ** **                                                                                                                         | ** ** | **2005**   | ** **  | **2004**   | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|------------|-------------|------------|------------|
| Net loss  applicable to common stock shareholders—as reported                                                                 |       | $          | (25,309,474 | )          | $          | (26,873,637 | ) |
| Add: Total  stock-based employee and director compensation expense, included in the  determination of net loss as reported         |       | 385,960    |        | 257,521    |       |
| Deduct: Total  stock-based employee and director compensation expense determined under the  fair value based method for all awards |       | (2,122,504 | )           | (2,097,222 | )          |
| Net loss  applicable to common stock shareholders—pro forma                                                                   |       | $          | (27,046,018 | )          | $          | (28,713,338 | ) |
| Net loss per common share—as reported                                                                                         |       | $          | (0.64       | )          | $          | (0.78 | ) |
| Net loss per common  share—pro forma                                                                                          |       | $          | (0.68       | )          | $          | (0.83 | ) |

 

Forpurposes of the weighted-average estimated fair value calculations, the fairvalue of each stock option grant was estimated on the date of grant using theBlack-Scholes option valuation model and the following assumptions:

| ** **                               | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|
| **Employee and Director Stock  Options** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Risk-free  interest rate                 |       | 3.85-4.43% |       | 2.79-4.13% |       |
| Dividend yield                           |       | None       |       | None       |       |
| Expected option  term (in years)         |       | 4.0        |       | 4.8        |       |
| Expected stock price  volatility         |       | 65.2-67.0% |       | 68.0-82.0% |       |

 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Based on the Black-Scholes option valuation model, theweighted-average estimated fair value of options granted was $2.66 and $3.31for the years ended December 31, 2005 and 2004. The total intrinsic valueof options exercised during the years ended December 31, 2005 and 2004 was$566,000 and $136,000, respectively. The total fair value of options vested was$2.0 million and $1.9 million in the years ended December 31, 2005 and2004, respectively.

TheCompany used the following assumptions to calculate the fair value of purchaserights granted under the ESPP for the years ended December 31, 2005 and2004.

| ** **                       | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|
| **Employee Stock Purchase Plan** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Risk-free  interest rate         |       | 3.22-4.33% |       | 0.94-2.32% |       |
| Dividend yield                   |       | None       |       | None       |       |
| Expected option  term (in years) |       | 0.5        |       | 0.5        |       |
| Expected stock price  volatility |       | 43.3-47.0% |       | 68.0-82.0% |       |

 

Based on the Black-Scholesoption valuation model, the weighted-average estimated fair value of purchaserights granted under the ESPP was $1.75 and $1.83 for the years ended December 31,2005 and 2004.

***1995 Stock Option Plan***

The Company’s 1995 Stock Option Plan (the 1995 Plan)was adopted by the Board of Directors and approved by the shareholders in September 1995,and has been subsequently amended. The 1995 Plan provided for the grant toemployees of the Company, including officers, of incentive stock options, andfor the grant of nonstatutory stock options to employees, directors andconsultants of the Company. The number of shares authorized under the 1995 Planis 4,700,000 shares, of which zero are available for future issuance at December 31,2006. In May 2004, the 1995 Plan was terminated with respect to grants ofnew stock options and all options which expire or are forfeited will be retiredfrom the pool.

Generally, the exercise price of all incentive stockoptions and nonstatutory stock options granted under the 1995 Plan must be atleast 100% and 85%, respectively, of the fair value of the common stock of theCompany on the grant date. The term of incentive and nonstatutory stock optionsmay not exceed 10 years from the date of grant. An option shall beexercisable on or after each vesting date in accordance with the terms setforth in the option agreement. The right to exercise an option generally vestsover four years at the rate of at least 25% by the end of the first year andthen ratably in monthly installments over the remaining vesting period of theoption.

