**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

**(Mark One)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the fiscal year endedDecember 31, 2005**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the transition periodfrom                     to                       **

**Commission file number 0-28308**

**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** |
|-------------------------|--------|-----------------------------------------------|
| None                    |   |                                          |

 

Securitiesregistered pursuant to Section 12(g) of the Act:

**Common Stock, $0.01 par value**

(Title of Class)

**Preferred Stock Purchase Rights,$0.01 par value**

(Title of Class)

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.

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

 

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act.

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

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

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

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act. (Check one):

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

 

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

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

 

The aggregate market value of the registrant’s votingshares of common stock held by non-affiliates of the registrant on June 30,2005, based on $7.61 per share, the last reported sale price on the NASDAQNational Market on that date, was $107.2 million.

The number of shares outstanding of each of theregistrant’s classes of common stock, as of March 1, 2006:

| **Class**                      | ** ** | **Number of Shares** |
|--------------------------------|------------|----------------------|
| Common Stock,  $0.01 par value |       | 17,417,734           |

 

The following documents areincorporated by reference into the Annual Report on Form 10-K:  Portions of the registrant’s definitive ProxyStatement for its 2006 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                                                                                                                    |       | 16       |
|                                                                                                                   |       | 1B.      |       | Unresolved Staff Comments                                                                                                       |       | 26       |
|                                                                                                                   |       | 2.       |       | Properties                                                                                                                      |       | 26       |
|                                                                                                                   |       | 3.       |       | Legal  Proceedings                                                                                                              |       | 26       |
|                                                                                                                   |       | 4.       |       | Submission of Matters to a Vote of Security Holders                                                                             |       | 27       |
| PART II                                                                                                           |       | 5.       |       | Market for the Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities          |       | 28       |
|                                                                                                                   |       | 6.       |       | Selected Consolidated Financial Data                                                                                            |       | 29       |
|                                                                                                                   |       | 7.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |       | 30       |
|                                                                                                                   |       | 7A.      |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                     |       | 43       |
|                                                                                                                   |       | 8.       |       | Financial Statements and Supplementary Data                                                                                     |       | 43       |
|                                                                                                                   |       | 9.       |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                  |       | 43       |
|                                                                                                                   |       | 9A.      |       | Controls and Procedures                                                                                                         |       | 44       |
|                                                                                                                   |       | 9B.      |       | Other  Information                                                                                                              |       | 46       |
| PART III                                                                                                          |       | 10.      |       | Directors and Executive Officers of the Registrant                                                                              |       | 47       |
|                                                                                                                   |       | 11.      |       | Executive Compensation                                                                                                          |       | 47       |
|                                                                                                                   |       | 12.      |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                                 |       | 47       |
|                                                                                                                   |       | 13.      |       | Certain Relationships and Related Transactions                                                                                  |       | 47       |
|                                                                                                                   |       | 14.      |       | Principal Accountant Fees and Services                                                                                          |       | 47       |
|                                                                                                                   |       |     |       |                                                                                                                            |       |     |
| PART IV                                                                                                           |       | 15.      |       | Exhibits and Financial Statement Schedules                                                                                      |       | 48       |
| SIGNATURES                                                                                                             |       | 49       |
| EXHIBIT INDEX                                                                                                          |       | 50       |
| INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND  FINANCIAL STATEMENT SCHEDULE        |       | F-1      |

 

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**PART I**

**Item 1.**                        Business.

**General**

CollaGenex Pharmaceuticals, Inc. and subsidiariesis a specialty pharmaceutical company currently focused on developing andmarketing innovative proprietary medical therapies to the dermatology market. Wecurrently market three prescription pharmaceutical products to the dermatologymarket through our professional dermatology sales force and generate revenuesfrom four prescription pharmaceutical products that we continue to sell to thedental market.

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 and develop andlaunch new products based on our proprietary platform technologies as well asother technologies. Our lead development candidates are: OraceaTM, for which aNew Drug Application, or NDA, is currently under review by the United StatesFood and Drug Administration, or FDA, for the treatment of rosacea; incyclinide(formerly known as COL-3), which is currently in Phase II dose-finding clinicaltrials for the treatment of acne; COL-118, a pre-clinical topical compoundbased upon the SansRosa technology that we are developing for the treatment oferythema (skin redness) associated with dermatological conditions; and ourRestoraderm® DermalDrug Delivery System, which is currently under development.

Our marketed dermatology products are: Pandel®, a prescriptioncorticosteroid; AlcortinTM, a prescription topical antifungal steroidcombination; and NovacortTM, a prescription topical steroid and anesthetic. In May 2002, we executed a sublicenseagreement with Altana Inc. to market and distribute Pandel to dermatologists inthe United States and Puerto Rico. 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 an orally administered, prescriptionpharmaceutical product that was approved by the FDA in September 1998 forthe treatment of adult periodontitis. We launched Periostat in January 1999,and by 2005 Periostat was the largest branded prescription pharmaceuticalproduct in the dental market. Between April 2004 and June 2005, wealso 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. 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 and, as a result of this generic launch, Mutual ceased purchasingproduct from us during June 2005. We also discontinued the promotion ofour other dental products on May 20, 2005. We continue to generate salesfrom Periostat and the other dental products, which include Atridox®, Atrisorb FreeFlow® and Atrisorb-D®, also referred to as the Atrix Products,and are licensed from Atrix Laboratories, Inc. (now known as QLT USA, Inc.).Based on data provided by a leading independent prescription tracking service,we estimate that Periostat’s share of the 20 mg doxycycline market wasapproximately 14% at December 31, 2005.

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 is our first FDA-approved IMPACS product. Oraceaand incyclinide are IMPACS compounds currently in clinical development for thetreatment of rosacea and acne, respectively. 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 acquisition of SansRosaPharmaceutical Development Inc., or SansRosa, 

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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 technology that originated from a Swedish collaborator. Wehave acquired all rights, title and interest to the Restoraderm technology. We haveformulated various prescription and over the counter products based on theRestoraderm technology, although we do not currently have a timetable foreither the initiation of clinical development or the launch of any Restoradermproducts.

We recently completed two Phase III clinical trialsfor our leading IMPACS product development candidate, Oracea, for the treatmentof rosacea, a dermatological condition. Oracea is a modified releaseformulation of a sub-anti-microbial dose of doxycycline, the same activeingredient as Periostat. On June 6, 2005, we announced the results of ourtwo double-blinded, placebo-controlled Phase III clinical studies for Oracea. Thetwo Phase III clinical trials were identical in design and conductedconcurrently. Both studies achieved their primary endpoint by demonstrating agreater reduction in inflammatory lesion count from baseline for theOracea-treated patients compared to the patients receiving placebo. In the twotrials, patients receiving Oracea experienced a 61% and 46% mean reduction ininflammatory lesions compared to 29% and 20% mean reduction in patientsreceiving placebo. On August 3, 2005, we announced that the United StatesPatent and Trademark Office, or USPTO, had published on its website that U.S. PatentApplication, serial no. 10/117,709, had been allowed. This patent covers theuse of sub-anti-microbial tetracyclines, including Oracea, andnon-antimicrobial tetracyclines, including incyclinide, for the treatment ofacne and acne rosacea. This patent application has a priority date of April 5,2002 and an expiration date 20 years from that date. We submitted our NDA forOracea to the FDA on August 1, 2005. On October 3, 2005, we announcedthat the NDA for Oracea had been accepted for review by the FDA. ThePrescription Drug User Fee Act (PDUFA) target date for reviewing the submissionis May 31, 2006.

In April 2005, we announced the completion of aPhase II proof-of-concept clinical trial for our second generation IMPACScompound, incyclinide, for the treatment of rosacea. On August 2, 2005,the results from this Phase II clinical trial evaluating incyclinide as atreatment for rosacea were presented at a major dermatology conference. ThePhase II trial was designed to establish proof of principle for incyclinide asa potential treatment for inflammatory dermatologic conditions. In thisdouble-blinded, placebo-controlled clinical trial, patients were administeredeither incyclinide or placebo once a day for 28 days. The study achieved itsprimary endpoint, demonstrating a statistically significant, greater reductionin inflammatory lesion count from baseline for the incyclinide treated patientscompared to patients on placebo. On September 26, 2005, we announced theinitiation of a Phase II, double-blinded, placebo-controlled, dose-findingclinical trial to evaluate the safety and efficacy of incyclinide for thetreatment of acne. This trial will enroll approximately 300 patients atapproximately 20 investigational centers throughout the United States. Thetrial will evaluate three dosage strengths of incyclinide and a placebo over a12-week period with the objective of determining a dose for Phase III testing. Weanticipate that the “last patient out” date will take place by the end of 2006.On November 9, 2005, we announced that the National Institutes of Healthhad awarded a grant of approximately $962,000 for additional research anddevelopment of incyclinide.

On December 14, 2005, we executed a SharePurchase Agreement, or the SansRosa Purchase Agreement, with SansRosa and allof the existing shareholders of SansRosa, or the SansRosa Shareholders,pursuant to which we acquired 51% of the outstanding shares of capital stock ofSansRosa. SansRosa is the assignee of certain U.S. Patent Cooperation Treatyand foreign patentapplications covering methods for treatment of redness associated with rosaceaand other skin disorders. Under the SansRosa Purchase Agreement, we have aright 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 shareholders of 

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SansRosa an additional$4.0 million to $6.0 million. The agreement also provides forearn-out payments linked to future product sales. 

On December 15, 2005, we executed a Restructuringand Exchange Agreement with each of the holders of our outstanding Series DCumulative Convertible Preferred Stock, or the Series D Stock, pursuant towhich, among other things, the Series D stockholders agreed to effect anexchange, or the Exchange, whereby we exchanged all 200,000 outstanding sharesof our Series D Stock for 200,000 shares of our Series D-1 CumulativeConvertible Preferred Stock, or the Series D-1 Stock.

Through the Exchange, the Series D stockholdershave agreed to, among other things (i) permanently waive their right toapprove our research and development expenditures in excess of $7.0 millionannually in exchange for a reduction in the conversion price of the Series DStock from $9.89 per share to $8.50 per share, and (ii) a reduction in thenumber of consecutive trading days during which the closing price of our commonstock must exceed two times the conversion price of the Series D-1 Stockbefore we can require mandatory conversion of the Series D-1 PreferredStock into common stock from 40 trading days to 30 trading days. As a result ofthe Exchange, the price at or above which our common stock must initially tradefor such 30-day period before we can require mandatory conversion of the Series D-1Stock, has been reduced from $19.78 per share to $17.00 per share.

On December 21, 2005, we entered into definitiveagreements with institutional and other investors to sell 2.9 million shares ofour common stock for an aggregate gross purchase price of $29.0 million. Thefirst closing of this transaction, for $15.5 million of the gross proceeds, washeld on December 23, 2005. The second closing of the transaction, for$13.5 million of the gross proceeds, occurred on January 6, 2006. The netproceeds of the offering were approximately $27.1 million after deducting theplacement agency fees and all offering expenses that were payable by us. RothCapital Partners, LLC acted as placement agent and SunTrust Robinson HumphreyCapital Markets acted as financial advisor to us in connection with theoffering.

During 2005, we added Douglas A. Poedtke to ourmanagement team as Vice President of Sales. In September 2005, we alsoannounced the appointment of George Lasezkay, Pharm.D., J.D., to our Board ofDirectors.

We are a Delaware corporation. We were incorporatedand began operations in 1992 under the name CollaGenex, Inc. and changedour name to CollaGenex Pharmaceuticals, Inc. in April 1996. Ourprincipal executive offices 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 CollaGenex Pharmaceuticals, Inc. and itssubsidiaries.

We are subject to the informational requirements ofthe Securities Exchange Act of 1934, as amended, or the Exchange Act, and,accordingly, file reports, proxy statements and other information with theSecurities and Exchange Commission. Such reports, proxy statements and otherinformation can be read and copied at the public reference facilitiesmaintained by the Securities and Exchange Commission at the Public ReferenceRoom, 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Informationregarding the operation 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 Internet address is www.collagenex.com. We are notincluding the information contained on our web site as a part of, orincorporating it by reference into, this Annual Report on Form 10-K. Wemake available free of charge on our website our Annual Reports on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-K andamendments to those reports filed or furnished pursuant to 

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Section 13(a) or15(d) of the Exchange Act, as soon as reasonably practicable after weelectronically file such material with, or furnish it to, the Securities andExchange Commission.

**CollaGenex Pharmaceuticals, Inc.—United Statestrademarks:**

Periostat®, Metastat®, Dermostat®, Nephrostat®, Osteostat®, Arthrostat®, Rheumastat®, Corneostat®, Gingistat®, IMPACSTM, PS20®, The Whole Mouth Treatment®, Restoraderm®, Dentaplex®, LytraTM, Periostat-MRTM, SansRosaTM,UnorthodoxyTM, AprecinTM, ZedaraTM and OraceaTM.

**CollaGenex Pharmaceuticals, Inc.—EuropeanCommunity trademarks:**

Periostat®, Nephrostat®, Optistat®, Xerostat®, SansRosaTM, UnorthodoxyTM, AprecinTM,ZedaraTM and OraceaTM.

**CollaGenex International, Ltd. (our wholly-ownedsubsidiary)—United Kingdom trademarks:**

Periostat®, Nephrostat®, Optistat®, Xerostat®, IMPACS®, Dentaplex®, Restoraderm®, Periocycline®, Periostatus® andPeriostat-MR®.

**CollaGenex International, Ltd.—European Community andUnited Kingdom trademarks:**

CollaGenex®, PS20®, Dermastat®, Periostan®, Periostat-SR®, “C” Logo® and“The Whole Mouth Treatment” Logo®.

**CollaGenex International, Ltd.—European CommunityTrademarks:**

PeriocyclineTM,RestoradermTM, and Periostat-MRTM.

Marks listed herein mayadditionally be registered in jurisdictions not specified in the above list. 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 Currently Marketed Dermatology Products***

Thethree prescription pharmaceutical dermatology products that we currently marketare summarized below:

| **Products** | ** ** | ** **    | ** ** | **Territory Where Marketed**       | ** ** | **Marketing Partner** |
|--------------|------------|---------------|------------|------------------------------------|------------|-----------------------|
| Pandel       |       | United States |       | Altana, Inc.                  |
| Alcortin     |       | United States |       | Primus  Pharmaceuticals, Inc. |
| Novacort     |       | United States |       | Primus Pharmaceuticals, Inc.  |

 

*Pandel*

In May 2002, we executed a Sublicense Agreementwith Altana Inc., the United States subsidiary of Altana Pharma AG, pursuant towhich we were granted the exclusive right to create improvements to, market,advertise, promote, distribute, offer for sale and sell, in the United Statesand Puerto Rico, Pandel, a mid-potency topical corticosteroid cream indicatedfor the relief of mild-to-moderate inflammatory disorders of the skin inadults, such as atopic dermatitis and psoriasis. Altana currently licenses therights to Pandel from Taisho Pharmaceutical Co., Ltd., a company organized andexisting under the laws of Japan. Pursuant to the terms of our sublicense, wepaid Altana an aggregate sublicense fee of $1.7 million in 2002. We purchasefrom Altana all Pandel products to be sold and promotional samples, and we arerequired to pay Altana a royalty fee equal to a percentage of the net sales ofPandel.

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*Alcortin andNovacort*

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. Themajority of marketing expenses, excluding sales force compensation and sampleproduct costs, related to the direct promotion of the Primus products arefunded by Primus. The majority of product sample product costs and all salesforce compensation are funded by us. The Promotion and Cooperation Agreementhas an initial 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.

***Other Product Offerings***

*Periostat*

Periostat, a 20 mg dose of doxycycline hyclate, is aunique sub-anti-microbial dosage strength of doxycycline that suppresses thechronic and progressive tissue degradation characteristic of adultperiodontitis, without exerting any anti-microbial effect. Adult periodontitisis a chronic disease characterized by the progressive loss of attachmentbetween the periodontal ligament and the surrounding alveolar bone, as well asbreakdown of the alveolar bone itself, ultimately resulting in tooth loss. Doxycyclineis an active ingredient of several FDA approved drugs and has been in use, athigher dosages, for approximately 40 years. At such higher doses, it is indicatedfor the treatment of microbial infections and, along with other tetracyclines,has a well established safety record. Periostat is intended to be taken orallyby the patient between dental visits.

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. We had also sold a separatelybranded version of Periostat to Mutual pursuant to a License and SupplyAgreement executed in April 2004 as part of a settlement of ouroutstanding patent litigation with Mutual. As a result of the launch of a thirdparty generic version of Periostat in May 2005, Mutual ceased purchasingproduct from us during June 2005.

*Atridox, AtrisorbFreeFlow and Atrisorb-D*

Pursuant to the terms of an exclusive License andMarketing Agreement that we executed with Atrix Laboratories, Inc. (nowknown as QLT USA, Inc.) in August 2001, we obtained the right tomarket, sell and distribute Atrix’s proprietary dental products, Atridox,Atrisorb FreeFlow and Atrisorb-D to the United States dental community.

Atridox is a locally-applied, anti-microbial therapyfor the treatment of chronic adult periodontitis. Atridox uses Atrix’s patenteddrug delivery technology, Atrigel®, for the targeted delivery of doxycycline,which, in sufficient concentrations, has been shown to reduce the levels ofbacteria in the periodontal pocket. Atridox is a gel that is placed intoaffected periodontal pockets by a dental professional and 

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resorbs over a two weekperiod. In pivotal double-blinded, placebo-controlled clinical trials conductedby Atrix, the administration of Atridox was shown to increase attachment levelbetween the gums and the teeth and decrease periodontal pocket depth inpatients with adult periodontitis.

Atrisorb FreeFlow is a guided tissue regeneration, orGTR, barrier product used in the surgical treatment of periodontal defects tohelp regenerate tissue. In periodontal surgery, a section of the gums called aflap is cut away from the underlying bone structure to allow the periodontistto repair the periodontal support structure. When the flap is subsequentlyrepositioned, a membrane barrier product such as Atrisorb FreeFlow is placedbetween the flap and the bone to prevent the downgrowth of epithelial tissues,which interferes with the re-attachment of the gums to the teeth.

Atrisorb-D is the first GTR barrier product toincorporate an antibiotic, which has been shown to reduce the incidence ofinfections during GTR procedures.

On February 22, 2006,we amended our License and Marketing Agreement with QLT, and have agreed tocontinue to sell the Atrix Products through our distributor and pay anincreased royalty on net sales and an increased transfer price, but we are nolonger 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 (6) months prior written notice.The amendment extends the term of the License and Marketing Agreement through December 31,2007.

***Our Previously Marketed Products***

*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. During the yearended December 31, 2005, we recorded $153,000 in residual contractrevenues under this agreement. We do not expect to earn any further residualcontract revenues from this agreement beyond December 31, 2005.

*AVAR*

In March 2003, weexecuted co-promotion agreements with Sirius Laboratories, Inc. pursuantto which we jointly marketed Sirius Laboratories’ AVARTM product line and Pandelto dermatologists in the United States. These agreements were mutuallyterminated on December 31, 2003. We did not receive any revenue during theyears ended December 31, 2004 or December 31, 2005 and do not expectto receive any future contract revenues from AVAR.

*Denavir*

In October 2002, weentered into a Product Detailing Agreement with Novartis Consumer Health, Inc.pursuant to which we co-promoted Denavir® to target dentists in the UnitedStates and received detailing fees and performance incentives from NovartisConsumer Health, Inc. The agreement with Novartis to co-promote Denavirexpired on September 30, 2003, and we and Novartis decided not to renewthe arrangement with respect to Denavir. We did not receive any revenue duringthe years ended 

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December 31,2004 or December 31, 2005 and do not expect to receive any future contractrevenues from Novartis with respect to Denavir.

**Sales and Marketing**

On May 16, 2005, we announced the restructuringof our sales force following the FDA’s approval of a third-party genericversion of Periostat. As a result of the restructuring, we discontinued alldirect selling promotional activities for our dental products and, as of December 31,2005, employed a 33-person, dedicated dermatology sales force. We are currentlyexpanding our sales force to 80 professionals in preparation for an anticipatedapproval and launch of Oracea during 2006.

We produce educational marketing materials, detailaids and product samples that are used extensively by our representatives intheir presentations to dermatology professionals. We also focus on providingcontinuing medical education programs and convention activities.

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.

**Manufacturing,Distribution and Suppliers**

In 1995, we entered into a supply agreement withHovione International Limited, or Hovione, pursuant to which the activeingredient in Periostat, doxycycline hyclate, is supplied to us by Hovione fromits offshore facilities. Hovione supplies a substantial portion of thedoxycycline used in the United States from two independent facilities,providing for a back-up supply in the event that one facility is unable tomanufacture. The initial term of the supply agreement expired on January 25,2000 and, pursuant to an addendum to that agreement, the term was extended to May 14,2006 and thereafter automatically renews for successive two-year periods unless,90 days prior to the expiration of any such periods, either party gives theother party written notice of termination. In addition, in the event of adefault that remains uncured for 90 days, the non-defaulting party canterminate the supply agreement effective immediately at the end of suchninety-day period. We rely on Hovione as our sole supplier of doxycycline, andhave no back-up supplier at 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 terminated at the time a generic 20 mg doxycycline hyclatetablet became available on the market. We now purchase the tablet formulationof Periostat from PMRS on a purchase order basis. Currently, PMRS is the solethird-party contract manufacturer to supply a tablet formulation of Periostatto us. PMRS is required to comply with current Good Manufacturing Practices, orcGMP, requirements.

In November 1998, we executed a DistributionServices Agreement with Cardinal Health Specialty Pharmaceutical Services, orSPS, pursuant to which SPS acts as our exclusive logistics provider forPeriostat in the United States and Puerto Rico. Under this agreement, SPSwarehouses and ships Periostat and Pandel from its central distributionfacility in LaVergne, Tennessee to wholesalers that distribute our products topharmacies 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,chargeback 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.

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In February 2002, we executed a Wholesale ServiceAgreement effective November 2001 with Cardinal Health SpecialtyPharmaceutical Distribution, or SPD, pursuant to which SPD acts as ournon-exclusive authorized distributor of Atridox, Atrisorb FreeFlow andAtrisorb-D. Under this agreement, as amended, SPD will also provide 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, we entered into an agreementwith a third party provider pursuant to which we have agreed to pay monthlyinvoiced costs and expensesin exchange for certain research and development services, process developmentand material preparation services relating to incyclinide.

In March 2006, weexecuted a Commercial Manufacturing Agreement effective December 31, 2005with Cardinal Health PTS, LLC, or PTS, pursuant to which PTS has agreed tomanufacture Oracea for us. Pursuant to the terms of the agreement, we agree to (i) furnishto PTS on a monthly basis a rolling forecast of product quantities for thesubsequent twelve-month period, the first three months of which shall becomebinding, and (ii) pay PTS a fee for the product, subject to an annualadjustment. The Commercial Manufacturing Agreement has an initial term of fouryears unless terminated earlier pursuant to its terms.

**Customers/Backlog**

During 2005, sales to Cardinal Health, Inc.,McKesson Corporation, Amerisource Bergen Corporation and Mutual, representedapproximately 37%, 24%, 12% and 22%, respectively, of our aggregate net productsales. We do not sell our products directly to drug chain retailers,supermarkets, independent pharmacies or other mass merchants.

Historically in the pharmaceutical wholesaledistribution industry, wholesalers were speculative in their purchasingpractices in anticipation of manufacturer product price increases. To managethis process, we maintain an Inventory Management Agreement with a majorwholesale customer. Under this agreement we are provided with weekly retailproduct demand information and current stocking levels for our products;additionally this wholesaler has agreed to manage the variability of its purchaseswithin specified limits. In return we provide this wholesaler the right topurchase a specific amount of inventory from us at the sales price in effectimmediately prior to announced price increases.

In April 2005, wealso executed Distribution Services Agreements with two wholesalers pursuant towhich we agree to pay a percentage of the net invoice cost in exchange forcertain product distribution, inventory management and administrative services.

**Research andDevelopment**

*Overview*

Our research anddevelopment activities are conducted primarily by third parties includingcontract research organizations and academic and government institutions. Themain focus of these activities is the research and development of novel and/orknown compounds for application in a variety of inflammatory andtissue-destructive disorders.

