Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

#### **FORM 10-Q**

#### ** **

| **x**                                                  | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|--------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                                   |                                                                                                     |
| **FOR THE QUARTERLY PERIOD ENDED  June 30, 2008** |
|                                                   |                                                                                                     |
| **OR**                                                 |
|                                                   |                                                                                                     |
| **o**                                                  | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                   |                                                                                                     |
| ** **                                             | **FOR THE TRANSITION PERIOD FROM         TO**                              |

 

**COMMISSION FILE NUMBER 001-13111**

 

**DEPOMED, INC.**

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITSCHARTER)

 

| **CALIFORNIA**                   | ** ** | **94-3229046**         |
|----------------------------------|------------|------------------------|
| (STATE OR OTHER  JURISDICTION OF |       | (I.R.S. EMPLOYER       |
| INCORPORATION OR  ORGANIZATION)  |       | IDENTIFICATION NUMBER) |

 

**1360 O’BRIEN DRIVE**

**MENLO PARK, CALIFORNIA 94025**

(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES,INCLUDING ZIP CODE)

 

**(650) 462-5900**

(REGISTRANT’S TELEPHONE NUMBER, INCLUDINGAREA CODE)

 

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

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

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

| Large  accelerated filer o | Accelerated  filer x | Non-accelerated  filer o                        | Smaller  reporting company o |
|----------------------------|---------------------------|-------------------------------------------------|-----------------------------------|
|                       |                      | (Do not check if a  smaller  reporting company) |                              |

 

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

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

 

Thenumber of issued and outstanding shares of the Registrant’s Common Stock, nopar value, as of August 5, 2008 was 48,116,510.

 

 

 

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Tableof Contents

 

**DEPOMED, INC.**

 
| ** **                                                                                                                          | ** ** | **PAGE**   |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **                                                                                                                          | ** ** | ** ** |
| **PART I – FINANCIAL INFORMATION**                                                                                        | ** ** | ** ** |
|                                                                                                                                |       |       |
| Item 1. Condensed  Consolidated Financial Statements:                                                                               |       |       |
|                                                                                                                                |       |       |
| Condensed Consolidated  Balance Sheets at June 30, 2008 (unaudited) and December 31, 2007                                 |       | 3          |
|                                                                                                                                |       |       |
| Condensed Consolidated  Statements of Operations for the three and six-month periods ended  June 30, 2008 and 2007 (unaudited) |       | 4          |
|                                                                                                                                |       |       |
| Condensed Consolidated  Statements of Cash Flows for the six-month periods ended June 30, 2008  and 2007 (unaudited)           |       | 5          |
|                                                                                                                                |       |       |
| Notes to  Condensed Consolidated Financial Statements                                                                               |       | 6          |
|                                                                                                                                |       |       |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations                                |       | 16         |
|                                                                                                                                |       |       |
| Item  3. Quantitative and Qualitative Disclosure About Market Risk                                                                  |       | 28         |
|                                                                                                                                |       |       |
| Item  4. Controls and Procedures                                                                                                    |       | 28         |
|                                                                                                                                |       |       |
| **PART II – OTHER  INFORMATION**                                                                                          | ** ** | ** ** |
|                                                                                                                                |       |       |
| Item 1.  Legal Proceedings                                                                                                          |       | 29         |
|                                                                                                                                |       |       |
| Item 1A. Risk  Factors                                                                                                              |       | 29         |
|                                                                                                                                |       |       |
| Item  2. Unregistered Sales of Equity Securities and Use of Proceeds                                                                |       | 41         |
|                                                                                                                                |       |       |
| Item  3. Defaults upon Senior Securities                                                                                            |       | 41         |
|                                                                                                                                |       |       |
| Item  4. Submission of Matters to a Vote of Security Holders                                                                        |       | 42         |
|                                                                                                                                |       |       |
| Item 5.  Other Information                                                                                                          |       | 42         |
|                                                                                                                                |       |       |
| Item 6. Exhibits                                                                                                                    |       | 43         |
|                                                                                                                                |       |       |
| Signatures                                                                                                                          |       | 44         |

 

2

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**PART I – FINANCIAL INFORMATION**

###### **ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

###### ** **

**DEPOMED, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands, except share andper share amounts)**

 
| ** **                                                                                                                                                                                                                                                                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                     | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                                                                                                                                     | ** ** | **(Unaudited)**   | ** ** | **(1)**               | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                     | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                                                                                |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                      |       | $                 | 48,934     |                  | $          | 14,374 |   |
| Marketable securities                                                                                                                                                                                                                                                          |       | 22,266            |       | 39,091                |       |
| Accounts receivable                                                                                                                                                                                                                                                            |       | 3,526             |       | 3,390                 |       |
| Unbilled accounts receivable                                                                                                                                                                                                                                                   |       | 361               |       | 233                   |       |
| Inventories                                                                                                                                                                                                                                                                    |       | 3,547             |       | 3,263                 |       |
| Prepaid and other current assets                                                                                                                                                                                                                                               |       | 3,497             |       | 2,418                 |       |
| Total current assets                                                                                                                                                                                                                                                           |       | 82,131            |       | 62,769                |       |
| Marketable securities                                                                                                                                                                                                                                                          |       | —            |       | 16,058                |       |
| Property and equipment, net                                                                                                                                                                                                                                                    |       | 1,271             |       | 1,621                 |       |
| Other assets                                                                                                                                                                                                                                                                   |       | 197               |       | 197                   |       |
|                                                                                                                                                                                                                                                                           |       | $                 | 83,599     |                  | $          | 80,645 |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                 | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                           |       |              |       |                  |       |
| Accounts payable                                                                                                                                                                                                                                                               |       | $                 | 722        |                  | $          | 1,134 |   |
| Accrued compensation                                                                                                                                                                                                                                                           |       | 1,365             |       | 1,558                 |       |
| Accrued clinical trial expense                                                                                                                                                                                                                                                 |       | 376               |       | 322                   |       |
| Other accrued liabilities                                                                                                                                                                                                                                                      |       | 3,510             |       | 3,322                 |       |
| Deferred product sales                                                                                                                                                                                                                                                         |       | 9,129             |       | 6,489                 |       |
| Deferred license revenue                                                                                                                                                                                                                                                       |       | 1,480             |       | 1,453                 |       |
| Other current liabilities                                                                                                                                                                                                                                                      |       | 51                |       | 56                    |       |
| Current portion of long-term debt                                                                                                                                                                                                                                              |       | 587               |       | —                |       |
| Total current liabilities                                                                                                                                                                                                                                                      |       | 17,220            |       | 14,334                |       |
| Deferred license revenue, non-current  portion                                                                                                                                                                                                                                 |       | 20,009            |       | 20,763                |       |
| Long-term debt, net of current portion                                                                                                                                                                                                                                         |       | 2,925             |       | —                |       |
| Other long-term liabilities                                                                                                                                                                                                                                                    |       | 326               |       | 28                    |       |
| Commitments                                                                                                                                                                                                                                                                    |       |              |       |                  |       |
| Shareholders’ equity:                                                                                                                                                                                                                                                     |       |              |       |                  |       |
| Preferred stock, no par value, 5,000,000  shares authorized; Series A convertible preferred stock, 25,000 shares  designated, 18,158 shares issued and outstanding at June 30, 2008 and  December 31, 2007, with an aggregate liquidation preference of $18,159 |       | 12,015            |       | 12,015                |       |
| Common stock, no par value, 100,000,000  shares authorized; 48,113,260 and 47,865,529 shares issued and outstanding at  June 30, 2008 and December 31, 2007, respectively                                                                                            |       | 169,726           |       | 168,287               |       |
| Accumulated deficit                                                                                                                                                                                                                                                            |       | (138,693          | )          | (134,892              | )          |
| Accumulated other comprehensive gain                                                                                                                                                                                                                                           |       | 71                |       | 110                   |       |
| Total shareholders’ equity                                                                                                                                                                                                                                                |       | 43,119            |       | 45,520                |       |
|                                                                                                                                                                                                                                                                           |       | $                 | 83,599     |                  | $          | 80,645 |   |

 

----

(1) Derived from the audited consolidated financial statements includedin the Company’s Annual Report on Form 10-K for the year ended December 31,2007.

 

See accompanying notes to CondensedConsolidated Financial Statements.

 

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**DEPOMED, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(in thousands, except share andper share amounts)**

**(Unaudited)**

 
| ** **                                                                          | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues:                                                                           |       |                                                |       |                                              |       |   |   |   |   |
| Product sales                                                                       |       | $                                                   | 5,519      |                                              | $          | 2,502 |   | $ | 10,745 |   | $ | 3,833 |   |
| Royalties                                                                           |       | 433                                                 |       | 45                                                |       | 545 |   | 79 |   |
| License revenue                                                                     |       | 363                                                 |       | 1,059                                             |       | 727 |   | 3,523 |   |
| Collaborative revenue                                                               |       | —                                              |       | 2                                                 |       | — |   | 2 |   |
| Total revenues                                                                      |       | 6,315                                               |       | 3,608                                             |       | 12,017 |   | 7,437 |   |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Costs and expenses:                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Cost of sales                                                                       |       | 962                                                 |       | 569                                               |       | 2,171 |   | 874 |   |
| Research and development                                                            |       | 4,680                                               |       | 6,129                                             |       | 10,750 |   | 14,701 |   |
| Selling, general and administrative                                                 |       | 5,241                                               |       | 6,323                                             |       | 11,748 |   | 12,550 |   |
| Gain on litigation settlement                                                       |       | (7,500                                              | )          | —                                            |       | (7,500 | ) | - |   |
| Total costs and expenses                                                            |       | 3,383                                               |       | 13,021                                            |       | 17,169 |   | 28,125 |   |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Income (loss) from operations                                                       |       | 2,932                                               |       | (9,413                                            | )          | (5,152 | ) | (20,688 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Other income (expense):                                                             |       |                                                |       |                                              |       |   |   |   |   |
| Interest and other income                                                           |       | 553                                                 |       | 456                                               |       | 1,356 |   | 866 |   |
| Interest expense                                                                    |       | (5                                                  | )          | —                                            |       | (5 | ) | - |   |
| Total other income (expense)                                                        |       | 548                                                 |       | 456                                               |       | 1,351 |   | 866 |   |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Net income (loss) before income taxes                                               |       | 3,480                                               |       | (8,957                                            | )          | (3,801 | ) | (19,822 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Provision for income taxes                                                          |       | —                                              |       | (3                                                | )          | –– |   | (4 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Net income (loss)                                                                   |       | 3,480                                               |       | (8,960                                            | )          | (3,801 | ) | (19,826 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Deemed dividend on preferred stock                                                  |       | (180                                                | )          | (170                                              | )          | (355 | ) | (337 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Net income (loss) applicable to common  stock shareholders                          |       | $                                                   | 3,300      |                                              | $          | (9,130 | ) | $ | (4,156 | ) | $ | (20,163 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Basic net income (loss) applicable to  common stock shareholders per common share   |       | $                                                   | 0.07       |                                              | $          | (0.20 | ) | $ | (0.09 | ) | $ | (0.46 | ) |
| Diluted net income (loss) applicable to  common stock shareholders per common share |       | $                                                   | 0.07       |                                              | $          | (0.20 | ) | $ | (0.09 | ) | $ | (0.46 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Shares used in computing basic net income  (loss) per common share                  |       | 48,041,855                                          |       | 46,233,946                                        |       | 47,954,052 |   | 44,166,899 |   |
| Shares used in computing diluted net income  (loss) per common share                |       | 48,405,333                                          |       | 46,233,946                                        |       | 47,954,052 |   | 44,166,899 |   |

 

See accompanying notes to CondensedConsolidated Financial Statements.

 

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**DEPOMED, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(in thousands)**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| **Operating Activities**                                                     | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                                                 | (3,801     | ) | $ | (19,826 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                              |       |   |   |
| Depreciation and amortization                                                |       | 631                                               |       | 469 |   |
| Employee and director stock-based  compensation                              |       | 1,135                                             |       | 1,031 |   |
| Stock-based compensation related to  consultants                             |       | 87                                                |       | 24 |   |
| Changes in assets and liabilities:                                           |       |                                              |       |   |   |
| Accounts receivable                                                          |       | (264                                              | )          | 7,349 |   |
| Inventories                                                                  |       | (284                                              | )          | 90 |   |
| Prepaid and other current assets                                             |       | (1,079                                            | )          | 753 |   |
| Accounts payable and other accrued  liabilities                              |       | 124                                               |       | (4,050 | ) |
| Accrued compensation                                                         |       | (192                                              | )          | (522 | ) |
| Deferred revenue                                                             |       | 1,913                                             |       | (4,361 | ) |
| Net cash used in operating activities                                        |       | (1,730                                            | )          | (19,043 | ) |
|                                                                         |       |                                              |       |   |   |
| **Investing Activities**                                                     | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Purchases of property and equipment                                          |       | (147                                              | )          | (121 | ) |
| Purchases of marketable securities                                           |       | (23,206                                           | )          | (21,594 | ) |
| Maturities of marketable securities                                          |       | 44,757                                            |       | 14,846 |   |
| Sales of marketable securities                                               |       | 11,159                                            |       | — |   |
| Net cash provided by (used in) investing  activities                         |       | 32,563                                            |       | (6,869 | ) |
|                                                                         |       |                                              |       |   |   |
| **Financing Activities**                                                     | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Proceeds from debt issuance                                                  |       | 3,800                                             |       | — |   |
| Debt issuance costs                                                          |       | (288                                              | )          | — |   |
| Proceeds from issuance of common stock                                       |       | 215                                               |       | 20,892 |   |
| Net cash provided by financing activities                                    |       | 3,727                                             |       | 20,892 |   |
|                                                                         |       |                                              |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                        |       | 34,560                                            |       | (5,020 | ) |
| Cash and cash equivalents at beginning of  period                            |       | 14,374                                            |       | 14,574 |   |
| Cash and cash equivalents at end of period                                   |       | $                                                 | 48,934     |   | $ | 9,554 |   |

 

See accompanying notes to CondensedConsolidated Financial Statements.

 

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** **

**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

**NOTE 1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

## ***Basisof Presentation***

## * *

These unaudited condensed consolidated financial statements and therelated footnote information of Depomed, Inc. (the Company or Depomed)have been prepared pursuant to the requirements of the Securities and ExchangeCommission (SEC) for interim reporting. As permitted under those rules, certainfootnotes or other financial information that are normally required by U.S.generally accepted accounting principles have been condensed or omittedpursuant to such rules and regulations. In the opinion of the Company’s management,the accompanying interim unaudited condensed consolidated financial statementsinclude all adjustments (consisting only of normal recurring adjustments)necessary for a fair presentation of the information for the periods presented.The results for the interim period ended June 30, 2008 are not necessarilyindicative of results to be expected for the entire year ending December 31,2008 or future operating periods.

 

The balance sheet as of December 31, 2007 has been derived fromthe audited financial statements at that date. The balance sheet does notinclude all of the information and footnotes required by U.S. generallyaccepted accounting principles for complete financial statements. For furtherinformation, refer to the financial statements and footnotes thereto includedin the Company’s annual report on Form 10-K for the year ended December 31,2007 filed with the SEC.

 

***Principles of Consolidation***

 

The consolidated financial statements include the accounts of theCompany and Depomed Development, Ltd. (DDL) through April 2007, at whichtime DDL was dissolved. DDL did not have any fixed assets, liabilities oremployees and will not perform any further product development on behalfof Depomed or any other entity. Material intercompany accounts and transactionshave been eliminated.

 

***Use of Estimates***

 

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

 

***Stock-Based Compensation***

* *

Effective January 1, 2006, Depomed implemented the provisions ofStatement of Financial Accounting Standards No. 123 (revised 2004), *Share-Based Payment* (FAS 123(R)), as interpreted by SECStaff Accounting Bulletin No. 107 (SAB 107), using the modifiedprospective transition method. FAS 123(R) is a revision of Statement ofFinancial Accounting Standards No. 123, *Accountingfor Stock-Based Compensation*(FAS 123), and supercedes APB Opinion No. 25,*Accounting for Stock Issued to Employees*(APB No. 25).**FAS 123(R) requirescompanies to recognize the cost of employee and director services received inexchange for awards of equity instruments, based on the grant-date fair valueof those awards, in the statement of operations. Using the modified prospectivetransition method of FAS 123(R), Depomed began recognizing fair-valuecompensation expense for stock-based awards, including stock options grantedand purchase rights issued under its employee purchase plan after January 1,2006. Compensation expense for stock-based awards granted prior toimplementation that were unvested and outstanding as of January 1, 2006 isrecognized over the requisite service period based on the grant-date fair valueof those options and awards as previously calculated under FAS 123. Thecompensation expense for stock-based compensation is based on the single-optionapproach, includes an estimate for forfeitures and is recognized over thevesting term of the options using the straight-line method. FAS 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. Depomed estimatesforfeitures based on historical experience.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

***(Unaudited)***

* *

On adoption of FAS 123(R),the Company concluded that its historical share option exercise experience didnot provide a reasonable basis upon which to estimate expected term andestimated the expected term of options granted by taking the average of thevesting term and the contractual term of the option, as illustrated by thesimplified method in SAB 107. SAB 107 allowed for use of the simplified methodto estimate expected term through December 31, 2007. In December 2007,the SEC issued SAB 110, which extended the ability for companies to utilize thesimplified method beyond December 31, 2007 under limited circumstances. AtJanuary 1, 2008, the Company concluded again that its historical shareoption exercise experience did not provide a reasonable basis upon which toestimate expected term because of the Company’s limited exercise history andalso elected to no longer utilize the simplified method. For options grantedafter January 1, 2008, the Company has estimated the expected term byusing the weighted average terms of a peer group of companies that grantoptions with similar vesting provisions. The expected term used for optionsgranted after January 1, 2008 is 5.04 years. See Note 6 of the Notes toCondensed Consolidated Financial Statements for further information regardingDepomed’s stock-based compensation expense.