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

The following tablesummarizes the activity for the three years ended December 31, 2006 underthe 1995 Plan:

| ** **                                                                        | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|
| Options outstanding at  December 31, 2003                                    |       | 3,820,898  |       |                                    | $          | 4.16 |   |   |
| Options granted at fair market value                                              |       | 74,490     |       |                                    | 7.32       |   |   |
| Options granted below fair market value                                           |       | 50,000     |       |                                    | 6.76       |   |   |
| Options exercised                                                                 |       | (35,902    | )          |                                    | 2.58       |   |   |
| Options forfeited                                                                 |       | (120,810   | )          |                                    | 5.25       |   |   |
| Options  outstanding at December 31, 2004                                    |       | 3,788,676  |       |                                    | $          | 4.24 |   |   |
| Options exercised                                                                 |       | (221,438   | )          |                                    | 2.91       |   |   |
| Options forfeited                                                                 |       | (156,744   | )          |                                    | 6.48       |   |   |
| Options expired                                                                   |       | (4,940     | )          |                                    | 4.36       |   |   |
| Options  outstanding at December 31, 2005                                    |       | 3,405,554  |       |                                    | $          | 4.22 |   |   |
| Options exercised                                                                 |       | (220,445   | )          |                                    | 1.99       |   |   |
| Options forfeited                                                                 |       | (92,203    | )          |                                    | 5.80       |   |   |
| Options expired                                                                   |       | (40,254    | )          |                                    | 6.03       |   |   |
| Options  outstanding at December 31, 2006                                    |       | 3,052,652  |       |                                    | $          | 4.31 |   |   |
| Options exercisable and expected to become  exercisable at December 31, 2006 |       | 3,051,597  |       |                                    | $          | 4.31 |   |   |
| Options  exercisable at December 31, 2006                                    |       | 2,970,831  |       |                                    | $          | 4.25 |   |   |

 

| ** **                                                                        | ** ** | **Weighted-  Average  Remaining  Contractual  Term (Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-----------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------|------------|
| Options  outstanding at December 31, 2006                                    |       |                                                              | 3.97       |                                |       |   | $ | 1,131,000 |   |   |
| Options exercisable and expected to become  exercisable at December 31, 2006 |       |                                                              | 3.97       |                                |       |   | $ | 1,131,000 |   |   |
| Options  exercisable at December 31, 2006                                    |       |                                                              | 3.88       |                                |       |   | $ | 1,131,000 |   |   |

 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Informationregarding the stock options outstanding at December 31, 2006 under the1995 Plan is summarized below:

| **Range of Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (Years)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------|------------|-------------------------|------------|-----------------------------------------|------------|
| $1.71 - $1.95                               |       |                    | 513,695    |                                                              |       |                                    | 5.92       |                    |       |                                    | $          | 1.74 |   |   | 513,695 |   |   | $ | 1.74 |   |   |
| $2.70 - $3.75                               |       |                    | 1,146,223  |                                                              |       |                                    | 2.32       |                    |       |                                    | 3.40       |   |   | 1,145,223 |   |   | 3.40 |   |   |
| $4.19 - $5.80                               |       |                    | 734,498    |                                                              |       |                                    | 4.34       |                    |       |                                    | 4.96       |   |   | 734,498 |   |   | 4.96 |   |   |
| $6.10 - $7.75                               |       |                    | 628,236    |                                                              |       |                                    | 5.06       |                    |       |                                    | 7.08       |   |   | 547,415 |   |   | 7.13 |   |   |
| $9.50 - $10.25                              |       |                    | 30,000     |                                                              |       |                                    | 1.33       |                    |       |                                    | 9.70       |   |   | 30,000 |   |   | 9.70 |   |   |
|                                        |       |                    | 3,052,652  |                                                              |       |                                    | 3.97       |                    |       |                                    | $          | 4.31 |   |   | 2,970,831 |   |   | $ | 4.25 |   |   |

 