*Technology*

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.

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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 and conditions,including, but not to those in dermatology, such as acne and rosacea.

Our license from SUNY also covers certain compoundsthat have shown potential in a number of preclinical models of excessiveconnective tissue breakdown. Our current research and development programsfocus on the potential use of IMPACS compounds for a variety of disorderscharacterized by inflammation and connective tissue destruction. Additionalresearch by SUNY researchers has been conducted to identify, synthesize andcharacterize a new generation of IMPACS compounds, and we have filed patentapplications on structure and use of these compounds.

Major research programswhich we have conducted over the last three years include: (i) Oracea forthe treatment of rosacea; (ii) the development of a “once-a-day”formulation of Periostat (Periostat-MRTM), which was discontinued in 2005; (iii) thedevelopment of incyclinide for acne; and (iv) the development of ourRestoraderm platform.

*Rosacea*

Rosacea is a condition that affects approximately 13.6million adults in the United States. Rosacea affects primarily the face and istypically characterized by the appearance of inflammatory lesions (papules,pustules and nodules), erythema (skin redness) and telangiectasia (spiderveins). If allowed to progress to a moderate or severe condition, rosacea cancause itching, pain and thickening of the skin. In severe cases, a disfiguringenlargement of the nose can develop, a condition known as rhinophyma.

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 andconducted concurrently.

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 

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two studies, respectively.In the 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 erythemaachieved statistical significance as erythema scores improved from 9.7 atbaseline to 7.0 at week 16 (p=0.017).

The total expensesincurred through December 31, 2005 relating to the development of Oraceawere approximately $8.0 million. We expect to incur an additional$4.7 million in 2006 to complete the development, including potentialfuture milestone payments.

*Oracea*

The development of amodified release technology for Oracea is being conducted in part through anagreement with Supernus Pharmaceuticals, Inc., or Supernus, successor ininterest to Shire Laboratories, Inc. Several patent applications relatingto the new formulation have been filed with the USPTO and through the UnitedStates Patent Cooperation Treaty. We have incurred approximately $830,000 inmilestone costs related to development work for a modified release formulationthrough December 31, 2005. The total future possible milestone paymentsthat may be payable to Supernus related to the modified release formulation forOracea are estimated to be $2.7 million. The possible future paymentsrelate primarily to regulatory approval milestones, both domestic andinternational, of products utilizing the Supernus technology and domesticlaunch of such products.

*COL-118*

In December 2005, we announced that we executedthe SansRosa Purchase Agreement with SansRosa. SansRosa is the assignee ofcertain U.S. Patent Cooperation Treaty and foreign patent applications coveringmethods for the treatment of redness associated with rosacea and other skindisorders.

Payment for shares ofSansRosa will be made in installments tied to the achievement of variousproduct development milestones. We will be solely responsible for product andclinical development. We made an initial payment of $750,000 for 51% of theshares of SansRosa. The remaining shares will be purchased upon the achievementof various milestones. If all milestones are achieved and a patented product isdeveloped and approved for sale, we could pay the shareholders of SansRosa anadditional $4.0 million to $6.0 million. The agreement also provides forearn-out payments linked to future product sales.

*Restoraderm*

In February 2002, we announced that we hadlicensed Restoraderm, a topical drug delivery technology. In August 2004,we purchased all right, title and interest in this technology, pursuant to theterms of an Asset Purchase and Product Development Agreement, or the PurchaseAgreement. The Purchase Agreement superseded our Co-operation, Development andLicense Agreement executed in February 2002. Under the terms of thePurchase Agreement, the purchase price of the assets shall be up to $1.0million, subject to the achievement of certain milestones. We are also requiredto pay certain product development milestone payments in the aggregate amountof up to approximately $2.0 million as well as royalty and sublicense fees uponproduct commercialization. As of December 31, 2004, approximately $283,000of these milestone and sublicense fees had been paid by us. We paid anadditional $150,000 in 2005. While we are currently conducting some formulationand stability work on products incorporating our Restoraderm technology, wehave not developed a timetable for clinical development or commercial 

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launch. Accordingly, it ispremature to estimate other future costs associated with the Restoradermtechnology.

The Restoraderm technologyis a unique, proprietary dermal drug delivery system, designed to enhance thedermal delivery of a variety of active ingredients and we believe it may beused as the platform on which to develop a portfolio of topical dermatologicalpharmaceuticals. The Restoraderm technology incorporates certain lipidcompositions to enhance the natural skin barrier and facilitate the delivery oftherapeutic active ingredients into the skin. The Restoraderm technology iscurrently under development, and we continue to evaluate a number ofRestoraderm product opportunities and their potential contribution to ourportfolio of pipeline products.

*IMPACS*

Our IMPACS technologycomprises a family of compounds which have shown the ability to inhibitinflammation as well as the activity of various enzymes in the inflammatorycascade that lead to tissue destruction. Periostat, our first FDA-approvedIMPACS compound, and Oracea, our modified release formulation, include the sameactive ingredient. We have completed Phase III clinical trials for each ofPeriostat and Oracea to demonstrate their safety and efficacy in treating adultperiodontitis and rosacea, respectively.

*Incyclinide in Acne*

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 dermatologic condition.In this double-blinded, placebo-controlled clinical study, patients were administered either incyclinideor placebo once a day for 28 days. Data was collected at baseline, day 14, day28 and day 42. Primary efficacy parameters measured the changes from baselineto endpoint (day 42) in total inflammatory lesion count and the clinician’serythema 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 while placebopatients showed an increase of 2.3 lesions. This difference was statisticallysignificant (p=0.0213). Importantly, the onset of action was rapid, withapproximately 80% of the reduction in lesion count observed at day 42 wasalready present at day 14. At endpoint, 75% of all incyclinide treated patientswere clear or near clear of disease symptoms as measured by the IGA score.Erythema showed a slightly better improvement in the incyclinide group, with a2.5 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.

Based on these encouraging results, we announced theinitiation of a Phase II, double-blinded, placebo-controlled, dose-findingclinical trial to evaluate the safety and efficacy of incyclinide for thetreatment of acne. This study will enroll 300 patients with moderate to severeacne at approximately 20 investigational centers throughout the United States.The study design will evaluate three dosage strengths of incyclinide and aplacebo over a 12-week period with the objective of determining a dose forPhase III testing. We anticipate that the last dose will be administered by theend of 2006.

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incyclinide has also beenin human clinical trials under the sponsorship of the National Cancer Institutefor the treatment of various cancers, including HIV-related Kaposi’s sarcoma. Aclinical trial that involved 75 patients who were administered solely incyclinide,showed a statistically significant tumor response rate from baseline. The studywill be published in the March 20th issue of the Journal of ClinicalOncology. We intend to evaluate incyclinide as a treatment for acne during2006. The total future anticipated expenses related to the development ofincyclinide for acne are currently estimated to be $32.0 million at thistime.

*Preclinical andOther Research and Development Activities*

In October 2002, we announced the execution of alicense agreement with Medtronic, Inc. involving our IMPACS compounds,pursuant to which Medtronic obtained an exclusive, worldwide license totechnology relating to the use of the compounds to treat aortic aneurysms andother forms of vascular disease with medical devices. This program is stillunderway.

Our research anddevelopment expenditures were approximately $14.0 million, $8.8 million,$5.5 million in 2005, 2004 and 2003, respectively. We expect to increaseour investment in research and development to approximately $17.0 million in2006.

**Patents, TradeSecrets and Licenses**

*Our Patents*

Our success will depend in part on patent and tradesecret protection for our technologies, products and processes, and on ourability to operate without infringement of proprietary rights of other partiesboth in the United States and in foreign countries. Because of the substantiallength of time and expense associated with bringing new products throughdevelopment to the marketplace, the pharmaceutical industry places considerableimportance on obtaining and maintaining patent and trade secret protection fornew technologies, products and processes.

We depend on our license from SUNY for all of ourIMPACS technology. The SUNY License grants us an exclusive worldwide license tomake and sell products employing tetracyclines that are designed or utilized toalter a biological process. In consideration of the license granted to us, we: (i) issuedto SUNY 78,948 shares of our common stock in 1992; and (ii) have agreed topay SUNY royalties on the net sales of licensed products, with minimum annualroyalty payments of $50,000 per year. The term of the license is until thelater of: (i) the expiration of the last to expire of the licensed patentsin each country; or (ii) November 18, 2018, at which time we have afully paid, non-exclusive license. Our rights under the SUNY License aresubject to certain statutory rights of the United States government resultingfrom federal support of research activities at SUNY.

**Thirty-one**United States patents and United States patentapplications held by SUNY are licensed to us under the SUNY License. SUNY alsohas obtained patents in certain European countries, Canada and Japan, and haspending patent applications in certain other foreign countries which correspondto its United States patents relating to methods of use of tetracyclines. Over eighty patents have been issued in foreign countries. Allof SUNY’s United States and foreign patents expire between 2004 and 2023.

On June 10, 2002, we executed a Development andLicensing Agreement with Supernus (successor in interest to Shire) pursuant towhich we 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. The total future milestonepayments that may be payable to Supernus related to the modified releaseformulation for Oracea are estimated to be $2.7 million. These possiblefuture payments 

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relate primarily toregulatory approval, both domestic and international, of products utilizing theSupernus technology and domestic launch of such products.

As well as the patents andpatent applications licensed from SUNY, which represent the core technology,and the technology licensed from Supernus, we own additional technology forwhich applications for United States patents have been filed and have beenissued. This includes various independently developed inventions relating tothe uses of tetracyclines, as well as the SansRosa technology and theRestoraderm technology. A total of eight United States patents are issued, andapproximately fifteen United States patent applications are pending, relativeto these technologies. Applications corresponding to each are pending pursuantto the United States Patent Cooperation Treaty in various foreignjurisdictions.

**GovernmentRegulation**

Government authorities regulate research, development,testing, manufacture, labeling, promotion, advertising, distribution, andmarketing of the products we develop and market. In the United States, the FDAregulates Atridox, Pandel, Periostat, Alcortin and Novacort and our products indevelopment as drugs under the Federal Food, Drug, and Cosmetic Act andimplementing regulations. The FDA regulates Atrisorb FreeFlow and Atrisorb-Das medical devices under the Food, Drug, and Cosmetic Act and implementingregulations. Both before and after approval or clearance of our products,failure to comply with FDA requirements may subject us to administrative orjudicial sanctions, such as the FDA’s refusal to approve pending applicationsor warning letters, product recalls, product seizures, total or partialsuspension of production or distribution, withdrawal of approvals, importdetentions, injunctions, and/or criminal prosecution.

Our products indevelopment are classified as drugs. The steps required before any of ourproduct 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 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.

Preclinical tests include laboratory evaluations ofproduct chemistry, toxicity, and formulation, as well as animal studies. Theresults of the preclinical tests, together with manufacturing information,analytical data, and a plan for studying the product in humans, are submittedto the FDA as part of an investigational new drug exemption, which must becomeeffective before human clinical trials may begin. An investigational new drugexemption automatically becomes effective 30 days after receipt by the FDA,unless before that time the FDA raises concerns or questions about issues suchas the conduct of the trials outlined in the investigational new drug exemption.In that case, the investigational new drug exemption is placed on clinical holdand the sponsor and the FDA must resolve any outstanding FDA concerns orquestions before clinical trials can proceed. Submission of an investigationalnew drug exemption does not always result in the FDA allowing clinical trialsto commence.

Clinical trials involve administration of theinvestigational drug to human subjects under the supervision of qualifiedinvestigators and are conducted under protocols detailing the objectives of the

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study, the parameters tobe used in monitoring safety, and the effectiveness criteria to be evaluated. Eachprotocol must be submitted to the FDA as part of the investigational new drugexemption process, and must be reviewed and approved by an independentInstitutional Review Board before it can begin.

Clinical trials typically are conducted in threesequential phases, but the phases may overlap or be combined. Phase Iusually involves the initial introduction of the investigational drug intopeople to evaluate its safety, dosage tolerance, phamacodynamics, and, ifpossible, to gain an early indication of its effectiveness. Phase IIusually involves trials in a limited patient population to evaluate dosagetolerance and appropriate dosage, identify possible adverse effects and safetyrisks and evaluate preliminarily the efficacy of the drug for specificindications. Phase III trials usually further evaluate clinical efficacyand test further for safety by using the drug in its final form in an expandedpatient population.

Assuming successful completion of the requiredclinical testing, the results of the preclinical studies and of the clinicalstudies, together with other detailed information, including information on themanufacture and composition of the drug, are submitted to the FDA in the formof a new drug application requesting approval to market the product for one ormore indications. Before approving an application, the FDA usually will inspectthe facility or the facilities at which the drug is manufactured, and will notapprove the product unless compliance with cGMP is satisfactory. If the FDAdetermines the application and the manufacturing facilities are acceptable, theFDA will issue an approval letter. If the FDA determines the application ormanufacturing facilities are not acceptable, the FDA will outline thedeficiencies in the submission and often will request additional testing orinformation. Notwithstanding the submission of any requested additionalinformation, the FDA ultimately may decide that the application does notsatisfy the regulatory criteria for approval.

The FDA approved our NDA for Periostat in 1998. TheAtrix Products and Pandel have also received FDA approval. However, we cannotbe sure that any additional approvals will be granted on a timely basis, if atall. After approval, certain changes to the approved product, such as addingnew indications, manufacturing changes, or additional labeling claims aresubject to further FDA review and approval. For example, before we can marketOracea, even though it has the same active ingredient as Periostat, we will berequired to obtain an additional FDA approval.

The FDA is currently reviewing our application forapproval of Oracea. The FDA has specified May 31, 2006 as the target dateby which it is expected to complete its review. The FDA may not meet its targetdate, and it may not approve our application on that date, or at all. As acondition of approval of an application, the FDA may require postmarketingtesting and surveillance to monitor the drug’s safety or efficacy. As part ofthe NDA for Periostat, the FDA requested a post-market animal study related tolong-term dosing and carcogenicity, which was completed in 2000.

We market two products, Alcortin and Novacort, under aPromotion and Cooperation Agreement with Primus. Neither product has anapproved NDA; whether either or both requires an NDA at this time is unclear. Ifthe FDA believes that an approved NDA is required, it could at any time seekone or more of the administrative or judicial sanctions listed above, theresult of which could be that we could no longer market these products.

In some circumstances, approved drugs are providedprotection from generic versions of the approved drug for specified timeperiods. For example, the law provides for patent protection and for marketexclusivity for new chemical entities and for chemical entities approved fornew indications. The FDA considered Periostat to be an antibiotic drug, and assuch in a class of drugs for which optimal protection was not available. Thedecision in January 2005 by the United States District Court for theDistrict of Columbia to uphold the FDA’s classificationof Periostat as an antibiotic drug meant that it was not entitled to theprotection otherwise available to non-antibiotic drugs under the Hatch Waxmanamendments to the Food, Drug, and Cosmetic Act. According to the reasoning inthat decision, our future sub-anti-microbial doxycycline compounds, such asOracea, will also be considered antibiotic drugs.

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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.For example, marketers and manufacturers of approved and cleared drugs andmedical devices 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 Periostat and our products indevelopment from third party suppliers and finish the products in third partymanufacturing 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 from country to country and the time required maybe longer or shorter than that required for FDA approval.

**Competition**

*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. We had also sold a separately branded version of Periostatto Mutual pursuant to a License and Supply Agreement executed in April 2004.As a result of the launch of a third party generic version of Periostat in May 2005,Mutual ceased purchasing product from us during June 2005. Based on dataprovided by a leading independentprescription tracking service, we estimate that Periostat’s share of the 20 mgdoxycycline market was approximately 14% at December 31, 2005. As aresult of this decline, we have been forced to reduce our reliance on Periostatand our selling resources devoted to Periostat and the Atrix Products.

*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.

Many of our competitors have significantly greaterfinancial resources and experience in research and development, manufacturing,preclinical testing, clinical trials, regulatory approvals and marketing approvedproducts than we do. Smaller or early stage companies may also prove to besignificant competitors, particularly through collaborative arrangements withlarge and established companies. Our commercial opportunity will be reduced oreliminated if our competitors develop and commercialize products that aresafer, more effective, have fewer side effects, are easier to administer or areless expensive than any products that we may develop. These third partiescompete with us in recruiting and 

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retaining qualifiedscientific and management personnel, establishing clinical trial sites andpatient registration for clinical trials, as well as in acquiring technologiesand technology licenses complementary to our programs or advantageous to ourbusiness.

If approved by the FDA,Oracea will compete against branded and generic oral tetracyclineproducts, and topical formulations such as branded and generic metronidazole,azelaic acid and sodium sulfacetamide/sulfur products. Many of these productshave been sold and promoted for years and have been established as useful andsafe 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 commercial or in human clinical trials include ConneticsCorporation, Allergan, Inc., Roche Inc., Galderma Laboratories, L.P., Medicis Pharmaceutical Corporation,Dusa Pharmaceuticals, Inc. and numerous generic pharmaceuticalmanufacturers.

**Employees**

Wehave historically outsourced our manufacturing, clinical trials, new drugapplication preparation, warehousing, distribution and other activities. Weintend to continue to outsource many of the activities which we havehistorically outsourced. As of December 31, 2005, we employed 80 persons. Eachof our management personnel has had extensive prior experience withpharmaceutical, biotechnology or medical products companies. We cannot becertain that we will be able to recruit and retain qualified inside sales andmarketing personnel, distributors or marketing partners or that our marketingand sales efforts will be successful. Currently, none of our employees arecovered by collective bargaining agreements. In general, our employees arecovered by confidentiality agreements. We consider relations with our employeesto 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 expectations, estimates, forecasts, andprojections and the beliefs and assumptions of our management including, without limitation, our expectationsregarding results of operations, selling, general and administrativeexpenses, research and development expenses, the sufficiency of our cash forfuture operations, and the success of our preclinical, clinical and developmentprograms and our dermatology franchise. Forward-looking statements may beidentified by the use of forward-looking terminology such as “may,” “could,” “will,”“expect,” “estimate,” “anticipate,” “continue,” or similar terms, variations ofsuch terms or the negative of those terms.*

*We cannot assure investors that our assumptions andexpectations will prove to have been correct. Important factors could cause ouractual results to differ materially from those indicated or implied byforward-looking statements. Such factors that could cause or contribute to suchdifferences include those factors discussed below. We undertake no intention orobligation to update or revise any forward-looking statements, whether as aresult of new information, future events or otherwise. If any of the followingrisks actually occur, our business, financial condition or results ofoperations would likely suffer.*

***We are depending heavily on the success of our mostadvanced product candidate, Oracea, for the treatment of rosacea, which isstill under regulatory review. If we are unable to obtain approval for andcommercialize Oracea, or experience significant delays in doing so, ourbusiness will be materially harmed.***

We have invested asignificant portion of our recent efforts and financial resources in thedevelopment of our most advanced product candidate, Oracea, for the treatmentof rosacea. Our ability to 

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generatesubstantial product revenues from Oracea, if ever, will depend heavily on thesuccessful development and commercialization of Oracea. The success of Oraceawill depend on several factors, including the following:

·       receiptof marketing approvals from the FDA and similar foreign regulatory authorities;and

·       acceptanceof the product by patients, the medical community and third party payors.

If we are unable to obtainFDA approval for and successfully commercialize Oracea, we may never realize revenuefrom this product candidate and we may have to curtail our other productdevelopment programs. As a result, our business would be materially harmed.

***We cannot rely on regulatory protections to preventthe approval of generic equivalents of 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 an antibiotic.On January 19, 2005, the United States District Court for the District ofColumbia upheld the FDA’s application of this principle to Periostat anddetermined that Periostat was not entitled to market exclusivity because itsactive ingredient, doxycycline, had previously been approved as an antibiotic. BecauseOracea also contains doxycycline as its active ingredient, it will also not beentitled to market exclusivity.

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 marketexclusivity it can be more difficult for us to prevent competitors from seekingapproval for copies of our proprietary products, and in such a case the valueof such products would be materially adversely affected. Without marketexclusivity, generic versions of our products could quickly gain market entryif they meet regulatory approval criteria. Thus, even if we gain approval ofOracea, because it will not be entitled to patent or non-patent marketexclusivity, third parties may enter the market which would materially harm ourbusiness.

***If we are not able to obtain and enforce patentprotection for Oracea or our other discoveries, our ability to commercializeour product candidates successfully will be harmed and we may not be able tooperate 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 proprietary rights to some patentsrelated to our current or future products and technologies. Because patentapplications in the United States and many foreign jurisdictions are typicallynot published until 18 months after filing,or in some cases not at all, and because publications of discoveries inscientific literature lag behind actual discoveries, we cannot becertain that we were the first to make the inventions claimed in issued patents or pending patent applications, orthat we were the first to file for protection of the inventions setforth in our patent applications. There are, for instance, patent applicantsthat claim to have invented elements of the SansRosa technology prior toSansRosa’s patent application filing date. As a result, we 

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may be required to obtainlicenses under third-party patents to market our proposed products. If licensesare not available to us on acceptable terms, or at all, we will not be able tomarket 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. The patent position of pharmaceutical or biotechnologycompanies, including ours, is generally uncertain and involves complex legaland factual considerations. The standards which the USPTO and its foreigncounterparts use to grant patents are not always applied predictably oruniformly and can change. There is also no uniform, worldwide policy regardingthe subject matter and scope of claims granted or allowable in pharmaceuticalor biotechnology patents. The laws of some foreign countries do not protectproprietary information to the same extent as the laws of the United States,and many companies have encountered significant problems and costs inprotecting their proprietary information in these foreign countries. Accordingly,we do not know the degree of future protection for our proprietary rights orthe breadth of claims allowed in any patents issued to us or to others. Theallowance of broader claims may increase the incidence and cost of patentinterference proceedings and/or opposition proceedings, and the risk ofinfringement litigation. On the other hand, the allowance of narrower claimsmay limit the value of our proprietary rights.

If issued, our patent forOracea may not contain claims sufficiently broad to protect us against thirdparties with similar products, or provide us with any competitive advantage. Moreover,once issued, 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 similar (including generic), though non-approved,doxycycline products for indications covered by our patents. If our patents areinvalidated or otherwise limited, other companies will be better able todevelop products and technologies that compete with ours, which could adverselyaffect our competitive business position, business prospects and financialcondition.

***We cannot assure you that our pursuit of business inthe dermatology market will be successful.***

We continue to implement our plans to expand into thedermatology market. We recently submitted an NDA with the FDA for Oracea totreat rosacea, and we continue to seek additional product licensingopportunities to enhance our near-term offerings to the dermatology market. Wehave also been allowed by the USPTO a patent for the use of sub-anti-microbialtetracyclines for the treatment of acne and acne rosacea, including Oracea.

While we have experience in the sales and marketing ofdental products, we have limited experience in the dermatology market. Thismarket is very competitive and some of our competitors have substantiallygreater resources than we have. Our future success will depend on, among otherthings, our ability to: (i) achieve market acceptance for any current orfuture dermatological offerings; (ii) hire and retain personnel withexperience in the dermatology market; (iii) execute our business plan withrespect to this market segment; and (iv) adapt to technical or regulatorychanges once operational.

At the same time, new product development is alengthy, complex and uncertain process that will require significant attentionand resources from management. A product candidate can fail at any stage of thedevelopment process due to, among other things, efficacy or safety concerns,the inability to obtain necessary regulatory approvals, the difficulty orexcessive cost to manufacture and/or the infringement of 

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patents or intellectualproperty rights of others. Furthermore, the sales of new products may prove tobe disappointing and fail to reach anticipated levels. We therefore cannotassure you that we will be successful in our pursuit of business in thedermatology market, or that we can sustain any business in which we achieveinitial success.

The success of our current technology platforms, andthat of any other future technology platforms we may purchase or in-license,will depend on the quality and integrity of the technologies licensed or soldto us. Despite our due diligence and the safeguards we have in place, we cannotguarantee the effectiveness or integrity of such technologies, nor can we becertain that others do not have intervening rights in such technologies. If anyof our in-licensed technologies proved ineffective, or if a third partysuccessfully asserted any right to such technologies, our ability to developnew products and implement our strategies would be materially adverselyaffected.

