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 SEPTEMBER 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 ITS CHARTER)

 

| **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, INCLUDING AREA 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 |
|------------------|--------|-----------------|

 

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

 

| 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 |
|------------------|--------|-----------------|

 

The number of issued andoutstanding shares of the Registrant’s Common Stock, no par value, as of November 6,2008 was 51,055,453.

 

 

 

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Table of Contents

 

**DEPOMED, INC.**

 
| ** **                                                                                                                                | **PAGE**   |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                                                      |       |
| **PART I – FINANCIAL INFORMATION**                                                                                              | ** ** |
|                                                                                                                                      |       |
| Item 1. Condensed Consolidated Financial Statements:                                                                                      |       |
|                                                                                                                                      |       |
| Condensed Consolidated Balance Sheets at  September 30, 2008 (unaudited) and December 31, 2007                                  | 3          |
|                                                                                                                                      |       |
| Condensed  Consolidated Statements of Operations for the three and nine-month periods  ended September 30, 2008 and 2007 (unaudited) | 4          |
|                                                                                                                                      |       |
| Condensed  Consolidated Statements of Cash Flows for the nine-month periods ended  September 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                                       | 17         |
|                                                                                                                                      |       |
| Item 3. Quantitative  and Qualitative Disclosure About Market Risk                                                                        | 30         |
|                                                                                                                                      |       |
| Item 4. Controls and  Procedures                                                                                                          | 30         |
|                                                                                                                                      |       |
| **PART II – OTHER INFORMATION**                                                                                                 | ** ** |
|                                                                                                                                      |       |
| Item 1. Legal Proceedings                                                                                                                 | 32         |
|                                                                                                                                      |       |
| Item  1A. Risk Factors                                                                                                                    | 32         |
|                                                                                                                                      |       |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                                                      | 43         |
|                                                                                                                                      |       |
| Item 3.  Defaults upon Senior Securities                                                                                                  | 43         |
|                                                                                                                                      |       |
| Item 4.  Submission of Matters to a Vote of Security Holders                                                                              | 43         |
|                                                                                                                                      |       |
| Item 5. Other Information                                                                                                                 | 43         |
|                                                                                                                                      |       |
| Item  6. Exhibits                                                                                                                         | 44         |
|                                                                                                                                      |       |
| Signatures                                                                                                                                | 45         |

 

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**PART I– FINANCIAL INFORMATION**

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

###### ** **

**DEPOMED, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands, except share and per share amounts)**

 
| ** **                                                                                                                                                                                                                                                                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                          | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                                                                                                                                          | ** ** | **(Unaudited)**        | ** ** | **(1)**               | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                          | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                           |       | $                      | 14,120     |                  | $          | 14,374 |   |
| Marketable securities                                                                                                                                                                                                                                                               |       | 71,332                 |       | 39,091                |       |
| Accounts receivable                                                                                                                                                                                                                                                                 |       | 3,612                  |       | 3,390                 |       |
| Unbilled accounts receivable                                                                                                                                                                                                                                                        |       | 510                    |       | 233                   |       |
| Inventories                                                                                                                                                                                                                                                                         |       | 3,008                  |       | 3,263                 |       |
| Prepaid and other current assets                                                                                                                                                                                                                                                    |       | 3,111                  |       | 2,418                 |       |
| Total current assets                                                                                                                                                                                                                                                                |       | 95,693                 |       | 62,769                |       |
| Marketable securities                                                                                                                                                                                                                                                               |       | —                 |       | 16,058                |       |
| Property and equipment, net                                                                                                                                                                                                                                                         |       | 1,116                  |       | 1,621                 |       |
| Other assets                                                                                                                                                                                                                                                                        |       | 197                    |       | 197                   |       |
|                                                                                                                                                                                                                                                                                |       | $                      | 97,006     |                  | $          | 80,645 |   |
| ** **                                                                                                                                                                                                                                                                          | ** ** | ** **             | ** ** | ** **            | ** ** |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                                                                                                                                      | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                                |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                                                                                                                    |       | $                      | 1,345      |                  | $          | 1,134 |   |
| Accrued compensation                                                                                                                                                                                                                                                                |       | 1,930                  |       | 1,558                 |       |
| Accrued clinical trial expense                                                                                                                                                                                                                                                      |       | 844                    |       | 322                   |       |
| Other accrued liabilities                                                                                                                                                                                                                                                           |       | 5,129                  |       | 3,322                 |       |
| Deferred product sales                                                                                                                                                                                                                                                              |       | 1,437                  |       | 6,489                 |       |
| Deferred license revenue                                                                                                                                                                                                                                                            |       | 2,529                  |       | 1,453                 |       |
| Other current liabilities                                                                                                                                                                                                                                                           |       | 302                    |       | 56                    |       |
| Current portion of long-term debt                                                                                                                                                                                                                                                   |       | 2,621                  |       | —                |       |
| Total current liabilities                                                                                                                                                                                                                                                           |       | 16,137                 |       | 14,334                |       |
| Deferred license revenue, non-current portion                                                                                                                                                                                                                                       |       | 30,376                 |       | 20,763                |       |
| Long-term debt, net of current portion                                                                                                                                                                                                                                              |       | 6,499                  |       | —                |       |
| Other long-term liabilities                                                                                                                                                                                                                                                         |       | 598                    |       | 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 September 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; 48,140,927  and 47,865,529 shares issued and outstanding at September 30, 2008 and  December 31, 2007, respectively                                                                                            |       | 170,527                |       | 168,287               |       |
| Accumulated deficit                                                                                                                                                                                                                                                                 |       | (138,965               | )          | (134,892              | )          |
| Accumulated other comprehensive (loss) gain                                                                                                                                                                                                                                         |       | (181                   | )          | 110                   |       |
| Total shareholders’ equity                                                                                                                                                                                                                                                     |       | 43,396                 |       | 45,520                |       |
|                                                                                                                                                                                                                                                                                |       | $                      | 97,006     |                  | $          | 80,645 |   |

