UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549





FORM
10-Q





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





For the quarterly period ended June
30, 2010.





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


for the
transition period from _____ to _____.




Commission
File Number


0-50481





AEOLUS PHARMACEUTICALS,
INC.


(Exact
Name of Registrant as Specified in Its Charter)





Delaware
              
              56-1953785(State
      or Other Jurisdiction of
                  Incorporation
      or Organization)
              
              (I.R.S. Employer
                  Identification
      No.)26361
      Crown Valley Parkway, Ste. 150
                Mission Viejo,
    California
              
              92691(Address
      of Principal Executive Offices)
              
              (Zip Code)
  (Registrant’s
      Telephone Number, Including Area Code)
              949-481-9825







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





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of accelerated
filer and large accelerated filer in Rule 12b-2 of the Exchange Act:




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




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).YES o NO x





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date.





Class
            Outstanding
      as of
              August 13, 2010Common
      Stock, par value $.01 per share
            59,925,249
      shares




1





AEOLUS
PHARMACEUTICALS, INC.


FORM
10-Q


For the
Quarter Ended June 30, 2010


Table of
Contents





PagePART I.FINANCIAL
      INFORMATIONItem 1.
                  Financial
      Statements
                  3Statement Regarding Financial
      Information
                  3Condensed Consolidated Balance
      Sheets as ofJune
      30, 2010
                    (unaudited)
      and September 30, 2009
                  4Condensed Consolidated Statements
      of Operations for the ThreeMonthsand Nine Months endedJune 30, 2010and 2009(unaudited)
                  5Condensed Consolidated Statements
      of Cash Flows for theNineMonths endedJune 30, 2010and 2009(unaudited)
                  6Notes to Condensed Consolidated
      Financial Statements
                  7Item 2.
                  Management’s Discussion and
      Analysis of Financial Condition and Results of
      Operations
                  14Item 3.
                  Quantitative and Qualitative
      Disclosures About Market Risk
                  17Item 4.
                  Controls and
      Procedures
                  17PART II. OTHER
      INFORMATIONItem 1.
                  Legal
      Proceedings
                  18Item 1A.
                  Risk
    Factors
                  18Item 2.
                  Unregistered Sales of Equity
      Securities and Use of Proceeds
                  18Item 3.
                  Defaults
      Upon Senior Securities
                  18Item 4.
                  Removed and
      Reserved
                  18Item
    5.
                  Other
      Information
                  18Item 6.
                  Exhibits
                  18SIGNATURES
                  19





2





AEOLUS
PHARMACEUTICALS, INC.





PART
I - FINANCIAL INFORMATION





ITEM 1. Financial
Statements.





Statement
Regarding Financial Information





The
condensed consolidated financial statements of Aeolus Pharmaceuticals, Inc. and
its wholly-owned subsidiary, Aeolus Sciences, Inc. (collectively the “Company”),
included herein have been prepared by management, without audit (except for the
Consolidated Balance Sheet as of September 30, 2009), pursuant to the rules and
regulations of the Securities and Exchange Commission (“SEC”). Certain
information normally included in the consolidated financial statements prepared
in accordance with accounting principles generally accepted in the United States
has been condensed or omitted pursuant to such rules and regulations. However,
the Company believes that the disclosures are adequate to make the information
presented not misleading. The Company recommends that you read the consolidated
financial statements included herein in conjunction with the audited
consolidated financial statements and notes thereto included in the Company’s
Annual Report on Form 10-K for the fiscal year ended September 30, 2009, filed
with the SEC on December 28, 2009.




3





AEOLUS PHARMACEUTICALS,
  INC.CONDENSED
      CONSOLIDATED BALANCE SHEETS(In
      thousands, except shares and per share
data)
  June
      30,
                    
                    
                    September
      30,2010
                    
                    
                    2009(Unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                    
                    $
                    457
                    
                    
                    $
                    646Prepaids
      and other current assets
                    
                    
                    50
                    
                    
                    
                    133Total
      current assets
                    
                    
                    507
                    
                    
                    
                    779Investment
      in CPEC, LLC
                    
                    
                    32
                    
                    
                    
                    32Total
      assets
                    
                    $
                    539
                    
                    
                    $
                    811LIABILITIES
      AND STOCKHOLDERS’ DEFICITCurrent
      liabilities:Accounts
      payable and accrued expenses
                    
                    $
                    330
                    
                    
                    $
                    774Short-term
      note payable
                    
                    
                    645
                    
                    
                    
                    0Total
      current liabilities
                    
                    
                    975
                    
                    
                    
                    774Non-current
      liabilities:Warrant
      liability
                    
                    
                    14,708
                    
                    
                    
                    0Senior
      convertible note
                    
                    
                    0
                    
                    
                    
                    600Long-term
      note payable
                    
                    
                    0
                    
                    
                    
                    594Total
      liabilities
                    
                    $
                    15,683
                    
                    
                    $
                    1,968Stockholders’
      deficit:Preferred
      stock, $.01 par value per share, 10,000,000 shares
    authorized:Series
      B nonredeemable convertible preferred stock, 600,000
sharesauthorized;
      475,087 shares issued and outstanding at June 30, 2010 and
                      September
      30, 2009
                    
                    
                    5
                    
                    
                    
                    5Common
      stock, $.01 par value per share, 200,000,000 shares
      authorized;48,224,320
      shares issued and outstanding
      at           June
      30, 2010 and37,563,392
      shares issued and outstanding at September 30, 2009
                    
                    
                    482
                    
                    
                    
                    376Additional
      paid-in capital
                    
                    
                    154,192
                    
                    
                    
                    159,657Accumulated
      deficit
                    
                    
                    (169,823
                    )
                    
                    
                    (161,195
                    )Total
      stockholders' deficit
                    
                    
                    (15,144
                    )
                    
                    
                    (1,157
                    )Total
      liabilities and stockholders' deficit
                    
                    $
                    539
                    
                    
                    $
                    811





The
accompanying notes are integral part of these unaudited condensed consolidated
financial statements.




4




AEOLUS PHARMACEUTICALS,
  INC.CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)(In
      thousands, except per share data)
  Three
      Months Ended
                                                                                        
                                                                                        
                                                                                        Nine
      Months EndedJune
      30,
                                                                                        
                                                                                        
                                                                                        June
      30,2010
                                                                                        
                                                                                        
                                                                                        2009
                                                                                        
                                                                                        
                                                                                        2010
                                                                                        
                                                                                        
                                                                                        2009RevenueGrant
      income
                                                                                        
                                                                                        $
                                                                                        -
                                                                                        
                                                                                        
                                                                                        $
                                                                                        -
                                                                                        
                                                                                        
                                                                                        $
                                                                                        -
                                                                                        
                                                                                        
                                                                                        $
                                                                                        -Costs
      and expenses:Research
      and development
                                                                                        
                                                                                        
                                                                                        275
                                                                                        
                                                                                        
                                                                                        
                                                                                        130
                                                                                        
                                                                                        
                                                                                        
                                                                                        885
                                                                                        
                                                                                        
                                                                                        
                                                                                        469General
      and administrative
                                                                                        
                                                                                        
                                                                                        475
                                                                                        
                                                                                        
                                                                                        
                                                                                        315
                                                                                        
                                                                                        
                                                                                        
                                                                                        1,337
                                                                                        
                                                                                        
                                                                                        
                                                                                        903Total
      costs and expenses
                                                                                        
                                                                                        
                                                                                        750
                                                                                        
                                                                                        
                                                                                        
                                                                                        445
                                                                                        
                                                                                        
                                                                                        
                                                                                        2,222
                                                                                        
                                                                                        
                                                                                        
                                                                                        1,372Loss
      from operations
                                                                                        
                                                                                        
                                                                                        (750
                                                                                        )
                                                                                        
                                                                                        
                                                                                        (445
                                                                                        )
                                                                                        
                                                                                        
                                                                                        (2,222
                                                                                        )
                                                                                        
                                                                                        
                                                                                        (1,372
                                                                                        )Interest
      (expense), net
                                                                                        
                                                                                        
                                                                                        (17
                                                                                        )
                                                                                        
                                                                                        
                                                                                        (114
                                                                                        )
                                                                                        
                                                                                        
                                                                                        (860
                                                                                        )
                                                                                        
                                                                                        
                                                                                        (322
                                                                                        )Other
      income (expense), net
                                                                                        
                                                                                        
                                                                                        (3,856
                                                                                        )
                                                                                        