 

***Revenue Recognition***

 

The Company recognizes revenue from the sale of its products, royaltiesearned and on payments received or services performed under contractualarrangements. Revenue arrangements with multiple elements are divided intoseparate units of accounting if certain criteria are met, including whether thedelivered element has stand-alone value to the customer and whether there isobjective and reliable evidence of the fair value of the undelivered items. Theconsideration received is allocated among the separate units based on theirrespective fair values, and the applicable revenue recognition criteria areapplied to each of the separate units.

 

Revenue is recognized when there is persuasive evidence that anarrangement exists, delivery has occurred and title has passed, the price isfixed or determinable and the Company is reasonably assured of collecting theresulting receivable.

 

·                  Product Sales -The Company sells GLUMETZA® and Proquin® XR product towholesalers and retail pharmacies that is subject to rights of return up totwelve months after product expiration. Given the Company’s limited history of selling GLUMETZA and Proquin XR,the Company currently cannot reliably estimate expected returns of the productat the time of shipment. Accordingly, the Company defers recognition of revenueon product shipments of GLUMETZA and Proquin XR until the right of return nolonger exists, which occurs at the earlier of the time GLUMETZA and Proquin XRunits are dispensed through patient prescriptions or expiration of the right ofreturn. The Company estimates patient prescriptions dispensed using an analysisof third-party information, including third-party market research data andinformation obtained from wholesalers with respect to inventory levels andinventory movement. As a result of this policy, the Company has a deferredrevenue balance of $9.1 million at June 30, 2008 related to GLUMETZA andProquin XR product shipments that have not been recognized as revenue, which isnet of wholesaler fees, retail pharmacy discounts and prompt payment discounts.The Company will recognize revenue upon the earlier to occur of prescriptionunits dispensed or expiration of the right of return until it can reliablyestimate product returns, at which time the Company will record a one-timeincrease in net revenue related to the recognition of revenue previouslydeferred. In addition, the costs of manufacturing GLUMETZA and Proquin XRassociated with the deferred revenue are recorded as deferred costs, which areincluded in inventory, until such time the related deferred revenue isrecognized.

 

·                  ProductSales Allowances – The Company recognizes products sales allowances as areduction of product sales in the same period the related revenue isrecognized.

 

·                  Wholesalerand Retail Pharmacy Discounts – The Company offers discounts to certain wholesaledistributors and retail pharmacies based on contractually determined rates. TheCompany accrues the discount on shipment to the respective wholesaledistributors and retail pharmacies and recognizes the discount as a reductionof revenue in the same period the related revenue is recognized.

 

·                  PatientSupport Programs - The Company has patient support programs in which patientsreceive co-pay assistance or a free limited supply of product fromparticipating pharmacies.  The Companyreimburses the pharmacies for these discounts and the related reimbursementcosts are accrued and treated as a reduction of revenue in the same period therelated revenue is recognized.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

***(Unaudited)***

* *

·                  Prompt PayDiscounts - The Company offers cash discounts to its customers, generally 2% ofthe sales price, as an incentive for prompt payment. Based on the Company’sexperience, the Company expects its customers to comply with the payment termsto earn the cash discount. The Company accounts for cash discounts by reducingaccounts receivable by the full amount and recognizes the discount as areduction of revenue in the same period the related revenue is recognized.

 

·                  MedicaidRebates – The Company participates in Medicaid rebate programs, which provideassistance to certain eligible low-income patients based on each individualstate’s guidelines regarding eligibility and services. Under the Medicaidrebate programs, the Company pays a rebate to each participating state,generally two to three months after the quarter in which the prescription isfilled. The Company estimates and accrues Medicaid rebates based on third-partymarket data regarding prescription payor information, historical usage, and changesin the level of discounts the Company offers that may affect the level ofMedicaid discount.

 

·                  Chargebacks –The Company provides discounts to authorized users of the Federal SupplySchedule (FSS) of the General Services Administration under an FSS contractnegotiated by the Department of Veterans Affairs.  These federal entities purchase products fromthe wholesale distributors at a discounted price, and the wholesaledistributors then charge back to the Company the difference between the currentretail price and the price the federal entity paid for the product.  The Company estimates and accrues chargebacksbased on current contract prices and historical chargeback activity.

 

·                  Royalties -Royalties are recognized as earned in accordance with the contract terms whenroyalties from licensees can be reliably measured and collectibility isreasonably assured.

 

In April 2008, the Company enteredinto a settlement and license agreement with Teva Pharmaceuticals USA, Inc.(Teva) in which the Company is entitled to receive royalties from Teva on salesby Teva or its affiliates of generic Glucophage®XR in the United States,subject to a $2.5 million aggregate cap. The royalties are calculated as apercentage of sales by Teva of generic Glucophage XR in the United States, asreported by a third-party market research company. The Company accruesroyalties from Teva each quarter based on Teva’s sales of generic Glucophage XRreported by the third-party market research company for that quarter. See Note4 of the Notes to Condensed Consolidated Financial Statements for furtherinformation on the settlement and license agreement.

 

Royalties received under the Company’sagreements with Biovail Laboratories s.r.l. (Biovail) and LG Life Sciences (LG)are recognized when the royalty payments are received as they are notestimable.

 

The Company recognized royalties underits license agreement with Esprit Pharma (Esprit) based on Esprit’s sales ofProquin XR, net of any estimated returns, discounts, rebates and chargebacks,subject to minimum annual royalties. The license agreement with Esprit wasterminated in July 2007.

 

·                     LicenseRevenue - Revenue from license arrangements is recognized when the Company hassubstantially completed its obligations under the terms of the arrangement andthe Company’s remaining involvement is inconsequential and perfunctory. If theCompany has significant continuing involvement under such an arrangement,license fees are recognized over the estimated performance period. License feepayments received in excess of amounts earned are classified as deferredrevenue until earned.

 

***Recently Issued AccountingStandards***

* *

InDecember 2007, the FASB ratified the final consensuses in Emerging IssuesTask Force (EITF) Issue No. 07-1, *Accountingfor Collaborative Arrangements* (EITF 07-1), which requirescertain income statement presentation of transactions with third parties and ofpayments between parties of the collaborative arrangement, along withdisclosure about the nature and purpose of the arrangement. EITF 07-1 iseffective for the Company beginning January 1, 2009. The Company does notexpect EITF 07-1 to have a material effect on its financial position, resultsof operations or cash flows.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

***(Unaudited)***

* *

EffectiveJanuary 1, 2008, the Company adopted EITF Issue No. 07-3, *Accounting for Nonrefundable Advance Payments for Goods or ServicesReceived for Use in Future Research and Development Activities*(EITF07-3). EITF 07-3 requires that nonrefundable advance payments for goods andservices that will be used or rendered in future R&D activities pursuant tocontractual arrangements be deferred and recognized as expense in the periodthat the related goods are delivered or services are performed. The adoption ofEITF 07-3 did not have a material impact on the Company’s financial position,results of operations or cash flows.

 

**NOTE 2.CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES**

 

 TheCompany considers all highly liquid investments with an original maturity (at dateof purchase) of three months or less to be cash equivalents. Cash and cashequivalents consist of cash on deposit with banks, money market instruments andcommercial paper. The Company places its cash, cash equivalents and marketablesecurities with high quality, U.S. financial institutions and, to date, has notexperienced material losses on any of its balances. The Company records cashequivalents at amortized cost, which approximates their fair value. Allmarketable securities are classified as available-for-sale since theseinstruments are readily marketable. These securities are carried at fair value,which is based on readily available market information, with unrealized gainsand losses included in accumulated other comprehensive loss within shareholders’equity. The Company uses the specific identification method to determine theamount of realized gains or losses on sales of marketable securities. Realizedgains or losses have been insignificant and are included in “interest and otherincome” in the condensed consolidated statement of operations. As of June 30,2008, the individual contractual period for all available-for-sale debtsecurities is less than two years.

 

The following table shows the grossunrealized losses and fair value of the Company’s investments with unrealizedlosses that are not deemed to be other-than-temporarily impaired, aggregated byinvestment category and length of time that individual securities have been ina continuous unrealized loss position, at June 30, 2008 (in thousands):

 
| ** **                             | ** ** | **Less than 12 months** | ** ** | **12 months or greater** | ** ** | **Total**           | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|---------------------|------------|
| **U.S. Debt Securities**     | ** ** | **Fair Value**                    | ** ** | **Gross  Unrealized  Losses**           | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** |
| U.S. government agency debt securities |       | $                                      | 1,001      |                                    | $          | (1                  | )          | $ | — |   | $ | — |   | $ | 1,001 |   | $ | (1 | ) |
| U.S. corporate debt securities         |       | 5,270                                  |       | (2                                      | )          | —              |       | — |   | 5,270 |   | (2 | ) |
| Total available-for-sale               |       | $                                      | 6,271      |                                    | $          | (3                  | )          | $ | — |   | $ | — |   | $ | 6,271 |   | $ | (3 | ) |

 

The gross unrealized losses above werecaused by interest rate increases. No significant facts or circumstances havearisen to indicate that there has been any deterioration in thecreditworthiness of the issuers of the Company’s securities. Based on theCompany’s review of these securities, including the assessment of the durationand severity of the unrealized losses and the Company’s ability and intent tohold the investments until maturity, there were no materialother-than-temporary impairments for these securities at June 30, 2008.

 

Effective January 1, 2008, the Companyadopted Statementof Financial Accounting Standards No. 157, *Fair Value Measurements* (FAS 157). FAS 157 defines fairvalue, establishes a framework for measuring fair value under generallyaccepted accounting principles and enhances disclosures about fair valuemeasurements. Fair value is defined under FAS 157 as the exchange price thatwould be received for an asset or paid to transfer a liability (an exit price)in the principal or most advantageous market for the asset or liability in anorderly transaction between market participants on the measurement date.Valuation techniques used to measure fair value under FAS 157 must maximize theuse of observable inputs and minimize the use of unobservable inputs. Thestandard describes a fair value hierarchy based on three levels of inputs, ofwhich the first two are considered observable and the last unobservable, thatmay be used to measure fair value which are the following:

 

·                  Level 1: Quoted prices in active markets for identical assets orliabilities.

 

·                  Level 2: Inputs other than Level 1 that are observable, eitherdirectly or indirectly, such as quoted prices for similar assets orliabilities; quoted prices in markets that are not active; or other inputs thatare observable or can be corroborated by observable market data forsubstantially the full term of the assets or liabilities.

 

·                  Level 3: Unobservable inputs that are supported by little or no marketactivity and that are significant to the fair value of the assets orliabilities.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (Continued)**

***(Unaudited)***

* *

Theadoption of FAS 157 did not have a material impact on the Company’s financialposition, results of operations or cash flows. In accordance with FAS 157, thefollowing table represents the Company’s fair value hierarchy for its financialassets measured at fair value on a recurring basis as of June 30, 2008 (inthousands):

 
| ** **                             | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------|------------|
| Money market funds                     |       | $                | 5,766      |             | $          | —           |       | $         | —     |   | $ | 5,766 |   |
| Commercial paper                       |       | —           |       | 12,691           |       | —           |       | 12,691    |       |
| U.S. government agency debt securities |       | —           |       | 36,693           |       | —           |       | 36,693    |       |
| U.S. corporate debt securities         |       | —           |       | 14,670           |       | —           |       | 14,670    |       |
| Total                                  |       | $                | 5,766      |             | $          | 64,054           |       | $         | —     |   | $ | 69,820 |   |

 

InFebruary 2007, the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities - Including anamendment of FASB Statement No. 115* (FAS 159), which provides afair value option election that permits entities to irrevocably elect tomeasure financial assets and liabilities (except for those that are specificallyscoped out of the Statement) at fair value as the initial and subsequentmeasurement attribute, with changes in fair value recognized in earnings asthey occur. FAS 159 permits the fair value option election on aninstrument-by-instrument basis at initial recognition of an asset or liabilityor upon an event that gives rise to a new basis of accounting for thatinstrument.  The Company did not elect to apply the fair value optionto any of its financial assets or liabilities; therefore, there has been noimpact on the Company’s financial position, results of operations or cashflows.

 

**NOTE 3.NET INCOME (LOSS) PER COMMON SHARE**

 

Basic net income (loss) per common share iscalculated based on the weighted-average number of shares of our common stockoutstanding during the period. Diluted net income (loss) per common share iscalculated based on the weighted-average number of shares of our common stockoutstanding and other dilutive securities outstanding during the period. Thepotential dilutive shares of our common stock resulting from the assumedexercise of outstanding stock options and equivalents and the assumed exerciseof the warrants are determined under the treasury stock method. Shares used inthe computation on net income (loss) per common share are as follows:

 
| ** **                        | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
|                              |       |                                                |       |                                              |       |   |   |   |   |
| Weighted-average shares - basic   |       | 48,041,855                                          |       | 46,233,946                                        |       | 47,954,052 |   | 44,166,899 |   |
| Effect of dilutive securities:    |       |                                                |       |                                              |       |   |   |   |   |
| Stock options                     |       | 357,476                                             |       | —                                            |       | — |   | — |   |
| Warrants                          |       | 6,002                                               |       | —                                            |       | — |   | — |   |
| Weighted-average shares - diluted |       | 48,405,333                                          |       | 46,233,946                                        |       | 47,954,052 |   | 44,166,899 |   |

 

For the three and six months ended June 30,2008, approximately 6.5 million and 8.4 million common stock equivalent sharesare not included because their effect is anti-dilutive. For the three and sixmonths ended June 30, 2007, approximately 8.8 million common stockequivalent shares are not included because their effect is anti-dilutive.

 

**NOTE 4.SETTLEMENT WITH TEVA PHARMACEUTICALS USA, INC.**

 

In April 2008, the Company enteredinto a settlement and license agreement with Teva related to the patentinfringement lawsuit filed by the Company against Teva affiliates IVAXCorporation and IVAX Pharmaceuticals, Inc. The settlement agreementprovided for a one-time payment to the Company of $7.5 million, which theCompany received in April 2008, and for a non-exclusive license in favorof Teva (including IVAX) to continue to market its generic Glucophage XR productin the United States.  The $7.5 millionone-time payment received by the Company was recognized as a gain on litigationsettlement within operating income during the second quarter of 2008.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

***(Unaudited)***

* *

The Company will also receive ongoingroyalty payments from Teva on sales by Teva (including IVAX) of genericGlucophage XR in the United States, which is calculated as a percentage ofsales, as reported by a third-party market research company.  The royaltyis subject to a $2.5 million aggregate cap. For the three and six months ended June 30, 2008, the companyrecognized $0.4 million in royalty revenue related to this arrangement.

 

**NOTE5.  LONG-TERM DEBT**

 

In June 2008, the Company entered intoa loan and security agreement with General Electric Capital Corporation, asagent (GECC), and Oxford Finance Corporation (Oxford) that provides the Companywith a $15.0 million credit facility.

 

The credit facility is available in up tothree tranches.  The first tranche of$3.8 million was advanced to the Company upon the closing of the loan agreement.  The second tranche of $5.6 million wasadvanced to the Company in July 2008. The third tranche of $5.6 million will be available to the Company untilSeptember 30, 2008, subject to the satisfaction of certain financial andclinical development milestones.

 

The Company will be required to payinterest on the first tranche for the first six months at an interest rate of11.59%.  Thereafter, the Company will berequired to pay the principal on the first tranche, plus interest at such rate,in 30 equal monthly installments. The second tranche will be interest-onlythrough December 31, 2008, with principal and interest payable thereafterin 30 equal monthly installments at an interest rate of 11.59%. The thirdtranche, if advanced to the Company, will be interest-only through December 31,2008, with principal and interest payable thereafter in 33 equal monthlyinstallments.  The interest rate on thethird tranche shall be the greater of (i) 11.59% and (ii) the sum of (a) therate published by the Board of Governors of the Federal Reserve System inFederal Reserve Statistical Release H.15 entitled “Selected Interest Rates”under the heading “U.S. Government Securities/Treasury Constant Maturities” asthe three year treasuries constant maturities rate plus (b) 8.37%.

 

 TheCompany will have the right to voluntarily prepay any tranches received underthe credit facility, in full or in part. Upon the date of any voluntaryprepayment of any of the tranches, the Company will be required to pay thelenders, a prepayment premium equal to: (i) 5% on such prepayment amount,if such prepayment is made within 14 months after the closing date, (ii) 4%on such prepayment amount, if such prepayment is made more than 14 months afterthe closing date but within 29 months after the closing date, and (ii) 3%on such prepayment amount, if such prepayment is made more than 29 months afterthe closing date, but on or before the maturity date of the respective tranche.

 

In the event the Company does not utilizethe entire credit facility by September 30, 2008, the Company will berequired to pay an unused line fee of 2% of any unused portion of the creditfacility.

 

The obligations of the Company under theloan agreement are secured by interests in all of the Company’s personal property,and proceeds from any intellectual property, but not by the Company’sintellectual property.