 

----

(1) Derived from the audited consolidated financial statementsincluded in 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 CONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, except share and per share amounts)**

**(Unaudited)**

 
| ** **                                                                          | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                          | ** ** | **2008**                                  | ** ** | **2007**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues:                                                                           |       |                                      |       |                                     |       |   |   |   |   |
| Product sales                                                                       |       | $                                         | 13,011     |                                     | $          | 3,832 |   | $ | 23,756 |   | $ | 7,666 |   |
| Royalties                                                                           |       | 516                                       |       | 2,546                                    |       | 1,060 |   | 2,625 |   |
| License revenue                                                                     |       | 584                                       |       | 46,481                                   |       | 1,311 |   | 50,003 |   |
| Collaborative and other revenue                                                     |       | —                                    |       | 1                                        |       | — |   | 3 |   |
| Total revenues                                                                      |       | 14,111                                    |       | 52,860                                   |       | 26,127 |   | 60,297 |   |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Costs and expenses:                                                                 |       |                                      |       |                                     |       |   |   |   |   |
| Cost of sales                                                                       |       | 2,396                                     |       | 724                                      |       | 4,567 |   | 1,598 |   |
| Research and development                                                            |       | 6,998                                     |       | 4,724                                    |       | 17,748 |   | 19,425 |   |
| Selling, general and administrative                                                 |       | 5,250                                     |       | 8,483                                    |       | 16,998 |   | 21,033 |   |
| Gain on termination of Esprit Pharma agreement                                      |       | —                                    |       | (5,000                                   | )          | — |   | (5,000 | ) |
| Gain on litigation settlement                                                       |       | —                                    |       | —                                   |       | (7,500 | ) | — |   |
| Total costs and expenses                                                            |       | 14,644                                    |       | 8,931                                    |       | 31,813 |   | 37,056 |   |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Income (loss) from operations                                                       |       | (533                                      | )          | 43,929                                   |       | (5,686 | ) | 23,241 |   |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Other income (expense):                                                             |       |                                      |       |                                     |       |   |   |   |   |
| Interest and other income                                                           |       | 515                                       |       | 638                                      |       | 1,871 |   | 1,504 |   |
| Interest expense                                                                    |       | (249                                      | )          | —                                   |       | (254 | ) | — |   |
| Total other income (expense)                                                        |       | 266                                       |       | 638                                      |       | 1,617 |   | 1,504 |   |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Net income (loss) before income taxes                                               |       | (267                                      | )          | 44,567                                   |       | (4,069 | ) | 24,745 |   |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Provision for income taxes                                                          |       | (4                                        | )          | (248                                     | )          | (4 | ) | (252 | ) |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Net income (loss)                                                                   |       | (271                                      | )          | 44,319                                   |       | (4,073 | ) | 24,493 |   |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Deemed dividend on preferred stock                                                  |       | (183                                      | )          | (174                                     | )          | (538 | ) | (511 | ) |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Net income (loss) applicable to common stock shareholders                           |       | $                                         | (454       | )                                        | $          | 44,145 |   | $ | (4,611 | ) | $ | 23,982 |   |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Basic net income (loss) applicable to common stock shareholders per  common share   |       | $                                         | (0.01      | )                                        | $          | 0.93 |   | $ | (0.10 | ) | $ | 0.53 |   |
| Diluted net income (loss) applicable to common stock shareholders per  common share |       | $                                         | (0.01      | )                                        | $          | 0.92 |   | $ | (0.10 | ) | $ | 0.52 |   |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Shares used in computing basic net income (loss) per common share                   |       | 48,123,668                                |       | 47,630,945                               |       | 48,011,004 |   | 45,334,269 |   |
| Shares used in computing diluted net income (loss) per common share                 |       | 48,123,668                                |       | 47,786,334                               |       | 48,011,004 |   | 45,801,242 |   |