                                                                                        
                                                                                        133
                                                                                        
                                                                                        
                                                                                        
                                                                                        (9,899
                                                                                        )
                                                                                        
                                                                                        
                                                                                        144Net
      loss
                                                                                        
                                                                                        $
                                                                                        (4,623
                                                                                        )
                                                                                        
                                                                                        $
                                                                                        (426
                                                                                        )
                                                                                        
                                                                                        $
                                                                                        (12,981
                                                                                        )
                                                                                        
                                                                                        $
                                                                                        (1,550
                                                                                        )Net
      loss per weighted share attributable to common
    stockholders:Basic
      and diluted
                                                                                        
                                                                                        $
                                                                                        (0.10
                                                                                        )
                                                                                        
                                                                                        $
                                                                                        (0.01
                                                                                        )
                                                                                        
                                                                                        $
                                                                                        (0.27
                                                                                        )
                                                                                        
                                                                                        $
                                                                                        (0.05
                                                                                        )Weighted
      average common shares outstanding:Basic
      and diluted
                                                                                        
                                                                                        
                                                                                        48,244
                                                                                        
                                                                                        
                                                                                        
                                                                                        37,468
                                                                                        
                                                                                        
                                                                                        
                                                                                        47,652
                                                                                        
                                                                                        
                                                                                        
                                                                                        33,865





The
accompanying notes are integral part of these unaudited condensed consolidated
financial statements.




5




AEOLUS PHARMACEUTICALS,
  INC.CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(In
      thousands)
  Nine
      Months EndedJune
      30,2010
                              
                              
                              2009Cash
      flows from operating activities:Net
      loss
                              
                              $
                              (12,981
                              )
                              
                              $
                              (1,550
                              )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Noncash
      compensation
                              
                              
                              407
                              
                              
                              
                              193Change
      in fair value of warrants
                              
                              
                              3,686
                              
                              
                              
                              -Change
      in fair value of trading securities
                              
                              
                              -
                              
                              
                              
                              (49
                              )Noncash
      consulting expense
                              
                              
                              14
                              
                              
                              
                              25Loss
      on sale of investments
                              
                              
                              -
                              
                              
                              
                              (133
                              )Noncash
      interest and warrant costs
                              
                              
                              7,020
                              
                              
                              
                              366Change
      in assets and liabilities:Prepaids
      and other assets
                              
                              
                              90
                              
                              
                              
                              5Accounts
      payable and accrued expenses
                              
                              
                              (31
                              )
                              
                              
                              (247
                              )Net
      cash used in operating activities
                              
                              
                              (1,795
                              )
                              
                              
                              (1,390
                              )Cash
      flows from investing activities:(Purchases)
      sales of investments and marketable securities
                              
                              
                              (7
                              )
                              
                              
                              751Net
      cash (used by)  provided by investing activities
                              
                              
                              (7
                              )
                              
                              
                              751Cash
      flows from financing activities:Repayment
      of short term note payable
                              
                              
                              -
                              
                              
                              
                              (368
                              )Proceeds
      from short term note payable
                              
                              
                              -
                              
                              
                              
                              3Proceeds
      from the issuance of common stock and warrants
                              
                              
                              1,650
                              
                              
                              
                              1,500Proceeds
      from exercise of warrants
                              
                              
                              17
                              
                              
                              
                              -Proceeds
      from issuance of Senior Convertible Notes
                              
                              
                              -
                              
                              
                              
                              375Costs
      related to the issuance of common stock and warrants
                              
                              
                              (54
                              )
                              
                              
                              (91
                              )Net
      cash provided by financing activities
                              
                              
                              1,613
                              
                              
                              
                              1,419Net
      (decrease) increase in cash and cash equivalents
                              
                              
                              (189
                              )
                              
                              
                              780Cash
      and cash equivalents at beginning of period
                              
                              
                              646
                              
                              
                              
                              399Cash
      and cash equivalents, end of period
                              
                              $
                              457
                              
                              
                              $
                              1,179
  6


AEOLUS
PHARMACEUTICALS, INC.





NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





A.         Organization
and Business and Basis of Presentation





Aeolus
Pharmaceuticals, Inc. is a biopharmaceutical company that is developing a new
class of catalytic antioxidant compounds as a medical countermeasure against
biological, chemical and radiological weapons as well as for diseases and
disorders of the central nervous system, respiratory system, autoimmune system
and oncology.  The Company’s initial target indications are as a
protective agent against the effects of acute radiation syndrome, sulfur mustard
gas exposure and chlorine gas exposure.  The Company has reported
positive safety results from two Phase I clinical trials of AEOL 10150, our lead
drug candidate, with no serious adverse events noted.





Funding
of the research on the Company’s lead compound, AEOL 10150 for use as a medical
countermeasure comes from a number of sources.  Development of the
compound for lung effects of acute radiation exposure has largely been funded by
Aeolus through programs at the University of Maryland and Duke
University.  In December 2009, the Company was informed by the
Biologic Advanced Research and Development Authority (BARDA) that it had been
chosen to submit a full proposal for funding of its Lung ARS program from its
current stage to FDA approval, based on a summary “white paper” submitted
earlier in 2009 by the Company.





Since
March of 2009, AEOL 10150 has also been under development as a medical
countermeasure for the GI effects of Acute Radiation Syndrome
(GI-ARS).  The GI-ARS program has been completely funded to date by
the National Institutes of Health-National Institute of Allergy and Infectious
Disease (NIH-NIAID).  Additional NIH-NIAID funded studies of AEOL
10150 in GI-ARS are expected to begin before the end of the fiscal
year.





For the
past two years, AEOL 10150 has been the subject of research and development as a
countermeasure for mustard and chlorine gas exposure through funding by NIH
CounterACT.  In May of 2010, the Company submitted white papers to
BARDA proposing long-term funding of 10150 as both a chlorine and mustard gas
countermeasure from the current stages of development to FDA
Approval.  A response to the white papers is expected before the end
of the fiscal year.  In any event, funding of the chlorine and mustard
gas programs is expected to continue through the NIH CounterACT
program.





The
Company has a second compound, AEOL 11207, which has been the subject of
research and development as a treatment for Parkinson’s Disease and
Epilepsy.  Currently, this research work is being funded through
grants to Dr. Manisha Patel at the University of Colorado from the Michael J.
Fox Foundation and Citizens United for Research in Epilepsy (CURE).





The
“Company” or “Aeolus” refers collectively to Aeolus Pharmaceuticals, Inc., a
Delaware corporation (“Aeolus”), and its wholly owned subsidiary, Aeolus
Sciences, Inc., a Delaware corporation. As of June 30, 2010, Aeolus also owned a
35.0% interest in CPEC LLC, a Delaware limited liability company (“CPEC”). The
Company’s primary operations are located in Mission Viejo,
California.




All
significant intercompany activity has been eliminated in the preparation of the
condensed consolidated financial statements. The unaudited condensed
consolidated financial statements have been prepared in accordance with the
requirements of Form 10-Q and Rule 10-01 of Regulation S-X. Some information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to those rules and regulations. In the opinion of management,
the accompanying unaudited consolidated financial statements include all
adjustments (consisting only of normal recurring adjustments) necessary to
present fairly the consolidated financial position, results of operations and
cash flows of the Company. The consolidated balance sheet at September 30, 2009
was derived from the Company’s audited financial statements included in the
Company’s Annual Report on Form 10-K for the fiscal year ended September 30,
2009. The unaudited condensed consolidated financial statements included herein
should be read in conjunction with the audited consolidated financial statements
and the notes thereto included in that Annual Report on Form 10-K and in the
Company’s other SEC filings. Results for the interim period are not necessarily
indicative of the results for any other period.





B.         Liquidity





The
Company has incurred significant losses from operations of approximately
$2,222,000 and $1,372,000, and cash outflows from operations of approximately
$1,795,000 and $1,390,000, for the nine months ended June 30, 2010 and for the
nine months ended June 30, 2009, respectively. The Company expects to incur
additional losses and negative cash flow from operations during the remainder of
fiscal year 2010 and for several more years.





On July
30, 2010, the Company announced the exercise of its “Put Option” with Xmark
Funds, under which the Company raised $1.65 million.  In addition, on
August 12, 2010, the Company completed a common stock and warrant financing for
$1 million, with the option to call another $1 million during the first quarter
of fiscal 2011.  The proceeds from these financings are expected to
enable the Company to continue operations into the first half of fiscal 2012
(see subsequent events).