In December 2002, the Board of Directorsauthorized an increase in the number of shares authorized for issuance underthe 1995 Plan by 1,306,811 shares. On May 29, 2003 at the 2003 AnnualMeeting of Shareholders, the Company’s shareholders approved this increase tothe 1995 Plan. In December 2002 and March 2003, the Company grantedoptions to purchase approximately 585,000 shares of common stock out of the1,306,811 share increase at exercise prices of $1.71 and $2.70**,** respectively, which represented the fairmarket values of the Company’s common stock on the respective dates of grant.However, as the options were not deemed authorized for grant until theshareholders approved the increase in the number of shares authorized under the1995 Plan, the applicable measurement date for accounting purposes was on thedate such approval was obtained. Since the fair market value of the underlyingcommon stock on May 29, 2003 was $3.50, which was greater than theexercise prices of the stock options granted, the Company was required to recordthe difference of approximately $1,015,000 as deferred stock-based compensationexpense to be recognized ratably over the vesting period of the related stockoptions under APB No. 25. For the year ended December 31, 2005,the Company recognized approximately $243,000 in stock-based compensationexpense related to these stock options.

In December 2003, the Board of Directors approveda stock option which was subject to the optionee’s acceptance of employmentwhich occurred in February 2004. Since the fair market value of theunderlying common stock was greater on the date of the optionee’s employmentthan on the grant date, the Company was required to record the difference ofapproximately $32,000 as deferred stock-based compensation expense to berecognized ratable over the vesting period of the related stock optionAPB No. 25. In the year ended December 31, 2005, the Companyrecognized approximately $8,000 in stock-based compensation related to thisstock option.

As described inNote 1 of the Notes to Consolidated Financial Statements, the Companyadopted FAS 123(R) on January 1, 2006 under the modifiedprospective transition method. In accordance with the provisions ofFAS 123(R), the Company eliminated the balance of the deferredcompensation calculated under APB No. 25 to the common stock accountfor these options on January 1, 2006 and began recognizing expense basedon the grant-date fair prospectively.

***2004 Equity Incentive Plan***

The Company’s 2004 Equity Incentive Plan (the 2004Plan) was adopted by the Board of Directors and approved by the shareholders inMay 2004. The 2004 Plan provides for the grant to employees of the 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Company, includingofficers, of incentive stock options, and for the grant of nonstatutory stockoptions to employees, directors and consultants of the Company. The number ofshares authorized under the 2004 Plan at December 31, 2006 was 3,500,000shares, of which 1,336,466 were available for future issuance.

Generally, the exercise price of all incentive stockoptions and nonstatutory stock options granted under the 2004 Plan must be atleast 100% and 85%, respectively, of the fair value of the common stock of theCompany on the grant date. The term of incentive and nonstatutory stock optionsmay not exceed 10 years from the date of grant. An option shall beexercisable on or after each vesting date in accordance with the terms setforth in the option agreement. The right to exercise an option generally vestsover four years at the rate of at least 25% by the end of the first year andthen ratably in monthly installments over the remaining vesting period of theoption.

The following tablessummarize the activity for the three years ended December 31, 2006 underthe 2004 Plan:

| ** **                                                                        | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|
| Options granted at fair  market value                                             |       | 557,944    |       |                                    | $          | 5.25 |   |   |
| Options  outstanding at December 31, 2004                                    |       | 557,944    |       |                                    | $          | 5.25 |   |   |
| Options granted at fair market value                                              |       | 471,738    |       |                                    | 5.08       |   |   |
| Options exercised                                                                 |       | (13,030    | )          |                                    | 4.98       |   |   |
| Options forfeited                                                                 |       | (50,242    | )          |                                    | 5.01       |   |   |
| Options outstanding  at December 31, 2005                                    |       | 966,410    |       |                                    | $          | 5.18 |   |   |
| Options granted at fair market value                                              |       | 1,284,250  |       |                                    | 5.75       |   |   |
| Options exercised                                                                 |       | (7,561     | )          |                                    | 5.09       |   |   |
| Options forfeited                                                                 |       | (100,156   | )          |                                    | 6.04       |   |   |
| Options  outstanding at December 31, 2006                                    |       | 2,142,943  |       |                                    | $          | 5.49 |   |   |
| Options exercisable and expected to become  exercisable at December 31, 2006 |       | 2,088,498  |       |                                    | $          | 5.48 |   |   |
| Options  exercisable at December 31, 2006                                    |       | 661,533    |       |                                    | $          | 5.53 |   |   |