***If we are not ableto obtain required regulatory approvals, we will not be able to commercializeour product candidates, and our ability to generate revenue will be materiallyimpaired.***

Failure to obtain regulatory approval for a productcandidate will prevent us from commercializing the product candidate. Otherthan Periostat, we have not received regulatory approval to market any of ourproduct candidates in any jurisdiction. We have only limited experience infiling and prosecuting the applications necessary to gain regulatory approvals.Securing FDA approval requires the submission of extensive preclinical andclinical data, information about product manufacturing processes and inspectionof facilities and supporting information to the FDA for each therapeuticindication to establish the product candidate’s safety and efficacy. Our futureproducts may not be effective, may be only moderately effective or may prove tohave undesirable or unintended side effects, toxicities or othercharacteristics that may preclude our obtaining regulatory approval or preventor limit commercial use.

The process of obtaining regulatory approvals isexpensive, often takes many years, if approval is obtained at all, and can varysubstantially based upon, among other things, the type, complexity and noveltyof the product candidates involved. Changes in the regulatory approval policyduring the development period, changes in or the enactment of additionalstatutes or regulations, or changes in regulatory review for each submittedproduct application, may cause delays in the approval or rejection of an application.

The FDA, and comparable authorities in othercountries, have substantial discretion in the approval process and may refuseto accept any application or may decide that our data is insufficient forapproval and require additional preclinical, clinical or other studies. Inaddition, varying interpretations of the data obtained from preclinical andclinical testing could influence how a product candidate is classified anddelay, limit or prevent regulatory approval of a product candidate. Any regulatoryapproval we ultimately obtain may be limited or subject to restrictions orpost-approval commitments that render the product not 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 we lose our sole supplier of doxycycline or ourmanufacturer of Oracea, our sales of Oracea, if any, will be interrupted,halted or less profitable.***

We do not have the resources, facilities orcapabilities to manufacture any of our products or product candidates.  We have no current plans to establish amanufacturing facility.  We expect thatwe will be dependent, to a significant extent, on contract manufacturers forcommercial scale manufacturing of our products or product candidates inaccordance with regulatory standards.

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We rely on a single supplier, Hovione InternationalLimited, or Hovione, for doxycycline, the active ingredient in Oracea. Thereare relatively few alternative suppliers of doxycycline and Hovione producesthe majority of the doxycycline used in the United States. Our current supplyagreement with Hovione expires on May 14, 2006 and thereafterautomatically renews for successive two-year periods unless, 90 days prior tothe expiration of any such periods, either party gives the other party writtennotice of termination. In addition, in the event of a default, uncured for 90days, the non-defaulting party can terminate the supply agreement effectiveimmediately at the end of such ninety-day period. We rely on Hovione as oursole supplier of doxycycline and have no back-up supplier at this time.Although Hovione maintains two manufacturing locations, if we achieveFDA approval for Oracea and are unable to procure a commercial quantity ofdoxycycline from Hovione on an ongoing basis at a competitive price, if Hovionefails to comply with cGMP, or if we cannot find a replacement supplier in atimely manner or with favorable pricing terms, our costs may increasesignificantly and we may experience delays in the supply of Oracea.

We entered into an agreement effective December 31,2005 with PTS, pursuant to which PTS has agreed to manufacture Oracea for us.Pursuant to the terms of the agreement, we agree to (i) furnish to PTS on amonthly basis a rolling forecast of product quantities for the subsequenttwelve-month period, the first three months of which shall become binding, and(ii) pay PTS a fee for the product, subject to an annual adjustment.  The agreement has an initial term of fouryears unless terminated earlier pursuant to its terms.

We intend to contract withadditional manufacturers for the commercial manufacture of an Oraceacapsule.  We believe, however, that itcould take up to one year to validate successfully a secondary manufacturer. Wecannot be certain that we will be able to enter into additional agreements onacceptable terms, if at all. In the event that Oracea is approved by the FDAand we are unable to obtain sufficient quantities of doxycycline or Oracea oncommercially reasonable terms, or in a timely manner, our business, financialcondition and results of operations would be materially adversely affected.

***If the federal regulatory status of Alcortin orNovacort changes, we may be unable to continue to market one or both of theseproducts.***

We market two products,Alcortin and Novacort, under a Promotion and Cooperation Agreement with Primus.The majority of sample product costs and all sales force compensation relatedto our promotion of Alcortin and Novacort are funded by us. Primus isresponsible for the manufacture of Alcortin and Novacort and it has not soughtFDA approval for these products because it believes that no approval isrequired. We cannot be sure that FDA will not object to the lack of approvalfor these products. If the FDA were to assert that these products requiredapproval, it could at any time seek to take administrative or judicial actionswhich could prevent us from marketing these products. Our inability to marketthese products could result in a temporary or permanent loss of revenue, whichmay be partially offset by a reduction in our promotional expenses related tothese products.

***Our products couldbe subject to restrictions or withdrawal from the market and we may be subjectto penalties if we fail to comply with regulatory requirements. Both before andafter approval or clearance, we, our vendors and suppliers, and our productsand product candidates are subject to extensive regulatory requirements.Failure to comply with these requirements could subject us to administrativeand judicial sanctions.***

Both before andafter approval or clearance of our products, we, our products, and ourmanufacturers are subject to extensive regulatory requirements covering, amongother things, manufacturing, advertising and promotion, labeling, adverse eventreporting, post-approval commitments, registration, record-keeping, export, anddistribution of samples. Failure to comply with regulatory requirements mayresult in:

·       restrictionson such products, manufacturers or manufacturing processes;

·       warningletters;

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·       withdrawalof the products from the market;

·       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.

***We cannot predictwith certainty the effect on our business of the decline in revenues generatedby the dental business following the commercial launch of generic versions ofPeriostat and the termination of our dental sales force.***

We have historically relied on sales of Periostat andMutual’s branded version of Periostat, together with revenues generated by theother products that made up our dental business, for most of our revenue.During the years ended December 31, 2005, 2004 and 2003, Periostat andMutual’s branded version of Periostat supplied by us (with respect to the yearsended December 31, 2005 and 2004), accounted for approximately 76%, 88% and82% of our total net revenues, respectively.

On May 13, 2005, the FDA approved a third partygeneric version of Periostat and a generic product was launched soon thereafterin late May 2005. Upon this generic launch, Mutual was no longer obligatedto purchase and is not expected to purchase their branded product from us. Wedo not anticipate future shipments of Mutual’s branded version of Periostatsupplied by us. In addition, we have had to disband our dental sales force anddelay or discontinue certain research and development activities in the dentalbusiness. Consequently, while we continue to generate cash flow from our dentalbusiness, our revenues and margins from Periostat and the other dental productswe sell have decreased significantly and will likely continue to decrease as aresult of the third party introduction of a generic version of Periostat. Ifthis decrease is more significant than we expect, and is combined with slowgrowth in, or a lack of revenues, if any, from new products, we may experience difficultyin managing our cash, which could have a material adverse effect on our abilityexecute our strategies and develop our dermatology business.

***Wewill need substantial additional funding and may be unable to raise capitalwhen needed, which would force us to delay, reduce or eliminate our productdevelopment programs and commercialization efforts.***

We expect that our research and development expenseswill increase in connection with our ongoing activities and that we will incursignificant commercialization expenses as we expand our marketing and salesefforts. We will need substantial additional funding and may be unable to raisecapital when needed or on attractive terms, which would force us to delay,reduce or eliminate our research and development programs and commercializationactivities.

We anticipate thatour current cash, cash equivalents and short-term investments at December 31,2005, together with the additional $11.7 million in net proceeds from the1,350,000 additional shares of common stock sold in January 2006, will besufficient to fund our operations through at least mid-2007.  However, our forecast of the period of timethrough which our financial resources will be adequate to support our operationsinvolves risks and uncertainties, and actual results could vary materially. Ourfuture funding requirements will depend on many factors, including:

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

·       thesuccess of our dermatology franchise;

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·       thesuccess of our preclinical, clinical and development programs;

·       revenuesand profits from sales of Periostat, Pandel and our other product candidates,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 revolvingcredit facility with Silicon Valley Bank;

·       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 regulatory approvals and clearances required tomarket and sell our products;

·       ourability to establish and maintain additional collaborations; and

·       thereceptivity of the capital markets to our future financings.

Until such time, if ever, as we can generatesubstantial product revenues, we expect to finance our cash needs throughpublic or private equity offerings, debt financings and corporate collaborationand licensing arrangements.  If we raiseadditional funds by issuing equity securities, our stockholders may experiencedilution.  Debt financing, if available,may involve agreements that include covenants limiting or restricting ourability to take specific actions, such as incurring additional debt, makingcapital expenditures or declaring dividends. Any debt financing or additional equity that we raise may contain terms,such as liquidation 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.

***We cannot assureyou that our clinical trials will be completed in a timely manner or will meetagreed upon end-points.***

As part of our plans to expand into the dermatologymarket, we will need to conduct extensive testing of our products, pursuant toprotocols that measure end points agreed with the FDA or other regulatoryagencies. We cannot guarantee that Phase I, Phase II, or Phase III testing for ourproducts in development will be completed successfully within any specifiedperiod of time, if at all. Many products that initially appear promising arefound, after clinical evaluation, not to be safe and effective. Also, we, orthe FDA, may suspend clinical trials at any time on various grounds, includinga finding that the subjects or patients are being exposed to an unacceptablehealth risk.

Delays in patient enrollment in clinical trials mayresult in increased costs and delays, which could have a harmful effect on ourability to develop products.

It may take severalyears to complete the testing of a product, and failure can occur at any stageof 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;

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·       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;

·       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 our productsto 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 we infringe orare alleged to infringe intellectual property rights of third parties, it willadversely affect our business.***

Our research, development and commercialization activities,as well as any product candidates or products resulting from these activities,may infringe or be claimed to infringe patents or patent applications underwhich we do not hold licenses or other rights. Third parties may own or controlthese patents and patent applications in the United States and abroad. Thesethird parties could bring claims against us or our collaborators that wouldcause us to incur substantial expenses and, if successful against us, couldcause us to pay substantial damages. Further, if a patent infringement suitwere brought against us or our collaborators, we or they could be forced tostop or delay research, development, manufacturing or sales of the product orproduct candidate that is the subject of the suit.

As a result of patent infringement claims, or in orderto avoid potential claims, we or our collaborators may choose or be required toseek a license from the third party and be required to pay license fees orroyalties or both. These licenses may not be available on acceptable terms, orat all. Even if we or our collaborators were able to obtain a license, therights may be nonexclusive, which could result in our competitors gainingaccess to the same intellectual property. Ultimately, we could be preventedfrom commercializing a product, or be forced to cease some aspect of ourbusiness operations, if, as a result of actual or threatened patentinfringement claims, we or our collaborators are unable to enter into licenseson acceptable terms. This could harm our business significantly.

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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 patent litigationand other proceedings, including interference proceedings declared by the USPTOand opposition proceedings in the European Patent Office, regardingintellectual property rights with respect to our products and technology. Thecost to us of any patent litigation or other proceeding, even if resolved inour favor, could be substantial. Some of our competitors may be able to sustainthe costs of such litigation or proceedings more effectively than we canbecause 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 absorb significantmanagement time.

***We depend uponthird party researchers and providers of clinical services to perform ascontractually required if we are to be successful in bringing new products tomarket.***

We do not have the ability independently to conductthe clinical trials required to obtain regulatory approval for our products. Werely on independent clinical investigators, contract research organizations 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 our future products to marketdepends on the quality and integrity of the data we present to regulatoryauthorities in order to obtain marketing authorizations. We cannot guaranteethe authenticity or accuracy of such data, nor can we be certain that such datahas not been fraudulently generated. The failure of these third parties tocarry out their obligations would materially adversely affect our ability todevelop and market new products and implement our strategies.

***We depend uponcertain key relationships to generate much of the technology required tomaintain our competitive position in the marketplace.***

Our IMPACS technology islicensed from SUNY, or the SUNY License, and other academic and researchinstitutions collaborating with SUNY. Under the SUNY License, we have anexclusive worldwide license to SUNY’s rights in certain patents and patentapplications to make and sell products employing tetracyclines to treat certaindisease conditions. The SUNY License imposes various payment and reportingobligations on us, and our failure to comply with these requirements permitsSUNY to terminate the SUNY License. If the SUNY License is terminated, we wouldlose our right to exclude competitors from commercializing similar products,and we could be excluded from marketing the same products if SUNY licensed theunderlying technology to a competitor after terminating the SUNY License. TheSUNY License is terminable by SUNY on 90 days prior notice only upon ourfailure to make timely payments, reimbursements or reports, if the failure isnot cured by us within 90 days. The termination of the SUNY License, or thefailure to obtain and maintain patent protection for our technologies, wouldhave a material adverse effect on our business, financial condition, liquidityand results of operations.

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***If our products causeinjuries, we may incur significant expense and liability.***

Our business may be adversely affected by potentialproduct liability claims arising out of the testing, manufacturing andmarketing of Periostat and other products developed by or for us or for whichwe have licensing or promotion and cooperation rights. We have an aggregate of$10 million in product liability insurance covering Periostat and Mutual’sbranded version of Periostat, our product candidates and products for which wehave licensing or promotion 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.

***Changes in stockoption accounting rules may have a significant adverse affect on ouroperating results.***

We have a history of using broad based employee stockoption programs to hire, incentive and retain our workforce in a competitivemarketplace. Statement of Financial Accounting Standards No. 123, “Accountingfor Stock-Based Compensation,” allows companies the choice of either using afair value method of accounting for options that would result in expenserecognition for all options granted, or using an intrinsic value method, asprescribed by Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees,” or APB 25, with a pro forma disclosure of theimpact on net income (loss) allocable to common stockholders of using the fairvalue option expense recognition method. We have elected to apply APB 25 and,accordingly, we generally have not recognized any expense with respect toemployee stock options as long as such options are granted at exercise pricesequal to the fair value of our common stock on the date of grant.

In December 2004, theFinancial Accounting Standards Board issued SFAS No. 123 (revised), “Share-BasedPayment” (Statement 123R). Statement 123R requires that the compensation costrelating to share-based payment transactions be recognized in financialstatements. That cost will be measured based on the grant-date fair value of theequity instruments issued, which may be determined with references to variousvaluation models. These models may involve extensive and complex analysis. Statement123R is effective for us beginning on January 1, 2006, which is the firstday of our 2006 fiscal year. We are in the process of reviewing Statement 123Rto determine which fair value determination model is most appropriate for us. Whilewe continue to evaluate the effect that the adoption of Statement 123R willhave on our financial position and results of operations, we currently expectthat our adoption of Statement 123R will adversely affect our operating resultsto some extent in future periods.

***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.

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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 1,2003 through December 31, 2005, as reported on the Nasdaq National Market:

| **Quarter Ended**   | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------|------------|------------|------------|----------|------------|---------|------------|
| March 31,  2003     |       | $          | 11.03      |     | $          | 6.66    |       |
| June 30,  2003      |       | $          | 13.27      |     | $          | 8.62    |       |
| September 30,  2003 |       | $          | 15.84      |     | $          | 10.50   |       |
| December 31,  2003  |       | $          | 11.82      |     | $          | 8.90    |       |
| 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    |       |

 

**Item1B.**                  UnresolvedStaff Comments.

Not applicable.

**Item 2.**                        Properties.

We own no real property. Ourprincipal executive offices, located at 41 University Drive, Suite 200,Newtown, Pennsylvania, consist of 14,204 square feet of leased space. Our leasefor such premises continues through April 2009.

**Item 3.**                        LegalProceedings.

*Mutual*

On April 8, 2004, we settled all pending litigation between us and Mutual.As part of the settlement, we paid to Mutual $2.0 million, whichrepresented a portion of the anticipated fees and expenses that we would saveas a result of the settlement of the pending actions with Mutual.

In connection with thesettlement, we and Mutual entered into a License and Supply Agreement pursuantto which Mutual received a license to sell a branded version of Periostat andwould purchase this product exclusively from us at prices below our averagemanufacturer’s price. The License and Supply Agreement also provided for us tomake price adjustments to Mutual after a generic version of Periostat hadbecome available on the market at a price lower than the selling price ofMutual’s branded version of Periostat. These adjustments were to take the formof rebates or credits to Mutual to reduce the acquisition cost of the brandedversion of Periostat in Mutual’s inventory or to offset rebates and similarretroactive price adjustments requested by, and actually provided by, Mutual toits customers. On May 13,2005, the FDA approved a third party generic version of Periostat that waslaunched in late May 2005. Upon this generic launch, Mutual was no longerobligated to purchase and did not purchase its branded version of Periostatfrom us.

*FDA*

In June 2003, wecommenced an action and filed a motion for a preliminary injunction in theUnited States District Court for the District of Columbia, or the FDALitigation, challenging the FDA’s decision 

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to treatPeriostat as an antibiotic drug, thus denying Periostat certain protectionsafforded non-antibiotic drugs under the Food, Drug, and Cosmetic Act andagainst FDA approval of generic copies of Periostat. On July 23, 2003, theUnited States District Court for the District of Columbia issued an injunctionin our favor. On January 20, 2005, the United States District Court forthe District of Columbia reached its decision on the merits of the FDALitigation, and dissolved the injunction that had prohibited the FDA fromapproving any ANDAs submitted for any generic version of Periostat. We lodged,but have now withdrawn, an appeal against this decision in the Court of Appealsfor the District of Columbia Circuit.

*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. Thelitigation on the merits of our patent infringement claims is still pendingbefore the Court in the Eastern District of New York.

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 costs fromSUNY. The cumulative legal patent defense, litigation and settlement costsincurred as of December 31, 2005 exceed the amount of the royalties earnedand payable to SUNY since our litigation commenced by approximately $4.1million. 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.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders.

Not applicable.

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**PART II**

**Item 5.**                        Marketfor the Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities.

***Market Information***

Since June 20, 1996, our common stock has tradedon the Nasdaq National 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, 2004 through December 31,2005, as reported on the Nasdaq National 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    |       |

 

***Holders***

As of March 1, 2006, the approximate number ofholders of record of our common stock was 99 and the approximate number ofbeneficial holders of our common stock was 3,893 as of March 3, 2006.

***Dividends***

We have never declared or paid any cash dividends onour common stock. Except as set forth below, we intend to retain earnings, ifany, to fund future growth and the operation of our business. On May 12,1999, we consummated a $20.0 million financing through the issuance of our Series DStock. As a result of such financing, we had certain common stock dividendobligations and continue to have certain cumulative cash dividend obligationsto 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 Silicon Valley Bankwhich expires on May 31, 2006.

***Recent Sales of Unregistered Securities***

The following information relates to all securities ofthe Company sold by us during the year ended December 31, 2005 which werenot registered under the securities laws at the time of grant, issuance and/orsale (and which were not previously reported on a Quarterly Report on Form 10-Q):

During the fourth quarterof 2005, we granted stock options pursuant to our 2005 Equity Incentive Planwhich were not registered under the Securities Act of 1933, as amended (the “SecuritiesAct”). All of such option grants were granted at the then current fair value ofthe common stock. The following table sets forth certain information regardingsuch grants during the quarter:

| **Number of Options  Granted** | ** ** | ** ** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|------------------------------------------|------------|------------|------------|------------------------------------------------|------------|
| 26,200                                   |       |       | $          | 9.19                                           |       |   |
|                                          |            |            |            |                                                |            |  |  |  |

 

We did not employ an underwriter in connection withthe issuance of the securities described above. We believe that the issuance ofthe foregoing securities was exempt from registration under either (i) Section 4(2) ofthe Securities Act as transactions not involving any public offering and suchsecurities having been acquired for investment and not with a view todistribution, or (ii) Rule 701 under the Securities Act astransactions made pursuant to a written compensatory benefit plan or pursuantto a written contract relating to compensation. All recipients had adequateaccess to information about us.

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**Item 6.**                        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 31,2005 and our consolidated balance sheets as of December 31, 2005 and 2004are 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 December 31, 2002 and 2001 and theconsolidated balance sheet data as of December 31, 2003, 2002 and 2001 arederived from our audited consolidated financial statements not included in thisAnnual Report on Form 10-K. The selected consolidated financial dataset forth below should be read in conjunction with and is qualified in itsentirety by our audited consolidated financial statements and related notesthereto found at “Item 15. Exhibits and Financial Statement Schedules” and “Item7. Management’s Discussion and Analysis of Financial Condition and Results ofOperations” which are included elsewhere in this Annual Report on Form 10-K.

| ** **                                                               | ** ** | **Years Ended December 31,**                                             | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2005**                                                                                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                               | ** ** | **(dollars in thousands except for per share data)** | ** ** |
| **Consolidated Statement of  Operation Data:**                           |       |                                                                                    | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |
| Revenues:                                                                |       |                                                                                    |       |   |   |   |   |   |   |   |   |
| Net product sales                                                        |       | $                                                                                       | 25,736     |   | $ | 51,739 |   | $ | 49,038 |   | $ | 42,111 |   | $ | 31,358 |   |
| Contract revenues                                                        |       | 481                                                                                     |       | 237 |   | 3,122 |   | 2,332 |   | 3,386 |   |
| License revenues                                                         |       | 188                                                                                     |       | 170 |   | 699 |   | 176 |   | 488 |   |
| Total revenues                                                           |       | 26,405                                                                                  |       | 52,146 |   | 52,859 |   | 44,619 |   | 35,232 |   |
| Operating expenses:                                                      |       |                                                                                    |       |   |   |   |   |   |   |   |   |
| Cost of product sales                                                    |       | 5,885                                                                                   |       | 7,446 |   | 7,362 |   | 6,713 |   | 5,825 |   |
| Research and development                                                 |       | 13,986                                                                                  |       | 8,843 |   | 5,462 |   | 4,394 |   | 3,764 |   |
| Selling, general and  administrative                                     |       | 25,242                                                                                  |       | 29,417 |   | 32,968 |   | 32,699 |   | 34,010 |   |
| 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                                                  |       | (19,892                                                                                 | )          | 7,072 |   | 6,367 |   | 813 |   | (8,367 | ) |
| Interest income                                                          |       | 1,086                                                                                   |       | 421 |   | 148 |   | 77 |   | 232 |   |
| Interest expense                                                         |       | —                                                                                  |       | — |   | — |   | (5 | ) | (17 | ) |
| Other (expense)/income                                                   |       | 1                                                                                       |       | 2 |   | (3 | ) | 17 |   | 8 |   |
| (Loss) income before  income taxes                                       |       | (18,805                                                                                 | )          | 7,495 |   | 6,512 |   | 902 |   | (8,144 | ) |
| Income taxes                                                             |       | —                                                                                  |       | 967 |   | 85 |   | — |   | — |   |
| Net (loss) income                                                        |       | $                                                                                       | (18,805    | ) | $ | 6,528 |   | $ | 6,427 |   | $ | 902 |   | $ | (8,144 | ) |
| Net (loss) income  allocable to common stockholders                      |       | $                                                                                       | (24,212    | ) | $ | 4,928 |   | $ | 4,827 |   | $ | (727 | ) | $ | (9,824 | ) |
| Basic net (loss) income  per share allocable to common stockholders(1)   |       | $                                                                                       | (1.67      | ) | $ | 0.35 |   | $ | 0.40 |   | $ | (0.06 | ) | $ | (0.94 | ) |
| Diluted net (loss) income  per share allocable to common stockholders(1) |       | $                                                                                       | (1.67      | ) | $ | 0.34 |   | $ | 0.38 |   | $ | (0.06 | ) | $ | (0.94 | ) |
| Shares used in computing  basic per share amounts(1)                     |       | 14,480,779                                                                              |       | 14,264,687 |   | 12,094,638 |   | 11,234,652 |   | 10,413,663 |   |
| Shares used in computing  diluted per share amounts(1)                   |       | 14,480,779                                                                              |       | 14,500,637 |   | 12,836,364 |   | 11,234,652 |   | 10,413,663 |   |

 

| ** **                                         | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                         | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                         | ** ** | **(in thousands)**               | ** ** |
| **Consolidated Balance Sheet Data:**               |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents  and short-term investments |       | $                                     | 44,425     |   | $ | 38,645 |   | $ | 32,670 |   | $ | 10,112 |   | $ | 6,171 |   |
| Working capital                                    |       | 34,643                                |       | 39,714 |   | 32,010 |   | 5,992 |   | 6,194 |   |
| Total assets                                       |       | 49,165                                |       | 52,346 |   | 44,132 |   | 17,634 |   | 14,698 |   |
| Accumulated deficit                                |       | (89,138                               | )          | (64,926 | ) | (69,854 | ) | (74,681 | ) | (73,954 | ) |
| Total stockholders’  equity                   |       | $                                     | 35,668     |   | $ | 41,215 |   | $ | 33,956 |   | $ | 8,352 |   | $ | 7,127 |   |

----

(1)           See Note 2 of Notes to ConsolidatedFinancial Statements for information concerning computation of net (loss)income per share allocable to common stockholders.

