**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

**(Mark One)**

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

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

**OR**

**o**                                  TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the transition periodfrom                   to                  **

**Commission file number0-28308**

**COLLAGENEX PHARMACEUTICALS, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                     |   | **52-1758016**                        |
|----------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)  |   |                                  |

 

| **41 University Drive, Newtown,  Pennsylvania** |   | **18940**  |
|-------------------------------------------------|--------|------------|
| (Address  of principal executive offices)       |   | (Zip Code) |

Registrant’s telephone number, including areacode  **(215) 579-7388**

Securities registered pursuant toSection 12(b) of the Act:

| **Title of each class**                                                                     |   | **Name of each exchange on which registered** |
|---------------------------------------------------------------------------------------------|--------|-----------------------------------------------|
| Common Stock,  $0.01 par value (excluding Preferred Stock Purchase Rights, $0.01 par value) |   | NASDAQ Global  Market                         |

 

Securities registeredpursuant to Section 12(g) of the Act:

**None**(Title of Class)

(Title of Class)

Indicate by check mark if the registrant is a well-knownseasoned issuer, as defined in Rule 405 of the Securities Act.

| Yes: |   | o |   | No: |   | x |
|------|--------|---|--------|-----|--------|---|

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

| Yes: |   | o |   | No: |   | x |
|------|--------|---|--------|-----|--------|---|

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.

| Yes: |   | x |   | No: |   | o |
|------|--------|---|--------|-----|--------|---|

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

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

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

| Yes: |   | o |   | No: |   | x |
|------|--------|---|--------|-----|--------|---|

The aggregate market valueof the registrant’s voting shares of common stock held by non-affiliates of theregistrant on June 30, 2006, based on $11.98 per share, the last reportedsale price on the NASDAQ Global Market on that date, was $151.9 million.

The number of sharesoutstanding of each of the registrant’s classes of common stock, as of March 1,2007:

| **Class**                      | ** ** | **Number  of Shares** |
|--------------------------------|------------|-----------------------|
| Common Stock,  $0.01 par value |       | 21,274,949            |

Thefollowing documents are incorporated by reference into the Annual Report on Form 10-K:  Portions of the registrant’s definitive ProxyStatement for its 2007 Annual Meeting of Stockholders are incorporated byreference into Part III of this Report.

 

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**TABLE OF CONTENTS**

|                                                                              | ** ** | **Item** | ** ** | ** **                                                                                                             | ** ** | **Page** |
|------------------------------------------------------------------------------|------------|----------|------------|------------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I                                                                  |       | 1.       |       | Business                                                                                                               |       | 1        |
|                                                                         |       | 1A.      |       | Risk Factors                                                                                                           |       | 17       |
|                                                                         |       | 1B.      |       | Unresolved Staff Comments                                                                                              |       | 27       |
|                                                                         |       | 2.       |       | Properties                                                                                                             |       | 27       |
|                                                                         |       | 3.       |       | Legal  Proceedings                                                                                                     |       | 27       |
|                                                                         |       | 4.       |       | Submission of Matters to a Vote of Security Holders                                                                    |       | 28       |
|                                                                         |       |     |       |                                                                                                                   |       |     |
| PART II                                                                 |       | 5.       |       | Market for the Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 29       |
|                                                                         |       | 6.       |       | Selected Consolidated Financial Data                                                                                   |       | 29       |
|                                                                         |       | 7.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                            |       | 31       |
|                                                                         |       | 7A.      |       | Quantitative and Qualitative Disclosures About Market  Risk                                                            |       | 47       |
|                                                                         |       | 8.       |       | Financial Statements and Supplementary Data                                                                            |       | 47       |
|                                                                         |       | 9.       |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                                  |       | 47       |
|                                                                         |       | 9A.      |       | Controls and Procedures                                                                                                |       | 47       |
|                                                                         |       | 9B.      |       | Other  Information                                                                                                     |       | 50       |
|                                                                         |       |     |       |                                                                                                                   |       |     |
| PART III                                                                |       | 10.      |       | Directors, Executive Officers and Corporate Governance  of the Registrant                                              |       | 51       |
|                                                                         |       | 11.      |       | Executive Compensation                                                                                                 |       | 51       |
|                                                                         |       | 12.      |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                        |       | 51       |
|                                                                         |       | 13.      |       | Certain Relationships and Related Transactions, and  Director Independence                                             |       | 51       |
|                                                                         |       | 14.      |       | Principal Accountant Fees and Services                                                                                 |       | 51       |
|                                                                         |       |     |       |                                                                                                                   |       |     |
| PART IV                                                                 |       | 15.      |       | Exhibits and Financial Statement Schedules                                                                             |       | 52       |
|                                                                         |       |     |       |                                                                                                                   |       |     |
| SIGNATURES                                                                   |       | 53       |
|                                                                         |       |     |       |                                                                                                                   |       |     |
| EXHIBIT  INDEX                                                               |       | 54       |
|                                                                         |       |     |       |                                                                                                                   |       |     |
| INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND  FINANCIAL STATEMENT SCHEDULE |       | F-1      |

 

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**PART I**

**Item1.**                        Business.

**General**

CollaGenex Pharmaceuticals, Inc.and subsidiaries is a specialty pharmaceutical company currently focused ondeveloping and marketing innovative proprietary medical therapies to thedermatology market. We currently market four prescription pharmaceuticalproducts to the dermatology market through our professional dermatology salesforce and generate revenues from four other prescription pharmaceuticalproducts that we continue to sell to the dental market. In May 2006, the U.S.Food and Drug Administration, or the FDA, granted us marketing approval forOraceaTM for the treatment of inflammatory lesions (papules and pustules) ofrosacea in adult patients. Oracea is the first FDA approved,orally-administered, systemically-delivered drug to treat rosacea. In July 2006,we launched Oracea to the U.S. dermatology community.

Our strategy is to becomea leading developer and marketer of innovative prescription pharmaceuticalproducts to the dermatology market. We intend to continue to market our currentproducts, including Oracea, and develop and launch new products based on ourproprietary platform technologies as well as other technologies. Our leaddevelopment candidates are: incyclinide (formerly known as COL-3), which iscurrently in two separate Phase II dose-finding clinical trials for thetreatment of acne and rosacea; COL-118, a topical compound for which we aredeveloping for the treatment of erythema (skin redness) associated withdermatological conditions and for which we recently completed the clinicalportion of a Phase I clinical trial; and our Restoraderm®, a foam-based,topical dermal drug delivery system, which is currently under development. 

Our marketed dermatologyproducts are: Oracea; Pandel®, a prescription corticosteroid we licensed fromAltana, Inc. in May 2002; AlcortinTM, a prescription topicalantifungal steroid combination; and NovacortTM, a prescription topical steroidand anesthetic. In June 2005, we executed a Promotion and CooperationAgreement with Primus Pharmaceuticals Inc., or Primus, to market Alcortin andNovacort to dermatologists. 

Our original dentalproduct, Periostat®, is an orally-administered, prescription pharmaceuticalproduct that was approved by the FDA in September 1998 for the treatmentof adult periodontitis. On May 20, 2005, we terminated our domestic dentalsales force and promotional activities for Periostat following the introductionof a third party generic version of the product. We also discontinued thepromotion of our other dental products on May 20, 2005. We continue togenerate sales from Periostat and three other dental products, which includeAtridox®, Atrisorb FreeFlow® and Atrisorb-D®, also referred to as the AtrixProducts, and are each licensed from Tolmar Inc., a subsidiary of Tecnofarma,S.A. 

In addition to ourmarketed products, we have a pipeline of product candidates in clinical andpreclinical development. These products are based on our proprietary platformtechnologies, IMPACSTM, SansRosaTM and Restoraderm. 

IMPACS (Inhibitors ofMultiple Proteases And CytokineS) are a group of compounds that demonstrate arange of anti-inflammatory activities as well as the ability to inhibit thebreakdown of connective tissue. Periostat and Oracea are our first FDA-approvedIMPACS products. incyclinide is an IMPACS compound currently in clinicaldevelopment for the treatment of acne and rosacea. Our IMPACS technology is licensed on a perpetualbasis from the Research Foundation of the State University of New York at StonyBrook, or SUNY. SUNY also conducts research and development on other potentialapplications of this technology on a project basis. Our SansRosatechnology, which we acquired in connection with the step acquisition ofSansRosa Pharmaceutical Development Inc., or SansRosa, in December 2005,****is a class of compounds that have shownpromise in reducing the redness associated with rosacea, and we intend toformulate and develop a topical treatment for rosacea based on one or more ofthese compounds. Our Restoraderm technology is a proprietary, foam-based,topical drug delivery 

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technologythat originated from a Swedish collaborator. We have acquired all rights, titleand interest to the Restoraderm technology. We have formulated variousprescription and over-the-counter products based on the Restoraderm technology.We are currently in the process of developing a timetable for clinicaldevelopment or commercial launch of the Restoraderm products.

OnMarch 1, 2007, we announced results of a Phase II dose-findingstudy designed to evaluate the safety and determine the therapeutic range ofincyclinide for the treatment of acne. The study determined the minimumeffective incyclinide dose for the treatment of acne, which was 10 mg per day,and greater efficacy was observed at 20 mg per day. We will continue the doseoptimization trial and initiate an additional Phase II cohort with theobjective to determine the maximum effective dose.

The double-blind,placebo-controlled trial enrolled a total of 302 acne patients at twenty-sevencenters. The patients were divided among four arms of the study andadministered either a placebo capsule or a 5 mg, 10 mg or 20 mg incyclinidecapsule. Patients were enrolled in three sequential cohorts, each consisting ofan active treatment group and a smaller placebo group. The first cohortreceived the lowest dose of 5 mg incyclinide and each subsequent cohortescalated to the next higher dose level of 10 mg and 20 mg, respectively. Thetotal number of placebo patients across the three cohorts was approximately thesame as each of the active treatment groups. Study-wide and in-cohort placeboanalyses were conducted to detect possible effects of the seasons on theplacebo response. Absent treatment, acne patients typically improve during thesummer months and worsen during the winter months.

On February 1, 2007we received written notice of termination from Altana, Inc. which providesfor the termination of the Sublicense Agreement relating to Pandel effective November 1,2007.

On December 18, 2006,we executed a Product License and Supply Agreement with MediGene AG, acorporation existing under the laws of Germany, for the marketing rights toOracea. Under the Product License and Supply Agreement, effective January 1,2007, MediGene receives the right to manufacture, register, market and sellOracea in the European Union, certain contiguous countries and Russia. Wereceived an upfront fee of $5.0 million less applicable withholding taxes ofapproximately $1.0 million, for which we expect to be reimbursed during2007, related to the execution of the agreement and are entitled to anadditional $7.5 million in milestone payments upon the achievement of certainannual sales thresholds. In addition, we will receive an agreed upon transferprice and a royalty of 12% of annual net sales up to $10 million and 15% ofannual net sales in excess of $10 million in the specified territories.

On November 21, 2006,we sold 3.5 million shares of our common stock to institutional and otherinvestors for an aggregate gross purchase price of $45.5 million. The netproceeds of the offering were approximately $42.5 million after deducting theplacement agency and financial advisory fees and all offering expenses thatwere payable by us.

On November 3, 2006,we announced that the U.S. Patent and Trademark Office, or the USPTO, hadlisted the status of U.S. Patent Application, Serial No. 10/117,709, orthe 709 Patent, as “allowed,” and that the allowed claims cover the use ofsub-antimicrobial tetracyclines for the treatment of acne and acne rosacea,including Oracea and incyclinide.

On October 9, 2006,we entered into a Sixth Loan Modification Agreement, or the SubsequentModification Agreement, with Silicon Valley Bank, or SVB, to amend and renewthe Loan and Security Agreement between us and SVB dated March 19, 2001,as previously amended, or the Loan Agreement. Pursuant to the terms of theSubsequent Modification Agreement, the expiration date of amended creditfacility has been extended to October 9, 2008. Under the amended creditfacility, we may borrow up to the lesser of (i) $10.0 million or (ii) 80%of eligible receivables plus certain specified amounts, subject to reductionduring the period October 9, 2006 through December 31, 2007. 

We are a Delawarecorporation. We were incorporated and began operations in 1992 under the nameCollaGenex, Inc. and changed our name to CollaGenex Pharmaceuticals, Inc.in April 1996. Our principal 

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executiveoffices are located at 41 University Drive, Suite 200, Newtown,Pennsylvania 18940, and our telephone number is (215) 579-7388.

In this Annual Report on Form 10-K,the terms “CollaGenex,” “we,” “us” and “our” includes CollaGenexPharmaceuticals, Inc. and its subsidiaries.

We are subject to theinformational requirements of the Securities Exchange Act of 1934, as amended,or the Exchange Act, and, accordingly, file reports, proxy statements and otherinformation with the Securities and Exchange Commission. Such reports, proxystatements and other information can be read and copied at the public referencefacilities maintained by the Securities and Exchange Commission at the PublicReference Room, 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Informationregarding the operation of the Public Reference Room may be obtained bycalling the Securities and Exchange Commission at 1-800-SEC-0330. TheSecurities and Exchange Commission maintains a web site (http://www.sec.gov)that contains material regarding issuers that file electronically with theSecurities and Exchange Commission.

Our website iswww.collagenex.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report onForm 10-K. We make available free of charge on our website our AnnualReports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reportson Form 8-K and amendments to those reports filed or furnished pursuant toSection 13(a) or 15(d) of the Exchange Act, as soon asreasonably practicable after we electronically file such material with, orfurnish it to, the Securities and Exchange Commission.

**CollaGenex Pharmaceuticals, Inc. trademarks: **

OraceaTM, Periostat®,Metastat®, Dermostat®, Nephrostat®, Osteostat®, Arthrostat®, Rheumastat®,Corneostat®, Gingistat®, IMPACSTM, PS20®, The Whole Mouth Treatment®,Restoraderm®, Dentaplex®, LytraTM, Periostat-MRTM, SansRosaTM, UnorthodoxyTM,UnorthodoxycyclineTM, AprecinTM, ZedaraTM, Optistat®, Xerostat®, Periocycline®,Periostatus®, CollaGenex®, Dermastat®, Periostan®, Periostat-SR®, “C” Logo® and“The Whole Mouth Treatment” Logo®, EsteemaxTM, RubazilTM, LytrazineTM, PalytraTM,LytrazacTM, PrestemeTM, ErubatinTM, RosoralTM, ReveerilTM, CycavinTM, ZyclinilTM, andImpakenTM.

Marks listed as registeredherein may be registered in the United States or in other jurisdictions. Allother trade names, trademarks or service marks appearing in this Annual Reporton Form 10-K are the property of their respective owners and are notproperty of CollaGenex Pharmaceuticals, Inc. or any of our subsidiaries.

**Products and Product Agreements**

***Our CurrentlyMarketed Dermatology Products***

The four prescriptionpharmaceutical dermatology products that we currently market are summarizedbelow:

| **Products** | ** ** | ** **     | ** ** | **Territory Where Marketed**       | ** ** | **Marketing Partner** |
|--------------|------------|----------------|------------|------------------------------------|------------|-----------------------|
| Oracea       |       | United States  |       | None                               |
| Pandel       |       | United States  |       | Altana, Inc.                  |
| Alcortin     |       | United States  |       | Primus Pharmaceuticals, Inc.  |
| Novacort     |       | United  States |       | Primus  Pharmaceuticals, Inc. |

 

*Oracea*

In May 2006, the FDAapproved Oracea for the treatment of inflammatory lesions (papules andpustules) of rosacea in adult patients. Oracea is the first FDA-approved,orally-administered, systemically-delivered drug to treat the inflammatorylesions (papules and pustules) of rosacea in adults. Rosacea is a chronicdisease affecting an estimated 14 million adults in the United States. Whilethe exact cause is 

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unknown,chronic inflammation appears to play a primary role in the pathology of rosacea.In July 2006, we launched Oracea to the U.S. dermatology community.Oracea, a 40 mg dose of doxycycline monohydrate in a capsule formulation of 30mg immediate release and 10 mg delayed release beads, deliversanti-inflammatory actions without demonstrated antimicrobial effects. Oracea isdosed once-daily. Oracea is not bioequivalent to other doxycyclineformulations; it has no generic equivalent. In clinical trials, Oracea hasdemonstrated a side effect profile similar to placebo. Safety beyond ninemonths has not been established.

On February 24, 2006,we filed a Marketing Authorization Application for Oracea with the UnitedKingdom’s Medicines and Healthcare Products Regulatory Agency. The UnitedKingdom will act as the Reference Member State in reviewing and processing thisApplication pursuant to the decentralized procedure for the approval andissuance of Marketing Authorizations in selected countries of the EuropeanUnion. On March 21, 2006, the European Patent Office published on itswebsite that patent application 02731267.7 (the European counterpart to the 709Patent) was allowed. This patent has a priority date of April 5, 2002 andcovers the use of sub anti-microbial doxycycline in the treatment of acne androsacea, including Oracea.

On December 18, 2006,we executed a Product License and Supply Agreement, effective January 1,2007, pursuant to which MediGene receives the right to manufacture, register,market and sell Oracea in the European Union, certain contiguous countries andRussia.

*Pandel*

In May 2002, weexecuted a Sublicense Agreement with Altana, Inc., the United Statessubsidiary of Altana Pharma AG, pursuant to which we were granted the exclusiveright to create improvements to, market, advertise, promote, distribute, offerfor sale and sell, in the United States and Puerto Rico, Pandel, a mid-potencytopical corticosteroid cream indicated for the relief of mild-to-moderateinflammatory disorders of the skin in adults, such as atopic dermatitis andpsoriasis. Altana currently licenses the rights to Pandel from TaishoPharmaceutical Co., Ltd., a company organized and existing under the laws ofJapan. Pursuant to the terms of our sublicense, we paid Altana an aggregatesublicense fee of $1.7 million in 2002. We purchase from Altana all Pandelproducts to be sold and promotional samples, and we are required to pay Altanaa royalty fee equal to a percentage of the net sales of Pandel. In November 2006,the sublicense agreement with Altana was amended to among other things permitAltana to terminate the agreement at any time upon nine months prior writtennotice. On February 1, 2007, we received written notice of terminationfrom Altana which provides for the termination of the Sublicense Agreementeffective November 1, 2007. Under the terms of the agreement we areentitled to a payment of $1.7 million from Altana, which represents initiallicense fees paid to Altana. Such payment is due from Altana upon terminationof the agreement.

*Alcortin and Novacort*

On June 6, 2005, weexecuted a Promotion and Cooperation Agreement with Primus. Under thisagreement, we acquiredthe right to promote Alcortin and Novacort to dermatologists in the UnitedStates. Alcortin (1% iodoquinol and 2% hydrocortisone) is a prescriptiontopical antifungal steroid combination, and Novacort (2% hydrocortisone acetateand 1% pramoxine HCl) is a prescription topical steroid and anesthetic. Bothproducts contain a proprietary Biopeptide Aloe ComplexTM which is designed toimprove skin penetration and help reduce inflammation. We have agreed to (i) maintain,manage and compensate a direct sales force sufficient to make the products thesubject of an agreed number of detail calls in the United States, and (ii) achievecertain agreed combined levels of sales of the products during a three-yearperiod. In exchange for our services, we earn a quarterly fee from Primus basedon a percentage of the gross profit arising from prescriptions written bydermatologists that result in sales of the products in the United States. ThroughJune 30, 2006, the majority of marketing expenses, excluding sales forcecompensation and sample product costs, related to the promotion of the Primusproducts were funded by 

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Primusand the majority of product sample costs and all sales force compensation werefunded by us. Pursuant to an amendment executed in October 2006, effectiveJuly 1, 2006, sample expenses and marketing costs, excluding sales forcecompensation, are funded 60% by us and 40% by Primus.

***Other ProductOfferings***

*Periostat*

Periostat, a 20 mg dose ofdoxycycline hyclate, is a unique sub-anti-microbial dosage strength ofdoxycycline that suppresses the chronic and progressive tissue degradationcharacteristic of adult periodontitis, without exerting any anti-microbialeffect. Adult periodontitis is a chronic disease characterized by theprogressive loss of attachment between the periodontal ligament and thesurrounding alveolar bone, as well as breakdown of the alveolar bone itself,ultimately resulting in tooth loss.

In September 1998,the FDA granted United States marketing approval for Periostat as an adjunct toscaling and root planing, or SRP, to promote attachment level gain and reducepocket depth in patients with adult periodontitis. Periostat was made availablefor prescription use in November 1998 and was fully launched commerciallyin January 1999. In May 2005, a third party generic version ofPeriostat was introduced to the dental market, and we discontinued all directselling and promotional activities for Periostat in the United States. We hadalso sold a separately branded version of Periostat to United ResearchLaboratories, Inc./Mutual Pharmaceutical Company, Inc., or Mutual,pursuant to a License and Supply Agreement executed in April 2004 as partof a settlement of our outstanding patent litigation with Mutual. As a resultof the launch of a third party generic version of Periostat in May 2005,Mutual ceased purchasing product from us during June 2005.

On November 3, 2004,CollaGenex International Ltd, or CIL, our wholly-owned U.K. subsidiary, soldits U.K. and European dental assets to Alliance Pharma plc, a U.K. specialtypharmaceuticals company. This agreement provided for the sale by CIL toAlliance of certain trademark rights, U.K. and European governmental marketingauthorizations, distribution agreements and other intangible assets relating tothe sale or potential sale of Periostat in the U.K., Europe, Israel, SouthAfrica, New Zealand and Australia.  Wealso entered into a Supply Agreement with Alliance pursuant to which we supplyPeriostat in bulk tablet form to Alliance at a negotiated fair value transferprice.

*Atridox, Atrisorb FreeFlow and Atrisorb-D*

Pursuant to the terms ofan exclusive License and Marketing Agreement that we executed with AtrixLaboratories, Inc. (now known as Tolmar Inc.) in August 2001, weobtained the right to market, sell and distribute Atrix’s proprietary dentalproducts, Atridox, Atrisorb FreeFlow and Atrisorb-D to the United Statesdental community.

Atridox is alocally-applied, anti-microbial therapy for the treatment of chronic adultperiodontitis using Atrix’s patented drug delivery technology, Atrigel®.Atrisorb FreeFlow is a guided tissue regeneration, or GTR, barrier product usedin the surgical treatment of periodontal defects to help regenerate tissue.Atrisorb-D is the first GTR barrier product to incorporate an antibiotic,which has been shown to reduce the incidence of infections during GTRprocedures.

On February 22, 2006,we amended our License and Marketing Agreement with Tolmar Inc., and haveagreed to continue to sell the Atrix Products through our distributor and payan increased royalty on net sales and an increased transfer price, but we areno longer required to make annual minimum expenditures for advertising andpromotional activities. In May 2005, we discontinued all direct sellingand promotional activities for the Atrix Products. Pursuant to the amendedagreement, either party may terminate the License and Marketing Agreement atany time, with or without cause, upon six months prior written notice. Theamendment extends the term of the License and Marketing Agreement throughDecember 31, 2007.

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***Our Previously Marketed Product***

*Vioxx*

Pursuant to a Co-PromotionAgreement we executed with Merck & Co., Inc., or Merck, in September 1999,we received the exclusive right to co-promote Vioxx®, a prescription strength,non-steroidal anti-inflammatory drug, to the dental community. The agreementprovided for certain payments by Merck to us upon sales of Vioxx. In September 2002,we executed an amendment, extension and restatement of the Co-PromotionAgreement which provided that the agreement would expire on December 31,2003. The Co-Promotion Agreement provides for indemnification of us by Merckagainst any claims arising from manufacturing or design defects in the Vioxxproduct or for which we, as the promoter of the product, may be strictly liableas if we were a seller of an inherently dangerous product. We have not to datebeen named as a defendant in any of the lawsuits which have been broughtagainst Merck in connection with this product. During the year ended December 31,2005, we recorded $153,000 in residual contract revenues under this agreement. Wedid not receive any contract revenues from this agreement during the year endedDecember 31, 2006 and will not earn any further contract revenue underthis agreement.

**Sales and Marketing**

We currently employ 80 sales force professionals whopromote our products directly to dermatology professionals. We also have fivenational account managers who regularly call on major drug wholesalers, managedcare organizations, large retail chains, formularies and similar organizations.We produce educationalmarketing materials, detail aids and product samples that are used extensivelyby our representatives in their presentations to dermatology professionals. Wealso focus on providing continuing medical education programs and conventionactivities.

Sales training is animportant component of our sales and marketing efforts. New representativesreceive four weeks of field training and three weeks of intensive officetraining in dermatology, territory management and selling skills. Trainingcontinues at district-level meetings throughout the year.  In acomplex regulatory environment, we also train sales personnel on compliancewith the relevant rules and guidelines of the FDA and other governmentagencies.

**Commercial Manufacturing,Distribution and Suppliers**

In March 2006, we executed a CommercialManufacturing Agreement effective December 31, 2005 with Cardinal HealthPTS, LLC, or PTS, pursuant to which PTS has agreed to manufacture Oracea for us.Pursuant to the terms of the agreement, we agreed to (i) furnish to PTS ona monthly basis a rolling forecast of product quantities for the subsequenttwelve-month period, the first three months of which shall become binding, and (ii) payPTS a fee for the product, subject to an annual adjustment. The CommercialManufacturing Agreement with PTS has an initial term of four years unlessterminated earlier pursuant to its terms.

In January 1995, we entered into a supplyagreement with Hovione International Limited, or Hovione, pursuant to which theactive ingredient in Periostat, doxycycline hyclate, is supplied to us byHovione from its offshore facilities. Our current supply agreement does notcover the purchase of doxycycline monohydrate, which is the active ingredientin Oracea. We are currently in discussions with Hovione to restructure ouragreement so that it will cover doxycycline monohydrate. During the course ofthese discussions we have been purchasing doxycycline monohydrate on a purchaseorder by purchase order basis. Hovione supplies a substantial portion of thedoxycycline hyclate and doxycycline monohydrate used in the United States fromtwo independent facilities, providing for a back-up supply in the event thatone facility is unable to manufacture. The term of the supply agreement hasbeen extended to May 14, 2008 and thereafter automatically renews forsuccessive two-year periods unless, 90 days prior to the expiration 

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of any such periods,either party gives the other party written notice of termination. In addition,in the event of a default that remains uncured for 90 days, the non-defaultingparty can terminate the supply agreement effective immediately at the end ofsuch ninety-day period. We rely on Hovione as our sole supplier of bothdoxycycline hyclate and doxycycline monohydrate, and have no back-up supplierat this time.

In September 2000, we entered into a Service andSupply Agreement with a contract manufacturer, Pharmaceutical ManufacturingResearch Services, Inc., or PMRS, for the tablet formulation of Periostat.This agreement was automatically terminated in May 2005 when a generic 20mg doxycycline hyclate tablet became available on the market. We now purchasePeriostat tablets from PMRS on a purchase order basis. Currently, PMRS is thesole third-party contract manufacturer to supply Periostat to us. PMRS isrequired to comply with current Good Manufacturing Practices, or cGMP,requirements.

In November 1998, we executed a DistributionServices Agreement with Cord Logistics, Inc. (now known as Cardinal HealthSpecialty Pharmaceutical Services, or SPS), pursuant to which SPS acts as ourexclusive logistics provider for our products, excluding the Atrix Products, inthe United States. Under this agreement, SPS warehouses and ships Oracea,Pandel and Periostat from its central distribution facility in LaVergne,Tennessee to wholesalers that distribute our products to retail and mail orderpharmacies throughout the United States for prescription sale to patients. SPSalso provides various customer and financial support services to us, includingbilling and collections, contract pricing maintenance, cash application, andchargeback processing and related reporting services. The Distribution ServicesAgreement had an initial term of three years with automatic renewal forsuccessive one-year periods unless notice of termination was provided by eitherparty 90 days prior to expiration. We negotiated a three-year extension of suchagreement having similar terms to the original agreement with an effective dateof March 1, 2002.

In February 2002, we executed a Wholesale ServiceAgreement effective November 2001 with National Specialty Services, Inc.,(now known as Oncology Therapeutic Networks, or OTN), pursuant to which OTNacts as our non-exclusive authorized distributor of Atridox, Atrisorb FreeFlowand Atrisorb-D. Under this agreement, as amended, OTN also provides certainadditional services, including marketing, sales detail report production andcontract administration. The Wholesale Service Agreement had an initial term ofthree years and renews automatically for successive one-year periods unlessnotice of termination is provided by either party 90 days prior to expiration.

In October 2005, weentered into an agreement with a third party provider pursuant to which we haveagreed to pay monthly invoiced costs and expenses in exchange for certain research anddevelopment services, process development and material preparation servicesrelating to incyclinide

**Customers/Backlog**

In April 2005, we executed Distribution Fee forService Agreements with two of our three major drug wholesalers pursuant towhich we agree to pay a percentage of the net invoice cost in exchange forcertain product distribution, inventory management and administrative services.The agreements have a three year term.

Due to the relatively short lead-time required to fillorders for our products, backlog of orders is not material to our business.

During 2006, sales toCardinal Health, Inc., McKesson Corporation, Amerisource BergenCorporation, represented approximately 44%, 31% and 13%, respectively, of ouraggregate net product sales. We do not sell our products directly to drug chainretailers, supermarkets, independent pharmacies or other mass merchants.

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**Research andDevelopment**

*Overview*

Our research and development activities are conductedprimarily by third parties including contract research organizations andacademic and government institutions. The main focus of these activities is theresearch and development of novel and/or known compounds for application in avariety of inflammatory and tissue-destructive disorders.

Major research programs which we have conducted overthe last three years include: (i) Oracea for the treatment of rosacea; (ii) thedevelopment of a “once-a-day” formulation of Periostat (Periostat-MRTM), whichwas discontinued in 2005; (iii) the development of incyclinide for acneand rosacea; (iv) the development of our SansRosa technology for thetreatment of redness associated with rosacea and other skin disorders; and (v) thedevelopment of our Restoraderm platform.

Ourresearch and development expenditures were approximately $15.4 million, $14.0million and $8.8 million in 2006, 2005 and 2004, respectively. Weexpect to increase our investment in research and development to approximately$24.0 million in 2007.

*Our Technology—IMPACS*

Our core technology is the IMPACS technology and islicensed from SUNY. It involves the use of a broad class of compounds (IMPACS)that have been chemically modified to retain and enhance their anti-collagenolyticand other properties but which may have the structure elements responsible fortheir antibiotic activity removed. These compounds inhibit the destruction ofthe connective tissues of the body and down-regulate the pathological hostresponse to a variety of external and internal mediators of inflammation andtissue destruction.

Our IMPACS technology comprises a family of compoundswhich have shown the ability to inhibit inflammation as well as the activity ofvarious enzymes in the inflammatory cascade that lead to tissue destruction. Wehave completed Phase III clinical trials for each of Periostat and Oracea todemonstrate their safety and efficacy in treating adult periodontitis androsacea, respectively, and have obtained FDA approval for these products.

The technology works in part by modulating theactivity of matrix metalloproteinases. Matrix metalloproteinases areresponsible for the normal turnover of collagen and other proteins that areintegral components of a variety of connective tissues such as skin, bone,cartilage and ligaments.

Under normal physiological conditions, the naturalbreakdown of collagen is in part regulated by the interaction between thedegradative properties of matrix metalloproteinases and a group of naturallyoccurring biomolecules called tissue inhibitors of metalloproteinases, whichmodulate the level of matrix metalloproteinase activity. In many pathologicalconditions, however, the balance between collagen production and degradation isdisrupted resulting in excessive loss of tissue collagen, a process calledcollagenolysis. One such example is the progressive destruction of theperiodontal ligament and alveolar bone in adult periodontitis. Similardegradative activity is associated with numerous other disorders andconditions, including, but not to those in dermatology, such as acne androsacea.

Our license from SUNY alsocovers certain compounds that have shown potential in a number of preclinicalmodels of excessive connective tissue breakdown. Our current research anddevelopment programs focus on the potential use of IMPACS compounds for avariety of disorders characterized by inflammation and connective tissuedestruction. Additional research by SUNY researchers has been conducted toidentify, synthesize and characterize a new generation of IMPACS compounds, andwe have filed patent applications on structure and use of these compounds.

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*Our Technology—SansRosa*

Our SansRosa technology was acquired as a result ofthe step acquisition of SansRosa in December 2005, and of the acquisitionof rights to other related patents. It covers a class of compounds that haveshown promise in reducing the redness associated with rosacea, and we areformulating and developing a topical treatment for rosacea based on one or moreof these compounds.

*Our Technology—Restoraderm*

Our Restoraderm technologyis a unique, proprietary dermal drug delivery system, which we acquired from aSwedish collaborator in 2004. It is designed to enhance the dermal delivery ofa variety of active ingredients and we believe it may be used as the platformon which to develop a portfolio of topical dermatological pharmaceuticals. TheRestoraderm technology incorporates certain lipid compositions to enhance thenatural skin barrier and facilitate the delivery of therapeutic activeingredients into the skin. The Restoraderm technology is currently underdevelopment, and we continue to evaluate a number of Restoraderm productopportunities and their potential contribution to our portfolio of pipeline products.

*ClinicalDevelopments—Oracea in Rosacea*

Rosacea is a condition that affects approximately 14million adults in the United States. Rosacea affects primarily the face and istypically characterized by the appearance of inflammatory lesions (papules, pustulesand nodules), erythema (skin redness) and telangiectasia (spider veins). Ifallowed to progress to a moderate or severe condition, rosacea can causeitching, pain and thickening of the skin. In severe cases, a disfiguringenlargement of the nose can develop, a condition known as rhinophyma. While theexact cause is unknown, chronic inflammation appears to play a primary role inthe pathology of rosacea.

In June 2005, we announced the positive outcomeof two Phase III double-blinded, placebo-controlled clinical studies designedto evaluate the safety and efficacy of Oracea, doxycycline (controlled releasecapsules) 40 mg, for the treatment of rosacea. The two double-blinded,placebo-controlled Phase III clinical studies were identical in design and conductedconcurrently.

Patients were administered either Oracea or placeboonce a day for 16 weeks. A total of 537 patients were enrolled in 28 centersacross the United States. At baseline, Oracea and placebo patients had a meanlesion count of 20.0 and 20.8, respectively. Using the Investigator’s GlobalAssessment (IGA) score, a subjective 5-point scale measuring disease severity,more than 90% of all patients in both treatment groups were characterized asmoderately to severely affected.

Both studies achieved their primary endpoint bydemonstrating a greater reduction in inflammatory lesion count from baselinefor the Oracea-treated patients compared to the placebo controls. In the twostudies, patients receiving Oracea experienced a 61% and 46% mean reduction ininflammatory lesions compared to 29% and 20%, respectively, in patientsreceiving placebo. The differences were clinically and statisticallysignificant (p-values of less than 0.001 in each study).

As secondary endpoints, the change in IGA score andthe “dichotomized” IGA at week 16 were analyzed. “Dichotomized” IGAmeasures the percentage of patients who were clear or near clear at the end ofthe study. Oracea-treated patients fared much better than placebo patients asevidenced by a statistically significant change from baseline in IGA withp-values of less than 0.001 and p=0.004 for the two studies, respectively. Inthe analysis of “dichotomized” IGA, there was a statistically significant,greater number of patients who were clear or near clear at the end of the studyin the Oracea group compared to the placebo group, with p=0.036 and p=0.012,respectively.

Another secondary endpoint was the analysis of thechange in erythema over the course of the study. In one study, erythema showeda trend towards improvement. In the second study, the reduction in 

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erythema achievedstatistical significance as erythema scores improved from 9.7 at baseline to7.0 at week 16 (p=0.017).

In May 2006, the FDA approved Oracea for thetreatment of inflammatory lesions (papules and pustules) of rosacea in adultpatients. In July 2006, we launched Oracea to the U.S. dermatologycommunity. Oracea, a once-daily 40 mg dose of doxycycline monohydrate in acapsule formulation of 30 mg immediate release and 10 mg delayed release beads,delivers anti-inflammatory actions without demonstrated antimicrobial effects.Oracea is the first FDA-approved, orally-administered, systemically-delivereddrug to treat the inflammatory lesions (papules and pustules) of rosacea inadults. Oracea is not bioequivalent to other doxycycline formulations; it hasno generic equivalent.

The total expenses incurred through December 31,2006 relating to the development of Oracea were approximately $10.0 million.

On February 2, 2007, we announced results of aPhase IV clinical study designed to evaluate the efficacy of combining Oraceacapsules and topical MetroGel in the treatment of rosacea. The trial alsoevaluated the effectiveness of Oracea for maintenance therapy in the treatmentof rosacea.