** **

See accompanying notes to Condensed Consolidated Financial Statements.

 

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**DEPOMED, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                   | ** ** | **2008**                                 | ** ** | **2007** | ** ** |
| **Operating Activities**                                                     |       |                                     |       |   |   |
| Net income (loss)                                                            |       | $                                        | (4,073     | ) | $ | 24,493 |   |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                                     |       |   |   |
| Depreciation and amortization                                                |       | 890                                      |       | 687 |   |
| Employee and director stock-based compensation                               |       | 1,752                                    |       | 1,430 |   |
| Stock-based compensation related to consultants                              |       | 198                                      |       | 42 |   |
| Changes in assets and liabilities:                                           |       |                                     |       |   |   |
| Accounts receivable                                                          |       | (500                                     | )          | 6,026 |   |
| Inventories                                                                  |       | 255                                      |       | 632 |   |
| Prepaid and other current assets                                             |       | (693                                     | )          | 1,336 |   |
| Accounts payable and other accrued liabilities                               |       | 3,357                                    |       | (3,440 | ) |
| Accrued compensation                                                         |       | 375                                      |       | (307 | ) |
| Deferred revenue                                                             |       | 5,637                                    |       | (39,593 | ) |
| Net cash provided by (used in) operating activities                          |       | 7,198                                    |       | (8,694 | ) |
|                                                                         |       |                                     |       |   |   |
| **Investing Activities**                                                     |       |                                     |       |   |   |
| Purchases of property and equipment                                          |       | (230                                     | )          | (137 | ) |
| Purchases of marketable securities                                           |       | (82,758                                  | )          | (38,677 | ) |
| Maturities of marketable securities                                          |       | 54,991                                   |       | 21,626 |   |
| Sales of marketable securities                                               |       | 11,159                                   |       | — |   |
| Net cash used in investing activities                                        |       | (16,838                                  | )          | (17,188 | ) |
|                                                                         |       |                                     |       |   |   |
| **Financing Activities**                                                     |       |                                     |       |   |   |
| Proceeds from debt issuance                                                  |       | 9,400                                    |       | — |   |
| Debt issuance costs                                                          |       | (303                                     | )          | — |   |
| Proceeds from issuance of common stock                                       |       | 289                                      |       | 20,892 |   |
| Net cash provided by financing activities                                    |       | 9,386                                    |       | 20,892 |   |
|                                                                         |       |                                     |       |   |   |
| Net decrease in cash and cash equivalents                                    |       | (254                                     | )          | (4,990 | ) |
| Cash and cash equivalents at beginning of period                             |       | 14,374                                   |       | 14,574 |   |
| Cash and cash equivalents at end of period                                   |       | $                                        | 14,120     |   | $ | 9,584 |   |

 

See accompanying notes to Condensed Consolidated Financial Statements.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 

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

 

## ***Basis of Presentation***

## * *

These unaudited condensed consolidated financialstatements and the related footnote information of Depomed, Inc. (theCompany or Depomed) have been prepared pursuant to the requirements of theSecurities and Exchange Commission (SEC) for interim reporting. As permittedunder those rules, certain footnotes or other financial information that arenormally required by U.S. generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations. In theopinion of the Company’s management, the accompanying interim unauditedcondensed consolidated financial statements include all adjustments (consistingonly of normal recurring adjustments) necessary for a fair presentation of theinformation for the periods presented. The results for the interim period endedSeptember 30, 2008 are not necessarily indicative of results to beexpected for the entire year ending December 31, 2008 or future operatingperiods.