 

The credit facility contains conditionsthat must be satisfied prior to any borrowing and affirmative and negativecovenants with which the Company must comply and imposes restrictions withregards to additional indebtedness, liens, various fundamental changes(including mergers and acquisitions), payments, investments, transactions withaffiliates, and other limitations customary in secured credit facilities. TheCompany was in compliance with such covenants as of June 30, 2008.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

***(Unaudited)***

* *

**NOTE6.  STOCK-BASED COMPENSATION**

 

The following table presents stock-based compensation expenserecognized under FAS 123(R) for stock options, stock awards and theCompany’s employee stock purchase program (ESPP) in the Company’s consolidatedstatements of operations (in thousands):

 
| ** **                                  | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                  | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                        |       |                                                |       |                                              |       |   |   |   |   |
| Cost of sales                               |       | $                                                   | 5          |                                              | $          | 5 |   | $ | 10 |   | $ | 9 |   |
| Research and development expense            |       | 181                                                 |       | 207                                               |       | 382 |   | 408 |   |
| Selling, general and administrative expense |       | 415                                                 |       | 350                                               |       | 830 |   | 638 |   |
| Total                                       |       | $                                                   | 601        |                                              | $          | 562 |   | $ | 1,222 |   | $ | 1,055 |   |

 

At June 30, 2008, Depomed had $5.1 million of total unrecognizedcompensation expense, net of estimated forfeitures, related to stock optiongrants that will be recognized over an average vesting period of 2.2 years.

 

**NOTE7.  COMPREHENSIVE INCOME (LOSS)**

 

Total comprehensive income (loss) for thethree and six months ended June 30, 2008 and 2007 approximates net income(loss) and includes unrealized gains and losses on marketable securities.

 

**NOTE 8.INVENTORIES**

 

Inventories relate to the manufacture ofthe Company’s GLUMETZA and Proquin XR products. Inventories are stated at thelower of cost or market and consist of the following (in thousands):

 
| ** **      | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------|------------|-----------------------------|------------|---------------------------------|------------|
| Raw materials   |       | $                           | 463        |                            | $          | 837 |   |
| Work-in-process |       | 75                          |       | 419                             |       |
| Finished goods  |       | 1,991                       |       | 1,184                           |       |
| Deferred costs  |       | 1,018                       |       | 823                             |       |
| Total           |       | $                           | 3,547      |                            | $          | 3,263 |   |

 

Deferred costs represent the costs ofGLUMETZA and Proquin XR product shipped for which recognition of revenue hasbeen deferred.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

**(Unaudited)**

** **

**NOTE 9.SHAREHOLDERS’ EQUITY**

 

***Series A Preferred Stock***

 

In January 2000, the Company issued 12,015 shares of Series APreferred Stock at a price of $1,000 per share. The Series A PreferredStock accrued a dividend of 7% per annum, compounded semi-annually and payablein shares of Series A Preferred Stock. The Series A Preferred Stockwas convertible at anytime between January 2002 and January 2006 intothe Company’s common stock. The original conversion price of the Series APreferred Stock was $12.00; however, as a result of the Company’s March 2002and October 2003 financings, the conversion price had been adjusted to$9.51 per share. In December 2004, the Company entered into an agreementwith the Series A Preferred shareholder to resolve a misunderstandingbetween the Company and the shareholder relating primarily to prior adjustmentsto the conversion price of the Series A Preferred Stock. Pursuant to theagreement, among other matters, the Company agreed to adjust the conversionprice to $7.50 per share. The Company and the shareholder also agreed tobinding interpretations of certain other terms related to the Series APreferred Stock conversion price.

 

Priorto December 2004, the amounts calculated as Series A Preferred stockdividends were accounted for as an adjustment to the conversion price followingEITF Issue No. 98-5, *Accounting forConvertible Securities with Beneficial Conversion Features or ContingentlyAdjustable Conversion Ratios*(Issue No. 98-5).**As a result of the modifications to thepreferred stock agreement in December 2004, the Company determined that a “significantmodification” of the agreement had been made, and, therefore, a new “commitmentdate” for accounting purposes had been established on December 10, 2004.The Company measured the difference between the carrying value of the preferredstock and the fair value of the modified preferred stock pursuant to EITF TopicNo. D-42, *The Effect on the Calculationof Earnings per Share for the Redemption or Induced Conversion of PreferredStock* and determined that the fair value of the modified securitywas less than the carrying value of the security prior to the modification. TheCompany also evaluated the effective conversion rate, after considering thereset rate of $7.50 per share in addition to the common stock issuable uponconversion of the unpaid, accumulated dividends. The fair value of theunderlying common stock on December 10, 2004 was $5.06 per share. TheCompany determined that the conversion rate, after including the effect of theunpaid dividends, did not result in a beneficial conversion feature, whichcould have had the effect of also providing a deemed dividend to the preferredshareholder. However, an anti-dilutionprovision of the Series A Preferred Stock was triggered by the Company’s January 2005financing, which adjusted the conversion price of the Series A PreferredStock to $7.12. As a result of the adjusted conversion price and an increasein the amount of common stock issuable upon conversion of the Series APreferred Stock due to additional accumulated dividends, the Series APreferred Stock now contains a “beneficial conversion feature” subject torecognition pursuant to Issue No. 98-5.

 

Inconjunction with the modification of the agreement, the Company issued awarrant to the Series A Preferred shareholder. The value of the warrantwas considered in determining the value of the modified security. The warrantis convertible into shares of the Company’s common stock during the periodbetween January 2006 and January 2009. The conversion price of thewarrant initially was $7.12, which was equal to the Series A PreferredStock conversion price in effect as of January 20, 2006. The conversionprice of the warrant decreases by approximately 4.8% per year during theconversion period, such that the number of shares of the Company’s common stockissuable upon conversion of the warrant will increase by approximately 5.1% peryear. The conversion of the warrant may be satisfied only by surrender of theoutstanding shares of Series A Preferred Stock.

 

TheSeries A Preferred Stock accrued dividends through January 20, 2006,which is the date the warrant initially became exercisable. As a result of theissuance of the warrant, the preferred stock may be surrendered in exchange forcommon stock for an additional three years through January 20, 2009. Aslong as the Series A Preferred Stock remains outstanding, the number ofshares into which the warrant can be converted increases as the conversionprice of the warrant decreases resulting in additional deemed dividends on the Series APreferred Stock. For the three and six months ended June 30, 2008, theCompany recognized Series A Preferred Stock deemed dividends ofapproximately $180,000 and $355,000, respectively, attributable to thebeneficial conversion feature from the accrued dividends and decreasing warrantprice. The Company will continue to recognize Series A Preferred Stockdeemed dividends until the earlier of, the time the Series A PreferredStock is surrendered or until January 2009.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

**(Unaudited)**

** **

As of June 30,2008, there were 18,158 shares of Series A Preferred Stock outstandingwith an aggregate liquidation preference of approximately $18.2 million. Thewarrant was convertible into 2,877,835 shares of the Company’s common stock ata conversion price of $6.31 as of June 30, 2008.

 

***Option Exercises***

 

During the three and sixmonths ended June 30, 2008, employees and consultants exercised options topurchase 1,905 and 2,947 shares of the Company’s common stock with net proceedsto the Company of approximately $3,000 and $7,000.

 

***Employee Stock Purchase Plan***

 

In May 2008, the Company sold 84,308shares under the ESPP. The shares were purchased at a weighted average exerciseprice of $2.47 with proceeds of approximately $0.2 million.

 

**NOTE 10.  RELATED PARTY TRANSACTIONS**

 

***John W. Fara, Ph.D.***

 

In August 2007,John W. Fara, Ph.D. retired from his positions as President, Chief ExecutiveOfficer and Chairman of the Company.  Dr. Faracontinued to serve as a member of the Company’s Board of Directors through the2008 Annual Meeting.  The Company enteredinto a consulting agreement with Dr. Fara, pursuant to which Dr. Farawill provide consulting services to the Company through December 31, 2009.From August 2007 through December 31, 2008, the Company will pay Dr. Fara$20,833 per month for his consulting services, and will reimburse Dr. Farafor COBRA and life insurance premiums. Dr. Fara will be paid on an hourlybasis for consulting services provided in 2009. For the three and six monthsended June 30, 2008, the Company incurred expense of approximately $62,000and $125,000, respectively, associated with this consulting agreement.

 

During the periodof his consultancy, Dr. Fara will continue to vest in all of his currentlyunvested stock options, and his vested stock options will remain exercisable.For the three and six months ended June 30, 2008, the Company recognizedapproximately $13,000 and $72,000, respectively, in stock compensation expenseassociated with these awards. In the event of a change in control of theCompany, as defined by the Company’s 2004 Equity Incentive Plan, all of Dr. Fara’sunvested options will fully vest, and any remaining monthly payments forconsulting under the agreement will be accelerated.

 

***John F. Hamilton***

 

In October 2007,John F. Hamilton retired from his position as Vice President, Finance and ChiefFinancial Officer of the Company.  TheCompany entered into a consulting agreement with Mr. Hamilton, pursuant towhich Mr. Hamilton will provide consulting services to the Company throughOctober 10, 2008. From October 10, 2007 through October 10,2008, the Company will pay Mr. Hamilton $25,667 per month for hisconsulting services. For the three and six months ended June 30, 2008, theCompany incurred expense of approximately $77,000 and $154,000, respectively,associated with this consulting agreement. In the event of a change in controlof the Company, as defined by the Company’s 2004 Equity Incentive Plan, anyremaining monthly payments for consulting under the agreement will beaccelerated. The Company will also reimburse Mr. Hamilton for COBRApremiums.

 

**NOTE11. INCOME TAXES**

 

The Companyadopted the provisions of FIN 48 on January 1, 2007. As of December 31,2007 and June 30, 2008, the Company had $2.9 million and $3.0 million ofunrecognized tax benefits, which is netted against deferred tax assets and isfully offset by a valuation allowance. All tax years since inception remain open to examination by the InternalRevenue Service and the California Franchise Tax Board until such time theCompany’s net operating losses and credits are either utilized or expire.Interest and penalties, if any, related to unrecognized tax benefits, would berecognized as income tax expense by the Company. As of the date of adoption ofFIN 48, the Company did not have any accrued interest or penaltiesassociated with unrecognized tax benefits. The Company does not foresee any material changes to unrecognized taxbenefits within the next twelve months.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

**(Unaudited)**

** **

**NOTE12. SUBSEQUENT EVENTS**

 

***Santarus, Inc.***

 

In July 2008,the Company entered into a promotion agreement with Santarus, Inc.(Santarus) granting Santarus exclusive rights to promote GLUMETZA in the UnitedStates. Santarus paid the Company a $12 million upfront fee, and based on theachievement of specified levels of annual GLUMETZA net product sales, Santarusmay be required to pay the Company additional one-time sales milestones,totaling up to $16 million.

 

Santarus isrequired to train its field sales representatives on GLUMETZA, and to beginpromotion of GLUMETZA in the fourth quarter of 2008. Santarus is also requiredto meet certain minimum promotion obligations during the term of the agreement,and required to make certain minimum marketing, advertising, medical affairsand other commercial support expenditures. The Company will continue to recordrevenue from the sales of GLUMETZA product and, beginning in the fourth quarterof 2008, will pay Santarus a fee ranging from 75% to 80% of the gross marginearned from net sales of GLUMETZA product in the United States.

 

Santarus will beresponsible for all costs associated with its sales force and for all othermarketing expenses associated with its promotion of GLUMETZA product. Depomedwill be responsible for overseeing product manufacturing and supply. A jointcommercialization committee has been formed to oversee and guide the strategicdirection of the GLUMETZA alliance.

 

Pursuant to theterms of the promotion agreement, Depomed retains the option to co-promote GLUMETZAproduct in the future to obstetricians and gynecologists. The promotionagreement will continue in effect until the expiration of the last-to-expirepatent or patent application with a valid claim in the territory covering aGLUMETZA product, unless terminated sooner.

 

***Long-Term Debt***

 

In July 2008,the Company received the second tranche of its credit facility with GECC andOxford (See Note 5). Proceeds from the second tranche were $5.6 million. Thesecond tranche will be interest-only through December 31, 2008, withprincipal and interest payable thereafter in 30 equal monthly installments atan interest rate of 11.59%.

 

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**ITEM 2. MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

### **FORWARD-LOOKING INFORMATION**

### ** **

Statements made in this “Management’s Discussionand Analysis of Financial Condition and Results of Operations” and elsewhere inthis Quarterly Report on Form 10-Q that are not statements of historicalfact are forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, as amended (the Securities Act), and Section 21Eof the Securities Exchange Act of 1934, as amended.  We have based these forward-lookingstatements on our current expectations and projections about futureevents.  Our actual results could differ materiallyfrom those discussed in, or implied by, these forward-looking statements.Forward-looking statements are identified by words such as “believe,” “anticipate,”“expect,” “intend,” “plan,” “will,” “may” and other similar expressions.  In addition, any statements that refer toexpectations, projections or other characterizations of future events orcircumstances are forward-looking statements. Forward-looking statementsinclude, but are not necessarily limited to, those relating to:

 

·                  ourability to find development and commercialization partners for Gabapentin GR®and other product candidates;

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

·                  thecommercial success and market acceptance of GLUMETZA® (metforminhydrochloride extended release tablets) in the United States;

·                  theefforts of Santarus, Inc. with respect to the commercialization ofGLUMETZA;

·                  theresults of our internal research and development efforts;

·                  acceptanceand approval of regulatory filings;

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

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

·                  theefforts of Watson Pharmaceuticals with respect to the commercialization ofProquin XR;

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

·                  ourplans to develop other product candidates.

 

Factors that could cause actual results or conditions to differ fromthose anticipated by these and other forward-looking statements include thosemore fully described in the “**RISK FACTORS**”section and elsewhere in this Quarterly Report on Form 10-Q. Wedisclaim any intent to update or revise these forward-looking statements toreflect new events or circumstances.

 

**ABOUTDEPOMED**

 

Depomed is a specialty pharmaceutical company focused on thedevelopment and commercialization of differentiated products that address largeand growing markets and are based on proprietary oral drug delivery technologies.  In 2004, we announced our determination toevolve from a solely product development focused company to an integratedspecialty pharmaceutical company, with sales and marketing of our own products.  Preliminary staffing for these activitiesbegan in 2005.  In 2006 and 2007, weenhanced our internal sales and marketing capabilities through the hiring ofadditional sales and marketing employees and the engagement of consultants.

 

We have developed two commercial products. GLUMETZA®(metformin hydrochloride extended release tablets) is a once-daily treatmentfor adults with type 2 diabetes that we currently commercialize alone in theUnited States, and will commercialize jointly with Santarus, Inc.(Santarus) beginning in the fourth quarter of 2008. Proquin® XR(ciprofloxacin hydrochloride extended release tablets) is a once-dailytreatment for uncomplicated urinary tract infections that we commercialize inthe United States with Watson Pharma (Watson).

 

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We have a three-pronged approach to product development designed tooptimize the use and value of our drug delivery technologies, while managingthe costs and risks associated with developing and commercializingpharmaceutical products. We develop products for our own account that aredesigned to compete in large growing markets and that can be highlydifferentiated from immediate release versions of the compounds upon which theyare based. Second, we selectively enter into collaborative partnerships withother companies where the unique capabilities of our technology can providesuperior value to a partner’s compound, resulting in significantly greatervalue for Depomed than a traditional fee-for-service arrangement. Third, weenter into arrangements that enable our technology to be applied by othercompanies to a greater number of compounds than our infrastructure can support,so as to derive additional value from our technology. In the future, we plan tocommercialize our proprietary products, relying on partners to cover the largeprimary care audiences, while maintaining co-promotion and distribution rightsin order to be in a position to create our own sales force when appropriate,thereby increasing the value to us of our products, and our control over them.

 

Our most advanced product candidate in development is Gabapentin GR, anextended release form of gabapentin. With respect to Gabapentin GR, we have completed a Phase 2 clinicaltrial for the treatment of women with menopausal hot flashes.  We have also completed a Phase 3 clinicaltrial for the treatment of postherpetic neuralgia (PHN), and have initiated asecond Phase 3 trial for the same indication. In addition, we have other product candidates in earlier stages ofdevelopment.

 

The following table summarizes our marketed products, and our productpipeline.

 

Marketed Products

 
| **Product**              | ** ** | **Indication**                        | ** ** | **Status(1)**                                                                                                                                                                                            |
|--------------------------|------------|---------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| GLUMETZA®           |       | Type 2 diabetes                       |       | Currently sold in the United States, Canada and  Korea.*Co-promoted in the US with Santarus beginning in  October 2008.  Canadian rights held by Biovail.  Korean rights held by LG Life Sciences.* |
|                     |       |                                  |       |                                                                                                                                                                                                     |
| Proquin® XR         |       | Uncomplicated urinary tract infection |       | Currently sold in the United States.

*Co-promoted in the US with Watson Pharma.*

* *

Regulatory application approved in Sweden.

*European rights held by Rottapharm/Madaus.*                    |
|                     |       |                                  |       |                                                                                                                                                                                                     |
| **Product  Pipeline**    |
| ** **               |
| Gabapentin GR®      |       | Postherpetic neuralgia                |       | Second Phase 3 study underway.                                                                                                                                                                           |
|                     |       |                                  |       |                                                                                                                                                                                                     |
|                     |       | Menopausal hot flashes                |       | Phase 2 study complete. Phase 3 study design and  endpoints agreed with the FDA.                                                                                                                         |
|                     |       |                                  |       |                                                                                                                                                                                                     |
|                     |       | Diabetic peripheral neuropathy        |       | Phase 2 study complete.                                                                                                                                                                                  |
|                     |       |                                  |       |                                                                                                                                                                                                     |
| Omeprazole               |       | Gastroesophageal reflux disease       |       | Phase 1a and Phase 2a proof of concept studies  completed.                                                                                                                                               |
|                     |       |                                  |       |                                                                                                                                                                                                     |
| Levodopa/Carbidopa       |       | Parkinson’s disease              |       | Preclinical development ongoing.                                                                                                                                                                         |
|                     |       |                                  |       |                                                                                                                                                                                                     |
| One undisclosed compound |       | Confidential                          |       | Preclinical development ongoing.                                                                                                                                                                         |

 

----

(1)             The sectionbelow entitled “Government Regulation” for additional information regarding thephases of drug development.