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**Item 7.   Management’s Discussion and Analysis ofFinancial 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 three prescription pharmaceutical products to the dermatologymarket through our professional dermatology sales force.

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 and develop andlaunch new products based on our proprietary platform technologies as well asother technologies. Our lead development candidates are: OraceaTM, for which aNew Drug Application, or NDA, is currently under review by the United StatesFood and Drug Administration, or FDA, for the treatment of rosacea; incyclinide(formerly known as COL-3), which is currently in Phase II dose-findingclinical trials for the treatment of acne; COL-118, a pre-clinicaltopical compound based upon the SansRosa technology that we are developing forthe treatment of erythema (skin redness) associated with dermatologicalconditions; and our Restoraderm Dermal Drug Delivery System, which is currentlyunder development.

Our marketed dermatology products are: Pandel®, aprescription corticosteroid we licensed from Altana, Inc. in May 2002,AlcortinTM, a prescription topical antifungal steroid combination, andNovacortTM, a prescription topical steroid and anesthetic. In June 2005, weexecuted a Promotion and Cooperation Agreement with Primus PharmaceuticalsInc., or Primus, to market Alcortin and Novacort to dermatologists.

We launched Periostat® in January 1999, and by2005, Periostat was the largest branded prescription pharmaceutical product inthe dental market. Between April 2004 and June 2005, we also sold aseparately 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 ouroutstanding patent litigation with Mutual. On May 20, 2005, we terminatedour dental sales force and promotion activities for Periostat following theintroduction of a third party generic version of the product, and as a resultof this generic launch, Mutual ceased purchasing product from us in June 2005.We also discontinued the promotion of our other dental products on May 20,2005. We continue to generate sales from Periostat and other dental products,which all treat periodontal disease and include Atridox®, Atrisorb FreeFlow®and Atrisorb-D®, or the Atrix Products, which are licensed from AtrixLaboratories, Inc. (now known as QLT USA, Inc.).

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, 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 is our first FDA-approved IMPACSproduct. Oracea and incyclinide are IMPACS compounds currently in clinicaldevelopment for the treatment of rosacea and acne, respectively. Our IMPACStechnology is licensed on a perpetual basis from the Research Foundation of theState University of New York at Stony Brook, or SUNY. Our SansRosa technologywas acquired in connection with our acquisition of SansRosa, and is an earlystage project to develop a topical treatment (COL-118) for the rednessassociated with rosacea. Our Restoraderm technology is a proprietary,foam-based, topical drug delivery technology that originated from a Swedishcollaborator. We 

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have acquired all rights,title and interest to the Restoraderm technology. We have formulated severalpotential products incorporating the Restoraderm technology with activeingredients commonly used to treat dermatological conditions, although we havenot yet developed timetables for the initiation of clinical development or thecommercial launch of any of these products.

We recently completed two Phase III clinical trialsfor our leading IMPACS product candidate, Oracea, for the treatment of rosacea,a dermatological condition. Oracea is a modified release form of asub-anti-microbial dose of doxycycline, the same active ingredient as Periostat.We submitted our NDA for Oracea to the FDA on August 1, 2005. On October 3,2005, we announced that the NDA for Oracea had been accepted for review by theFDA. The Prescription Drug User Fee Act (PDUFA) target date for reviewing thesubmission is May 31, 2006. In April 2005, we announced thecompletion of a Phase II proof-of-concept clinical trial for our secondgeneration IMPACS compound, incyclinide for the treatment of rosacea. In September 2005,we initiated a 300-patient, double-blinded, placebo-controlled, Phase IIdose-finding clinical trial to evaluate the safety and efficacy of incyclinidefor the treatment of acne. On November 9, 2005, we announced that theNational Institutes of Health had awarded a grant of approximately $962,000 foradditional research into the potent anti-inflammatory effects of incyclinide.

On December 21, 2005, we entered into definitiveagreements with institutional and other investors to sell 2.9 million shares ofour common stock for an aggregate purchase price of $29.0 million. The firstclosing of this transaction, for $15.5 million of the gross proceeds, was heldon December 21, 2005. The second closing of this transaction, for $13.5million of the gross proceeds, occurred on January 6, 2006. The netproceeds of the offering were approximately $27.1 million after deducting theplacement agency fees and all offering expenses that were payable by us. RothCapital Partners, LLC acted as placement agent and SunTrust Robinson HumphreyCapital Markets acted as financial advisor to us in connection with theoffering.

We were founded in 1992and completed an initial public offering of our common stock in 1996. Werecorded our first profit in the third quarter of 2002. Although we achievednet income of $6.5 million, $6.4 million and $902,000 for the years ended December 31,2004, 2003 and 2002, respectively, we incurred losses in every other year sinceinception and have an accumulated deficit of $89.1 million at December 31,2005.

**Results of Operations**

*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 |   |

 

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 toMutual. The decrease in 2005 net product sales was primarily due to lowerPeriostat net sales as a result of the launch of a third party genericcompetitor in May 2005. Based on data provided by a leading independentprescription tracking service, we estimate that Periostat’s share of thedoxycycline market was 14% at December 31, 2005. Contract revenues duringthe year ended December 31, 2005 were derived primarily from our Promotionand Cooperation Agreement with Primus and residual contract revenues from ourexpired agreement with Merck & Co., Inc., or Merck, 

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forVioxx®. Licensing revenues during the year ended December 31, 2005consisted 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 ProductSales**

| **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, if any.

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. 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 andDevelopment**

| **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 accounted for totalcosts of approximately $5.0 million;

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

·       theinitial purchase price installment for SansRosa technology totaling $750,000;

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

·       clinicaland manufacturing development and formulation work for Periostat-MR, our oncedaily, controlled release formulation of doxycycline, 40 mg, for the treatmentof adult periodontitis, which accounted for total costs of approximately $1.3 million.

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

We estimate that if Oracea and incyclinide aredeveloped to the point of commercialization, the additional formulation andclinical development expenses and milestone fees expected to be incurred overthe next five years would be approximately $35.0 to $38.0 million. We havediscontinued all development work on Periostat-MR following the launch ofgeneric competition to Periostat in May 2005 and our decision to exit thedental business. While we are currently conducting some formulation andstability work on products incorporating our Restoraderm technology, we havenot developed a timetable for clinical development or commercial launch. Accordingly,it is premature to estimate other future costs associated with the Restoradermtechnology. It is also premature to estimate future development and clinicalcosts associated with the SansRosa technology.

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

·       clinicaland manufacturing development work for Oracea which accounted for total costsof approximately $2.7 million;

·       clinicaland manufacturing development and formulation work for Periostat-MR, whichaccounted for total costs of approximately $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, which accounted for total costs ofapproximately $868,000;

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

·       clinicaland manufacturing development work for incyclinide was $673,000.

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 $11.0 million in direct selling and sales trainingexpenses, approximately $7.1 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.The decrease in 

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selling, general andadministrative expenses during the year ended December 31, 2005 comparedto the year ended December 31, 2004 was primarily attributable todecreased personnel costs as a result of the April 2004 sales forcerestructuring and the May 2005 termination of our dental sales andmarketing activities and the corresponding reduction of 63 employees, includingour dental sales force.

Legal settlement consisted of $2.0 million duringthe year ended December 31, 2004 that resulted from the accrual for aone-time payment 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, the Company had paid all but $96,000 of suchrestructuring charges, which related exclusively to the May 2005restructuring.

**Gainon Sale of U.K. and European Dental Assets**

During 2004, we sold ourU.K. and European dental assets to Alliance for net pretax proceeds ofapproximately $3.0 million. A provision of $945,000 was made for anticipatedU.K. income taxes due on this sale. In accordance with generally acceptedaccounting principles, the pretax gain on this sale of assets is includedwithin operating income and the income tax provision is included within incometaxes.

**OtherIncome/Expense**

| **Other Income/Expense** | ** ** | ** **                           | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                    | ** ** | **(dollars in thousands)** | ** ** |
| Interest income               |       | $                                    | 1,086      |     |       | 158.0      | %          |     | $          | 421 |   |
|                               |            |                                      |            |          |            |            |            |          |            |  |  |  |  |

 

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

**PreferredStock Dividend and Series D Preferred Stock Restructuring and Exchange**

Preferred stock dividendsincluded in net income allocable to common stockholders were $1.7 millionduring the year ended December 31, 2005 and $1.6 million during the yearended December 31, 2004. Such preferred stock dividends are paid in cashand are the result of our obligations in connection with the issuance of our Series D Cumulative ConvertiblePreferred Stock, or the Series D Stock, in May 1999. Pursuantto the terms of our Series D-1Cumulative Convertible Preferred Stock, or the Series D-1 Stock, theholders of the Series D-1 Stock are entitled to dividends payable incash at a current rate of 9.0% per annum, which are declared and paid every sixmonths. The annual dividend rate increases by 1.0% per annum on May 19,2006 and each subsequent anniversary thereof until the earlier of the date thatall of the shares of Series D-1 Stock are (i) converted into sharesof common stock, or (ii) redeemed. On December 15, 2005, certainterms of the Amended Certificate of Designation, Preferences and Rights of theSeries D Stock were amended in connection with the execution of aRestructuring and Exchange Agreement, and the Series D Stock was exchangedfor shares of Series D-1 Stock. In 2005, we recorded a $3.7 millionnon-cash charge in connection with the Series D Stock Restructuring andExchange.

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*Years EndedDecember 31, 2004 and December 31, 2003*

**Revenues**

| **Revenues**      | ** ** | ** **                           | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** |
|-------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **        | ** ** | **(dollars in thousands)** | ** ** |
| Net Product Sales |       | $                                    | 51,739     |     |       | 5.5        | %          |     | $          | 49,038 |   |
| Contract Revenues |       | 237                                  |       |     | (92.4      | )%         |       | 3,122    |       |
| License Revenues  |       | 170                                  |       |     | (75.7      | )%         |       | 699      |       |
| Total             |       | $                                    | 52,146     |     |       | (1.3       | )%         |     | $          | 52,859 |   |

 

During the year ended December 31, 2004, netproduct sales included net sales of Periostat, Mutual’s branded version ofPeriostat, the Atrix Products and Pandel. During the year endedDecember 31, 2003, net product sales included net sales of Periostat, theAtrix Products and Pandel. During 2004, we recorded $7.0 million in sales toMutual. Net product sales for the year ended December 31, 2004 increasedover the prior year due to increases in the number of prescriptions forPeriostat, including Mutual’s branded version of Periostat, and Pandel as wellas price increases in the products we sell to wholesalers offset in part by thelower average selling price recognized on sales to Mutual. During the yearended December 31, 2004, Mutual’s branded version of Periostat accountedfor approximately 20% of the tablets dispensed to patients who received andfilled a prescription for Periostat.

Contract revenues for the year ended December 31,2004 decreased 92.4% to $237,000 from approximately $3.1 million during theyear ended December 31, 2003, primarily due to the expiration and/ormutual termination of our co-promotion agreements with Merck, Novartis ConsumerHealth, Inc. and Sirius Laboratories, Inc. during 2003. The 2004revenue consists of residual contract revenue from our expired agreement withMerck for Vioxx.

We recorded $170,000 and$699,000 in licensing revenues for the years ended December 31, 2004 andDecember 31, 2003, respectively, relating to various internationaldistribution agreements. Our 2004 license revenues included $45,000 from theamortization of previously deferred upfront licensing fees that are beingamortized over the expected performance periods of the agreements, $96,000 fromthe acceleration of previously unamortized deferred upfront licensing feesrelated to European licensing agreements that were transferred to AlliancePharma plc, or Alliance, as part of the sale of certain U.K. and Europeandental assets in October 2004, and $29,000 in licensing revenue from aCanadian distribution partner. We recorded licensing revenues of $699,000during the year ended December 31, 2003. This amount included $425,000 inmilestones fees received from foreign marketing partners upon the achievementof certain milestones, $222,000 from the acceleration of previously unamortizeddeferred up-front licensing fees relating to a licensing agreement that wasterminated in 2003, and $52,000 from the amortization of deferred up-frontlicense fees over the expected performance periods of the agreements.

**Cost of ProductSales**

| **Cost of Product Sales** | ** ** | ** **                           | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                               | ** ** | **(dollars in thousands)** | ** ** |
| Cost of Product  Sales                   |       | $                                    | 7,446      |     |       | 1.1        | %          |     | $          | 7,362 |   |
| Percent of Net Product  Sales            |       | 14.4                                 | %          |     | N/A        |       |       | 15.0     | %          |
|                                          |            |                                      |            |          |            |            |            |          |            |  |  |  |  |

 

Cost of product sales includes product packaging,third-party royalties, amortization of product licensing fees, and the costsassociated with the manufacturing, the acquisition of manufactured product, andstorage and stability of our current products.

Cost of product sales wereapproximately $7.4 million, or 14.4% of net product sales during the year endedDecember 31, 2004, compared to approximately $7.4 million, or 15.0% of netproduct sales during 

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the yearended December 31, 2003. As a percentage of net product sales, cost of netproduct sales decreased slightly compared to the year ended December 31,2003, due to Periostat price increases and product mix that were partiallyoffset by the lower average selling price recognized on sales to Mutual in2004.

**Research andDevelopment**

| **Research and Development** | ** ** | ** **                           | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                             | ** ** | **(dollars in thousands)** | ** ** |
| Research and  development              |       | $                                    | 8,843      |     |       | 61.9       | %          |     | $          | 5,462 |   |
|                                        |            |                                      |            |          |            |            |            |          |            |  |  |  |  |

 

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, report writing and regulatory compliance costs.

Research and development expenses increasedapproximately $3.4 million, or 61.9%, to approximately $8.8 million during theyear ended December 31, 2004 from approximately $5.5 million duringthe year ended December 31, 2003.

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

·       ourcontinuing clinical and manufacturing development work for Oracea whichaccounted for total costs of approximately $2.7 million;

·       ourcontinuing clinical and manufacturing development and formulation work forPeriostat-MR, which accounted for total costs of approximately $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, which accounted for total costs ofapproximately $868,000;

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

·       ourclinical and manufacturing development work for incyclinide was $673,000.

Personnel and direct internal overhead expenses,including consulting and regulatory costs, incurred during the year endedDecember 31, 2004 were approximately $2.0 million.

Significantdevelopment projects conducted during the year ended December 31, 2003included:

·       themanufacturing, development and formulation work for Periostat-MR and Oracea,which accounted for total costs of approximately $269,000;

·       stabilitytesting and milestone fees for several potential products utilizing theRestoraderm technology, which accounted for total costs of approximately$817,000;

·       severalPhase IV studies for Periostat in various dental applications, which accountedfor total costs of approximately $391,000; and

·       aPhase III clinical trial to evaluate Periostat for the treatment of rosacea, whichaccounted for total costs of approximately $2.0 million.

Personnel and directinternal overhead expenses, including consulting and regulatory costs, incurredduring the year ended December 31, 2003 were approximately $1.9 million.

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**Selling, General and Administrative**

| **Selling, General and Administrative** | ** ** | ** **                           | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                                             | ** ** | **(dollars in thousands)** | ** ** |
| Selling, General  and Administrative                   |       | $                                    | 29,417     |     |       | (10.8      | )%         |     | $          | 32,968 |   |
| Legal settlement                                       |       | 2,000                                |       |     | 185.7      | %          |       | 700      |       |
| Restructuring  charge                                  |       | 348                                  |       |     | N/A        |       |       | —   |       |
| Total                                                  |       | $                                    | 31,765     |     |       | (5.7       | )%         |     | $          | 33,668 |   |

 

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

Selling, general and administrative expenses decreased10.8% to approximately $29.4 million during the year endedDecember 31, 2004 from approximately $33.0 million during the yearended December 31, 2003. The decrease in selling, general and administrativeexpenses during the year ended December 31, 2004 compared to the yearended December 31, 2003 was primarily due to reduced sales force expensesas a result of our April 2004 sales force restructuring and a significantdecrease in marketing and promotional expenses associated with products subjectto third-party co-promotion agreements that expired or were mutually terminatedat the end of 2003, as well as decreased patent litigation costs in 2004 ascompared to 2003.

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.

Significant components of selling, general and administrativeexpenses incurred during the year ended December 31, 2003 includedapproximately $15.7 million in direct selling and sales training expenses,approximately $8.5 million in marketing expenses (including advertising andpromotion expenditures for Periostat, the Atrix Products and Pandel andco-promotion expenses relating to Vioxx and AVARTM), approximately $8.5 millionin general and administrative expenses, which include business development,finance, legal and corporate activities. General and administrative expensesfor the year ended December 31, 2003 also included a $251,000 non-cashcompensation expense related to the modifications of certain stock options heldby Brian M. Gallagher, who left the Company in 2003.

Legal settlement incurred during the year ended December 31,2004 consisted of the $2.0 million payment to Mutual in connection with thesettlement of all outstanding litigation. Legal settlement incurred during theyear ended December 31, 2003 consisted of a $700,000 payment to West-wardPharmaceutical Corporation in connection with the settlement of all outstandinglitigation.

Restructuring chargesduring the year ended December 31, 2004 consisted of $348,000 thatresulted from the April 2004 reorganization of our sales organization intodedicated dental and dermatology sales forces. All such charges were paid as ofDecember 31, 2004.

**Gainon Sale of U.K. and European Dental Assets**

During 2004, we sold ourU.K. and European dental assets to Alliance for net pretax proceeds ofapproximately $3.0 million. A provision of $945,000 was made for anticipatedU.K. income taxes due on this sale. In accordance with generally acceptedaccounting principles, the pretax gain on this sale of assets is includedwithin operating income and the income tax provision is included within incometaxes.

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**OtherIncome/Expense**

| **Other Income/Expense** | ** ** | ** **                           | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                    | ** ** | **(dollars in thousands)** | ** ** |
| Interest income               |       | $                                    | 421        |     |       | 184.5      | %          |     | $          | 148 |   |
|                               |            |                                      |            |          |            |            |            |          |            |  |  |  |  |

 

Interest income increasedto $421,000 for the year ended December 31, 2004 compared to $148,000 forthe year ended December 31, 2003. This increase was due primarily tohigher average investment balances and investment yields in 2004.

**Preferred Stock Dividend**

Preferred stock dividendsincluded in net income allocable to common stockholders were $1.6 millionduring each of the years ended December 31, 2004 and December 31,2003. Such preferred stock dividends are paid in cash and are the result of ourobligations in connection with the issuance of our Series D Stock in May 1999.

**Liquidity and Capital 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.

We believe thatother key factors that could affect our internal and external sources of cashare:

·       Thesuccess of our dermatology franchise;

·       Thesuccess of our preclinical, clinical and development programs (research anddevelopment expenses are estimated to be approximately $17.0 million in 2006);

·       Revenuesand profits from sales of Periostat, Pandel and our other product candidates,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 revolvingcredit facility with Silicon Valley Bank; and

·       Thereceptivity of the capital markets to our future financings.

In December 2005 and January 2006, we raised$27.1 million in a public offering, net of placement agency fees and alloffering expenses that were payable by us from the sale of 2.9 million sharesof our common stock at a price of $10.00 per share.

On June 7, 2004, we entered into a LoanModification Agreement with Silicon Valley Bank to renew and amend ourrevolving credit facility, which had expired on March 15, 2004. Theamended credit facility expires on May 31, 2006. Under the amended creditfacility, we may borrow up to the lesser of $5.0 million or 80% of eligibleaccounts receivable, as defined under the amended credit facility. The amountavailable to us is reduced by any outstanding letters of credit which may beissued under the amended credit facility in amounts totaling up to $2.0 million.As we pay down amounts under any letter of credit, the amount 

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available to us under thecredit facility increases. We are not obligated to draw amounts under theamended credit facility and any borrowings shall bear interest, payablemonthly, at the current prime rate. As of December 31, 2005, we had no outstanding borrowings or lettersof credit. We are currently in discussions with Silicon Valley Bank regardingthe renewal of the line of credit, however, we cannot offer assurance that suchdiscussions will result in a renewal.

At December 31, 2005, we had cash, cashequivalents and short-term investments of approximately $44.4 million, an increase of approximately $5.8 million comparedto the approximately $38.6 million balance at December 31, 2004. Thisincrease is a result of the proceeds received from the public offering of1,550,000 shares of our common stock in December 2005, offset in part bynet cash used in operating activities during the year ended December 31,2005 and net investments made in 2005. Cash, cash equivalents and short terminvestments at December 31, 2005 did not include the net proceeds of $11.7million from the sale of 1,350,000 shares of common stock that closed in January 2006.In accordance with investment guidelines approved by our Board of Directors,cash balances in excess of those required to fund operations have been investedin government notes, commercial paper and money market funds. Our workingcapital at December 31, 2005 was $34.6million compared to $39.7 million at December 31, 2004. During theyear ended December 31, 2005, we invested approximately $392,000 in capital expenditures and$900,000 for in-process research and development, paid $1.6 million in cash dividends to the holders of our Series D-1Stock and liquidated approximately $8.6 million (net of purchases) ofshort-term investments.

We anticipate that ourcurrent cash, cash equivalents and short-term investments at December 31,2005, together with the additional $11.7 million in net proceeds from the1,350,000 additional shares of common stock sold in January 2006, will besufficient to fund our operations through at least mid-2007. However, ourforecast of the period of time through which our financial resources will beadequate to support our operations is a forward-looking statement that involvesrisks and uncertainties, and actual results could vary materially.

***Cash Flows/Cash Management***

The principal use of cash in operating activitiesduring the year ended December 31, 2005 was the payment of operatingexpenses and related working capital liabilities. Cash flows from operationscan vary significantly due to various factors including the timing of paymentsmade to our vendors, including research and development vendors, vendor paymentterms, customer mix and customer payment terms.

Investing activitiesduring the year ended December 31, 2005 consisted primarily of purchasesand sales of short-term investments, capital purchases and acquired in-processresearch and development. Financing activities during the year ended December 31,2005 consisted primarily of the cash inflows from our December 2005offering of 1,550,000 shares of our common stock, the exercise of common stockoptions, and the payment of preferred dividends to the holders of our Series DStock.

***Contractual Obligations***

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

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Belowis a table which presents our contractual obligations and commercialcommitments as of December 31, 2005:

| ** **                                         | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                   | ** ** | ** **                                | ** ** | **Total** | ** ** | **2006** | ** ** | **2007 and 2008** | ** ** | **2009 and 2010** | ** ** | **2011 and after** | ** ** |
| Operating Leases(1)                                |       | $                                         | 1,443,000  |   | $ | 554,000 |   |   | $ | 694,000 |   |   |   | $ | 195,000 |   |   |   | $ | 0 |   |   |
| Cash Dividends on  Series D-1 Preferred Stock |       | $                                         | 11,312,000 | (2) | $ | 1,928,000 | (2) |   | $ | 4,456,000 | (2) |   |   | $ | 4,928,000 | (2) |   |   |   | (2) |   |
| Total Contractual  Obligations                     |       | $                                         | 12,755,000 | (2) | $ | 2,482,000 |   |   | $ | 5,150,000 |   |   |   | $ | 5,123,000 |   |   |   |   | (2) |   |
|                                                    |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Such amounts primarilyinclude minimum rental payments for our office lease in Newtown, Pennsylvania,as well as payments for sales force computer equipment leases. 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 $337,000 per year.