 

| ** **                                                                        | ** ** | **Weighted-  Average  Remaining  Contractual  Term (Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-----------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------|------------|
| Options outstanding  at December 31, 2006                                    |       |                                                              | 8.82       |                                |       |   | $ | 27,000 |   |   |
| Options exercisable and expected to become  exercisable at December 31, 2006 |       |                                                              | 8.81       |                                |       |   | $ | 26,000 |   |   |
| Options  exercisable at December 31, 2006                                    |       |                                                              | 8.29       |                                |       |   | $ | — |   |   |

 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Informationregarding the stock options outstanding at December 31, 2006 under the2004 Plan is summarized below:

| **Range of Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (Years)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------|------------|-------------------------|------------|-----------------------------------------|------------|
| $3.28 - $4.91                               |       |                    | 504,935    |                                                              |       |                                    | 9.11       |                    |       |                                    | $          | 4.07 |   |   |   | 99,195 |   |   |   | $ | 4.34 |   |   |
| $5.03 - $5.63                               |       |                    | 482,200    |                                                              |       |                                    | 8.08       |                    |       |                                    | 5.09       |   |   |   | 255,785 |   |   |   | 5.08 |   |   |
| $5.73 - $6.20                               |       |                    | 348,583    |                                                              |       |                                    | 8.84       |                    |       |                                    | 6.12       |   |   |   | 124,626 |   |   |   | 6.13 |   |   |
| $6.29 - $7.78                               |       |                    | 807,225    |                                                              |       |                                    | 9.06       |                    |       |                                    | 6.33       |   |   |   | 181,927 |   |   |   | 6.41 |   |   |
|                                        |       |                    | 2,142,943  |                                                              |       |                                    | 8.82       |                    |       |                                    | $          | 5.49 |   |   |   | 661,533 |   |   |   | $ | 5.53 |   |   |

 

**NOTE 9.**          SHAREHOLDERS’EQUITY

***Series A Preferred Stock***

The Company’s  Series APreferred Stock accrued a dividend of 7% per annum, compounded semi-annuallyand payable in shares of Series A Preferred Stock. The Series APreferred Stock was convertible at anytime between January 2002 and January 2006into the Company’s common stock. The original conversion price of the Series APreferred Stock was $12.00; however, as a result of the Company’s March 2002and October 2003 financings, the conversion price had been adjusted to$9.51 per share. In December 2004, the Company entered into an agreementwith the Series A Preferred shareholder to resolve a misunderstandingbetween the Company and the shareholder relating primarily to prior adjustmentsto the conversion price of the Series A Preferred Stock. Pursuant to theagreement, among other matters, the Company agreed to adjust the conversionprice to $7.50 per share. The Company and the shareholder also agreed tobinding interpretations of certain other terms related to the Series APreferred Stock conversion price.

Prior to December 2004, the amounts calculated asSeries A Preferred stock dividends were accounted for as an adjustment tothe conversion price following EITF Issue No. 98-5, *Accounting for Convertible Securities with BeneficialConversion Features or Contingently Adjustable Conversion Ratios*(IssueNo. 98-5).**As a resultof the modifications to the preferred stock agreement in December 2004,the Company determined that a “significant modification” of the agreement hadbeen made, and, therefore, a new “commitment date” for accounting purposes hadbeen established on December 10, 2004. The Company measured the differencebetween the carrying value of the preferred stock and the fair value of themodified preferred stock pursuant to EITF Topic No. D-42, *The Effect on the Calculation of Earnings per Sharefor the Redemption or Induced Conversion of Preferred Stock* anddetermined that the fair value of the modified security was less than thecarrying value of the security prior to the modification. The Company alsoevaluated the effective conversion rate, after considering the reset rate of$7.50 per share in addition to the common stock issuable upon conversion of theunpaid, accumulated dividends. The fair value of the underlying common stock onDecember 10, 2004 was $5.06 per share. The Company determined that theconversion rate, after including the effect of the unpaid dividends, did notresult in a beneficial conversion feature, which could have had the effect ofalso providing a deemed dividend to the preferred shareholder. However, an anti-dilution provision of the Series APreferred Stock was triggered by the Company’s January 2005 financing,which adjusted the conversion price of the Series A Preferred Stock to$7.12. As a result of the adjusted conversion price and an increase inthe amount of common stock 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