7




If the
Company is unable to obtain additional financing to fund operations beyond the
first half of fiscal year 2012, it will need to eliminate some or all of its
activities, merge with another company, sell some or all of its assets to
another company, or cease operations entirely. There can be no assurance that
the Company will be able to obtain additional financing on favorable terms or at
all, or that the Company will be able to merge with another Company or sell any
or all of its assets.





C.         Net
LossPer Common
Share





The
Company computes basic net loss per weighted average share attributable to
common stockholders using the weighted average number of shares of common stock
outstanding during the period. The Company computes diluted net income (loss)
per weighted average share attributable to common stockholders using the
weighted average number of shares of common and dilutive potential common shares
outstanding during the period. Potential common shares consist of stock options,
convertible debt, warrants and convertible preferred stock using the treasury
stock method and are excluded if their effect is
anti-dilutive.  Diluted weighted average common shares excluded
incremental shares of approximately 59,925,249 for the nine months
ended June 30, 2010 issuable upon the exercise or conversion of convertible
debt, stock options to purchase common stock, convertible preferred stock and
warrants to purchase common stock. These shares were excluded due to their
anti-dilutive effect as a result of the Company’s net loss for the nine months
ended June 30, 2010. Diluted weighted average common shares included
incremental shares issuable upon conversion of the Senior Convertible Notes but
excluded incremental shares of approximately 36,585,000, for the nine
months ended June 30, 2009 due to their anti-dilutive effect as a result of the
Company’s net loss for the nine months ended June 30, 2009.





D.           Warrant
Liability





On
October 1, 2009, the Company adopted new accounting guidance originally referred
to as Emerging Issues Task Force 07-5, recently codified by FASB to be ASC
815.  The new guidance revised existing guidance for determining
whether an Instrument (or Embedded Feature) is indexed to an entity’s own
stock.  Equity-linked instruments (or embedded features) that
otherwise meet the definition of a derivative are not accounted for as
derivatives if certain criteria are met, one of which is that the instrument (or
embedded feature) must be indexed to the entity’s own stock.  The
Company applied the new guidance to outstanding instruments as of October 1,
2009.  The fair value of the warrants affected by the new guidance at
the dates of issuance totaled $8,282,000 and was initially recorded as a
component of additional paid-in capital. Upon adoption of the new guidance, the
Company recorded a decrease to the opening balance of additional-paid-in capital
of $8,142,000 and recorded a decrease to accumulated deficit totaling
$4,353,000, representing the decrease in the fair value of the warrants from the
date of issuance to October 1, 2009.  The fair value of the warrants
at October 1, 2009 of $3,789,000 was classified as a liability in the balance
sheet as of that date.





Future
increases or decreases in fair value of the warrants will be included as a
component of other income (expenses) in the accompanying statement of operations
for the respective period.  As of June 30, 2010, the liability for
warrants increased to approximately $14,708,000, resulting in an additional
charge to the statements of operations for the three months and nine months
ended June 30, 2010 of approximately $3,856,000 and $9,899,000,
respectively.  The warrant liability and revaluations have not and
will not have any impact on the Company’s working capital, liquidity, or
business operations.





E.         Note
Payable





Senior
Convertible Notes to Related Parties





On August
1, 2008, the Company entered into a Securities Purchase Agreement (the "SCN
Purchase Agreement") with three accredited institutional
investors  (the "Investors") pursuant to which the Company agreed to
sell to the Investors units comprised of senior unsecured convertible notes of
the Company (the "Notes"), in an aggregate principal amount of up to $5,000,000,
which shall bear interest at a rate of 7% per year and mature on the 30-month
anniversary of their date of issuance, and warrants to purchase up to an
aggregate of 10,000,000 additional shares of Common Stock (the "Warrant
Shares"), each with an initial exercise price of $0.50 per share, subject to
adjustment pursuant to the warrants (the "Warrants") (collectively the “SCN
Financing”). Each unit (collectively, the "Units") is comprised of $1,000 in
Note principal and Warrants to purchase up to 2,000 shares of the Company's
common stock, par value $0.01 per share (the "Common Stock"), and has a purchase
price of $1,000.





On August
1, 2008, the Company sold and issued to the Investors 500 Units comprised of
Notes in the aggregate principal amount of $500,000 and Warrants to purchase up
to 1,000,000 shares of Common Stock for an aggregate purchase price of $500,000
(the "Financing").





On each
of September 4, 2008, October 1, 2008, November 3, 2008 and December 1, 2008,
the Company sold and issued to the Investors 125 Units comprised of Notes in the
aggregate principal amount of $125,000 and Warrants to purchase up to 250,000
shares of Common Stock for an aggregate purchase price of $125,000 (the
"Subsequent Financings").





The Notes
issued in the Financing and the Subsequent Financings had an initial conversion
price of $0.35 per share, subject to adjustment pursuant to the
Notes.  In addition, the Investors had the option to purchase up to an
additional 4,000 Units, in one or more closings (each, an "Election Closing") at
their sole option at any time on or before December 31, 2013.




8




Interest
on the Notes accrued at the rate of 7.0% per annum from the date of issuance,
and was payable semi-annually, on January 31 and July 31 of each
year.  Interest was payable, at the Company's sole election, in cash
or shares of Common Stock, to holders of Notes on the record date for such
interest payments, with the record dates being each January 15 and July 15
immediately preceding an interest payment date.   The effective
interest rate of the Note including the effect of the amortization of the
embedded conversion feature and the note discount is 39.4 percent.





The net
proceeds to the Company from the sale of 1,000 Units in the Financing and
Subsequent Financing, after deducting for expenses, were approximately
$844,000.  The Company used the net proceeds to fund the development
of AEOL 10150 and to fund ongoing operations of the Company.  Offering
costs of the private placement were $156,000 and were allocated to the Notes and
Warrants based upon their respective fair values.  The offering costs
attributed to the Notes in the amount of $100,000 were capitalized as Debt
Issuance Costs.  The Debt Issuance Costs were amortized over the life
of the Notes in the Financing.





In
connection with a financing that occurred on October 6, 2009 and is more fully
described in Note F – Stockholders’ Equity,  the holders of the Notes
agreed to convert all $1,000,000 of the Company’s Notes  into Common Stock
at a conversion rate of $0.35 per share and to exchange their remaining option
to purchase an additional $4,000,000 in Notes for warrants to purchase up to
14,285,714 shares of Common Stock with an initial exercise price of $0.28 per
share, subject to adjustment pursuant to the warrants (the “Note
Warrants”).





On
December 24, 2009, the “Company entered into an amendment (the “Amendment”) to
the Securities Purchase and Exchange Agreement dated October 6, 2009 (the
“October 2009 Purchase Agreement”) pursuant to which the Company agreed to lower
the conversion price of the Notes from $0.35 per share to $0.28 per share and as
a result, issued an additional 714,286 shares of the Company’s Common
Stock.  The Amendment was executed to resolve a misunderstanding
regarding one of the financing terms in the October 6, 2009 financing between
the Company and the investors in the financing.  The Company did not
receive any proceeds from the issuance.   As a result of the
amendment and issuance of the additional shares, the Company recorded a charge
of $343,000 in the Statement of Operations as interest expense for the value of
the shares issued on the date of issuance.





Affiliates
of Xmark Opportunity Partners, LLC were the sole investors in the SCN Financing.
Together with its affiliates, Xmark Opportunity Partners, LLC beneficially owned
approximately 52% of the Company's outstanding common stock prior to the
Financing. Xmark Opportunity Partners, LLC is the sole manager of Goodnow
Capital, L.L.C. and possesses sole power to vote and direct the disposition of
all securities of the Company held by Goodnow. Goodnow has the right to
designate up to two directors for election to the Company's Board of Directors,
pursuant to the terms of a purchase agreement between Goodnow and the Company.
David C. Cavalier, a current Director of the Company, and Managing Partner of
XMark Opportunity Partners LLC, is President of Goodnow.  The
transaction was evaluated by Management and the Board of Directors for fairness
to ensure the terms were reasonable given the related party nature of the SCN
Financing by providing an option for non-related party investors to participate
in the transaction.