(2)          Pursuant to the terms ofour Series D-1 Stock, the holders of the Series D-1 Stockare entitled to dividends payable in cash at a current rate of 9.0% per annum,which are declared and paid every six months. The annual dividend rateincreases by 1.0% per annum on May 19, 2006 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.

On June 10, 2002, we executed a Development andLicensing Agreement with Supernus Pharmaceuticals, Inc., or Supernus(successor in interest to Shire Laboratories, Inc.) pursuant to which wewere granted an exclusive worldwide license (including the right to sublicense)to use Supernus technology and patents to develop prescription products for thetreatment of various inflammatory disorders. Under the agreement, certainproduct development functions will be performed for us by Supernus. We havecommitted to pay Supernus milestone payments in cash or, at our option, in acombination of cash and our common stock, upon the achievement of certainclinical and regulatory milestones. For rosacea-indicated development, thesepayments could total up to $2.7 million in the aggregate. Under the agreementwe must also pay Supernus a percentage of net sales of any products utilizingany part of the licensed technology. We expect to make these payments in 2006if we obtain FDA approval for Oracea in the United States and approval invarious international locations and commercially launch Oracea in the UnitedStates.

On August 19, 2004, we executed an Asset Purchaseand Product Development Agreement with respect to Restoraderm technology, orthe Restoraderm Purchase Agreement. Under the terms of the Restoraderm PurchaseAgreement, we purchased all right, title and interest in the intellectualproperty and related rights to the Restoraderm topical drug delivery system,which we intend to develop for dermatological applications. Pursuant to theterms of the Restoraderm Purchase Agreement, the purchase price of the assetsshall be up to $1.0 million, subject to the achievement of certain milestones. Wemay be required to pay certain product development milestone payments in theaggregate amount of up to approximately $2.0 million as well as royalty andsublicense fees upon product commercialization.

On December 14, 2005, we executed a SharePurchase Agreement, or the SansRosa Purchase Agreement, with SansRosaPharmaceutical Development, Inc., or SansRosa, and all of the existingshareholders of SansRosa, or the SansRosa Shareholders, pursuant to which weacquired 51% of the outstanding shares of capital stock of SansRosa, or theShares. SansRosa is the assignee of various U.S. Patent Cooperation Treaty andforeign patentapplications covering methods for treatment of redness associated with rosaceaand other skin disorders.

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We made an initial paymentof $750,000 for the Shares. 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. In theevent all such regulatory and development milestones are achieved and apatented product is developed and approved for sale, depending on the timing ofsuch events, we could pay the SansRosa Shareholders $4.0 million to $6.0million in additional consideration for the remaining outstanding shares ofSansRosa capital stock. The SansRosa Purchase Agreement also provides forspecified earn-out payments to the SansRosa Shareholders based on futureproduct sales. In certain instances, we are entitled to offset certain expensesagainst future purchases of capital stock or earn-out payments.

**CriticalAccounting 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, stockcompensation and the valuation of deferred taxes, acquired product rights andinventory.

***Revenue Recognition***

Except for Periostat and Mutual sales beginning in thesecond quarter of 2005, we recognize product sales revenue upon shipment towholesale customers, net of estimated future returns, estimates forchargebacks, wholesale distribution fees, if applicable, rebates, genericintroductions and current inventory levels in the distribution channel providedthat collection was probable and no significant obligations remained. Followingthe launch of generic competition to Periostat, and commencing with the secondquarter of 2005, we now recognize Periostat sales revenue primarily based onsales to end-users, which we estimate using prescription demand data generatedby a leading independent prescription tracking service, as well as on-handinventory estimates in the distribution channel. Accordingly, since the launchof generic competition to Periostat may increase the rate of product returnsfrom the distribution channel, we have accrued $1.2 million for potentialproduct returns in accrued expenses on the consolidated balance sheet at December 31,2005.

Upon the launch of the third party generic equivalentto Periostat, our agreement with Mutual provides for rebates to be paid toMutual to compensate Mutual and its customers for price erosion on the value ofcertain of its inventories of Mutual’s branded version of Periostat. Accordingly,we have deferred revenues associated with our shipments of these products untilsuch future time as the selling price becomes fixed and determinable. At December 31,2005, our consolidated balance sheet included $3,000 in deferred revenueassociated with sales of Mutual’s branded version of Periostat.

Pursuant to our Promotionand Cooperation Agreement with Primus contract revenues for Alcortin andNovacort are fee-based arrangements where revenue is earned as prescriptionsare filled and recognized as a percentage of the gross profit earned by Primus.We do not take title to the inventory sold by Primus under the PromotionAgreement.

***Stock-Based Compensation***

It is our policy to apply Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations to account for our stock option grants rather than Statement ofFinancial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”and related 

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interpretations. As such,compensation expense is recorded on fixed stock option grants only if themarket value of the underlying stock exceeds the exercise price of the optionat the date of grant and is recognized on a straight-line basis over thevesting period. Had we applied SFAS No. 123, which requires recordingstock option grants at their fair value, our net (loss) income would havevaried from the reported net (loss) income as we would have recorded additionalexpenses in each period. See Note 2 to our Consolidated Financial Statementsfor the pro forma effect of applying SFAS No. 123 to our results ofoperations and earnings per share allocable to common stockholders.

***DeferredTaxes***

Inassessing the realizability of deferred tax assets, we consider the likelihoodthat part or all of the deferred tax assets will not be realized. Thisassessment requires significant judgment and estimates. The ultimaterealization of the deferred tax assets is dependent upon the generation offuture taxable income during the period in which those temporary differencesbecome deductible. We consider our history of losses, scheduled reversal ofdeferred tax assets and liabilities and projected future taxable income overthe 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. While we were profitable for the years ended December 31,2004 and 2003, we have incurred a net loss for the year ended December 31,2005 and uncertainty regarding our future profitability has prevented us fromreaching the “more likely than not” conclusion required under the applicableliterature to recognize deferred tax assets on our consolidated balance sheet.

***AcquiredProduct Rights***

Productrights are stated at cost, amortized over the shorter of the estimated usefullife of the products or the contract term which such rights have been licensed,using the straight-line method. Amortization of product rights is charged tocost of product sales.

Weare required to test for asset impairment of acquired product rights wheneverevents or circumstances indicate that the carrying value of an asset may not berecoverable. We apply SFAS No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” in order to determine whether or not an assetwas impaired. This standard requires an impairment analysis when indicators ofimpairment are present. If such indicators are present, the standard indicatesthat if the sum of the future expected cash flows from the asset, undiscountedand without interest charges, is less than the carrying value, an assetimpairment must be recognized in the financial statements. The amount of theimpairment is the difference between the fair value of the asset and thecarrying value of the asset.

Inmaking future cash flow analyses of our acquired product rights, we makeassumptions relating to:  (i) theintended use of the product rights and the expected future cash flows resultingdirectly from such use; (ii) generic competitor activities and regulatoryinitiatives that affect our products; and (iii) customer preferences andexpected managed care reimbursement.

As a result of a change in the contractual life of theLicensing and Marketing Agreement with Atrix, we adjusted the current andfuture amortization of its acquired product rights asset to reflect a usefullife through December 31, 2007. (see note 7 to our Consolidated FinancialStatements).

***Inventories***

Criticalaccounting estimates and assumptions, related to inventory carrying values areevaluated periodically and consider the saleable quantities of inventory versusquantities of inventory on-hand.

Duringthe year ended December 31, 2005, we recorded a charge of $1.0 million forthe estimated excess inventory of Periostat and Mutual’s branded version ofPeriostat due to decreased demand following the introduction of a third partygeneric version of Periostat.

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***Recently Issued Accounting Standards***

In December 2004, the Financial AccountingStandards Board (the “FASB”) issued SFAS No. 123 (revised 2004), “Share-BasedPayment” (“SFAS 123R”), which replaces SFAS No. 123, “*Accounting for Stock Based Compensation*”**andsupercedes APB Opinion No. 25 (“Opinion No. 25”) “*Accountingfor Stock Issued to Employees.*”  SFAS 123R requires all share-based paymentsto employees to be recognized in the financial statements based on their fairvalues. Share-based payments include grants of employee stock options andliabilities that are based on the fair value of our equity instruments or thatmay be settled by the issuance of such equity instruments. The pro formadisclosures previously permitted under SFAS No. 123 may no longer be providedin lieu of recording these payments in our financial statements.

We are required to adopt SFAS 123R as of January 1,2006, and we expect this adoption to have a material effect on our results ofoperations and earnings per share. We estimate the financial impact ofexpensing options in 2006 will result in additional expense of between $3.0million and $3.5 million. We have not yet determined the precise method ofadoption for SFAS 123R and whether it will result in amounts that are similarto the current pro forma disclosures under SFAS No. 123 in Note 2 to ourConsolidated Financial Statements.

In November 2005, theFASB issued FASB Staff Position SFAS 123(R)-3,*Transition Election Related to Accounting for the Tax Effects ofShare-based Payment Awards*, that provides an elective alternativetransition method of calculating the pool of excess tax benefits available toabsorb tax deficiencies recognized subsequent to the adoption of SFAS 123R (the“APIC Pool”) to the method otherwise required by paragraph 81 of SFAS 123R. Wemay take up to one year from the effective date of the FSP to evaluate ouravailable alternatives and make our one-time election. We are currentlyevaluating the alternative methods in connection with our adoption of SFAS123R.

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

We had cash and cash equivalents and short-terminvestments at December 31, 2005 which are exposed to the impact ofinterest rate changes and our interest income fluctuates as interest rateschange. Due to the short-term nature of our investments in money market funds,the carrying values of our cash equivalents approximate their fair value at December 31,2005. Our short-term investments in commercial paper, certificates of depositand government notes are 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, 2005, wasapproximately $18.2 million and 2.6%, respectively. A one percent change in theinterest rate would have resulted in a $415,000 impact to interest income forthe year ended December 31, 2005.

**Item 8.**        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.”

**Item 9.**        Changesin and Disagreements With Accountants on Accounting and Financial Disclosure.

Not applicable.

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**Item 9A.**     Controlsand Procedures.

**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 31,2005. 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 the 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. Managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving their objectivesand management necessarily applies its judgment in evaluating the cost-benefitrelationship of possible controls and procedures. Based on this evaluation, ourchief executive officer and chief financial officer concluded that, as of December 31,2005, our disclosure controls and procedures were effective at the reasonableassurance level.

**2.   InternalControls Over Financial Reporting**

(a)   Management’sAnnual Report on Internal Control Over Financial Reporting

The management of CollaGenex is responsible forestablishing and maintaining adequate internal control over financial reporting.Internal control over financial reporting is defined in Rule 13a-15(f) or15d-15(f) promulgated under the Securities Exchange Act of 1934 as aprocess designed by, or under the supervision of, the company’s principalexecutive and principal financial officers and effected by the company’s boardof directors, management and other personnel, to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generally acceptedaccounting principles and includes 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 inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

CollaGenex’ management, including the supervision andparticipation of the Chief Executive Officer and Chief Financial Officer,assessed the effectiveness of the Company’s internal control over financialreporting as of December 31, 2005. In making this assessment, the Company’smanagement used the 

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criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) in “InternalControl—Integrated Framework.”

Based on our assessment, management has concludedthat, as of December 31, 2005, the Company’s internal control overfinancial 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 IndependentRegistered Public 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. and subsidiaries maintained effective internalcontrol over financial reporting as of December 31, 2005, based oncriteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO).CollaGenex Pharmaceuticals, Inc.’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the Company’s internal control over financialreporting based on 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.

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In our opinion, management’s assessment thatCollaGenex Pharmaceuticals, Inc. and subsidiaries maintained effectiveinternal control over financial reporting as of December 31, 2005, isfairly stated, in all material respects, based on criteria established inInternal Control—Integrated Framework issued by COSO. Also, in our opinion,CollaGenex Pharmaceuticals, Inc. and subsidiaries maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued 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 31,2005 and 2004, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2005, and the related financial statement schedule,and our report dated March 15, 2006**expressedan unqualified opinion on those consolidated financial statements and relatedschedule.

/s/  KPMG LLP

Philadelphia, PennsylvaniaMarch 15, 2006

(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, 2005 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**

**Item 10.**                 Directorsand Executive Officers 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 2006 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 National Market by filingsuch amendment or waiver with the Securities and Exchange Commission and byposting it on our website.

**Item 11.**                 ExecutiveCompensation.

The discussion under theheading “Executive Compensation” in our definitive proxy statement for the 2006Annual Meeting of Stockholders is incorporated herein by reference to suchproxy statement. The information specified in Item 402(k) and (l) ofRegulation S-K and set forth in our definitive proxy statement for the 2006Annual Meeting of Stockholders is not incorporated by reference.

**Item 12.**                 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 2006Annual Meeting of Stockholders is incorporated herein by reference to suchproxy statement.

**Item 13.**                 CertainRelationships and Related Transactions.

The discussion under theheading “Certain Relationships and Related Transactions” in our definitiveproxy statement for the 2006 Annual Meeting of Stockholders is incorporatedherein by reference to such proxy statement.

**Item 14.**                 PrincipalAccountant Fees and Services.

The discussion under theheading “Independent Registered Public Accounting Firm’s Fees and Other Matters”in our definitive proxy statement for the 2006 Annual Meeting of Stockholdersis incorporated herein by reference to such proxy statement.

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**PART IV**

**Item15.**                 Exhibits andFinancial Statement Schedules.
| (a)    | (1)    | Financial Statements.                                                                               |
|--------|--------|-----------------------------------------------------------------------------------------------------|
|   |   | Reference is made to the  Index to Consolidated Financial Statements and Schedule on Page F-1. |
|   | (2)    | Financial Statement Schedule.                                                                       |
|   |   | Reference is made to the  Index to Consolidated Financial Statements and Schedule on Page F-1. |
|   | (3)    | Exhibits.                                                                                           |
|   |   | Reference is made  to the Index to Exhibits on Page 50.                                        |

 

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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,2006.

|   | 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  ExecutiveOfficer               |       | March 16,  2006 |
| Colin W. Stewart                     |          | and Director (Principal  Executive Officer) |       |                 |
| /s/ NANCY C. BROADBENT               |          | Chief Financial  Officer and Treasurer           |       | March 16,  2006 |
| Nancy C. Broadbent                   |          | (Principal Financial and  Accounting Officer)    |       |                 |
| /s/ BRIAN M. GALLAGHER PH.D.         |          | Director                                         |       | March 13,  2006 |
| Brian M. Gallagher,  Ph.D.           |          |                                             |       |                 |
| /s/ PETER R. BARNETT, D.M.D.         |          | Director                                         |       | March 16,  2006 |
| Peter R. Barnett, D.M.D.             |          |                                             |       |                 |
| /s/ ROBERT C. BLACK                  |          | Director                                         |       | March 16,  2006 |
| Robert C. Black                      |          |                                             |       |                 |
| /s/ JAMES E. DAVERMAN                |          | Chairman of the  Board and Director              |       | March 16,  2006 |
| James E. Daverman                    |          |                                             |       |                 |
| /s/ ROBERT J. EASTON                 |          | Director                                         |       | March 16,  2006 |
| Robert J. Easton                     |          |                                             |       |                 |
| /s/ ROBERT A. BEARDSLEY, PH.D.       |          | Director                                         |       | March 13,  2006 |
| Robert A. Beardsley,  Ph.D.          |          |                                             |       |                 |
| /s/ W. JAMES O’SHEA             |          | Director                                         |       | March 13,  2006 |
| W. James O’Shea                 |          |                                             |       |                 |
| /s/ GEORGE M. LASEZKAY, PHARM., J.D. |          | Director                                         |       | March 14,  2006 |
| George M. Lasezkay, Pharm., J.D.     |          |                                             |       |                 |

 

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**COLLAGENEXPHARMACEUTICALS, 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                                                                                                                             |       |                             |       |                  |   |   |   | * |
| 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            |   | 10.1          |   |   |
| 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   SanRosa Pharmaceutical Development, Inc.                                                                |   |                                      |   |                 |   |          |   | *      |
| 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          |   |   |

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| ***Material   Contracts—Supply, License, Distribution*** |
|---------------------------------------------------------------|
| 10.10†                                                   |   | 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 |   |   |
| 10.11†                                                   |   | Supply Agreement, dated   January 23, 1995, between the Company and Hovione International Limited |   | S-1   (333-03852) |   | Effective   6-20-1996 |   | 10.2 |   |   |
| 10.12†                                                   |   | 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 |   |   |
| 10.13                                                         |   | Form of Material   Transfer Agreement between the Company and Researchers |   | S-1   (333-03582) |   | Effective   6-20-1996 |   | 10.9 |   |   |
| 10.14†                                                   |   | 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 |   |   |
| 10.15†                                                   |   | 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 |   |   |
| 10.16                                                         |   | 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 |   |   |
| 10.17                                                         |   | 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 |   |   |
| 10.18                                                         |   | License Agreement,   dated August 24, 2001, by and between the Company and Atrix   Laboratories, Inc. |   | 10-Q   (000-28308)   10-Q/A   (000-28308) |   | 11-14-2001 2-14-2002 |   | 10.1   10.1 |   |   |

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| 10.19†                            |   | Wholesale Service   Agreement, effective as of November 1, 2001, by and between the Company   and National Specialty Services, Inc. (now known as Cardinal Health   Specialty Pharmaceutical Distribution)                     |   | 10-Q   (000-28308) |   | 5-15-2002 |   | 10.1   |   |   |
|----------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|--------|-----------|--------|--------|--------|--------|
| 10.20†                            |   | 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   Cardinal Health Specialty Pharmaceutical Distribution) |   | 10-Q   (000-28308) |   | 5-15-2002 |   | 10.2   |   |   |
| 10.21†                            |   | Agreement, dated   May 24, 2002, between the Company and Altana, Inc.                                                                                                                                                          |   | 10-Q   (000-28308) |   | 8-14-2002 |   | 10.1   |   |   |
| 10.22                                  |   | 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  |   |   |
| 10.23†                            |   | 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   |   |   |
| 10.24†                            |   | 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   |   |   |
| 10.25†                            |   | 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   |   |   |
| 10.26†                            |   | 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   |   |   |
| 10.27                                  |   | Amendment to License   and Marketing Agreement, dated August 24, 2001, by and between the   Company and Atrix Laboratories, Inc. (now known as QLT USA, Inc.),   dated February 22, 2006                             |   |               |   |      |   |   |   | *      |
| 10.28                                  |   | Commercial   Manufacturing Agreement dated as of March 1, 2006, by and between the   Company and Cardinal Health PTS, LLC                                                                                                           |   |               |   |      |   |   |   | *      |
| ***Material   Contracts—Leases*** |
| 10.29                                  |   | 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   |   |   |

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| ***Material Contracts—Miscellaneous***                                 |
|-----------------------------------------------------------------------------|
| 10.30                                                                       |   | 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 |   |   |
| 10.31                                                                       |   | 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*** |
| 10.32#                                                                      |   | Non-Employee Director   Compensation Summary |   |   |   |   |   |   |   | * |
| 10.33#                                                                      |   | Executive Officer   Compensation Summary |   |   |   |   |   |   |   | * |
| 10.34#                                                                      |   | 1992 Stock Option Plan |   | S-1   (333-03582) |   | Effective   6-20-1996 |   | 10.12 |   |   |
| 10.35#                                                                      |   | 1996 Stock Option Plan |   | S-1   (333-03582) |   | Effective   6-20-1996 |   | 10.13 |   |   |
| 10.36#                                                                      |   | 1996 Non-Employee   Director Stock Option Plan |   | S-1   (333-03582) |   | Effective   6-20-1996 |   | 10.14 |   |   |
| 10.37#                                                                      |   | 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 |   |   |
| 10.38#                                                                      |   | 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 |   |   |
| 10.39#                                                                      |   | 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 |   |   |
| 10.40#                                                                      |   | Form of   Indemnification Agreement executed by each of the Company’s directors and   officers |   | S-1   (333-03852) |   | Effective   6-20-1996 |   | 10.7 |   |   |
| 10.41#                                                                      |   | 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 |   |   |
| 10.42#                                                                      |   | Form of Change of   Control Agreement executed with each of Colin Stewart, Nancy C. Broadbent,   David Pfeiffer, Andrew Powell, Klaus Theobald and Greg Ford |   | 10-Q   (000-28308) |   | 11-14-2002 |   | 10.1 |   |   |
| 10.43#                                                                      |   | Form of Incentive   Bonus Agreement executed with David F. Pfeiffer |   | 10-Q   (000-28308) |   | 11-14-2003 |   | 10.1 |   |   |

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| 10.44# |   | 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   |   |   |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|--------|-----------|--------|--------|--------|--------|
| 10.45# |   | Consulting Agreement,   dated March 18, 2003, by and between the Company and Brian Gallagher                                |   | 8-K   (000-28308)     |   | 3-19-2003 |   | 10.2   |   |   |
| 10.46# |   | 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  |   |   |
| 10.47# |   | 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   |   |   |
| 10.48# |   | 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   |   |   |
| 10.49# |   | 2005 Equity Incentive   Plan                                                                                                     |   | Def 14A   (000-28308) |   | 4-20-2005 |   |   |   |   |
| 10.50# |   | Form of   Nonstatutory Stock Option Agreement for 2005 Equity Incentive Plan                                                |   | 10-Q   (000-28308)    |   | 8-9-2005  |   | 10.1   |   |   |
| 10.51# |   | Form of Incentive   Stock Option Agreement for 2005 Equity Incentive Plan                                                   |   | 10-Q   (000-28308)    |   | 8-9-2005  |   | 10.2   |   |   |
| 10.52# |   | 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   |   |   |
| 10.53# |   | 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   |   |   |
| 10.54# |   | 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   |   |   |
| 10.55# |   | 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   |   |   |
| 10.56# |   | 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   |   |   |
| 10.57# |   | 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   |   |   |
| 10.58# |   | 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   |   |   |

55

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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.

56

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**COLLAGENEXPHARMACEUTICALS, INC.INDEX TO CONSOLIDATED FINANCIAL STATEMENTSAND FINANCIAL STATEMENT SCHEDULE**

|                                                                                                                                | ** ** | **Page** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm                                                                       |       | F-2      |
| Consolidated Balance Sheets as of December 31,  2005 and 2004                                                             |       | F-3      |
| Consolidated Statements of Operations for the years  ended December 31, 2005, 2004, and 2003                              |       | F-4      |
| Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2005, 2004 and 2003           |       | F-5      |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2005, 2004 and 2003                               |       | F-6      |
| Notes to  Consolidated Financial Statements                                                                                    |       | F-7      |
| Financial Statement Schedule—Valuation and Qualifying  Accounts for the years ended December 31, 2005, 2004 and 2003 |       | F-33     |

 

F-1

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**Report of Independent RegisteredPublic Accounting Firm**

The Board of Directors and Stockholders

CollaGenex Pharmaceuticals, Inc.:

We have audited the accompanying consolidated balancesheets of CollaGenex Pharmaceuticals, Inc. and subsidiaries as of December 31,2005 and 2004, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2005. 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 financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of CollaGenex Pharmaceuticals, Inc. and subsidiaries as of December 31,2005 and 2004 and the results of their operations and their cash flows for eachof the years in the three-year period ended December 31, 2005, 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.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of CollaGenex Pharmaceuticals, Inc. andsubsidiaries’ internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO), and our report dated March 15, 2006 expressed an unqualifiedopinion on management’s assessment of, and the effective operation of, internalcontrol over financial reporting.