 

Ourintellectual property position includes ten issued patents and seventeen patentapplications pending in the United States.

 

***Significant Developments for the Quarter Ended June 30,2008.***

 

·                  In April 2008,we entered into a settlement and license agreement with Teva PharmaceuticalsUSA, Inc. (Teva) related to our patent infringement lawsuit against Tevaaffiliates IVAX Corporation and IVAX 

Pharmaceuticals, Inc. (IVAX). In connection with the agreement, we received a $7.5 million payment andare entitled up to $2.5 million in future royalties on Teva’s genericGlucophage® XR (metformin hydrochloride extended release tablets)product in the United States.

 

·                  In April 2008,Karen A. Dawes was appointed to the Company’s Board of Directors.

 

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·                  In June 2008,we entered into a $15.0 million credit facility with General Electric CreditCompany and Oxford Finance Corporation, and drew $3.8 million under thefacility. We drew an additional $5.6 million under the facility in July 2008.

 

·                  In June 2008,we held an end-of-Phase 2 meeting with the FDA related to our Phase 3registration program for Gabapentin GR in menopausal hot flashes.

 

·                  In June 2008,we received a Notice of Allowance from the United States Patent and TrademarkOffice for an additional patent application covering Gabapentin GR.

 

·                  Revenue for thethree months ended June 30, 2008 was $6.3 million, compared to $3.6million for the three months ended June 30, 2007.

 

·                  Operatingexpenses for the three months ended June 30, 2008 were $2.4 millioncompared to $12.5 million for the three months ended June 30, 2007.Operating expenses for the three months ended June 30, 2008 included aone-time gain of $7.5 million on litigation related to the IVAX settlement,which had the effect of reducing operating expenses for the quarter.

 

·                  Cash, cashequivalents and marketable securities were $71.2 million as of June 30,2008 compared to $69.5 million as of December 31, 2007.

 

**RECENTPRODUCT DEVELOPMENTS**

 

***MARKETED PRODUCTS***

 

***GLUMETZA®***

 

*Santarus, Inc.*In July 2008, we entered into a promotion agreement with Santarus, Inc.(Santarus) granting Santarus exclusive rights to promote GLUMETZA in the UnitedStates. Santarus paid us a $12 million upfront fee, and based on theachievement of specified levels of annual GLUMETZA net product sales, Santarusmay be required to pay us additional one-time sales milestones, totaling up to$16 million.

 

Santarus isrequired to train its field sales representatives on GLUMETZA, and to beginpromotion of GLUMETZA in the fourth quarter of 2008. Santarus is also requiredto meet certain minimum promotion obligations during the term of the agreement,and required to make certain minimum marketing, advertising, medical affairsand other commercial support expenditures. We will continue to record revenuefrom the sales of GLUMETZA product and, beginning in the fourth quarter of2008, will pay Santarus a fee ranging from 75% to 80% of the gross marginearned from net sales of GLUMETZA product in the United States.

 

Santarus will beresponsible for all costs associated with its sales force and for all othermarketing expenses associated with its promotion of GLUMETZA product. We willbe responsible for overseeing product manufacturing and supply. A jointcommercialization committee has been formed to oversee and guide the strategicdirection of the GLUMETZA alliance.

 

Pursuant to theterms of the promotion agreement, we retain the option to co-promote GLUMETZAproduct in the future to obstetricians and gynecologists. The promotionagreement will continue in effect until the expiration of the last-to-expirepatent or patent application with a valid claim in the territory covering aGLUMETZA product, unless terminated sooner.

 

*Contract Sales Organization*. In February 2008, we enteredinto a professional detailing services agreement with Publicis Selling Services(Publicis) pursuant to which approximately 33 part-time Publicis salesrepresentatives detail GLUMETZA to physicians. Publicis began detailing GLUMETZA to physicians in February 2008.The arrangement with Publicis is scheduled to end in September 2008.

 

*1000mg Formulation*.  In December 2007, the FDAapproved the 1000mg formulation for marketing in the United States.  In June 2008, we began selling the1000mg GLUMETZA.

 

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***Proquin® XR***

 

*Rottapharm/Madaus*.  In November 2005, we entered into adistribution and supply agreement for Proquin XR in Europe with a privatelyowned specialty pharmaceutical company, Madaus S.r.l., that was acquired byRottapharm in June 2007. Under the terms of the agreement, we granted anexclusive right to Madaus for the commercialization of Proquin XR in Europe andagreed to supply Madaus with commercial quantities of Proquin XR tablets inbulk form.  In March 2006, Madausfiled a Marketing Authorization Application for Proquin XR with the MedicalProducts Agency in Sweden. In July 2008, the Medical Products Agency inSweden approved the Marketing Authorization. We received a $0.3 million advancepayment from Rottapharm for supply of future product in August 2008.

 

***PRODUCT CANDIDATES***

 

## ***GabapentinGR*****®**

## * *

*Postherpetic Neuralgia*.  In March 2008, we initiated dosing ofthe first patient in a second Phase 3 clinical trial for Gabapentin GR forPHN.  The study is a randomized,double-blind, placebo-controlled study of approximately 450 PHN patients.  Patients in the study are randomized into twotreatment arms:  placebo, or 1800mg ofGabapentin GR dosed once daily. The study is being conducted at sites in theUnited States, Russia and Argentina.

 

The primary objective of the study is to assess theefficacy of Gabapentin GR in reducing the pain associated with PHN, measuredfrom baseline pain scores to the end of a ten-week treatment period on thebasis of the Likert pain scale.  Secondary objectives include anassessment of changes from baseline in sleep interference, and additionalpatient and clinician assessments of pain and quality of life.

 

The primary differences in the ongoing study relativeto the Phase 3 PHN study we concluded in 2007 are:  (a) there is only one active treatmentarm (1800 mg once daily) rather than two; and (b) patients enrolled in thestudy must have “stable PHN disease” for at least six months, rather than threemonths, following healing of the shingles rash.

 

*Menopausal Hot Flashes*.    In February 2008, weannounced positive results of our Phase 2 trial for Gabapentin GR formoderate-to-severe menopausal hot flashes.

 

*Phase 2 Study.*  In June 2007, we randomized the firstpatient in a Phase 2 double-blind, placebo-controlled, multi-center trialevaluating Gabapentin GR for the treatment of women with moderate-to-severemenopausal hot flashes.  The 124 patientstudy was fully enrolled in September 2007.

 

*Study Design.*The study included124 menopausal women (approximately 30 per group) with recurrent, moderate tosevere hot flashes and was conducted at eight sites in the United States.  The total study treatment duration after screeningand baseline was 13 weeks.  The primaryobjective of the study was to investigate the relationship between blood plasmaconcentrations of gabapentin observed in menopausal women after administrationof Gabapentin GR and the frequency of hot flashes in those women.  The plasma concentration data(pharmacokinetics) and the hot flash frequency and severity data(pharmacodynamics) are being used to construct a PK/PD dose response modeldesigned to identify the dosing regimen to utilize in the Phase 3 program.

 

In order to facilitate the generation of an optimal dose responsemodel, patients in each of the three active treatment arms remained on a stableGabapentin GR dose for five weeks at an initial dose, followed by five weeks ona stable, incrementally higher dose, as follows.

 
| **Treatment Group**           | ** ** | **Weeks 2 –  6** | ** ** | **Weeks 8 –  12** |
|-------------------------------|------------|-----------------------|------------|------------------------|
| A (“1800mg group”)  |       | 600mg PM              |       | 600mg AM+ 1200mg PM    |
| B (“2400mg group”)  |       | 600mg AM+ 600mg PM    |       | 600mg AM+ 1800mg PM    |
| C (“3000mg group”)  |       | 1200mg PM             |       | 1200mg AM+ 1800mg PM   |
| D (“placebo group”) |       | placebo               |       | placebo                |

 

Each stable dosing regimen was preceded by a one-week titration period

 

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*Efficacy*. Gabapentin GR demonstrated a reduction inthe mean frequency of moderate to severe hot flashes, and in the mean totaldaily severity of hot flashes, in all active treatment groups. Statisticalsignificance relative to placebo from baseline to the end of the study wasobserved in the 1800mg and 2400mg treatment groups with regard to frequency,and statistical significance was observed in the 1800mg treatment group withregard to severity. The severity of hot flashes is based on a mean dailycomposite score, where a moderate hot flash is assigned a score of “2” and asevere hot flash is assigned a score of “3”. The primary efficacy outcomesobserved in the study are set forth in the table below.

 
| ** **               | ** ** | **Mean Daily Frequency (#)** | ** ** | **Mean Total Daily Severity Score** | ** ** |
|--------------------------|------------|---------------------------------------------|------------|---------------------------------------------------------|------------|
| **Treatment Group** | ** ** | **Baseline**                                | ** ** | **End of treatment**                          | ** ** | **Baseline** | ** ** | **End of treatment** | ** ** |
| 1800mg                   |       | 10.1                                        |       | 2.7 (p = 0.016)                                         |       | 24.0 |   | 6.4 (p = 0.022) |   |
| 2400mg                   |       | 11.8                                        |       | 3.0 (p = 0.03)                                          |       | 29.6 |   | 7.9 (p = 0.063) |   |
| 3000mg                   |       | 11.4                                        |       | 3.9 (p = 0.229)                                         |       | 27.8 |   | 10.2 (p = 0.334) |   |
| placebo                  |       | 10.6                                        |       | 5.1                                                     |       | 26.7 |   | 12.6 |   |

 

*Safety. *GabapentinGR was generally well tolerated in the study, with one, two, one and threepatients, respectively, withdrawing due to adverse events from the placebo,1800mg, 2400mg and 3000mg groups.  Themost common side effects observed in the study were headache, somnolence,dizziness and nausea.  The incidence ofthose side effects in each of the treatment groups is set forth in the tablebelow.

 
| **Treatment Group** | ** ** | **Somnolence (%)** | ** ** | **Dizziness (%)** | ** ** | **Headache (%)** | ** ** | **Nausea (%)** | ** ** |
|--------------------------|------------|-------------------------|------------|------------------------|------------|-----------------------|------------|---------------------|------------|
| 1800mg                   |       | 16                      |       | 10                     |       | 32                    |       | 16                  |       |
| 2400mg                   |       | 16                      |       | 39                     |       | 32                    |       | 3                   |       |
| 3000mg                   |       | 16                      |       | 9                      |       | 25                    |       | 3                   |       |
| placebo                  |       | 3                       |       | 10                     |       | 10                    |       | 7                   |       |

 

*Phase 3 Registration Program. *In June 2008, we held an end-of-Phase 2 meeting with the FDA regardingour proposed Phase 3 registration program for Gabapentin GR in menopausal hotflashes, after which we finalized the design of the program.  The Phase 3registration program will include two randomized, double-blind,placebo-controlled studies of approximately 540 patients per study.  Ineach study, patients will be randomized into three treatment arms:  (i) placebo;(ii) 1200mg of Gabapentin GR dosed once daily; or (iii) a total doseof 1800mg of Gabapentin GR dosed 600mg in the morning and 1200mg in theevening.  The treatment duration in one of the studies will be threemonths.  The treatment duration in the other study will be six months, inorder to assess safety and persistence of efficacy.

 

The primary efficacy endpoints in both studies will be reductions inthe mean frequency of moderate to severe hot flashes, and the average severityof hot flashes, in both cases after four weeks and twelve weeks of stabletreatment.  Various secondary efficacy endpoints will be measured as well.

 

***OTHER RESEARCH AND DEVELOPMENT AND COLLABORATIVEPROGRAMS***

 

*Supernus*.  In September 2006, we entered into acollaboration agreement with Supernus Pharmaceuticals, Inc. to developthrough a Phase 1 study a product candidate leveraging our AcuForm drugdelivery technology.  The cost andownership of the program is shared between the parties equally. Thecollaboration agreement includes provisions pursuant to which the parties maynegotiate and enter into a definitive agreement for the further development andfor commercialization, by either or both parties, of the product candidate. Thefeasibility phase of the collaboration was completed in April 2008 andboth parties have elected not to continue to develop the product candidate.

 

***OTHER EVENTS***

 

*Patent Lawsuit Settlement**. *In April 2008, we entered into a Settlement and LicenseAgreement with Teva Pharmaceuticals USA, Inc. (collectively with itsaffiliates, Teva) related to the patent infringement lawsuit we filed againstTeva affiliates IVAX Corporation and IVAX Pharmaceuticals, Inc. in January 2006,in which we alleged infringement of the Company’s patents (US Patent Nos. 6,340,475and 6,635,280 (the Asserted Patents)) by IVAX’s extended release metforminhydrochloride tablets.

 

Pursuant to the settlement Agreement:  (a) the parties dismissed and releasedall claims associated with the litigation; (b) we received a one-time paymentof $7.5 million in April 2008; (c) we granted Teva a non-exclusivelicense to the Asserted Patents (including IVAX) to continue to market itsgeneric Glucophage® XR (metformin hydrochloride extended releasetablets) product in the United States under the Asserted Patents; and (d) wewill receive ongoing royalty payments from Teva on sales by Teva (includingIVAX) of generic Glucophage XR in the United States.  The royalty issubject to a $2.5 million aggregate cap.

 

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*Credit Facilit**y. *In June 2008, we entered into a $15.0 million secured creditfacility with General Electric Capital Corporation and Oxford FinanceCorporation.  The credit facility isdescribed below under “**LIQUIDITY AND CAPITALRESOURCES”.**

 

**CRITICAL ACCOUNTING POLICIES**

 

Criticalaccounting policies are those that require significant judgment and/orestimates by management at the time that the financial statements are preparedsuch that materially different results might have been reported if otherassumptions had been made. We consider certain accounting policies related torevenue recognition, accrued liabilities and stock-based compensation to becritical policies. Except as described below under “***Stock-BasedCompensation***”, there have been no changes to our criticalaccounting policies since we filed our 2007 Annual Report on Form 10-Kwith the Securities and Exchange Commission on March 12, 2008. For adescription of our critical accounting policies, please refer to our 2007Annual Report on Form 10-K.

 

***Stock-Based Compensation***

 

As of January 1, 2006, we began accounting for stock-basedcompensation in accordance with Statement of Financial Accounting Standards No. 123(revised 2004), *Share-Based Payment* (FAS 123(R)),using the modified prospective transition method. We use the Black-Scholesoption valuation model to estimate the fair value of stock options and EmployeeStock Purchase Plan (ESPP) shares. The Black-Scholes model requires the inputof highly subjective assumptions. The most significant assumptions are ourestimates of the expected volatility and the expected term of the award. Forour volatility assumption, we use the historical volatility of our common stockover the expected term of the options.

 

On adoption of FAS 123(R),we concluded that our historical share option exercise experience did notprovide a reasonable basis upon which to estimate expected term and estimatedthe expected term of options granted by taking the average of the vesting termand the contractual term of the option, as illustrated by the simplified methodin SEC Staff Accounting Bulletin (SAB) No. 107 (SAB 107).  SAB 107 allowed for use of the simplifiedmethod to estimate expected term through December 31, 2007, and we usedthe simplified method to estimate the expected term for fiscal years 2006 and2007. In December 2007, the SEC issued SAB 110, which extended the abilityfor companies to utilize the simplified method beyond December 31, 2007under limited circumstances. However, we elected to no longer utilize thesimplified method after December 31, 2007. At January 1, 2008, weconcluded again that our historical share option exercise experience did notprovide a reasonable basis upon which to estimate expected term because oflimited exercise history.  For optionsgranted after January 1, 2008, we have estimated the expected term byusing the weighted average of a peer group of companies that grant options withsimilar vesting provisions.  The expectedterm used for options granted after January 1, 2008 is 5.04 years.

 

As required, we review our valuation assumptions at each grant dateand, as a result, we are likely to change our valuation assumptions used tovalue employee stock-based awards granted in future periods. FAS 123(R) requiresthat employee and director stock-based compensation costs be recognized overthe vesting period of the award, and we have elected to use the straight-lineattribution method.

 

FAS 123(R) requires forfeitures to be estimated at the time ofgrant and revised, if necessary, in subsequent periods if actual forfeituresdiffer from those estimates. We estimated forfeitures based on historicalexperience. Prior to the adoption of FAS 123(R), pro forma information requiredunder FAS 123 included forfeitures as they occurred.