Elan
Note Payable





In August
2002, Aeolus borrowed from Elan Corporation, plc. (“Elan”)
$638,000.  The note payable accrued interest at 10% compounded
semi-annually. The note was convertible at the option of Elan into shares of the
Company’s Series B non-voting convertible preferred stock (“Series B Stock”) at
a rate of $43.27 per share. The original note matured on December 21,
2006.  However, in February 2007, the Company and Elan terminated the
note, the Company paid $300,000 in cash to Elan,  Elan forgave
$225,000 of the note payable and Elan and the Company entered into a new
two-year note payable in the amount of $453,000 under substantially the same
terms as the original note.  In February 2009, the Company and Elan
agreed to amend the note payable to extend the maturity date of the convertible
promissory note from February 7, 2009 to February 7, 2011 and increased the
interest rate of the convertible promissory note from 10% to 11% effective
February 7, 2009. As of the date of the Amendment, an aggregate of $553,000 in
principal and interest was outstanding under the convertible promissory note. In
the event of an event of default under the convertible promissory note, Elan may
demand immediate payment of all amounts outstanding under the note. For purposes
of the note, an event of default includes, among other items, a default in the
payment of the note principal or interest when due and payable, an uncured
breach by the Company of its obligations to Elan pursuant the agreements under
which the convertible promissory note was issued, an inability of the Company to
pay its debts in the normal course of business, the cessation of business
activities by the Company (other than as a result of a merger or consolidation
with a third party) without Elan’s prior written consent and the appointment of
a liquidator, receiver, administrator, examiner, trustee or similar officer of
the Company or over all or substantially all of its assets under the
law.





During
the term of the note payable, Elan has the option to convert the note into
shares of Series B Preferred Stock at a rate of $9.00 per share.  Upon
the maturity of the note payable, Aeolus has the option to repay the note either
in cash or in shares of Series B Stock and warrants having a then fair market
value of the amount due; provided that the fair market value used for
calculating the number of shares to be issued will not be less than $13.00 per
share. As of June 30, 2010, the outstanding balance, including interest, on the
note payable to Elan was approximately $645,000.




9




F.          
Stockholders’
Equity





On
October 6, 2009, the Company entered into the October 2009 Purchase Agreement
with several accredited institutional investors  (the "October 2009
Investors") pursuant to which the Company sold and issued to the October 2009
Investors in a private placement an aggregate of 5,892,857 units (the “Units”),
comprised of an aggregate of 5,892,857 shares of Common Stock (the “Shares”) and
warrants to purchase up to an aggregate of 11,785,714 additional shares of
Common Stock (the “October 2009 Warrants”), with an initial exercise price of
$0.28 per share, subject to adjustment pursuant to the October 2009 Warrants,
with each Unit representing one share of Common Stock and a October 2009 Warrant
to purchase two shares of Common Stock, at a purchase price of $0.28 per Unit
for aggregate gross proceeds of $1,650,000 (collectively, the “October 2009
Financing”).  The October 2009 Warrants are exercisable for a seven
year period from their date of issuance; contain a “cashless exercise” feature
that allows the holder to exercise the October 2009 Warrants without a cash
payment to the Company under certain circumstances; contain a dividend
participation right which allows the holder to receive any cash dividends paid
on the Common Stock without exercising the October 2009 Warrant and contain a
provision that provides for the reduction of the exercise price to $0.01 in the
event of any such payment of cash dividends by the Company or upon a change of
control and contain anti-dilution provisions in the event of a stock dividend or
split, dividend payment or other issuance, reorganization, recapitalization or
similar event.





The
Company also granted to the October 2009 Investors the option to acquire,
collectively, up to an additional 5,892,857 additional Units (the “Additional
Units”), comprised of an aggregate of 5,892,857 shares of Common Stock and
warrants to purchase up to an aggregate of 11,785,714 additional shares of
common stock at the per Additional Unit purchase price of $0.28 (the “Call
Option”). In addition, the October 2009 Investors granted to the Company the
option to require these October 2009 Investors, severally and not jointly, to
acquire up to 5,892,857 Additional Units, less any Additional Units acquired
under the Call Option, at the per Additional Unit purchase price of $0.28 (the
“Put Option”).  The Call Option was exercisable at any time, and from
time to time, on or prior to June 30, 2010.  The Put Option was
exercisable at any time from June 30, 2010 to July 30, 2010. On July 30, 2010,
the Company exercised the full Put Option and received $1.65 million in cash and
issued 5,892,857 common shares and 11,785,714 warrants to the October 2009
Investors (see Subsequent Events).





In
addition, the October 2009 Investors agreed to convert all $1,000,000 of the
Company’s Senior Convertible Notes issued in 2008 (the “Notes”) into Common
Stock at a conversion rate of $0.35 per share (the “Conversion Shares”), which
was subsequently lowered to $0.28 as discussed below and to exchange their
remaining option to purchase an additional $4,000,000 in Senior Convertible
Notes for warrants to purchase up to 14,285,714 shares of Common Stock in
substantially the same of form and terms of the October 2009 Warrants issued in
the October 2009 Financing, including an initial exercise price of $0.28 per
share, subject to adjustment pursuant to the warrants (the “Note
Warrants”).  As consideration for the October 2009 Investors to
convert the Notes, the Company agreed to exchange warrants to purchase up to
2,000,000 shares of Common Stock issued to the October 2009 Investors in
connection with the sale of the Notes, warrants to purchase up to 2,150,000
shares of Common Stock issued to the October 2009 Investors and one of their
affiliates in connection with a financing completed in November 2005 and
warrants to purchase up to 13,392,857 shares of Common Stock issued to the
October 2009 Investors in connection with a financing completed in March 2009
(collectively, the “Prior Warrants”) for warrants to purchase up to 17,542,857
shares of Common Stock in substantially the same form and terms of the October
2009 Warrants issued in the October 2009 Financing, including an initial
exercise price of $0.28 per share, subject to adjustment pursuant to the
warrants (the “Exchange Warrants”) (collectively, the
“Conversion”).





In
connection with the October 2009 Financing and the Conversion, the Company also
entered into a Registration Rights Agreement (the “October 2009 Rights
Agreement”) with the Investors.  In addition, the Investors agreed to
terminate the Company’s Registration Rights Agreements dated November 21, 2005
and March 30, 2009.  Pursuant to the October 2009 Rights Agreement,
the Company agreed to file one or more registration statements (collectively,
the “Registration Statements”) with the Securities and Exchange Commission (the
“SEC”) covering the resale of the Shares, the Conversion Shares and all shares
of common stock issuable upon exercise of the Warrants, the Note Warrants and
the Exchange Warrants (collectively, the “Registrable Securities”) upon demand
of the holders of a majority of the Registrable Securities (a “Demand
Registration”).  Such holders have the right to two Demand
Registrations, subject to certain exceptions.  In the event the
holders exercise their right to a Demand Registration, the Company has agreed to
file a Registration Statement to register the resale of the Registrable
Securities within a certain number of days after the request and to use
commercially reasonable efforts to cause the Registration Statement to be
declared effective by the SEC as soon as practicable after the filing
thereof.  The Company also agreed to use its commercially reasonable
efforts to keep the Registration Statements effective for a specified
period.





The net
proceeds to the Company from the October 2009 Financing, after deducting for
expenses, were approximately $1.6 million. The Company intends to use the net
proceeds from the Financing to finance animal efficacy studies in Acute
Radiation Syndrome, the development of AEOL 10150 and ongoing operations of the
Company.





The fair
value of the October 2009 Warrants, the Note Warrants and the Exchange Warrants
was estimated to be $10,585,000 using the Black-Scholes option pricing model
with the following assumptions: dividend yield of 0%; expected volatility of
93%; risk free interest rate of 2.9%; and an expected life of seven
years.   The fair value of the Prior Warrants cancelled on
October 6, 2009 was $3,352,000.   The proceeds from the October
2009 Financing were allocated based upon the relative fair values of the October
2009 Warrants and the Shares.  Due to the anti-dilution provisions of
the October 2009 Warrants, the Note Warrants and the Exchange Warrants, these
warrants were deemed to be a liability under current accounting guidance and as
a result the warrant liability was increased by $7,233,000 of which $6,213,000
was recorded as a charge to the Statement of Operations and $1,020,000 of
proceeds from the October 2009 Financing was allocated to the value of the
October 2009 Warrants.