The double-blind,placebo-controlled trial enrolled a total of 72 rosacea patients at threecenters. The patients were administered either Oracea capsules plus MetroGel orplacebo capsules plus MetroGel once a day for 12 weeks. MetroGel wasdiscontinued at Week 12, and patients continued to receive either Oracea orplacebo through Week 16. Measurements of the changes in the number ofinflammatory lesions were taken at Weeks 4, 8, 12 and 16. The primary efficacyendpoint of the study was the mean change in inflammatory lesions at Weeks 12and 16. The study successfully met this endpoint and demonstrated astatistically significant, greater reduction in inflammatory lesions at Weeks12 and 16 in the Oracea plus MetroGel group compared to the placebo plusMetroGel group.

*ClinicalDevelopments—incyclinide*

incyclinide is a second generation compound from ourIMPACS technology and has demonstrated a range of potent anti-inflammatoryactivities in various preclinical and clinical studies. In 2005, we announcedresults from a Phase II clinical trial evaluating incyclinide as a treatmentfor rosacea. The Phase II study was designed to establish proof ofprinciple for incyclinide as a potential treatment for a dermatologiccondition. In this double-blinded, placebo-controlled clinical study, patientswith rosacea wereadministered either incyclinide or placebo once a day for 28 days. Data wascollected at baseline, Day 14, Day 28 and Day 42. Primaryefficacy parameters measured the changes from baseline to endpoint (Day 42)in total inflammatory lesion count and the clinician’s erythema score.

The study enrolled 14 patients with a mean age of 50.1years. Eight patients received 10 mg of incyclinide once daily and sixpatients received placebo once daily. At baseline, incyclinide and placebopatients had mean lesion counts of 23.4 and 23.0, respectively. Using the IGAscore, the two patient groups were characterized as moderately to severelyaffected by the disease.

The study achieved its primary endpoint, demonstratinga greater reduction in inflammatory lesion count from baseline for theincyclinide treated patients compared to the patients on placebo. At endpoint(Day 42), incyclinide patients had a mean reduction of 12.8 lesions whileplacebo patients showed an increase of 2.3 lesions. This difference wasstatistically significant (p=0.0213). Importantly, the onset of action wasrapid, with approximately 80% of the reduction in lesion count observed at Day42 was already present at Day 14. At endpoint, 75% of all incyclinide treatedpatients were clear or near clear of disease symptoms as measured by the IGAscore. Erythema showed a slightly better improvement in the incyclinide group,with a 2.5 point reduction in the clinician’s erythema assessment score for theincyclinide group compared to a 1.7 point reduction for the placebo group.incyclinide was well-tolerated and the adverse event profile was unremarkable.

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In the fourth quarter of2005, we announced the initiation of a Phase II, double-blinded,placebo-controlled, dose-finding clinical trial to evaluate the safety andefficacy of incyclinide for the treatment of acne. We reported these results inMarch 2007.

The double-blind,placebo-controlled trial enrolled a total of 302 acne patients at 27 centers.The patients were divided among four arms of the study and administered eithera placebo capsule or a 5 mg, 10 mg or 20 mg incyclinide capsule. Patients were enrolledin three sequential cohorts, each consisting of an active treatment group and asmaller placebo group. The first cohort received the lowest dose of 5 mgincyclinide and each subsequent cohort escalated to the next higher dose levelof 10 mg and 20 mg, respectively. The total number of placebo patients acrossthe three cohorts was approximately the same as each of the active treatmentgroups. Study-wide and in-cohort placebo analyses were conducted to detectpossible effects of the seasons on the placebo response. Absent treatment, acnepatients typically improve during the summer months and worsen during thewinter months.

Each cohort of the studywas administered either a placebo or incyclinide capsule once a day for 12weeks. The primary endpoint of the study was the reduction in inflammatorylesion count at 12 weeks. Patients were evaluated at Baseline, Weeks 3, 6, 9,12 and 16 (four weeks after the final capsule was administered). The averagenumber of inflammatory lesions at baseline was approximately 24 andwell-balanced across the four treatment arms.

incyclinide waswell-tolerated with most adverse events being mild or moderate. The adverseevents were equally distributed across all treatment groups, including placebo.Laboratory and clinical safety assessments were unremarkable.

Efficacy was assessed inan intent-to-treat analysis comparing the lesion count profile over the courseof the study. No apparent drug effect was observed in the 5 mg patient cohortat any visit. In the 10 mg patient group, a drug effect was observed comparedto both the total placebo group and the in-cohort placebo group.

The 20 mg patient cohortshowed the greatest reduction in inflammatory lesions compared to placebo, witha rapid onset of action. This cohort had a 25.9% reduction in inflammatorylesion count at Week 3 compared to a 9.4% effect in the in-cohort placebogroup. At Weeks 6, 9 and 12, the reductions in inflammatory lesions for theincyclinide group were 36.0%, 36.1% and 31.7%, respectively, compared to 17.5%,23.8% and 26.5%, respectively, for the in-cohort placebo group. At Weeks 3 and6, the data showed a trend towards statistical significance, with p-values lessthan 0.07.

When compared to the totalplacebo group, the reductions in inflammatory lesions in the 20 mg cohort werestatistically significant at Weeks 6 (p=0.041) and 9 (p=0.037). The greatestreduction in inflammatory lesion count occurred at Week 9 and was less apparentat week 12.

A secondary endpoint ofthe study evaluated the change in the IGA score, a subjective measurement ofdisease severity. As with the inflammatory lesion count, the 5 mg cohort couldnot be differentiated from the total placebo group. The 10 mg cohort showed astatistically significant but modest improvement in the IGA score compared tothe total placebo group at Week 9 (p=0.022), and the 20 mg group showed agreater improvement in the IGA score compared to the total placebo group atWeek 6 (p=0.065) and Week 9 (p=0.026). The performance of the three cohortscompared to placebo in the change in IGA score further confirmed thedose-relationship across the three incyclinide cohorts.

The total futureanticipated expenses related to the development of incyclinide for acne androsacea is currently estimated to be between $15.0 and $20.0 million.

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*Preclinical and Other Research and DevelopmentActivities*

*COL-118*

In the fourth quarter of2006, we initiated a Phase I clinical trial evaluating COL-118 for thetreatment of erythema (redness associated with rosacea) and other skin disorders.This Phase I study was clinically completed in February 2007.

*Restoraderm*

We are currentlyconducting some formulation and stability work on products incorporating ourRestoraderm technology and we are still in the process of developing atimetable for clinical development or commercial launch.

*Other IMPACS Activities*

In October 2002, weannounced the execution of a license agreement with Medtronic, Inc.involving our IMPACS compounds, pursuant to which Medtronic obtained anexclusive, worldwide license to technology relating to the use of the compoundsto treat aortic aneurysms and other forms of vascular disease with medicaldevices. This program is still underway, but neither we nor Medtronic havedeveloped a timetable for clinical development or commercial launch of anyproduct.

**Patents, Trade Secrets and Licenses**

*Overview*

We have patents, or patentapplications, covering all of our technologies. Some are owned, and some arelicensed from third parties.

Our IMPACS technology islicensed from SUNY, referred to herein as the SUNY License, and other academicand research institutions collaborating with SUNY. Thirty-six United Statespatents and United States patent applications held by SUNY are licensed to usunder the SUNY License. We have also licensed technology from SupernusPharmaceuticals, Inc., or Supernus, successor in interest to Shire Laboratories, Inc. Inaddition to the patents and patent applications licensed from SUNY, whichrepresent the core technology, and the technology licensed from Supernus, wealso own technology for which applications for United States patents have beenfiled and have been issued. This includes various independently developedinventions relating to the uses of tetracyclines, as well as the SansRosatechnology and the Restoraderm technology. A total of eight United Statespatents are issued, and approximately fifteen United States patent applicationsare pending, relative to these technologies. Applications corresponding to eachare pending pursuant to the United States Patent Cooperation Treaty in variousforeign jurisdictions.

*Acquired and Licensed Intellectual Property*

Under the SUNY License, wehave an exclusive worldwide license to SUNY’s rights in certain patents andpatent applications to make and sell products employing tetracyclines to treatcertain disease conditions.

In January 1992, weentered into the SUNY License and have subsequently amended the SUNY Licensetwice. The SUNY License grants us an exclusive worldwide license to make andsell products employing tetracyclines that are designed or utilized to alter abiological process. In consideration of the license granted to us, we:  (i) issued to SUNY 78,948 shares of ourcommon stock in 1992; and (ii) have agreed to pay SUNY royalties on thenet sales of licensed products, with minimum annual royalty payments of $50,000per year. The term of the license is until the later of: (i) theexpiration of the last to expire of the licensed patents in each country; or (ii) November 18,2018, at which time we have a fully paid, non-exclusive license. Our rightsunder the SUNY License are subject to certain statutory rights of 

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theUnited States government resulting from federal support of research activitiesat SUNY. We are entitledto deduct costs incurred to defend SUNY patents from current and futureroyalties due to SUNY.   In the eventthat cumulative legal costs exceed the amount of the royalties payable to SUNY,the amount of such excess is accumulated to offset future royalties earned bySUNY, if any, on net sales of products based on the SUNY technology.

In February 2002, weannounced that we had licensed Restoraderm, a topical drug delivery technology.In August 2004, we purchased all right, title and interest in thistechnology, pursuant to the terms of an Asset Purchase and Product DevelopmentAgreement, or the Restoraderm Purchase Agreement. The Restoraderm PurchaseAgreement superseded our Co-operation, Development and License Agreementexecuted in February 2002. Under the terms of the Restoraderm Purchase Agreement,the purchase price of the assets shall be up to $1.0 million, subject to theachievement of certain milestones. We are also required to pay certain productdevelopment milestone payments in the aggregate amount of up to approximately$2.0 million as well as royalty and sublicense fees upon productcommercialization. As of December 31, 2006, approximately $500,000 ofthese milestone and sublicense fees had been paid by us.

On June 10, 2002, weexecuted a Development and Licensing Agreement with Supernus pursuant to whichwe were granted an exclusive worldwide license (including the right tosublicense) to use Supernus technology and patents to develop prescriptionproducts for the treatment of various inflammatory disorders. Under theagreement, certain product development functions will be performed for us bySupernus. We have committed to pay Supernus milestone payments in cash or, atour option, in a combination of cash and our common stock, upon the achievementof certain clinical and regulatory milestones. Through December 31, 2006,the total milestone payments made to Supernus related to Oracea were $2.7million. For rosacea-indicated development, these future payments could totalup to $1.0 million in the aggregate and relate primarily to internationalapproval and international commercialization of Oracea. Under the agreement, wemust also pay Supernus royalties based on a percentage of net sales of anyproducts utilizing any part of the licensed technology, including Oracea. Webegan incurring royalties to Supernus in the third quarter of 2006 as a resultof our July 2006 launch of Oracea.

On December 14, 2005,we executed a Share Purchase Agreement, or the SansRosa Purchase Agreement, toacquire all the shares of SansRosa from the existing shareholders of SansRosa,or the SansRosa Shareholders. SansRosa is the assignee of certain patentapplications covering methods for treatment of redness associated with rosaceaand other skin disorders. The agreement also provides for royalty payments toformer SansRosa Shareholders if there are future sales of productsincorporating SansRosa technology.

In March 2006, weacquired from an individual inventor all right, title and interest in certainadditional patents related to the SansRosa technology in consideration for alump sum payment. The agreement also provides for royalty payments if there arefuture sales of products incorporating SansRosa technology.

*Our Patents*

Our success will depend inpart on patent and trade secret protection for our technologies, products andprocesses, and on our ability to operate without infringement of proprietaryrights of other parties both in the United States and in foreign countries. Becauseof the substantial length of time and expense associated with bringing new productsthrough development to the marketplace, the pharmaceutical industry placesconsiderable importance on obtaining and maintaining patent and trade secretprotection for new technologies, products and processes.

Thirty-six United Statespatents and United States patent applications held by SUNY are licensed to usunder the SUNY License. SUNY also has obtained patents in certain Europeancountries, Canada and 

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Japan,and has pending patent applications in certain other foreign countries whichcorrespond to its United States patents relating to methods of use oftetracyclines. Over eighty patents have been issued in foreign countries. Allof SUNY’s United States and foreign patents expire between 2004 and 2023.

Our Oracea product iscovered by various patents and patent applications, including the 709 Patent,and 11/061,866, or the 866 Application. On May 17, 2006, we announced thatwe had submitted additional references to the USPTO, that may be relevant tothe examination of the 709 Patent and other applications based thereon. Thisapplication relates to the use of sub-antimicrobial and chemically modifiedtetracyclines for the treatment of acne and acne rosacea, including Oracea andincyclinide. The USPTO had previously issued a Notice of Allowance of thisapplication in August 2005, and a patent was scheduled to issue on May 23,2006, but the application was withdrawn from issuance for consideration of theadditional references. On July 20, 2006, we announced that the USPTO hadissued a non-final rejection of this patent application directed to methods fortreating acne with Oracea.

On September 1, 2006,we announced that we had submitted our response to the non-final rejection fromthe USPTO. We limited the scope of our claim to the use of sub-antimicrobialtetracyclines since the chemically modified tetracyclines, includingincyclinide, are the subject of application Serial No. 10/757,656, or the656 Application. On November 3, 2006, we received a notice of allowancefrom the USPTO regarding the 709 Patent. The allowed claims under the 709Patent cover the use of sub-antimicrobial tetracyclines for the treatment ofacne and acne rosacea. We will continue to prosecute the 656 Application.

In February 2007, wereceived a Notice of Allowance from the USPTO regarding the 866 Application. Theallowed claims under the 866 Application cover the use of sub-antimicrobialtetracyclines for the treatment of certain symptoms of rosacea.

**Government Regulation**

Government authoritiesregulate research, development, testing, manufacture, labeling, promotion,advertising, distribution, and marketing of the products we develop and market.In the United States, the FDA regulates Oracea, Atridox, Pandel, Periostat,Alcortin and Novacort and our products in development as drugs under theFederal Food, Drug, and Cosmetic Act and implementing regulations. The FDAregulates Atrisorb FreeFlow and Atrisorb-D as medical devices under theFood, Drug, and Cosmetic Act and implementing regulations. Both before andafter approval or clearance of our products, failure to comply with FDArequirements may subject us to administrative or judicial sanctions, such asthe FDA’s refusal to approve pending applications or warning letters, productrecalls, product seizures, total or partial suspension of production ordistribution, withdrawal of approvals, import detentions, injunctions, and/orcriminal prosecution.

Ourproducts in development are classified as drugs. The steps required before anyof our product candidates may be marketed in the United States include:

·       preclinicallaboratory tests, animal studies, and formulation studies;

·       submissionto the FDA of an investigational new drug exemption for human clinical testing,which must become effective before human clinical trials may begin;

·       adequateand well-controlled clinical trials to establish the safety and efficacy of thedrug for each indication;

·       submissionto the FDA of an new drug application, or NDA, for approval;

·       satisfactorycompletion of an FDA inspection of the manufacturing facility or facilities atwhich the drug is produced to assess compliance with cGMP; and

·       FDAreview and approval of the NDA.

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Preclinical tests includelaboratory evaluations of product chemistry, toxicity, and formulation, as wellas animal studies. The results of the preclinical tests, together withmanufacturing information, analytical data, and a plan for studying the productin humans, are submitted to the FDA as part of an investigational new drugexemption, which must become effective before human clinical trials may begin. Aninvestigational new drug exemption automatically becomes effective 30 daysafter receipt by the FDA, unless before that time the FDA raises concerns orquestions about issues such as the conduct of the trials outlined in the investigationalnew drug exemption. In that case, the investigational new drug exemption isplaced on clinical hold and the sponsor and the FDA must resolve anyoutstanding FDA concerns or questions before clinical trials can proceed. Submissionof an investigational new drug exemption does not always result in the FDAallowing clinical trials to commence.

Clinical trials involveadministration of the investigational drug to human subjects under thesupervision of qualified investigators and are conducted under protocolsdetailing the objectives of the study, the parameters to be used in monitoringsafety, and the effectiveness criteria to be evaluated. Each protocol must besubmitted to the FDA as part of the investigational new drug exemption process,and must be reviewed and approved by an independent Institutional Review Boardbefore it can begin.

Clinical trials typicallyare conducted in three sequential phases, but the phases may overlap or becombined. Phase I usually involves the initial introduction of theinvestigational drug into people to evaluate its safety, dosage tolerance,pharmacodynamics, and, if possible, to gain an early indication of itseffectiveness. Phase II usually involves trials in a limited patientpopulation to evaluate dosage tolerance and appropriate dosage, identifypossible adverse effects and safety risks and evaluate preliminarily theefficacy of the drug for specific indications. Phase III trials usuallyfurther evaluate clinical efficacy and test further for safety by using thedrug in its final form in an expanded patient population.

Assuming successfulcompletion of the required clinical testing, the results of the preclinicalstudies and of the clinical studies, together with other detailed information,including information on the manufacture and composition of the drug, aresubmitted to the FDA in the form of a new drug application requesting approvalto market the product for one or more indications. Before approving anapplication, the FDA usually will inspect the facility or the facilities atwhich the drug is manufactured, and will not approve the product unlesscompliance with cGMP is satisfactory. If the FDA determines the application andthe manufacturing facilities are acceptable, the FDA will issue an approvalletter. If the FDA determines the application or manufacturing facilities arenot acceptable, the FDA will outline the deficiencies in the submission andoften will request additional testing or information. Notwithstanding thesubmission of any requested additional information, the FDA ultimately maydecide that the application does not satisfy the regulatory criteria forapproval.

The FDA approved our NDAfor Oracea in 2006 and our NDA for Periostat in 1998. The Atrix Products andPandel have also received FDA approval. However, we cannot be sure that anyadditional approvals for our product candidates will be granted on a timelybasis, if at all. After approval, certain changes to the approved product, suchas adding new indications, manufacturing changes, or additional labeling claimsare subject to further FDA review and approval. As part of the NDA forPeriostat, the FDA requested a post-market animal study related to long-termdosing and carcogenicity, which was completed in 2000. As part of the NDA forOracea, the FDA requested certain post-approval studies related to Oracea beconducted. Such studies are currently in progress.

We market two products,Alcortin and Novacort, under a Promotion and Cooperation Agreement with Primus.Neither product has an approved NDA; whether either or both requires an NDA atthis time is unclear. If the FDA believes that an approved NDA is required, itcould at any time seek one or more of the administrative or judicial sanctionslisted above, the result of which could be that we could no longer market theseproducts.

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In some circumstances, approved drugs are providedprotection from generic versions of the approved drug for specified timeperiods. For example, the law provides for market exclusivity for new chemicalentities and for certain classes of chemical entities approved for newindications. However, since Periostat and Oracea contain doxycycline as anactive ingredient, and doxycycline has previously been approved as anantibiotic, the FDA classifies both drugs as antibiotics which are not entitled to the market exclusivityprotection otherwise available to new drugs under the Hatch Waxman amendmentsto the Food, Drug, and Cosmetic Act.  This classification is controlling even thoughboth Periostat and Oracea have been shown in clinical trials to have noanti-microbial effects.

Though Oracea is also classified by the FDA as anantibiotic, the following language in the prescribing information for Oraceadiffers from labeling for antibiotics with antimicrobial actions:  “The dose of Oracea differs from that ofdoxycycline used to treat infections.” In addition, the prescribing information for Oracea includes a sectionon microbiology which states, “The plasma concentrations achieved with Oraceaduring administration are less than the concentration required to treat bacterialdiseases. *Invivo* microbiological studiesutilizing a similar drug exposure for up to 18 months demonstrated nodetectable long-term effects on bacterial flora sampled from the oral cavity,skin, intestinal tract and vagina. Oracea should not be used for treating bacterial infections, providingantibacterial prophylaxis, or eliminating microorganisms associated with anybacterial disease.”

Like drugs, medical devices also require FDAauthorization before they can be marketed in the United States. AtrisorbFreeFlow and Atrisorb-D have received clearance for marketing. Modifications tothose products, however, could require additional approval or clearance.

Approved and cleared drugs and medical devices remainsubject to comprehensive regulation by the FDA while they are being marketed. Forexample, marketers and manufacturers of approved and cleared drugs and medicaldevices are required to report certain adverse reactions and productionproblems, if any, to the FDA, and to comply with requirements concerningadvertising and promotional labeling for their products. The FDA does notpermit marketing or promotion of an approved or cleared drug product or medicaldevice for an unapproved or uncleared use. Also, quality control andmanufacturing procedures must continue to conform to the FDA’s requirements forcGMP (for drugs) or Quality Systems Regulation (for medical devices) afterapproval. Accordingly, we, our manufacturers, and our suppliers must continueto expend time, money, and effort to maintain compliance with manufacturingrequirements and other aspects of regulatory compliance. The FDA periodicallyinspects manufacturers to assess compliance with manufacturing and otherrequirements. We buy bulk active ingredient for Oracea, Periostat and our productsin development from third party suppliers and finish the products in thirdparty manufacturing facilities. The other products we market, Atridox, AtrisorbFreeFlow, Atrisorb-D and Pandel are provided by suppliers.

In addition to theapplicable FDA requirements, we are subject to foreign regulatory authoritiesgoverning clinical trials and drug sales. Whether or not FDA approval has beenobtained, approval of a pharmaceutical product by the comparable regulatoryauthorities of foreign countries must be obtained prior to the commencement ofmarketing of the product in those countries. The approval process varies fromcountry to country and the time required may be longer or shorter than thatrequired for FDA approval.

**Competition**

*Dermatology*

The market for dermatology products is characterizedby rapidly advancing technologies, intense competition and a strong emphasis onproprietary products. We face competition from many different sources,including commercial pharmaceutical and biotechnology enterprises, technologycompanies, such as laser therapy providers and cosmeceutical companies.

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Many of our competitors have significantly greaterfinancial resources and experience in research and development, manufacturing,preclinical testing, clinical trials, regulatory approvals and marketingapproved products than we do. Smaller or early stage companies may also proveto be significant competitors, particularly through collaborative arrangementswith large and established companies. Our commercial opportunity will bereduced or eliminated if our competitors develop and commercialize productsthat are safer, more effective, have fewer side effects, are easier toadminister or are less expensive than any products that we may develop. Thesethird parties compete with us in recruiting and retaining qualified scientificand management personnel, establishing clinical trial sites and patientregistration for clinical trials, as well as in acquiring technologies andtechnology licenses complementary to our programs or advantageous to ourbusiness.

Oracea competes against brandedand generic oral tetracycline products, and topical formulations such asbranded and generic metronidazole, azelaic acid and sodium sulfacetamide/sulfurproducts. Many of these products have been sold and promoted for years and havebeen established as useful and safe in the treatment of rosacea.

There are also manycompanies and academic and research institutions researching and developingpotential treatments for acne and rosacea. Some of these companies are largepharmaceutical companies, while others are smaller companies that may alsoprove to be significant competitors, particularly through collaborativearrangements with large pharmaceutical and biotechnology companies. Companieswith products either commercially available or in human clinical trials includeStiefel Labs, Allergan, Inc., Roche Inc., Galderma Laboratories, L.P., WarnerChilcott Inc., Intendis GmbH, Medicis Pharmaceutical Corporation, Dusa Pharmaceuticals, Inc.and numerous generic pharmaceutical manufacturers.

*Dental*

In September 1998,the FDA granted United States marketing approval for Periostat as an adjunct toSRP to promote attachment level gain and reduce pocket depth in patients withadult periodontitis. Periostat was made available for prescription use in November 1998and was fully launched commercially in January 1999. In May 2005, athird party generic version of Periostat was introduced to the dental marketand we discontinued all selling and promotional activities for Periostat andthe Atrix Products. Based on data provided by a leading independentprescription tracking service, we estimate that Periostat’s share of the 20 mgdoxycycline market was approximately 4% at December 31, 2006.

**Employees**

We have historicallyoutsourced our manufacturing, clinical trials, NDA preparation, warehousing,distribution and other activities. We intend to continue to outsource many ofthe activities which we have historically outsourced. As of December 31,2006, we employed 130 persons. Each of our management personnel has hadextensive prior experience with pharmaceutical, biotechnology or medicalproducts companies. We cannot be certain that we will be able to recruit andretain qualified inside sales and marketing personnel, distributors ormarketing partners or that our marketing and sales efforts will be successful. Currently,none of our employees are covered by collective bargaining agreements. Ingeneral, our employees are covered by confidentiality agreements. We considerrelations with our employees to be excellent.

**Item 1A.**                RiskFactors.

*Statementscontained or incorporated by reference in this Annual Report on Form 10-Kthat are not based on historical fact are “forward-looking statements” withinthe meaning of the Private Securities Litigation Reform Act of 1995, Section 27Aof the Securities Act of 1933, as amended, and Section 21E of the ExchangeAct. These forward-looking statements regarding future events and our futureresults are based on current*

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*expectations, estimates, forecasts, and projectionsand the beliefs and assumptions of our management including, withoutlimitation, our expectations regarding revenues, results of operations,selling, general and administrative expenses, research and developmentexpenses, the sufficiency of our cash for future operations, and the success ofour preclinical, clinical and development programs and our dermatologyfranchise. Forward-looking statements may be identified by the use offorward-looking terminology such as “believe,” “could increase the likelihood,”“hope,” “target,” “project,” “goals,” “potential,” “predict,” “might,” “expect,”“intend,” “is planned,” “should,” “will enable,” “would be expected,” “lookforward,” “may provide,” “would,” “may,” “could,” “will,” “expect,” “estimate,”“anticipate,” “continue,” or similar terms, variations of such terms or thenegative of those terms.*

*We cannot assureinvestors that our assumptions and expectations will prove to have been correct.Important factors could cause our actual results to differ materially fromthose indicated or implied by forward-looking statements. Such factors thatcould cause or contribute to such differences include those factors discussedbelow. We undertake no intention or obligation to update or revise anyforward-looking statements, whether as a result of new information, futureevents or otherwise. If any of the following risks actually occur, ourbusiness, financial condition, results of operations or liquidity would likelysuffer.*

***Weare depending heavily on the commercial success of Oracea. If we are unable tosuccessfully commercialize Oracea our business will be materially harmed.***

We have invested a significant portion of our recentefforts and financial resources in the development of Oracea for the treatmentof rosacea. Our ability to generate substantial product revenues from Oraceawill depend heavily on the successful commercialization of Oracea. While wehave generated revenue from Oracea since the product’s July 2006 launch,it is premature to determine the future success and growth, if any, of theOracea product brand. The success of Oracea will depend primarily on theacceptance of the product by patients, the medical community and third partypayors.

Although we currently derive additional revenue frommarketing and/or selling other products other than Oracea (Periostat, the AtrixProducts, the Primus products and Pandel) our revenue and profitability in thenear future will depend on our ability to market and sell Oracea successfully.

***We cannotrely on regulatory protections to prevent the approval of generic equivalentsof our products.***

In connection with the regulatory approval process,some approved new drug products can obtain exclusivity that will preventgeneric versions of the products from entering the marketplace for a period oftime. In the United States, market exclusivity is available for new chemicalentities and for significant changes in already approved drug products, such asa new use.

Market exclusivity is, however, not available to drugsthat contain an active ingredient that has already been approved as anantibiotic and marketed prior to 1998. On January 19, 2005, the UnitedStates District Court for the District of Columbia upheld the FDA’s applicationof this principle to Periostat and determined that Periostat was not entitledto market exclusivity because its active ingredient, doxycycline, hadpreviously been approved as an antibiotic. Because Oracea also containsdoxycycline as its active ingredient, it will also not be entitled to marketexclusivity.

In the European Community regulatory marketexclusivity is a function of how long the competent authorities may determinethat data submitted in marketing approval applications may not be referenced byothers. The period of so-called data exclusivity to which a new product may beentitled can vary from eleven years to none at all. This depends on how aproduct is classified and can turn on the application of regulatory standardsof which there has been no authoritative interpretation to date. We cannotpredict what period of data exclusivity, if any, may be enjoyed by Oracea inthe European Community.

With limited or no market exclusivity it could be moredifficult for us to prevent competitors from seeking approval for copies of ourproprietary products, and in such a case the value of such products 

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would be materiallyadversely affected. Without market exclusivity, generic versions of ourproducts could quickly gain market entry if they meet regulatory approvalcriteria. Thus, despite the FDA’s May 2006 approval of Oracea, because itwill not be entitled to market exclusivity, third parties may enter the marketwhich would materially harm our business.

***If weare not able to obtain and enforce patent protection for Oracea or our otherdiscoveries, our ability to commercialize our product candidates successfullywill be harmed and we may not be able to operate our business profitably.***

Our success depends, in part, on our ability toprotect proprietary methods and technologies that we develop under the patentand other intellectual property laws of the United States and other countries,so that we can prevent others from using our inventions and proprietaryinformation. However, we may not hold or obtain proprietary rights to somepatents related to our current or future products and technologies, and we maynot, under relevant patent laws, be considered to be inventors of technologieswe believe we have developed.

Because publications of discoveries in scientificliterature lag behind actual discoveries, and such publications may not come tolight despite diligent searches, we cannot be certain that we were the first tomake the inventions claimed in our issued patents or pending patentapplications. Similarly, because patent applications in the United States andmany foreign jurisdictions are typically not published until 18 months afterfiling, or in some cases not at all, we cannot be certain that we were thefirst to make the inventions claimed or to file for protection of theinventions set forth in our patent applications. As a result, we may not begranted additional patents or our existing patents may be found to be invalid. Wemay also be required to obtain licenses under third-party patents to market ourproposed products. If licenses are not available to us on acceptable terms, orat all, we will not be able to market the affected products.

Our strategy depends on our ability to identify ourdiscoveries rapidly and to seek patent protection for them. This process isexpensive and time consuming, and we may not be able to file and prosecute allnecessary or desirable patent applications at a reasonable cost or in a timelymanner. Despite our efforts to protect our proprietary rights, unauthorizedparties may be able to obtain and use information that we regard as proprietary.The issuance of a patent does not guarantee that it is valid or enforceable, soeven if we obtain patents, they may not be valid or enforceable against thirdparties. In addition, the issuance of a patent does not guarantee that we havethe right to practice the patented invention. Third parties may have blockingpatents that could be used to prevent us from marketing our own patentedproduct and practicing our own patented technology.

Our pending patent applications may not result inissued patents, or may result in patents that do not cover our future products.The patent position of pharmaceutical or biotechnology companies, includingours, is generally uncertain and involves complex legal and factual considerations.The standards which the USPTO and its foreign counterparts use to grant patentsare not always applied predictably or uniformly and can change. There is alsono uniform, worldwide policy regarding the subject matter and scope of claimsgranted or allowable in pharmaceutical or biotechnology patents. The laws ofsome foreign countries do not protect proprietary information to the sameextent as the laws of the United States, and many companies have encounteredsignificant problems and costs in protecting their proprietary information inthese foreign countries. Accordingly, we do not know the degree of futureprotection for our proprietary rights or the breadth of claims allowed in anypatents issued to us or to others. The allowance of broader claims may increasethe incidence and cost of patent interference proceedings and/or oppositionproceedings. On the other hand, the allowance of narrower claims may limit thevalue of our proprietary rights.

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A number of our pendingpatent applications are related and include claims that are intended to coverOracea and/or incyclinide. On November 3, 2006, we received a notice ofallowance from the USPTO regarding the 709 Patent. The allowed claims under the709 Patent cover the use of sub-antimicrobial tetracyclines for the treatmentof acne and acne rosacea.

The USPTO had previouslyissued a notice of allowance of the 709 Patent in August 2005. However, onMay 17, 2006, before issuance of the patent, we announced that we hadsubmitted additional references to the USPTO that may have been relevant to theexamination of the application. Accordingly, we requested continuingexamination of the 709 Patent and other applications based on it.

On July 20, 2006, weannounced that the USPTO had issued a non-final rejection of this patentapplication. In responding to that non-final rejection, we limited the scope ofthe claims in the application to the use of sub-antimicrobial tetracyclinessince the chemically modified tetracylines, including incyclinide, are thesubject of the 656 Application, which we will continue to prosecute.

Our issued patent relatingto Oracea, and if issued, our other patents relating to incyclinide, may notcontain claims sufficiently broad to protect us against third parties withsimilar products, or provide us with any competitive advantage. Moreover, onceissued, any of our patents may be challenged, narrowed, invalidated orcircumvented. In addition, the patent rights in our products that derive fromclaims under method of use patents may be hard to assert or enforce if medicalprofessionals prescribe or dispense similar (including generic), thoughnon-approved, doxycycline products for indications covered by our patents. Ifour patents are invalidated or otherwise limited, other companies will bebetter able to develop products and technologies that compete with ours, whichcould adversely affect our competitive business position, business prospectsand financial condition.

***Wecannot assure you that our pursuit of business in the dermatology market willbe successful.***

We continue to implementour plans to expand into the dermatology market. In May 2006, the FDAapproved Oracea for the treatment of rosacea in adults, and in July 2006,we commenced our trade launch of Oracea in the United States. While we havebegun to generate revenue from Oracea sales in connection with the product’sJuly 2006 trade-launch, it is premature to determine the future successand growth, if any, of the Oracea product brand. We continue to seek additionalproduct licensing opportunities to enhance our near-term offerings to thedermatology market. Even if we succeed in our efforts to identify and licenseadditional products, it is not possible to guarantee that in licensed productswill continue indefinitely to be available to us. For instance, on February 1, 2007 we received writtennotice of termination of our agreement with Altana which provides for thetermination of our rights in Pandel effective November 1, 2007.

The dermatology market isvery competitive and some of our competitors have substantially greaterresources than we have. Our future success will depend on, among other things,our ability to: (i) achieve market acceptance for any current or future dermatologicalofferings, including acceptance from managed care and similar organizations;(ii) hire and retain personnel with experience in the dermatology market;(iii) execute our business plan with respect to this market segment; and(iv) adapt to technical or regulatory changes.

At the same time, newproduct development is a lengthy, complex and uncertain process that willrequire significant attention and resources from management. A productcandidate can fail at any stage of the development process due to, among otherthings, efficacy or safety concerns, the inability to obtain necessaryregulatory approvals, the difficulty or excessive cost to manufacture and/orthe infringement of patents or intellectual property rights of others.Furthermore, the sales of new products may prove to be disappointing and failto reach anticipated levels. We therefore cannot assure you that we will besuccessful in our pursuit of business in the dermatology market, or that we cansustain any business in which we achieve initial success.

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The success of our currenttechnology platforms, and that of any other future technology platforms we maypurchase or in-license, will depend on the quality and integrity of thetechnologies licensed or sold to us. Despite our due diligence and thesafeguards we have in place, we cannot guarantee the effectiveness or integrityof such technologies, nor can we be certain that others do not have interveningrights in such technologies. If any of our in-licensed technologies provedineffective, or if a third party successfully asserted any right to suchtechnologies, our ability to develop new products and implement our strategieswould be materially adversely affected.

***If weare not able to obtain required regulatory approvals, we will not be able tocommercialize our product candidates, and our ability to generate revenue willbe materially impaired.***

Failure to obtainregulatory approval for a product candidate will prevent us fromcommercializing the product candidate. Other than Oracea and Periostat, we havenot received regulatory approval to market any of our product candidates in anyjurisdiction. We have only limited experience in filing and prosecuting theapplications necessary to gain regulatory approvals. Securing FDA and othercomparable authority approval, requires the submission of extensive preclinicaland clinical data, information about product manufacturing processes andinspection of facilities and supporting information to the FDA and othercomparable authorities  for eachtherapeutic indication to establish the product candidate’s safety and efficacy.Our future products may not be effective, may be only moderately effective ormay prove to have undesirable or unintended side effects, toxicities or othercharacteristics that may preclude our obtaining regulatory approval or preventor limit commercial use.

The process of obtainingregulatory approvals is expensive, often takes many years, if approval isobtained at all, and can vary substantially based upon, among other things, thetype, complexity and novelty of the product candidates involved. Changes in theregulatory approval policy during the development period, changes in or theenactment of additional statutes or regulations, or changes in regulatoryreview for each submitted product application, may cause delays in the approvalor rejection of an application.

The FDA, and comparableauthorities in other countries, have substantial discretion in the approvalprocess and may refuse to accept any application or may decide that our data isinsufficient for approval and require additional preclinical, clinical or otherstudies. In addition, varying interpretations of the data obtained frompreclinical and clinical testing could influence how a product candidate isclassified and delay, limit or prevent regulatory approval of a productcandidate. Any regulatory approval we ultimately obtain may be limited orsubject to restrictions or post-approval commitments that render the productnot commercially viable.