issuable upon conversionof the Series A Preferred Stock due to additional accumulated dividends,the Series A Preferred Stock now contains a “beneficial conversion feature”subject to recognition pursuant to Issue No. 98-5.

In conjunction with the modification of the agreement,the Company issued a warrant to the Series A Preferred shareholder. Thevalue of the warrant was considered in determining the value of the modifiedsecurity. The warrant is convertible into shares of the Company’s common stockduring the period between January 2006 and January 2009. Theconversion price of the warrant initially was $7.12, which was equal to the Series APreferred Stock conversion price in effect as of January 20, 2006. Theconversion price of the warrant decreases by approximately 4.8% per year duringthe conversion period, such that the number of shares of the Company’s commonstock issuable upon conversion of the warrant will increase by approximately5.1% per year. The conversion of the warrant will be satisfied only bysurrender of the outstanding shares of Series A Preferred Stock.

The Series A Preferred Stock accrued dividendsthrough January 20, 2006, which is the date the warrant initially becameexercisable. As a result of the issuance of the warrant, the preferred stockmay be surrendered in exchange for common stock for an additional three yearsthrough January 20, 2009. As long as the Series A Preferred Stockremains outstanding, the number of shares into which the warrant can beconverted increases as the conversion price of the warrant decreases resultingin additional deemed dividends on the Series A Preferred Stock. For theyears ended December 31, 2006, 2005 and 2004, the Company recognized Series APreferred Stock deemed dividends of approximately $665,000, $842,000 and zero,respectively, attributable to the beneficial conversion feature from theaccrued dividends and decreasing warrant price. The Company will continue torecognize Series A Preferred Stock deemed dividends until the earlier of,the time the Series A Preferred Stock is surrendered or until January 2009.

As of December 31,2006, there were 18,158 shares of Series A Preferred Stock outstandingwith an aggregate liquidation preference of approximately $18,159,000. Thewarrant was convertible into 2,672,423 shares of the Company’s common stock ata conversion price of $6.79 as of December 31, 2006.

***Employee Stock Purchase Plan***

In May 2004, the ESPP was approved by theshareholders. The ESPP is qualified under Section 423 of the InternalRevenue Code. The ESPP is designed to allow eligible employees to purchaseshares of the Company’s common stock through periodic payroll deductions. Theprice of the common stock purchased under the ESPP must be equal to at least85% of the lower of the fair market value of the common stock on the commencementdate of each offering period or the specified purchase date. The number ofshares authorized for issuance under the ESPP as of December 31, 2006 was500,000, of which 218,686 shares were available for future issuance.

In 2006, the Company sold131,223 shares of its common stock under the ESPP. The shares were purchased ata weighted average purchase price of $3.25 with proceeds of approximately$426,000.

***Warrant and Option Exercises***

During 2006, the Company issued 980,813 shares ofcommon stock to warrant holders with net proceeds to the Company ofapproximately $2,042,000. Warrants to purchase an additional 526,285 shares ofour common stock were surrendered in connection with a cashless exercisefeature of the exercised warrants during 2006. The weighted-average exercise price of the warrants exercised during2006 was $3.48. As of December 31, 2006, there were 500,173 shares ofcommon stock reserved for issuance for all 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

outstandingwarrants with a weighted-average exercise price of $2.16. The outstandingwarrants are fully exercisable and expire in April 2008.

Employees and consultantsexercised options to purchase 228,006 shares of the Company’s common stock withnet proceeds to the Company of $477,000 during the year ended December 31,2006, respectively.