10




Affiliates
of Xmark Opportunity Partners, LLC are the sole investors in the Financing and,
together with the Company, are the sole participants in the Conversion. Together
with its affiliates, Xmark Opportunity Partners, LLC beneficially owned
approximately 71% of the Company's outstanding common stock prior to the
Financing and the Conversion.  Xmark Opportunity Partners, LLC is the
sole manager of Goodnow Capital, L.L.C. and possesses sole power to vote and
direct the disposition of all securities of the Company held by Goodnow. Goodnow
has the right to designate up to two directors for election to the Company's
Board of Directors pursuant to the terms of a purchase agreement between Goodnow
and the Company. David C. Cavalier, a current employee, Director and
Chairman of the Board of the Company, and Managing Partner of XMark Opportunity
Partners LLC, is President of Goodnow.





On
December 24, 2009, the Company entered into an amendment (the “Amendment”) to
the October 2009 Purchase Agreement pursuant to which the Company agreed to
lower the conversion price of the Notes from $0.35 per share to $0.28 per share
and as a result, issued to the investors in the Company’s October 2009 Financing
an additional 714,286 shares of the Company’s Common Stock upon conversion of
the Notes (the “Issuance”).  The Agreement was executed to resolve a
misunderstanding regarding one of the Financing terms between the Company and
the investors in the Financing.  The Company did not receive any
proceeds from the Issuance.  The fair value of the common stock on the
date of issuance was $343,000 and was charged to the Statement of Operations as
interest expense.





On March
30, 2009, Aeolus entered into a Securities Purchase Agreement (the "Purchase
Agreement") with two accredited institutional investors  (the "March
2009 Investors") pursuant to which the Company sold and issued to the March 2009
Investors in a private placement an aggregate of 5,357,143 units (the “March
2009 Units”), comprised of an aggregate of 5,357,143 shares of Common Stock of
the Company (the “Shares”) and warrants to purchase up to an aggregate of
13,392,857 additional shares of Common Stock (the “March 2009 Warrants”), with
an initial exercise price of $0.35 per share, subject to adjustment pursuant to
the March 2009 Warrants, with each March 2009 Unit representing one share of
Common Stock and a March 2009 Warrant to purchase two-and-one-half shares of
Common Stock, at a purchase price of $0.28 per March 2009 Unit for aggregate
gross proceeds of $1,500,000 (collectively, the “March 2009
Financing”).  The March 2009 Warrants are exercisable for a five year
period from their date of issuance; contain a “cashless exercise” feature that
allows the holder to exercise the March 2009 Warrants without a cash payment to
the Company under certain circumstances; contain a dividend participation right
which allows the holder to receive any cash dividends paid on the Common Stock
without exercising the March 2009 Warrant and contain a provision that provides
for the reduction of the exercise price to $0.01 in the event of any such
payment of cash dividends by the Company; and contain standard anti-dilution
provisions that provide for the adjustment of the exercise price and the number
of shares of common stock that can be purchased in the event of a financing at a
price per share below the exercise price, a stock dividend or split, dividend
payment or other issuance, reorganization, recapitalization or similar
event.





The fair
value of the March 2009 Warrants was estimated to be $4,129,000 using the
Black-Scholes option pricing model with the following assumptions: dividend
yield of 0%; risk free interest rate of 1.7%; expected volatility of 164%; and
an expected life of five years.





Offering
costs of the March 2009 Financing were $91,000 resulting in net proceeds to the
Company of approximately $1.4 million. The Company intends to use the net
proceeds from the March 2009 Financing to finance the development of AEOL 10150
and to fund ongoing operations of the Company.  Affiliates of Xmark
Opportunity Partners, LLC were the sole investors in the Financing.





As a
result of the March 2009 Financing, the Company was required to lower the
exercise price of 4,687,000 warrants previously issued in November 2005 and May
2007 to $0.28 per share, the purchase price of the March 2009 Units issued in
the March 2009 Financing.   As a result of the change in the
exercise price, these warrants were revalued resulting in an increase in the
value of $38,000 which was charged to the statement of operations during the
second quarter of fiscal year 2009.





In
connection with the SCN Financing, Aeolus issued warrants to purchase 2,000,000
shares at an exercise price of $0.50 per share with a five year
term.  The fair value of the warrants issued on August 1, 2008 was
estimated to be $282,000 using the Black-Scholes option pricing model with the
following assumptions: dividend yield of 0%; expected volatility of 128% risk
free interest rate of 3.2%; and an expected life of five years.  The
fair value of the warrants issued on September 4, 2008 was estimated to be
$53,000 using the Black-Scholes option pricing model with the following
assumptions: dividend yield of 0%; expected volatility of 130% risk free
interest rate of 3.0%; and an expected life of five
years.    The fair value of the warrants issued on October
1, 2008 was estimated to be $93,000 using the Black-Scholes option pricing model
with the following assumptions: dividend yield of 0%; expected volatility of
133% risk free interest rate of 2.9%; and an expected life of five
years.    The fair value of the warrants issued on November
3, 2008 was estimated to be $76,000 using the Black-Scholes option pricing model
with the following assumptions: dividend yield of 0%; expected volatility of
139% risk free interest rate of 2.7%; and an expected life of five
years.    The fair value of the warrants issued on December
1, 2008 was estimated to be $75,000 using the Black-Scholes option pricing model
with the following assumptions: dividend yield of 0%; expected volatility of
138% risk free interest rate of 1.7%; and an expected life of five
years.




11




In
addition, as a result of the SCN Financing, the Company was required to lower
the exercise price of 4,687,000 warrants previously issued in the November 2005
Financing and in the 2007 Financing to $0.35 per share, the conversion price of
the Notes issued in the SCN Financing.   As a result of the
change in the exercise price, these warrants were revalued resulting in an
increase in the value of $118,000 which was charged to the statement of
operations during the fourth quarter of fiscal year 2008.





As of
June 30, 2010, warrants to purchase 53,440,953 shares of common stock were
outstanding. Details of the warrants for common stock outstanding at June 30,
2010 were as follows:


Number of Shares
                              
                              
                              Exercise Price
                              
                              Expiration Date350,000
                              
                              
                              $
                              0.28
                              
                              November
      20102,126,668
                              
                              
                              $
                              0.28
                              
                              May
      201243,614,285
                              
                              
                              $
                              0.28
                              
                              October
      201620,000
                              
                              
                              $
                              0.39
                              
                              September
      201450,000
                              
                              
                              $
                              0.35
                              
                              May
      201115,000
                              
                              
                              $
                              0.50
                              
                              September
      201415,000
                              
                              
                              $
                              0.60
                              
                              September
      20147,000,000
                              
                              
                              $
                              0.75
                              
                              June
      201150,000
                              
                              
                              $
                              1.00
                              
                              May
      201150,000
                              
                              
                              $
                              1.50
                              
                              May
      201150,000
                              
                              
                              $
                              2.00
                              
                              May
      201150,000
                              
                              
                              $
                              2.50
                              
                              May
      201150,000
                              
                              
                              $
                              0.38
                              
                              April
      202053,440,953
                              
                              
                              $
                              0.35





Below is
a summary of warrant activity for the nine months ended June 30,
2010:




Weighted
      AverageRemaining
      Contractual
                          
                          
                          AggregrateNumber
      of Shares
                          
                          
                          Exercise
      Price
                          
                          
                          Term
      (in years)
                          
                          
                          Intrinsic
      ValueOutstanding
      at 9/30/2009
                          
                          
                          27,379,525
                          
                          
                          $
                          0.46
                          
                          
                          
                          3.25
                          
                          
                          $
                          1,051,248Granted
                          
                          
                          43,664,285
                          
                          
                          $
                          0.28
                          
                          
                          
                          6.27
                          
                          
                          $
                          5,234,714Exercised
                          
                          
                          (60,000
                          )
                          
                          $
                          0.28
                          
                          
                          
                          1.89
                          
                          
                          $
                          9,000Expired
      or Canceled
                          
                          
                          (17,542,857
                          )
                          
                          $
                          0.36
                          
                          
                          
                          3.27
                          
                          
                          $
                          927,643Forfeited
                          
                          
                          
                          
                          
                          $
                          0.00
                          
                          
                          
                          
                          
                          
                          $
                          0Vested
      RSAsOutstanding
      at 6/30/2010
                          
                          
                          53,440,953
                          
                          
                          $
                          0.35
                          
                          
                          
                          5.33
                          
                          
                          $
                          5,532,114




As
discussed previously, the Warrants expiring in November 2010, May 2012 and
October 2016 are deemed to be liabilities and as such are carried at their fair
value as a liability on the Balance Sheet.