/s/  KPMG LLP

Philadelphia, Pennsylvania

March 15, 2006

F-2

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIES**

**ConsolidatedBalance SheetsDecember 31, 2005 and 2004(Dollars in thousands, except per share data)**

| ** **                                                                                                                                                             | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Assets**                                                                                                                                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                        |       |       |       |       |       |
| Cash and cash equivalents                                                                                                                                              |       | $          | 26,219     |       | $          | 11,889 |   |
| Short-term investments                                                                                                                                                 |       | 18,206     |       | 26,756     |       |
| Accounts receivable, net of allowances of $104 and  $258 in 2005 and 2004, respectively                                                                                |       | 1,530      |       | 7,208      |       |
| Inventories                                                                                                                                                            |       | 630        |       | 2,692      |       |
| Prepaid expenses and other current assets                                                                                                                              |       | 1,462      |       | 2,096      |       |
| Total current assets                                                                                                                                                   |       | 48,047     |       | 50,641     |       |
| Equipment and  leasehold improvements, net                                                                                                                             |       | 539        |       | 498        |       |
| Acquired product  rights, net                                                                                                                                          |       | 536        |       | 1,164      |       |
| Other assets                                                                                                                                                           |       | 43         |       | 43         |       |
| Total assets                                                                                                                                                           |       | $          | 49,165     |       | $          | 52,346 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                         |       |       |       |       |       |
| Current liabilities:                                                                                                                                                   |       |       |       |       |       |
| Accounts payable                                                                                                                                                       |       | $          | 5,411      |       | $          | 4,317 |   |
| Accrued expenses                                                                                                                                                       |       | 6,024      |       | 5,810      |       |
| Accrued financing costs                                                                                                                                                |       | 1,069      |       | —     |       |
| Preferred dividends payable                                                                                                                                            |       | 900        |       | 800        |       |
| Total current liabilities                                                                                                                                              |       | 13,404     |       | 10,927     |       |
| Deferred revenue                                                                                                                                                       |       | 93         |       | 204        |       |
| Commitments and  contingencies (Notes 5, 6, 7, 8 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 issued and outstanding in 2005 and  none in 2004 (liquidation value $20,900)  |       | 2          |       | —     |       |
| 200,000 shares of Series D Cumulative Convertible  Preferred Stock issued and outstanding in 2004 and none in 2005, (liquidation  value $20,800)                  |       | —     |       | 2          |       |
| 150,000 shares of Series A Participating  Preferred Stock, $0.01 par value, designated and no shares issued and  outstanding in 2005 and 2004                     |       | —     |       | —     |       |
| Common stock, $0.01 par value; 25,000,000 shares  authorized, 16,054,797 and 14,385,877 shares issued and outstanding in 2005  and 2004, respectively                  |       | 161        |       | 144        |       |
| Additional  paid-in capital                                                                                                                                            |       | 124,647    |       | 106,016    |       |
| Accumulated other  comprehensive loss                                                                                                                                  |       | (4         | )          | (21        | )          |
| Accumulated  deficit                                                                                                                                                   |       | (89,138    | )          | (64,926    | )          |
| Stockholders’ equity                                                                                                                                              |       | 35,668     |       | 41,215     |       |
| Total liabilities  and stockholders’ equity                                                                                                                       |       | $          | 49,165     |       | $          | 52,346 |   |

 

See accompanying notes to consolidated financial statements.

F-3

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**COLLAGENEXPHARMACEUTICALS, INC.AND SUBSIDIARIESConsolidated Statements of OperationsYears ended December 31, 2005, 2004 and 2003(Dollars in thousands, except per share data)**

| ** **                                                            | ** ** | **2005**                                                     | ** ** | **2004**                                                                | ** ** | **2003**                                                                | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Revenues:                                                             |       |                                                         |       |                                                                    |       |                                                                    |       |
| Net product sales                                                     |       | $      25,736                  |       | $      51,739                             |       | $      49,038                             |       |
| Contract revenues                                                     |       | 481                                                          |       | 237                                                                     |       | 3,122                                                                   |       |
| License revenues                                                      |       | 188                                                          |       | 170                                                                     |       | 699                                                                     |       |
| Total revenues                                                        |       | 26,405                                                       |       | 52,146                                                                  |       | 52,859                                                                  |       |
| Costs and  expenses:                                                  |       |                                                         |       |                                                                    |       |                                                                    |       |
| Cost of product sales                                                 |       | 5,885                                                        |       | 7,446                                                                   |       | 7,362                                                                   |       |
| Research and development                                              |       | 13,986                                                       |       | 8,843                                                                   |       | 5,462                                                                   |       |
| Selling, general and administrative                                   |       | 25,242                                                       |       | 29,417                                                                  |       | 32,968                                                                  |       |
| Restructuring charge                                                  |       | 1,184                                                        |       | 348                                                                     |       | —                                                                  |       |
| Legal settlement                                                      |       | —                                                       |       | 2,000                                                                   |       | 700                                                                     |       |
| Gain on sale of UK and European dental assets                         |       | —                                                       |       | (2,980                                                                  | )          | —                                                                  |       |
| Total costs and expenses                                              |       | 46,297                                                       |       | 45,074                                                                  |       | 46,492                                                                  |       |
| Operating (loss) income                                               |       | (19,892                                                      | )          | 7,072                                                                   |       | 6,367                                                                   |       |
| Other income  (expense):                                              |       |                                                         |       |                                                                    |       |                                                                    |       |
| Interest income                                                       |       | 1,086                                                        |       | 421                                                                     |       | 148                                                                     |       |
| Other, net                                                            |       | 1                                                            |       | 2                                                                       |       | (3                                                                      | )          |
| (Loss) income before income taxes                                     |       | (18,805                                                      | )          | 7,495                                                                   |       | 6,512                                                                   |       |
| Income taxes                                                          |       | —                                                       |       | 967                                                                     |       | 85                                                                      |       |
| Net (loss) income                                                     |       | (18,805                                                      | )          | 6,528                                                                   |       | 6,427                                                                   |       |
| Preferred stock dividends                                             |       | 1,727                                                        |       | 1,600                                                                   |       | 1,600                                                                   |       |
| Preferred stock  restructuring charge (note 5)                        |       | 3,680                                                        |       | —                                                                  |       | —                                                                  |       |
| Net (loss) income  allocable to common stockholders                   |       | $     (24,212                       | )          | $         4,928            |       | $         4,827            |       |
| Basic net (loss) income per share allocable to  common stockholders   |       | $         (1.67 | )          | $           0.35 |       | $           0.40 |       |
| Diluted net (loss) income per share allocable to  common stockholders |       | $         (1.67 | )          | $           0.34 |       | $           0.38 |       |
| Weighted average  shares used in computing per share amounts:         |       |                                                         |       |                                                                    |       |                                                                    |       |
| Basic                                                                 |       | 14,480,779                                                   |       | 14,264,687                                                              |       | 12,094,638                                                              |       |
| Diluted                                                               |       | 14,480,779                                                   |       | 14,500,637                                                              |       | 12,836,364                                                              |       |

 

See accompanying notes to consolidated financial statements.

F-4

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**COLLAGENEXPHARMACEUTICALS, INC. AND SUBSIDIARIESConsolidated Statements of Stockholders’ EquityYears ended December 31, 2005, 2004 and 2003(Dollars in thousands)**
|                                                                                                       | ** ** | **Series D  cumulative  convertible** | ** ** | **Series D-1  cumulative  convertible** | ** **    | ** **            | ** ** | ** **     | ** ** | ** **            | ** ** | ** **     | ** **    | ** **                       | ** ** | ** **                                   | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------------|---------------|-----------------------|------------|----------------|------------|-----------------------|------------|----------------|---------------|----------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                            | ** ** | **preferred stock**                   | ** ** | **preferred stock**                     | ** **    | **Common stock** | ** ** | ** **     | ** ** | **Accumulated**       | ** ** | ** **     | ** **    | ** **                       | ** ** | ** **                                   | ** ** |
| ** **                                                                                            | ** ** | **Number  of shares**                      | ** ** | **Par  value**                               | ** **    | **Number  of shares** | ** ** | **Par  value** | ** ** | **Number  of shares** | ** ** | **Par  value** | ** **    | **Additional  paid-in  capital** | ** ** | **other  comprehensive  income (loss)** | ** ** | **Accumulated  deficit** | ** ** | **Total  stockholders  equity** | ** ** | **Total  comprehensive  income** | ** ** |
| Balance,  December 31, 2002                                                                      |       | 200,000                                    |       |                                         | $ 2      |                  |       |           | —     |                  |       |           | $ — |                             |       | 11,377,631                                   |       |   | $ 114 |   |   |   | $ 82,917 |   |   |   | $ — |   |   |   | $ (74,681 | ) |   |   | $  8,352 |   |   |   |   |   |   |
| Exercise of common  stock options and warrants                                                   |       | —                                     |       |                                         | —        |                  |       |           | —     |                  |       |           | —        |                             |       | 464,569                                      |       |   | 4 |   |   |   | 1,819 |   |   |   | — |   |   |   | — |   |   |   | 1,823 |   |   |   |   |   |   |
| Issuance of common  stock, net of issuance cost                                                  |       | —                                     |       |                                         | —        |                  |       |           | —     |                  |       |           | —        |                             |       | 2,000,000                                    |       |   | 20 |   |   |   | 18,683 |   |   |   | — |   |   |   | — |   |   |   | 18,703 |   |   |   |   |   |   |
| Cash dividends  declared on Series D cumulative convertible preferred stock                      |       | —                                     |       |                                         | —        |                  |       |           | —     |                  |       |           | —        |                             |       | —                                       |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (1,600 | ) |   |   | (1,600 | ) |   |   |   |   |   |
| Compensation  expense resulting from the modification of options                                      |       | —                                     |       |                                         | —        |                  |       |           | —     |                  |       |           | —        |                             |       | —                                       |       |   | — |   |   |   | 251 |   |   |   | — |   |   |   | — |   |   |   | 251 |   |   |   |   |   |   |
| Net income                                                                                            |       | —                                     |       |                                         | —        |                  |       |           | —     |                  |       |           | —        |                             |       | —                                       |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 6,427 |   |   |   | 6,427 |   |   |   | $ 6,427 |   |   |
| Balance,  December 31, 2003                                                                      |       | 200,000                                    |       |                                         | $ 2      |                  |       |           | —     |                  |       |           | $ — |                             |       | 13,842,200                                   |       |   | $ 138 |   |   |   | $ 103,670 |   |   |   | $ — |   |   |   | $ (69,854 | ) |   |   | $ 33,956 |   |   |   | $ 6,427 |   |   |
| Exercise of common  stock options and warrants                                                   |       | —                                     |       |                                         | —        |                  |       |           | —     |                  |       |           | —        |                             |       | 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 cost                                                  |       | —                                     |       |                                         | —        |                  |       |           | —     |                  |       |           |          |                             |       | 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 income                                                                           |       | —                                     |       |                                         | —        |                  |       |           | —     |                  |       |           | —        |                             |       | —                                       |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | $ (18,788 | ) |   |
| Balance,  December 31, 2005                                                                      |       | —                                     |       |                                         | $ — |                  |       |           | 200,000    |                  |       |           | $ 2      |                             |       | 16,054,797                                   |       |   | $ 161 |   |   |   | $ 124,647 |   |   |   | $ (4 | ) |   |   | $ (89,138 | ) |   |   | $ 35,668 |   |   |   |   |   |   |

 

See accompanying notes to consolidated financial statements.

F-5

 

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**COLLAGENEXPHARMACEUTICALS, INC.**

**ANDSUBSIDIARIES**

**ConsolidatedStatements of Cash FlowsYears ended December 31, 2005, 2004 and 2003(Dollars in thousands)**

| ** **                                                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash flows from  operating activities:                                             |       |     |       |     |       |     |       |
| Net (loss) income                                                                  |       | $        | (18,805    | )        | $          | 6,528    |       | $ | 6,427 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |     |       |     |       |     |       |
| Noncash compensation expense                                                       |       | —   |       | —   |       | 251      |       |
| Depreciation and amortization expense                                              |       | 883      |       | 875      |       | 954      |       |
| Write-down of inventory                                                            |       | 1,020    |       | —   |       | —   |       |
| Write-off of fixed assets                                                          |       | 96       |       | —   |       | —   |       |
| Accounts receivable provisions                                                     |       | (154     | )          | (101     | )          | (36      | )          |
| Gain on sale of UK and European dental assets                                      |       | —   |       | (2,980   | )          | —   |       |
| Charge for in-process research and development                                     |       | 750      |       | 300      |       | —   |       |
| Change in assets  and liabilities:                                                 |       |     |       |     |       |     |       |
| Accounts receivable                                                                |       | 5,832    |       | (1,199   | )          | (2,713   | )          |
| Inventories                                                                        |       | 1,042    |       | (1,020   | )          | (257     | )          |
| Prepaid expenses and other assets                                                  |       | 634      |       | (380     | )          | (688     | )          |
| Accounts payable                                                                   |       | 1,094    |       | 588      |       | (258     | )          |
| Accrued expenses                                                                   |       | 364      |       | 217      |       | 1,392    |       |
| Deferred revenue                                                                   |       | (111     | )          | (122     | )          | (235     | )          |
| Net cash (used in) provided by operating activities                                |       | (7,355   | )          | 2,706    |       | 4,837    |       |
| Cash flows from  investing activities:                                             |       |     |       |     |       |     |       |
| Capital expenditures                                                               |       | (392     | )          | (292     | )          | (305     | )          |
| Net proceeds from the sale of UK and European dental  assets                       |       | —   |       | 2,980    |       | —   |       |
| Acquisition of product rights                                                      |       | —   |       | —   |       | (900     | )          |
| Purchase of in-process research and development                                    |       | (900     | )          | (150     | )          | —   |       |
| Purchases of short-term investments                                                |       | (35,420  | )          | (26,777  | )          |     |       |
| Maturities of short-term investments                                               |       | 43,987   |       | —   |       | —   |       |
| Net cash provided by (used in) investing activities                                |       | 7,275    |       | (24,239  | )          | (1,205   | )          |
| Cash flows from  financing activities:                                             |       |     |       |     |       |     |       |
| Proceeds from issuance of common stock                                             |       | 16,037   |       | 2,352    |       | 20,526   |       |
| Payment of preferred dividends                                                     |       | (1,627   | )          | (1,600   | )          | (1,600   | )          |
| Net cash provided by financing activities                                          |       | 14,410   |       | 752      |       | 18,926   |       |
| Net increase (decrease) in cash and cash equivalents                               |       | 14,330   |       | (20,781  | )          | 22,558   |       |
| Cash and cash  equivalents at beginning of year                                    |       | 11,889   |       | 32,670   |       | 10,112   |       |
| Cash and cash  equivalents at end of year                                          |       | $        | 26,219     |     | $          | 11,889   |       | $ | 32,670 |   |

 

See accompanying notes to consolidated financial statements.

F-6

----

**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

**(1)   Business**

CollaGenex Pharmaceuticals, Inc. and subsidiaries(“the Company”) is a specialty pharmaceutical company currently focused ondeveloping and marketing innovative proprietary medical therapies to thedermatology market. The Company currently markets three prescriptionpharmaceutical products to the dermatology market through the Company’sprofessional dermatology sales force and generates revenue from prescriptionpharmaceutical products that the Company continues to sell to the dental market.The Company’s marketed dermatology products are Pandel®, a prescriptioncorticosteroid cream the Company licensed from Altana, Inc. (“Altana”),the United States subsidiary of Altana Pharma AG in May 2002,AlcortinTM, a prescription topical antifungal steroid combination, andNovacortTM, a prescription topical steroid and anesthetic. The Company ispromoting Alcortin and Novacort to dermatology offices pursuant to a Promotionand Cooperation Agreement executed in June 2005 (the “Promotion Agreement”)with Primus Pharmaceuticals, Inc. (“Primus”).

Prior to the May 2005 introduction of a thirdparty generic version of Periostat®, the Company’s dental sales force detailedfour prescription pharmaceutical products to the dental market. On May 20,2005, the Company discontinued all sales 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® (the“Atrix Products”) which are licensed from Atrix Laboratories, Inc. (nowknown as QLT USA, Inc.). The Company had also sold a separately brandedversion of Periostat to United Research Laboratories, Inc./MutualPharmaceutical Company, Inc. (“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.

During 2003, the Companyalso co-promoted Vioxx® under an agreement with Merck and Co. (“Merck”) andDenavir® under an agreement with Novartis Consumer Health, Inc. (“Novartis”)to dental professionals on a contract basis. In March 2003, the Companywas engaged in an agreement with Sirius Laboratories, Inc. (“Sirius”) toco-promote Sirius’ AVARTM product line and the Company’s Pandel productline to dermatologists in the United States. The co-promotion agreements withMerck, Novartis and Sirius expired or were mutually terminated as of December 31,2003. The Company continued to earn nominal residual revenues under itsnon-compete provisions from Merck through 2005.

**(2)   Summaryof Significant Accounting Policies**

***Principles of Consolidation***

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

F-7

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

***Cash, Cash Equivalents 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. AtDecember 31, 2005 and 2004, all of the Company’s short-term investments,carried at fair value, were classified as available-for-sale with unrealizedgains and losses included as a separate component of stockholders’ equity. Theaccumulated net unrealized loss on short-term investments was $4 and $21 at December 31,2005 and 2004, respectively. Short-term investments consisted of the followingat December 31, 2005 and 2004:

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

 

| **2004**          | ** ** | ** ** | ** ** | **Amortized cost** | ** ** | **Gross  unrealized gain** | ** ** | **Gross  unrealized loss** | ** ** | **Fair value** | ** ** |
|-------------------|------------|------------|------------|-------------------------|------------|---------------------------------|------------|---------------------------------|------------|---------------------|------------|
| U.S. Agency Notes |       |       | $          | 19,586                  |       |                            |       | $                               | —     |                |       |   | $ | (18 | ) |   |   | $ | 19,568 |   |   |
| Commercial Paper  |       |       | 7,191      |                    |       |                            | —     |                            |       |                | (3         | ) |   |   | 7,188 |   |   |
|              |       |       | $          | 26,777                  |       |                            |       | $                               | —     |                |       |   | $ | (21 | ) |   |   | $ | 26,756 |   |   |

 

***Inventories***

Inventories are stated at the lower of cost or market.Cost is determined using the first-in, first-out method.

Estimates and assumptionsrelated to inventory carrying values are evaluated periodically and considerthe saleable quantities of inventory versus quantities of inventory on-hand.

***Acquired Product Rights***

Product rights are statedat cost, amortized over the shorter of the estimated useful life of theproducts or the contract term for which such rights have been licensed, usingthe straight-line method. Amortization of product rights is charged to cost ofproduct sales.

***Equipment and Leasehold 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.

F-8

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**COLLAGENEX PHARMACEUTICALS, INC.**

**AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

***Segment Information***

The Company operates asone business 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.

***Financial Instruments***

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. Short-terminvestments are carried at fair value.

***Net Product Sales***

Except for Periostat and Mutual sales beginning in thesecond quarter of 2005, the Company recognizes product sales revenue uponshipment to wholesale customers, net of estimated future returns and estimatesfor chargebacks, applicable wholesale distribution fees, rebates and currentinventory levels in the distribution channel, provided that collection wasprobable and no significant obligations remained. Following the launch of athird party generic competitor to Periostat in May 2005 and commencingwith the second quarter of 2005, the Company recognizes Periostat sales revenueprimarily based on sales to end-users, which are estimated using prescriptiondispensing data generated by a leading independent prescription tracking service,as well as on-hand inventory estimates in the distribution channel. Since thelaunch of generic competition to Periostat may result in increased productreturns existing in the wholesale and retail channel, the Company has accruedan estimated liability of $1,267 for potential Periostat and other productreturns in accrued expenses on the consolidated balance sheet at December 31,2005. (See note 3)

Upon the May 2005launch of a third party generic equivalent to Periostat, the Company’sagreement with Mutual provided for rebates to be paid to Mutual to compensateMutual and its customers for price erosion on the value of certain of itsinventories of Mutual’s branded version of Periostat. Accordingly, the Companyhas deferred revenues associated with such shipments of these products untilsuch future time as the selling price becomes fixed and determinable. At December 31,2005, the consolidated balance sheet included $3 in current deferred revenueassociated with sales of Mutual’s branded version of Periostat. (See note 3)

***Contract Revenues***

Contract revenues arefee-based arrangements with third parties where revenue is earned asprescriptions are filled and recognized as a percentage of the gross profitearned in accordance with the related contract terms. The Company does not taketitle to the inventory sold under these fee-based arrangements.

F-9

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

***License Revenue***

Milestone revenue from license arrangements isrecognized upon completion of the milestone event if it represents theachievement of a significant step in the research, development or regulatoryprocess. Payments, if any, received in advance of performance under a contractare deferred and recognized when earned. Upfront license fees where the Companyhas continuing involvement are deferred and recognized over the estimatedperformance period of each individual licensing agreement in accordance withthe SEC’s Staff Accounting Bulletin No. 104, “Revenue Recognition” (SAB104).

In 2003, SAB 104 replacedStaff Accounting Bulletin No. 101 (SAB 101), which the Company adopted in2000. The provisions related to up-front license fees were unchanged in SAB 104versus SAB 101. During 2005, 2004, and 2003, respectively, the Company recorded$12, $140 and $52 in license revenues that were deferred upon theimplementation of SAB 101 and previously recognized as license revenues underthe historical revenue recognition policy prior to the adoption of SAB 101.

***Advertising Costs***

The Company recordsadvertising expense when incurred. Such amounts are charged to selling, generaland administrative expenses in the consolidated statements of operations.Advertising costs for 2005, 2004 and 2003 were $55, $24 and $139, respectively.

***Acquired In-Process Research and Development***

Coststo acquire in-process research and development projects and technologies whichhave not achievedtechnicalfeasibility at the date of acquisition are expensed as research and developmentexpense as incurred.

***Research and Development***

Research and productdevelopment costs are expensed as incurred. Research and development expensesconsist primarily of personnel costs and funds paid to third parties for theprovision of services and materials for drug development, manufacturing andformulation enhancements, clinical trials, statistical analysis and reportwriting and regulatory compliance costs, including governmental filing fees.

***Accounting for Income Taxes***

Deferred tax assets andliabilities are determined based on differences between the financial reportingand tax bases of assets and liabilities and are measured using the tax ratesand laws expected to be in effect when such differences are expected to reverse.The measurement of deferred tax assets is reduced, if necessary, by a valuationallowance for any tax benefits that are not expected to be realized. The effecton deferred tax assets and liabilities of a change in tax rates is recognizedin the period that such tax rate changes are enacted.

***Management Estimates***

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that 

F-10

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

affectthe amounts reported in the consolidated financial statements and accompanyingnotes. Actual results could differ from those estimates.

***Stock-Based Compensation***

Statement of Financial Accounting Standards (SFAS) No. 123(“SFAS No. 123”) encourages but does not require companies to recordcompensation cost for stock-based employee and director compensation plans atfair value. Rather than adopt the recommended fair value method, the Companyhas elected to account for stock-based compensation under Accounting PrinciplesBoard (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”,and related interpretations. Under Opinion No. 25, compensation cost forstock options issued to employees and directors is measured as the excess, ifany, of the market price of the Company’s common stock over the exercise priceat the date both the number of shares and exercise price per share are known(measurement date). Such amounts are amortized on a straight-line basis over the respective vesting periods of the optiongrants. Transactions with non-employees (if any) in which goods orservices are the consideration received for the issuance of equity instrumentsare accounted for on a fair-value-basis in accordance with SFAS No. 123and related interpretations.

Had the Company adopted the fair value method andrecognized the grant-date fair value of the equity instruments issued (usingone of the various valuation models permitted), the compensation cost relatingto the Company’s share-based payment transactions would have been recognized inthe Company’s financial statements. The pro forma net (loss) income allocableto common stockholders and net (loss) income per share allocable to commonstockholders if the Company had adopted the fair value based method ofaccounting in accordance with SFAS No. 123, as amended by SFAS No. 148,“Accounting For Stock Based Compensation—Transition and Disclosures andAmendment of SFAS 123”, are set out below. Option forfeitures are accounted for as they occurred andno amounts of compensation expense have been capitalized into inventory or other assets, but instead areconsidered period expenses in the pro forma amounts.

| ** **                                                                                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net (loss) income  allocable to common stockholders:                                                               |       |     |       |     |       |     |       |
| As reported                                                                                                        |       | $        | (24,212    | )        | $          | 4,928    |       | $ | 4,827 |   |
| Add: Stock-based employee compensation expenses  included in net (loss) income allocable to common stockholders(1) |       | —   |       | —   |       | 251      |       |
| Less: Stock-based employee compensation under fair  value based method(1)                                          |       | (2,796   | )          | (3,679   | )          | (5,015   | )          |
| Pro forma net (loss) income                                                                                        |       | $        | (27,008    | )        | $          | 1,249    |       | $ | 63 |   |
| Basic net (loss) income  per share allocable to common stockholders:                                               |       |     |       |     |       |     |       |
| As reported                                                                                                        |       | $        | (1.67      | )        | $          | 0.35     |       | $ | 0.40 |   |
| Pro forma net (loss) income                                                                                        |       | $        | (1.87      | )        | $          | 0.09     |       | $ | 0.01 |   |
| Diluted net (loss)  income per share allocable to common stockholders                                              |       |     |       |     |       |     |       |
| As reported                                                                                                        |       | $        | (1.67      | )        | $          | 0.34     |       | $ | 0.38 |   |
| Pro forma net  (loss) income                                                                                       |       | $        | (1.87      | )        | $          | 0.09     |       | $ | 0.01 |   |

----

(1)          Amounts have not beentax-effected as a result of the Company’s significant net operating losscarryforwards.