Even if regulatoryapproval of a product is granted, the approval may be subject to limitations onthe indicated uses for which the product may be marketed or to the conditionsof approval, or contain requirements for costly post-marketing testing andsurveillance to monitor the safety or efficacy of the product.

***If welose our sole supplier of doxycycline or our manufacturer of Oracea, our salesof Oracea will be interrupted, halted or less profitable.***

We do not have theresources, facilities or capabilities to manufacture any of our products orproduct candidates. We have no current plans to establish a manufacturingfacility. We expect that we will be dependent, to a significant extent, oncontract manufacturers for commercial scale manufacturing of our products orproduct candidates in accordance with regulatory standards.

We rely on Hovione, as oursole supplier of both doxycycline hyclate and doxycycline monohydrate, and haveno back-up supplier at this time. Doxycycline monohydrate is the activeingredient in Oracea. Hovione has two FDA-approved, validated manufacturingfacilities that we believe will provide us with 

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someprotection against supply interruption. We are, however, seeking a back-upsupplier, but there are relatively few alternative suppliers of doxycycline,and Hovione produces the majority of the doxycycline used in the United States.Our current supply agreement with Hovione does not cover the purchase ofdoxycycline monohydrate, which is the active ingredient in Oracea. We arecurrently in discussions with Hovione to restructure our agreement so that itwill cover doxycycline monohydrate. During the course of these discussions wehave been purchasing doxycycline monohydrate on a purchase order by purchaseorder basis. The term of the supply agreement expires on May 14, 2008 andthereafter automatically renews for successive two-year periods unless, 90 daysprior to the expiration of any such periods, either party gives the other partywritten notice of termination. In addition, in the event of a default, uncuredfor 90 days, the non-defaulting party can terminate the supply agreementeffective immediately at the end of such ninety-day period. Although Hovionemaintains two manufacturing locations, if we are unable to procure a commercialquantity of doxycycline from Hovione on an ongoing basis at a competitiveprice, if Hovione fails to comply with cGMP or if we cannot find a replacementsupplier in a timely manner or with favorable pricing terms, our costs mayincrease significantly and we may experience delays in the supply and sale ofOracea.

We entered into anagreement effective December 31, 2005 with PTS pursuant to which PTS hasagreed to manufacture Oracea for us. We intend to contract with additionalmanufacturers for the commercial manufacture of an Oracea capsule. We believe,however, that it could take up to one year to validate successfully a secondarymanufacturer. We cannot be certain that we will be able to enter intoadditional agreements on acceptable terms, if at all. In the event that we areunable to obtain sufficient quantities of doxycycline or Oracea on commerciallyreasonable terms or in a timely manner, our business, financial condition andresults of operations would be materially adversely affected.

***Ifthe federal regulatory status of Alcortin or Novacort changes, we may be unableto continue to market one or both of these products.***

We market two products,Alcortin and Novacort, under a Promotion and Cooperation Agreement with Primus.Sixty percent of sample product and promotion costs and all sales forcecompensation related to our promotion of Alcortin and Novacort are funded byus. Primus is responsible for the manufacture of Alcortin and Novacortand  has not sought FDA approval forthese products because Primus believes that no approval is required. We cannotbe sure that FDA will not object to the lack of approval for these products. Ifthe FDA were to assert that these products required approval, it could at anytime seek to take administrative or judicial actions which could prevent us frommarketing these products. Our inability to market these products could resultin a temporary or permanent loss of revenue, which may be partially offset by areduction in our promotional expenses related to these products.

***Ourproducts could be subject to restrictions or withdrawal from the market and wemay be subject to penalties if we fail to comply with regulatory requirements.Both before and after approval or clearance, we, our products and productcandidates and our manufacturers are subject to extensive regulatoryrequirements. Failure to comply with these requirements could subject us toadministrative and judicial sanctions.***

Bothbefore and after approval or clearance of our products, we, our products andproduct candidates, and our manufacturers are subject to extensive regulatoryrequirements covering, among other things, manufacturing, advertising andpromotion, labeling, adverse event reporting, post-approval commitments,registration, record-keeping, export, and distribution of samples. Failure tocomply with regulatory requirements may result in:

·       restrictionson such products, manufacturers or manufacturing processes;

·       warningletters;

·       withdrawalof the products from the market;

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·       refusalto approve pending applications or supplements to approved applications that wesubmit;

·       recall;

·       fines;

·       suspensionor withdrawal of regulatory approvals;

·       refusalto permit the import or export of our products;

·       productseizure; and

·       injunctions or theimposition of civil or criminal penalties.

***Wemay be unable to raise additional capital if needed, which would force us todelay, reduce or eliminate our product development programs andcommercialization efforts.***

Weexpect that our research and development expenses will increase in connectionwith our ongoing activities and that we will incur significantcommercialization expenses as we expand our marketing and sales efforts. Wewill need additional funding to meet these additional expenses and may beunable to raise capital when needed or on attractive terms, which would forceus to delay, reduce or eliminate our research and development programs andcommercialization activities. If we generate revenues and incur expenses at ouranticipated levels, we anticipate that our current cash, cash equivalents andshort-term investments at December 31, 2006 will be sufficient to fund ouroperations through at least the end of 2007. However, our forecast of theperiod of time through which our financial resources will be adequate tosupport our operations involves risks and uncertainties, and actual resultscould vary materially. Our future funding requirements will depend on manyfactors, including:

·       thecost of commercialization activities, including product marketing and sales;

·       thesuccessful commercialization of Oracea and its acceptance by managed careorganizations and other third party payors;

·       thesuccess of obtaining European Union approval of Oracea and in turn the successof MediGene AG, our foreign marketing partner for Oracea, in commercializingOracea in the European Union;

·       thesuccess of our dermatology franchise;

·       thesuccess of our prosecution of the 656 Application related to the use ofchemically modified tetracyclines for the treatment of acne and acne rosacea,including incyclinide;

·       theissuance of the 709 Patent;

·       receiptand maintenance of marketing approvals from the FDA and similar foreignregulatory authorities for our product candidates;

·       thesuccess of our preclinical, clinical and development programs;

·       revenuesand profits from sales of Oracea, Pandel, and Periostat, and our other productcandidates, as well as the products we co-promote;

·       theterms and conditions of our outstanding Series D-1 CumulativeConvertible Preferred Stock, or Series D-1 Stock;

·       ourability to continue to meet the covenant requirements under our amendedrevolving credit facility with SVB;

·       thecosts involved in preparing, filing, prosecuting, maintaining and enforcingpatent claims and other patent-related costs, including potential litigation costsand the results of such litigation;

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·       theextent to which we acquire or invest in businesses, products and technologies;

·       thecosts involved in obtaining and maintaining regulatory approvals and clearancesrequired to market and sell our products; and

·       thereceptivity of the capital markets to any future financings.

Until such time, if ever,as we can generate substantial product revenues, we expect to finance our cashneeds through public or private equity offerings, debt financings and corporatecollaboration and licensing arrangements. If we raise additional funds byissuing equity securities, our stockholders may experience dilution. Debtfinancing, if available, may involve agreements that include covenants limitingor restricting our ability to take specific actions, such as incurringadditional debt, making capital expenditures or declaring dividends. Any debtfinancing or additional equity that we raise may contain terms, such asliquidation and other preferences that are not favorable to us or ourstockholders. If we raise additional funds through collaboration and licensingarrangements with third parties, it may be necessary to relinquish valuablerights to our technologies, research programs or products or grant licenses onterms that may not be favorable to us.

***Wecannot assure you that our clinical trials will be completed in a timely manneror will meet agreed upon end-points.***

As part of our plans toexpand into the dermatology market, we will need to conduct extensive testingof our products, pursuant to protocols that measure end points agreed with theFDA or other regulatory agencies. We cannot guarantee that Phase I, Phase II,or Phase III testing for our products in development will be completedsuccessfully within any specified period of time, if at all. Many products thatinitially appear promising are found, after clinical evaluation, not to be safeand effective. Also, we, or the FDA, may suspend clinical trials at any time onvarious grounds, including a finding that the subjects or patients are beingexposed to an unacceptable health risk.

Delays in patientenrollment in clinical trials may result in increased costs and delays, whichcould have a harmful effect on our ability to develop products.

It maytake several years to complete the testing of a product, and failure can occurat any stage of testing. For example:

·       interimresults of preclinical or clinical studies do not necessarily predict theirfinal results, and results in early studies might not be seen in later studies;

·       potentialproducts that appear promising at early stages of development may ultimatelyfail for a number of reasons, including the possibility that the products maybe ineffective, less effective than products of our competitors or causeharmful side effects;

·       anypreclinical or clinical test may fail to produce results satisfactory to theFDA or foreign regulatory authorities;

·       preclinicaland clinical data can be interpreted in different ways, which could delay,limit or prevent regulatory approval;

·       wemay not be able to manufacture the investigational or commercial product insufficient quantity or quality or at acceptable cost;

·       negativeor inconclusive results from a preclinical study or clinical trial or adversemedical events during a clinical trial could cause a preclinical study orclinical trial to be repeated or a program to be terminated, even if otherstudies or trials relating to the program are successful;

·       theFDA can place a hold on a clinical trial if, among other reasons, it finds thatpatients enrolled in the trial are or would be exposed to an unreasonable andsignificant risk of illness or injury;

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·       wemay encounter delays or rejections based on changes in regulatory agencypolicies during the period in which we develop a drug or the period requiredfor review of any application for regulatory agency approval; and

·       ourclinical trials may not demonstrate the safety and efficacy needed for ourproducts to receive regulatory approval.

If we are required toconduct additional clinical trials or other studies beyond those that wecurrently contemplate, if we are unable to successfully complete our clinicaltrials or other studies or if the results of these trials or studies are notpositive or are only modestly positive, we may be delayed in obtainingmarketing approval, we may not be able to obtain marketing approval or we mayobtain approval for indications that are not as broad as intended. Our productdevelopment costs will also increase if we experience delays in testing orapprovals. Significant clinical trial delays could allow our competitors tobring products to market before we do and impair our ability to commercializeour products or potential products. If any of this occurs, our business will bematerially harmed.

***If weinfringe or are alleged to infringe intellectual property rights of thirdparties, it will adversely affect our business.***

Our research, developmentand commercialization activities, as well as any product candidates or productsresulting from these activities, may infringe or be claimed to infringe patentsor patent applications under which we do not hold licenses or other rights. Thirdparties may own or control these patents and patent applications in the UnitedStates and abroad. These third parties could bring claims against us or ourcollaborators that would cause us to incur substantial expenses and, ifsuccessful against us, could cause us to pay substantial damages. Further, if apatent infringement suit were brought against us or our collaborators, we orthey could be forced to stop or delay research, development, manufacturing orsales of the product or product candidate that is the subject of the suit.

As a result of patentinfringement claims, or in order to avoid potential claims, we or ourcollaborators may choose or be required to seek a license from the third partyand be required to pay license fees or royalties or both. These licenses maynot be available on acceptable terms, or at all. Even if we or ourcollaborators were able to obtain a license, the rights may be nonexclusive,which could result in our competitors gaining access to the same intellectualproperty. Ultimately, we could be prevented from commercializing a product, orbe forced to cease some aspect of our business operations, if, as a result ofactual or threatened patent infringement claims, we or our collaborators areunable to enter into licenses on acceptable terms. This could harm our businesssignificantly.

There has been substantiallitigation and other proceedings regarding patent and other intellectualproperty rights in the pharmaceutical and biotechnology industries. In additionto infringement claims against us, we may become a party to other patentlitigation and other proceedings, including interference proceedings declaredby the USPTO and opposition proceedings in the European Patent Office,regarding intellectual property rights with respect to our products andtechnology. The cost to us of any patent litigation or other proceeding, evenif resolved in our favor, could be substantial. Some of our competitors may beable to sustain the costs of such litigation or proceedings more effectivelythan we can because of their substantially greater financial resources. Uncertaintiesresulting from the initiation and continuation of patent litigation or otherproceedings could have a material adverse effect on our ability to compete inthe marketplace. Patent litigation and other proceedings may also absorbsignificant management time.

***Wedepend upon third party researchers and providers of clinical services toperform as contractually required if we are to be successful in bringing newproducts to market.***

We do not have the abilityindependently to conduct the clinical trials required to obtain regulatoryapproval for our products. We rely on independent clinical investigators,contract research organizations 

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andother third party service providers for successful execution of our clinicaltrials, but do not control many aspects of their activities. We are responsiblefor ensuring that each of our clinical trials is conducted in accordance withthe general investigational plan, protocols for the trial and applicableregulatory requirements. Moreover, the FDA requires us to comply withstandards, commonly referred to as Good Clinical Practices, for conducting andrecording and reporting the results of clinical trials to assure that data andreported results are credible and accurate and that the rights, integrity andconfidentiality of trial participants are protected. Our reliance on thirdparties that we do not control does not relieve us of these responsibilitiesand requirements. Third parties may not, however, complete activities onschedule, or may not conduct our clinical trials in accordance with regulatoryrequirements or our stated protocols. Furthermore the data that they generatemay not be accurate or may, in extreme cases, be fraudulent.

Our ability to bring ourfuture products to market depends on the quality and integrity of the data wepresent to regulatory authorities in order to obtain marketing authorizations. Wecannot guarantee the authenticity or accuracy of such data, nor can we becertain that such data has not been fraudulently generated. The failure ofthese third parties to carry out their obligations would materially adverselyaffect our ability to develop and market new products and implement ourstrategies.

***Wedepend upon certain key relationships to generate much of the technologyrequired to maintain our competitive position in the marketplace.***

Our IMPACS technology islicensed under the SUNY License and other academic and research institutionscollaborating with SUNY. Under the SUNY License, we have an exclusive worldwidelicense to SUNY’s rights in certain patents and patent applications to make andsell products employing tetracyclines to treat certain disease conditions. TheSUNY License imposes various payment and reporting obligations on us, and ourfailure to comply with these requirements permits SUNY to terminate the SUNYLicense. If the SUNY License is terminated, we would lose our right to excludecompetitors from commercializing similar products, and we could be excludedfrom marketing the same products if SUNY licensed the underlying technology toa competitor after terminating the SUNY License. The SUNY License is terminableby SUNY on 90 days prior notice only upon our failure to make timely payments,reimbursements or reports, if the failure is not cured by us within 90 days.The termination of the SUNY License, or the failure to obtain and maintainpatent protection for our technologies, would have a material adverse effect onour business, financial condition, liquidity and results of operations.

***Ifour products cause injuries, we may incur significant expense and liability.***

Our business may beadversely affected by potential product liability claims arising out of thetesting, manufacturing and marketing of Periostat, Oracea and other productsdeveloped by or for us or for which we have licensing or promotion andcooperation rights. We continually evaluate the limits and adequacy of ourproduct liability insurance coverage and currently have an aggregate of$10.0 million in product liability insurance covering Periostat, andOracea, our product candidates and products for which we have licensing orpromotion and cooperation rights.

Our insurer has also notified us that our generalproduct liability policy will not cover claims arising from our past sales ofVioxx, to the extent such claims are made after December 31, 2004. Thisdoes not affect our rights under the Co-Promotion Agreement with Merck, whichprovides for indemnification of us by Merck against any claims arising frommanufacturing or design defects in the Vioxx product or for which we, as theseller of the product, may be strictly liable as a seller of an inherentlydangerous product.

Our insurance may notadequately protect us against product liability claims. Insufficient insurancecoverage or the failure to obtain indemnification from third parties for theirrespective liabilities may expose us to product liability claims and/or recallsand could cause our business, financial condition and results of operations todecline.

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***Our stock price ishighly volatile and, therefore, the value of your investment may fluctuatesignificantly.***

The market price of our common stock has fluctuatedand may continue to fluctuate as a result of variations in our quarterlyoperating results. These fluctuations may be exaggerated if the trading volumeof our common stock is low. In addition, the stock market in general hasexperienced dramatic price and volume fluctuations from time to time. Thesefluctuations may or may not be based upon any business or operating results. Ourcommon stock may experience similar or even more dramatic price and volumefluctuations that may continue indefinitely.

Thefollowing table sets forth the high and low last sale prices per share for ourcommon stock for each of the quarters in the period beginning January 1,2004 through December 31, 2006, as reported on the NASDAQ Global Market:

| **Quarter Ended**   | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------|------------|------------|------------|----------|------------|---------|------------|
| March 31,  2004     |       | $          | 14.16      |     | $          | 10.07   |       |
| June 30,  2004      |       | $          | 13.21      |     | $          | 8.70    |       |
| September 30,  2004 |       | $          | 9.49       |     | $          | 6.09    |       |
| December 31,  2004  |       | $          | 7.49       |     | $          | 5.37    |       |
| March 31, 2005      |       | $          | 7.52       |     | $          | 4.50    |       |
| June 30,  2005      |       | $          | 7.61       |     | $          | 3.99    |       |
| September 30,  2005 |       | $          | 9.95       |     | $          | 7.15    |       |
| December 31,  2005  |       | $          | 12.07      |     | $          | 8.50    |       |
| March 31, 2006      |       | $          | 14.80      |     | $          | 11.27   |       |
| June 30,  2006      |       | $          | 14.67      |     | $          | 10.52   |       |
| September 30,  2006 |       | $          | 13.22      |     | $          | 8.52    |       |
| December 31, 2006   |       | $          | 14.65      |     | $          | 11.35   |       |

 

**Item1B.**                  UnresolvedStaff Comments.

Not applicable.

**Item2.**                        Properties.

We own no real property. Ourprincipal executive offices, located at 41 University Drive, Suite 200,Newtown, Pennsylvania, consist of 18,163 square feet of leased space. Our leasefor such premises continues through July 2009.

**Item3.**                        LegalProceedings.

*IVAX and CorePharma*

On October 1, 2004, we filed a complaint forpatent infringement against IVAX Pharmaceuticals Inc., or IVAX, and CorePharmaLLC, or CorePharma, in the United States District Court for the EasternDistrict of New York. In our complaint, we alleged that the submission of ANDAsby each of IVAX and CorePharma for 20 mg tablets of doxycycline hyclateinfringed United States Patent RE 34,656, for which we are the exclusivelicensee. We also alleged that any manufacture, importation, marketing and saleof generic 20 mg tablets of doxycycline hyclate by IVAX and CorePharma wouldinfringe the RE 34,656 patent. We sought an injunction preventing IVAX andCorePharma from introducing 20 mg tablets of doxycycline hyclate in the UnitedStates. The injunction was denied by the Court on June 16, 2005. We, IVAX, and CorePharma have since agreednot to pursue litigation on the merits of our patent infringement claims of thecounter claims alleged by IVAX and CorePharma. On May 10, 2006, the Courtin the Eastern District of New York entered a Stipulated Order of Dismissalwith Prejudice as to the 

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mattersat issue with CorePharma, and on September 20, 2006 a similar order wasentered with respect to IVAX.

Under the SUNY License, weare entitled to deduct costs incurred to defend its patents, including the $2.0million settlement payment to Mutual in April 2004, from current andfuture royalties due to SUNY on net sales of Periostat and sales to Mutual. Weanticipate that our future legal costs in these matters relating to patentinfringement and defense will be reimbursed by SUNY pursuant to the SUNYLicense to the extent that these legal expenses do not exceed royalties earnedby SUNY. In the event such cumulative legal costs exceed the amount of theroyalties’ payable to SUNY, we will not be able to recover such legal costsfrom SUNY. The cumulative legal patent defense, litigation and settlement costsincurred as of December 31, 2006 exceed the amount of the royalties earnedand payable to SUNY since our litigation commenced by approximately $3.6million. These amounts, which have been expensed, will be available to offsetfuture royalties earned by SUNY, if any, on net sales of products based on theSUNY technology.

**Item4.**                        Submissionof Matters to a Vote of Security Holders.

Not applicable.

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**PART II**

**Item5.**                        Market forthe Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities.

***Market Information***

Since June 20, 1996,our common stock has traded on the NASDAQ Global Market under the symbol “CGPI.”

The following table setsforth the high and low last sale prices per share for our common stock for eachof the quarters in the period beginning January 1, 2005 through December 31,2006, as reported on the NASDAQ Global Market:

| **Quarter Ended**   | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------|------------|------------|------------|----------|------------|---------|------------|
| March 31,  2005     |       | $          | 7.52       |     | $          | 4.50    |       |
| June 30,  2005      |       | $          | 7.61       |     | $          | 3.99    |       |
| September 30,  2005 |       | $          | 9.95       |     | $          | 7.15    |       |
| December 31,  2005  |       | $          | 12.07      |     | $          | 8.50    |       |
| March 31,  2006     |       | $          | 14.80      |     | $          | 11.27   |       |
| June 30,  2006      |       | $          | 14.67      |     | $          | 10.52   |       |
| September 30,  2006 |       | $          | 13.22      |     | $          | 8.52    |       |
| December 31, 2006   |       | $          | 14.65      |     | $          | 11.35   |       |

 

***Holders***

As of March 7, 2007,the approximate number of holders of record of our common stock was 88 and theapproximate number of beneficial holders of our common stock was 3,979 as of March 12,2007.

***Dividends***

We have never declared orpaid any cash dividends on our common stock. Except as set forth below, weintend to retain earnings, if any, to fund future growth and the operation ofour business. On May 12, 1999, we consummated a $20.0 million financingthrough the issuance of our Series D Cumulative Convertible PreferredStock, or Series D Stock. As a result of such financing, we had certaincommon stock dividend obligations and continue to have certain cumulative cashdividend obligations to the holders of the Series D Stock, who now hold Series D-1Stock as a result of the Restructuring and Exchange Agreement we executed withsuch holders on December 15, 2005. Such arrangement also limits ourability to generally declare dividends to our common stockholders. In addition,our ability to generally declare dividends to our common stockholders isfurther limited by the terms of our credit facility with SVB, which expires on October 9,2008.

***Equity CompensationPlan Information***

Information relating tocompensation plans under which our equity securities are authorized forissuance is set forth under “Security Ownership of Certain Beneficial Ownersand Management and Related Stockholder Matters” in our definitive proxystatement for our 2007 Annual Meeting of Stockholders.

**Item6.**                        SelectedConsolidated Financial Data.

The selected consolidatedfinancial data set forth below with respect to our consolidated statement ofoperations for each of the years in the three-year period ended December 31,2006 and our consolidated balance sheets as of December 31, 2006 and 2005are derived from and qualified by reference to our audited consolidatedfinancial statements and the related notes thereto found at “Item 15. Exhibitsand Financial Statement Schedules” herein. The consolidated statement ofoperations data for the years ended 

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December 31,2003 and 2002  and the consolidatedbalance sheet data as of December 31, 2004, 2003 and 2002 are derived fromour audited consolidated financial statements not included in this Annual Reporton Form 10-K. Historical results are not necessarily indicative offuture results. The selected consolidated financial data set forth below shouldbe read in conjunction with and is qualified in its entirety by our auditedconsolidated financial statements and related notes thereto found at “Item 15.Exhibits and Financial Statement Schedules” and “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations” whichare included elsewhere in this Annual Report on Form 10-K.

| ** **                                                               | ** ** | **Years Ended December 31,**                                             | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006(2)**                                                                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                               | ** ** | **(dollars in thousands except for per share data)** | ** ** |
| **Consolidated  Statement of Operation Data:**                           |       |                                                                                    |       |   | ** ** | ** ** | ** ** | ** ** |   |   |   |
| Revenues:                                                                |       |                                                                                    |       |   |   |   |   |   |   |   |   |
| Net product sales                                                        |       | $                                                                                       | 24,448     |   | $ | 25,736 |   | $ | 51,739 |   | $ | 49,038 |   | $ | 42,111 |   |
| Contract revenues                                                        |       | 1,390                                                                                   |       | 481 |   | 237 |   | 3,122 |   | 2,332 |   |
| License revenues                                                         |       | 64                                                                                      |       | 188 |   | 170 |   | 699 |   | 176 |   |
| Grant revenues                                                           |       | 471                                                                                     |       | — |   | — |   | — |   | — |   |
| Total revenues                                                           |       | 26,373                                                                                  |       | 26,405 |   | 52,146 |   | 52,859 |   | 44,619 |   |
| Operating  expenses:                                                     |       |                                                                                    |       |   |   |   |   |   |   |   |   |
| Cost of product sales                                                    |       | 5,473                                                                                   |       | 5,885 |   | 7,446 |   | 7,362 |   | 6,713 |   |
| Research and development                                                 |       | 15,394                                                                                  |       | 13,986 |   | 8,843 |   | 5,462 |   | 4,394 |   |
| Selling, general and administrative                                      |       | 40,925                                                                                  |       | 25,242 |   | 29,417 |   | 32,968 |   | 32,699 |   |
| Restructuring charge                                                     |       | —                                                                                  |       | 1,184 |   | 348 |   | — |   | — |   |
| Legal settlement                                                         |       | —                                                                                  |       | — |   | 2,000 |   | 700 |   | — |   |
| Gain on sale of U.K. and European dental assets                          |       | —                                                                                  |       | — |   | (2,980 | ) | — |   | — |   |
| Operating (loss) income                                                  |       | (35,419                                                                                 | )          | (19,892 | ) | 7,072 |   | 6,367 |   | 813 |   |
| Interest income                                                          |       | 2,001                                                                                   |       | 1,087 |   | 421 |   | 148 |   | 77 |   |
| Interest expense                                                         |       | (16                                                                                     | )          | — |   | — |   | — |   | (5 | ) |
| Other income (expense)                                                   |       | —                                                                                  |       | — |   | 2 |   | (3 | ) | 17 |   |
| (Loss) income before income taxes                                        |       | (33,434                                                                                 | )          | (18,805 | ) | 7,495 |   | 6,512 |   | 902 |   |
| Income taxes                                                             |       | —                                                                                  |       | — |   | 967 |   | 85 |   | — |   |
| Net (loss) income                                                        |       | $                                                                                       | (33,434    | ) | $ | (18,805 | ) | $ | 6,528 |   | $ | 6,427 |   | $ | 902 |   |
| Net (loss) income allocable to common stockholders                       |       | $                                                                                       | (35,362    | ) | $ | (24,212 | ) | $ | 4,928 |   | $ | 4,827 |   | $ | (727 | ) |
| Basic net (loss) income per share allocable to common stockholders(1)    |       | $                                                                                       | (1.98      | ) | $ | (1.67 | ) | $ | 0.35 |   | $ | 0.40 |   | $ | (0.06 | ) |
| Diluted net (loss) income per share allocable to common  stockholders(1) |       | $                                                                                       | (1.98      | ) | $ | (1.67 | ) | $ | 0.34 |   | $ | 0.38 |   | $ | (0.06 | ) |
| Shares used in computing basic per share amounts(1)                      |       | 17,902,257                                                                              |       | 14,480,779 |   | 14,264,687 |   | 12,094,638 |   | 11,234,652 |   |
| Shares used in computing diluted per share amounts(1)                    |       | 17,902,257                                                                              |       | 14,480,779 |   | 14,500,637 |   | 12,836,364 |   | 11,234,652 |   |

 

| ** **                                        | ** ** | **As of December 31,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                        | ** ** | **2006(2)**                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                        | ** ** | **(in thousands)**               | ** ** |
| **Consolidated Balance Sheet  Data:**             |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and short-term investments |       | $                                     | 65,830     |   | $ | 44,425 |   | $ | 38,645 |   | $ | 32,670 |   | $ | 10,112 |   |
| Working capital                                   |       | 59,636                                |       | 34,643 |   | 39,714 |   | 32,010 |   | 5,992 |   |
| Total assets                                      |       | 79,207                                |       | 49,165 |   | 52,346 |   | 44,132 |   | 17,634 |   |
| Accumulated deficit                               |       | (123,500                              | )          | (89,138 | ) | (64,926 | ) | (69,854 | ) | (74,681 | ) |
| Total stockholders’ equity                   |       | $                                     | 62,302     |   | $ | 35,668 |   | $ | 41,215 |   | $ | 33,956 |   | $ | 8,352 |   |

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(1)           See Note 2 ofNotes to Consolidated Financial Statements for information concerningcomputation of net (loss) income per share allocable to common stockholders.

(2)           See Note 9 of the Notes to Consolidated FinancialStatements for information concerning our adoption of SFAS No. 123Reffective January 1, 2006.

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

Our management’sdiscussion and analysis of our financial condition and results of operationsinclude the identification of certain trends and other statements that maypredict or anticipate future business or financial results that are subject toimportant factors that could cause our actual results to differ materially fromthose indicated. See Item 1A, “Risk Factors.”

**Overview**

CollaGenex Pharmaceuticals, Inc. and subsidiariesis a specialty pharmaceutical company currently focused on developing andmarketing innovative proprietary medical therapies to the dermatology market. Wecurrently market four prescription pharmaceutical products to the dermatologymarket through our professional dermatology sales force and generate revenuesfrom four other prescription pharmaceutical products that we continue to sellto the dental market. In May 2006, the U.S. Food and Drug Administration,or the FDA, granted us marketing approval for OraceaTM for the treatment ofinflammatory lesions (papules and pustules) of rosacea in adult patients. Oraceais the first FDA approved, orally-administered, systemically-delivered drug totreat rosacea. In July 2006, we launched Oracea to the U.S. dermatologycommunity.

Our strategy is to become a leading developer andmarketer of innovative prescription pharmaceutical products to the dermatologymarket. We intend to continue to market our current products, including Oracea,and develop and launch new products based on our proprietary platformtechnologies as well as other technologies. Our lead development candidatesare: incyclinide (formerly known as COL-3), which is currently in twoseparate Phase II dose-finding clinical trials for the treatment of acne androsacea; COL-118, a topical compound for which we are developing for thetreatment of erythema (skin redness) associated with dermatological conditionsand for which we recently completed the clinical portion of a Phase I clinicaltrial; and our Restoraderm®, a foam-based, topical dermal drug delivery system,which is currently under development.

Our marketed dermatology products are: Oracea; Pandel®,a prescription corticosteroid we licensed from Altana, Inc. in May 2002;AlcortinTM, a prescription topical antifungal steroid combination; and NovacortTM,a prescription topical steroid and anesthetic. In June 2005, we executed aPromotion and Cooperation Agreement with Primus Pharmaceuticals Inc., orPrimus, to market Alcortin and Novacort to dermatologists.

Our original dental product, Periostat®, is anorally-administered, prescription pharmaceutical product that was approved bythe FDA in September 1998 for the treatment of adult periodontitis. On May 20,2005, we terminated our dental sales force and promotional activities forPeriostat following the introduction of a third party generic version of theproduct. We also discontinued the promotion of our other dental products on May 20,2005. We continue to generate sales from Periostat and three other dentalproducts, which include Atridox®, Atrisorb FreeFlow® and Atrisorb-D®, alsoreferred to as the Atrix Products, and are each licensed from Tolmar Inc., asubsidiary of Tecnofarma, S.A.

In addition to our marketed products, we have apipeline of product candidates in clinical and preclinical development. Theseproducts are based on our proprietary platform technologies, IMPACSTM, SansRosaTMand Restoraderm.

IMPACS (Inhibitors of Multiple Proteases AndCytokineS) are a group of compounds that demonstrate a range ofanti-inflammatory activities as well as the ability to inhibit the breakdown ofconnective tissue. Periostat and Oracea are our first FDA-approved IMPACSproducts. incyclinide is an IMPACS compound currently in clinical developmentfor the treatment of acne and rosacea. Our IMPACS technology is licensed on a perpetualbasis from the Research Foundation of the State University of New York at StonyBrook, or SUNY. SUNY also conducts research and development on other potential 

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applicationsof this technology on a project basis. Our SansRosa technology, which weacquired in connection with the acquisition of SansRosa PharmaceuticalDevelopment Inc., or SansRosa, in December 2005,****is a class of compounds that have shown promise in reducingthe redness associated with rosacea, and we intend to formulate and develop atopical treatment for rosacea based on one or more of these compounds. OurRestoraderm technology is a proprietary, foam-based, topical drug deliverytechnology that originated from a Swedish collaborator. We have acquired allrights, title and interest to the Restoraderm technology. We have formulatedvarious prescription and over the counter products based on the Restoradermtechnology. We do not currently have a timetable for either the initiation ofclinical development or the launch of any Restoraderm products.

We were founded in 1992and completed an initial public offering of our common stock in 1996. Althoughwe achieved net income for the years ended December 31, 2004, 2003 and2002 we have incurred losses in every other year since inception and have anaccumulated deficit of  $123.5 million atDecember 31, 2006.

**Results ofOperations**

*Years Ended December 31,2006 and December 31, 2005*

**Revenues**

| **Revenues**              | ** ** | ** **                           | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|---------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                | ** ** | **(dollars in thousands)** | ** ** |
| Oracea Net Product  Sales |       | $                                    | 11,933     |     |       | N/A        |       |     | $          | — |   |
| Other Net  Products Sales |       | 12,515                               |       |     | (51.4      | )%         |       | 25,736   |       |
| Total Net Product Sales   |       | 24,448                               |       |     | (5.0       | )%         |       | 25,736   |       |
| Contract Revenues         |       | 1,390                                |       |     | 189.0      | %          |       | 481      |       |
| License Revenue           |       | 64                                   |       |     | (66.0      | )%         |       | 188      |       |
| Grant Revenues            |       | 471                                  |       |     | N/A        |       |       | —   |       |
| Total Revenues            |       | $                                    | 26,373     |     |       | (0.1       | )%         |     | $          | 26,405 |   |

 

Net product sales of Oracea, Periostat, Pandel and theAtrix Products during the year ended December 31, 2006 were approximately$24.4 million. Net revenues from the sale of dermatology products were nearly70% of total revenue in 2006 compared to 31% in 2005, reflecting our transitionfrom a dental pharmaceutical company to a company focused on developing andmarketing prescription pharmaceutical products for the dermatology market. Thedecrease in net product sales was primarily due to lower Periostat net salesand the elimination of sales of United Research Laboratories, Inc./Mutual Pharmaceutical Company, Inc.,or Mutual’s, branded version of Periostat as a result of the launch of athird party generic competitor in May 2005, offset in part by net sales ofOracea following its market launch in July 2006.

Contract revenues duringthe year ended December 31, 2006, were derived primarily from ourPromotion and Cooperation Agreement with Primus for the Alcortin and Novacortproducts. The Promotion and Cooperation Agreement was executed inJune 2005; the increase in 2006 is attributable to having a full year ofsales. During the year ended December 31, 2005, contract revenues wereprimarily derived from residual contract revenue from our expired agreementwith Merck & Co., Inc. for Vioxx® and from our Promotion andCooperation Agreement with Primus for the Alcortin and Novacort products. Licenserevenues during each of the years ended December 31, 2006 and 2005consisted primarily of international licensing revenues for Periostat. Licenserevenues during the year ended December 31, 2005, included $132,000 inlicense revenue representing the unamortized portion of up front licensereceived in the year 2000 related to Periostat, which was terminated in March 2005.Grant revenues of $471,000 recognized during the year ended December 31,2006 represent reimbursements received during the year 

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from theNational Institutes of Health, or NIH, pursuant to the November 2005 grantrelated to our incyclinide development program.

**Cost of Product Sales**

| **Cost of Product Sales** | ** ** | ** **                           | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                               | ** ** | **(dollars in thousands)** | ** ** |
| Cost of Product  Sales                   |       | $                                    | 5,473      |     |       | (7.0       | )%         |     | $          | 5,885 |   |
| Percent of Net Product  Sales            |       | 22.4                                 | %          |     | N/A        |       |       | 22.9     | %          |
|                                          |            |                                      |            |          |            |            |            |          |            |  |  |  |  |

 

Cost of product sales includes product packaging,third party royalties, amortization of product licensing fees, costs associatedwith the manufacturing, storage and stability of Oracea, (in 2006), Periostat,and Mutual’s branded version of Periostat (in 2005), and the transfer price andstorage costs associated with our products, as well as charges taken to reflectdecreases in inventory carrying value.

Cost of product sales during the year ended December 31,2006, includes a charge of $257,000 associated with the write-down of excessand short dated inventories. Excluded from cost of product sales during theyear ended December 31, 2006 was approximately $700,000 of pre-FDAapproval Oracea manufacturing expenses.

Cost of product sales forthe year ended December 31, 2005 includes a charge of approximately $1.0million associated with the estimated excess inventories of Periostat andMutual’s branded version of Periostat as a result of the launch by a thirdparty generic competitor which occurred in May 2005.