G.         Stock-Based
Compensation





Below is
a summary of stock option activity for the nine months ended June
30:




12




Weighted
      AverageNumber
      of
                          
                          
                          
                          
                          
                          Remaining
      Contractual
                          
                          
                          AggregrateShares
                          
                          
                          Exercise
      Price
                          
                          
                          Term
      (in years)
                          
                          
                          Intrinsic
      ValueOutstanding
      at 9/30/2009
                          
                          
                          6,175,015
                          
                          
                          $
                          1.58
                          
                          
                          
                          6.96
                          
                          
                          $
                          137,913Granted
                          
                          
                          185,000
                          
                          
                          $
                          0.35
                          
                          
                          
                          9.53
                          
                          
                          $
                          8,825Exercised
                          
                          
                          
                          
                          
                          $
                          0.00
                          
                          
                          
                          0.00
                          
                          
                          $
                          0Expired or
      Canceled
                          
                          
                          (1,200
                          )
                          
                          $
                          51.25
                          
                          
                          
                          0.00
                          
                          
                          $
                          0Forfeited
                          
                          
                          (421,250
                          )
                          
                          $
                          0.62
                          
                          
                          
                          
                          
                          
                          $
                          4,500Vested
    (RSAs)Outstanding
      at 6/30/2010
                          
                          
                          5,937,565
                          
                          
                          $
                          1.60
                          
                          
                          
                          6.24
                          
                          
                          $
                          163,775


For the
nine months ended June 30, 2010 and 2009, all stock options were issued with an
exercise price at or above the fair market value of the Company’s common stock
on the date of grant.





The
details of stock options for the nine months ended June 30, 2010 were as
follows:




Options
      Outstanding
                              
                              
                              Options
      ExercisableNumber
                              
                              
                              Weighted
                              
                              
                              Weighted
      Average
                              
                              
                              Number
                              
                              
                              WeightedRange
      of
                              
                              
                              Outstanding
      at
                              
                              
                              Average
      Exercise
                              
                              
                              Remaining
                              
                              
                              Exercisable
      at June
                              
                              
                              Average
      ExerciseExercise
      Prices
                              
                              
                              June
      30, 2010
                              
                              
                              Price
                              
                              
                              Contractual
      Life
                              
                              
                              30,
      2010
                              
                              
                              Price$
                              0.29-0.32
                              
                              
                              
                              1,526,250
                              
                              
                              $
                              0.30
                              
                              
                              
                              8.72
                              
                              
                              
                              1,509,583
                              
                              
                              $
                              0.30$
                              0.33-0.45
                              
                              
                              
                              903,500
                              
                              
                              $
                              0.39
                              
                              
                              
                              8.82
                              
                              
                              
                              784,545
                              
                              
                              $
                              0.39$
                              0.55-0.75
                              
                              
                              
                              768,111
                              
                              
                              $
                              0.65
                              
                              
                              
                              6.41
                              
                              
                              
                              768,111
                              
                              
                              $
                              0.65$
                              0.78-0.90
                              
                              
                              
                              794,335
                              
                              
                              $
                              0.87
                              
                              
                              
                              5.91
                              
                              
                              
                              794,335
                              
                              
                              $
                              0.87$
                              0.91-1.50
                              
                              
                              
                              1,382,019
                              
                              
                              $
                              1.46
                              
                              
                              
                              3.25
                              
                              
                              
                              1,382,019
                              
                              
                              $
                              1.461.52
                              
                              
                              
                              2,500
                              
                              
                              $
                              1.52
                              
                              
                              
                              4.25
                              
                              
                              
                              2,500
                              
                              
                              $
                              1.52$
                              1.55-2.10
                              
                              
                              
                              211,750
                              
                              
                              $
                              1.85
                              
                              
                              
                              4.22
                              
                              
                              
                              211,750
                              
                              
                              $
                              1.85$
                              2.50-11.50
                              
                              
                              
                              188,624
                              
                              
                              $
                              4.95
                              
                              
                              
                              3.27
                              
                              
                              
                              188,624
                              
                              
                              $
                              4.95$
                              12.85-20.00
                              
                              
                              
                              79,754
                              
                              
                              $
                              15.10
                              
                              
                              
                              1.09
                              
                              
                              
                              79,754
                              
                              
                              $
                              15.10$
                              22.50-51.25
                              
                              
                              
                              80,722
                              
                              
                              $
                              36.75
                              
                              
                              
                              0.15
                              
                              
                              
                              80,722
                              
                              
                              $
                              36.75$
                              0.29-51.25
                              
                              
                              
                              5,937,565
                              
                              
                              $
                              1.60
                              
                              
                              
                              6.23
                              
                              
                              
                              5,801,943
                              
                              
                              $
                              1.63




Stock-based
compensation expense recognized in the statement of operations is as follows (in
thousands):





For
      the three months ended June 30,
                
                For
      the nine months ended June 30,2010
                2009
                
                2010
                2009Research
      and Development Expenses
                
                8
                11
                
                41
                34General
      and Administrative Expenses
                
                79
                71
                
                366
                15987
                82
                
                407
                193




The total
deferred compensation expense for outstanding and unvested stock options for the
nine months ended June 30, 2010 was approximately $32,000.  The
weighted average remaining recognition period for the total deferred
compensation expense is approximately six months. The fair value of the options
associated with the above compensation expense was determined at the date of the
grant using the Black-Scholes option pricing model with the following weighted
average assumptions:





For
      the nine months ended June 302010
                
                2009Dividend
      yield
                
                0%
                
                0%Expected
      volatility
                
                95%
      - 96%
                
                96%–
      209%Risk-free
      interest rate
                
                3.3%
      - 3.5%
                
                2.6%
      - 3.8%Expected
      term
                
                10
      years
                
                10
      years





13





H.           Commitments





The
Company has acquired assets still in development and entered into research and
development arrangements with third parties that may require milestone and
royalty payments to the third party contingent upon the occurrence of certain
future events linked to the success of the asset in development. Milestone
payments may be required, contingent upon the successful achievement of an
important point in the development life-cycle of the pharmaceutical product
(e.g., approval of the product for marketing by a regulatory agency). If
required by the arrangement, the Company may have to make royalty payments based
upon a percentage of the sales of the pharmaceutical product in the event that
regulatory approval for marketing is obtained.





These
arrangements may be material individually, and in the unlikely event that
milestones for multiple products covered by these arrangements were reached in
the same period, the aggregate charge to expense could be material to the
results of operations in any one period. In addition, these arrangements often
give Aeolus the discretion to unilaterally terminate development of the product,
which would allow Aeolus to avoid making the contingent payments; however,
Aeolus is unlikely to cease development if the compound successfully achieves
clinical testing objectives.





I.           Subsequent
Events





On July
30, 2010, the Company exercised the “Put Option” granted by the Investors to the
Company in the October 2009 financing.  As a result of the exercise,
the Company received $1.65 million in gross proceeds from the investors in
exchange for 5,892,857 additional Units (the “Additional Units”), comprised of
an aggregate of 5,892,857 shares of Common Stock and warrants to purchase up to
an aggregate of 11,785,714 additional shares of common stock at a purchase price
of $0.28.  Cash proceeds from the put exercise are expected to be
$1.63 million after legal costs associated with the exercise and subsequent
issuance of stock and warrants.





On July
30, 2010, the Company and Mr. John McManus amended and restated Mr. McManus’
employment agreement, dated July 14, 2006, with the Company. Under the Amended
and Restated Employment Agreement (the “Restated Agreement”), Mr. McManus will
continue to serve as President, Chief Executive Officer and Chief Operating
Officer of the Company. Pursuant to the agreement, Mr. McManus will be paid
$20,850 a month. However, in the event, on or prior to June 30, 2011, the
Company (i) enters into one or more binding agreements for the sale and issuance
of equity of the Company in one or more financings, (ii) enters into one or more
binding partnership, licensing, collaboration, development or similar
agreements, or (iii) is awarded one or more grants or contracts, all of which
taken together collectively entitle the Company to receive gross proceeds of at
least $10,000,000 (the “Threshold Amount”) (excluding any proceeds received from
the Investors or any affiliate thereof), Mr. McManus’ salary shall be increased
to $33,333 per month, effective as of the date of such agreement or award, when
combined with all prior agreements or awards, entitles the Company to the
Threshold Amount.