 

### **RESULTS OF OPERATIONS**

### ** **

*Three and Six MonthsEnded June 30, 2008 and 2007*

* *

### **Revenue**

### ** **

Totalrevenues are summarized in the following table (in thousands):

 

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| ** **              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **              | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Product sales:          |       |                                                |       |                                              |       |   |   |   |   |
| GLUMETZA                |       | $                                                   | 5,405      |                                              | $          | 2,502 |   | $ | 10,571 |   | $ | 3,833 |   |
| Proquin XR              |       | 114                                                 |       | —                                            |       | 174 |   | — |   |
| Total product sales     |       | 5,519                                               |       | 2,502                                             |       | 10,745 |   | 3,833 |   |
|                    |       |                                                |       |                                              |       |   |   |   |   |
| Royalties:              |       |                                                |       |                                              |       |   |   |   |   |
| GLUMETZA                |       | 72                                                  |       | 45                                                |       | 184 |   | 79 |   |
| Teva                    |       | 361                                                 |       | —                                            |       | 361 |   | — |   |
| Total royalties         |       | 433                                                 |       | 45                                                |       | 545 |   | 79 |   |
|                    |       |                                                |       |                                              |       |   |   |   |   |
| License revenue:        |       |                                                |       |                                              |       |   |   |   |   |
| GLUMETZA                |       | 363                                                 |       | 364                                               |       | 727 |   | 1,632 |   |
| Proquin XR              |       | —                                              |       | 695                                               |       | — |   | 1,391 |   |
| AcuForm technology |       | —                                              |       | —                                            |       | — |   | 500 |   |
| Total license revenue   |       | 363                                                 |       | 1,059                                             |       | 727 |   | 3,523 |   |
|                    |       |                                                |       |                                              |       |   |   |   |   |
| Collaborative revenue   |       | —                                              |       | 2                                                 |       | — |   | 2 |   |
|                    |       |                                                |       |                                              |       |   |   |   |   |
| Total revenues          |       | $                                                   | 6,315      |                                              | $          | 3,608 |   | $ | 12,017 |   | $ | 7,437 |   |

 

***Product sales***

 

TheGLUMETZA product that we sell to wholesalers and retail pharmacies is subjectto rights of return of up to twelve months after product expiration. Given thelimited sales history of GLUMETZA and return privileges, we currently cannotreliably estimate expected returns of the product at the time of shipment.  We defer recognition of revenue on productshipments of GLUMETZA until the right of return no longer exists, which occursat the earlier of the time GLUMETZA units are dispensed through patientprescriptions or expiration of the right of return. We estimate the volume ofprescription units dispensed by pharmacies based on an analysis of third-partyinformation, including third-party market research data and informationobtained from certain wholesalers with respect to inventory levels. For thethree and six months ended June 30, 2008, we recognized approximately $5.4million and $10.6 million of product sales of GLUMETZA, respectively, which isnet of estimated patient support program discounts, wholesaler fees, stockingallowances, prompt payment discounts, chargebacks and Medicaid rebates. We havedeferred recognition of revenue on GLUMETZA product shipments to customerswhich we estimate have not been dispensed through patient prescriptions. At June 30,2008, we have a deferred revenue balance, which is classified as a liability onthe consolidated balance sheet, of $8.0 million associated with the deferral ofrevenue on GLUMETZA product shipments, which is net of estimated wholesalerfees, retail pharmacy discounts and prompt payment discounts.

 

Theincrease in GLUMETZA product revenue for the three and six months ended June 30,2008 as compared to the three and six months ended June 30, 2007 is theresult of an additional year of promotional and marketing efforts related toGLUMETZA, as GLUMETZA was launched in September 2006. In October 2007,we terminated our promotion agreement related to GLUMETZA with King and King’spromotion obligations ended in December 2007. In February 2008, webegan detailing GLUMETZA through a contract sales organization, as we do nothave an established sales organization. Product sales for GLUMETZA relative toits current runrate will depend on the success of our promotion partner,Santarus. Santarus is required to begin promotion of GLUMETZA in the fourthquarter of 2008.

 

InOctober 2007, we re-launched Proquin XR with Watson, and began selling towholesalers and retail pharmacies. We defer recognition of revenue on productshipments of Proquin XR until the right of return no longer exists, whichoccurs at the earlier of the time Proquin XR units are dispensed throughpatient prescriptions or expiration of the right of return. At June 30,2008, we have a deferred revenue balance, which is classified as a liability onthe consolidated balance sheet, of $1.1 million associated with thedeferral of revenue on Proquin XR product shipments, which is net of estimatedwholesaler fees, retail pharmacy discounts, stocking allowances and promptpayment discounts.

 

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***Royalties***

 

GLUMETZAroyalties relate to royalties we received from Biovail based on net sales ofGLUMETZA in Canada and royalties we received from LG based on net sales of LG’sversion of GLUMETZA, Novamet GR, in Korea. We began receiving royalties fromBiovail in the first quarter of 2006 and from LG in the first quarter of 2007.

 

InApril 2008, we entered into a settlement and license agreement with Tevarelated to the patent infringement lawsuit against Teva affiliates IVAXCorporation and IVAX Pharmaceuticals, Inc. we initiated in January 2006related to Teva’s generic Glucophage XR tablets. In connection with thesettlement and license agreement we may receive up to $2.5 million in futureroyalties on Teva’s generic Glucophage XR product in the United States. For thequarter ended June 30, 2008, we recognized $0.4 million in royalty revenuerelated to this arrangement.

 

***License revenue***

 

Licenserevenue for the three and six months ended June 30, 2008 consisted solelyof license revenue recognized from the $25.0 million upfront license feereceived from Biovail in July 2005. We are recognizing the $25.0 millionlicense fee payment as revenue ratably until February 2023, whichrepresents the estimated length of time our obligations exist under thearrangement related to royalties we are obligated to pay Biovail on net salesof GLUMETZA in the United States and for our obligation to use Biovail as oursole supplier of the 1000mg GLUMETZA.

 

Licenserevenue for the three months ended June 30, 2007 consisted of revenuerecognized related to the Biovail agreement for GLUMETZA and Esprit Pharmaagreement for Proquin XR. License revenue for the six months ended June 30,2007 consisted of revenue recognized related to the Biovail agreement forGLUMETZA, the Esprit Pharma agreement for ProQuin XR, the LG Life Sciencesagreement for GLUMETZA, and the Biovail agreement related to our AcuForm drugdelivery technology.

 

Ourlicense agreement with Esprit for Proquin XR provided for $50.0 million inlicense fees from Esprit. We received $30.0 million in license fees in July 2005and an additional $10.0 million in December 2006. The final $10.0 millioninstallment was paid in July 2007. The first $40.0 million in license feesreceived were recognized as revenue ratably commencing on our receipt of thefees through June 2020, which represented the length of time we wereobligated to manufacture Proquin XR under our Proquin XR supply agreement withEsprit. In July 2007, we and Esprit terminated the license and supplyagreements, and all deferred revenue related to license fees previouslyreceived from Esprit was fully recognized as revenue in July 2007.

 

Wereceived a $0.6 million upfront license fee from LG in August 2004 and a$0.5 million milestone payment received in November 2006 with respect toLG’s approval to market LG’s version of GLUMETZA, Novamet GR, in the Republicof Korea. These payments were originally deferred and amortized as licenserevenue over the estimated length of time we were obligated to provideassistance in development and manufacturing. In January 2007, we amendedour agreement with LG, granted LG a license to certain of the Company’sintellectual property rights to manufacture the 500mg Novamet GR in exchangefor royalties on net sales of Novamet GR in Korea, and removed the provisionsof the original agreement providing for the supply of 500mg Novamet GR tabletsby us to LG. Under the amended agreement, we no longer have continuingperformance obligations to LG, and recognized the remaining $0.9 million ofpreviously deferred license revenue in the first quarter of 2007.

 

InFebruary 2007, we received $0.5 million from Biovail upon entering into alicense and development agreement with Biovail granting Biovail an option tolicense our AcuForm drug delivery technology to develop and commercializeup to two pharmaceutical products. We had no continuing performance obligationsunder the agreement and recognized the entire upfront license fee as revenue inthe first quarter of 2007.

 

**Cost ofSales**

 

Cost of sales consists of costs of the active pharmaceuticalingredient, contract manufacturing and packaging costs, inventory write-downs,product quality testing, internal employee costs related to the manufacturingprocess, distribution costs and shipping costs related to our product sales.Total cost of sales for the three and six months ended June 30, 2008, ascompared to the prior year, was as follows (in thousands):

 
| ** **    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **    | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Cost of sales |       | $                                                   | 962        |                                              | $          | 569 |   | $ | 2,171 |   | $ | 874 |   |
|               |            |                                                     |            |                                                   |            |  |  |  |  |  |  |  |  |

 

Cost of sales for the three and six months ended June 30, 2008 and2007 relates primarily to costs associated with the sale of GLUMETZA andProquin XR. Cost of sales increased in 2008 over 2007 primarily as a result ofan increase in GLUMETZA product sales. During the six months ended June 30,2008, cost of sales also included approximately $0.3 million in inventorywrite-downs related to slow moving Proquin XR inventory that we expect will notbe sold prior to its expiration date.

 

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The costs of manufacturing associated with deferred revenue on GLUMETZAand Proquin XR product shipments are recorded as deferred costs, which areincluded in inventory, until such time the related deferred revenue isrecognized.

 

**Researchand Development Expense**

 

Ourresearch and development expenses currently include costs for scientificpersonnel, supplies, equipment, outsourced clinical and other researchactivities, consultants, depreciation, facilities and utilities. The scope andmagnitude of future research and development expenses cannot be predicted atthis time for our product candidates in the early phases of research anddevelopment, as it is not possible to determine the nature, timing and extentof clinical trials and studies, the FDA’s requirements for a particular drugand the requirements and level of participation, if any, by potential partners.As potential products proceed through the development process, each step istypically more extensive, and therefore more expensive, than the previous step.Success in development therefore, generally results in increasing expendituresuntil actual product launch.

 

Totalresearch and development expense for the three and six months ended June 30,2008, as compared to the prior year, was as follows (in thousands):

 
| ** **                        | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Research and development expense  |       | $                                                   | 4,680      |                                              | $          | 6,129 |   | $ | 10,750 |   | $ | 14,701 |   |
| Dollar change from prior year     |       | (1,449                                              | )          |                                              |       | (3,951 | ) |   |   |
| Percentage change from prior year |       | (23.6                                               | )%         |                                              |       | (26.9 | )% |   |   |
|                                   |            |                                                     |            |                                                   |            |  |  |  |  |  |  |  |  |

 

The decrease in research and development expense for the three and sixmonths ended June 30, 2008 as compared to the three and six months ended June 30,2007 was primarily due to lower clinical research organization expenses relatedto our first Phase 3 clinical trial for Gabapentin GR for the treatment ofpostherpetic neuralgia, which was completed in the first half of 2007, and alsodue to lower headcount as a result of the implementation of a reduction inforce in September 2007. We commenced a second Phase 3 clinical trial forGabapentin GR for the treatment of postherpetic neuralgia during the firstquarter of 2008 and expect to commence a Phase 3 clinical trial for GabapentinGR for the treatment of menopausal hot flashes in the second half of 2008. Weexpect research and development expense to increase in subsequent quarters of2008.

 

Wecategorize our research and development expense by project. The table belowshows research and development costs for our major clinical developmentprograms, as well as other expenses associated with all other projects in ourproduct pipeline.

 
| ** **                              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                              | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Gabapentin GR (PHN)                     |       | $                                                   | 3,222      |                                              | $          | 3,668 |   | $ | 7,188 |   | $ | 10,109 |   |
| Gabapentin GR (Hot Flashes)             |       | 824                                                 |       | 1,269                                             |       | 2,240 |   | 1,936 |   |
| Other projects                          |       | 634                                                 |       | 1,192                                             |       | 1,322 |   | 2,656 |   |
| Total research and development expenses |       | $                                                   | 4,680      |                                              | $          | 6,129 |   | $ | 10,750 |   | $ | 14,701 |   |

 

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**Selling, General and AdministrativeExpense**

 

Selling,general and administrative expenses primarily consist of personnel expenses tosupport our operating activities, marketing and promotion expenses associatedwith GLUMETZA and Proquin XR, facility costs and professional expenses, such aslegal and accounting fees. Total selling, general and administrative expenses,as compared to the prior year, were as follows (in thousands):

 
| ** **                          | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                          | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Selling, general and administrative |       | $                                                   | 5,241      |                                              | $          | 6,323 |   | $ | 11,748 |   | $ | 12,550 |   |
| Dollar change from prior year       |       | (1,082                                              | )          |                                              |       | (802 | ) |   |   |
| Percentage change from prior year   |       | (17.1                                               | )%         |                                              |       | (6.4 | )% |   |   |
|                                     |            |                                                     |            |                                                   |            |  |  |  |  |  |  |  |  |

 

The decrease in selling,general and administrative expense for the three and six months ended June 30,2008 as compared to the three and six months ended June 30, 2007, wasprimarily due to a decrease in legal expenses related to our litigation withIVAX and a decrease in promotion fee expense, as we and King terminated our promotionagreement in October 2007, and we no longer are required to pay Kingpromotion fees related to GLUMETZA. Beginning in the fourth quarter of 2008, we are required to paypromotion fees to Santarus related to GLUMETZA and expect selling, general and administrativeexpense to increase in the second half of 2008.

 

**Gain onLitigation Settlement**

 

InApril 2008, we entered into a settlement and license agreement with Tevarelated to the patent infringement lawsuit filed by us against Teva affiliatesIVAX Corporation and IVAX Pharmaceuticals, Inc. The settlement agreementprovided for a one-time payment to us of $7.5 million, which we received in April 2008,and for a non-exclusive license in favor of Teva (including IVAX) to continueto market its generic Glucophage XR product in the United States.  We recognized the $7.5 million one-timepayment received as a gain on litigation within operating income during thesecond quarter of 2008.

 

**Interest Income and Expense**

 
| ** **                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **(in thousands)**       | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Interest and other income     |       | $                                                   | 553        |                                              | $          | 456 |   | $ | 1,356 |   | $ | 866 |   |
| Interest expense              |       | (5                                                  | )          | —                                            |       | (5 | ) | — |   |
| Net interest income (expense) |       | 548                                                 |       | 456                                               |       | 1,351 |   | 866 |   |
|                               |            |                                                     |            |                                                   |            |  |  |  |  |  |  |  |  |

 

Interest and otherincome increased during the three and six months ended June 30, 2008 ascompared to the corresponding periods in 2007 due to higher investment balancesin 2008 resulting from the receipt of $29.7 million in termination fees fromKing and $17.5 million in license and termination fees from Esprit in thesecond half of 2007. Interest expense relates to interest on the creditfacility we entered into in June 2008. We expect interest expense toincrease in subsequent quarters.

 

**LIQUIDITYAND CAPITAL RESOURCES**

** **
| **(in thousands)**                           | ** ** | **June 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Cash, cash equivalents and marketable  securities |       | $                       | 71,200     |                        | $          | 69,523 |   |
|                                                   |            |                         |            |                             |            |  |  |

 

Since inception through June 30,2008, we have financed our product development efforts and operations primarilyfrom private and public sales of equity securities and from license andtermination fees from collaborative and license partners.

 

In December 2006,we entered into a common stock purchase agreement with Azimuth Opportunity,Ltd., pursuant to which Azimuth is committed to purchase, from time to time andat our sole discretion, up to the lesser of (a) $30.0 million of ourcommon stock, or (b) 8,399,654 shares of common stock. InAugust 2008, the agreement was amended and the term of the agreement wasextended until December 2010. Sales to Azimuth under the agreement, if any,will be made at a price equal to the average closing price of our common stockover a given pricing period, minus a discount ranging from approximately 3.8%to 6.4%, which varies based on a threshold price set by us. Upon each sale ofthe our common stock to Azimuth under the agreement, we have also agreed to payReedland Capital Partners a placement fee equal to approximately 1.1% of theaggregate dollar amount of common stock purchased by Azimuth. Azimuth is notrequired to purchase our common stock when the price of our common stock isbelow $2 per share. As of June 30, 2008, we have not sold any common stockto Azimuth under this common stock purchase agreement.

 

In June 2008, weentered into a credit facility with General Electric Capital Corporation andOxford Finance Corporation. The credit facility is available in up to threetranches.  The first tranche of $3.8million was advanced us upon the closing of the loan agreement.  In July 2008, we received the secondtranche of $5.6 million. The third tranche of $5.6 million will be available tous until September 30, 2008, subject to the satisfaction of certainfinancial and clinical development milestones.

 

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We will be required to pay interest on thefirst tranche for the first six months at an interest rate of 11.59%.  Thereafter, we will be required to pay theprincipal on the first tranche, plus interest at such rate, in 30 equal monthlyinstallments. The second tranche is interest-only through December 31,2008, with principal and interest payable thereafter in 30 equal monthlyinstallments and has an interest rate of 11.59%.  The third tranche, if advanced to us, will beinterest-only through December 31, 2008, with principal and interestpayable thereafter in 33 equal monthly installments.  The interest rate on each of the thirdtranche shall be the greater of (i) 11.59% and (ii) the sum of (a) therate published by the Board of Governors of the Federal Reserve System inFederal Reserve Statistical Release H.15 entitled “Selected Interest Rates”under the heading “U.S. Government Securities/Treasury Constant Maturities” asthe three year treasuries constant maturities rate plus (b) 8.37%. As of June 30, 2008,advances on the credit facility were $3.8 million at an interest rate of11.59%.

 

In the event that we do not draw the entire$15.0 million available under the credit facility by September 30, 2008,we will be required to pay an unused line fee of 2% of any unused portion ofthe credit facility.  Our obligationsunder the Loan Agreement are secured by interests in all of our personalproperty, and proceeds from any intellectual property, but not by ourintellectual property.  The loanagreement contains conditions precedent that must be satisfied prior to anyborrowing and affirmative and negative covenants with which we mustcomply.  The loan agreement imposes restrictions with regards toadditional indebtedness, liens, various fundamental changes (including mergersand acquisitions), payments, investments, transactions with affiliates, andother limitations customary in secured credit facilities.  As of June 30, 2008, we were incompliance with such covenants. The loan agreement provides that events ofdefault will exist in certain circumstances, including failure to make paymentof principal or interest on the loans when required, failure to perform certainobligations under the loan agreement and related documents, defaults in certainother indebtedness and certain other events.  Upon an event of default,the principal amount of the loan may become due immediately.

 

As of June 30,2008, we have accumulated net losses of $138.7 million. We expect to continueto incur operating losses in 2008. We anticipate that our existing capitalresources will permit us to meet our capital and operational requirementsthrough at least the end of 2009. We base this expectation on our current operatingplan, which may change as a result of many factors.