**Research and Development**

| **Research and Development** | ** ** | ** **                           | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                             | ** ** | **(dollars in thousands)** | ** ** |
| Research and  development              |       | $                                    | 15,394     |     |       | 10.1       | %          |     | $          | 13,986 |   |
|                                        |            |                                      |            |          |            |            |            |          |            |  |  |  |  |

 

Research and development expenses consist primarily offunds paid to third parties for the provision of services and materials fordrug development, pre-FDA approval manufacturing and production costs relatedto Oracea, including milestone fees, manufacturing and formulationenhancements, clinical trials, purchased in-process research and development,statistical analysis report writing and regulatory compliance costs (includingnew drug approval submission and filing fees).

Significantdevelopment projects conducted during the year ended December 31, 2006included:

·       clinicaland manufacturing development activities for incyclinide of approximately $8.0 million;

·       clinicaland manufacturing activities (including pre-FDA approval production andvalidation costs) and regulatory compliance costs for Oracea of approximately$1.5 million;

·       variousPhase IV clinical trials and post approval studies related to Oracea ofapproximately $1.2 million; and

·       in-processresearch and development and manufacturing development costs related to COL-118of approximately $1.0 million.

Personnel and direct internal overhead expenses,including consulting and regulatory costs incurred during the year ended December 31,2006, were approximately $3.6 million.

We estimate that if incyclinide is developed to thepoint of commercialization for both acne and rosacea indications, theadditional formulation and clinical development expenses and milestone feesexpected to be incurred to product commercialization, would be between $15.0 millionand $20.0 million. 

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We are currentlyconducting formulation and stability work on products incorporating ourRestoraderm technology, and we are reviewing product options and the timetableassociated with clinical development or commercial launch. It is premature toestimate future development and clinical costs associated with COL-118. Weanticipate that our personnel and direct internal expenses will increase in2007 as we add additional clinical personnel. We discontinued all developmentwork on Periostat-MR following the launch of generic competition to Periostatin May 2005 and our decision to exit the dental business.

Significantdevelopment projects conducted during the year ended December 31, 2005included:

·       clinicaland manufacturing development work for Oracea of approximately $5.0 million;

·       clinicaland manufacturing development work for incyclinide of $3.1 million;

·       clinicaland manufacturing development and formulation work for Periostat-MR ofapproximately $1.3 million;

·       stabilitytesting and formulation costs for potential products utilizing our Restoradermtechnology, of approximately $1.1million; and

·       theinitial purchase price installment for SansRosa technology of $750,000.

Personnel and directinternal overhead expenses, including consulting and regulatory costs incurredduring the year ended December 31, 2005, were approximately $2.7 million.

**Selling, General and Administrative**

| **Selling, General and Administrative** | ** ** | ** **                           | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                                             | ** ** | **(dollars in thousands)** | ** ** |
| Selling, General  and Administrative                   |       | $                                    | 40,925     |     |       | 62.1       | %          |     | $          | 25,242 |   |
| Restructuring  charge                                  |       | —                               |       |     | N/A        |       |       | 1,184    |       |
| Total                                                  |       | $                                    | 40,925     |     |       | 54.9       | %          |     | $          | 26,426 |   |

 

Selling, general and administrative expenses consistprimarily of personnel salaries and benefits, including non-cash stock-basedcompensation expense in 2006, direct marketing costs, professional, legal andconsulting fees, insurance and general office expenses.

Significant components of selling, general andadministrative expenses incurred during the year ended December 31, 2006included approximately $15.7 million in direct selling and sales trainingexpenses, approximately $15.3 million in marketing expenses (includingadvertising and promotion expenditures for Oracea, the Primus products andPandel) and approximately $9.9 million in general and administrative expenses,which include business development, finance, legal and corporate activities. Significantcomponents of selling, general and administrative expenses incurred during theyear ended December 31, 2005 included approximately $10.4 million indirect selling and sales training expenses, approximately $7.7 million inmarketing expenses (including advertising and promotion expenditures forPeriostat, the Atrix Products, the Primus products and Pandel), andapproximately $7.1 million in general and administrative expenses, whichinclude business development, finance, legal and corporate activities. Theincrease in selling, general and administrative expense of approximately $15.7million during the year ended December 31, 2006 compared to the year endedDecember 31, 2005, was primarily due to $2.9 million of non-cashstock-based compensation expense, increased marketing costs of $7.1 millionprimarily associated with Oracea pre-launch and post-launch activities andincreased direct sales force and sales training costs related to Oracea ofapproximately $4.7 million and an increase in various general andadministrative costs of $1.0 million.

The restructuring chargeduring the year ended December 31, 2005 consisted of a $1.2 million chargerelated to a reorganization following the approval of a third party genericversion of Periostat. Of this 

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charge,$813,000 related to employee severance costs while the remaining portion wasprimarily related to the write-off of assets. As a result of the restructuring,we ceased all domestic sales activities related to Periostat and our dentalfranchise.

**Other Income/Expense**

| **Other Income/Expense** | ** ** | ** **                           | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                    | ** ** | **(dollars in thousands)** | ** ** |
| Interest income               |       | $                                    | 2,001      |     |       | 84.3       | %          |     | $          | 1,087 |   |
|                               |            |                                      |            |          |            |            |            |          |            |  |  |  |  |

 

The increase in interestincome was due to higher average short-term investment and cash equivalentbalances and corresponding yields in 2006 compared to 2005.

**Preferred StockDividend and Series D-1 Preferred Stock Restructuring and Exchange**

Preferred stock dividends included in net lossallocable to common stockholders were $1.9 million during the year ended December 31,2006 and $1.7 million during the year ended December 31, 2005. Suchpreferred stock dividends are paid in cash and are the result of ourobligations in connection with the issuance of our Series D Cumulative ConvertiblePreferred Stock, or the Series D Stock, in May 1999. On December 15,2005, we executed a Restructuring and Exchange Agreement with each of theholders of our outstanding Series D Stock, pursuant to which, among otherthings, the Series D stockholders agreed to effect an exchange, whereby weexchanged all 200,000 outstanding shares of our Series D Stock for 200,000shares of our Series CumulativeConvertible Preferred D-1 Stock, or the Series D-1Stock. In 2005, we also recorded a $3.7 million non-cash charge in connectionwith the Series D Stock Restructuring and Exchange Agreement.

Pursuant to the terms ofour Series D-1Stock, the holders of the Series D-1 Stock are entitled todividends payable in cash at a current rate of 10.0% per annum, which aredeclared and paid every six months. The annual dividend rate increases by 1.0%per annum on May 19, 2007 and each subsequent anniversary thereof untilthe earlier of the date that all of the shares of Series D-1 Stockare (i) converted into shares of common stock, or (ii) redeemed.

*Years Ended December 31,2005 and December 31, 2004*

**Revenues**

| **Revenues**      | ** ** | ** **                           | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|-------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **        | ** ** | **(dollars in thousands)** | ** ** |
| Net Product Sales |       | $                                    | 25,736     |     |       | (50.3      | )%         |     | $          | 51,739 |   |
| Contract Revenues |       | 481                                  |       |     | 103.0      | %          |       | 237      |       |
| License Revenues  |       | 188                                  |       |     | 10.6       | %          |       | 170      |       |
| Total             |       | $                                    | 26,405     |     |       | (49.4      | )%         |     | $          | 52,146 |   |

 

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Revenues during the yearended December 31, 2005 included approximately $25.7 million in netproduct sales of Periostat, Mutual’s branded version of Periostat, Pandel andthe Atrix Products. During 2005, we recorded $5.6 million in sales to Mutual. Thedecrease in 2005 net product sales was primarily due to lower Periostat netsales as a result of the launch of a third party generic competitor in May 2005.Based on data provided by a leading independent prescription tracking service,we estimate that Periostat’s share of the doxycycline market was 14% at December 31,2005. Contract revenues during the year ended December 31, 2005 werederived primarily from our Promotion and Cooperation Agreement with Primus andresidual contract revenues from our expired agreement with Merck & Co., Inc.,or Merck, for Vioxx. Licensing revenues during the year ended December 31,2005 consisted primarily of international licensing revenues for Periostat and$132,000 in license revenue representing the unamortized portion of upfrontlicense revenue received in 2000 from the License and Supply Agreement withShowa Yakuhin Kako Co., Ltd., which was terminated in March 2005. Duringthe year ended December 31, 2004, contract revenues were primarily derivedfrom residual contract revenues from our expired agreement with Merck andlicense revenues consisted primarily of international license fees forPeriostat, including the amortization of the Showa Yakuhin Kako Co., Ltd.license.

**Cost of Product Sales**

| **Cost of Product Sales** | ** ** | ** **                           | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                               | ** ** | **(dollars in thousands)** | ** ** |
| Cost of Product  Sales                   |       | $                                    | 5,885      |     |       | (21.0      | )%         |     | $          | 7,446 |   |
| Percent of Net Product  Sales            |       | 22.9                                 | %          |     | N/A        |       |       | 14.4     | %          |
|                                          |            |                                      |            |          |            |            |            |          |            |  |  |  |  |

 

Cost of product sales includes product packaging,third party royalties, amortization of product licensing fees, and the costsassociated with the manufacturing, storage and stability of Periostat, Mutual’sbranded version of Periostat, Pandel and the Atrix Products, as well as chargestaken to reflect decreases in inventory carrying value.

Cost of product sales forthe year ended December 31, 2005 included a charge of approximately$1.0 million associated with the estimated excess inventories of Periostatand Mutual’s branded version of Periostat as a result of the launch by a thirdparty generic competitor. Cost of product sales also increased as a percentageof net product sales as a result of lower average selling prices to Mutual, agreater absorption of fixed overhead expense over a smaller net sales base anda change in product mix during the year ended December 31, 2005 ascompared the year ended December 31, 2004.

**Research and Development**

| **Research and Development** | ** ** | ** **                           | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                             | ** ** | **(dollars in thousands)** | ** ** |
| Research and  development              |       | $                                    | 13,986     |     |       | 58.2       | %          |     | $          | 8,843 |   |
|                                        |            |                                      |            |          |            |            |            |          |            |  |  |  |  |

 

Research and development expenses consist primarily offunds paid to third parties for the provision of services and materials fordrug development, including milestone fees, manufacturing and formulationenhancements, clinical trials, purchased in-process research and development,statistical analysis and report writing and regulatory compliance costs(including a drug approval submission and filing fees).

Significantdevelopment projects conducted during the year ended December 31, 2005included:

·       continuingclinical and manufacturing development work for Oracea of approximately $5.0 million;

·       clinicaland manufacturing development work for incyclinide of $3.1 million;

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·       clinicaland manufacturing development and formulation work for Periostat-MR ofapproximately $1.3 million;

·       stabilitytesting and formulation costs for potential products utilizing our Restoradermtechnology of approximately $1.1million; and

·       theinitial purchase price installment for SansRosa technology of $750,000.

Personnel and direct internal overhead expenses, includingconsulting and regulatory costs incurred during the year ended December 31,2005, were approximately $2.7 million.

Significantdevelopment projects conducted during the year ended December 31, 2004included:

·       clinicaland manufacturing development work for Oracea of approximately $2.7 million;

·       clinicaland manufacturing development and formulation work for Periostat-MR, ofapproximately $2.2 million;

·       in-processresearch and development charges associated with developing our Restoradermtechnology, including milestone fees and formulation and stability testingcosts for two potential products, of approximately $868,000;

·       clinicaland manufacturing development work for incyclinide of $673,000; and

·       thecompletion of a Phase III clinical trial to evaluate Periostat for thetreatment of rosacea, which accounted for $417,000 in expense.

Personnel and directinternal overhead expenses, including consulting and regulatory costs incurredduring the year ended December 31, 2004 were approximately $2.0 million.

**Selling, General and Administrative**

| **Selling, General and Administrative** | ** ** | ** **                           | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                                             | ** ** | **(dollars in thousands)** | ** ** |
| Selling, General  and Administrative                   |       | $                                    | 25,242     |     |       | (14.2      | )%         |     | $          | 29,417 |   |
| Legal settlement                                       |       | —                               |       |     | N/A        |       |       | 2,000    |       |
| Restructuring  charge                                  |       | 1,184                                |       |     | 240.2      | %          |       | 348      |       |
| Total                                                  |       | $                                    | 26,426     |     |       | (16.8      | )%         |     | $          | 31,765 |   |

 

Selling, general and administrative expenses consistprimarily of personnel salaries and benefits, direct marketing costs,professional, legal and consulting fees, insurance and general office expenses.

Significant components of selling, general andadministrative expenses incurred during the year ended December 31, 2005included approximately $10.4 million in direct selling and sales trainingexpenses, approximately $7.7 million in marketing expenses (includingadvertising and promotion expenditures for Periostat, the Atrix Products, thePrimus products and Pandel) and approximately $7.1 million in general andadministrative expenses, which include business development, finance, legal andcorporate activities. Significant components of selling, general andadministrative expenses incurred during the year ended December 31, 2004included approximately $15.0 million in direct selling and sales trainingexpenses, approximately $7.5 million in marketing expenses (includingadvertising and promotion expenditures for Periostat, the Atrix Products andPandel), and approximately $6.9 million in general and administrative expenses,which include business development, finance, legal and corporate activities. Thedecrease in selling, general and administrative expenses during the year ended December 31,2005 compared to the year ended December 31, 2004 was primarilyattributable to decreased personnel costs as a result of the April 2004sales force restructuring and the May 2005 termination of our domesticdental sales and marketing activities and the corresponding reduction of 63employees, including our dental sales force.

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Legal settlement consisted of $2.0 million duringthe year ended December 31, 2004 that resulted from the accrual for apayment to Mutual in connection with the settlement of all outstandinglitigation between us and Mutual.

Restructuring chargesduring the year ended December 31, 2005 consisted of $1.2 million relatedto a reorganization following the approval of a third party generic version ofPeriostat in May of 2005. As aresult of the restructuring, we ceased all of our dental sales and marketingactivities, including the termination of 63 employees. Restructuring expenses during the yearended December 31, 2004 consistedof $348,000 that resulted from the April 2004 reorganization of our salesorganization into dedicated dental and dermatology sales forces. These chargesconsisted primarily of severance costs and the write-off of fixed assets. As ofDecember 31, 2005, we had paid all but $96,000 of such restructuringcharges, which related exclusively to the May 2005 restructuring.

**Gain on Sale ofU.K. and European Dental Assets**

During 2004, we sold ourU.K. and European dental assets to Alliance Pharma plc, a U.K. specialtypharmaceuticals company, for net pretax proceeds of approximately $3.0 million.A provision of $945,000 was made for anticipated U.K. income taxes due on thissale. In accordance with United States generally accepted accountingprinciples, the pretax gain on this sale of assets is included within operatingincome and the income tax provision is included within income taxes.

**Other Income/Expense**

| **Other Income/Expense** | ** ** | ** **                           | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                    | ** ** | **(dollars in thousands)** | ** ** |
| Interest income               |       | $                                    | 1,087      |     |       | 158.0      | %          |     | $          | 421 |   |
|                               |            |                                      |            |          |            |            |            |          |            |  |  |  |  |

 

The increase in interestincome was due primarily to higher average investment yields in 2005 comparedto 2004.

**Preferred StockDividend**

Preferred stock dividends included in net (loss)income allocable to common stockholders were $1.7 million during the yearended December 31, 2005 and $1.6 million during the year ended December 31,2004. Such preferred stock dividends were paid in cash and are the result ofour obligations in connection with the issuance of our Series D Stock in May 1999.

In 2005, we also recordeda $3.7 million non-cash charge in connection with the Series D StockRestructuring and Exchange Agreement as previously described.

**Liquidity andCapital Resources**

***Cash Requirements/Sources and Uses of Cash***

We require cash tofund our operating expenses, capital expenditures and dividend payments on ouroutstanding Series D-1 Stock. We have historically funded our cashrequirements primarily through the following:

·       Publicofferings and private placements of our preferred and common stock;

·       Cashflows from operations; and

·       Exerciseof stock options and warrants.

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Webelieve that other key factors that could affect our internal and externalsources of cash are:

·       Thecost of commercialization activities, including product marketing and sales;

·       Thesuccessful commercialization of Oracea and its acceptance by managed careorganizations and other third party payors;

·       Successfullyobtaining European Union approval of Oracea and in turn the success of MediGeneAG, our foreign marketing partner for Oracea, in commercializing Oracea in theEuropean Union;

·       Thesuccess of our dermatology franchise;

·       Thesuccess of our prosecution of the application Serial No. 10/757,656related to the use of chemically modified tetracyclines for the treatment ofacne and acne rosacea, including incyclinide;

·       Theissuance of U.S. Patent Application, Serial No. 10/117,709;

·       Receiptand maintenance of marketing approvals from the FDA and similar foreignregulatory authorities for our product candidates;

·       Thesuccess of our preclinical, clinical and development programs;

·       Revenuesand profits from sales of Oracea, Pandel, and Periostat, and our other productcandidates, as well as the products we co-promote;

·       Theterms and conditions of our outstanding Series D-1 Stock;

·       Ourability to continue to meet the covenant requirements under our amendedrevolving credit facility with Silicon Valley Bank, or SVB;

·       Thecosts involved in preparing, filing, prosecuting, maintaining and enforcingpatent claims and other patent-related costs, including potential litigationcosts and the results of such litigation;

·       Theextent to which we acquire or invest in businesses, products and technologies;

·       Thecosts involved in obtaining and maintaining regulatory approvals and clearancesrequired to market and sell our products; and

·       Thereceptivity of the capital markets to any future financings.

On December 18, 2006,we executed a Product License and Supply Agreement with MediGene AG, acorporation existing under the laws of Germany, for the marketing rights toOracea. Under the Product License and Supply Agreement, effective January 1,2007, MediGene receives the right to manufacture, register, market and sellOracea in the European Union, certain contiguous countries and Russia. Wereceived an upfront fee of $5.0 million less applicable withholding taxes ofapproximately $1.0 million, for which we expect to be reimbursed during2007, related to the execution of the agreement and are entitled to anadditional $7.5 million in milestone payments upon the achievement of certainannual sales thresholds. In addition, we will receive an agreed upon transferprice and a royalty of 12% of annual net sales up to $10 million and 15% ofannual net sales in excess of $10 million in the specified territories.

In October 2002, weannounced the execution of a license agreement with Medtronic, Inc.involving our IMPACS compounds, pursuant to which Medtronic obtained anexclusive, worldwide license to technology relating to the use of the compoundsto treat aortic aneurysms and other forms of vascular disease with medical devices.This program is still underway**.**In anamendment to the Medtronic License dated January 27, 2007, we agreed tonarrow the scope of Medtronic’s rights, to provide that the license may becomenon-exclusive if certain milestones are not timely met, and to accelerate thetiming of the first milestone payment of $250,000 so that it was payable as anadvance payment due upon execution of the amendment. Further milestone payments of $500,000 and $2,000,000, respectively,become due upon first human use and first commercial sale, of a productincorporating IMPACS technology. Medtronic must 

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also pay royalties based on a percentage of netsales of such a product. Neither we nor Medtronic have developed a timetablefor clinical development or commercial launch of any product.

In November 2006, weraised $42.5 million in a public offering, net of placement agency fees and allrelated offering expenses. In December 2005 and January 2006, weraised $11.6 million and $15.5 million, respectively, in a public offering, netof placement agency fees and all related offering expenses.

On May 31, 2006, weentered into a Fifth Loan Modification Agreement, or the ModificationAgreement, with SVB to amend and renew the Loan and Security Agreement betweenus and SVB dated March 19, 2001, as previously amended, or the LoanAgreement, which expired on May 31, 2006. Pursuant to the terms of theModification Agreement, among other things, (i) the expiration date ofamended credit facility was extended to May 31, 2007 and (ii) covenantsrequiring us to (A) maintain a Minimum Adjusted Quick Ratio, as definedtherein, and (B) maintain a minimum of $2.0 million in cash, net ofborrowings under the Loan Agreement, were eliminated. Under the amended creditfacility, we were permitted to borrow up to the lesser of $5.0 million or 80%of eligible receivables, as defined under the Loan Agreement. The amountavailable to us was reduced by any outstanding letters of credit issued underthe amended credit facility in amounts totaling up to $2.0 million. As we paiddown amounts under any letter of credit, the amount available to us under theamended credit facility increased.

On October 9, 2006,we entered into the Sixth Loan Modification Agreement, or the SubsequentModification Agreement with SVB to amend and renew the Loan Agreement. Pursuantto the terms of the Subsequent Modification Agreement, the expiration date ofamended credit facility has been extended to October 9, 2008. Under theamended credit facility, we may borrow up to the lesser of (i) $10.0million or (ii) 80% of eligible receivables plus certain specifiedamounts, subject to reduction during the period October 9, 2006 through December 31,2007. The amount available to us is reduced by any outstanding letters ofcredit that may be issued under the amended credit facility in amounts totalingup to $2.0 million. As we pay down amounts under any letter of credit, theamount available to us under the credit facility increases. We are notobligated to draw down any amounts under the amended credit facility and anyborrowings shall bear interest, payable monthly, at SVB’s prime rate. Under theSubsequent Modification Agreement, we are charged an unused line credit fee of0.25% per annum. In addition, under the amended credit facility, we are subjectto financial covenants that require us to maintain minimum liquidity andtangible net worth levels on a quarterly basis. No letters of credit wereoutstanding at December 31, 2006. We were not obligated to draw down anyamounts under the amended credit facility and any borrowings bear interest,payable monthly, at SVB’s prime rate, or 8.25%, at December 31, 2006. Underthe Subsequent Modification Agreement, we are charged an unused line credit feeof 0.25% per annum. We had no borrowings outstanding at December 31, 2006.

At December 31, 2006,we had cash, cash equivalents and short-term investments of approximately $65.8million compared to the approximately $44.4 million balance at December 31,2005. This increase is primarily a result of the proceeds from the publicoffering of 4,850,000 shares of our common stock, offset in part by net cashused in operating activities during the year ended December 31, 2006. Inaccordance with investment guidelines approved by our Board of Directors, cashbalances in excess of those required to fund operations have been invested ingovernment notes, commercial paper, certificates of deposit and money marketfunds. Our working capital at December 31, 2006 was $59.6 million comparedto $34.6 million at December 31, 2005. During the year ended December 31,2006, we invested approximately $439,000 in capital expenditures,$1.7 million in Oracea milestone fees, and $250,000 for in-processresearch and development, paid approximately $1.8 million in cash dividends tothe holders of our Series D-1 Stock and received proceeds ofapproximately $1.1 million (net of purchases) of short-term investments.

We anticipate that our (i) currentcash, cash equivalents and short-term investments at December 31, 2006, (ii) theavailability of funds from our line of credit with SVB and (iii) ourability to control variable spending, will be sufficient to fund our operationsthrough at least the end of 2007. In addition, we may 

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alsofinance our cash needs through public or private equity offerings, debtfinancings, corporate collaboration or licensing arrangements. However, thereis no assurance that these financing alternatives will be available onattractive terms, if at all, when needed or in amounts sufficient to fund ouroperations. Our forecast of the period of time through which our financialresources will be adequate to support our operations is a forward-lookingstatement that involves risks and uncertainties, and actual results could varymaterially.

***Cash Flows/CashManagement***

The principal use of cashin operating activities during the year ended December 31, 2006 was thepayment of operating expenses and related working capital liabilities. Cashflows from operations can vary significantly due to various factors includingthe level of revenues and collection of receivable therein, the timing ofpayments made to our vendors, vendor payment terms, customer mix and customerpayment terms.

Cash, cash equivalents andshort-term investments totaled $65.8 million, or 83% of total assets at December 31,2006, compared to $34.4 million, or 70% of total assets at December 31,2005. Net cash used by operating activities for the year ended December 31,2006 was $31.0 million, which includes a net loss of $33.4 million.

Investing activitiesduring the year ended December 31, 2006 consisted primarily of payments ofOracea related milestones of $1.7 million, net purchases, sales and maturitiesof short-term investments of $1.1 million, capital purchases of $439,000 and acquiredin-process research and development of $250,000. Financing activities duringthe year ended December 31, 2006 consisted primarily of the cash inflowsof $54.1 million from our December 2005 offering of 1,550,000 shares ofour common stock and our November 2006 offering of 3,500,000 shares of ourcommon stock, the exercise of common stock options, and the payment ofpreferred dividends to the holders of our Series D-1 Stock.

***ContractualObligations***

Our major outstanding contractual obligations relateto cash dividends on our outstanding Series D-1 Stock and operatingleases for our office space.

Belowis a table which presents our contractual obligations and commercialcommitments as of December 31, 2006:

| ** **                                         | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                   | ** ** | ** **                                | ** ** | **Total** | ** ** | **2007** | ** ** | **2008 and 2009** | ** ** | **2010 and 2011** | ** ** | **2012 and after** | ** ** |
| Capital Leases(1) (including  interest)            |       | $                                         | 277,265    |   | $ | 105,416 |   |   | $ | 171,849 |   |   |   | — |   |   |   | — |   |   |
| Operating Leases(2)                                |       | $                                         | 2,399,349  |   | $ | 954,881 |   |   | $ | 1,444,468 |   |   |   | — |   |   |   | — |   |   |
| Cash Dividends on  Series D-1 Preferred Stock |       | $                                         | 12,641,095 | (3) | $ | 2,128,219 | (3) |   | $ | 4,856,438 | (3) |   |   | $ | 5,656,438 | (3) |   |   | (3 | ) |   |
| Total Contractual Obligations                      |       | $                                         | 15,317,709 | (3) | $ | 3,188,516 |   |   | $ | 6,472,755 |   |   |   | $ | 5,656,438 |   |   |   | (3 | ) |   |
|                                                    |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          OnJuly 28, 2006, we entered into a three year capital lease for computerequipment.

(2)          Suchamounts primarily consist of minimum rental payments for our office lease inNewtown, Pennsylvania, payments for sales force equipment operating leases andpayments for leased vehicles in use by certain members of our sales force. In May 1999,we entered into a lease agreement relating to our office space in Newtown,Pennsylvania. The lease has an initial term of ten years. Rent is expected tobe approximately $420,000 per year. In January 2006, we entered into a leasefor commercial 

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vehicles to be usedby certain members of our sales force. The lease has a term of three years withannual payments of approximately $350,000.

(3)          Pursuantto the terms of our Series D-1 Stock, the holders of the Series D-1Stock are entitled to dividends payable in cash at a current rate of 10.0% perannum, which are declared and paid every six months. The annual dividend rateincreases by 1.0% per annum on May 19, 2007 and each subsequentanniversary thereof until the earlier of the date that all of the shares of Series D-1Stock are (i) converted into shares of common stock, or (ii) redeemed.

In January 1992 weentered into license with SUNY, for all of our IMPACS Technology, or the SUNYLicense and have subsequently amended the SUNY License twice. The SUNY Licensegrants us an exclusive worldwide license to make and sell products employingtetracyclines that are designed or utilized to alter a biological process. Inconsideration of the license granted to us, we: (i) issued to SUNY 78,948 shares of our common stock in 1992; and (ii) haveagreed to pay SUNY royalties on the net sales of licensed products, withminimum annual royalty payments of $50,000 per year. The term of the license isuntil the later of: (i) the expiration of the last to expire of thelicensed patents in each country; or (ii) November 18, 2018, at whichtime we have a fully paid, non-exclusive license. Our rights under the SUNYLicense are subject to certain statutory rights of the United States governmentresulting from federal support of research activities at SUNY. We are entitled to deduct costs incurred todefend SUNY patents from current and future royalties due to SUNY.   In the event that cumulative legal costsexceed the amount of the royalties’ payable to SUNY, the amount of such excessis accumulated to offset future royalties earned by SUNY, if any, on net salesof products based on the SUNY technology.

On June 10, 2002, weexecuted a Development and Licensing Agreement with Supernus Pharmaceuticals, Inc.,or pursuant to which we were granted an exclusive worldwide license (includingthe right to sublicense) to use Supernus technology and patents to developprescription products for the treatment of various inflammatory disorders.Under the agreement, certain product development functions will be performedfor us by Supernus. We have committed to pay Supernus milestone payments incash or, at our option, in a combination of cash and our common stock, upon theachievement of certain clinical and regulatory milestones. Through December 31,2006, the total milestone payments made to Supernus related to Oracea were $2.7million. For rosacea-indicated development, these future payments could totalup to $1.0 million in the aggregate and relate primarily to internationalapproval and international commercialization of Oracea. Under the agreement wemust also pay Supernus royalties based on a percentage of net sales of anyproducts utilizing any part of the licensed technology, including Oracea. Webegan making royalty payments to Supernus in the fourth quarter of 2006 as aresult of our July 2006 launch of Oracea.

On August 19, 2004,we executed an Asset Purchase and Product Development Agreement with respect toRestoraderm technology, or the Restoraderm Purchase Agreement. Under the termsof the Restoraderm Purchase Agreement, we purchased all right, title andinterest in the intellectual property and related rights to the Restoradermtopical drug delivery system, which we intend to develop for dermatologicalapplications. Pursuant to the terms of the Restoraderm Purchase Agreement, thepurchase price of the assets shall be up to $1.0 million, subject to theachievement of certain milestones. We may be required to pay certain productdevelopment milestone payments in the aggregate amount of up to approximately$2.0 million as well as royalty and sublicense fees upon productcommercialization.

On December 14, 2005,we executed a Share Purchase Agreement, the SansRosa Purchase Agreement, withSansRosa and all of the existing shareholders of SansRosa, or the SansRosaShareholders, pursuant to which we acquired 51% or 2,483,830 shares of theoutstanding shares of capital stock of SansRosa in exchange for a payment of$750,000. In 2006, we acquired additional shares of the outstanding stock inexchange for a payment of $100,000 which was offset by the payment to a thirdparty to acquire the related technology. Our total ownership in SansRosa at December 31,2006 is 61%. For accounting purposes, the 2005 SansRosa acquisition was treatedas the acquisition of in-process research 

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anddevelopment. The cost of the acquisition was charged to in-process research anddevelopment since the SansRosa technology has not achieved technicalfeasibility at this time. SansRosa is the assignee of certain patentapplications covering methods for treatment of redness associated with rosaceaand other skin disorders. Under the SansRosa Purchase Agreement, we have theright to purchase all of the remaining shares of SansRosa capital stock uponthe achievement of specified regulatory and development milestones. If allmilestones are achieved and a patented product is developed and approved forsale, we will pay the SansRosa Shareholders an additional $4.0 million to $6.0million. The agreement also provides for royalty payments to the SansRosaShareholders if future product sales incorporate the SansRosa technology.

We entered into change ofcontrol agreements, or the Existing Agreements, with each of the followingofficers, collectively referred to as the Officers: Colin W. Stewart (December 8,2003), Nancy C. Broadbent (September 18, 2002), David F. Pfeiffer (September 18,2002), Klaus Theobald (February 1, 2004), Andrew K. W. Powell (September 23,2004) and Greg Ford (August 9, 2004).

Under the ExistingAgreements, in the event the employment of an Officer was terminated as aresult of an Involuntary Termination within 24 months of a Change of Control,each as defined in the Existing Agreements, the Officers were entitled toreceive, among other things, (i) a lump sum payment of 1.5 times basesalary and 1.5 times the average bonus paid for the three fiscal years prior tothe Termination Date, as defined in the Existing Agreements, (ii) healthcoverage and benefits for a period of 24 months and (iii) certainoutplacement/administrative support for a period of 18 months. In addition,under the Existing Agreements, if a Change of Control occurred while Ms. Broadbentor Messrs. Stewart, Pfeiffer, Theobald, Powell or Ford was employed by us,regardless of whether their employment relationship with us continued followingsuch Change of Control, then all stock options granted to these individualsprior to the Change of Control would become fully vested and exercisable as ofthe date of the Change of Control to the extent such stock options wereoutstanding and unexercisable at the time of such termination.

On October 16, 2006,we entered into a new change of control agreement with Mr. Stewart, or theStewart Agreement, and a new form of change of control agreement with each ofthe remaining Officers, such form referred to as the Management Agreement,together with the Stewart Agreement, the Agreements, which Agreements supersedethe Existing Agreements.

The Agreements contain theabove-described provisions of the Existing Agreements, except that, in theevent the employment of an Officer is terminated as a result of an InvoluntaryTermination within 24 months of a Change of Control (i) the StewartAgreement provides that the lump sum payment will be 2.5 times base salary and2.5 times the average bonus paid for the three fiscal years prior to theTermination Date and (ii) the form of Management Agreement provides thatthe lump sum payment will be 2 times base salary and 2 times the average bonuspaid for the three fiscal years prior to the Termination Date.

In addition, each of theAgreements provides for an additional payment if the Officer would be subjectto an excise tax, interest or penalty based on a payment provided for in theapplicable Agreement.

**Critical Accounting Policies and Estimates**

Management’s discussionand analysis of its financial position and results of operations are based uponour consolidated financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States of America. Thepreparation of these financial statements requires management to make judgmentsand estimates that affect the reported amounts of assets, liabilities, revenuesand expenses and related disclosure of contingent assets and liabilities. Managementbelieves the critical accounting policies and areas that require the mostsignificant judgments and estimates to be used in the preparation of theconsolidated financial statements pertain to revenue recognition, stock compensationand the valuation of deferred taxes, intangible assets and inventory.

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***Revenue Recognition***

We generally recognizerevenues for product sales upon shipment to wholesale customers, net ofestimated returns and estimates for chargebacks, applicable wholesaledistribution fees and rebates provided that collection was probable and nosignificant obligations remained. Following the launch of a third party genericcompetitor to Periostat in May 2005 and commencing with the second quarterof 2005, we began recognizing Periostat sales revenue based on product sales toend-users, which are estimated using prescription dispensing data generated byan independent prescription tracking service. While we do not independentlyverify the prescription dispensing data, we do analyze shipments and estimatesof channel inventory to determined if the prescription dispensing data is consistentwith our records. The launch of generic competition to Periostat resulted inincreased product returns from the wholesale and retail channels. As of December 31,2006, we have a liability of $612,000 for potential Periostat product returnsin accrued expenses on the Consolidated Balance Sheet for estimated returnsprior to the change to a prescription based revenue recognition model.

For new product launchesour policy is to recognize revenue on a net prescription value basis usingdispensing data generated by an independent prescription tracking service untiltrade channel inventories are reduced to targeted stocking levels and we havesufficient data to determine product acceptance in the marketplace which willenable us to estimate product returns based on historical data of Periostat andsimilar products. Net prescription value is calculated by deducting estimatesfor chargebacks, wholesale distribution fees, patient rebates, governmentrebates and any other launch discounts offered from the applicable gross salesvalue. When inventories have been reduced to target wholesale and retail levelsand we have the ability to estimate product returns, we recognize product salesupon shipment, net of discounts, returns and allowances. During the fourthquarter of 2006, based on sales levels and prescription data related to thefourth quarter of 2006 and the number of units on hand in the pipeline relativeto overall demand for the product, we determined that Oracea inventories withour customers had reached normal targeted levels. At such time, we beganrecognizing Oracea revenues on a shipment basis, net applicable discounts andallowances. Oracea revenues for the year ended December 31, 2006, reflectrevenue recognition on a shipment basis, net of applicable discounts andallowances as the Company recognized, in the fourth quarter of 2006,approximately $2,800,000 in previously deferred Oracea revenues from the thirdquarter of 2006.

As described above, werecord sales discounts, allowances and returns upon recognizing product sales.We only accept unopened returns of damaged or expired products. The returnallowance, when estimatable, is based on an analysis of the historical returnsof the product and similar products and we consider current end user demand andwholesale and retail inventory levels. If product returns are not estimatable,we defer revenue recognition for all outstanding products in the wholesale andretail channel that is subject to return. Pursuant to an agreement with onemajor customer, product returns are not permitted. Chargebacks, wholesaledistribution fees and rebates are based on an analysis of the applicableagreements and historical experience. In addition, we also consider the volumeand price of the product in the channel, trends in wholesaler and retailerinventory levels, conditions that might affect end-user demand (such as genericcompetition) and other relevant factors.

During the third quarterof 2006, we launched Oracea to the U.S. dermatology community. As part of suchlaunch, we introduced a patient rebate program for Oracea prescriptions. Onlypatients presenting the computer-coded card to their pharmacists were entitledto receive the rebate. In accordance with Emerging Issues Task Force Issue No. 01-09,*“Accounting for Consideration Given by a Vendor toa Customer”*, we have accounted for these patient rebates as a reductionof net product sales on our Consolidated Statements of Operations for the yearended December 31, 2006.