***Shareholder Rights Plan***

On April 21, 2005,the Company adopted a shareholder rights plan, (the Rights Plan). Under theRights Plan, the Company distributed one preferred share purchase right foreach share of common stock outstanding at the close of business on May 5,2005. If a person or group acquires 20% or more of the Company’s common stockin a transaction not pre-approved by the Company’s Board of Directors, eachright will entitle its holder, other than the acquirer, to buy additionalshares of the Company’s common stock at 50% of its market value, as defined inthe Rights Plan. In addition, if an unapproved party acquires more than 20% ofthe Company’s common stock, and the Company is later acquired by the unapprovedparty or in a transaction in which all shareholders are not treated alike,shareholders with unexercised rights, other than the unapproved party, will beentitled to receive upon exercise of the rights, common stock of the mergerparty or asset buyer with a value of twice the exercise price of the rights. Eachright also becomes exercisable for one one-thousandth of a share of the Company’sSeries RP preferred stock at the right’s then current exercise price tendays after an unapproved third party makes, or announces an intention to make,a tender offer or exchange offer that, if completed, would result in theunapproved party acquiring 20% or more of the Company’s common stock. The Boardof Directors may redeem the rights for a nominal amount before an event thatcauses the rights to become exercisable. The rights will expire on April 21,2015.

***Equity Line of Credit***

In December 2006, theCompany entered into a common stock purchase agreement with AzimuthOpportunity, Ltd., which provides that, upon the terms and conditions set forthin the purchase agreement, Azimuth is committed to purchase up to the lesser of(a) $30,000,000 of the Company’s common stock, or (b) 8,399,654shares of common stock, which was equal to the number of shares that is oneless than 20% of the issued and outstanding shares of the Company’s commonstock as of December 11, 2006, over the 24 month term of the purchaseagreement. From time to time over the term of the Purchase Agreement, and atthe Company’s discretion, the Company may present Azimuth with draw downnotices requiring Azimuth to purchase a specified dollar amount of shares ofits common stock, subject to certain limits and so long as specified conditionsare met. The shares of common stock will be sold at a discount ranging from3.775% to 6.375%, which varies based on a threshold price set by the Company.Upon each sale of the Company’s common stock to Azimuth under the agreement,the Company has also agreed to pay Reedland Capital Partners a placement feeequal to 1.125% of the aggregate dollar amount of common stock purchased byAzimuth. Azimuth is not required to purchase the Company’s common stock whenthe price of the Company’s common stock is below $2 per share. As of December 31,2006, the Company has not sold any shares under this common stock purchaseagreement.

**NOTE 10.**   INCOMETAXES

As of December 31, 2006, the Company had netoperating loss carryforwards for federal income tax purposes of approximately $112,000,000,which expire in the years 2010 through 2026 and federal research 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

and development taxcredits of approximately $2,700,000 which expire in the years 2011 through 2026.Net operating loss carryforwards for state income tax purposes wereapproximately $76,000,000, which expire in the years 2012 through 2016 andstate research and development tax credits were approximately $2,800,000 whichhave no expiration date.

Utilization of the Company’s net operating loss andcredit carryforwards may be subject to a substantial annual limitation due toownership change limitations provided by the Internal Revenue Code of 1986 andsimilar state provisions. The annual limitation may result in the expiration ofnet operating losses and credits before utilization.

Deferred income taxesreflect the net tax effects of net operating loss and tax credit carryovers andtemporary differences between the carrying amounts of assets and liabilitiesfor financial reporting purposes and the amounts used for income tax purposes.Significant components of the Company’s deferred tax assets are as follows:

| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| **Deferred Tax Assets:**           | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net operating  loss carryforwards            |       | $                                          | 41,900,000 |   | $ | 40,400,000 |   | $ | 39,500,000 |   |
| Research credit  carryforwards               |       | 4,500,000                                  |       | 3,000,000 |   | 2,000,000 |   |
| In-process  research and development         |       | 3,500,000                                  |       | 3,900,000 |   | 3,200,000 |   |
| Capitalized  research expenses               |       | 1,800,000                                  |       | 2,200,000 |   | 1,300,000 |   |
| Deferred revenue                             |       | 22,700,000                                 |       | 10,000,000 |   | — |   |
| Other, net                                   |       | 1,600,000                                  |       | 400,000 |   | 200,000 |   |
| Total deferred  tax assets                   |       | 76,000,000                                 |       | 59,900,000 |   | 46,200,000 |   |
| Valuation  allowance for deferred tax assets |       | (76,000,000                                | )          | (59,900,000 | ) | (46,200,000 | ) |
| Deferred tax assets, net                     |       | $                                          | —     |   | $ | — |   | $ | — |   |

 

Realization of deferred tax assets is dependent uponfuture earnings, if any, the timing and amount of which are uncertain.Accordingly, the net deferred tax assets have been fully offset by a valuationallowance. The valuation allowance increased by $16,100,000, $13,700,000 and$10,700,000 during the years ended December 31, 2006, 2005 and 2004,respectively. The Company’s tax provision for the years ended December 31,2006, 2005 and 2004 included $83,000, zero and $99,000, respectively, offoreign taxes related to license fee withholdings by the Republic of Korea.

Theprovision for income taxes is from continuing operations and consists of thefollowing:

| ** **                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| **Current:**                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Foreign                           |       | $                                          | 83,000     |   |   | $ | — |   |   | $ | 99,000 |   |
| **Deferred:**                     |       |                                       |       |   |   |   |   |   |   |
| Foreign                           |       | —                                     |       |   | — |   |   | — |   |
| Total provision for  income taxes |       | $                                          | 83,000     |   |   | $ | — |   |   | $ | 99,000 |   |

 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Thedifference between the actual tax rate and the statutory rates is as follows:

| ** **                            | ** ** | **Year Ended December 31,** | ** **  |
|---------------------------------------|------------|--------------------------------------------|-------------|
| ** **                            | ** ** | **2006**                                   | ** **  | **2005** | ** ** | **2004** | ** ** |
| Tax at federal  statutory rate of 34% |       | $                                          | (13,457,000 | ) | $ | (8,319,000 | ) | $ | (9,297,000 | ) |
| State tax, net of  federal benefit    |       | —                                     |        | — |   | — |   |
| Foreign tax                           |       | 83,000                                     |        | — |   | 99,000 |   |
| Net operating  losses not benefited   |       | 12,674,000                                 |        | 8,250,000 |   | 9,089,000 |   |
| Other                                 |       | 783,000                                    |        | 69,000 |   | 199,000 |   |
|                                  |       | $                                          | 83,000      |   | $ | — |   | $ | 99,000 |   |

 

**NOTE 11.**      SUMMARIZEDQUARTERLY DATA (UNAUDITED)

Thefollowing tables set forth certain consolidated statements of operations datafor each of the eight quarters beginning with the quarter ended March 31,2005 through the quarter ended December 31, 2006. This quarterlyinformation is unaudited, but has been prepared on the same basis as the annualconsolidated financial statements and, in the opinion of management, reflectsall adjustments, consisting only of normal recurring adjustments necessary fora fair representation of the information for the periods presented. Operatingresults for any quarter are not necessarily indicative of results for anyfuture period.
|                                                         | ** ** | **2006 Quarter Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                              | ** ** | **March 31**                | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| Total revenues                                          |       | $                                | 1,342,159  |   | $ | 2,213,365 |   | $ | 958,784 |   | $ | 5,036,910 |   |
| Cost of sales                                           |       | 74,353                           |       | 1,050,836 |   | 320,417 |   | 155,138 |   |
| Loss from  operations                                   |       | (8,347,569                       | )          | (10,503,485 | ) | (13,125,033 | ) | (9,631,375 | ) |
| Net loss                                                |       | (7,752,710                       | )          | (9,917,408 | ) | (12,633,119 | ) | (9,356,051 | ) |
| Net loss  applicable to common stock shareholders  |       | (7,925,342                       | )          | (10,079,596 | ) | (12,798,237 | ) | (9,521,371 | ) |
| Basic and diluted  net loss per share                   |       | $                                | (0.19      | ) | $ | (0.24 | ) | $ | (0.31 | ) | $ | (0.23 | ) |