 

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

 

·          salesof our marketed products;

·          expendituresrelated to our commercialization and development efforts;

·          financialterms of definitive license agreements or other commercial agreements we enterinto, if any;

·          resultsof research and development efforts;

·          changesin the focus and direction of our research and development programs;

·          technological advances;

·          resultsof clinical testing, requirements of the FDA and comparable foreign regulatoryagencies; and

·          acquisitionsor investment in complimentary businesses, products or technologies.

 

We will need substantial funds of our own or fromthird parties to:

 

·          conductresearch and development programs;

·          conductpreclinical and clinical testing; and

·          manufacture(or have manufactured) and market (or have marketed) our marketed products andproduct candidates.

 

Our existing capital resources may not besufficient to fund our operations until such time as we may be able togenerate sufficient revenues to support our operations. We have limited creditfacilities and, except for the common stock purchase agreement with Azimuth andour credit facility described above, we have no other committed sources ofcapital. To the extent that our capital resources are insufficient to meet ourfuture capital requirements, we will have to raise additional funds through thesale of our equity securities or from development and licensing arrangements tocontinue our development programs. We may be unable to raise suchadditional capital on favorable terms, or at all. If we raise additionalcapital by selling our equity or convertible debt securities, the issuance ofsuch securities could result in dilution of our shareholders’ equity positions.If adequate funds are not available we may have to:

 

·          delay,postpone or terminate clinical trials;

·          significantlycurtail commercialization of our marketed products or other operations; and/or

·          obtainfunds through entering into collaboration agreements on unattractive terms.

 

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The inability to raise additional capital would have amaterial adverse effect on our company.

 

### **Cash Flows from Operating Activities**

### ** **

Cash used in operating activities during the six months ended June 30,2008 was approximately $1.7 million, compared to cash used in operatingactivities of approximately $19.0 million for the six months ended June 30,2007. During the six months ended June 30, 2008 and 2007, cash used inoperating activities was primarily due to our net loss adjusted for stock-basedcompensation, depreciation expense and movements in working capital.

 

The decrease in cash used in operating activities for the six monthsended June 30, 2008 as compared to six months ended June 30, 2007 wasprimarily due to a decrease in net loss.

 

**CashFlows from Investing Activities**

 

Net cash provided by investing activities during the six months ended June 30,2008 was approximately $32.6 million and consisted primarily of a net decreasein marketable securities. Cash used in investing activities during the sixmonths ended June 30, 2007 was approximately $6.9 million and consistedprimarily of a net increase in marketable securities.

 

**Cash Flows from Financing Activities**

 

Cash provided byfinancing activities during the six months ended June 30,2008 was approximately $3.7 million compared tocash provided by financing activities of approximately $20.9 million for thesame period in 2007. For the six months ended June 30, 2008, cash provided by financing activities primarilyconsisted of proceeds from our credit facility. For the six months endedJune 30, 2007, cash provided by financingactivities consisted of $20.0 million in proceeds from our registereddirect offering in April 2007 and $0.9 million in cash proceeds fromexercises of stock options and our ESPP.

 

**ContractualObligations**

 

As of June 30,2008, our aggregate contractual obligations are as shown in the following table(in thousands):

 
| ** **                 | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **Total** | ** ** |
|----------------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|-----------|------------|
| Operating leases           |       | $                               | 1,521      |               | $          | 3,227              |       | $         | 961        |   | $ | 5,709 |   |
| Related party arrangements |       | 215                             |       | —             |       | —             |       | 215       |       |
| Purchase commitments       |       | 4,266                           |       | —             |       | —             |       | 4,266     |       |
|                       |       | $                               | 6,002      |               | $          | 3,227              |       | $         | 961        |   | $ | 10,190 |   |

 

At June 30, 2008,we had non-cancelable purchase orders and minimum purchase obligations ofapproximately $0.9 million under our manufacturing agreement with PatheonPuerto Rico, Inc. for the manufacture of the 500mg GLUMETZA and $0.8million under our supply agreement with Biovail for the supply of the 1000mgGLUMETZA. We also had a non-cancelable purchase order to purchase in January 2009approximately $2.6 million of gabapentin, the active ingredient in GabapentinGR, from a third-party supplier. The amounts disclosed only represent minimumpurchase requirements. Actual purchases are expected to exceed these amounts.

 

We have a consultingarrangement with John W. Fara, Ph.D., our former Chairman, President and ChiefExecutive and current member of the Company’s Board of Directors and areobligated to pay Dr. Fara $125,000 for consulting services for theremainder of 2008. We also have a consulting arrangement with John F. Hamilton,our former Vice President, Finance and Chief Financial Officer and areobligated to pay Mr. Hamilton $90,000 for consulting services through October 2008.

 

The contractualobligations reflected in this table exclude $3.2 million of contingentmilestone payments we may be obligated to pay in the future under oursublicense agreement with PharmaNova. These payments relate to variousmilestones for the product candidate under the sublicense agreement, includingdosing of the first patient in any Phase 3 trial, submission to the FDA of anNDA, and FDA approval of an NDA. The above table also excludes any futureroyalty payments we may be required to pay on products we have licensed or anypromotion fees associated with our promotion agreement with Watson.

 

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**ITEM 3. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

There have been no significant changes in ourmarket risk compared to the disclosures in Item 7A of our Annual Report on Form 10-Kfor the year ended December 31, 2007.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

***Evaluation of Disclosure Controls and Procedures***

 

An evaluation was performed under thesupervision and with the participation of our management, including the Company’sPresident and Chief Executive Officer along with its interim principalaccounting and financial officer, of the effectiveness of the design andoperation of our disclosure controls and procedures as of the end of the periodcovered by this quarterly report. Based on that evaluation, our management,including the Company’s President and Chief Executive Officer along with itsinterim principal accounting and financial officer, concluded that ourdisclosure controls and procedures were effective.

 

We review and evaluate the design andeffectiveness of our disclosure controls and procedures on an ongoing basis toimprove our controls and procedures over time and to correct any deficienciesthat we may discover in the future. Our goal is to ensure that our seniormanagement has timely access to all material financial and non-financialinformation concerning our business. While we believe the present design of ourdisclosure controls and procedures is effective to achieve our goal, futureevents affecting our business may cause us to significantly modify ourdisclosure controls and procedures.

 

***Changes in Internal Controls***

 

There were no changes in our internalcontrols over financial reporting during the quarter ended June 30, 2008that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

 

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**PART II– OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

***Depomed v. IVAX***

 

Until April 2008,we were involved in legal proceedings relating to some of our intellectualproperty rights.  In January 2006, we filed a complaint against IVAXCorporation (IVAX) in the U.S. District Court for the Northern District ofCalifornia for infringement of U.S. Patent Nos. 6,340,475 and 6,635,280, bothof which we own.  The patents relate toour AcuForm delivery technology.

 

In April 2008, weentered into a Settlement and License agreement with Teva Pharmaceuticals USA, Inc.,an affiliate of IVAX, related to the litigation.  Pursuant to the settlement Agreement:  (a) the parties dismissed the patentlitigation and released all claims associated with the litigation; (b) wereceived a one-time payment of $7.5 million in April 2008; (c) wegranted Teva a non-exclusive license to the Asserted Patents (including IVAX)to continue to market its generic Glucophage® XR (metforminhydrochloride extended release tablets) product in the United States under theAsserted Patents; and (d) we will receive ongoing royalty payments fromTeva on sales by Teva (including IVAX) of generic Glucophage XR in the UnitedStates.  The royalty is subject to a $2.5 million aggregate cap.

 

***Biovail and Depomed v. Apotex (Canadian Generic GLUMETZA Litigation)***

 

In December 2007,Apotex, Inc. (Apotex) filed the Canadian equivalent of an Abbreviated NewDrug Application in Canada seeking approval to market a generic version of the500mg formulation of GLUMETZA in Canada. Apotex’s regulatory filing alleges that certain of the Canadian patentsthat we have licensed to Biovail in connection with Biovail’s commercializationof GLUMETZA in Canada are invalid and unenforceable, and that Apotex’sformulation does not infringe our patents. Pursuant to the intellectual property enforcement provisions of ourCanadian license agreement with Biovail for GLUMETZA, Biovail has the firstright to prosecute, and pay for expenses related to, any Canadian litigationrelated to generic challenges to GLUMETZA. In January 2008, Biovail filed suit against Apotex in Canada inresponse to Apotex’s regulatory filing, and we have been joined to the lawsuitas a co-plaintiff with Biovail because we are the licensor of the patents atissue in the suit.  The initiation of thelawsuit automatically stays approval of Apotex’s formulation for 24months.  An adverse outcome in thismatter could substantially weaken our Canadian intellectual property.

 

**ITEM 1A. RISK FACTORS**

 

The risk factors presented below amend andrestate the risk factors previously disclosed in our Annual Report on Form 10-Kfor the year ended December 31, 2007.

 

The following factors, along with thosedescribed above under **“MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS –LIQUIDITY AND CAPITAL RESOURCES”** should be reviewed carefully, inconjunction with the other information contained in this Report and ourconsolidated financial statements. These factors, among others, could causeactual results to differ materially from those currently anticipated andcontained in forward-looking statements made in this Form 10-Q andpresented elsewhere by our management from time to time. See “Part I, Item2—Forward-Looking Information.”

 

**Our priorPhase 3 trial for Gabapentin GR failed to meet the primary efficacy endpointand there can be no assurance this product will be approved.**

 

In July 2007, we announced that our drugcandidate Gabapentin GR failed to meet the primary efficacy endpoint in a Phase3 trial for postherpetic neuralgia (PHN). In March 2008, we initiated another Phase 3 registration trial forthe product for the PHN indication.  Weare pursuing discussions with potential development and marketing partnersrelated to the continued development of Gabapentin GR for PHN.  However, we may not secure a development andmarketing arrangement on terms favorable to us, or at all.

 

We submitted to the FDA a protocol for aPhase 3 registration trial for Gabapentin GR to the FDA for a special protocolassessment, or SPA, pursuant to which we requested that the FDA assess whetherthe protocol is adequate to meet the scientific and regulatory requirements necessaryto support marketing approval of Gabapentin GR for PHN.  The FDA did provide us with guidance andcomments on our proposed protocol, but indicated that the protocol was noteligible for an SPA under FDA requirements. Accordingly, there can be no assurance that the FDA will approveGabapentin GR for PHN for marketing even if we meet the primary endpoint in ourcurrent Phase 3 trial.

 

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We will incur significant additional expensesand will not know for at least one to two years whether the drug is safe andeffective such that it could be approved for marketing.  Even if these trials are successful, theapproval date for the drug will not occur for at least 18 months, which meansthat we will not receive revenue from drug sales for a number of years, if atall.

 

**Our clinical trials may not demonstrate that Gabapentin GRfor menopausal hot flashes is safe and effective.  If our clinical trials of Gabapentin GR formenopausal hot flashes do not demonstrate safety and efficacy, or if theclinical trials are delayed or terminated, our business will be harmed.**

 

Togain regulatory approval from the FDA to market Gabapentin GR for menopausalhot flashes, our planned Phase 3 registration trials must demonstrate thesafety and efficacy of the product candidate. Clinical development is a long, expensive and uncertain process and is subjectto delays.  The results of our Phase 2clinical trial are not necessarily indicative of the results we will obtain inlater clinical trials.  Accordingly,future clinical trials may not demonstrate that Gabapentin GR is effective formenopausal hot flashes.

 

Inaddition, data obtained from pivotal clinical trials are susceptible to varyinginterpretations, which could delay, limit or prevent regulatory approval. Toobtain marketing approval, we may decide, or the FDA or other regulatoryauthorities may require us, to pursue additional pivotal clinical or otherstudies. These trials could significantly delay the approval andcommercialization of Gabapentin GR for menopausal hot flashes and would requireus to commit significant additional financial resources. Even after we conductthese additional clinical trials, we may not receive regulatory approval tomarket the product.

 

Manyother factors could delay or result in termination of our clinical trials,including:

 

·     negative or inconclusiveresults;

·     slow patient enrollment or patientnoncompliance with the protocol;

·     adverse medical events or sideeffects among patients during the clinical trials;

·     FDA inspections of our clinicaloperations; and

·     real or perceived lack ofeffectiveness or safety of the product candidate.

 

**We depend heavily on Santarus, Inc. for thesuccessful commercialization of GLUMETZA in the United States.**

 

In July 2008, we entered into a promotion agreement with Santarus, Inc.pursuant to which Santarus will promote GLUMETZA in the United States throughits sales force beginning in the fourth quarter of 2008. Under the agreement,in exchange for promotion fees, Santarus is required to market and promoteGLUMETZA to physicians in the United States, to deliver annual detail calls topotential GLUMETZA prescribers, and to maintain a sales force of a minimumsize.  Although we have retained rights to promote GLUMETZA toobstetricians/gynecologists, or ob/gyns, and to retain revenues fromincremental sales generated by ob/gyns, we call upon, ob/gyns generally do notprescribe significant amounts of metformin products.  In addition, we do not have any immediateplans to establish a sales force, or contract with a third party to act as oursales force, for the purpose of exercising our GLUMETZA co-promotionrights.  Accordingly, the success of thecommercialization of GLUMETZA will depend in large part on Santarus’ marketingand promotion efforts.  Factors that mayaffect the success of our promotion arrangement with Santarus include thefollowing:

 

·     Santarus may acquire or developalternative products;

·     Santarus may pursuehigher-priority programs, or change the focus of its marketing programs;

·     Santarus may in the futurechoose to devote fewer resources to GLUMETZA;

·     GLUMETZA may fail to achievegreater market acceptance; and

·     Santarus may fail to comply withits obligations under our promotion agreement.

 

Any of the preceding factors could affectSantarus’ commitment to the collaboration, which, in turn, could adversely affectthe commercial success of GLUMETZA.  Any failure to successfullycommercialize GLUMETZA could have a material adverse effect on our business,financial conditions, results of operations and cash flows.

 

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**Thedevelopment of drug candidates is inherently uncertain and we cannot be certainthat any of our product candidates will be approved for marketing or, if approved,will achieve market acceptance.**

 

We have the followingprograms in clinical development: Gabapentin GR for neuropathic pain,Gabapentin GR for menopausal hot flashes, and omeprazole for gastroesophagealreflux disease. We also have other product candidates in earlier stages ofdevelopment.

 

Our own product candidates and those of our collaborative partners aresubject to the risk that any or all of them may be found to be ineffective orunsafe, or otherwise may fail to receive necessary regulatoryclearances.  Additionally, clinical trial results in earlier trials may not beindicative of results that will be obtained in subsequent larger trials, as wasthe case with the Phase 3 trial for Gabapentin GR for the treatment ofpostherpetic neuralgia that we completed in 2007.

 

We are unable to predict whether any of these product candidates willreceive regulatory clearances or be successfully manufactured or marketed.  Further, due to the extended testing andregulatory review process required before marketing clearance can be obtained,the time frames for commercialization of any products are long anduncertain.  Even if these other productcandidates receive regulatory clearance, our products may not achieve ormaintain market acceptance. Also, substantially all of our product candidatesuse the AcuForm technology.  If itis discovered that the AcuForm technology could have adverse effects orother characteristics that indicate it is unlikely to be effective as adelivery system for drugs or therapeutics, our product development efforts andour business would be significantly harmed.

 

**We****depend on Watson Pharmaceuticals for the successfulcommercialization of Proquin XR in the United States.**

 

In July 2007, we granted Watson Pharmaceuticals co-exclusive marketingrights to Proquin XR in the United States for the urology specialty and long-term care sales channels. In September 2007,we expanded our promotion arrangement with Watson to include the ob/gynspecialty as well. As described above, we do not have a permanent commercialsales force and do not, for the foreseeable future, expect to have theresources to successfully promote Proquin XR on our own. Accordingly, we willdepend on Watson to successfully promote this drug. Our prior marketing partnerfor Proquin XR, Esprit Pharma, was unable to successfully commercialize ProquinXR following its initial launch in November 2005. As a result, we andEsprit agreed to terminate the license in July 2007. It is possible thatWatson could also have similar difficulties commercializing Proquin XR. IfWatson fails to successfully commercialize Proquin XR, our business,financial condition and results of operations may be materially and adverselyaffected.

 

**Wehave limited in-house sales and marketing resources, which we will require inorder to successfully co-promote GLUMETZA and Proquin XR through our own salesforce.**

 

Although we have engaged a contract sales organization to promoteGLUMETZA on a temporary basis, and we have the right to promote Proquin XRthrough our own sales force, or through third parties, we have no sales forceand limited marketing and sales staff. The success of our own promotion efforts for GLUMETZA, Proquin XR andany other product candidates that receive regulatory approval that we choose tomarket or co-market will require that we substantially enhance our in-housemarketing and sales force with technical expertise, or make arrangements withthird parties to perform these services for us.  The development of the infrastructureassociated with these activities involves substantial resources, andconsiderable attention of our management and key personnel. To the extent thatwe enter into marketing and sales arrangements with other companies, ourrevenues will depend on the efforts of others. These efforts may not be successful.  If we fail to fully develop marketing andsales capabilities, or enter into arrangements with third parties, our revenuesmay suffer.

 

**Weare responsible for the distribution of GLUMETZA and Proquin XR, and we havelimited experience with distribution of pharmaceutical products.**

 

We are responsible for the distribution of GLUMETZA and Proquin XR inthe United States.  Our in-housecommercial operations and distribution capabilities are limited.  In addition, we have entered intodistribution arrangements with third parties, including Cardinal Health,AmeriSource Bergen and McKesson, and we will depend on them to ensure that ourmarketed products are widely available. To continue to support our commercialization effort related to ourmarketed products, we must continue to enhance our internal commercialinfrastructure, and continue to contract with capable third parties to assistus in our commercialization efforts.  Thecontinued development of that infrastructure will also require substantialresources, which may divert the attention of our management and keypersonnel.  The efforts of third partieswith whom we contract for distribution of our products may not be successful.  Any failure on our part to successfullydevelop distribution capabilities could cause delays in product sales and incurincreased costs.