F-11

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

Theweighted average fair values of stock options granted to employees during 2005,2004 and 2003 were $4.20, $6.75 and $6.39 per share, respectively, on the dateof grant. Such fair values were determined using the Black-Scholes optionpricing model and are based on the following weighted average assumptions:

| ** **                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected life in  years— |       |     |       |     |       |     |       |
| Employees and directors       |       | 6.12     |       | 7.02     |       | 7.00     |       |
| Risk-free  interest rate      |       | 4.05     | %          | 3.87     | %          | 3.52     | %          |
| Volatility                    |       | 73       | %          | 80       | %          | 81       | %          |
| Expected dividend yield       |       | —   | %          | —   | %          | —   | %          |

 

***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 domestic manufacturing of Periostat tablets and has an agreement with asingle company to supply the active ingredient in Periostat. A single companyalso provides all warehousing and distribution services to the Company.

During 2005, three distributors and Mutual accountedfor 37%, 24%, 12% and 22% of net product sales, respectively. Threedistributors accounted for 59%, 28% and 8% of gross accounts receivablebalances as of December 31, 2005. During 2004, three distributors andMutual accounted for 33%, 29%, 19%, and 14% of net product sales, respectively.These same customers accounted for 30%, 26%, 8%, and 32% of the gross accountsreceivable balances as of December 31, 2004. During 2003, threedistributors accounted for 43%, 31% and 20% of net product sales, respectively.

During the years ended December 31,2005, 2004 and 2003, Periostat and Mutual’s branded version of Periostataccounted for approximately 76%, 88% and 82% of the Company’s total netrevenues, respectively.

***Impairment of Long-Lived Assets***

The Company evaluateslong-lived assets and intangible assets for impairment when factors indicatethat the carrying amount of an asset may not be recoverable. When factorsindicate that an asset should be evaluated for possible impairment, the Companyreviews the realizability of the long-lived assets by comparing the asset’sprojected undiscounted net cash flows to its carrying value. Impairment, ifany, is recognized as the difference between the asset’s carrying value and itsfair value. As a result of a change in the contractual life of the Licensingand Marketing Agreement with Atrix (the “Atrix License Agreement”), the Companyhas adjusted its current and future amortization of its acquired product rightsasset to reflect a useful life through December 31, 2007 (see note 7).

F-12

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

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

Basic income per share (EPS) is calculated by dividingnet (loss) income allocable to common stockholders by the weighted averageshares of common stock outstanding. Net (loss) income allocable to commonstockholders includes dividends and other charges on the preferred stock. DilutedEPS reflects the potential dilution that could occur if outstanding options andwarrants were exercised and/or convertible securities were converted intocommon stock.

As of December 31,2005, the Company had outstanding stock options and stock warrants that werenot included in the calculation of diluted net loss per share allocable tocommon stockholders because doing so would have been anti-dilutive. Suchstock options and warrants to purchase 3,345,267 shares of common stock havebeen excluded from the computation of diluted EPS for the year ended December 31,2005. During the years ended December 31, 2005, 2004 and 2003, the Companyhad approximately 2,353,000, 2,020,000 and 2,020,000 of potential common stockshares from convertible preferred stock that were not included in the calculationof diluted net (loss) income per share allocable to common stockholders becausedoing so would have been anti-dilutive. For the years ended December 31,2004 and 2003, for diluted earnings per share there were common stockequivalents of 235,950 and 741,726, respectively, as a result of “in-the-money”stock options and warrants calculated using the treasury method. Excluded fromthe computation of diluted EPS were 2,213,550 and 860,280 shares of “out-of-the-money”stock options and warrants for the years ended December 31, 2004 and 2003as they were anti-dilutive.

***Recently Issued Accounting Standards***

In December 2004, theFinancial Accounting Standards Board issued SFAS No. 123 (revised 2004), “Share-BasedPayment” (“SFAS 123R”), which replaces SFAS No. 123, and supercedes APBOpinion No. 25. SFAS 123R requires all share-based payments to employees,including grants of employee stock options and purchases under the employeestock purchase plan and liabilities that are based on the fair value of theCompany’s equity instruments or that may be settled by the issuance of suchequity instruments, to be recognized in the financial statements based on theirfair values. The pro forma disclosures previously permitted under SFAS No. 123,no longer will be an alternative to financial statement recognition. TheCompany is required to adopt SFAS 123R effective January 1, 2006. UnderSFAS 123R, the Company must determine the appropriate fair value model to beused for valuing share-based payments, the amortization method for compensationcost and the transition method to be used at date of adoption. The transitionmethods include prospective and retroactive adoption options. Under theretroactive options, prior periods may be restated either as of the beginningof the year of adoption or for all periods presented. The prospective methodrequires that compensation expense be recorded at the beginning of the firstquarter of adoption of SFAS 123R for all unvested stock options and restrictedstock based upon the previously disclosed SFAS No. 123 methodology andamounts. The retroactive methods would record compensation expense beginningwith the first period restated for all unvested stock options and restrictedstock. We expect the adoption of SFAS No. 123 will have a material impacton our results of operations and earnings per share. We are evaluating therequirements of SFAS 123R and have not yet determined the method of adoptionand we have not determined whether this adoption will result in amounts thatare similar to the current pro forma disclosures under SFAS No. 123 (seeabove) to these consolidated financial statements.

F-13

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

***Reclassification***

Certainamounts in the 2004 and 2003 consolidated financial statements have beenreclassified to conform to the 2005 presentation.

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

***Inventories***

Inventoriesat December 31, 2005 and 2004 consist of the following:

| ** **      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
| Raw materials   |       | $        | 77         |     | $          | 395 |   |
| Work-in-process |       | —   |       | 394      |       |
| Finished goods  |       | 553      |       | 1,903    |       |
|            |       | $        | 630        |     | $          | 2,692 |   |

 

During year ended December 31, 2005, the Companyrecorded a charge to cost of product sales of $1,020 for excess inventory ofPeriostat and Mutual’s branded version of Periostat. The charge resulted fromdecreased demand for Periostat and the termination of the Company’s License andSupply Agreement with Mutual both of which resulted from the introduction of athird party generic version of Periostat in May 2005.

***Equipment and Leasehold Improvements***

Equipmentand leasehold improvements at December 31, 2005 and 2004 consist of thefollowing:

| ** **                                       | ** ** | **2005** | ** ** | **2004** | ** ** | **Useful Life** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|----------------------|------------|
| Computer and office  equipment                   |       | $        | 1,309      |     | $          | 1,365                |       | 3-5 years |   |
| Exhibit equipment                           |       | 97       |       | 496      |       | 5 years              |       |
| Leasehold improvements                           |       | 87       |       | 60       |       | Shorter of 10 years  |       |
|                                             |       | $        | 1,493      |     | $          | 1,921                |       | or lease term |   |
| Less: accumulated  depreciation and amortization |       | (954     | )          | (1,423   | )          |                 |       |
|                                             |       | $        | 539        |     | $          | 498                  |       |   |   |

 

During the year-ended December 31,2005, the Company wrote off $820 of fixed assets of which $724 were fullydepreciated.

***Acquired Product Rights***

Acquiredproduct rights at December 31, 2005 and 2004 consist of the following:

| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Acquired product rights         |       | $        | 2,700      |     | $          | 2,700 |   |
| Less: accumulated  amortization |       | (2,164   | )          | (1,536   | )          |
|                            |       | $        | 536        |     | $          | 1,164 |   |

 

F-14

----

**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

 

Amortizationexpense, which is included in cost of product sales, was $628, $585 and $586 in2005, 2004 and 2003, respectively. Expected amortization of acquired product rightsis as follows:

| 2006   |   | 268 |   |
|--------|--------|-----|--------|
| 2007   |   | 268 |   |
|   |   | $   | 536    |   |
|        |        |     |        |  |

 

***Accrued Expenses***

Accruedexpenses at December 31, 2005 and 2004 consist of the following:

| ** **                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Contracted  development and manufacturing costs |       | $        | 739        |     | $          | 1,648 |   |
| Sales and  marketing costs                      |       | 239      |       | 212      |       |
| Payroll and  related costs                      |       | 2,097    |       | 1,731    |       |
| Professional and  consulting fees               |       | 232      |       | 159      |       |
| Deferred revenue                                |       | 58       |       | 54       |       |
| Distribution fees  and rebates                  |       | 237      |       | 225      |       |
| Product returns                                 |       | 1,267    |       | 592      |       |
| Foreign taxes                                   |       | 945      |       | 945      |       |
| State and  franchise taxes                      |       | 110      |       | 99       |       |
| Restructuring                                   |       | 96       |       | —   |       |
| Other                                           |       | 4        |       | 145      |       |
|                                            |       | $        | 6,024      |     | $          | 5,810 |   |

 

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

On March 12, 2001, the Company consummated aprivate equity offering of 1,500,000 shares of common stock for an aggregatepurchase price of $7,500, which generated net proceeds to the Company ofapproximately $6,800. In addition, the investors in this financing were issuedan aggregate of 400,000 warrants that were exercisable for up to three yearsinto 400,000 shares of the Company’s common stock at an exercise price of $6.00per share. The consideration received for such warrants is included in theaggregate proceeds received in the financing. During 2004, all 400,000 of thesewarrants were exercised into 189,043 shares of the Company’s common stock. Accordinglynone of the 400,000 warrants remain outstanding at December 31, 2005. TheCompany also issued warrants to purchase an aggregate of 150,000 shares of theCompany’s common stock, exercisable for up to three years at an exercise priceof $5.70 per share, to its financial advisor in this financing. During 2002,7,140 warrants were exercised into 4,654 shares of the Company’s common stock. During2003, the remaining 142,860 warrants were exercised into 92,195 shares of theCompany’s common stock. The majority of these warrant exercises were incashless transactions. Accordingly, none of the 150,000 warrants remainoutstanding at December 31, 2005. As a result of this financing, theconversion price of the Company’s Series D Cumulative ConvertiblePreferred Stock (the “Series D Stock”) was reduced to $9.94 per share (Seenote 5). Such conversion price was 

F-15

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

further reduced to $9.91per share in connection with the sale of shares of the Company’s common stockto Atrix (See note 7), and was further reduced to $8.50 per share as aresult of the exchange of all 200,000 outstanding shares of Series D Stockfor 200,000 shares of the Company’s Series D-1 CumulativeConvertible Preferred Stock (the “Series D-1 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 and pursuant to the terms of a warrant agreement executed by the Company,the Company issued Kingsbridge a warrant to purchase 40,000 shares of itscommon stock at an exercise price of $9.38 per share. The conversion price ofthe Company’s Series D Stock was further reduced to $9.89 as a result ofthe issuance of shares under the equity line and the issuance of such warrant(see note 5). Such warrant is exercisable as of August 14, 2002, and willexpire on August 13, 2007. No warrants have been exercised and all 40,000warrants are outstanding at December 31, 2005.

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 holder topurchase 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 31,2005, 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.

In October 2003, the Company sold 2,000,000shares of its common stock in a public offering for an aggregate purchase priceof $20,000, which generated net proceeds to the Company of approximately$18,703, after the payment of placement agent fees and related expenses.

F-16

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

On December 21,2005, the Company entered into definitive agreements with institutional andother investors to sell 2,900,000 shares of the Company’s common stock for anaggregate purchase price of $29,000. On December 23, 2005, the Companyclosed on the first tier of the offering issuing 1,550,000 shares of commonstock in exchange for net proceeds of $14,388 after deducting approximately$1,069 in placement agency fees and other offering expenses that were accruedby the Company at December 31, 2005. This closing is reflected in theCompany’s consolidated balance sheet and statement of stockholder’s equity asof December 31, 2005. On January 6, 2006, the Company closed on thesecond tier of the offering issuing 1,350,000 shares of common stock inexchange for $12,667 of net proceeds.

**(5) Preferred Stock Agreements**

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 ofpreferred stock. The holders of preferred stock would normally be entitled toreceive a preference payment in the event of any liquidation, dissolution orwinding-up of the Company before any payment is made to the holders ofthe 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.

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 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 $1,727, $1,600 and $1,600 were declared in 2005, 2004 and 2003,respectively.

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 9.0% per annum, which are declared and paid everysix months. The annual dividend rate shall increase by 1.0% per annum on May 19,2006 and each subsequent anniversary thereof until the earlier of the date thatall of the shares of Series D-1 Stock are (i) converted intoshares of common stock, or (ii) redeemed.

F-17

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

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 National Market. The Company is entitled to pay thedefault dividends in shares of common stock in the event the Company cannot paycash dividends because of a deficiency in cash or a prohibition under Delawarelaw, such that a cash payment would have a material adverse effect on theCompany.

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 certain conditions by the Company. Each share of Series D-1Stock is convertible, at the option of its holder, at any time, into shares ofcommon stock determined by dividing $100 by the conversion price, which iscurrently $8.50 per share, for each share of Series D-1 Stockconverted. The conversion price of the Series D-1 Stock shall beadjusted, on a weighted average basis, upon the issuance of securities, optionsor warrants at a price per share less than the then effective conversion price.In the event the Company fails to declare dividends after the Company has beennotified of an event of default for failure to pay dividends, the holders of amajority of the Series D-1 Stock shall have the option to elect tohave the conversion price of the Series D-1 Stock reset to the thenfair value of the Company’s common stock, based upon the five-day trailingaverage 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 662¤3%of the Series D-1 Stock is required for certain actions by theCompany, including creating or issuing stock ranking senior to the Series D-1Stock. The approval of the holders of at least a majority of the Series D-1Stock is required for certain actions by the Company, including payingdividends, other than those on the Series D-1 Stock, incurringindebtedness in excess of $10,000 for working capital purposes, disposing ofthe Company’s assets, except in the ordinary course of business, andacquisitions in any calendar year 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 atDecember 31, 2005 equaled $20,900.

F-18

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

Each outstandingshare of Series D-1 Stock is redeemable, at the Company’s option asfollows:  at $100 per share plus allaccrued and unpaid dividends if less than 5% of the Series D-1 Stockoriginally issued are outstanding and at $100 per share plus accrued and unpaiddividends in the event of a change in control of the Company.

**(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. For accounting purposes,the SansRosa transaction was treated as the acquisition of in-process researchand development. The cost of the acquisition was charged to in-process researchand development since the SansRosa technology has not achieved technical feasibilityat this time. SansRosa is the assignee of certain patent applications coveringmethods for treatment of redness associated with rosacea and other skindisorders. Under the SansRosa Purchase Agreement, the Company has the right topurchase all of the remaining shares of SansRosa capital stock upon theachievement of specified regulatory and development milestones. If allmilestones are achieved and a patented product is developed and approved forsale, the Company will pay the shareholders of SansRosa an additional $4,000 to$6,000. The agreement also provides for royalty payments currently, to minorityshareholders linked to future product sales.

TheCompany’s policy is to consolidate the accounts and results of operations ofits majority-owned subsidiaries, including SansRosa. SansRosa did not havesignificant operations during the period from December 14, 2005 through December 31,2005. No expenses were incurred nor were revenues earned by SansRosa during theperiod from December 14, 2005 through December 31, 2005. Accordingly,no minority interest liability has been accrued at December 31, 2005. Sincethe minority shareholders have no obligation to fund the ongoing losses ofSansRosa, no minority interest receivable will be recorded.

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

In June 2005, the Company entered into thePromotion Agreement with Primus under which the Company agreed to promoteAlcortin, a prescription topical antifungal steroid combination, and Novacort,a prescription topical steroid and anesthetic. Under the Promotion Agreement,the Company will receive a percentage of the gross profit arising fromprescriptions written by dermatology professionals (or offices) that result insales of the products in the United States. The majority of marketing expenses,excluding sales force compensation and sample product costs, related to thepromotion of the Primus products are funded by Primus. The majority of productsample costs and all sales force compensation are funded by the Company. TheCompany is required to deliver a minimum amount of annual contract year salespresentations to dermatologists. The Company has also agreed to achieve certainlevels of product prescriptions as measured on an annual contract year basis. ThePromotion Agreement has an initial term that extends through June 30, 2008and then renews automatically for successive additional terms of one year unlessearlier terminated pursuant to the terms of the agreement.

F-19

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

On August 19, 2004, the Company executed an AssetPurchase and Product Development Agreement (the “Purchase Agreement”) relatingto its Restoraderm technology that superseded its Co-operation, Development andLicense Agreement executed in February 2002. Under the terms of thePurchase Agreement, the Company purchased all right, title and interest in theintellectual property and related rights to the RestoradermTM topical drug delivery system. The Companyintends to develop Restoraderm for dermatological applications. In accordancewith the terms of the Purchase Agreement, the purchase price of the assets willbe up to $1,000 subject to the achievement of certain milestones. The Companyis also required to pay product development milestone payments in the aggregateamount of up to approximately $2,000 and royalty and sublicense fees, ifapplicable, upon product commercialization. During the year ended December 31,2004, the Company incurred approximately $300 in research and developmentexpenses related to the asset purchase. During the year ended December 31,2004, the Company incurred approximately $133 related to the productdevelopment milestones, which was charged to research and development in theconsolidated statements of operations. The purchase was charged to in-processresearch and development since the Restoraderm technology has not achievedtechnical feasibility when acquired.

Pursuant to a Co-Promotion Agreement the Companyexecuted with Merck in September 1999, the Company received the exclusiveright 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.

On August 24, 2001, the Company signed the AtrixLicense Agreement with Atrix to market the Atrix Products to the United Statesdental markets. Pursuant to the terms of the Atrix License Agreement, amongother things, Atrix will manufacture the dental products for the Company at anagreed upon transfer price and will receive royalties on future net sales ofthe products each calendar year. The Company paid a $1,000 licensing fee toAtrix in 2001 to market such products in the United States.  The $1,000 license fee payment has beencapitalized and is being amortized to cost of product sales over the estimateduseful life of the license on a straight-line basis (see below). On anannual basis commencing with fiscal year 2003, the Company was required to makemarketing expenditures to promote the Atrix dental products equal to the lesserof $4,000 or 30% of the Company’s contribution margin, as defined in theagreement, for the promotion of a specific Atrix product that the Companymarkets plus the lesser of $2,000 or 30% of the Company’s contribution margin,as defined in the agreement, for the promotion of a separate Atrix product thatthe Company markets. These annual requirements were met by the Company in 2004.The Company terminatedits dental promotional activities in May 2005 and was no longer requiredto meet the minimum annual spending requirements for 2005.

F-20

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

On February 22, 2006, the Company amended itsAtrix License Agreement and has agreed to continue to sell the Atrix Productsthrough its distributor and pay an increased royalty on net sales and anincreased transfer price, but the Company is no longer required to make annualminimum expenditures for advertising and promotional activities. Pursuant tothe amended agreement, either party may terminate the Agreement at any time,with or without cause, upon six (6) months prior written notice. Theamendment amends the term of the License and Marketing Agreement through December 31,2007. Accordingly, the Company has adjusted the estimated remaining useful lifeof Atrix product right asset through December 31, 2007.

In addition, pursuant to the terms of a Stock PurchaseAgreement dated August 24, 2001 by and between the Company and Atrix,Atrix purchased 330,556 unregistered shares of the Company’s common stock foran aggregate purchase price of approximately $3,000. As a result of the sale ofsuch shares to Atrix, the conversion price of the Series D Stock wasreduced to $9.91 per share.

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.

Pursuant to the terms of its agreement, the Companypaid Altana an aggregate sublicense fee of $1,700, of which $900 was paid in2003. The sublicense fee has been capitalized and is fully amortized at 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 may beterminated by the Company: (i) at any time, without cause, upon twelvemonths prior written notice; (ii) if Altana shall commit any uncured,willful or material breach of the provisions of the agreement; or (iii) ifAltana shall cease to manufacture or supply the product to the Company. Altanamay terminate the agreement: (i) at any time, without cause, upon twelvemonths written notice; (ii) if the Company shall commit any uncured,willful or material breach of the provisions of the agreement; (iii) ifthe Company shall cease to offer the product for distribution to its customers;or (iv) if the Company fails to make certain payments or fulfill certaininvoicing obligations.

During the year ended December 31, 2005, $132 oflicense revenues was recognized to reflect the elimination of any continuinginvolvement related to the upfront license revenue from the License and SupplyAgreement with Showa Yakuhin Kako Co., Ltd. which was terminated in March 2005.

On March 14, 2003, the Company terminated itslicense agreement with Roche S.P.A. for the marketing and distribution ofPeriostat in Italy. As a result of the termination of the agreement, during2003, the Company accelerated the recognition of the remaining $222 ofunamortized deferred revenue related to the $400 up-front payment received in1996 and also recognized $425 related to the collection of outstanding milestonepayments from Roche.

F-21

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

In March 2003, the Company executed co-promotionagreements with Sirius pursuant to which the Company and Sirius jointlymarketed both the Sirius’ AVAR product line and Pandel to dermatologists in theUnited States. This agreement was mutually terminated in December 2003.

**OnOctober 1, 2002, the Company entered into a Product Detailing Agreementwith Novartis pursuant to which the Company co-promoted Denavir to targetdentists in the United States and received detailing fees and performanceincentives from Novartis. The agreement with Novartis to co-promote Denavirexpired on September 30, 2003, and the Company and Novartis decided not torenew the arrangement with respect to Denavir.**

**(8)**Lineof Credit

On June 7,2004, the Company entered into a Loan Modification Agreement with SiliconValley Bank to renew and extend its revolving credit facility. The creditfacility had expired on March 15, 2004. The amended credit facilityexpires on May 31, 2006. Under the amended credit facility, the Companymay borrow up to the lesser of $5,000 or 80% of eligible accounts receivable,as defined under the amended credit facility. The amount available to theCompany is reduced by any outstanding letters of credit which may be issuedunder the amended credit facility in amounts totaling up to $2,000. As theCompany pays down amounts under any letter of credit, the amount available toit under the credit facility increases. As of December 31, 2004, theCompany had an outstanding letter of credit approximating $544 that served ascollateral for certain future inventory purchase commitments of the Company, ifany. No letter of credit was outstanding at December 31, 2005. The Companyis not obligated to draw down any amounts under the amended credit facility andany borrowings shall bear interest, payable monthly, at the current prime rateor 7.25% at December 31, 2005. The Company is charged an unused linecredit fee of 0.375% of the unused line per annum. As of December 31, 2005and 2004, the Company had no borrowings outstanding.

**(9)**Stock Option Plans

The Company has four stock-based compensationplans:

The 1992 Stock Option Plan, as amended, (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 a price, for the incentive options, not less than thefair value on the measurement date. Such options are exercisable for a periodof ten years from the grant date and generally vest over a four year period. Allsuch 291,000 options available under the 1992 Plan were granted by 1996.

The Nonemployee Director Stock Option Plan (the “NonemployeeDirector Plan”) provides for the issuance of stock options to new nonemployeedirectors to purchase up to 300,000 shares of common stock at an exercise priceequal to the fair value on the date of grant. Such options vest 20% per annumcommencing one year from the grant date.

The 1996 Stock Option Plan, as amended, (the “1996Plan”) provides 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 a price, for the incentive options, not less than the fairvalue on the measurement date. Incentive and nonqualified options granted toindividuals owning more than 10% of the voting power of all 

F-22

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

classes of stock at thetime of grant must have an exercise price no less than 110% of the fair valueon the date of grant. Such options are exercisable for a period of ten yearsfrom the grant date and generally vest over a two to five year period, and maybe accelerated for certain grants in certain circumstances.