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***Deferred Taxes***

In assessing therealizability of deferred tax assets, we consider the likelihood that part orall of the deferred tax assets will not be realized. This assessment requiressignificant judgment and estimates. The ultimate realization of the deferredtax assets is dependent upon the generation of future taxable income during theperiod in which those temporary differences become deductible. We consider ourhistory of losses, scheduled reversal of deferred tax assets and liabilities,deferred tax planning strategies, if any, and projected future taxable incomeover the periods in which the deferred tax asset items are deductible. The TaxReform Act of 1986 contains provisions that may limit the net operating lossand research and experimentation credit carryforwards available to be used inany given year upon the occurrence of certain events, including significantchanges in ownership interest. We have incurred a net loss for the years ended December 31,2006 and 2005, and uncertainty regarding our future profitability has preventedus from reaching the “more likely than not” conclusion required under theapplicable literature to recognize deferred tax assets on our ConsolidatedBalance Sheet.

***Intangible Assets***

Acquired product rightsand Oracea milestone fees are stated at cost, amortized over the shorter of theestimated useful life of the products or the contract term under which suchrights have been licensed, using the straight-line method. Amortization ofacquired product rights and Oracea milestone fees are charged to cost ofproduct sales.

We are required to testfor asset impairment of acquired product rights and Oracea milestone feeswhenever events or circumstances indicate that the carrying value of an assetmay not be recoverable. We apply Statement of Financial Accounting Standards,or SFAS No. 144, “*Accounting for theImpairment or Disposal of Long-Lived Assets*,” in order to determinewhether or not an asset is impaired. This standard requires an impairmentanalysis when indicators of impairment are present. When such indicators arepresent, the standard indicates that if the sum of the future expected cashflows from the asset, undiscounted and without interest charges, are less thanthe carrying value, an asset impairment must be recognized in the financialstatements. The amount of the impairment is the difference between the fairvalue of the asset and the carrying value of the asset.

In making future cash flowanalyses of our intangible assets we make assumptions relating to:  (i) the intended use of the product andthe expected future cash flows resulting directly from such use; (ii) genericcompetitor activities and regulatory initiatives that affect our products; and (iii) customerpreferences and expected managed care reimbursement.

***Inventories***

Inventory carrying valuesare evaluated periodically and consider the saleable quantities of inventoryversus quantities of inventory on-hand.

During the year ended December 31,2006, we recorded write-downs of $257,000 for excess and short-dated inventory.During the year ended December 31, 2005, we recorded a charge of $1.0million for the excess inventory of Periostat and Mutual’s branded version ofPeriostat due to the anticipated decreased demand following the introduction ofa third party generic version of Periostat that occurred in May 2005.

We classify directmanufacturing costs relating to inventory and samples manufactured in advanceof a new product launch as research and development expense until such time aswe receive an approval letter from the FDA for a new product. Following FDAapproval of the product, we capitalize any inventory costs relating to thatproduct that were not previously expensed.

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***Stock-BasedCompensation***

As part of our adoption ofSFAS No. 123 (revised 2004), “Share-Based Payment,” or SFAS No. 123R,as of January 1, 2006, we recognized the fair value of stock-basedcompensation awards in our consolidated financial statements using the modifiedprospective method. We apply the Black-Scholes option pricing model todetermine the fair value of stock options on the date of grant, and we estimatekey assumptions that are important elements in the model, such as the expectedstock-price volatility and expected stock option life. Our estimates of theseimportant assumptions and expected forfeiture rates are based on historicaldata and judgment regarding market trends and factors. These estimates are notintended to predict actual future events or the value ultimately realized byindividuals who receive equity awards.

Critical accountingestimates and the related assumptions are evaluated periodically as conditionswarrant, and changes to such estimates are recorded as new information orchanged conditions require revision.

***Recently IssuedAccounting Pronouncements***

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No. 108,“*Considering the Effects of Prior Year Misstatementswhen Quantifying Financial Misstatements in Current Year Financial Statements*,”which expresses the Staff’s views regarding the process of quantifyingfinancial statement misstatements. Companies are required to quantify theimpact of correcting all misstatements, including both the carryover andreversing effects of prior year misstatements, on the current year financialstatements. The techniques most commonly used in practice to accumulate andquantify misstatements are generally referred to as the “rollover” (currentyear income statement perspective) and “iron curtain” (year-end balance sheet perspective)approaches. The financial statements would require adjustment when eitherapproach results in quantifying a misstatement that is material, afterconsidering all relevant quantitative and qualitative factors. At the effectivedate of adoption (January 1, 2006 for us), the misstatements considered immaterialunder a registrant’s previous method of quantifying misstatements but materialunder SAB 108 may be corrected as an accounting change by adjustingopening retained earnings rather than being included in the current yearstatement of operations. The adoption of SAB No. 108 did not have animpact on our consolidated financial statements.

In June 2006, theFinancial Accounting Standards Board, or the FASB, issued Interpretation No. 48,“*Accounting for Uncertainty in Income Taxes—AnInterpretation of FASB Statement No. 109*,” or FIN 48. FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements and prescribes a threshold ofmore-likely-than-not for recognition of tax benefits of uncertain tax positionstaken or expected to be taken in a tax return. FIN 48 also provides relatedguidance on measurement, derecognition, classification, interest and penalties,and disclosure. Differences between the amounts recognized in the financialstatements prior to the adoption of FIN 48 and the amounts reported after adoptionwill be accounted for as a cumulative-effect adjustment recorded to thebeginning balance of retained earnings.

As required, we will adoptFIN 48 on January 1, 2007. Prior to the adoption of FIN 48, our policy wasto recognize tax benefits of uncertain tax positions only if it was probablethat the position would be sustained. Accordingly, we anticipate that certainaccrued expenses for uncertain tax positions will be reversed upon adoption ofFIN 48 due to the lower recognition threshold. Based on our analysis, weestimate that accrued expenses will decrease in the amount of $945,000 andretained earnings will increase by the same amount as of January 1, 2007as a result of the adoption in FIN 48.

In November 2005, theFASB issued FASB Staff Position SFAS 123(R)-3, *TransitionElection Related to Accounting for the Tax Effects of Share-based PaymentAwards,* or SFAS No. 123(R)-3, that provides an electivealternative transition method of calculating the pool of excess tax benefitsavailable to absorb tax deficiencies recognized subsequent to the adoption ofSFAS No. 123R to the method otherwise required 

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byparagraph 81 of SFAS No. 123R. The adoption of SFAS No. 123(R)-3 didnot have an impact on our consolidated finanical statements.

In September 2006,the FASB issued SFAS No. 157, “*FairValue Measurements*”, or SFAS 157. SFAS 157 clarifies thedefinition of fair value, establishes a framework for measuring fair value andexpands the disclosures on fair value measurements. SFAS 157 is effective forus beginning January 1, 2008. We are currently evaluating the impact ofSFAS 157 adoption on our consolidated financial statements.

**Item 7A.**                Quantitativeand Qualitative Disclosures about Market Risk

We had cash and cashequivalents and short-term investments at December 31, 2006 which areexposed to the impact of interest rate changes and our interest incomefluctuates as interest rates change. Due to the short-term nature of ourinvestments in money market funds, the carrying values of our cash equivalentsapproximate their fair value at December 31, 2006. Our short-terminvestments in commercial paper, certificates of deposit and government notesare carried at fair value.

The carrying amount, whichapproximates fair value, and the annualized weighted average nominal interestrate of our short-term investment portfolio at December 31, 2006, wasapproximately $19.3 million and 4.8%, respectively. A one percent change in theinterest rate would have resulted in a $478,000 impact to interest income forthe year ended December 31, 2006.

**Item8.**                        FinancialStatements and Supplementary Data

The financial statementsand supplementary data required to be filed pursuant to this Item 8 areappended to this Annual Report on Form 10-K. A list of the financialstatements and financial statement schedules filed herewith is found at “Item15. Exhibits and Financial Statement Schedules.”

**Item9.**                        Changes inand Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable.

**Item9A.**                Controls andProcedures

**1.**                 DisclosureControls and Procedures

Our management, with theparticipation of our chief executive officer and chief financial officer,evaluated the effectiveness of our disclosure controls and procedures as of December 31,2006. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, means controlsand other procedures of a company that are designed to ensure that informationrequired to be disclosed by a company in the reports that it files or submitsunder the Securities Exchange Act of 1934 is recorded, processed, summarizedand reported, within the time periods specified in the SEC’s rules andforms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed bya company in the reports that it files or submits under the Securities ExchangeAct of 1934 is accumulated and communicated to the company’s management,including its principal executive and principal financial officers, asappropriate to allow timely decisions regarding required disclosure. Ourmanagement recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving theirobjectives and management necessarily applies its judgment in evaluating thecost-benefit relationship of possible controls and procedures. Based on thisevaluation, our chief executive officer and chief financial officer concludedthat, as of December 31, 2006, our disclosure controls and procedures wereeffective at the reasonable assurance level.

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**2.**                  InternalControls over Financial Reporting

(a)   Management’s Annual Report on Internal Control over FinancialReporting

The management ofCollaGenex is responsible for establishing and maintaining adequate internalcontrol over financial reporting. Internal control over financial reporting isdefined in Rule 13a-15(f) or 15d-15(f) promulgatedunder the Securities Exchange Act of 1934 as a process designed by, or underthe supervision of, the company’s principal executive and principal financialofficers and effected by the company’s board of directors, management and otherpersonnel, to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles andincludes those policies and procedures that:

·       Pertainto the maintenance of records that in reasonable detail accurately and fairlyreflect the transactions and dispositions of the assets of the company;

·       Providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and

·       Providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Projections of any evaluation of effectiveness to futureperiods are subject to the risk that controls may become inadequate because ofchanges in conditions, or that the degree of compliance with the policies orprocedures may deteriorate.

CollaGenex’ management,including the supervision and participation of the Chief Executive Officer andChief Financial Officer, assessed the effectiveness of the Company’s internalcontrol over financial reporting as of December 31, 2006. In making thisassessment, the Company’s management used the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) in“Internal Control - Integrated Framework.”

Based on our assessment,management has concluded that, as of December 31, 2006, the Company’sinternal control over financial reporting is effective based on those criteria.

The Company’sindependent registered public accounting firm has issued its report on ourassessment and the effectiveness of the Company’s internal control overfinancial reporting. This report appears below.

(b)   Report of the Independent Registered Public Accounting Firm

**Report of Independent RegisteredPublic Accounting Firm**

The Board of Directors and StockholdersCollaGenex Pharmaceuticals, Inc.:

We have audited management’s assessment, included inthe accompanying Management’s Annual Report on Internal Control over FinancialReporting**that CollaGenexPharmaceuticals, Inc. maintained effective internal control over financialreporting as of December 31, 2006, based on criteria established inInternal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). CollaGenex Pharmaceuticals, Inc.’smanagement is responsible for 

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maintaining effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment thatCollaGenex Pharmaceuticals, Inc. maintained effective internal controlover financial reporting as of December 31, 2006, is fairly stated, in allmaterial respects, based on criteria established in Internal Control—IntegratedFramework issued by COSO. Also, in our opinion, CollaGenex Pharmaceuticals, Inc.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by COSO.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of CollaGenex Pharmaceuticals, Inc.and**subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2006, and the related financial statementschedule, and our report dated March 15, 2007**expressed an unqualified opinion on those consolidatedfinancial statements and related schedule.

/s/  KPMG LLP

Philadelphia, PennsylvaniaMarch 15, 2007

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(c)   Changes inInternal Control over Financial Reporting

No change in our internalcontrol over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred during the fiscal quarterended as of December 31, 2006 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

**Item 9B.**               OtherInformation

Not applicable.

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**PART III**

**Item10.**                 Directors,Executive Officers and Corporate Governance of the Registrant.

The information relating to our directors, nomineesfor election as directors, executive officers and audit committee under theheadings “Election of Directors”, “Executive Officers”, “Section 16(a) BeneficialOwnership Reporting Compliance” and “Corporate Governance” in our definitiveproxy statement for the 2007 Annual Meeting of Stockholders is incorporatedherein by reference to such proxy statement.

We have adopted a writtencode of business conduct and ethics that applies to our directors, officers andemployees, including our principal executive officer, principal financialofficer, principal accounting officer or controller, or persons performingsimilar functions. We make available our code of business conduct and ethicsfree of charge through our website which is located at *www.collagenex.com*. We intend to discloseany amendments to, or waivers from, our code of business conduct and ethicsthat are required to be publicly disclosed pursuant to rules of theSecurities and Exchange Commission and the Nasdaq Stock Market by filing suchamendment or waiver with the Securities and Exchange Commission and by postingit on our website.

**Item11.**                 ExecutiveCompensation.

The discussion under theheading “Executive Compensation” in our definitive proxy statement for the 2007Annual Meeting of Stockholders is incorporated herein by reference to suchproxy statement. The information specified in Item 407(e)(5) of RegulationS-K and set forth in our definitive proxy statement for the 2007 Annual Meetingof Stockholders is not incorporated by reference.

**Item12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.

The discussion under theheading “Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters” in our definitive proxy statement for the 2007Annual Meeting of Stockholders is incorporated herein by reference to suchproxy statement.

**Item13.**                 CertainRelationships and Related Transactions, and Director Independence.

The discussion under theheadings “Certain Relationships and Related Transactions” and “CorporateGovernance” in our definitive proxy statement for the 2007 Annual Meeting ofStockholders is incorporated herein by reference to such proxy statement.

**Item14.**                 PrincipalAccountant Fees and Services.

The discussion under theheading “Auditors’ Fees” in our definitive proxy statement for the 2007 AnnualMeeting of Stockholders is incorporated herein by reference to such proxystatement.

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**PART IV**

**Item15.**                 Exhibits andFinancial Statement Schedules

(a)           (1)   Financial Statements.

Reference is made to theIndex to Consolidated Financial Statements and Schedule on Page F-1.

(2)   Financial Statement Schedule.

Reference is made to theIndex to Consolidated Financial Statements and Schedule on Page F-36.

(3)   Exhibits.

Reference is made to the Index to Exhibits on Page 54.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned; thereunto duly authorized this 16th day of March,2007.

|        | COLLAGENEX PHARMACEUTICALS, INC. |
|--------|----------------------------------|
|   | By:                              | /s/ COLIN W. STEWART |
|   |                             | Colin W. Stewart, Chief Executive Officer and |
|   |                             | President |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

|                                    | **Signature** | ** **                                    | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|------------------------------------|---------------|-----------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/ COLIN W. STEWART               |          | President, Chief  Executive Officer           |       | March 16,  2007 |
| Colin W. Stewart                   |          | and Director (Principal  Executive Officer)   |       |                 |
| /s/ NANCY C. BROADBENT             |          | Chief Financial  Officer and Treasurer        |       | March 16,  2007 |
| Nancy C. Broadbent                 |          | (Principal Financial and  Accounting Officer) |       |                 |
| /s/ PETER R. BARNETT, D.M.D.       |          | Director                                      |       | March 16,  2007 |
| Peter R. Barnett, D.M.D.           |          |                                          |       |                 |
| /s/ ROBERT C. BLACK                |          | Director                                      |       | March 13,  2007 |
| Robert C. Black                    |          |                                          |       |                 |
| /s/ JAMES E. DAVERMAN              |          | Chairman of the  Board and Director           |       | March 16,  2007 |
| James E. Daverman                  |          |                                          |       |                 |
| /s/ ROBERT J. EASTON               |          | Director                                      |       | March 16,  2007 |
| Robert J. Easton                   |          |                                          |       |                 |
| /s/ ROBERT A. BEARDSLEY, PH.D.     |          | Director                                      |       | March 14,  2007 |
| Robert A. Beardsley,  Ph.D.        |          |                                          |       |                 |
|                               |          | Director                                      |       |                 |
| W. James O’Shea               |          |                                          |       |                 |
|                               |          | Director                                      |       |                 |
| George M. Lasezkay, Pharm.D., J.D. |          |                                          |       |                 |

 

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**COLLAGENEX PHARMACEUTICALS, INC.FORM 10-K EXHIBIT INDEX**

| ** **                                                 | ** ** | ** **                                                                                                                                                                                                  | ** ** | **Incorporated by Reference to** | ** ** | ** **                 | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|----------------------------|------------|
| **Exhibit   No.**                                          | ** ** | **Description**                                                                                                                                                                                             | ** ** | **Form and   SEC File No.**      | ** ** | **SEC   Filing Date** | ** ** | **Exhibit   No.** | ** ** | **Filed with   this 10-K** | ** ** |
| ***Articles  of Incorporation and By-Laws***               |       |                                                                                                                                                                                                        |       |                                            |       |                       |       |   |   |   |   |
| 3.1                                                        |       | Amended and Restated  Certificate of Incorporation                                                                                                                                                          |       | S-1  (333-03582)                                |       | Effective  6-20-1996       |       |   | 3.1 |   |   |   |   |
| 3.2                                                        |       | Amended and Restated  By-Laws                                                                                                                                                                               |       | 10-Q  (000-28308)                               |       | 11-14-2002                 |       |   | 3.1 |   |   |   |   |
| 3.3                                                        |       | Amended Certificate of  Designation, Preferences and Rights of the Series D Cumulative  Convertible Preferred Stock, dated as of October 15, 2001                                                 |       | 8-K  (000-28308)                                |       | 10-18-2001                 |       |   | 4.1 |   |   |   |   |
| 3.4                                                        |       | Amended Certificate of  Designation of Series A Participating Preferred Stock, as filed with the  Secretary of State of the State of Delaware on June 5, 2002                                     |       | 8-K  (000-28308)                                |       | 6-5-2002                   |       |   | 4.2 |   |   |   |   |
| 3.5                                                        |       | Certificate of  Designation, Preferences and Rights of the Series D-1 Cumulative  Convertible Preferred Stock                                                                                          |       | 8-K  (000-28308)                                |       | 12-19-2005                 |       |   | 3.1 |   |   |   |   |
| ***Instruments  Defining the Rights of Security Holders*** |       |                                                                                                                                                                                                        |       |                                            |       |                       |       |   |   |   |   |
| 4.1                                                        |       | Specimen certificate  evidencing shares of common stock, par value $.01 per share                                                                                                                           |       | 10-K  (000-28308)                               |       | 3-16-06                    |       |   | 4.1 |   |   |   |   |
| 4.2                                                        |       | Registration Rights  Agreement, dated September 29, 1995, by and among the Company and  certain investors, as supplemented                                                                             |       | S-1  (333-03582)                                |       | Effective  6-20-1996       |       |   | 4.1 |   |   |   |   |
| 4.3                                                        |       | Fourth Investment  Agreement as of September 29, 1995 by and among the Company and certain  investors                                                                                                  |       | S-1  (333-03582)                                |       | Effective  6-20-1996       |       |   | 4.3 |   |   |   |   |
| 4.4                                                        |       | Amended and Restated  Shareholder Protection Rights Agreement, dated as of May 29, 2002, by  and between the Company and American Stock Transfer & Trust Company                              |       | 8-K  (000-28308)                                |       | 6-5-2002                   |       |   | 4.1 |   |   |   |   |
| 4.5                                                        |       | Stockholders and  Registration Rights Agreement, dated March 19, 1999, by and among the  Company, OCM Principal Opportunities Fund, L.P. and the Purchasers set forth  therein                         |       | 8-K  (000-28308)                                |       | 5-26-1999                  |       |   | 10.2 |   |   |   |   |
| 4.6                                                        |       | Amendment No. 1 to  Stockholders and Registration Rights Agreement, dated March 19, 1999, by  and among the Company, OCM Principal Opportunities Fund, L.P. and the  Purchasers set forth therein |       | 8-K  (000-28308)                                |       | 10-18-2001                 |       |   | 10.1 |   |   |   |   |

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| 4.7                                                                            |   | Amendment No. 2 to  Stockholders and Registration Rights Agreement, dated March 19, 1999, by  and among the Company, OCM Principal Opportunities Fund, L.P. and the  Purchasers set forth therein                                                        |   | 8-K  (000-28308)                       |   | 10-18-2001          |   |   | 10.2         |   |   |   |   |
|--------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|---------------------|--------|--------|--------------|--------|--------|--------|--------|
| 4.8                                                                            |   | Restructuring and  Exchange Agreement, dated December 15, 2005, by and among the Company  and the Holders of Outstanding Series D Cumulative Convertible Preferred  Stock                                                                                |   | 8-K  (000-28308)                       |   | 12-19-2005          |   |   | 10.1         |   |   |   |   |
| ***Material  Contracts—Stock Purchase, Financing and Credit Agreements*** |   |                                                                                                                                                                                                                                                               |   |                                   |   |                |   |   |         |
| 10.1                                                                           |   | Stock Purchase Agreement  dated March 19, 1999, between OCM Principal Opportunities Fund, L.P. and  other Purchasers set forth therein                                                                                                                        |   | 8-K  (000-28308)                       |   | 3-25-1999           |   |   | 10.3         |   |   |   |   |
| 10.2                                                                           |   | Common Stock Purchase  Agreement, dated February 14, 2002, by and between the Company and  Kingsbridge Capital Limited                                                                                                                                        |   | 8-K  (000-28308)                       |   | 2-15-2002           |   |   | 10.1         |   |   |   |   |
| 10.3                                                                           |   | Warrant dated  February 14, 2002 issued to Kingsbridge Capital Limited                                                                                                                                                                                        |   | 8-K  (000-28308)                       |   | 2-15-2002           |   |   | 10.2         |   |   |   |   |
| 10.4                                                                           |   | Form of Common  Stock Purchase Agreement dated March 12, 2001, between the Company and  the Investors set forth therein, together with Form of Registration  Rights Agreement as an exhibit thereto and Form of Warrant as an exhibit  thereto |   | 8-K  (000-28308)                       |   | 3-16-2001           |   |   | 10.1         |   |   |   |   |
| 10.5†                                                                     |   | Share Purchase  Agreement, dated December 14, 2005, by and among SansRosa Pharmaceutical  Development, Inc. and each of the shareholders of SansRosa  Pharmaceutical Development, Inc.                                                              |   | 10-K  (000-28308)                      |   | 3-16-06             |   |   | 10.5         |   |   |   |   |
| 10.6                                                                           |   | Loan and Security  Agreement, dated May 19, 2001, between the Company and Silicon Valley  Bank                                                                                                                                                                |   | 10-K  (000-28308)  10-K/A  (000-28308) |   | 3-26-2001  1-2-2002 |   |   | 10.24  10.24 |   |   |   |   |
| 10.7                                                                           |   | First Loan Modification  Agreement, dated as of March 22, 2002, by and between the Company and  Silicon Valley Bank                                                                                                                                           |   | 10-Q  (000-28308)                      |   | 5-15-2002           |   |   | 10.4         |   |   |   |   |
| 10.8                                                                           |   | Second Loan Modification  Agreement, dated as of March 27, 2002, between the Company and Silicon  Valley Bank                                                                                                                                                 |   | 10-Q  (000-28308)                      |   | 5-15-2002           |   |   | 10.5         |   |   |   |   |
| 10.9                                                                           |   | Fourth Loan Modification  Agreement, dated June 7, 2004, by and between the Company and Silicon  Valley Bank                                                                                                                                                  |   | 8-K  (000-28308)                       |   | 6-7-2004            |   |   | 10.1         |   |   |   |   |
| 10.10                                                                          |   | Fifth Loan Modification  Agreement, dated May 31, 2006, by and between the Company and Silicon  Valley Bank                                                                                                                                                   |   | 8-K  (000-28308)                       |   | 6-6-06              |   |   | 10.1         |   |   |   |   |

55

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| 10.11                                                        |   | Sixth Loan Modification  Agreement, dated October 9, 2006, by and between the Company and Silicon  Valley Bank                                                                                                                |   | 8-K  (000-28308)                       |   | 10-12-06              |   |   | 10.1       |   |   |   |   |
|--------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|-----------------------|--------|--------|------------|--------|--------|--------|--------|
| ***Material  Contracts—Supply, License, Distribution*** |   |                                                                                                                                                                                                                               |   |                                   |   |                  |   |   |       |   |   |
| 10.12†                                                  |   | Assignment of Amendment  to and Restatement of Agreement, dated January 13, 1992 by and among the  Company, Johnson & Johnson Consumer Products, Inc. and Research  Foundation of State University of New York  |   | S-1  (333-03852)                       |   | Effective  6-20-1996  |   |   | 10.1       |   |   |   |   |
| 10.13†                                                  |   | Supply Agreement, dated  January 23, 1995, between the Company and Hovione International Limited                                                                                                                              |   | S-1  (333-03852)                       |   | Effective  6-20-1996  |   |   | 10.2       |   |   |   |   |
| 10.14†                                                  |   | First Addendum dated  December 10, 2001, to the Supply Agreement, dated January 23, 1995,  between the Company and Hovione International Limited                                                                         |   | 8-K  (000-28308)                       |   | 12-10-2001            |   |   | 10.1       |   |   |   |   |
| 10.15                                                        |   | Form of Material  Transfer Agreement between the Company and Researchers                                                                                                                                                      |   | S-1  (333-03582)                       |   | Effective  6-20-1996  |   |   | 10.9       |   |   |   |   |
| 10.16†                                                  |   | Distribution Services  Agreement, dated August 15, 1998, between the Company and Cord  Logistics, Inc. (now known as Cardinal Health Specialty Pharmaceutical  Services)                                                 |   | 10-Q  (000-28308)                      |   | 11-16-1998            |   |   | 10.4       |   |   |   |   |
| 10.17†                                                  |   | Exclusive Distribution  Agreement, dated as of March 1, 2002, by and between the Company and  Cord Logistics, Inc. (now known as Cardinal Health Specialty  Pharmaceutical Services)                                     |   | 10-Q  (000-28308)                      |   | 5-15-2002             |   |   | 10.3       |   |   |   |   |
| 10.18                                                        |   | Services and Supply  Agreement, dated as of September 26, 2000, as amended by Letter  Agreement, dated as of December 1, 2000, by and between the Company and  Pharmaceutical Manufacturing Research Services, Inc. |   | 10-Q  (000-28308)                      |   | 5-15-2001             |   |   | 10.1       |   |   |   |   |
| 10.19                                                        |   | Letter Agreement, dated  as of June 26, 2001, by and between the Company and Pharmaceutical  Manufacturing Research Services, Inc.                                                                                       |   | 10-Q  (000-28308)                      |   | 8-14-2001             |   |   | 10.1       |   |   |   |   |
| 10.20                                                        |   | License Agreement, dated  August 24, 2001, by and between the Company and Atrix  Laboratories, Inc. (now known as Tolmar Inc., a subsidiary of  Technofarma, S.A.                                                        |   | 10-Q  (000-28308)  10-Q/A  (000-28308) |   | 11-14-2001  2-14-2002 |   |   | 10.1  10.1 |   |   |   |   |
| 10.21†                                                  |   | Wholesale Service  Agreement, effective as of November 1, 2001, by and between the Company  and National Specialty Services, Inc. (now known as Oncology Therapeutic  Networks)                                          |   | 10-Q  (000-28308)                      |   | 5-15-2002             |   |   | 10.1       |   |   |   |   |

56

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| 10.22† |   | First Amendment to  Wholesale Service Agreement, effective as of November 12, 2001, by and  between the Company and National Specialty Services, Inc. (now known as  Oncology Therapeutic Networks)                       |   | 10-Q  (000-28308) |   | 5-15-2002 |   |   | 10.2   |   |   |   |   |
|-------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|-----------|--------|--------|--------|--------|--------|--------|--------|
| 10.23† |   | Agreement, dated  May 24, 2002, between the Company and Altana, Inc.                                                                                                                                                      |   | 10-Q  (000-28308) |   | 8-14-2002 |   |   | 10.1   |   |   |   |   |
| 10.24       |   | Amendments dated  October 6, 2003 and November 17, 2006 to Agreement, dated  May 24, 2002, between the Company and Altana, Inc.                                                                                 |   |              |   |      |   |   |   |   |   | *      |   |
| 10.25† |   | Letter Agreement, dated  as of September 12, 2002, by and between the Company and Pharmaceutical  Manufacturing Research Services, Inc.                                                                                   |   | 10-K              |   | 3-31-2003 |   |   | 10.35  |   |   |   |   |
| 10.26† |   | License and Supply  Agreement, dated April 8, 2004, among the Company, Mutual Pharmaceutical  Company, Inc. and United Research Laboratories, Inc.                                                                   |   | 8-K  (000-28308)  |   | 4-8-2004  |   |   | 10.1   |   |   |   |   |
| 10.27† |   | Distribution Services  Agreement, dated as of April 1, 2005, by and between the Company and  Cardinal Health                                                                                                                   |   | 10-Q  (000-28308) |   | 5-5-2005  |   |   | 10.1   |   |   |   |   |
| 10.28† |   | Core Distribution  Agreement, dated as of April 19, 2005, by and between the Company and  McKesson Company                                                                                                                     |   | 10-Q  (000-28308) |   | 5-5-2005  |   |   | 10.2   |   |   |   |   |
| 10.29† |   | Promotion and  Cooperation Agreement, dated as of June 6, 2005, by and between the  Company and Primus Pharmaceuticals, Inc.                                                                                              |   | 8-K  (000-28308)  |   | 6-10-2005 |   |   | 99.1   |   |   |   |   |
| 10.30       |   | Amendment dated  October 30, 2006 to Promotion and Cooperation Agreement, dated as of  June 6, 2005, by and between the Company and Primus  Pharmaceuticals, Inc.                                                    |   |              |   |      |   |   |   |   |   | *      |   |
| 10.31       |   | Amendment to License and  Marketing Agreement, dated August 24, 2001, by and between the Company  and Atrix Laboratories, Inc. (now known as Tolmar Inc., a subsidiary of Technofarma, S.A), dated February 22, 2006 |   | 10-K  (000-28308) |   | 3-16-06   |   |   | 10.27  |   |   |   |   |
| 10.32       |   | Commercial Manufacturing  Agreement dated as of March 1, 2006, by and between the Company and  Cardinal Health PTS, LLC                                                                                                        |   | 10-K  (000-28308) |   | 3-16-06   |   |   | 10.28  |   |   |   |   |
| 10.33† |   | Product License and Supply  Agreement, dated December 18, 2006 by and between the Company and  MediGene AG                                                                                  |   | 8-K  (000-28308)  |   | 12-22-06  |   |   | 10.1   |   |   |   |   |

57

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| ***Material  Contracts—Leases***                                      |   |                                                                                                                                                          |   |              |   |                 |   |   |   |   |   |
|----------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|----------------------|--------|--------|--------|--------|--------|
| 10.34                                                                      |   | Lease Agreement dated  March 15, 1999, between the Company and Newton Venture IV Associates,  effective May 15, 1999                                |   | 10-Q  (000-28308) |   | 5-7-1999             |   |   | 10.1   |   |   |   |   |
| ***Material  Contracts—Miscellaneous***                               |   |                                                                                                                                                          |   |              |   |                 |   |   |   |   |   |
| 10.35                                                                      |   | Asset Purchase and  Product Development Agreement, dated August 19, 2004, by and between the  Company and Thomas Skold                                   |   | 10-Q  (000-28308) |   | 11-9-2004            |   |   | 10.2   |   |   |   |   |
| 10.36                                                                      |   | Sale of Assets  Agreement, dated November 3, 2004, by and among CollaGenex International  Limited, Alliance Pharmaceuticals Ltd. and Alliance Pharma plc |   | 10-K  (000-28308) |   | 3-10-2005            |   |   | 10.43  |   |   |   |   |
| ***Material  Contracts—Management Contracts and Compensation Plans*** |   |                                                                                                                                                          |   |              |   |                 |   |   |   |
| 10.37#                                                                     |   | Non-Employee Director  Compensation Summary                                                                                                                   |   |              |   |                 |   |   |   |   |   | * |   |
| 10.38#                                                                     |   | Executive Officer  Compensation Summary                                                                                                                       |   |              |   |                 |   |   |   |   |   | * |   |
| 10.39#                                                                     |   | 1992 Stock Option Plan                                                                                                                                        |   | S-1  (333-03582)  |   | Effective  6-20-1996 |   |   | 10.12  |   |   |   |   |
| 10.40#                                                                     |   | 1996 Stock Option Plan                                                                                                                                        |   | S-1  (333-03582)  |   | Effective  6-20-1996 |   |   | 10.13  |   |   |   |   |
| 10.41#                                                                     |   | 1996 Non-Employee  Director Stock Option Plan                                                                                                                 |   | S-1  (333-03582)  |   | Effective  6-20-1996 |   |   | 10.14  |   |   |   |   |
| 10.42#                                                                     |   | Form of  Non-Disclosure Agreement executed by all Employees as employed from time to  time                                                               |   | S-1  (333-03852)  |   | Effective  6-20-1996 |   |   | 10.4   |   |   |   |   |
| 10.43#                                                                     |   | Form of  Non-Competition Agreement executed by each of Nancy C. Broadbent and David  Pfeiffer                                                            |   | S-1  (333-03852)  |   | Effective  6-20-1996 |   |   | 10.5   |   |   |   |   |
| 10.44#                                                                     |   | Form of Mutual  Non-Disclosure Agreement executed by certain consultants and research  collaborators as retained from time to time                       |   | S-1  (333-03852)  |   | Effective  6-20-1996 |   |   | 10.6   |   |   |   |   |
| 10.45#                                                                     |   | Form of  Indemnification Agreement executed by each of the Company’s directors and  officers                                                        |   | S-1  (333-03852)  |   | Effective  6-20-1996 |   |   | 10.7   |   |   |   |   |
| 10.46#                                                                     |   | Forms of Consulting  Agreement executed by each of Lorne M. Golub and Thomas F. McNamara                                                                      |   | S-1  (333-03582)  |   | Effective  6-20-1996 |   |   | 10.8   |   |   |   |   |
| 10.47#                                                                     |   | Form of Change of  Control Agreement executed with each of Nancy C. Broadbent, David Pfeiffer,  Andrew Powell, Klaus Theobald and Greg Ford              |   | 8-K  (000-28308)  |   | 10-17-06             |   |   | 10.2   |   |   |   |   |
| 10.48#                                                                     |   | Form of Change of  Control Agreement executed with Colin W. Stewart                                                                                      |   | 8-K  (000-28308)  |   | 10-17-06             |   |   | 10.1   |   |   |   |   |
| 10.49#                                                                     |   | Form of Incentive  Bonus Agreement executed with David F. Pfeiffer                                                                                       |   | 10-Q  (000-28308) |   | 11-14-2003           |   |   | 10.1   |   |   |   |   |

58

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| 10.50# |   | Transition Agreement and  Release, dated March 18, 2003, by and between the Company and Brian  Gallagher                  |   | 8-K  (000-28308)     |   | 3-19-2003 |   |   | 10.1   |   |   |   |   |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|--------|-----------|--------|--------|--------|--------|--------|--------|--------|
| 10.51# |   | Consulting Agreement,  dated March 18, 2003, by and between the Company and Brian Gallagher                               |   | 8-K  (000-28308)     |   | 3-19-2003 |   |   | 10.2   |   |   |   |   |
| 10.52# |   | Non-Statutory Stock  Option Agreement, dated December 7, 2004, by and between the Company and  Robert A. Beardsley, Ph.D. |   | 10-K  (000-28308)    |   | 3-10-2005 |   |   | 10.42  |   |   |   |   |
| 10.53# |   | Non-Statutory Stock  Option Agreement, dated September 23, 2004, by and between the Company  and Andrew Powell            |   | 10-Q  (000-28308)    |   | 11-9-2004 |   |   | 10.1   |   |   |   |   |
| 10.54# |   | Non-Statutory Stock  Option Agreement, dated September 22, 2005, by and between the Company  and George M. Lasezkay       |   | 8-K  (000-28308)     |   | 9-26-2005 |   |   | 10.1   |   |   |   |   |
| 10.55# |   | 2005 Equity Incentive  Plan                                                                                                    |   | Def 14A  (000-28308) |   | 4-20-2005 |   |   |   |   |   |   |   |
| 10.56# |   | Form of  Nonstatutory Stock Option Agreement for 2005 Equity Incentive Plan                                               |   | 10-Q  (000-28308)    |   | 8-9-2005  |   |   | 10.1   |   |   |   |   |
| 10.57# |   | Form of Incentive  Stock Option Agreement for 2005 Equity Incentive Plan                                                  |   | 10-Q  (000-28308)    |   | 8-9-2005  |   |   | 10.2   |   |   |   |   |
| 10.58# |   | Nonstatutory Stock  Option Agreement dated as of June 29, 2005 by and between the Company  and Peter R. Barnett, D.M.D.   |   | 10-Q  (000-28308)    |   | 8-9-2005  |   |   | 10.3   |   |   |   |   |
| 10.59# |   | Nonstatutory Stock  Option Agreement dated as of June 29, 2005 by and between the Company  and Robert C. Black            |   | 10-Q  (000-28308)    |   | 8-9-2005  |   |   | 10.4   |   |   |   |   |
| 10.60# |   | Nonstatutory Stock  Option Agreement dated as of May 26, 2005 by and between the Company and  Brian M. Gallagher, Ph.D.   |   | 10-Q  (000-28308)    |   | 8-9-2005  |   |   | 10.5   |   |   |   |   |
| 10.61# |   | Nonstatutory Stock  Option Agreement dated as of May 26, 2005 by and between the Company and  James E. Daverman           |   | 10-Q  (000-28308)    |   | 8-9-2005  |   |   | 10.6   |   |   |   |   |
| 10.62# |   | Nonstatutory Stock  Option Agreement dated as of June 29, 2005 by and between the Company  and Robert J. Easton           |   | 10-Q  (000-28308)    |   | 8-9-2005  |   |   | 10.7   |   |   |   |   |
| 10.63# |   | Nonstatutory Stock  Option Agreement dated as of June 29, 2005 by and between the Company  and W. James O’Shea       |   | 10-Q  (000-28308)    |   | 8-9-2005  |   |   | 10.8   |   |   |   |   |
| 10.64# |   | Nonstatutory Stock  Option Agreement dated as of June 29, 2005 by and between the Company  and Robert A. Beardsley, Ph.D. |   | 10-Q  (000-28308)    |   | 8-9-2005  |   |   | 10.9   |   |   |   |   |

59

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| ***Additional  Exhibits*** |   |                                                                                                                                                                                               |   |   |   |   |   |   |   |   |   |
|----------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| 21                         |   | List of Subsidiaries                                                                                                                                                                               |   |   |   |   |   |   |   |   |   | * |   |
| 23.1                       |   | Consent of KMPG LLP                                                                                                                                                                                |   |   |   |   |   |   |   |   |   | * |   |
| 31.1                       |   | Certification by Chief  Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a) of  the Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 |   |   |   |   |   |   |   |   |   | * |   |
| 31.2                       |   | Certification by Chief  Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a) of  the Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 |   |   |   |   |   |   |   |   |   | * |   |
| 32.1                       |   | Certification by Chief  Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.  Section 1350 as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002          |   |   |   |   |   |   |   |   |   | * |   |

----

†                    Confidentialtreatment requested as to certain portions, which portions have been separatelyfiled with the Securities and Exchange Commission.