 

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**Wedepend on our marketing partners for the successful commercialization ofGLUMETZA in Canada and Korea, and of Proquin XR in Europe.**

 

We have licensed exclusive marketing rights to the 500mg GLUMETZA inCanada to Biovail, and in Korea to LG Life Sciences.  Biovail launched the 500mg GLUMETZA in Canadain November 2005, and LG launched a 500mg product in Korea in 2006 underthe trade name Novamet GR.  We have alsoentered into a supply and distribution agreement with Madaus, a companyacquired by Rottapharm in June 2007, related to the commercialization ofProquin XR in Europe. If our international commercial partners fail tosuccessfully commercialize products we have licensed to them, our business andfuture revenues may be adversely affected.

 

**Our credit facility contains operating covenants that mayrestrict our business and financing activities.**

 

We entered into a $15.0 million credit facility with OxfordFinance Corporation and General Electric Capital Corporation in June 2008.  We have drawn $9.4 million under the facilityas of August 5, 2008.  The creditfacility is secured by a pledge of all of our assets other than intellectualproperty, and contains a variety of operational covenants, includinglimitations on our ability to incur liens or additional debt, makedispositions, pay dividends, redeem our stock, make certain investments andengage in certain merger, consolidation or asset sale transactions andtransactions with affiliates, among other restrictions.  Any future debt financing we enter into mayinvolve similar or more restrictive covenants affecting our operations.  Our borrowings under the credit facility orany future debt financing we do will need to be repaid, which createsadditional financial risk for our company, particularly if our business, orprevailing financial market conditions, are not conducive to paying off orrefinancing our outstanding debt obligations. Furthermore, our failure tocomply with the covenants in the credit facility could result in an event ofdefault that, if not cured or waived, could result in the acceleration of allor a substantial portion of our debt, which could have a material adverseeffect on our cash position and significantly harm our business.

 

**Ourexisting resources may not be sufficient to fund our operations until such timeas we may be able to generate sufficient revenues to support our operations.**

 

Our existing capital resources may not be sufficient to fund ouroperations until such time as we may be able to generate sufficient revenues tosupport our operations.  We have limitedcredit facilities and, except for the $5.6 million undrawn portion of ourcredit facility with Oxford Finance Corporation and General Electric CapitalCorporation and our common stock purchase agreement with Azimuth, we have noother committed sources of capital.  Ourlate stage clinical development programs will require considerable financialresources, and we may not be successful in entering into development andmarketing arrangements in which a collaborative partner will pay for the costsof those programs. To the extent that our capital resources are insufficient tomeet our future capital requirements, we will have to raise additional fundsthrough the sale of our equity securities or from development and licensingarrangements to continue our development programs. We may be unable to raisesuch additional capital on favorable terms, or at all. If we raise additionalcapital by selling our equity or convertible debt securities, the issuance ofsuch securities could result in dilution of our shareholders’ equity positions.If adequate funds are not available we may have to:

 

·                  delay, postpone or terminate clinical trials;

·                  significantly curtail commercialization ofour marketed products or other operations; and/or

·                  obtain funds through entering intocollaboration agreements on unattractive terms.

 

The inability to raise additionalcapital could have a material adverse effect on our business.

 

**We areexpecting operating losses in the future.**

 

To date, we have recorded revenues from license fees, product sales,royalties, collaborative research and development arrangements and feasibilitystudies.  For the six months ended June 30,2008, we recorded total revenues of $12.0 million and for the years ended December 31,2007, 2006 and 2005, we recorded total revenue of $65.6 million, $9.6 million,and $4.4 million, respectively. For the six months ended June 30, 2008, weincurred a net loss of $3.8 million and for the years ended December 31,2006 and 2005 we incurred net losses of $39.7 million, and $24.5 million,respectively. The termination of our license agreement with Esprit in July 2007,including the accelerated recognition of previously deferred revenue under thearrangement, and termination fees received associated with the termination ofour promotion agreement with King have resulted in our reaching profitabilityin 2007.  In addition, primarily as aresult of the $7.5 million payment we received in the settlement of our patentinfringement lawsuit against IVAX Corporation, we were also profitable in thesecond quarter of 2008.  However, as wecontinue our research and development efforts, preclinical testing and clinicaltrial activities, we anticipate that we will incur operating losses in fiscalyear 2008.  Therefore, we expect ourcumulative losses to increase. These losses, among other things, have had, andwe expect that they will continue to have, an adverse impact on our totalassets, shareholders’ equity and working capital.

 

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**Ouroperating results may fluctuate and affect our stock price.**

 

The following factors will affect our operating results andmay result in a material adverse effect on our stock price:

 

·                  results of clinical trials for our productcandidates;

·                  announcements regarding development plans forour drug candidates, including Gabapentin GR;

·                  the degree of commercial success of GLUMETZAand Proquin XR;

·                  regulatory actions;

·                  adverse events related to our products,including recalls;

·                  interruptions of manufacturing or supply;

·                  results of litigation;

·                  developments concerning proprietary rights,including patents, infringement allegations and litigation matters;

·                  variations in revenues obtained fromcollaborative agreements, including milestone payments, royalties, license feesand other contract revenues;

·                  decisions by collaborative partners toproceed or not to proceed with subsequent phases of a collaboration or program;

·                  market acceptance of the AcuForm technology;

·                  adoption of new technologies by us or ourcompetitors;

·                  the introduction of new products by ourcompetitors;

·                  manufacturing costs and difficulties;

·                  third-party reimbursement policies; and

·                  the status of our compliance with theprovisions of the Sarbanes-Oxley Act of 2002.

 

As a result of these factors, our stock price may continue to bevolatile and investors may be unable to sell their shares at a price equal to,or above, the price paid. Additionally, any significant drops in our stockprice, such as the one we experienced following the announcement of ourGabapentin GR Phase 3 trial results, could give rise to shareholder lawsuits,which are costly and time consuming to defend against and which may adverselyaffect our ability to raise capital while the suits are pending, even if thesuits are ultimately resolved our favor.

 

**Ourcollaborative arrangements may give rise to disputes over commercialterms, contract interpretation and ownership of our intellectual property andmay adversely affect the commercial success of our products.**

 

We currently have a collaboration arrangement with Patheon, Inc.related to the potential development of product candidates for thirdparties.  We also have a developmentcollaboration agreement with Supernus, Inc. providing for the developmentof a product candidate through feasibility. However, neither we nor Supernus intend to further develop the productcandidate.  In addition, we have in thepast and may in the future enter into other collaborative arrangements,some of which have been based on less definitive agreements, such as memorandaof understanding, material transfer agreements, options or feasibilityagreements.  We may not execute definitiveagreements formalizing these arrangements. Collaborative relationships are generally complex and may give riseto disputes regarding the relative rights, obligations and revenues of theparties, including the ownership of intellectual property and associated rightsand obligations, especially when the applicable collaborative provisions havenot been fully negotiated and documented. Such disputes can delay collaborativeresearch, development or commercialization of potential products, and can leadto lengthy, expensive litigation or arbitration. The terms of collaborativearrangements may also limit or preclude us from developing products ortechnologies developed pursuant to such collaborations. Additionally, thecollaborators under these arrangements might breach the terms of their respectiveagreements or fail to prevent infringement of the licensed patents by thirdparties. Moreover, negotiating collaborative arrangements often takesconsiderably longer to conclude than the parties initially anticipate, whichcould cause us to enter into less favorable agreement terms that delay or deferrecovery of our development costs and reduce the funding available to supportkey programs.

 

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We may be unable to enter into futurecollaborative arrangements on acceptable terms, which would harm our ability todevelop and commercialize our current and potential future products. Further,even if we do enter into collaboration arrangements, it is possible that ourcollaborative partners may not choose to develop and commercializeproducts using the AcuForm technology. Other factors relating tocollaborations that may adversely affect the commercial success of ourproducts include:

 

·                  any parallel development by acollaborative partner of competitive technologies or products;

·                  arrangements with collaborativepartners that limit or preclude us from developing products or technologies;

·                  premature termination of acollaboration agreement; or

·                  failure by a collaborative partner todevote sufficient resources to the development and commercial sales of productsusing the AcuForm technology.

 

Our collaborative arrangements do not necessarilyrestrict our collaborative partners from competing with us or restrict theirability to market or sell competitive products. Our current and any futurecollaborative partners may pursue existing or other development-stageproducts or alternative technologies in preference to those being developed incollaboration with us. Our collaborative partners may also terminate theircollaborative relationships with us or otherwise decide not to proceed withdevelopment and commercialization of our products.

 

**We may be unable to protect our intellectualproperty and may be liable for infringing the intellectual property ofothers.**

 

Our success will depend in part on ourability to obtain and maintain patent protection for our products andtechnologies, and to preserve our trade secrets.  Our policy is to seek to protect ourproprietary rights, by, among other methods, filing patent applications in theUnited States and foreign jurisdictions to cover certain aspects of ourtechnology. We currently hold ten issued United States patents, and haveseventeen patent applications pending in the United States.  In addition,we are preparing patent applications relating to our expanding technology forfiling in the United States and abroad.  We have also applied for patentsin numerous foreign countries. Some of those countries have granted ourapplications and other applications are still pending. Our pending patentapplications may lack priority over others’ applications or may not result inthe issuance of patents. Even if issued, our patents may not be sufficientlybroad to provide protection against competitors with similar technologies andmay be challenged, invalidated or circumvented, which could limit our abilityto stop competitors from marketing related products or may not provide us withcompetitive advantages against competing products. We also rely on tradesecrets and proprietary know-how, which are difficult to protect. We seek toprotect such information, in part, through entering into confidentialityagreements with employees, consultants, collaborative partners and othersbefore such persons or entities have access to our proprietary trade secretsand know-how. These confidentiality agreements may not be effective in certaincases, due to, among other things, the lack of an adequate remedy for breach ofan agreement or a finding that an agreement is unenforceable. In addition, ourtrade secrets may otherwise become known or be independently developed bycompetitors.

 

Our ability to develop our technologies andto make commercial sales of products using our technologies also depends on notinfringing others’ patents or other intellectual property rights. We are notaware of any intellectual property claims against us.  However, thepharmaceutical industry has experienced extensive litigation regarding patentsand other intellectual property rights. For example, Pfizer has initiatedseveral suits against companies marketing generic gabapentin products, claimingthat these products infringe Pfizer’s patents. The results of this litigationcould adversely impact the commercialization of pharmaceutical products thatcontain gabapentin as an active pharmaceutical ingredient.  Also, patentsissued to third parties relating to sustained release drug formulations orparticular pharmaceutical compounds could in the future be asserted against us,although we believe that we do not infringe any valid claim of anypatents.  If claims concerning any of our products were to arise and itwas determined that these products infringe a third party’s proprietary rights,we could be subject to substantial damages for past infringement or be forcedto stop or delay our activities with respect to any infringing product, unlesswe can obtain a license, or we may have to redesign our product so that it doesnot infringe upon others’ patent rights, which may not be possible or couldrequire substantial funds or time.  Such a license may not be available onacceptable terms, or at all.  Even if we, our collaborators or ourlicensors were able to obtain a license, the rights may be nonexclusive, whichwould give our competitors access to the same intellectual property.  Inaddition, any public announcements related to litigation or interferenceproceedings initiated or threatened against us, even if such claims are withoutmerit, could cause our stock price to decline.

 

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From time to time, we may become aware ofactivities by third parties that may infringe our patents.  Infringementby others of our patents may reduce our market shares (if a related product isapproved) and, consequently, our potential future revenues and adversely affectour patent rights if we do not take appropriate enforcement action.  Wemay need to engage in litigation in the future to enforce any patents issued orlicensed to us or to determine the scope and validity of third-partyproprietary rights.  Our issued or licensed patents may not be held validby a court of competent jurisdiction. Whether or not the outcome of litigationis favorable to us, defending a lawsuit takes significant time, may beexpensive and may divert management attention from other business concerns. Wemay also be required to participate in interference proceedings declared by theUnited States Patent and Trademark Office for the purpose of determining thepriority of inventions in connection with our patent applications or otherparties’ patent applications. Adverse determinations in litigation orinterference proceedings could require us to seek licenses which may not beavailable on commercially reasonable terms, or at all, or subject us tosignificant liabilities to third parties.  If we need but cannot obtain alicense, we may be prevented from marketing the affected product.

 

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

 

Wehave an exclusive sublicense from PharmaNova, Inc. to a patent held by theUniversity of Rochester to develop and commercialize in the United States agabapentin product for the treatment of hot flashes associated withmenopause.  Because a method-of-usepatent, such as the patent we have sublicensed from PharmaNova, covers only aspecified use of a particular compound, not a particular composition of matter,we cannot prevent others from commercializing gabapentin.  Accordingly, physicians could prescribeanother manufacturer’s gabapentin to treat hot flashes in menopausal womenrather than Gabapentin GR, or pharmacists could seek to fill prescriptions forGabapentin GR with another manufacturer’s gabapentin.  Although any such “off-label” use wouldviolate our licensed patent, effectively monitoring compliance with ourlicensed patent may be difficult and costly.

 

**It is difficult to develop a successful product. If we do notdevelop a successful product we may not be able to raise additional funds.**

 

The drug development process is costly, time-consuming and subject tounpredictable delays and failures. Before we or others make commercial sales ofproducts using the AcuForm technology, other than GLUMETZA and Proquin XR,we, our current and any future collaborative partners will need to:

 

·                  conduct preclinical and clinical testsshowing that these products are safe and effective; and

·                  obtain regulatory approval from the FDA orforeign regulatory authorities.

 

We will have to curtail, redirect or eliminate our product developmentprograms if we or our collaborative partners find that:

 

·                  the AcuForm technology has unintended orundesirable side effects; or

·                  product candidates that appear promising inpreclinical or early-stage clinical studies do not demonstrate efficacy inlater-stage, larger scale clinical trials.

 

Even when or if our products obtain regulatory approval, successfulcommercialization requires:

 

·                  market acceptance;

·                  cost-effective commercial scale production;and

·                  reimbursement under private or governmentalhealth plans.

 

Any material delay or failure in the governmental approval processand/or the successful commercialization of our potential products wouldadversely impact our financial position and liquidity and would make itdifficult for us to raise financing on favorable terms, if at all.

 

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

 

For planning purposes, wesometimes estimate the timing of the accomplishment of various scientific,clinical, regulatory and other product development and commercializationgoals.  These milestones may include ourexpectations regarding the commercial launch of our products by us or our licensees, and the commencement orcompletion of scientific studies and clinical trials and the submission ofregulatory filings.  From time to time,we may publicly announce the expected timing of some of these milestones, suchas the completion of an ongoing clinical trial, the initiation of otherclinical programs, or the commercial launch of products.  All of these milestones are based on avariety of assumptions.  The actualtiming of these milestones can vary considerably from our estimates dependingon numerous factors, some of which are beyond our control, including:

 

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·                  our available capital resources;

·                  the efforts of our marketing partnerswith respect to the commercialization of our products;

·                  the rate of progress, costs andresults of our clinical trial and research and development activities,including the extent of scheduling conflicts with participating clinicians andclinical institutions and our ability to identify and enroll patients who meetclinical trial eligibility criteria;

·                  our receipt of approvals by the FDAand other regulatory agencies and the timing thereof;

·                  other actions by regulators;

·                  our ability to access sufficient,reliable and affordable supplies of components used in the manufacture of ourproduct candidates, including materials for our AcuForm technology; and

·                  the costs of ramping up andmaintaining manufacturing operations, as necessary.

 

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

 

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

 

We rely on clinicalinvestigators and clinical sites to enroll patients and other third parties tomanage our trials and to perform related data collection and analysis. However,we may be unable to control the amount and timing of resources that the clinicalsites that conduct the clinical testing may devote to our clinical trials.  If our clinical investigators and clinicalsites fail to enroll a sufficient number of patients in our clinical trials orfail to enroll them on our planned schedule, we will be unable to completethese trials or to complete them as planned, which could delay or prevent usfrom obtaining regulatory approvals for our product candidates.

 

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

 

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

 

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

 

Further, with respect to our approved products, onceregulatory approval is obtained, a marketed product and its manufacturer aresubject to continual review. The discovery of previously unknown problems witha product or manufacturer may result in restrictions on the product,manufacturer or manufacturing facility, including withdrawal of the productfrom the market. Manufacturers of approved products are also subject to ongoingregulation, including compliance with FDA regulations governing current GoodManufacturing Practices (cGMP). Failure to comply with manufacturingregulations can result in, among other things, warning letters, fines,injunctions, civil penalties, recall or seizure of products, total or partialsuspension of production, refusal of the government to renew marketingapplications and criminal prosecution.

 

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

 

All marketing activities associated with GLUMETZA and ProquinXR, as well as marketing activities related to any other products for which weobtain regulatory approval, will be subject to numerous federal and state lawsgoverning the marketing and promotion of pharmaceutical products. The FDA regulatespost-approval promotional labeling and advertising to ensure that theyconform to statutory and regulatory requirements. In addition to FDArestrictions, the marketing of prescription drugs is subject to laws andregulations prohibiting fraud and abuse under government healthcare programs.For example, the federal healthcare program antikickback statute prohibitsgiving things of value to induce the prescribing or purchase of products thatare reimbursed by federal healthcare programs, such as Medicare and Medicaid.In addition, federal false claims laws prohibit any person from knowinglypresenting, or causing to be presented, a false claim for payment to thefederal government. Under this law, the federal government in recent years hasbrought claims against drug manufacturers alleging that certain marketingactivities caused false claims for prescription drugs to be submitted tofederal programs. Many states have similar statutes or regulations, which applyto items and services reimbursed under Medicaid and other state programs, or,in some states, regardless of the payer. If we, or our collaborative partners,fail to comply with applicable FDA regulations or other laws or regulationsrelating to the marketing of our products, we could be subject to criminalprosecution, civil penalties, seizure of products, injunction, and exclusion ofour products from reimbursement under government programs, as well as otherregulatory actions against our product candidates, our collaborative partnersor us.