On August
12, 2010, the Company announced an additional financing with existing
investors.  Under the terms of the August 2010 Financing agreement,
Aeolus received $1 million in gross proceeds in exchange for the issuance of 2.5
million shares of common stock and warrants to purchase up to 1,875,000 shares
at an exercise price of $0.50 per share.   The Company also
granted to the August 2010 Investors the option to acquire, collectively, up to
an additional 2,500,000 Additional Units, comprised of an aggregate of 2,500,000
shares of Common Stock and warrants to purchase up to an aggregate of 1,875,000
additional shares of common stock at an exercise price of $0.50 (the “Call
Option”). In addition, the August 2010 Investors granted to the Company the
option to require these August 2010 Investors, severally and not jointly, to
acquire up to 2,500,000 Additional Units, less any Additional Units acquired
under the Call Option, at the per Additional Unit purchase price of $0.40 (the
“Put Option”).  The Call Option is exercisable at any time, and from
time to time, on or prior to December 31, 2010.  The Put Option is
exercisable at any time from November 30, 2010 to December 30,
2010.  However, the Investors shall have the right to terminate the
Put Option if they reasonably determine that a material adverse event, condition
or circumstance has occurred with respect to the prospects of the Company’s AEOL
10150 drug candidate for acute radiation syndrome; provided that the Company’s
failure to receive a grant or financing shall not, by itself, constitute a
material adverse event, condition or circumstance with respect
thereto.





Management
has evaluated for subsequent events through the date these financial statements
were filed and determined that no other material subsequent events have
occurred.








Item 2.Management’s
Discussion and Analysis of Financial Condition and Results of
Operations.





Introduction





Unless
otherwise noted, the terms “we,” “our” or “us” refer collectively to AeolusPharmaceuticals, Inc.
and our wholly owned subsidiary, Aeolus Sciences, Inc.




14




This
report contains, in addition to historical information, statements by us with
respect to expectations about our business and future results which are
“forward-looking” statements under the Private Securities Litigation Reform Act
of 1995. These statements and other statements made elsewhere by us or by our
representatives, which are identified or qualified by words such as “likely,”
“will,” “suggests,” “expects,” “might,” “believe,” “could,” “should,” “may,”
“estimates,” “potential,” “predict,” “continue,” “would,” “anticipates,”
“plans,” or similar expressions, are based on a number of assumptions that are
subject to risks and uncertainties. Such statements include, but are not limited
to, those relating to Aeolus’ product candidates, as well as its proprietary
technologies and uncertainties and other factors that may cause Aeolus’ actual
results to be materially different from historical results or from any results
expressed or implied by such forward-looking statements. Important factors that
could cause results to differ include risks associated with uncertainties of
progress and timing of clinical trials, scientific testing, obtaining regulatory
approval, the need to obtain funding for pre-clinical and clinical trials and
operations, the scope and validity of intellectual property protection for
Aeolus’ product candidates, proprietary technologies and their uses, new
accounting and SEC requirements and competition from other biopharmaceutical
companies. Certain of these factors and others are more fully described in
Aeolus’ filings with the SEC, including, but not limited to, Aeolus’ Annual
Report on Form 10-K for the fiscal year ended September 30, 2009.  All
forward-looking statements are based on information available as of the date
hereof, and we do not assume any obligation to update such forward-looking
statements. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date hereof.





Operations
Summary





We are
developing a new class of catalytic antioxidant compounds as a medical
countermeasure against biological, chemical and radiological weapons as well as
for diseases and disorders of the central nervous system, respiratory system,
autoimmune system and oncology.  Our initial target indications are as
a protective agent against the effects of acute radiation syndrome, sulfur
mustard gas exposure and chlorine gas exposure.  We have reported
positive safety results from two Phase I clinical trials of AEOL 10150, our lead
drug candidate, with no serious adverse events noted.





On May
12, 2010, the Company was notified by Chemical Biological Medical Systems that
it had not been awarded a contract for development of AEOL 10150 as a
countermeasure for GI-Acute Radiation System.  Development of the compound
for GI-ARS continues and continues to be funded by the National Institutes of
Health (NIH) – National Institutes of Allergies and Immunological Disorders
(NIAID).   The decision by CBMS does not have a financial impact on
the Company as funding from CBMS was not considered as a component of Aeolus’
programs for budgeting purposes.  Review of the Company’s proposal for
a contract with the Biologic Advanced Research and Development Authority (BARDA)
for development of AEOL 10150 in Lung ARS continues.





We do not
have any revenue, other than grant income, and therefore we must rely on public
or private equity offerings, debt financings, collaboration arrangements or
grants to finance our operations.





Need for Additional
Funds





With the
financings announced in July and August 2010 (see subsequent events), we believe
we have adequate financial resources to fund our operations into the
first half of fiscal year 2012.  In order to fund on-going
operating cash requirements beyond the first half of fiscal year 2012, or
to accelerate or expand our programs, however, we may need to raise significant
additional funds. Our need for additional financing is discussed under
“Liquidity and Capital Resources”, and is updated in Subsequent
Events.





Results of
Operations





Three months ended June 30,
2010 versus three months ended June 30 2009





We had a
net loss of approximately $4,623,000 for the three months ended June 30, 2010,
versus a net loss of approximately $426,000 for the three months ended June 30,
2009.   Of the loss for the three months ended June 30, 2010,
approximately $3,856,000 of the loss was due to the impact of changes to the
fair value of warrants under accounting rules.





Research
and development (“R&D”) expenses increased about $145,000, or 112%, to
$275,000 for the three months ended June 30, 2010 from approximately $130,000
for the three months ended June 30, 2009.  R&D expenses were
higher during the three months ended June 30, 2010 versus June 30, 2009 due to
an increase in Lung ARS related research activities.  Preclinical fees
increased about $52,000 over the comparable period in 2009 due to increased
animal study activity to support the Company’s ARS development
program.  The Company currently has eight studies in progress: the
study of its drug candidates as a potential countermeasure against the effects
of sulfur mustard gas on the lung and skin, as a protectant against the effects
of radiation on the lungs and on the gastro-intestinal tract, as a
countermeasure against the effects of chlorine gas, as a potential treatment for
epilepsy and for the potential treatment for Parkinson’s disease.





R&D
expenses for our antioxidant program have totaled approximately $36,407,000 from
inception through June 30, 2010. Because of the uncertainty of our research and
development and clinical studies, we are unable to predict the level of spending
and the anticipated program completion date, if any.




15




General
and administrative (“G&A”) expenses increased about $160,000, or 51%, to
approximately $475,000 for the three months ended June 30, 2010 from
approximately $315,000 for the three months ended June 30, 2009.  Salaries
and wages increased by about $38,000 due to the hiring of a new employee during
the first quarter of fiscal 2010.   Investor relations expenses
increased by $48,000, due to increased IR-related activities performed by
outside consultants, and legal fees increased by $43,000.





We
incurred interest expense of approximately $17,000 for the three months ended
June 30, 2010 compared to interest expense of about $114,000 for the three
months ended June 30, 2009.  The decrease in interest expense is
primarily the result of the conversion of a note payable to equity.





As
disclosed previously, certain of the Company’s warrants to purchase common stock
were deemed to be a liability upon adoption of a new accounting pronouncement on
October 1, 2009.  Subsequent changes to the fair market value resulted
in an offsetting charge on the statements of operations of about $3,856,000 for
the three month period ended June 30, 2010.  The warrant liability and
revaluations have not and will not have any impact on the Company’s working
capital, liquidity, or business operations.





Ninemonths endedJune 30, 2010 versusninemonths endedJune 30, 2009





We had a
net loss of approximately $12,981,000 for the nine months ended June 30, 2010,
versus a net loss of approximately $1,550,000 for the nine months ended June 30,
2009.   The loss for the first nine months of 2010 included
$9,899,000 in non-cash charges for change in fair value of
warrants.





Research
and development (“R&D”) expenses increased by about $416,000, or 89%, to
approximately $885,000 for the nine months ended June 30, 2010 from about
$469,000 for the nine months ended June 30, 2010.  R&D expenses
were higher during the nine months ended June 30, 2010 versus June 30, 2009 due
to an increase in research activities to support the Company’s Lung ARS
development program and the retention of a consultant to assist in the writing
of proposals for government funding described in the discussion of three months
results.  For the nine months ended June 30, 2010, consultant expenses
increased by about $186,000 due to costs associated with the aforementioned
consultant.  Preclinical fees increased about $187,000 over the
comparable period in 2009 due to increased animal studies to support the
Company’s ARS development program.  The Company currently has eight
studies in progress: the study of its drug candidates as a potential
countermeasure against the effects of sulfur mustard gas on the lung and skin,
as a protestant against the effects of radiation on the lungs and on the
gastro-intestinal tract, as a countermeasure against the effects of chlorine
gas, as a potential treatment for epilepsy and for the potential treatment for
Parkinson’s disease.