The 2005 Equity Incentive Plan (the “2005 Plan”)provides for the granting of incentive and nonqualified options, restricted stockawards, restricted stock units and other stock-based awards, including thegrant of stock appreciation rights to employees, officers, directors,consultants, advisors, and other service providers to purchase shares of theCompany’s common stock at a price, for the incentive options, not less than thefair value on the measurement date. The number of shares of common stock thatmay be issued under the 2005 Plan shall be equal to 1,000,000 shares plus anyshares of common stock reserved for issuance under the 1996 Plan uponexpiration of the 1996 Plan in March 2006. The maximum number of shares ofcommon stock that may be issued under the 2005 Plan shall be 1,500,000.Incentive and nonqualified options granted to individuals owning more than 10%of the voting power of all classes of stock at the time of grant must have anexercise price no less than 110% of the fair value on the date of grant. Suchoptions are exercisable for a period of ten years from the grant date andgenerally vest over a five year period, and may be accelerated for certaingrants in certain circumstances.

During 2005, 2004 and 2003, certain existingnon-executive members of the Board of Directors were granted 115,000, 116,907and 74,500 options, respectively, at a weighted average exercise price of$5.71, $9.10 and $10.80 per share, respectively. These grants were issued underthe 1996 Plan. Such options vest 25% per annum, commencing one year from thegrant date.

At December 31, 2005, there were 457,155 sharesavailable for grant under the 1996 Plan, 75,000 under the Nonemployee DirectorPlan, and 921,600 under the 2005 Plan.

Thefollowing table summarizes the stock option activity for all plans for 2003through 2005:

| ** **                       | ** ** | **Options** | ** ** | **Weighted average  exercise price per share** | ** ** |
|----------------------------------|------------|-------------|------------|--------------------------------------------------------------------|------------|
| Balance, December 31,  2002 |       | 2,955,170   |       |                                                               | $          | 8.91 |   |   |
| Granted                          |       | 899,350     |       |                                                               | 10.23      |   |   |
| Exercised                        |       | (374,374    | )          |                                                               | 4.52       |   |   |
| Cancelled                        |       | (47,142     | )          |                                                               | 10.38      |   |   |
| Balance,  December 31, 2003 |       | 3,433,004   |       |                                                               | 9.72       |   |   |
| Granted                          |       | 744,007     |       |                                                               | 9.12       |   |   |
| Exercised                        |       | (354,634    | )          |                                                               | 6.19       |   |   |
| Cancelled                        |       | (551,154    | )          |                                                               | 10.95      |   |   |
| Balance,  December 31, 2004 |       | 3,271,223   |       |                                                               | 9.76       |   |   |
| Granted                          |       | 482,755     |       |                                                               | 6.20       |   |   |
| Exercised                        |       | (118,920    | )          |                                                               | 4.88       |   |   |
| Cancelled                        |       | (329,791    | )          |                                                               | 10.40      |   |   |
| Balance,  December 31, 2005 |       | 3,305,267   |       |                                                               | $          | 9.35 |   |   |

 

F-23

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

As of December 31,2005, the following options were outstanding and exercisable by price range:****

| ** **                                                             | ** ** | **Outstanding** | ** ** | **Exercisable**             | ** ** |
|------------------------------------------------------------------------|------------|-----------------|------------|-----------------------------|------------|
| **Range of exercise  prices**                                | ** ** | ** **      | ** ** | **Number of  options** | ** ** | **Weighted  average  remaining  contractual  life (in years)** | ** ** | **Weighted  average  exercise price  per share** | ** ** | **Number of  options** | ** ** | **Weighted  average  exercise price  per share** | ** ** |
| $  0.33  –   $4.49                       |       |            | 700        |                        |       |   | 9.37 |   |   |   | $ | 4.08 |   |   | — |   |   | $ | — |   |   |
|     4.50  –     6.99 |       |            | 914,235    |                        |       |   | 7.54 |   |   |   | 5.69 |   |   | 363,060 |   |   | 5.61 |   |   |
|     7.01  –     8.88 |       |            | 390,770    |                        |       |   | 6.41 |   |   |   | 8.09 |   |   | 280,882 |   |   | 8.01 |   |   |
|     9.00  –   11.88                 |       |            | 1,595,882  |                        |       |   | 6.06 |   |   |   | 10.07 |   |   | 887,462 |   |   | 9.98 |   |   |
| $12.00 – $24.25                                                   |       |            | 403,680    |                        |       |   | 3.64 |   |   |   | 15.97 |   |   | 403,680 |   |   | 15.97 |   |   |
|                                                                   |       |            | 3,305,267  |                        |       |   | 6.22 |   |   |   | $ | 9.35 |   |   | 1,935,084 |   |   | $ | 10.13 |   |   |
|                                                                        |            |                 |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As a result of a transition agreement with Brian M.Gallagher, Ph.D., the Company’s former chairman, chief executive officer andpresident, the Company recognized a non-cash compensation charge of $251 forthe year ended December 31, 2003 relating to the acceleration of vestingof certain in-the-money stock options held by Dr. Gallagher.

On December 8,2003, the Company granted stock options to Colin W. Stewart, its presidentand chief executive officer, effective the date of commencement of hisemployment. These options were granted without stockholder approval under thefollowing terms:  300,000 non-qualifiedstock options, exercise price equal to the fair value on the grant date,ten-year term and vesting at the rate of 20% for each year of service with theCompany. In certain circumstances, if the closing price of the Company’s commonstock exceeds a pre-determined per share price for a certain number ofconsecutive days, a portion of such options will vest immediately. This did notoccur during 2003, 2004 or 2005.

**(10)**Income Taxes

The Companyutilizes the asset and liability method of accounting for income taxes inaccordance with SFAS No. 109, “Accounting for Income Taxes”. Under theasset and liability method, deferred taxes are determined based on thedifferences between the financial statement and tax bases of assets andliabilities and for loss and credit carryforwards using currently enacted taxrates.

Theprovision for income taxes is as follows:

| ** **  | ** ** | **Year Ended December 31,** | ** ** |
|-------------|------------|--------------------------------------------|------------|
| **Current** | ** ** | ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Federal     |       |                                       | $          | — |   |   | $ | 22 |   |   | $ | 80 |   |   |
| Foreign     |       |                                       | —     |   |   | 945 |   |   | — |   |   |
| State       |       |                                       | —     |   |   | — |   |   | 5 |   |   |
|        |       |                                       | $          | — |   |   | $ | 967 |   |   | $ | 85 |   |   |
|             |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-24

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

Reconciliationsof the income tax expense from the Federal statutory rates for 2005, 2004 and2003 are as follows:

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Statutory Federal  income tax               |       | $                                          | (6,393     | ) | (34.0 | )% | $ | 2,548 |   | 34.0 | % | $ | 2,214 |   | 34.0 | % |
| Adjustments  resulting from:                |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Foreign income taxed at differentrates      |       | —                                     |       | — |   | 9 |   | 0.1 |   | — |   | — |   |
| State taxes, net of Federal benefit    |       | —                                     |       | — |   | — |   | — |   | 3 |   | — |   |
| Permanent items and others                  |       | (63                                        | )          | (0.3 | ) | 87 |   | 1.2 |   | (316 | ) | (4.8 | ) |
| Increase  (decrease) in valuation allowance |       | 6,456                                      |       | 34.3 |   | (1,677 | ) | (22.4 | ) | (1,816 | ) | (27.9 | ) |
| Total income tax expense                    |       | $                                          | —     |   | — | % | $ | 967 |   | 12.9 | % | $ | 85 |   | 1.3 | % |

 

Thetax effects of temporary differences that give rise to significant portions ofthe deferred tax assets at December 31, 2005 and 2004 are presented below:

| ** **                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:             |       |     |       |     |       |
| Depreciation and amortization    |       | $        | 526        |     | $          | 356 |   |
| Net operating loss carryforwards |       | 26,163   |       | 20,184   |       |
| Tax credit carryforwards         |       | 1,043    |       | 1,043    |       |
| Accrued expenses                 |       | 836      |       | 921      |       |
| Deferred revenue                 |       | 488      |       | 96       |       |
| Total gross deferred assets      |       | 29,056   |       | 22,600   |       |
| Less valuation allowance         |       | (29,056  | )          | (22,600  | )          |
| Net deferred  taxes              |       | $        | —     |     | $          | — |   |

 

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, 2005 and 2004.

The net change in the valuation allowance for theyears ended December 31, 2005 and 2004 was an increase of approximately$6,456 and decrease of $1,677, respectively, related primarily to the increasein net operating losses in 2005 and utilization of net operating losses in 2004.

At December 31, 2005, the Company hadapproximately $74,000 of Federal and $38,000 of state net operating losscarryforwards available to offset future taxable income for tax reportingpurposes. The Federal net operating loss carryforwards will begin to expire in2010. The state net operating losses have 

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

begun to expire and willcontinue to expire through 2015, if not utilized. Included in the Company’s netoperating loss carryforward are deductions relating to the exercise ofnon-qualified stock options in the amount of $8,266, which tax benefit will becredited to additional paid-in capital to the extent such tax assets arerealized in the future. The Company also has research and development taxcredit carryforwards of approximately $893 available to reduce Federal incometaxes which begin expiring in 2007.

Section 382 andSection 383 of the Internal Revenue Code of 1986 subjects the futureutilization of net operating losses and certain other tax attributes, such asresearch and development credits, to an annual limitation in the event of anownership change, as defined. Due to the Company’s 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 31,2005, approximately $59,000 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 andJanuary 2006 common stock sale of 2,900,000 shares of common stock. Inaddition to the section 382 and 383 limitations, the state net operatingloss carryforwards are subject to a $2,000 annual limitation.

**(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 the licensedpatents in each country. The Company is required to pay all patent fees andrelated legal costs under the license, as well as to support certain additionalresearch efforts. In addition, the Company is liable to SUNY for annual royaltyfees based on net Periostat sales, if any, as defined in the agreement. Legalcosts incurred by the Company in defending the patents underlying thetechnology license are deducted from royalties paid to SUNY (See note 15). Aminimum annual royalty of $50 per year is required for the duration of thetechnology license. The Company incurred royalty expense for this technology of$899, $1,933 and $1,832 in 2005, 2004 and 2003, respectively.

**(12) Sales Force 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 and marketingactivities that could no longer be utilized by the Company. As of December 31,2005, $96 of the restructuring charge had not yet been paid and is a 

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

component of accruedexpenses on the Company’s consolidated balance sheet. (See note 3)  The accrued expense of $96 is expected to bepaid during 2006.

On April 22, 2004,the Company announced the restructuring of its pharmaceutical salesorganization into dedicated dental and dermatology sales forces. The Companyincurred a $348 restructuring charge during the year ended December 31,2004. As of December 31, 2005, all of these costs have been paid by theCompany.

**(13) Commitments and Contingencies**

TheCompany maintains various operating leases, primarily for office space andequipment. As of December 31, 2005, future minimum payments undernoncancellable operating leases are as follows:

| 2006  |   | $   | 554    |   |
|-------|--------|-----|--------|--------|
| 2007  |   | 360 |   |
| 2008  |   | 334 |   |
| 2009  |   | 195 |   |
| Total |   | $   | 1,443  |   |

 

Expense under operating leases (includingrestructuring charges) for the years ended December 31, 2005, 2004 and2003 totaled $546, $520 and $327, respectively.

During December 2003, the Company entered into athree-year operating lease agreement for certain sales force automationequipment. Under this agreement the Company is required to make monthly paymentsthrough January 2007, based on the monthly number of users.

On June 10, 2002, the Company executed aDevelopment and Licensing Agreement with Supernus Pharmaceuticals, Inc.,or Supernus, successor in interest to Shire Laboratories, Inc. pursuant towhich the Company was granted an exclusive worldwide license (including theright to sublicense) to use Supernus’ drug delivery technology to develop,make, have made, use, supply, export, import, register and sell products forthe treatment of various inflammatory disorders.  The Company committed to make certain futurepayments to Supernus, in cash or, at the Company’s option, a combination ofcash and the Company’s common stock, upon the achievement of certain clinicaland regulatory milestones. The Company incurred $830 in such milestone costs in2005 which was charged to research and development expense in 2005. The Companypaid in cash $415 of this charge in 2005. The remaining $415 was paid in cashin January 2006. Future payments could be as much as $2,670 in theaggregate and relate primarily to regulatory approval, both domestic andinternational, of products utilizing the Supernus technology and domesticlaunch of such products. The Company will also pay a royalty on future netsales of products, if any, utilizing any part of the technology.

In December 2003,Brian M. Gallagher, Ph.D., the Company’s former chairman, chief executiveofficer and president, left the Company. Dr. Gallagher continues to serveas a member of the Company’s Board of Directors and, until December 2005,acted as a consultant to the Company. The Company incurred $304 and $324respectively, in consulting fees to Dr. Gallagher in each of the yearsended 

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

December 31,2005 and 2004. In 2003, the Company incurred $20 in such consulting expense andalso recognized a non-cash stock compensation charge of approximately $251relating to the acceleration of vesting of certain in-the-money stock optionsheld by Dr. Gallagher.

**(14) LegalSettlements and Proceedings**

In November 2002, the Company commenced an actionin the United States District Court for the Eastern District of New Yorkseeking to prevent West-ward Pharmaceutical Corporation (“West-ward”) fromselling 20 mg capsules of doxycycline hyclate to treat adult periodontitis,which the Company believed would infringe patents covering the Company’sPeriostat product. On November 7, 2003, the Company settled all pendinglitigation between the Company and West-ward. In the settlement, West-wardconsented to a judgment enjoining West-ward and any party acting in concertwith West-ward from making and selling a generic version of Periostat until theCompany’s patents expire or are declared invalid or unenforceable by a court ofcompetent jurisdiction. In connection with this settlement, the Company agreedto pay a portion of West-ward’s actual legal expenses in the amount of $700,which was recorded in 2003.

In July 2003, the Company commenced an actionagainst Mutual in the United States District Court for the Eastern District ofNew York seeking to prevent Mutual from introducing 20 mg tablets ofdoxycycline hyclate into the market in the United States. The Company’s suitalleged infringement of patents covering the Company’s Periostat product. On April 8,2004, the Company announced that it had settled all pending litigation betweenthe Company and Mutual. In the settlement, Mutual agreed and confessed tojudgment that the Company’s Periostat patents are valid and would be infringedby the commercial manufacture, use, sale, importation or offer for sale of thegeneric version of Periostat for which Mutual had submitted its Abbreviated NewDrug Application, or ANDA. The Company paid to Mutual $2,000, which representeda portion of the anticipated fees and expenses that the Company would save as aresult of the settlement of the pending actions with Mutual. This charge wasrecorded in 2004.

In connection with the settlement, the Company andMutual entered into a License and Supply Agreement pursuant to which Mutualreceived a license to sell a branded version of Periostat and would purchasethis product exclusively from the Company at prices below the Company’s averagemanufacturer’s price. The License and Supply Agreement also provided for theCompany to make price adjustments to Mutual after a generic version ofPeriostat had become available on the market at a price lower than the sellingprice of Mutual’s branded version of Periostat. These adjustments were to takethe form of rebates or credits to Mutual to reduce the acquisition cost of thebranded version of Periostat in Mutual’s inventory or to offset rebates andsimilar retroactive price adjustments requested by, and actually provided by,Mutual to its customers.

On May 13, 2005, the FDA approved a third partygeneric version of Periostat that was launched in late May 2005. Upon thisgeneric launch, Mutual was no longer obligated to purchase its branded versionof Periostat from the Company and ceased purchasing from the Company in June 2005.

In June 2003, the Company commenced an action andfiled a motion for a preliminary injunction in the United States District Courtfor the District of Columbia challenging the FDA’s decision to treat Periostatas an antibiotic drug, thus denying Periostat certain protections affordednon-antibiotic drugs 

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

under the Food, Drug, andCosmetic Act and against FDA approval of generic copies of Periostat (the “FDALitigation”). On July 23, 2003, the United States District Court for theDistrict of Columbia issued an injunction in favor of the Company. On January 20,2005, the United States District Court for the District of Columbia reached itsdecision on the merits of the FDA Litigation, and dissolved the injunction thathad prohibited the FDA from approving any ANDAs submitted for any genericversion of Periostat. The Company lodged, but has now withdrawn, an appealagainst this decision in the Court of Appeals for the District of ColumbiaCircuit.

On October 1, 2004, the Company filed a complaintfor patent infringement against IVAX Pharmaceuticals Inc. (“IVAX”) andCorePharma LLC (“CorePharma”) in the United States District Court for theEastern District of New York. In its complaint, the Company alleged that thesubmission of ANDAs by each of IVAX and CorePharma for 20 mg tablets ofdoxycycline hyclate infringed United States Patent RE 34,656, for which theCompany is the exclusive licensee. The Company also alleged that anymanufacture, importation, marketing and sale of generic 20 mg tablets ofdoxycycline hyclate by IVAX and CorePharma would infringe the RE 34,656 patent.The Company sought an injunction preventing IVAX and CorePharma fromintroducing 20 mg tablets of doxycycline hyclate in the United States. Theinjunction was denied by the Court on June 16, 2005. The litigation on themerits of the Company’s patent infringement claims is still pending before theCourt in the Eastern District of New York.

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. Currently, the Company is not involved in any arbitrationand/or other legal proceedings that it expects to have a material effect on thebusiness, financial condition, results of operations or liquidity of theCompany. All legal costs are expensed as incurred.

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

Under the Company’slicense agreement with SUNY covering Periostat, the Company is entitled todeduct costs incurred to defend its patents, including the $2,700 in settlementpayments to Mutual and West-Ward, from current and future royalties due to SUNYon net sales of products based on the SUNY technology. During the years ended December 31,2005, 2004, and 2003, the Company incurred $1,100, $4,116 (which included the$2,000 Mutual settlement), and $3,757 (which included the $700 West-wardsettlement), in legal defense, litigation, and settlement costs, respectively,of which $899, $1,933, and $1,750 were deducted from royalties earned by SUNYduring these periods, respectively (See note 11). The cumulative legal patentdefense, litigation and settlement costs incurred to date exceed the amount ofthe royalties payable to SUNY, earned during the litigation period, as of December 31,2005 by $4,140. These amounts, which have been expensed, will be available tooffset future royalties earned by SUNY, if any, on net sales of products basedon the SUNY technology.

**(16) Saleof U.K. and European Dental Assets**

On November 3, 2004, CollaGenex International Ltd(“CIL”), a wholly-owned U.K. subsidiary of the Company, sold its U.K. andEuropean dental assets to Alliance for net proceeds of $2,980. This agreement 

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

provided for the sale byCIL to Alliance of certain trademark rights, U.K. and European governmentalmarketing authorizations, distribution agreements and other intangible assetsrelating to the sale or potential sale of Periostat in the U.K., Europe,Israel, South Africa, New Zealand and Australia. The agreement also grantedAlliance an option to acquire a license to register and market Periostat-MRTM, aonce-daily, modified release form of Periostat, for adult periodontitis in thesame territories. The Company has retained all rights to Periostat-MR for allother clinical indications. The Company also entered into a Supply Agreementwith Alliance pursuant to which the Company will supply Periostat in bulktablet form to Alliance at a negotiated fair value 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 $74 in net product sales related to bulk shipments ofPeriostat to Alliance during the years ended December 31, 2005 and 2004.

**(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’saccount. During each of the years ended December 31, 2004 and 2003, theCompany made a discretionary contribution of $100 to the 401(k) Plan. In2005, the 401(k) plan was amended to allow an employer sponsored matchingcontribution of 20% on each dollar for the first 6% of the compensationdeferred by the participant. During 2005, the Company made matchingcontributions of $78 to the 401(k) Plan.

**(18) Related Party Transactions**

A current member of the Company’s Board of Directorsis also a 1.0% holder of the Company’s Series D-1 Stock which wasexchanged for shares of Series D Stock in connection with the execution ofthe Restructuring and Exchange Agreement in December 2005 (Seenote 5).

During 2003, the Company engaged an outside firm toperform certain consulting services for approximately $55. One of the primarystakeholders in the outside firm is a member of the Company’s Board ofDirectors.

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

**(19) QuarterlyFinancial Data (Unaudited)**

Thetables below summarize the Company’s unaudited quarterly operating results for2005 and 2004:

| ** **                                                                | ** ** | **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 | ) |   |

 

| ** **                                                                         | ** ** | **Three months ended** | ** **    |
|------------------------------------------------------------------------------------|------------|----------------------------------|---------------|
| ** **                                                                         | ** ** | **March 31,  2004**         | ** **    | **June 30,  2004** | ** ** | **September 30,  2004** | ** ** | **December 31,  2004** | ** ** |
| Total revenues                                                                     |       |                             | $ 13,406 |   |   | $ 14,445 |   |   | $ 11,075 |   |   |   | $ 13,220 |   |   |
| Gross margin on  product sales                                                     |       |                             | 11,327        |   |   | 12,320 |   |   | 9,454 |   |   |   | 11,192 |   |   |
| Net (loss) income                                                                  |       |                             | (34           | ) |   | 1,998 |   |   | 1,125 |   |   |   | 3,439 |   |   |
| Net (loss) income  allocable to common stockholders                                |       |                             | (434          | ) |   | 1,598 |   |   | 725 |   |   |   | 3,039 |   |   |
| Basic and diluted net  (loss) income per share allocable to common stockholders(1) |       |                             | $ (0.03  | ) |   | $   0.11 |   |   | $   0.05 |   |   |   | $   0.21 |   |   |

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(1)          Quarterlyfigures do not summate to annualized figure due to the quarterly EPScomputation being done independently.

**(20) SupplementalCash Flow Information**

| ** **                                                             | ** ** | **Years Ended**                  | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Supplemental schedule of  non-cash investing and financing activities: |       |                                  |       |   |   |   |   |
| Accrued liability for licenses                                         |       | $     — |       | $ 150 |   | $ — |   |
| 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 |   | $ 800 |   |
| Supplemental disclosure  of cash flow information:                     |       |                                  |       |   |   |   |   |
| Cash paid for  income taxes                                            |       | $     — |       | $ 25 |   | $ 197 |   |

 

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 

F-31

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**COLLAGENEX PHARMACEUTICALS, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003 (Dollars in thousands, except per share data)**

200,000 shares of the Series D-1Stock. The Company recorded a non-cash charge on the consolidated statement ofoperations of $3,680 related to this Exchange Agreement in the fourth quarterof 2005.

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 alloffering expenses that were accrued by the Company at December 31, 2005.

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**COLLAGENEXPHARMACEUTICALS, INC. AND SUBSIDIARIESFINANCIAL STATEMENT SCHEDULEValuation and Qualifying AccountsYears Ended December 31, 2005, 2004 and 2003(in thousands)**

| **Description**                      | ** ** | ** ** | ** ** | **Balance at the  Beginning of  Period** | ** ** | **Additions**                                      | ** ** | **Deductions** | ** ** | **Balance at the  End of Period** | ** ** |
|--------------------------------------|------------|------------|------------|---------------------------------------------------------|------------|----------------------------------------------------|------------|----------------|------------|-------------------------------------------------------|------------|
| **Accounts  Receivable  Allowance:** | ** ** | ** ** | ** ** | ** **                                              | ** ** | **Charged to  Statement of  Operations** | ** ** | ** **     | ** ** | ** **                                            | ** ** |
| 2005                                 |       |       | $          | 258                                                     |       |                                               |       | $              | 1,950      | (1)                                                   |       |   | $ | 2,104 | (2) |   |   | $ | 104 |   |   |
| 2004                                 |       |       | $          | 359                                                     |       |                                               |       | $              | 2,580      | (1)                                                   |       |   | $ | 2,681 | (2) |   |   | $ | 258 |   |   |
| 2003                                 |       |       | $          | 395                                                     |       |                                               |       | $              | 2,190      | (1)                                                   |       |   | $ | 2,226 | (2) |   |   | $ | 359 |   |   |
|                                      |            |            |            |                                                         |            |                                                    |            |                |            |                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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

(2)          Amounts representchargebacks and cash discounts processed.

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