 

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

 

To market any of our products outside of the UnitedStates, we and our collaborative partners, including Madaus, are subject tonumerous and varying foreign regulatory requirements, implemented by foreignhealth authorities, governing the design and conduct of human clinical trialsand marketing approval for drug products. The approval procedure varies amongcountries and can involve additional testing, and the time required to obtainapproval may differ from that required to obtain FDA approval. The foreignregulatory approval process includes all of the risks associated with obtainingFDA approval set forth above, and approval by the FDA does not ensure approvalby the health authorities of any other country, nor does the approval byforeign health authorities ensure approval by the FDA.

 

**If we or our marketing partners are unable to obtainacceptable prices or adequate reimbursement for our products from third-partypayers, we will be unable to generate significant revenues.**

 

In both domestic and foreign markets, sales of ourproduct candidates will depend in part on the availability of adequatereimbursement from third-party payers such as:

 

·                  government health administrationauthorities;

·                  private health insurers;

·                  health maintenance organizations;

·                  pharmacy benefit managementcompanies; and

·                  other healthcare-relatedorganizations.

 

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

 

Federal and state governments in the United States andforeign governments continue to propose and pass new legislation designed tocontain or reduce the cost of healthcare. Existing regulations affectingpricing may also change before many of our product candidates are approved formarketing. Cost control initiatives could decrease the price that we receivefor any product we may develop.

 

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

 

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

 

Bristol-MyersSquibb is currently marketing a sustained release formulation of metformin,Glucophage XR, with which GLUMETZA competes. The limited license thatBristol-Myers Squibb obtained from us under our November 2002 settlementagreement extends to certain current and internally-developed future compounds,which may increase the likelihood that we will face competition fromBristol-Myers Squibb in the future on products in addition to GLUMETZA. Severalother companies, including Barr Pharmaceuticals, Inc., Mylan Laboratories, Inc.and Teva Pharmaceutical Industries, Ltd. have received FDA approval for and areselling a controlled-release metformin product.

 

Bayer Corporation developeda once-daily ciprofloxacin product for the treatment of urinary tractinfections, which is currently marketed by Schering-Plough Corporation. There arealso generic versions of that product on the market. There may be othercompanies developing products competitive with GLUMETZA and Proquin XR of whichwe are unaware.

 

Gabapentinis currently marketed by Pfizer as Neurontin for adjunctive therapy for epilepticseizures and for postherpetic pain. Pfizer’s basic U.S. patents relating toNeurontin have expired, and numerous companies have received approval to marketgeneric versions of the immediate release product. In addition, Pfizer hasdeveloped a new product, LyricaTM (pregabalin), which has been approved formarketing in the United States and the European Union.

 

Competitionin pharmaceutical products and drug delivery systems is intense. We expectcompetition to increase. Competing technologies or products developed in thefuture may prove superior to the AcuForm technology or products usingthe AcuForm technology, either generally or in particular market segments.These developments could make the AcuForm technology or products using theAcuForm technology noncompetitive or obsolete.

 

Mostof our principal competitors have substantially greater financial, sales,marketing, personnel and research and development resources than we do. Inaddition, many of our potential collaborative partners have devoted, andcontinue to devote, significant resources to the development of their own drugdelivery systems and technologies.

 

**We depend on third parties who are single sourcesuppliers to manufacture GLUMETZA, Proquin XR and our other productcandidates.  If these suppliers areunable to manufacture GLUMETZA, Proquin XR or our product candidates, ourbusiness will be harmed.**

 

We are responsible for the supply and distribution ofGLUMETZA, and Patheon, Puerto Rico, Inc., a subsidiary of Patheon, Inc.,is our sole supplier for tablets of the 500mg strength of GLUMETZA pursuant toa supply agreement we entered into with MOVA Pharmaceuticals in December 2006.  Biovail is our sole supplier for the 1000mgformulation GLUMETZA.  We will be unableto manufacture GLUMETZA in a timely manner if we are unable to obtain GLUMETZA500mg tablets from our contract manufacturer, active pharmaceutical ingredientfrom suppliers, or excipient suppliers, or GLUMETZA 1000mg tablets fromBiovail.

 

We are also responsible for supply and distribution ofProquin XR.  For the manufacture ofProquin XR tablets, we have entered into an agreement with Patheon, Puerto Rico,Inc., as our sole supplier. We purchase the active ingredient for Proquin XRfrom Uquifa Mexico, S.A., a sole supplier to us, on a purchase order basis. Wewill also be responsible for the manufacture of bulk Proquin XR tablets toMadaus for the European market, if the product is approved for marketing inEuropean jurisdictions.  We intend topurchase Proquin XR tablets from Patheon, Puerto Rico, Inc. for that purpose.If we are unable, for whatever reason, to obtain the active pharmaceuticalingredient or Proquin XR tablets from our contract manufacturers, we may beunable to manufacture Proquin XR in a timely manner, if at all.

 

Although we have obtained clinical batches ofGabapentin GR from a contract manufacturer, we currently have no long-termsupply arrangement with respect to Gabapentin GR.  Any failure to obtain clinical supplies of GabapentinGR could adversely affect our Gabapentin GR clinical development programs.

 

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**We depend on third parties to manufacture ourproducts, which could adversely affect our ability to deliver our products tomarket on a timely or competitive basis.**

 

We do not have, and we do not intend to establish inthe foreseeable future, internal commercial scale manufacturing capabilities.Rather, we intend to use the facilities of third parties to manufactureproducts for Phase 3 clinical trials and commercialization. Our dependenceon third parties for the manufacture of products using the AcuForm technologymay adversely affect our ability to deliver such products on a timely orcompetitive basis.  The manufacturingprocesses of our third party manufacturers may be found to violate theproprietary rights of others. If we are unable to contract for a sufficientsupply of required products on acceptable terms, or if we encounter delays anddifficulties in our relationships with manufacturers, the market introductionand commercial sales of our products will be delayed, and our future revenuewill suffer.

 

**A successful product liability claim against uscould materially harm our business.**

 

Ourbusiness involves exposure to potential product liability risks that areinherent in the development and production of pharmaceutical products. We haveobtained product liability insurance for clinical trials currently underway andforecasted 2008 sales of our products, but:

 

·                  we may be unable to obtain productliability insurance for future trials;

·                  we may be unable to obtain productliability insurance for future products;

·                  we may be unable to maintain productliability insurance on acceptable terms;

·                  we may be unable to secure increasedcoverage as the commercialization of the AcuForm technology proceeds; or

·                  our insurance may not provide adequateprotection against potential liabilities.

 

Ourinability to obtain adequate insurance coverage at an acceptable cost couldprevent or inhibit the commercialization of our products. Defending a lawsuitwould be costly and significantly divert management’s attention from conductingour business. If third parties were to bring a successful product liabilityclaim or series of claims against us for uninsured liabilities or inexcess of insured liability limits, our business, financial condition andresults of operations could be materially harmed.

 

**Our success is dependent in large part upon thecontinued services of our CEO and senior management with whom we do not haveemployment agreements.**

 

Oursuccess is dependent in large part upon the continued services of our Presidentand Chief Executive Officer, Carl A. Pelzel, and other members of our executivemanagement team, and on our ability to attract and retain key management andoperating personnel. We do not have agreements with Mr. Pelzel or any ofour other executive officers that provide for their continued employment withus. Our former Chairman, President and Chief Executive Officer retired in August 2007,and our Chief Financial Officer retired in October 2007, and our ChiefFinancial Officer has not yet been replaced on a permanent basis.  We may have difficulty filling open seniorscientific, financial and commercial positions. Management, scientific andoperating personnel are in high demand in our industry and are often subject tocompeting offers. The loss of the services of one or more members of managementor key employees or the inability to hire additional personnel as needed couldresult in delays in the research, development and commercialization of ourproducts and potential product candidates.

 

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

 

Our success depends on our ability to continuallyenhance and broaden our product offerings in response to changing customerdemands, competitive pressures and technologies. Accordingly, we may in thefuture pursue the acquisition of complementary businesses, products ortechnologies instead of developing them ourselves. We have no currentcommitments with respect to any acquisition or such investment. We do not knowif we would be able to successfully complete any acquisitions, or whether wewould be able to successfully integrate any acquired business, product ortechnology or retain any key employees. Integrating any business, product ortechnology we acquire could be expensive and time consuming, disrupt ourongoing business and distract our management. If we were to be unable tointegrate any acquired businesses, products or technologies effectively, ourbusiness would suffer. In addition, any amortization or charges resulting fromthe costs of acquisitions could harm our operating results.

 

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**We have implemented certainanti-takeover provisions.**

 

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

 

We have adopted a shareholder rights plan, commonlyknown as a “poison pill”. The provisions described above, our poison pill andprovisions of the California General Corporation Law may discourage, delay orprevent a third party from acquiring us.

 

**Increased costs associated with corporate governancecompliance may significantly impact our results of operations.**

 

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

 

These developments could make it more difficult for usto attract and retain qualified members of our board of directors, or qualifiedexecutive officers.  We are presentlyevaluating and monitoring regulatory developments and cannot estimate thetiming or magnitude of additional costs we may incur as a result.  To the extent these costs are significant,our selling, general and administrative expenses are likely to increase.

 

**If we sell shares of our common stock under ourequity line of credit arrangement or in other future financings, existingcommon shareholders will experience immediate dilution and, as a result, ourstock price may go down.**

 

We may from time to time issue additional shares ofcommon stock at a discount from the current trading price of our commonstock.  As a result, our existing commonshareholders will experience immediate dilution upon the purchase of any sharesof our common stock sold at such discount. For example, in December 2006, we entered into a common stockpurchase agreement with Azimuth Opportunity Ltd., pursuant to which we may sellshares of common stock at a discount to the prevailing market price rangingfrom approximately 3.8% to 6.4%, excluding an additional placement agent fee ofapproximately 1.1% payable by us on the gross offering proceeds. In addition,as other capital raising opportunities present themselves, we may enter intofinancing or similar arrangements in the future, including the issuance of debtsecurities, preferred stock or common stock. If we issue common stock orsecurities convertible into common stock, our common shareholders willexperience dilution and this dilution will be greater if we find it necessaryto sell securities at a discount to prevailing market prices.

 

**If we are unable to satisfy regulatory requirementsrelating to internal controls, our stock price could suffer.**

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires companiesto conduct a comprehensive evaluation of their internal control over financial reporting.  At the end of each fiscal year, we mustperform an evaluation of our internal control over financial reporting, includein our annual report the results of the evaluation, and have our externalauditors publicly attest to such evaluation. If material weaknesses were found in our internal controls in thefuture, if we fail to complete future evaluations on time, or if our externalauditors cannot attest to our future evaluations, we could fail to meet ourregulatory reporting requirements and be subject to regulatory scrutiny and aloss of public confidence in our internal controls, which could have an adverseeffect on our stock price.

 

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**Business interruptions could limitour ability to operate our business.**

 

Our operations arevulnerable to damage or interruption from computer viruses, human error,natural disasters, telecommunications failures, intentional acts of vandalismand similar events. In particular, our corporate headquarters are located inthe San Francisco Bay area, which has a history of seismic activity. We havenot established a formal disaster recovery plan, and our back-up operations andour business interruption insurance may not be adequate to compensate us for lossesthat occur. A significant business interruption could result in losses ordamages incurred by us and require us to cease or curtail our operations.

 

**ITEM 2.****    ****UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

In April 2008, weissued 160,476 shares of our common stock to a warrant holder in connectionwith a cashless exercise feature related to the exercise of warrants topurchase 419,154 shares of our common stock. The warrants were among thoseissued to accredited investors in April 2003 in a previously disclosedprivate placement transaction exempt from registration under the provisions of Rule 506of Regulation D promulgated under the Securities Act of 1933, as amended. Theresale of the shares issued upon the exercise of the warrants has beenregistered on an effective Form S-3 registration statement we filed withthe SEC on May 2, 2003.

 

**ITEM 3.****    ****DEFAULTS UPON SENIOR SECURITIES**

 

Not applicable.

 

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**ITEM 4.****    ****SUBMISSION OF MATTERS TO A VOTEOF SECURITY HOLDERS**

 

The Company held its annual meeting ofshareholders on May 23, 2008 to consider and vote on the followingproposals: (i) the election of directors until the next annual meeting ofshareholders (Proposal 1); (ii) an amendment of the 2004 Equity IncentivePlan (the “2004 Plan”) to increase the number of shares of common stockissuable under the 2004 Plan by an additional 1,750,000 shares to an aggregateof 6,750,000 shares (Proposal 2); and (iii) the ratification of Ernst &Young LLP as the independent registered public accounting firm of the Companyfor the fiscal year ending December 31, 2008 (Proposal 3).

 

Proposal 1:   Theshareholders of Depomed elected eight directors to serve until the next annualmeeting of shareholders.  The votesregarding the election of directors were as follows:

 
| ** **              | ** ** | **Shares Voted For** | ** ** | **Votes Withheld** | ** ** |
|-------------------------|------------|--------------------------------|------------|-------------------------|------------|
| Craig R. Smith, M.D.    |       | 35,316,300                     |       | 2,101,489               |       |
| G. Steven Burrill       |       | 35,838,308                     |       | 1,579,481               |       |
| Karen A. Dawes          |       | 36,771,789                     |       | 646,000                 |       |
| Carl A. Pelzel          |       | 36,765,762                     |       | 652,027                 |       |
| James A. Schoeneck      |       | 36,759,039                     |       | 658,750                 |       |
| Peter D. Staple         |       | 36,764,909                     |       | 652,880                 |       |
| Julian N. Stern         |       | 33,165,348                     |       | 4,252,441               |       |
| David B. Zenoff, D.B.A. |       | 36,037,513                     |       | 1,380,276               |       |

 

Proposal 2:  Theshareholders of Depomed approved the amendment of the 2004 Plan to increase thenumber of shares of common stock issuable under the 2004 Plan by an additional1,750,000 shares to an aggregate of 6,750,000 shares with the following votes:

 
| For     |   | 19,650,593 |   |
|---------|--------|------------|--------|
| Against |   | 5,156,824  |   |
| Abstain |   | 10,614     |   |

 

Proposal 3:  Theshareholders of Depomed approved the appointment of Ernst & Young LLPas the independent registered public accounting firm of the Company for thefiscal year ending December 31, 2008 with the following votes:

 
| For     |   | 37,229,219 |   |
|---------|--------|------------|--------|
| Against |   | 160,834    |   |
| Abstain |   | 27,736     |   |

 

**ITEM 5.****    ****OTHER INFORMATION**

 

In August 2008, the Company and Azimuth Opportunity Ltd. amended thecommon stock purchase agreement entered into in December 2006, extending theterm of the agreement until December 2010. The common stock purchase agreementis described under “**LIQUIDITY AND CAPITALRESOURCES**”.

 

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**ITEM 6. EXHIBITS**

 
| (a)    |   | Exhibits |                                                                                                                                             |
|--------|--------|----------|--------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   | 10.1*    | Settlement  and License Agreement dated April 4, 2008 between the Company and Teva  Pharmaceuticals USA, Inc.                          |
|   |   | 10.2     | 2004  Equity Incentive Plan                                                                                                                      |
|   |   | 10.3     | Lease Extension Agreement dated March 18, 2008 between the  Company and Menlo Business Park, LLC                                            |
|   |   | 10.4     | Second  Lease Extension Agreement dated March 18, 2008 between the Company and  Menlo Business Park, LLC                                    |
|   |   | 10.5     | Third  Lease Extension Agreement dated March 18, 2008 between the Company and  Menlo Business Park, LLC                                     |
|   |   | 10.6*    | Loan  and Security Agreement dated June 27, 2008 between the Company, General  Electric Capital Corporation and Oxford Finance Corporation  |
|   |   | 10.7*    | Promotion  Agreement dated July 21, 2008 between the Company and  Santarus, Inc.                                                       |
|   |   | 10.8     | Amendment No. 1 to Common Stock Purchase Agreement between the  Company and Azimuth Opportunity Ltd., dated as of August 8, 2008. |
|   |   | 31.1     | Certification  pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934  of Carl A. Pelzel                                 |
|   |   | 31.2     | Certification  pursuant to Rule 13a-14(a) under the Securities Exchange Act of  1934 of Tammy L. Cameron                               |
|   |   | 32.1     | Certification  pursuant to 18 U.S.C. Section 1350 of Carl A. Pelzel                                                                         |
|   |   | 32.2     | Certification  pursuant to 18 U.S.C. Section 1350 of Tammy L. Cameron                                                                       |

 

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* Confidential Treatment Requested

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##### **SIGNATURES**

##### ** **

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
| Date:  August 8, 2008 | DEPOMED, INC.             |
|----------------------------|--------------------------------|
|                       |                           |
|                       |                           |
|                       | /s/  Carl A. Pelzel            |
|                       | Carl  A. Pelzel                |
|                       | President  and                 |
|                       | Chief  Executive Officer       |
|                       |                           |
|                       |                           |
|                       | /s/  Tammy L. Cameron          |
|                       | Tammy  L. Cameron              |
|                       | Corporate  Controller          |
|                       | (Interim  Principal Accounting |
|                       | and  Financial Officer)        |

 

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