#                 Managementcontracts or compensatory plans or arrangements required to be filed as anexhibit hereto pursuant to Item 15(a) of Form 10-K.

60

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**COLLAGENEXPHARMACEUTICALS, INC.**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

**ANDFINANCIAL STATEMENT SCHEDULE**

|                                                                                                                             | ** ** | **Page** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm                                                                    |       | F-2      |
| Consolidated Balance  Sheets as of December 31, 2006 and 2005                                                          |       | F-3      |
| Consolidated Statements of Operations for the years  ended December 31, 2006, 2005 and 2004                            |       | F-4      |
| Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2006, 2005 and 2004             |       | F-5      |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004                            |       | F-6      |
| Notes to  Consolidated Financial Statements                                                                                 |       | F-7      |
| Financial Statement Schedule - Valuation and  Qualifying Accounts for the years ended December 31, 2006, 2005 and 2004 |       | F-37     |

 

F-1

----

**Reportof Independent Registered Public Accounting Firm**

The Board of Directors and StockholdersCollaGenex Pharmaceuticals, Inc.:

We have audited the accompanying consolidated balancesheets of CollaGenex Pharmaceuticals, Inc. and subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2006. In connection with our audits of theconsolidated financial statements, we also have audited the financial statementschedule, “Valuation and Qualifying Accounts.” These consolidated financialstatements and financial statement schedule are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements and financial statement schedule based on ouraudits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the consolidated financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the consolidated financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of CollaGenex Pharmaceuticals, Inc. and subsidiaries as of December 31,2006 and 2005 and the results of their operations and their cash flows for eachof the years in the three-year period ended December 31, 2006, inconformity with U.S. generally accepted accounting principles. Also in ouropinion, the related financial statement schedule when considered in relationto the basic consolidated financial statements taken as a whole, presentsfairly, in all material aspects, the information set forth therein.

As discussed in notes 2 and 9 to the consolidatedfinancials, effective January 1, 2006, the Company adopted the fair valuemethod of accounting for stock-based compensation as required by Statement ofFinancial Accounting Standards, No. 123(R) “Share-Based Payment.”

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of CollaGenex Pharmaceuticals, Inc.’sinternal control over financial reporting as of December 31, 2006, basedon criteria established in *Internal Control—IntegratedFramework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO),and our report dated March 15, 2007 expressed an unqualified opinion onmanagement’s assessment of, and the effective operation of, internal controlover financial reporting.

/s/  KPMG LLP

Philadelphia, PennsylvaniaMarch 15, 2007

F-2

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**COLLAGENEX PHARMACEUTICALS, INC.AND SUBSIDIARIESConsolidated Balance SheetsDecember 31, 2006 and 2005(Dollars in thousands, except per share data)**

| ** **                                                                                                                                                                                                                                          | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Assets**                                                                                                                                                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                                                                                     |       |       |       |       |       |
| Cash and cash equivalents                                                                                                                                                                                                                           |       | $          | 46,493     |       | $          | 26,219 |   |
| Short-term investments                                                                                                                                                                                                                              |       | 19,337     |       | 18,206     |       |
| Accounts receivable, net of allowances of $187 and  $104 in 2006 and 2005, respectively                                                                                                                                                             |       | 6,071      |       | 1,428      |       |
| Inventories                                                                                                                                                                                                                                         |       | 1,959      |       | 630        |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                           |       | 2,416      |       | 1,564      |       |
| Total current assets                                                                                                                                                                                                                                |       | 76,276     |       | 48,047     |       |
| Equipment and  leasehold improvements, net                                                                                                                                                                                                          |       | 1,008      |       | 539        |       |
| Intangible  assets, net                                                                                                                                                                                                                             |       | 1,882      |       | 536        |       |
| Other assets                                                                                                                                                                                                                                        |       | 41         |       | 43         |       |
| Total assets                                                                                                                                                                                                                                        |       | $          | 79,207     |       | $          | 49,165 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                                                                                |       |       |       |       |       |
| Accounts payable                                                                                                                                                                                                                                    |       | $          | 9,066      |       | $          | 5,411 |   |
| Accrued expenses                                                                                                                                                                                                                                    |       | 7,574      |       | 6,024      |       |
| Accrued equity financing costs                                                                                                                                                                                                                      |       | —     |       | 1,069      |       |
| Preferred dividends payable                                                                                                                                                                                                                         |       | —     |       | 900        |       |
| Total current liabilities                                                                                                                                                                                                                           |       | 16,640     |       | 13,404     |       |
| Other non-current  liabilities                                                                                                                                                                                                                      |       | 265        |       | 93         |       |
| Commitments and  contingencies (Notes 5, 6, 7, 8, 11 and 13)                                                                                                                                                                                        |       |       |       |       |       |
| Stockholders’ equity:                                                                                                                                                                                                                          |       |       |       |       |       |
| Preferred stock, $0.01 par value, 5,000,000 shares  authorized, 200,000 shares of Series D-1 Cumulative Convertible  Preferred Stock designated, issued and outstanding 2006 and 2005 (liquidation  value $21,000 at 2006 and $20,900 at 2005) |       | 2          |       | 2          |       |
| 150,000 shares of Series A Participating  Preferred Stock, $0.01 par value, designated and no shares issued or  outstanding at 2006 and 2005, respectively                                                                                     |       | —     |       | —     |       |
| Common stock, $0.01 par value; 75,000,000 and 25,000,000  shares authorized, 21,191,724, and 16,054,797 shares issued and outstanding  in 2006 and 2005                                                                                             |       | 212        |       | 161        |       |
| Additional  paid-in capital                                                                                                                                                                                                                         |       | 185,581    |       | 124,647    |       |
| Accumulated other  comprehensive income (loss)                                                                                                                                                                                                      |       | 7          |       | (4         | )          |
| Accumulated  deficit                                                                                                                                                                                                                                |       | (123,500   | )          | (89,138    | )          |
| Stockholders’ equity                                                                                                                                                                                                                           |       | 62,302     |       | 35,668     |       |
| Total liabilities  and stockholders’ equity                                                                                                                                                                                                    |       | $          | 79,207     |       | $          | 49,165 |   |

 

See accompanying notes to consolidated financial statements.

F-3

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**

**Consolidated Statements of OperationsYears ended December 31, 2006, 2005 and 2004(Dollars in thousands, except per share data)**

| ** **                                                            | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Revenues:                                                             |       |       |       |       |       |       |       |
| Net product sales                                                     |       | $          | 24,448     |       | $          | 25,736     |       | $ | 51,739 |   |
| Contract revenues                                                     |       | 1,390      |       | 481        |       | 237        |       |
| License revenues                                                      |       | 64         |       | 188        |       | 170        |       |
| Grant revenues                                                        |       | 471        |       | —     |       | —     |       |
| Total revenues                                                        |       | 26,373     |       | 26,405     |       | 52,146     |       |
| Costs and  expenses:                                                  |       |       |       |       |       |       |       |
| Cost of product sales                                                 |       | 5,473      |       | 5,885      |       | 7,446      |       |
| Research and development                                              |       | 15,394     |       | 13,986     |       | 8,843      |       |
| Selling, general and administrative                                   |       | 40,925     |       | 25,242     |       | 29,417     |       |
| Restructuring charge                                                  |       | —     |       | 1,184      |       | 348        |       |
| Legal settlement                                                      |       | —     |       | —     |       | 2,000      |       |
| Gain on sale of UK and European dental assets                         |       | —     |       | —     |       | (2,980     | )          |
| Total costs and expenses                                              |       | 61,792     |       | 46,297     |       | 45,074     |       |
| Operating (loss) income                                               |       | (35,419    | )          | (19,892    | )          | 7,072      |       |
| Other income  (expense):                                              |       |       |       |       |       |       |       |
| Interest income                                                       |       | 2,001      |       | 1,087      |       | 423        |       |
| Interest expense                                                      |       | (16        | )          | —     |       | —     |       |
| (Loss) income before income taxes                                     |       | (33,434    | )          | (18,805    | )          | 7,495      |       |
| Income taxes                                                          |       | —     |       | —     |       | 967        |       |
| Net (loss) income                                                     |       | (33,434    | )          | (18,805    | )          | 6,528      |       |
| Preferred stock dividends                                             |       | 1,928      |       | 1,727      |       | 1,600      |       |
| Preferred stock  restructuring charge                                 |       | —     |       | 3,680      |       | —     |       |
| Net (loss) income  allocable to common stockholders                   |       | $          | (35,362    | )          | $          | (24,212    | )          | $ | 4,928 |   |
| Basic net (loss) income per share allocable to  common stockholders   |       | $          | (1.98      | )          | $          | (1.67      | )          | $ | 0.35 |   |
| Diluted net (loss) income per share allocable to  common stockholders |       | $          | (1.98      | )          | $          | (1.67      | )          | $ | 0.34 |   |
| Weighted average  shares used in computing per share amounts:         |       |       |       |       |       |       |       |
| Basic                                                                 |       | 17,902,257 |       | 14,480,779 |       | 14,264,687 |       |
| Diluted                                                               |       | 17,902,257 |       | 14,480,779 |       | 14,500,637 |       |

 

See accompanying notes to consolidated financial statements.

F-4

----

**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIESConsolidated Statements of Stockholders’ EquityYears ended December 31, 2006, 2005 and 2004(Dollars in thousands)**

| ** ** | ** ** | **Series D**          | ** ** | **Series D-1**      | ** ** | ** **                 | ** ** | ** **     | ** ** | ** **                 | ** ** | ** **      | ** ** | ** **           | ** ** | ** **                            | ** ** | ** **               | ** ** |
|------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|----------------|------------|----------------------------|------------|-----------------|------------|----------------------|------------|---------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | **cumulative**             | ** ** | **cumulative**           | ** ** | ** **                 | ** ** | ** **     | ** ** | ** **                 | ** ** | ** **      | ** ** | ** **           | ** ** | ** **                            | ** ** | ** **               | ** ** |
| ** ** | ** ** | **convertible**            | ** ** | **convertible**          | ** ** | ** **                 | ** ** | ** **     | ** ** | ** **                 | ** ** | **Accumulated** | ** ** | ** **           | ** ** | ** **                            | ** ** | ** **               | ** ** |
| ** ** | ** ** | **preferred stock**   | ** ** | **preferred stock** | ** ** | **Common stock**      | ** ** | **Additional** | ** ** | **other**                  | ** ** | ** **      | ** ** | **Total**            | ** ** | ** **                            | ** ** |
| ** ** | ** ** | **Number  of shares** | ** ** | **Par  value**           | ** ** | **Number  of shares** | ** ** | **Par  value** | ** ** | **Number  of shares** | ** ** | **Par  value**  | ** ** | **paid-in  capital** | ** ** | **comprehensive  income (loss)** | ** ** | **Accumulated  deficit** | ** ** | **stockholders’  equity** | ** ** | **Comprehensive  income (loss)** | ** ** |
|            |            |                            |            |                          |            |                            |            |                |            |                            |            |                 |            |                      |            |                                       |            |                          |            |  |  |  |  |

| Balance,  January 1, 2004                                                                        |   |   | 200,000  |   |   |   | $ 2      |   |   |   | —  |   |   |   | $ — |   |   | 13,842,200 |   |   | $ 138 |   |   |   | $ 103,670 |   |   |   | $ —        |   |   |   | $ (69,854  | )      |   |   | $ 33,956 |   |   |   |                     |   |   |
|-------------------------------------------------------------------------------------------------------|--------|--------|----------|--------|--------|--------|---------------|--------|--------|--------|---------|--------|--------|--------|---------------|--------|--------|------------|--------|--------|------------|--------|--------|--------|----------------|--------|--------|--------|----------------------|--------|--------|--------|-----------------|--------|--------|--------|---------------|--------|--------|--------|--------------------------|--------|--------|
| Exercise of common  stock options                                                                     |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | 543,677    |   |   | 6          |   |   |   | 2,346          |   |   |   | —               |   |   |   | —          |   |   |   | 2,352         |   |   |   |                     |   |   |
| Cash dividends  declared on Series D cumulative convertible preferred stock                      |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | —               |   |   |   | (1,600          | )      |   |   | (1,600        | )      |   |   |                     |   |   |
| Net income                                                                                            |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | —               |   |   |   | 6,528           |   |   |   | 6,528         |   |   |   | $   6,528 |   |   |
| Net unrealized  loss on short-term investments                                                        |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | (21                  | )      |   |   | —          |   |   |   | (21           | )      |   |   | (21                      | )      |   |
| Total  comprehensive income                                                                           |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | —               |   |   |   | —          |   |   |   | —        |   |   |   | $   6,507 |   |   |
| Balance,  December 31, 2004                                                                      |   |   | 200,000  |   |   |   | $ 2      |   |   |   | —  |   |   |   | $ — |   |   | 14,385,877 |   |   | $ 144 |   |   |   | $ 106,016 |   |   |   | $ (21           | )      |   |   | $ (64,926  | )      |   |   | $ 41,215 |   |   |   |                     |   |   |
| Exercise of common  stock options                                                                     |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | 118,920    |   |   | 1          |   |   |   | 579            |   |   |   | —               |   |   |   | —          |   |   |   | 580           |   |   |   |                     |   |   |
| Cash dividends  declared on Series D and Series D-1 cumulative convertible  preferred stock |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | —               |   |   |   | (1,727          | )      |   |   | (1,727        | )      |   |   |                     |   |   |
| Series D  preferred stock restructuring and exchange (note 5)                               |   |   | (200,000 | )      |   |   | (2            | )      |   |   | 200,000 |   |   |   | 2             |   |   | —     |   |   | —     |   |   |   | 3,680          |   |   |   | —               |   |   |   | (3,680          | )      |   |   | —        |   |   |   |                     |   |   |
| Issuance of common  stock, net of issuance costs                                                      |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   |          |   |   | 1,550,000  |   |   | 16         |   |   |   | 14,372         |   |   |   | —               |   |   |   | —          |   |   |   | 14,388        |   |   |   |                     |   |   |
| Net loss                                                                                              |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | —               |   |   |   | (18,805         | )      |   |   | (18,805       | )      |   |   | $ (18,805           | )      |   |
| Net unrealized  gain on short-term investments                                                        |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | 17                   |   |   |   | —          |   |   |   | 17            |   |   |   | 17                       |   |   |
| Total  comprehensive loss                                                                             |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | —               |   |   |   | —          |   |   |   | —        |   |   |   | $ (18,788           | )      |   |
| Balance,  December 31, 2005                                                                      |   |   | —   |   |   |   | $ — |   |   |   | 200,000 |   |   |   | $ 2      |   |   | 16,054,797 |   |   | $ 161 |   |   |   | $ 124,647 |   |   |   | $  (4      | )      |   |   | $ (89,138  | )      |   |   | $ 35,668 |   |   |   |                     |   |   |
| Exercise of common  stock options                                                                     |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | 286,927    |   |   | 3          |   |   |   | 2,518          |   |   |   | —               |   |   |   | —          |   |   |   | 2,521         |   |   |   |                     |   |   |
| Cash dividends  declared on Series D-1 cumulative convertible preferred stock                         |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | —               |   |   |   | (928            | )      |   |   | (928          | )      |   |   |                     |   |   |
| Issuance of common  stock, net of issuance costs                                                      |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | 4,850,000  |   |   | 48         |   |   |   | 55,130         |   |   |   | —               |   |   |   | —          |   |   |   | 55,178        |   |   |   |                     |   |   |
| Share-based  compensation                                                                             |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | 3,286          |   |   |   | —               |   |   |   | —          |   |   |   | 3,286         |   |   |   |                     |   |   |
| Net loss                                                                                              |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | —               |   |   |   | (33,434         | )      |   |   | (33,434       | )      |   |   | $ (33,434           | )      |   |
| Net unrealized  gain on short-term investments                                                        |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   | —     |   |   | —     |   |   |   | —         |   |   |   | 11                   |   |   |   | —          |   |   |   | 11            |   |   |   | 11                       |   |   |
| Total  comprehensive loss                                                                             |   |   | —   |   |   |   | —        |   |   |   | —  |   |   |   | —        |   |   |       |   |   |       |   |   |   |           |   |   |   |                 |   |   |   |            |   |   |   |          |   |   |   | $ (33,423           | )      |   |
| Balance, December 31,  2006                                                                      |   |   | —   |   |   |   | $ — |   |   |   | 200,000 |   |   |   | $ 2      |   |   | 21,191,724 |   |   | $ 212 |   |   |   | $ 185,581 |   |   |   | $   7 |   |   |   | $ (123,500 | )      |   |   | $ 62,302 |   |   |   |                     |   |   |

 

See accompanying notes to consolidated financial statements.

F-5

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**

**Consolidated Statements of CashFlows**

**Years ended December 31,2006, 2005 and 2004**

**(Dollars in thousands)**

| ** **                                                                                   | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash flows from  operating activities:                                                       |       |     |       |     |       |     |       |
| Net (loss) income                                                                            |       | $        | (33,434    | )        | $          | (18,805  | )          | $ | 6,528 |   |
| Adjustments to  reconcile net income to net cash (used in) provided by operating activities: |       |     |       |     |       |     |       |
| Stock-based compensation                                                                     |       | 3,286    |       | —   |       | —   |       |
| Write-down of inventory                                                                      |       | 257      |       | 1,020    |       | —   |       |
| Write-off of fixed assets                                                                    |       | —   |       | 96       |       | —   |       |
| Depreciation and amortization expense                                                        |       | 643      |       | 883      |       | 875      |       |
| Accounts receivable recovery (provisions)                                                    |       | 83       |       | (154     | )          | (101     | )          |
| Charge for in-process research and development                                               |       | 300      |       | 750      |       | 300      |       |
| Gain on sale of UK and European dental assets                                                |       | —   |       | —   |       | (2,980   | )          |
| Change in assets  and liabilities:                                                           |       |     |       |     |       |     |       |
| Accounts receivable                                                                          |       | (4,726   | )          | 5,832    |       | (1,199   | )          |
| Inventories                                                                                  |       | (1,586   | )          | 1,042    |       | (1,020   | )          |
| Prepaid expenses and other assets                                                            |       | (850     | )          | 634      |       | (380     | )          |
| Accounts payable                                                                             |       | 3,655    |       | 1,094    |       | 588      |       |
| Accrued expenses                                                                             |       | 1,459    |       | 364      |       | 217      |       |
| Other non-current liabilities                                                                |       | (107     | )          | (111     | )          | (122     | )          |
| Net cash (used in) provided by operating activities                                          |       | (31,020  | )          | (7,355   | )          | 2,706    |       |
| Cash flows from  investing activities:                                                       |       |     |       |     |       |     |       |
| Capital expenditures                                                                         |       | (439     | )          | (392     | )          | (292     | )          |
| Net proceeds from the sale of UK and European dental  assets                                 |       | —   |       | —   |       | 2,980    |       |
| Purchase of in-process research and development                                              |       | (250     | )          | (900     | )          | (150     | )          |
| Payment of Oracea milestone fees                                                             |       | (1,670   | )          | —   |       | —   |       |
| Purchases of short-term investments                                                          |       | (39,155  | )          | (35,420  | )          | (26,777  | )          |
| Sales and maturities of short-term investments                                               |       | 38,035   |       | 43,987   |       | —   |       |
| Net cash (used in) provided by investing activities                                          |       | (3,479   | )          | 7,275    |       | (24,239  | )          |
| Cash flows from  financing activities:                                                       |       |     |       |     |       |     |       |
| Proceeds from issuance of common stock, net                                                  |       | 54,109   |       | 15,458   |       | —   |       |
| Net proceeds from the exercise of stock options and  warrants                                |       | 2,521    |       | 579      |       | 2,352    |       |
| Principal payments on capital leases                                                         |       | (29      | )          | —   |       | —   |       |
| Payment of preferred dividends                                                               |       | (1,828   | )          | (1,627   | )          | (1,600   | )          |
| Net cash provided by financing activities                                                    |       | 54,773   |       | 14,410   |       | 752      |       |
| Net increase (decrease) in cash and cash equivalents                                         |       | 20,274   |       | 14,330   |       | (20,781  | )          |
| Cash and cash  equivalents at beginning of year                                              |       | 26,219   |       | 11,889   |       | 32,670   |       |
| Cash and cash  equivalents at end of year                                                    |       | $        | 46,493     |     | $          | 26,219   |       | $ | 11,889 |   |

 

See accompanying notes to consolidated financial statements.

F-6

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (dollars in thousands, except for per share amounts)**

**(1) Business**

CollaGenex Pharmaceuticals, Inc.and subsidiaries ,or the Company, is a specialty pharmaceutical companycurrently focused on developing and marketing innovative proprietary medicaltherapies to the dermatology market. As of December 31, 2006, the Companymarkets four prescription pharmaceutical products to the dermatology marketthrough their professional dermatology sales force and generate revenues fromfour other prescription pharmaceutical products that the Company continues tosell to the dental market. In May 2006, the U.S. Food and DrugAdministration, or the FDA, granted the Company marketing approval for OraceaTMfor the treatment of inflammatory lesions (papules and pustules) of rosacea inadult patients. Oracea is the first FDA approved, orally-administered,systemically-delivered drug to treat rosacea. In July 2006, the Companylaunched Oracea to the U.S. dermatology community.

The Company’s marketeddermatology products are: Oracea; Pandel®, a prescription corticosteroid theCompany licensed from Altana, Inc. in May 2002; AlcortinTM, aprescription topical antifungal steroid combination; and NovacortTM, aprescription topical steroid and anesthetic. In June 2005, the Companyexecuted a Promotion and Cooperation Agreement with Primus PharmaceuticalsInc., or Primus, to market Alcortin and Novacort to dermatologists.

Priorto the May 2005 introduction of a third party generic version ofPeriostat®, the Company’s dental sales force detailed four prescriptionpharmaceutical products to the dental market. On May 20, 2005, the Companydiscontinued all domestic sales force and promotion activities for theseproducts. The Company currently still generates sales from these dentalproducts, which all treat periodontal disease and include the Company’s ownproduct Periostat, as well as Atridox®, Atrisorb FreeFlow® and Atrisorb-D®, orthe Atrix Products, which are licensed from Atrix Laboratories, Inc. (nowknown as Tolmar Inc., a subsidiary of Tecnofarma, S.A.). The Company had alsosold a separately branded version of Periostat to United Research Laboratories, Inc./MutualPharmaceutical Company, Inc., or Mutual, pursuant to a License and SupplyAgreement executed in April 2004 as part of a settlement of the Company’soutstanding patent litigation with Mutual. As a result of the launch of a thirdparty generic version of Periostat in May 2005, Mutual ceased purchasingproduct from the Company during June 2005.

**(2) Summary of Significant Accounting Policies**

***Principles ofConsolidation***

The accompanyingconsolidated financial statements include the results of operations of theCompany and its majority-owned subsidiaries. All intercompany accounts andtransactions have been eliminated in consolidation.

***Cash, CashEquivalents and Short-term Investments***

TheCompany considers all highly liquid investments with an original maturity ofthree months or less to be cash equivalents. Cash equivalent investments areheld at amortized cost, which approximates fair value. All short-terminvestments have original maturity dates of between three months and one year.The Company’s short-term investments are primarily comprised of commercialpaper and government notes. At December 31, 2006 and 2005, all of theCompany’s short-term investments, carried at fair value, were classified asavailable-for-sale with unrealized gains and losses included as a separatecomponent of stockholders’ equity. The accumulated net unrealized gain onshort-term investments was $7 at 

F-7

----

**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

December 31, 2006 and the accumulated netunrealized loss on short-term investments was $4 at December 31, 2005. Short-terminvestments consisted of the following at December 31, 2006 and 2005:

| **2006**                          | ** ** | ** ** | ** ** | **Amortized cost** | ** ** | **Gross  unrealized gain** | ** ** | **Gross  unrealized loss** | ** ** | **Fair value** | ** ** |
|-----------------------------------|------------|------------|------------|-------------------------|------------|---------------------------------|------------|---------------------------------|------------|---------------------|------------|
| Certificates of Deposit |       |       | $          | 7,196                   |       |                            |       | $                               | —     |                |       |   | $ | (1 | ) |   |   | $ | 7,195 |   |   |
| U.S. Agency Notes(1)              |       |       | 10,351     |                    |       |                            | 7          |                            |       |                | —     |   |   |   | 10,358 |   |   |
| Commercial Paper                  |       |       | 1,783      |                    |       |                            | 1          |                            |       |                | —     |   |   |   | 1,784 |   |   |
| Total                             |       |       | $          | 19,330                  |       |                            |       | $                               | 8          |                |       |   | $ | (1 | ) |   |   | $ | 19,337 |   |   |

 

| **2005**                         | ** ** | ** ** | ** ** | **Amortized cost** | ** ** | **Gross  unrealized gain** | ** ** | **Gross  unrealized loss** | ** ** | **Fair value** | ** ** |
|----------------------------------|------------|------------|------------|-------------------------|------------|---------------------------------|------------|---------------------------------|------------|---------------------|------------|
| Certificate of Deposit |       |       | $          | 748                     |       |                            |       | $                               | —     |                |       |   | $ | — |   |   |   | $ | 748 |   |   |
| U.S. Agency Notes(1)             |       |       | 17,462     |                    |       |                            | —     |                            |       |                | (4         | ) |   |   | 17,458 |   |   |
|                             |       |       | $          | 18,210                  |       |                            |       | $                               | —     |                |       |   | $ | (4 | ) |   |   | $ | 18,206 |   |   |

----

(1)          U.S.Agency notes are comprised of Fannie Mae, Freddie Mac, Farmer Mac, Federal FarmCredit and Federal Home Loan Bank. If held to maturity, these holdings allowthe issuer to settle the securities at a price no less than the amortized cost.

***Inventories***

Inventories are stated atthe lower of cost or market. Cost is determined using the first-in, first-outmethod. Critical accounting estimates and assumptions related to inventorycarrying values are evaluated periodically and consider the saleable quantitiesof inventory versus quantities of inventory on-hand.

The Company classifiesdirect manufacturing costs relating to inventory and samples manufactured inadvance of a new product launch as research and development expense until suchtime as it receives an approval letter from the FDA for a new product. FollowingFDA approval of the product, the Company capitalizes any inventory costsrelating to that product that were not previously expensed.

***Intangible Assets,Net***

Intangible assets, whichconsist of acquired product rights and Oracea milestone fees paid post-FDAapproval are stated at cost less accumulated amortization. Amortization iscomputed using the straight-line method over the shorter of the estimateduseful life of the products or the contract term for which such rights havebeen licensed. Amortization of acquired product rights and Oracea milestonefees are charged to cost of product sales.

The Company is required totest for asset impairment of acquired product rights and Oracea milestone feeswhenever events or circumstances indicate that the carrying value of an assetmay not be recoverable. The Company applies Statement of Financial AccountingStandards, or SFAS No. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets*,” in order todetermine whether or not an asset is impaired. This standard requires animpairment analysis when indicators of impairment are present. When suchindicators are present, the standard indicates that if the sum of the futureexpected cash flows from the asset, undiscounted and without interest charges,are less than the carrying value, an asset impairment must be recognized in thefinancial statements. The amount of the impairment is the difference betweenthe fair value of the asset and the carrying value of the asset.

F-8

----

**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

In making future cash flowanalyses of our intangible assets, the Company makes assumptions relatingto:  (i) the intended use of theproduct and the expected future cash flows resulting directly from such use; (ii) genericcompetitor activities and regulatory initiatives that affect our products; and (iii) customerpreferences and expected gross to net discounts.

***Equipment andLeasehold Improvements***

Equipment and leaseholdimprovements, consisting of computer and office equipment, exhibit equipmentand leasehold improvements are recorded at cost. Depreciation and amortizationare calculated using the straight-line method over the estimated usefullives of the assets or the related lease term, whichever is shorter, and aregenerally three to ten years. Expenditures for repairs and maintenance areexpensed as incurred.

***Segment Information***

The Company operates as onebusiness that is managed by a single management team reporting to the chiefexecutive officer. The Company does not prepare discrete financial informationwith respect to separate product or product candidate areas or by location anddoes not have separately reportable segments.

Duringeach of the years ended December 31, 2006, 2005 and 2004, the Company’stotal net revenues were comprised of the following:

| ** **           | ** ** | **Year-ended December 31,** | ** ** |
|----------------------|------------|---------------------------------------|------------|
|                      | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Oracea               |       |                                  | 45         | % |   | none |   | none |   |
| Other dermatology(1) |       |                                  | 25         | % |   | 31% |   | 17% |   |
| Dental               |       |                                  | 28         | % |   | 69% |   | 83% |   |
| Grant revenue        |       |                                  | 2          | % |   | none |   | none |   |

----

(1)          Includes the Company’sestimate for Periostat prescriptions written by dermatologists.

***FinancialInstruments***

The carrying amounts ofcash and cash equivalents, short-term investments, accounts receivable,accounts payable, accrued expenses and preferred dividends payable approximatefair value because of the short term nature of these instruments.

***Share-BasedCompensation***

As part of the Company’s adoptionof Statement of Financial Accounting Standards (SFAS) No. 123 (revised2004), *Share-Based Payment,*orSFAS No. 123R, as of January 1, 2006, the Company has recognized thefair value of share-based compensation awards in the Company’s consolidated financialstatements using the modified prospective method. The Company applies theBlack-Scholes option pricing model to determine the fair value of stock optionson the date of grant and estimates key assumptions that are important elementsin the model, such as the expected stock-price volatility and expected stockoption life. The Company’s estimates of these key assumptions and expectedforfeiture rates are based on historical data and judgment regarding markettrends and factors. These estimates are not intended to predict actual futureevents or the value ultimately realized by individuals who receive equityawards.

F-9

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

***Net Product Sales***

The Company generally recognizes revenues for productsales upon shipment to wholesale customers, net of estimated returns andestimates for chargebacks, applicable wholesale distribution fees and rebatesprovided that collection was probable and no significant obligations remained. However,following the launch of a third party generic competitor to Periostat in May 2005and commencing with the second quarter of 2005, the Company began recognizingPeriostat sales revenue based on product sales to end-users, which areestimated using prescription dispensing data generated by an independentprescription tracking service, as well as on-hand inventory estimates in thedistribution channel. The launch of generic competition to Periostat resultedin increased product returns from the wholesale and retail channels.

The Company records sales discounts, allowances,rebates and returns upon recognizing product sales. The Company only acceptsreturns of damaged or expired products. The return allowance, when estimatable,is based on an analysis of the historical returns of the product and theCompany considers current end user demand and wholesale and retail inventorylevels. If product returns are not estimatable, the Company defers revenuerecognition for all outstanding product in the wholesale and retail channelthat is subject to return. Chargebacks, wholesale distribution fees and rebatesare based on an analysis of the applicable agreements and historical experience.In addition, the Company also considers the volume and price of the product inthe channel, trends in wholesaler and retailer inventory levels, conditionsthat might affect end-user demand (such as generic competition) and otherrelevant factors. Below details the activity in the reserves mentioned aboveduring the years ended December 31, 2006 and 2005.

| **2006**                                  | ** ** | ** ** | ** ** | **Beginning  Balance** | ** ** | **Current   provision  related to  sales made  in the current  period** | ** ** | **Actual returns  or credits in the  current period** | ** ** | **Ending  Balance** | ** ** |
|-------------------------------------------|------------|------------|------------|------------------------|------------|--------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|---------------------|------------|
| Accounts receivable allowances:           |       |       |       |                   |       |                                                                                             |       |                                                                           |       |                |       |   |   |   |   |   |   |
| Chargebacks                               |       |       | $          | 78                     |       |                                                                                             |       | $                                                                              | 1,702      |                |       |   | $ | (1,707 | ) |   |   | $ | 73 |   |   |
| Cash discounts                            |       |       | 26         |                   |       |                                                                                             | 621        |                                                                           |       |                | (533       | ) |   |   | 114 |   |   |
| Total                                     |       |       | $          | 104                    |       |                                                                                             |       | $                                                                              | 2,323      |                |       |   | $ | (2,240 | ) |   |   | $ | 187 |   |   |
| Accounts payable/Accrued expenses:        |       |       |       |                   |       |                                                                                             |       |                                                                           |       |                |       |   |   |   |   |   |   |
| Patient rebates                           |       |       | $          | —                 |       |                                                                                             |       | $                                                                              | 866        |                |       |   | $ | (788 | ) |   |   | $ | 78 |   |   |
| Product returns  (excluding Periostat)(1) |       |       | 98         |                   |       |                                                                                             | 496        |                                                                           |       |                | (210       | ) |   |   | 384 |   |   |
| Government rebates                        |       |       | 158        |                   |       |                                                                                             | 262        |                                                                           |       |                | (340       | ) |   |   | 80 |   |   |
| Wholesale distribution  fees              |       |       | 79         |                   |       |                                                                                             | 639        |                                                                           |       |                | (422       | ) |   |   | 296 |   |   |
| Total                                     |       |       | $          | 335                    |       |                                                                                             |       | $                                                                              | 2,263      |                |       |   | $ | (1,760 | ) |   |   | $ | 838 |   |   |

 

F-10

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

 

| **2005**                                  | ** ** | ** ** | ** ** | **Beginning  Balance** | ** ** | **Current   provision   related to   sales made   in the current  period** | ** ** | **Actual returns  or credits in the  current period** | ** ** | **Ending   Balance** | ** ** |
|-------------------------------------------|------------|------------|------------|------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|---------------------------|------------|
| Accounts receivable allowances:           |       |       |       |                   |       |                                                                                                               |       |                                                                           |       |                      |       |   |   |   |   |   |   |
| Chargebacks                               |       |       | $          | 153                    |       |                                                                                                               |       | $                                                                              | 1,467      |                      |       |   | $ | (1,542 | ) |   |   | $ | 78 |   |   |
| Cash discounts                            |       |       | 104        |                   |       |                                                                                                               | 485        |                                                                           |       |                      | (563       | ) |   |   | 26 |   |   |
| Total                                     |       |       | $          | 257                    |       |                                                                                                               |       | $                                                                              | 1,952      |                      |       |   | $ | (2,105 | ) |   |   | $ | 104 |   |   |
| Accounts payable/Accrued expenses:        |       |       |       |                   |       |                                                                                                               |       |                                                                           |       |                      |       |   |   |   |   |   |   |
| Product returns  (excluding Periostat)(1) |       |       | $          | 41                     |       |                                                                                                               |       | $                                                                              | 141        |                      |       |   | $ | (84 | ) |   |   | $ | 98 |   |   |
| Government rebates                        |       |       | 226        |                   |       |                                                                                                               | 946        |                                                                           |       |                      | (1,014     | ) |   |   | 158 |   |   |
| Wholesale distribution  fees              |       |       | 65         |                   |       |                                                                                                               | 289        |                                                                           |       |                      | (275       | ) |   |   | 79 |   |   |
| Total                                     |       |       | $          | 332                    |       |                                                                                                               |       | $                                                                              | 1,376      |                      |       |   | $ | (1,373 | ) |   |   | $ | 335 |   |   |

 

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(1)          The returns provisionfor Periostat at December 31, 2006 and 2005 amounts to $612 and $1,267,respectively, and is comprised of a reserve for all estimated outstandingwholesale and retail inventory subject to return, due to an inability toestimate returns. (see note above).