 
|                                                         | ** ** | **2005 Quarter Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                              | ** ** | **March 31**                | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| Total revenues                                          |       | $                                | 18,750     |   | $ | 428,468 |   | $ | 795,032 |   | $ | 3,163,079 |   |
| Cost of sales                                           |       | —                           |       | — |   | — |   | 908,521 |   |
| Loss from  operations                                   |       | (6,714,172                       | )          | (7,841,526 | ) | (7,408,775 | ) | (4,547,054 | ) |
| Net loss                                                |       | (6,775,437                       | )          | (6,812,039 | ) | (6,966,879 | ) | (3,912,917 | ) |
| Net loss  applicable to common stock shareholders  |       | (6,969,094                       | )          | (7,022,322 | ) | (7,185,168 | ) | (4,132,890 | ) |
| Basic and diluted net  loss per share                   |       | $                                | (0.18      | ) | $ | (0.18 | ) | $ | (0.18 | ) | $ | (0.10 | ) |

 

**NOTE 12.**      SUBSEQUENTEVENTS

***LG Life Sciences***

In January 2007, theCompany and LG Life Sciences further amended the parties’ license anddistribution agreement, originally entered into in August 2004 andsubsequently amended in November 2006. The amendment grants LG a licenseto manufacture the 500mg GLUMETZA in 

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**DEPOMED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

exchangefor royalties on net sales of GLUMETZA in Korea, and to remove the provisionsof the original agreement providing for the supply of 500mg GLUMETZA tablets bythe Company to LG.

***Biovail***

In February 2007, the Company entered into alicense and development agreement with Biovail granting Biovail an option tolicense the AcuForm drug delivery technology to develop and commercializeup to two pharmaceutical products. Pursuant to the agreement, Biovail paid theCompany an upfront fee of $500,000 in February 2007, and is contingentlyobligated to pay the Company additional fees related to the exercise of thelicense option, the initiation of the first Phase 3 trial for each productand upon receipt of U.S. regulatory approval for each product. The agreementalso stipulates that Biovail make royalty payments to the Company on netcommercial sales of any product developed under the Agreement.

Also in February 2007, the Company amended itsstock purchase agreement with Biovail originally entered into in May 2002.The amended stock purchase agreement removed Biovail’s observer rights on theCompany’s board of directors and removed the right of first negotiation infavor of Biovail with respect to any acquisition transactions of the Company.

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**SCHEDULE II:    VALUATION AND QUALIFYING ACCOUNTS**

| ** **                                             | ** ** | ** **                                   | ** ** | **Additions**                                                   | ** ** | ** **                                                                      | ** ** | ** **              | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|-------------------------|------------|
| **Description**                                        | ** ** | **Balance at  Beginning of  Year** | ** ** | **Charged as a  Reduction to  Revenue (1)** | ** ** | **Charged as a  Reduction of  Deferred   Revenue (1)** | ** ** | **Deductions (2)** | ** ** | **Balance at End  of Year** | ** ** |
| Sales allowances,  discounts, chargebacks and rebates: |       |                                         |       |                                                            |       |                                                                            |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Year ended December 31, 2006                      |       |                                         | $          | —                                                          |       |                                                                            |       | $                       | 131,000    |   |   |   | $ | 1,507,000 |   |   |   | $ | (1,267,000 | ) |   |   | $ | 371,000 |   |   |
| Year ended December 31, 2005                      |       |                                         | —     |                                                            |       |                                                                            | —     |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Year ended  December 31, 2004                     |       |                                         | —     |                                                            |       |                                                                            | —     |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
|                                                        |            |                                              |            |                                                                 |            |                                                                                 |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Additions to salesdiscounts and allowances are recorded as a reduction of deferred revenue untilsuch time revenue is recognized.

(2)          Deductions to salesdiscounts and allowances relate to discounts or allowances actually taken orpaid.

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