General
and administrative (“G&A”) expenses increased approximately $434,000, or
48%, to approximately $1,337,000 for the nine months ended June 30, 2010 from
about $903,000 for the nine months ended June 30, 2009.  Salaries and
wages increased by about $100,000 due to the hiring of a new employee during the
first quarter of fiscal 2010.  Consulting stock expense increased by
about $207,000 as a result of a higher level of grant activity to employees,
consultants, and directors.  Investor relations expenses increased by
$80,000, due to increased IR-related activities performed by outside
consultants, and legal fees increased by $87,000.





We
incurred interest expense of approximately $860,000 for the nine months ended
June 30, 2010 compared to interest expense of about $322,000 for the nine months
ended June 30, 2009.  The expense in the nine month period ended June
30, 2010 reflects about $826,000 incurred in the first quarter of fiscal year
2010, mostly due to charges as a result of the conversion of the Senior
Convertible Notes on October 6, 2009.  In the second and third
quarters of 2010, interest expense dropped significantly principally due to the
conversion of the aforementioned note payable to equity (and the recognition of
the related non-legal fees in the first quarter).





As
previously disclosed, certain of the Company’s warrants to purchase common stock
were deemed to be a liability upon adoption of a new accounting pronouncement on
October 1, 2009.  Subsequent changes to the fair market value resulted
in an offsetting charge on the statements of operations of about $9,899,000 for
the nine month period ended June 30, 2010.  The warrant liability and
revaluations have not and will not have any impact on the Company’s working
capital, liquidity, or business operations.





Liquidity and Capital
Resources





We do not
have any revenue and therefore we rely on investors, grants, collaborations and
licensing of our compounds to finance our operations. At June 30, 2010, we had
approximately $457,000 of cash and cash equivalents, a decrease of $189,000 from
September 30, 2009. The decrease in cash was primarily due to the funding of
expenses from operations, which was more than the $1.6 million in net proceeds
from the October 2009 Financing.  We believe we have adequate
financial resources to conduct operations into the first quarter of fiscal year
2012, but in order to fund on-going operating cash requirements beyond that
point, or to further accelerate or expand our programs, we need to raise
significant additional funds (see Subsequent Events).




16




We
incurred significant losses from operations of approximately $2,222,000 and
$1,372,000, and cash outflows from operations of approximately $1,795,000 and
$1,390,000, for the nine months ended June 30, 2010 and for the nine months
ended June 30, 2009, respectively. Our ongoing future cash requirements will
depend on numerous factors, particularly the progress of our catalytic
antioxidant program and clinical trials and our ability to negotiate and
complete collaborative agreements or out-licensing arrangements. In order to
help fund our on-going operating cash requirements, we intend to seek new
collaborations for our antioxidant research program that include initial cash
payments and on-going research support. In addition, we might sell additional
shares of our stock and/or convertible debentures and explore other strategic
and financial alternatives, including a merger with another company, the sale of
stock and/or debt, the establishment of new collaborations for current research
programs, that include initial cash payments and ongoing research support and
the out-licensing of our compounds for development by a third
party.





There are
significant uncertainties as to our ability to access potential sources of
capital. We may not be able to enter into any collaboration on terms acceptable
to us, or at all, due to conditions in the pharmaceutical industry or in the
economy in general or based on the prospects of our catalytic antioxidant
program. Even if we are successful in obtaining collaboration for our
antioxidant program, we may have to relinquish rights to technologies, product
candidates or markets that we might otherwise develop ourselves. These same
risks apply to any attempt to out-license our compounds.





Similarly,
due to market conditions, the illiquid nature of our stock and other possible
limitations on equity offerings, we may not be able to sell additional
securities or raise other funds on terms acceptable to us, if at all. Any
additional equity financing, if available, would likely result in substantial
dilution to existing stockholders.





Our
forecast of the period of time through which our financial resources will be
adequate to support our operations is forward-looking information, and actual
results could vary.





Off-Balance Sheet
Commitments





We do not
have any off-balance sheet arrangements that have or are reasonably likely to
have a current or future effect on our financial condition, changes in financial
condition, revenues or expenses, results of operations, liquidity, capital
expenditures or capital resources.





ITEM 3.Quantitative
and Qualitative Disclosures About Market Risk.





Our
exposure to market risk is presently limited to the interest rate sensitivity of
our cash and cash equivalents, which is affected by changes in the general level
of U.S. interest rates. However, we believe that we are not subject to any
material market risk exposure and do not expect that changes in interest rates
would have a material effect upon our financial position. A hypothetical 10%
change in interest rates would not have a material effect on our Statement of
Operations or Cash Flows for the nine months ended June 30, 2010. We do not have
any foreign currency or other derivative financial instruments. Our debt bears
interest at a fixed rate.





ITEM 4.
Controls and
Procedures.





Evaluation
of Disclosure Controls and Procedures





As
defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934 as amended, our management is responsible for establishing and maintaining
adequate internal control over financial reporting. Internal control over
financial reporting is a process designed by, or under the supervision of, our
principal executive and principal financial officer and effected by our board of
directors, management and other personnel, to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted
accounting principles. Because of its inherent limitations, internal control
over financial reporting may not prevent or detect misstatements. Also,
projections of any evaluation of effectiveness to future periods are subject to
risk that controls may become inadequate because of changes in conditions, or
that the degree of compliance with the policies or procedures may
deteriorate.





Management’s
Report on Internal Control over Financial Reporting





As
required by Securities and Exchange Commission Rule 13a-15(b), we carried out an
evaluation, under the supervision and with the participation of management,
including our Chief Executive Officer and Chief Financial
Officer.  Our management assessed the effectiveness of our internal
control over financial reporting as of June 30, 2010. In making this assessment,
our management used the criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) in Internal Control-Integrated
Framework. Based upon its assessment, management concluded that, as of
June 30, 2010, our internal control over financial reporting was not effective
due to a material weakness existing with respect to the segregation of
duties.





A
“material weakness,” as defined by the Standards of the Public Company
Accounting Oversight Board (PCAOB) is a deficiency, or a combination of
deficiencies, in internal control over financial reporting, such that there is a
reasonable possibility that a material misstatement of the Company’s annual or
interim financial statements will not be prevented or detected on a timely
basis. This material weakness has not resulted in an adjustment or misstatements
to the financial statements.




17





Management
has determined that given the Company’s size, level of operations and financial
resources, it is not practicable for the Company to eliminate the segregation of
controls weakness and therefore management has established mitigating controls
to minimize the impact of the lack of segregation of duties.  To
address this material weakness, the Company engaged an executive search firm to
conduct a search for a full time Chief Financial Officer. The Company is
continuing a search process for a new Chief Financial Officer and expects to
hire a new Chief Financial Officer by the end of September
2010.  Additionally, our Audit Committee has taken an active role in
reviewing and discussing the identified material weakness with our auditors and
senior management. Our management and the Audit Committee will actively monitor
the implementation and effectiveness of the remediation measures taken by our
financial management.





Changes
in Internal Control over Financial Reporting





Except as noted
above, there have been no changes in our internal control over financial
reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities
Exchange Act of 1934, as amended) during the quarter ended June 30, 2010 that
has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting.





PART
II.  OTHER INFORMATION





ITEM 1.Legal
Proceedings.





None.





ITEM
1A. Risk
Factors.





None.





ITEM 2. Unregistered
Sales of Equity Securities and Use of Proceeds.





None.





ITEM 3. Defaults
Upon Senior Securities.





None.




ITEM 4. Removed and
Reserved.





N/A.





ITEM 5. Other
Information.




None.





ITEM 6. Exhibits





Exhibit
      #
            
            Description31.1
            
            Certification
      of the Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a)
      and 15d-14(a).31.2
            
            Certification
      of the Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a)
      and 15d-14(a).32.1
            
            Certification
      by the Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. §1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
      of 2002.





18





SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





AEOLUS
      PHARMACEUTICALS, INC.Date:August 13,
      2010
                          By:
                          /s/
      John L. McManusJohn
      L. McManus
                            President
      and Chief Executive Officer
                            (Principal
      Executive Officer)
                            Chief
      Financial Officer, Treasurer and Secretary
                            (Principal
      Financial and Accounting Officer)





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