For new product launches,includingthe Oracea launch in July 2006, the Company’s policy is torecognize revenue on a net prescription value basis using dispensing datagenerated by an independent prescription tracking service until trade channelinventories are reduced to targeted stocking levels and the Company hassufficient data to determine product acceptance in the marketplace which willenable the Company to estimate product returns based on historical data ofsimilar products. Net prescription value is calculated by deducting estimatesfor chargebacks, wholesale distribution fees, patient rebates, governmentrebates and any other launch discounts offered from the applicable gross salesvalue. When customer inventories have been reduced to targeted wholesale andretail levels and new product acceptance can be ascertained, the Company beginsto recognize product sales upon shipment, net of discounts, rebates andallowances, including a returns reserve allowance. During the fourth quarter of2006, based on sales levels and the prescription data related to the fourthquarter of 2006 and the number of units on hand in the pipeline relative to theoverall demand for the product, the Company began recognizing Oracea revenueson a shipment basis, net of applicable discounts and allowances. Accordingly,Oracea revenues for the year ended December 31, 2006 reflect revenuerecognition on a shipment basis, net of applicable discounts, rebates andallowances as the Company recognized, in the fourth quarter of 2006,approximately $2,800 in previously deferred Oracea revenues.

During the third quarterof 2006, the Company launched Oracea to the U.S. dermatology community. As partof such launch, the Company introduced a patient rebate program for Oraceaprescriptions. Only patients presenting the computer-coded card to theirpharmacists were entitled to receive the rebate. In accordance with EmergingIssues Task Force Issue No. 01-09, *“Accountingfor Consideration Given by a Vendor to a Customer,”* the Company hasaccounted for these patient rebates as a reduction of net product sales on theCompany’s Consolidated Statement of Operations for the year endedDecember 31, 2006.

F-11

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

***Contract and License Revenues***

Related to license and contract revenues,non-refundable up-front fees are deferred and amortized to revenue over therelated performance period. The Company estimates the performance period basedon the specific terms of each collaborative agreement. The Company recognizesperiodic payments over the period that the Company performs the relatedactivities under the terms of the agreements. Revenue resulting from theachievement of milestone events stipulated in the agreements is recognized whenthe milestone is achieved. Milestones are based upon the occurrence of asubstantive element specified in the contract or as a measure of substantiveprogress towards completion under the contract.

Pursuant to the Company’sPromotion and Cooperation Agreement, or the Promotion Agreement, with Primuscontract revenues for Alcortin and Novacort are fee-based arrangements wherecontract revenue is earned as prescriptions are filled and recognized as apercentage of the gross profit earned by Primus. The Company does not taketitle to the inventory sold by Primus under the Promotion Agreement.

***Grant Revenues***

During the fourth quarter of 2005, the Companyreceived notice that a grant had been approved by the National Institutes ofHealth, or NIH, to fund additional research by the Company and itscollaborators on the potent anti-inflammatory effects of incyclinide. TheCompany expenses such research expenditures as they are incurred and recognizesgrant revenue when earned for the portion of the expenditures that arereimbursable by the NIH. The Company recognized $471 in grant revenues duringyear ended December 31, 2006.

***Advertising Costs***

The Company recordsadvertising costs as expense when incurred. Such amounts are charged toselling, general and administrative expenses in the consolidated statements ofoperations. Advertising costs for 2006, 2005 and 2004 were $692, $55 and $24,respectively.

***Research and Development***

Research and product development costs are expensed asincurred. Research and development expenses consist primarily of personnelcosts and funds paid to third parties for the provision of services andmaterials for drug development, manufacturing and formulation enhancements,clinical trials, statistical analysis and report writing and regulatorycompliance costs, including governmental filing fees.

Costs to acquirein-process research and development projects and technologies which have notachieved technical feasibility at the date of acquisition are expensed asresearch and development expense as incurred.

***Deferred Taxes***

Income taxes are accounted for under the asset andliability method. In estimating the Company’s income tax provision, the Companyrecognizes the benefit of an uncertain tax position that the Company has takenor expects to take on income tax returns filed if such tax positions isprobable of being sustained. Deferred tax assets and liabilities are recognizedfor the future tax consequences attributable to differences 

F-12

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases and operating loss and tax credit carryforwards. Deferredtax assets and liabilities are measured using enacted tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to be recovered or settled. The effect on deferred tax assets andliabilities of a change in tax rates is recognized in income in the period thatincludes the enactment date.

In assessing therealizability of deferred tax assets, the Company considers the likelihood thatpart or all of the deferred tax assets will not be realized. This assessmentrequires significant judgment and estimates. The ultimate realization of thedeferred tax assets is dependent upon the generation of future taxable incomeduring the period in which those temporary differences become deductible. TheCompany considers its history of losses, scheduled reversal of deferred taxassets and liabilities, tax planning strategies and projected future taxableincome over the periods in which the deferred tax asset items are deductible. TheTax Reform Act of 1986 contains provisions that may limit the net operatingloss and research and experimentation credit carryforwards available to be usedin any given year upon the occurrence of certain events, including significantchanges in ownership interest. The Company incurred net losses for the yearsended December 31, 2006 and 2005 and uncertainty regarding the Company’sfuture profitability has prevented the Company from reaching the “more likelythan not” conclusion required under the applicable literature to recognizedeferred tax assets on the Consolidated Balance Sheet.

***Management Estimates***

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the amounts reported in the consolidated financialstatements and accompanying notes. Actual results could differ from thoseestimates.

***Concentration of Credit and Other Risks***

The Company invests its excess cash in money marketfunds with major U.S. financial institutions, commercial paper and governmentnotes. The Company has established investment guidelines focused on protectingthe safety and liquidity of this invested cash.

The Company currently contracts with a single sourcefor the manufacturing of Oracea capsules and Periostat tablets and has anagreement with a single company to supply the active ingredient in Oracea andPeriostat. A single company also provides all warehousing and distributionservices to the Company.

During 2006, three distributors accounted for 44%,31%, and 13% of net product sales, respectively. Two distributors accounted for39% and 35%, of gross accounts receivable balances as of December 31, 2006.During 2005, three distributors and Mutual accounted for 37%, 24%, 12%, and 22%of net product sales, respectively. Three distributors accounted for 59%, 28%,and 8% of the gross accounts receivable balances as of December 31, 2005. During2004, three distributors and Mutual accounted for 33%, 29%, 19% and 14% of netproduct sales, respectively.

During the years ended December 31,2006, 2005 and 2004, Periostat and Mutual’s branded version of Periostataccounted for approximately 19%, 76%, and 88% of the Company’s total netrevenues, 

F-13

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

respectively.During the year ended December 31, 2006, Oracea accounted forapproximately 45% of the Company’s total net revenues.

***Net (Loss) Income Per Share***

Basic (loss) income per share (EPS) is calculated bydividing net (loss) income allocable to common stockholders by the weightedaverage shares of common stock outstanding. Net (loss) income allocable tocommon stockholders includes dividends (including dividends in arrears—see Note5) and other charges on the preferred stock. Diluted EPS reflects the potentialdilution that could occur if outstanding options and warrants were exercisedand/or convertible securities were converted into common stock.

As of December 31,2006 and 2005, the Company had outstanding stock options and stock warrantsthat were not included in the calculation of diluted net loss per shareallocable to common stockholders because doing so would have been anti-dilutive.Such stock options and warrants to purchase 2,774,372 shares and 3,345,267shares of common stock have been excluded from the computation of diluted EPSfor the years ended December 31, 2006 and 2005, respectively. During theyears ended December 31, 2006, 2005 and 2004, the Company hadapproximately 2,353,000, 2,353,000, and 2,020,000 of potential common stockshares from convertible preferred stock that were not included in thecalculation of diluted net (loss) income per share allocable to commonstockholders because doing so would have been anti-dilutive. For the yearended December 31, 2004, for diluted earnings per share there were commonstock equivalents of 235,950 as a result of “in-the-money” stock options andwarrants calculated using the treasury method. Excluded from the computation ofdiluted EPS were 2,213,550 shares of “out-of-the-money” stock options andwarrants for the year ended December 31, 2004 as they were anti-dilutive.

***Recently Issued Accounting Standards***

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin (SAB) No. 108, “*Considering the Effects of Prior Year Misstatements when QuantifyingFinancial Misstatements in Current Year Financial Statements*,” whichexpresses the Staff’s views regarding the process of quantifying financialstatement misstatements. Companies are required to quantify the impact ofcorrecting all misstatements, including both the carryover and reversingeffects of prior year misstatements, on the current year financial statements.The techniques most commonly used in practice to accumulate and quantifymisstatements are generally referred to as the “rollover” (current year incomestatement perspective) and “iron curtain” (year-end balance sheet perspective)approaches. The financial statements would require adjustment when eitherapproach results in quantifying a misstatement that is material, afterconsidering all relevant quantitative and qualitative factors. In the year ofadoption (January 1, 2006 for the Company), the misstatements previouslyconsidered immaterial under the Company’s previous method of qualifyingmisstatements, that are material under SAB No. 108 may be corrected as anaccounting change by adjusting opening retained earnings rather than being includedin the current year statement of operations. The adoption of SAB No. 108did not have an impact on the Company’s consolidated financial statements.

In June 2006, the Financial Accounting StandardsBoard, or the FASB, issued Interpretation No. 48, “*Accounting for Uncertainty in Income Taxes—AnInterpretation of FASB Statement No. 109*,” or FIN 48. FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial 

F-14

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

statements and prescribesa threshold of more-likely-than-not for recognition of tax benefits ofuncertain tax positions taken or expected to be taken in a tax return. FIN 48also provides related guidance on measurement, derecognition, classification,interest and penalties, and disclosure. Differences between the amountsrecognized in the financial statements prior to the adoption of FIN 48 and theamounts reported after adoption will be accounted for as a cumulative-effectadjustment recorded to the beginning balance of retained earnings.

The Company will adopt FIN 48 on January 1, 2007.Prior to the adoption of FIN 48, the Company’s policy was to recognize taxbenefits of uncertain tax positions only if it was probable that the positionwould be sustained. Accordingly, the Company anticipates that certain accruedexpenses for uncertain tax positions will be reversed upon adoption of FIN 48due to the lower recognition threshold. Based on the analysis, it is estimatedthat accrued expenses will decrease in the amount of $945, and retainedearnings will increase by the same amount as of January 1, 2007 as aresult of the adoption in FIN 48.

In November 2005, the FASB issued FASB StaffPosition SFAS 123(R)-3, *TransitionElection Related to Accounting for the Tax Effects of Share-based PaymentAwards*, or SFAS No. 123(R)-3, that provides an electivealternative transition method of calculating the pool of excess tax benefitsavailable to absorb tax deficiencies recognized subsequent to the adoption ofSFAS No. 123R to the method otherwise required by paragraph 81 of SFASNo. 123R. The adoption of SFAS No. 123(R)-3 did not have animpact on the Company’s consolidated financial statements.

In September 2006,the FASB issued SFAS Statement No. 157, “*FairValue Measurements*”, or SFAS 157. SFAS 157 clarifies the definitionof fair value, establishes a framework for measuring fair value and expands thedisclosures on fair value measurements. SFAS 157 is effective for the Companybeginning January 1, 2008. The Company is currently evaluating the impactof SFAS 157 adoption on its consolidated financial statements.

***Reclassification***

Certain prior yearbalances have been reclassified to conform to the current year presentation.

**(3) Composition ofCertain Financial Statement Captions**

***Inventories***

Inventoriesat December 31, 2006 and 2005 consist of the following:

| ** **      | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
| Raw materials   |       | $        | 978        |     | $          | 77 |   |
| Work-in-process |       | 339      |       | —   |       |
| Finished goods  |       | 642      |       | 553      |       |
|            |       | $        | 1,959      |     | $          | 630 |   |

 

During the year endedDecember 31, 2006, the Company recorded charges to cost of product salesof $257 for excess and short - dated inventories. During year endedDecember 31, 2005, the Company recorded charges to cost of product salesof $1,020 for excess inventory of Periostat and Mutual’s branded 

F-15

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

versionof Periostat. The charge resulted from decreased demand for Periostat and thetermination of the Company’s License and Supply Agreement with Mutual both ofwhich resulted from the introduction of a third party generic version ofPeriostat in May 2005.

**Equipment andLeasehold Improvements**

Equipmentand leasehold improvements at December 31, 2006 and 2005 consist of thefollowing:

| ** **                                       | ** ** | **2006** | ** ** | **2005** | ** ** | **Useful Life**                | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|-------------------------------------|------------|
| Computer and  office equipment                   |       | $        | 1,632      |     | $          | 1,309                               |       | 3-5  years |   |
| Equipment under  capital lease                   |       | 279      |       | —   |       | 3  years                            |       |
| Exhibit equipment                           |       | 173      |       | 97       |       | 5  years                            |       |
| Leasehold  improvements                          |       | 197      |       | 87       |       | Shorter  of 10 years or  lease term |       |
|                                             |       | $        | 2,281      |     | $          | 1,493                               |       |   |   |
| Less: accumulated  depreciation and amortization |       | (1,273   | )          | (954     | )          |                                |       |
|                                             |       | $        | 1,008      |     | $          | 539                                 |       |   |   |

 

***Intangible Assets, Net***

Intangibleassets, net at December 31, 2006 and 2005 consist of the following:

| ** **                     | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                     | ** ** | **Gross**                       | ** ** | **Accumulated  Amortization**   | ** ** | **Net** | ** ** | **Gross** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| Oracea milestone  fees         |       | $                               | 1,670      |                            |       | $ | (56 | ) |   | $ | 1,614 |   | $ | — |   |   | $ | — |   |   | $ | — |   |
| Atrix acquired  product rights |       | 1,876                           |       |                            | (1,608     | ) |   | 268 |   | 1,876 |   |   | (1,340 | ) |   | 536 |   |
| Total intangible assets        |       | $                               | 3,546      |                            |       | $ | (1,664 | ) |   | $ | 1,882 |   | $ | 1,876 |   |   | $ | (1,340 | ) |   | $ | 536 |   |

 

In August 2001, the Company signed a licenseagreement with Atrix Laboratories, Inc. (now known as Tolmar Inc.), forthe rights to market the Atrix Products in the United States. The Atrixacquired product rights are being amortized, through December 2007.

Oracea milestone fees represent the Oracea formulationmilestones paid post-FDA approval of Oracea and are being amortized on astraight-line basis over a fifteen year period commencing in July 2006.

F-16

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

Amortizationexpense, which is included in cost of product sales, was $324, $628 and $585 in2006, 2005 and 2004, respectively. Expected amortization of intangible assetsis as follows:

| 2007                |   | $     | 379    |   |
|---------------------|--------|-------|--------|--------|
| 2008                |   | 111   |   |
| 2009                |   | 111   |   |
| 2010                |   | 111   |   |
| 2011 and thereafter |   | 1,170 |   |
| Total               |   | $     | 1,882  |   |

 

***Accrued Expenses***

Accruedexpenses at December 31, 2006 and 2005 consist of the following:

| ** **                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
| Payroll and  related costs        |       | $        | 3,041      |     | $          | 2,097 |   |
| Research and  development costs   |       | 1,257    |       | 739      |       |
| Product returns                   |       | 996      |       | 1,267    |       |
| Foreign taxes  (notes 2 and 16)   |       | 945      |       | 945      |       |
| Sales and  marketing costs        |       | 864      |       | 239      |       |
| Professional and  consulting fees |       | 132      |       | 232      |       |
| State and  franchise taxes        |       | 161      |       | 110      |       |
| Deferred revenue                  |       | 80       |       | 58       |       |
| Government  rebates               |       | 80       |       | 237      |       |
| Other                             |       | 18       |       | 4        |       |
| Restructuring                     |       | —   |       | 96       |       |
| Total                             |       | $        | 7,574      |     | $          | 6,024 |   |

 

**(4) Stockholders’Equity—Common Stock**

On February 14, 2002, the Company entered into anequity line arrangement under the terms of a Common Stock Purchase Agreementwith Kingsbridge Capital Limited. Pursuant to this agreement, the Company wasable, at its sole discretion and from time to time through February 13,2003, to sell shares of its common stock to Kingsbridge at a discount to marketprice, as determined prior to each such sale. The equity line provided for thesale of up to $8,500 in registered shares of the Company’s common stock toKingsbridge. The equity line terminated pursuant to its terms on February 13,2003 and, prior to such termination, the Company issued an aggregate of 151,522shares of common stock for gross proceeds of $1,266.

In connection with the consummation of such equityline arrangement with Kingsbridge Capital Limited, in 2002 and pursuant to theterms of a warrant agreement executed by the Company, the Company issuedKingsbridge a warrant to purchase 40,000 shares of its common stock at anexercise price of $9.38 per share. The conversion price of the Company’s Series DCumulative Convertible Preferred Stock, or Series D Stock, was reduced to$9.89 as a result of the issuance of shares under the equity line 

F-17

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

and the issuance of suchwarrant (see note 5). Such warrant is exercisable, and will expire on August 13,2007. No warrants have been exercised and all 40,000 warrants are outstandingat December 31, 2006.

On May 29, 2002, the Company’s Board of Directorsapproved an Amended and Restated Shareholder Protection Rights Agreement (the “RightsAgreement”). American Stock Transfer & Trust Company is the rightsagent under the Rights Agreement. Each Right, once exercisable, entitles the holderto purchase from the Company one one-hundredth of a share of the Company’s Series AParticipating preferred stock at an exercise price of $65 per share. All Rightsexpire on September 26, 2007 unless earlier redeemed. At December 31,2006, the Rights were neither exercisable nor traded separately from theCompany’s common stock, and become exercisable only if a person or a group ofaffiliated or associated persons has acquired, or obtained the right toacquire, beneficial ownership of 20% or more of the voting power of alloutstanding shares of the Company’s common stock and in certain other limitedcircumstances. Upon separation from the common stock, each Right will entitlethe holder, other than the acquiring person that has triggered such separation,to effectively purchase certain shares of the Company’s common stock equal inmarket value to two times the then applicable exercise price of the Right. Ifthe Company is acquired in a merger or other business combination transaction,or 50% or more of the Company’s assets or earning power are sold in one or morerelated transactions, the Rights will entitle holders, upon exercise of theRights, to receive shares of common stock of the acquiring or surviving companywith a market value equal to twice the exercise price of each Right.

On December 21, 2005, the Company entered intodefinitive agreements with institutional and other investors to sell 2,900,000shares of the Company’s common stock for an aggregate purchase price of $29,000.On December 23, 2005, the Company closed on the first tier of the offeringissuing 1,550,000 shares of common stock in exchange for net proceeds of$14,388 after deducting approximately $1,069 in placement agency fees and otheroffering expenses that were accrued by the Company at December 31, 2005. OnJanuary 6, 2006, the Company closed on the second tier of the offeringissuing 1,350,000 shares of common stock in exchange for $12,663 of netproceeds.

On November 21, 2006,the Company sold 3,500,000 shares of its common stock to institutional andother investors for an aggregate gross purchase price of $45,500. The netproceeds of the offering were approximately $42,500 after deducting theplacement agency and financial advisory fees and all offering expenses thatwere payable by the Company.

**(5) Preferred StockAgreements**

The Company’s Board of Directors may, without furtheraction by the Company’s stockholders, direct the issuance and determine therights, preferences and limitations of one or more series of shares of preferredstock. The holders of preferred stock would normally be entitled to receive apreference payment in the event of any liquidation, dissolution or winding-upof the Company before any payment is made to the holders of the common stock.

On May 12, 1999, the Company consummated a$20,000 financing through the issuance of 200,000 shares of Series D Stock, which generatednet proceeds to the Company of approximately $18,500. OCM PrincipalOpportunities Fund, L.P. (“OCM”) led the investor group, which also includedcertain then current stockholders of the Company.

F-18

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

On December 15, 2005, the Company executed aRestructuring and Exchange Agreement with each of the holders of the Series DStock pursuant to which the Series D stockholders agreed to effect anexchange whereby the Company would exchange all 200,000 outstanding shares of Series DStock for 200,000 shares of the Company’s Series D-1 CumulativeConvertible Preferred Stock, or Series D-1 Stock. The Companyrecorded a non-cash charge to net (loss) income allocable to commonstockholders on the consolidated statement of operations of $3,680 related tothis Exchange Agreement in the fourth quarter of 2005.

On December 19, 2005, the Company filed aCertificate of Designations, Preferences and Rights of the Series D-1Cumulative Convertible Preferred Stock with the Secretary of State of the Stateof Delaware and on December 21, 2005, the Company exchanged all 200,000outstanding shares of Series D Stock for 200,000 shares of Series D-1Stock. As of December 21, 2005, there were no outstanding shares of Series DStock.

Beginning May 12, 2002, the holders of Series DStock were paid dividends in cash at a rate of 8.0% per annum. Beginning May 12,2005, the dividend rate, on the Series D Stock increases 100 basis pointsper year. Dividends on the Series D Stock and Series D-1 Stocktotaling $928, $1,727, and $1,600 were declared in 2006, 2005 and 2004,respectively. In January 2007, the Company declared $1,000 in dividends onthe Series D-1 Stock. Under US GAAP, dividends do not become aliability until declared. Accordingly, the $1,000 declaration of dividends in January 2007is not recorded as a liability in the accompanying consolidated balance sheetas of December 31, 2006. However, for purposes of calculating basic anddiluted EPS for the year ended December 31, 2006, on the consolidatedstatement of operations the $1,000 of cumulative preferred stock dividends inarrears are deductible from net loss in arriving at net loss allocable tocommon stockholders. There were no amounts of cumulative preferred stockdividends in arrears as of  December 31,2005.

Pursuant to the terms of the Series D-1Stock, the holders of the Series D-1 Stock are entitled to dividendspayable in cash at a rate of 10.0% per annum, which are declared and paid everysix months. The annual dividend rate increases by 1.0% per annum each May 19until the earlier of the date that all of the shares of Series D-1Stock are (i) converted into shares of common stock, or (ii) redeemed.

The dividend payable to the holders of the Series D-1Stock shall be doubled upon an event of default, which is defined as, amongother things, default on the payment of dividends, material breaches of thatcertain Stock Purchase Agreement, dated March 19, 1999, by and among theCompany, OCM, and the purchasers set forth therein or that certain Stockholdersand Registration Rights Agreement, dated March 19, 1999, as amended, byand among the Company, OCM and the purchasers set forth therein, the filing ofa bankruptcy petition by or against the Company, acceleration of indebtednessin excess of $1,000, a change in control, or the failure of the Company’scommon stock to actively trade on the American Stock Exchange, New York StockExchange or the Nasdaq Stock Market. The Company is entitled to pay the defaultdividends in shares of common stock in the event the Company cannot pay cashdividends because of a deficiency in cash or a prohibition under Delaware law,such that a cash payment would have a material adverse effect on the Company.

The Series D Stock was convertible into commonshares of the Company at an initial conversion price of $11.00 per share,subject to adjustment (see below and note 7), at any time by the holder andunder 

F-19

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

certain conditions by theCompany. Each share of Series D-1 Stock is convertible, at theoption of its holder, at any time, into shares of common stock determined bydividing $100 by the conversion price, which is currently $8.50 per share, foreach share of Series D-1 Stock converted. The conversion price ofthe Series D-1 Stock shall be adjusted, on a weighted average basis,upon the issuance of securities, options or warrants at a price per share lessthan the then effective conversion price. In the event the Company fails todeclare dividends after the Company has been notified of an event of defaultfor failure to pay dividends, the holders of a majority of the Series D-1Stock shall have the option to elect to have the conversion price of the Series D-1Stock reset to the then fair value of the Company’s common stock, based uponthe five-day trailing average closing price of the common stock (see below).

Each share of Series D-1 Stock isconvertible, at the Company’s option, into shares of the Company’s commonstock, at the applicable conversion rate, at any time after the common stockhas traded at a price per share of at least 200% above the conversion pricethen in effect for 30 consecutive trading days, provided that the shares ofcommon stock to be issued upon such conversion are registered under theSecurities Act of 1933, as amended.

The Series D-1 Stock is entitled to votetogether with the holders of the Company’s common stock on all matters to bevoted on by the Company’s stockholders generally, on an as-converted to commonstock basis. The approval of the holders of at least 66 2/3% of the Series D-1Stock is required for certain actions by the Company, including creating orissuing stock ranking senior to the Series D-1 Stock. The approvalof the holders of at least a majority of the Series D-1 Stock isrequired for certain actions by the Company, including paying dividends, otherthan those on the Series D-1 Stock, incurring indebtedness in excessof $10,000 for working capital purposes, disposing of the Company’s assets,except in the ordinary course of business, and acquisitions in any calendaryear period in excess of $10,000.

In the event of any liquidation, dissolution orwinding up of the Company, whether voluntary or involuntary, the holders ofoutstanding shares of Series D-1 Stock shall be entitled to receiveout of the Company’s assets available for distribution to the Company’sstockholders, an amount equal to $100 per share of Series D-1 Stockplus all cumulative dividends, whether or not earned or declared, which at December 31,2006 equaled $21,000.

Each outstanding share of Series D-1 Stockis redeemable, at the Company’s option as follows:  at $100 per share plus all accrued and unpaiddividends if less than 5% of the Series D-1 Stock originally issuedare outstanding and at $100 per share plus accrued and unpaid dividends in theevent of a change in control of the Company.

F-20

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

**(6) Acquisition**

On December 14, 2005, the Company executed aShare Purchase Agreement (the “SansRosa Purchase Agreement”), with SansRosaPharmaceutical Development, Inc., (“SansRosa”), and all of the existingshareholders of SansRosa (the “SansRosa Shareholders”), pursuant to which theCompany acquired 51% or 2,483,830 shares of the outstanding shares of capitalstock of SansRosa in exchange for a payment of $750. In 2006, the Companyacquired additional shares of the outstanding stock in exchange for a paymentof $100, which was offset by the payment to a third party to acquire therelated technology. The Company’s total ownership in SansRosa at December 31,2006 is 61%. For accounting purposes, the 2005 SansRosa acquisition was treatedas the acquisition of in-process research and development. The cost of theacquisition was charged to in-process research and development since theSansRosa technology has not achieved technical feasibility at this time.SansRosa is the assignee of certain patent applications covering methods fortreatment of redness associated with rosacea and other skin disorders. Underthe SansRosa Purchase Agreement, the Company has the right to purchase all ofthe remaining shares of SansRosa capital stock upon the achievement of specifiedregulatory and development milestones. If all milestones are achieved and apatented product is developed and approved for sale, the Company will pay theshareholders of SansRosa an additional $4,000 to $6,000. The agreement alsoprovides for royalty payments to the SansRosa Shareholders if future productsales incorporate the SansRosa technology.

The Company’s policy is toconsolidate the accounts and results of operations of its majority-ownedsubsidiaries, including SansRosa. SansRosa did not have significant operationsduring the period from December 14, 2005 through December 31, 2006. Accordingly,no minority interest liability has been accrued at December 31, 2006 or2005. Since the minority shareholders have no obligation to fund the ongoinglosses of SansRosa, no minority interest receivable has been recorded.

**(7) Licensing/Co-PromotionAgreements**

***MediGene AG***

On December 18, 2006,the Company executed a License and Supply Agreement with MediGene AG thatbecame effective on January 1, 2007. Under this agreement, MediGene hasthe right to manufacture, register, market and sell Oracea in the EuropeanUnion, certain contiguous countries and Russia. The Company was paid an upfront non-refundable fee of $5,000 less applicable withholding taxes of approximately$1,000, for which the Company expects to be reimbursed during 2007, uponexecution of the agreement and is entitled to an additional $7,500 in milestonepayments upon the achievement of certain annual sales thresholds. In addition,the Company will receive an agreed upon transfer price and a royalty of 12% ofannual net sales up to $10,000 and 15% of annual net sales in excess of$10,000.

***Primus***

In June 2005, theCompany entered into the Promotion Agreement with Primus under which theCompany agreed to promote Alcortin, a prescription topical antifungal steroidcombination, and Novacort, a prescription topical steroid and anesthetic. Underthe Promotion Agreement, the Company receives a percentage of the gross profitarising from prescriptions written by dermatology professionals (or offices)that result in sales of the products in the United States. The majority ofmarketing expenses, excluding 

F-21

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

salesforce compensation and sample product costs, related to the promotion of thePrimus products are funded by Primus. The majority of product sample costs andall sales force compensation are funded by the Company. The Company is requiredto deliver a minimum amount of annual contract year sales presentations todermatologists. The Company has also agreed to achieve certain levels ofproduct prescriptions as measured on an annual contract year basis. On July 1,2006, the Company and Primus amended the Promotion Agreement. As a result ofthe amendment, sample expense and marketing costs, excluding sales force compensation,are funded 60% by the Company and 40% by Primus. The Promotion Agreement has aninitial term that extends through June 30, 2008 and then renewsautomatically for successive additional terms of one year unless earlierterminated pursuant to the terms of the agreement.

***Restoraderm***

On August 19, 2004,the Company executed an Asset Purchase and Product Development Agreement (the “PurchaseAgreement”) relating to its Restoraderm® technology that superseded its Co-operation,Development and License Agreement executed in February 2002. Under theterms of the Purchase Agreement, the Company purchased all right, title andinterest in the intellectual property and related rights to the Restoradermtopical drug delivery system. The Company intends to develop Restoraderm fordermatological applications. In accordance with the terms of the PurchaseAgreement, the purchase price of the assets will be up to $1,000 subject to theachievement of certain milestones. The Company is also required to pay productdevelopment milestone payments in the aggregate amount of up to approximately$2,000 and royalty and sublicense fees, if applicable, upon productcommercialization. During the year ended December 31, 2006, the Companyincurred approximately $100 related to product development milestones. Duringthe year ended December 31, 2004, the Company incurred approximately $300in research and development expenses related to the asset purchase. During theyear ended December 31, 2004, the Company incurred approximately $133related to the product development milestones, which was charged to researchand development in the consolidated statements of operations. The purchase wascharged to in-process research and development since the Restoraderm technologyhad not achieved technical feasibility when acquired.

***Merck***

Pursuant to a Co-PromotionAgreement the Company executed with Merck in September 1999, the Companyreceived the exclusive right to co-promote Vioxx®, a prescription strength non-steroidalanti-inflammatory drug. The agreement provided for certain payments byMerck to the Company upon sales of Vioxx to the dental community. On September 23,2002, the Company executed an amendment, extension and restatement of such Co-PromotionAgreement which expired on December 31, 2003. The Company continued toearn nominal residual contract revenues through 2005 from this agreement. TheCo-Promotion Agreement also provides for indemnification of the Companyby Merck against any claims arising from manufacturing or design defects in theproduct or for which the Company, as the promoter of the product, may bestrictly liable as if it had been a seller of an inherently dangerous product. Duringthe years ended December 31, 2005 and 2004, the Company recorded $153 and$237, respectively, in residual contract revenues under this agreement. TheCompany did not receive any contract revenues from this agreement during theyear ended December 31, 2006, and will not earn any further contractrevenue under this agreement.

F-22

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

***Atrix***

On August 24, 2001, the Company signed the AtrixLicense Agreement with Atrix, now known as Tolmar Inc., to market the AtrixProducts to the United States dental markets. Pursuant to the terms of theAtrix License Agreement, among other things, Atrix will manufacture the dentalproducts for the Company at an agreed upon transfer price and will receiveroyalties on future net sales of the products each calendar year. The Companypaid a $1,000 licensing fee to Atrix in 2001 to market such products in theUnited States.  The $1,000 license feepayment has been capitalized and is being amortized to cost of product salesover the estimated useful life of the license on a straight-line basis(see below). On an annual basis the Company was required to make minimummarketing expenditures to promote the products equal to the lesser of $4,000 or30% of the Company’s contribution margin, as defined in the agreement, for thepromotion of a specific Atrix product that the Company markets plus the lesserof $2,000 or 30% of the Company’s contribution margin, as defined in theagreement, for the promotion of a separate Atrix product that the Companymarkets. These annual requirements were met by the Company in 2004. The Company terminated its domestic dentalpromotional activities in May 2005 and accordingly was no longer requiredto meet the minimum annual spending on a going forward basis.

On February 22, 2006,the Company amended its Atrix License Agreement and has agreed to continue tosell the Atrix Products through its distributor and pay an increased royalty onnet sales and an increased transfer price to Tolmar Inc., but the Company is nolonger required to make annual minimum expenditures for advertising andpromotional activities. Pursuant to the amended agreement, either party mayterminate the Agreement at any time, with or without cause, upon six (6) monthsprior written notice. The amendment amends the term of the License andMarketing Agreement through December 31, 2007. Accordingly, the Companyhas adjusted the estimated remaining useful life of Atrix product right assetthrough December 31, 2007.

***Altana***

On May 24, 2002, the Company executed aSublicense Agreement with Altana pursuant to which the Company was granted theexclusive right to create improvements to, market, advertise, promote,distribute, offer for sale and sell, in the United States and Puerto Rico,Pandel Cream, a mid-potency topical corticosteroid indicated for the relief ofmild-to-moderate inflammatory disorders of the skin such as atopic dermatitisand psoriasis. Altana currently licenses such rights from Taisho PharmaceuticalCo., Ltd., a company organized and existing under the laws of Japan. TheCompany purchases all Pandel products to be sold from Altana.

Pursuantto the terms of its agreement, the Company paid Altana an aggregate sublicensefee of $1,700. At the time of payment, the sublicense fee was capitalized andamortized over its expected useful life (fully amortized as of December 31,2005). In addition, the Company is required to pay a royalty fee equal to apercentage of the net sales of the product, if any. The agreement was amendedin November 2006 as it relates to its’ termination clauses. The agreementmay be terminated by the Company at any time, without cause, upon twelve monthsprior written notice; or upon certain events as defined in the amendedagreement. In addition, Altana may terminate the agreement at any time, withoutcause, upon nine months prior written notice to the Company, provided thatAltana shall not provide any such notice prior to February 1, 2007 or uponcertain events as defined in the amended agreement. On 

F-23

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

February 1, 2007, the Company received noticefrom Altana of its intent to terminate the agreement on November 1, 2007.Under the terms of the agreement, the Company will receive $1,700 whichrepresents initial license fees paid to Altana. Such payment is due from Altanaupon termination of the agreement.

**(8) Line of Credit**

Inprior years, the Company had entered into a credit facility with Silicon ValleyBank. On October 9, 2006, the Company entered into a Sixth LoanModification Agreement with Silicon Valley Bank. Pursuant to the terms of thisagreement, the expiration date of the credit facility has been extended to October 9,2008. Under the amended credit facility, the Company may borrow up to thelesser of (i) $10,000 or (ii) 80% of eligible receivables pluscertain specified amounts, subject to reduction during the period October 9,2006 through December 31, 2007. The amount available to the Company isreduced by any outstanding letters of credit that may be issued under theamended credit facility in amounts totaling up to $2,000. As the Company paysdown amounts under any letter of credit, the amount available to it under thecredit facility increases. The Company is not obligated to draw down anyamounts under the amended credit facility and any borrowings shall bearinterest, payable monthly, at Silicon Valley Bank’s prime rate or 8.25% at December 31,2006. Under the Sixth Loan Modification Agreement, the Company is charged anunused line credit fee of 0.25% per annum. During the years ended December 31,2006, 2005 and 2004 the Company’s unused line of credit fee was $25, $20 and $9,respectively. In addition, under the amended credit facility, the Company issubject to financial covenants that require the Company to maintain certainminimum liquidity and tangible net worth levels on a quarterly basis. As of December 31,2006 and 2005, the Company had no borrowings outstanding.

**(9) Share-BasedCompensation**

At December 31, 2006, the Company had one activestock-based employee compensation plan. Stock option awards to employees aregranted with an exercise price equal to the market value of the Company’scommon stock on the date of grant. The option awards generally have a term often years and generally vest over a period ranging from two to five years.  Certain options are subject to acceleratedvesting if there is a change in control (as defined in the plan and change ofcontrol agreements, if applicable).

Prior to January 1, 2006, the Company accountedfor stock-based employee compensation, including stock options, using themethod prescribed in Accounting Principles Board (APB) Opinion No. 25, “*Accounting for Stock Issued to Employees*”and related Interpretations. Under APB Opinion No. 25, no compensationcost was recognized for stock options with an exercise price equal to the fairmarket value of the Company’s common stock on the date of grant, and a disclosurewas made regarding the pro forma effect on net earnings (loss) and basic anddiluted EPS assuming compensation cost had been recognized in accordance withSFAS No. 123, “*Accounting forStock-Based Compensation,*” or SFAS No.123.

F-24

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

Thefollowing table illustrates the effect on net (loss) income and basic anddiluted net (loss) income per common share if the Company had applied the fairvalue recognition provisions of SFAS No. 123 to stock-based employeecompensation during the years ended December 31, 2005 and 2004 (optionforfeitures are accounted for as they occurred and no amounts of compensationexpense have been capitalized into inventory or other assets, but instead areconsidered period expenses in the pro forma amounts):

| ***In thousands, except per share data***                                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net (loss) income  allocable to common stockholders - as reported                                          |       | $        | (24,212    | )        | $          | 4,928 |   |
| Add: Stock-based  compensation included in the determination of net loss as reported                       |       | —   |       | —   |       |
| Deduct: Total  stock-based compensation expense determined under the fair value method for  all grants (1) |       | (2,796   | )          | (3,679   | )          |
| Net (loss) income  allocable to common stockholders—pro forma                                         |       | $        | (27,008    | )        | $          | 1,249 |   |
| Basic net (loss) income  per share allocable to common stockholders:                                       |       |     |       |     |       |
| As reported net (loss) income                                                                              |       | $        | (1.67      | )        | $          | 0.35 |   |
| Pro forma net (loss) income                                                                                |       | $        | (1.87      | )        | $          | 0.09 |   |
| Diluted net income  (loss) per share allocable to common stockholders:                                     |       |     |       |     |       |
| As reported net (loss) income                                                                              |       | $        | (1.67      | )        | $          | 0.34 |   |
| Pro forma net  (loss) income                                                                               |       | $        | (1.87      | )        | $          | 0.09 |   |

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(1)         Amounts have not beentaxed as a result of the Company’s net operating loss carry-forwards and fullvaluation allowance.

On December 16, 2004, the FASB issued SFAS No. 123R,which requires companies to measure and recognize compensation expense for allstock-based payments at fair value. SFAS No. 123R eliminatesaccounting for stock-based compensation transactions using APB Opinion No. 25,and generally requires that such transactions be accounted for using prescribedfair-value-based methods. Effective January 1, 2006, the Company adoptedSFAS No. 123R using the modified prospective method. Under APBOpinion No. 25, no compensation expense related to stock option grants wasrecorded in the consolidated statements of operations for the years ended December 31,2005 and 2004. The results for prior periods have not been restated. Under the “modifiedprospective” method, compensation costs are recognized for all newly granted ormodified stock-based awards and for the unvested portion of all awards grantedprior to the effective date.

The Company is using the straight-line method torecognize stock-based compensation expense. The amount of stock-basedcompensation recognized during a period is based on the value of the awardsthat vest in that period. SFAS No. 123R requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates. The term “forfeitures” isdistinct from “cancellations” or “expirations” and represents only the unvestedportion of the surrendered option. The Company has applied an annual forfeiturerate of 2.8% to all unvested options as of the date of adoption and for theyear ending December 31, 2006. This analysis is re-evaluated quarterly andthe forfeiture rate is adjusted as necessary. Ultimately, the actual expenserecognized over the vesting period will only be for those shares that vest.

F-25

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

During the year ending December 31, 2006, theCompany recorded $3,286 of stock-based compensation cost. This amount iscomposed of $423 related to research and development expenses and $2,863related to selling, general and administrative expenses. No amount ofstock-based compensation cost has been capitalized into inventory or otherassets during the year ended December 31, 2006.

As a result of adopting SFAS No. 123R, theCompany’s loss allocable to common stockholders for the year ended December 31,2006, was $3,286 greater than if the Company had continued to account forstock-based compensation under APB Opinion No. 25. Basic and diluted lossper share allocable to common stockholders for the year ended December 31,2006, would have been $1.79 per share if the Company had not adopted SFAS No. 123R,compared to reported basic and diluted loss per share allocable to commonstockholders of $1.98 per share.

Since inception, the Company has had four stock-basedcompensation plans. The Company issues new shares of common stock upon theexercise of stock options. The only active plan at December 31, 2006 isthe 2005 Equity Incentive Plan, or the 2005 Plan.

The 1992 Stock Option Plan, as amended, or the 1992Plan, provided for the granting of incentive and nonqualified options todirectors, employees and consultants to purchase up to 291,000 shares of theCompany’s common stock at an exercise price not less than the fair value on thegrant date. Such options are exercisable for a period of ten years from thegrant date and generally vest over a four-year period. All 291,000 optionsavailable under the 1992 Plan were granted by 1996.

The 1996 Non-Employee Director Stock Option Plan, orthe Non-Employee Director Plan, provided for the granting of stock options tonew non-employee directors to purchase up to 300,000 shares of common stock atan exercise price not less than the fair value on the grant date. Such optionsare exercisable for a period of ten years from the date of grant and generallyvest over a five-year period. The Non-Employee Director Plan expired in March 2006.Unissued shares under the Non-Employee Director Plan were eligible to bereissued into other active Company stock-based compensation plans.

The 1996 Stock Option Plan, as amended, or the 1996Plan, provided for the granting of incentive and nonqualified options toemployees and consultants to purchase up to 3,000,000 shares of the Company’scommon stock at an exercise price not less than the fair value on the grantdate. Such options are exercisable for a period of ten years from the grantdate and generally vest over a two-to-five-year period, although vesting foroptions granted to certain Company officers is subject to acceleration undercertain circumstances, as these options are performance-based. The 1996 Planexpired in March 2006, at which time all unissued options were rolled overto the 2005 Plan.

The 2005 Plan provides for the issuance of incentiveand nonqualified options, restricted stock awards, restricted stock units andother stock-based awards, including the grant of stock appreciation rights toemployees, officers, directors, consultants, advisors, and other serviceproviders to purchase shares of the Company’s common stock at a price pershare, for the incentive options, not less than the fair value of a share ofthe Company’s common stock on the grant date. The number of shares of commonstock that can be issued pursuant to the 2005 Plan is 1,000,000 shares plus therollover of 476,555 remaining shares of common stock reserved for issuanceunder the 1996 Plan upon its expiration in March 2006. At December 31,2006, stock options were only available for issuance under the 2005 Plan. Suchoptions are exercisable for a period of ten years from the grant date andgenerally vest over a five-year period. At 

F-26

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

December 31, 2006,there were 889,155 shares of common stock available to be granted under the2005 Plan.

Certain options granted in 2003 are being amortized ata rate that is accelerated versus the contractual vesting period of suchoptions as these options are performance-based and it is anticipated that theperformance criteria will be met prior to straight-line vesting.

In May 2006, the Company accelerated the vestingof certain options held by a former member of the Company’s Board of Directors.Accordingly, a charge of $92 was recorded for the year ended December 31,2006 to reflect the fair value of such options on the date of modification.

Thefollowing table summarizes activity under all stock option plans for the yearsended December 31, 2006, 2005, and 2004:

| *** ***                                              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Weighted-average  fair value of options granted per share |       | $        | 7.70       |     | $          | 4.20     |       | $ | 6.79 |   |
| Intrinsic value of  options exercised                     |       | $        | 1,198      |     | $          | 358      |       | $ | 1,887 |   |

 

At December 31, 2006, the value of the unvestedportion of all outstanding stock-related awards was $6,822 which the Companyexpects to amortize and recognize as compensation expense over theweighted-average service period of approximately 3.0 years.

The amount of cash received during the years ended December 31,2006, 2005 and 2004 from the exercise of options was $2,521, $579, and $2,352,respectively. No related tax benefit from the exercise of such options wasrealized as a result of the Company’s net operating loss carryforwards and fullvaluation allowance.

Thefair values of the options granted during the years ended December 31,2006, 2005 and 2004 were determined using the Black-Scholes option pricingmodel, which incorporates various assumptions. The risk-free rate of interestfor the average contractual life of the option is based on U.S. GovernmentSecurities Treasury Constant Maturities. Expected volatility is based on thehistorical daily volatility of the Company’s common stock. The expected life isdetermined using the short-cut method permitted under Staff Accounting BulletinNo. 107, *Share-Based Payment*.The expected dividend rate yield is zero because the Company currently does notpay or expect to pay dividends to common stockholders. The following are theweighted average assumptions used during the years ended December 31, 2006,2005, and 2004:

| ** **               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected life in  years  |       | 6.50     |       | 6.12     |       | 7.02     |       |
| Risk-free  interest rate |       | 4.63     | %          | 4.05     | %          | 3.87     | %          |
| Volatility               |       | 69       | %          | 73       | %          | 80       | %          |
| Expected dividend yield  |       | —   | %          | —   | %          | —   | %          |

 

F-27

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

TheCompany has granted stock options to officers, directors and employees asfollows: 

| ** **                             | ** ** | **Number of   Shares Subject   to Issuance** | ** ** | **Weighted   Average   Exercise   Price** | ** ** | **Weighted   Average   Remaining   Contractual   Term** | ** ** | **Aggregate   Intrinsic   Value ($000)** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| Outstanding at  January 1, 2004   |       |                                                                  | 3,433,004  |                                                     |       |                                                                        | $          | 9.72                                                    |       |   |   |   |   |   |   |   |   |   |
| Granted                                |       |                                                                  | 744,007    |                                                     |       |                                                                        | 9.12       |                                                    |       |   |   |   |   |   |   |   |   |
| Cancelled                              |       |                                                                  | (551,154   | )                                                        |       |                                                                        | 10.95      |                                                    |       |   |   |   |   |   |   |   |   |
| Exercised                              |       |                                                                  | (354,634   | )                                                        |       |                                                                        | 6.19       |                                                    |       |   |   |   |   |   |   |   |   |
| Outstanding at  December 31, 2004 |       |                                                                  | 3,271,223  |                                                     |       |                                                                        | $          | 9.76                                                    |       |   |   |   |   |   |   |   |   |   |
| Granted                                |       |                                                                  | 482,755    |                                                     |       |                                                                        | 6.20       |                                                    |       |   |   |   |   |   |   |   |   |
| Cancelled                              |       |                                                                  | (329,791   | )                                                        |       |                                                                        | 10.40      |                                                    |       |   |   |   |   |   |   |   |   |
| Exercised                              |       |                                                                  | (118,920   | )                                                        |       |                                                                        | 4.88       |                                                    |       |   |   |   |   |   |   |   |   |
| Outstanding at  December 31, 2005 |       |                                                                  | 3,305,267  |                                                     |       |                                                                        | $          | 9.35                                                    |       |   |   |   |   |   |   |   |   |   |
| Granted                                |       |                                                                  | 510,500    |                                                     |       |                                                                        | 11.40      |                                                    |       |   |   |   |   |   |   |   |   |
| Cancelled                              |       |                                                                  | (50,250    | )                                                        |       |                                                                        | 9.64       |                                                    |       |   |   |   |   |   |   |   |   |
| Exercised                              |       |                                                                  | (286,927   | )                                                        |       |                                                                        | 8.79       |                                                    |       |   |   |   |   |   |   |   |   |
| Outstanding at  December 31, 2006 |       |                                                                  | 3,478,590  |                                                     |       |                                                                        | $          | 9.69                                                    |       |   |   | 5.95 years |   |   |   | $ | 14,888 |   |   |
| Unvested at  December 31, 2006    |       |                                                                  | 1,373,428  |                                                     |       |                                                                        | $          | 9.31                                                    |       |   |   | 8.20 years |   |   |   | $ | 6,400 |   |   |
| Exercisable at  December 31, 2006 |       |                                                                  | 2,105,162  |                                                     |       |                                                                        | $          | 9.94                                                    |       |   |   | 4.51 years |   |   |   | $ | 8,484 |   |   |

 

TheCompany had the following stock options available for exercise:

| ** **              | ** ** | **Weighted Average   Remaining   Contractual Term** | ** ** | **Weighted   Average   Exercise Price** | ** ** | **Number of   Shares   Exercisable** | ** ** | **Aggregate   Intrinsic Value   ($000)**(1) | ** ** |
|-------------------------|------------|-------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-----------------------------------------------------|------------|------------------------------------------------------------|------------|
| December 31,  2006 |       |                                                                    | 4.51       |                                                   |       |                                                | $          | 9.94                                                       |       |   | 2,105,162 |   |   | $ | 8,484 |   |   |
| December 31,  2005 |       |                                                                    | 4.50       |                                                   |       |                                                | $          | 10.13                                                      |       |   | 1,935,084 |   |   | $ | 3,754 |   |   |
| December 31, 2004  |       |                                                                    | 4.23       |                                                   |       |                                                | $          | 7.35                                                       |       |   | 1,789,962 |   |   | N/A(1) |   |   |

----

(1)         The aggregate intrinsicvalue on this table was calculated based on the positive difference between theclosing sales price of the Company’s common stock on the balance sheet date andthe exercise prices of the underlying options. The intrinsic value of optionsexercisable at December 31, 2004 is not applicable as a result of theweighted average exercise price of such options exceeding the closing saleprice of the Company’s common stock on December 31, 2004.

F-28

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

**(10) IncomeTaxes**

Theprovision for income taxes is as follows:

| ** **  | ** ** | **Year Ended December 31,** | ** ** |
|-------------|------------|--------------------------------------------|------------|
| **Current** | ** ** | ** **                                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Federal     |       |                                       | $          | — |   |   |   | $ | — |   |   | $ | 22 |   |
| Foreign     |       |                                       | —     |   |   |   | — |   |   | 945 |   |
| State       |       |                                       | —     |   |   |   | — |   |   | — |   |
| ** **  |       |                                       | $          | — |   |   |   | $ | — |   |   | $ | 967 |   |
|             |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Reconciliationsof the income tax expense from the Federal statutory rates for 2006, 2005 and2004 are as follows:

| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| **Effective  Rate Reconciliation**           | ** ** | ** **                                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Pretax income at  statutory rates            |       | $                                          | (11,368    | ) | (34.0 | )% | $ | (6,393 | ) | (34.0 | )% | $ | 2,548 |   | 34.0 | % |
| Adjustments relating  from:                  |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Foreign income  taxed at different rates     |       |                                       |       |   |   |   |   |   |   | 9 |   | 0.1 |   |
| State taxes, net  of federal benefit         |       | —                                     |       | — |   | — |   |   |   | — |   |   |   |
| Stock-based  compensation                    |       | 583                                        |       | 1.7 |   | — |   |   |   | — |   |   |   |
| Other permanent  differences and adjustments |       | 750                                        |       | 2.3 |   | (63 | ) | (0.3 | ) | 87 |   | 1.2 |   |
| Increase  (decrease) in valuation allowance  |       | 10,035                                     |       | 30.0 |   | 6,456 |   | 34.3 |   | (1,677 | ) | (22.4 | ) |
| Expected tax expense                         |       | $                                          | —     |   | $ | — | % | $ | — |   | $ | — | % | $ | 967 |   | 12.9 | % |
|                                              |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thetax effects of temporary differences that give rise to significant portions ofthe deferred tax assets at December 31, 2006 and 2005 are presented below:

| ** **                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets:                     |       |     |       |     |       |
| Accumulated depreciation and amortization |       | $        | 657        |     | $          | 526 |   |
| Net operating loss carryforwards          |       | 35,408   |       | 26,163   |       |
| Tax credit carryforwards                  |       | 1,052    |       | 1,043    |       |
| Accrued expenses                          |       | 1,714    |       | 836      |       |
| Deferred revenue                          |       | 260      |       | 488      |       |
| Total gross deferred assets               |       | 39,091   |       | 29,056   |       |
| Less valuation allowance                  |       | (39,091  | )          | (29,056  | )          |
| Net deferred  taxes                       |       | $        | —     |     | $          | — |   |

 

F-29

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

In assessing the realizability of deferred tax assets,management considers whether it is more likely than not that some portion orall of the deferred tax assets will not be realized. The ultimate realizationof deferred tax assets is dependent upon the generation of future taxableincome during the periods in which temporary differences are deductible andcarryforwards are available. Due to the uncertainty of the Company’s ability torealize the benefit of the deferred tax assets, the net deferred tax assets arefully offset by a valuation allowance at December 31, 2006 and 2005.

The net change in the total valuation allowance forthe years ended December 31, 2006 and 2005 were increases of $10,035 and$6,456 respectively, related primarily to the increase in net operating lossesin 2006 and 2005. At December 31, 2006, the Company had approximately$105,000 of Federal and $42,000 of state net operating loss carryforwardsavailable to offset future taxable income for tax reporting purposes. TheFederal net operating loss carryforwards will begin to expire in 2010. Thestate net operating losses have begun to expire and will continue to expirethrough 2026, if not utilized. Included in the Company’s net operating losscarryforward are deductions relating to the exercise of stock options in theamount of $9,100, which tax benefit will be credited to additional paid-incapital to the extent such tax assets are realized in the future. The Companyalso has research and development tax credit carryforwards of approximately$893 available to reduce Federal income taxes which begin expiring in 2007.

Section 382 and Section 383of the Internal Revenue Code of 1986 subjects the future utilization of netoperating losses and certain other tax attributes, such as research anddevelopment credits, to an annual limitation in the event of an ownershipchange, as defined. Due to the Company’s previous equity transactions, aportion of the Federal net operating losses and tax credits of the Company aresubject to an annual limitation of approximately $3,800. To the extent that anysingle-year limitation is not utilized to the full amount of the limitation,such unused amounts are carried over to subsequent years until the earlier ofits utilization or the expiration of the relevant carryforward period. As of December 31,2006, approximately $94,000 is immediately available to offset future taxableincome. The annual net operating loss utilization may be further limited ifadditional changes in ownership occur. The Company is currently evaluating suchfurther limitations that could result from the December 2005, January 2006and November 2006 common stock sales of an aggregate of 6,400,000 sharesof common stock. In addition to the section 382 and 383 limitations, thestate net operating loss carryforwards are subject to a $2,000 annuallimitation for 2006 and the greater of 12.5% of taxable income or $3,000 fortax years after 2006.

**(11) TechnologyLicense**

At the time of itsformation in 1992, the Company entered into an agreement with the ResearchFoundation of the State University of New York at Stony Brook (“SUNY”) wherebythe Company received an option to acquire a technology license. The Company’soption to acquire the license was exercised in 1995 and remains in effect for aperiod not to exceed twenty years from the date of the first sale of productincorporating the technology under license or the last to expire of thelicensed patents in each country. The Company is required to pay all patentfees and related legal costs under the license, as well as to support certainadditional research efforts. In addition, the Company is liable to SUNY forannual royalty fees based on net Oracea and Periostat sales, if any, as definedin the agreement. Legal costs incurred by the Company in defending the patentsunderlying the technology license are deducted from royalties paid to SUNY (Seenote 15). A minimum annual royalty of $50 per year is required for the 

F-30

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

durationof the technology license. The Company incurred royalty expense (recordedwithin cost of sales) for this technology of $498, $899, and $1,933 in 2006,2005 and 2004, respectively.

**(12) SalesForce Restructuring**

On May 16, 2005, the Company announced therestructuring of its sales force following the FDA’s approval of a third partygeneric version of Periostat. As a result of the restructuring, the Companyceased all dental promotional activities. The Company incurred a $1,184restructuring charge during the year ended December 31, 2005. Of thischarge, $813 related to employee severance costs while the remaining portionwas primarily related to the write-off of tangible assets and payments dueunder an operating lease associated with the Company’s dental sales andmarketing activities that could no longer be utilized by the Company. As of December 31,2006 all of these costs have been paid by the Company.

On April 22, 2004, the Company announced therestructuring of its pharmaceutical sales organization into dedicated dentaland dermatology sales forces. The Company incurred a $348 restructuring chargeduring the year ended December 31, 2004. As of December 31, 2005, allof these costs have been paid by the Company.

**(13) OtherCommitments and Contingencies**

During 2006, the Company entered into a capital leasecovering certain computer equipment that expires in 2009. At December 31,2006, the gross amount of computer equipment and related accumulatedamortization recorded under capital leases were $279 and $39, respectively.Amortization of assets held under capital leases is included with depreciationexpense. The Company also has several noncancelable operating leases, primarilyfor office space and automobiles, that expire over the next three years.

Futureminimum lease payments under noncancelable operating leases (with initial orremaining lease terms in excess of one year) and future minimum capital leasepayments as of December 31, 2006 are: 

| **Year ending December 31:** | ** ** | ** ** | ** ** | **Capital Leases** | ** ** | **Operating Leases** | ** ** |
|---------------------------------------------|------------|------------|------------|-------------------------|------------|---------------------------|------------|
| 2007                                        |       |       | $          | 105                     |       |                      |       | $ | 955 |   |   |
| 2008                                        |       |       | 105        |                    |       |                      | 903        |   |   |
| 2009                                        |       |       | 67         |                    |       |                      | 541        |   |   |
| Total minimum lease payments                |       |       | $          | 277                     |       |                      |       | $ | 2,399 |   |   |
| Less amount representing interest           |       |       | 27         |                    |       |                      |       |   |   |
| Present value of  capital lease payments    |       |       | $          | 250                     |       |                      |       |   |   |   |

 

Expenses under operatingleases including restructuring charges, for the years ended December 31,2006, 2005 and 2004 totaled $875, $546 and $520, respectively.

F-31

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

***Change in Control Agreements***

The Company entered into change of control agreements,or the Existing Agreements, with each of the following officers, collectivelyreferred to as the Officers: Colin W. Stewart (December 8, 2003), Nancy C.Broadbent (September 18, 2002), David F. Pfeiffer (September 18,2002), Klaus Theobald (February 1, 2004), Andrew K. W. Powell (September 23,2004) and Greg Ford (August 9, 2004).

Under the Existing Agreements, in the event theemployment of an Officer was terminated as a result of an InvoluntaryTermination within 24 months of a Change of Control, each as defined in theExisting Agreements, the Officers were entitled to receive, among other things,(i) a lump sum payment of 1.5 times base salary and 1.5 times the averagebonus paid for the three fiscal years prior to the Termination Date, as definedin the Existing Agreements, (ii) health coverage and benefits for a periodof 24 months and (iii) certain outplacement/administrative support for aperiod of 18 months. In addition, under the Existing Agreements, if a Change ofControl occurred while Ms. Broadbent or Messrs. Stewart, Pfeiffer,Theobald, Powell or Ford was employed by the Company, regardless of whethertheir employment relationship with the Company continues following such Changeof Control, then all stock options granted to these individuals prior to theChange of Control would become fully vested and exercisable as of the date ofthe Change of Control to the extent such stock options were outstanding andunexercisable at the time of such termination.

On October 16, 2006, the Company entered into anew change of control agreement with Mr. Stewart, or the StewartAgreement, and a new form of change of control agreement with each of theremaining Officers, such form referred to as the Management Agreement, togetherwith the Stewart Agreement, the Agreements, which supersede the ExistingAgreements.

The Agreements contain the above-described provisionsof the Existing Agreements, except that, in the event the employment of anOfficer is terminated as a result of an Involuntary Termination within 24months of a Change of Control (i) the Stewart Agreement provides that thelump sum payment will be 2.5 times base salary and 2.5 times the average bonuspaid for the three fiscal years prior to the Termination Date and (ii) theform of Management Agreement provides that the lump sum payment will be 2 timesbase salary and 2 times the average bonus paid for the three fiscal years priorto the Termination Date.

In addition, each of theAgreements provides for an additional payment if the Officer would be subjectto an excise tax, interest or penalty based on a payment provided for in theapplicable Agreement.

***Other Commitments***

On June 10, 2002, the Company executed a Developmentand Licensing Agreement with Supernus Pharmaceuticals, Inc., or Supernus(successor in interest to Shire) pursuant to which the Company was granted anexclusive worldwide license (including the right to sublicense) to use Supernustechnology and patents to develop prescription products for the treatment ofvarious inflammatory disorders. Under the agreement, certain productdevelopment functions will be performed for the Company by Supernus. TheCompany has committed to pay Supernus milestone payments in cash or, at itsoption, in a combination of cash and our common stock, upon the achievement ofcertain clinical and regulatory milestones. For rosacea-indicated development,these future payments could total up to $1,000 in the aggregate and relateprimarily to international approval and international commercialization ofOracea. Through December 31, 

F-32

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

2006, the total milestonepayments made to Supernus related to Oracea were $2,700 of which $1,700 hasbeen capitalized. Under the Development and Licensing Agreement with Supernus,the Company must also pay Supernus royalties based on a percentage of net salesof any products utilizing any part of the licensed technology.

In December 2003,Brian Gallagher, Ph.D., the Company’s former chairman, chief executive officerand president, left the Company and until December 2005,Dr. Gallagher acted as a consultant to the Company. The Company incurred$304 and $324, respectively, in consulting fees to Dr. Gallagher in eachof the years ended December 31, 2005 and 2004.

***Other Matters***

As described in note 7, the Company has committed tomake potential future “milestone” payments to third parties as part of theCompany’s in-licensing and development programs primarily in the area ofresearch and development agreements. Payments generally become due and payableonly upon the achievement of certain developmental, regulatory and/orcommercial milestones. Because the achievement of these milestones is neitherprobable nor reasonably estimable, the Company has not recorded a liability onits consolidated balance sheet for any such contingencies.

The Company is involved invarious other claims and legal actions arising in the ordinary course ofbusiness at December 31, 2006. In the opinion of management, the ultimatedisposition of these matters will not have a material adverse effect on theCompany’s consolidated financial position, results of operations, or liquidity.

**(14) LegalSettlements and Proceedings**

***IVAX and CorePharma***

On October 1, 2004, the Company filed a complaintfor patent infringement against IVAX Pharmaceuticals Inc., or IVAX, andCorePharma LLC, or CorePharma, in the United States District Court for theEastern District of New York. In its complaint, the Company alleged that thesubmission of abbreviated new drug applications by each of IVAX and CorePharmafor 20 mg tablets of doxycycline hyclate infringed United States Patent RE34,656, for which the Company is the exclusive licensee. The Company alsoalleged that any manufacture, importation, marketing and sale of generic 20 mgtablets of doxycycline hyclate by IVAX and CorePharma would infringe the RE34,656 patent. The Company sought an injunction preventing IVAX and CorePharmafrom introducing 20 mg tablets of doxycycline hyclate in the United States. Theinjunction was denied by the Court on June 16, 2005. The Company, IVAX andCorePharma have since agreed not to pursue litigation on the merits of theCompany’s patent infringement claims of the counterclaims alleged by IVAX andCorePharma. On May 10, 2006, the Court in the Eastern District of New Yorkentered a Stipulated Order of Dismissal with Prejudice as to the matters atissue with CorePharma, and on September 20, 2006 a similar order wasentered with respect to IVAX.

F-33

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

In addition to the aboveproceedings, the Company is involved in, or has been involved in, arbitrationsor various other legal proceedings that arise from the normal course ofbusiness. The Company cannot predict the timing or outcome of these claims andother proceedings. At December 31, 2006, the Company is not involved inany arbitration and/or other legal proceedings that it expects to have amaterial adverse effect on the business, financial condition, results ofoperations or liquidity of the Company. All legal costs are expensed asincurred.

**(15)** LegalExpenses to Defend Periostat Patents

Under the Company’slicense agreement with SUNY covering Periostat and Oracea, the Company isentitled to deduct costs incurred to defend its patents, including the $2,700in settlement payments to Mutual and West-Ward, from current and futureroyalties due to SUNY on net sales of products based on the SUNY technology. Duringthe years ended December 31, 2006, 2005, and 2004, the Company incurred$23, $1,100, and $4,116 (which included the $2,000 Mutual settlement) in legaldefense, litigation, and settlement costs, respectively. The Company deducted$498, $899, and $1,933, from royalties earned by SUNY during the years endedDecember 31, 2006, 2005 and 2004, respectively (see note 11). Thecumulative legal patent defense, litigation and settlement costs incurredduring the litigation period through December 31, 2006 exceed the amountof the royalties payable to SUNY by $3,666. These excess amounts, which havebeen expensed, will be available to offset future royalties earned by SUNY, ifany, on net sales of products based on the SUNY technology.

**(16) Sale of U.K. and European Dental Assets**

On November 3, 2004,CollaGenex International Ltd (“CIL”), a wholly-owned U.K. subsidiary of theCompany, sold its U.K. and European dental assets to Alliance for net proceedsof $2,980. This agreement provided for the sale by CIL to Alliance of certaintrademark rights, U.K. and European governmental marketing authorizations,distribution agreements and other intangible assets relating to the sale orpotential sale of Periostat in the U.K., Europe, Israel, South Africa, NewZealand and Australia. The agreement also granted Alliance an option to acquirea license to register and market Periostat-MRTM, a once-daily, modified releaseform of Periostat, for adult periodontitis in the same territories. The Companyhas retained all rights to Periostat-MR for all other clinical indications. TheCompany also entered into a Supply Agreement with Alliance pursuant to whichthe Company will supply Periostat in bulk tablet form to Alliance at anegotiated transfer price.

The Company recorded netproceeds of $2,980 from the sale during the year ended December 31, 2004. Thenet proceeds represent the $3,300 payment from Alliance less professional feesincurred in connection with the transaction. As a result of the transaction,the Company also recognized $96 in previously deferred license revenues duringthe year ended December 31, 2004. In addition to these revenues, theCompany also recognized $223, $74 and $74 in net product sales related to bulkshipments of Periostat to Alliance during each of the years ended December 31,2006, 2005 and 2004, respectively.

As part of this sale in2004, the Company recorded a liability of $945 within accrued expenses foranticipated U.K. income taxes due on this sale. As described in note 2, theCompany adopted FIN 48 on January 1, 2007. As a result of the adoption,this liability was reversed on January 1, 2007 as the threshold for thistax uncertainty was above more-likely-than not. On January 19, 2007, theCompany received a notice from the U.K. taxing authorities saying that no changeswere needed to the Company’s tax return which means that no additional taxeswere due related to this transaction.

F-34

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

**(17) 401(k) Salary Reduction Plan**

In January 1995, theCompany adopted a 401(k) Salary Reduction Plan (the “401(k) Plan”)available to all employees meeting certain eligibility requirements. The 401(k) Planpermits participants to contribute up to 15% of their annual salary, asdefined, not to exceed the limits established by the Internal Revenue Code. Allcontributions made by participants vest immediately in the participant’s account.During the year ended December 31, 2004 the Company made a discretionarycontribution of $100 to the 401(k) Plan. In 2005, the 401(k) plan wasamended to allow an employer sponsored matching contribution of 20% on eachdollar for the first 6% of the compensation deferred by the participant. TheCompany made matching contributions of $92 and $78 during the years ended December 31,2006 and 2005.

**(18) Related Party Transactions**

A current member of theCompany’s Board of Directors is also a 1.0% holder of the Company’s Series D-1Stock which was exchanged for shares of Series D Stock in connection withthe execution of the Restructuring and Exchange Agreement in December 2005(See note 5).

**(19) Quarterly Financial Data (Unaudited)**

Thetables below summarize the Company’s unaudited quarterly operating results for2006 and 2005:

| ** **                                                                | ** ** | **Three months ended** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                | ** ** | **March 31,  2006**         | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** |
| Total revenues                                                            |       |                             | $          | 3,722 |   |   | $ | 3,792 |   |   | $ | 5,633 |   |   |   | $ | 13,226 |   |   |
| Gross margin on  product sales                                            |       |                             | 2,449      |   |   | 2,261 |   |   | 3,665 |   |   |   | 10,600 |   |   |
| Net loss                                                                  |       |                             | (8,852     | ) |   | (9,877 | ) |   | (9,875 | ) |   |   | (4,830 | ) |   |
| Net loss  allocable to common stockholders                                |       |                             | (9,316     | ) |   | (10,341 | ) |   | (10,375 | ) |   |   | (5,330 | ) |   |
| Basic and diluted net  loss per share allocable to common stockholders(1) |       |                             | $          | (0.54 | ) |   | $ | (0.59 | ) |   | $ | (0.59 | ) |   |   | $ | (0.28 | ) |   |

 

| ** **                                                                | ** ** | **Three months ended** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                | ** ** | **March 31,  2005**         | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** |
| Total revenues                                                            |       |                             | $          | 12,035 |   |   | $ | 6,917 |   |   | $ | 4,500 |   |   |   | $ | 2,953 |   |   |
| Gross margin on  product sales                                            |       |                             | 9,371      |   |   | 5,171 |   |   | 3,446 |   |   |   | 1,863 |   |   |
| Net loss                                                                  |       |                             | (2,058     | ) |   | (5,415 | ) |   | (4,924 | ) |   |   | (6,408 | ) |   |
| Preferred stock  restructuring charge                                     |       |                             | —     |   |   | — |   |   | — |   |   |   | (3,680 | ) |   |
| Net loss  allocable to common stockholders                                |       |                             | (2,458     | ) |   | (5,842 | ) |   | (5,378 | ) |   |   | (10,534 | ) |   |
| Basic and diluted net  loss per share allocable to common stockholders(1) |       |                             | $          | (0.17 | ) |   | $ | (0.41 | ) |   | $ | (0.37 | ) |   |   | $ | (0.72 | ) |   |

----

(1)          Quarterlyfigures do not sum to annualized figure due to the quarterly EPS computationbeing done independently.

F-35

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (dollars in thousands, except for per share amounts)**

**(20) Supplemental Cash Flow Information**

| ** **                                                             | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Supplemental schedule of non-cash investing and  financing activities: |       |                                        |       |   |   |   |   |   |   |   |   |
| Accrued liability for licenses                                         |       |                                        | $          | — |   |   | $ | — |   |   | $ | 150 |   |   |
| Accrued liabilities for in-process research and  development licenses  |       |                                        | $          | 50 |   |   | $ | — |   |   | $ | — |   |   |
| Accrued liabilities for leasehold improvements                         |       |                                        | $          | 70 |   |   | $ | — |   |   | $ | — |   |   |
| Accrued liabilities for capital leases                                 |       |                                        | $          | 250 |   |   | $ | — |   |   | $ | — |   |   |
| Preferred stock restructuring charge (See note 5)                      |       |                                        | $          | — |   |   | $ | 3,680 |   |   | $ | — |   |   |
| Accrued liability for common stock offering fees  (See note 4)         |       |                                        | $          | — |   |   | $ | 1,069 |   |   | $ | — |   |   |
| Cash dividends declared but not paid on preferred  stock               |       |                                        | $          | — |   |   | $ | 900 |   |   | $ | 800 |   |   |
| Cash paid for income taxes                                             |       |                                        | $          | — |   |   | $ | — |   |   | $ | 25 |   |   |
| Cash paid for  interest                                                |       |                                        | $          | 15 |   |   | $ | — |   |   | $ | — |   |   |

 

 

 

F-36

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIESFINANCIAL STATEMENT SCHEDULEValuation and Qualifying AccountsYears Ended December 31, 2006, 2005 and 2004(in thousands)**

| **Description**                       | ** ** | ** ** | ** ** | **Balance at the  Beginning of  Period** | ** ** | **Additions**                                      | ** ** | **Deductions** | ** ** | **Balance at the  End of Period** | ** ** |
|---------------------------------------|------------|------------|------------|---------------------------------------------------------|------------|----------------------------------------------------|------------|----------------|------------|-------------------------------------------------------|------------|
| **Accounts  Receivable  Allowances:** | ** ** | ** ** | ** ** | ** **                                              | ** ** | **Charged to  Statement of  Operations** | ** ** | ** **     | ** ** | ** **                                            | ** ** |
| 2006                                  |       |       | $          | 104                                                     |       |                                               |       | $              | 2,323      | (1)                                                   |       |   | $ | 2,240 | (2) |   |   | $ | 187 |   |   |
| 2005                                  |       |       | $          | 257                                                     |       |                                               |       | $              | 1,952      | (1)                                                   |       |   | $ | 2,105 | (2) |   |   | $ | 104 |   |   |
| 2004                                  |       |       | $          | 359                                                     |       |                                               |       | $              | 2,580      | (1)                                                   |       |   | $ | 2,681 | (2) |   |   | $ | 258 |   |   |

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(1)          Amounts are recognizedas a reduction from gross sales.

(2)          Amounts representchargebacks and cash discounts processed**.**

F-37

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