 

The balance sheet as of December 31, 2007 hasbeen derived from the audited financial statements at that date. The balancesheet does not include all of the information and footnotes required by U.S.generally accepted accounting principles for complete financial statements. Forfurther information, refer to the financial statements and footnotes theretoincluded in 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 theaccounts of the Company and Depomed Development, Ltd. (DDL) through April 2007,at which time DDL was dissolved. DDL did not have any fixed assets, liabilitiesor employees and will not perform any further product development onbehalf of Depomed or any other entity. Material intercompany accounts andtransactions have been eliminated.

 

***Use of Estimates***

 

The preparation of financial statements in conformity with U.S.generally accepted accounting principles requires management to make estimatesand assumptions that affect the amounts reported in the financial statementsand accompanying notes. Actual results could differ from those estimates.

 

***Stock-BasedCompensation***

* *

Effective January 1, 2006, Depomed implementedthe provisions of Statement of Financial Accounting Standards No. 123 (revised2004), *Share-Based Payment* (FAS 123(R)), asinterpreted by SEC Staff Accounting Bulletin No. 107 (SAB 107), using themodified prospective transition method. FAS 123(R) is a revision ofStatement of Financial 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. Depomedestimates forfeitures based on historical experience.

 

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**DEPOMED, INC.**

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

***(Unaudited)***

* *

On adoption of FAS 123(R), the Company concluded thatits historical share option exercise experience did not provide a reasonablebasis upon which to estimate expected term and estimated the expected term ofoptions granted by taking the average of the vesting term and the contractualterm of the option, as illustrated by the simplified method in SAB 107. SAB 107allowed for use of the simplified method to estimate expected term through December 31,2007. In December 2007, the SEC issued SAB 110, which extended the abilityfor companies to utilize the simplified method beyond December 31, 2007under limited circumstances. At January 1, 2008, the Company concludedagain that its historical share option exercise experience did not provide areasonable basis upon which to estimate expected term because of the Company’slimited exercise history and also elected to no longer utilize the simplifiedmethod. For options granted after January 1, 2008, the Company hasestimated the expected term by using the weighted average terms of a peer groupof companies that grant options with similar vesting provisions. The expectedterm used for options granted after January 1, 2008 is 5.04 years. SeeNote 6 of the Notes to Condensed Consolidated Financial Statements for furtherinformation regarding Depomed’s stock-based compensation expense.

 

***Revenue Recognition***

 

The Company recognizes revenue from the sale of itsproducts, royalties earned, and on payments received and services performedunder contractual arrangements. Revenue arrangements with multiple elements aredivided into separate units of accounting if certain criteria are met,including whether the delivered element has stand-alone value to the customerand whether there is objective and reliable evidence of the fair value of theundelivered items. The consideration received is allocated among the separateunits based on their respective fair values, and the applicable revenuerecognition criteria are applied to each of the separate units.

 

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

 

·                  Product Sales:

 

·                  GLUMETZA®:The Company sells GLUMETZA product to wholesalers and retail pharmacies that issubject to rights of return up to twelve months after product expiration. TheCompany began shipping GLUMETZA product to customers in the third quarter of2006. Prior to the third quarter of 2008, the Company was unable to reasonablyestimate expected returns of the product at the time of shipment, andtherefore, deferred revenue on product shipments of GLUMETZA until the productwas dispensed through patient prescriptions. The quantity of prescription unitsdispensed was estimated based on analysis of third-party information, includingthird-party market research data and information obtained from wholesalers withrespect to inventory levels and inventory movement. Based on the shipmenttrends, prescription trends and product returns history for GLUMETZA over twoyears through the third quarter of 2008 and based on an analysis of returnrates of companies with products that have similar characteristics and similarreturn policies within the metformin prescription market, the Company concludedit had the information needed to reasonably estimate product returns during thethird quarter of 2008. Beginning in the third quarter of 2008, the Companybegan recognizing revenue for GLUMETZA sales at the time of shipment to itscustomers. Consequently, for the quarter ended September 30, 2008, theCompany recognized a one time increase of $6.3 million in net product sales ofGLUMETZA, representing product sales previously deferred, net of estimatedproduct returns, managed care and Medicaid rebates, wholesaler and retailpharmacy discounts, chargebacks and prompt payment discounts. This changeresulted in a one-time $5.3 million reduction to net loss and decreased netloss per share by $0.11 for the three and nine months ended September 30,2008.

 

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**DEPOMED, INC.**

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

***(Unaudited)***

* *

·                  Proquin®XR:The Company sells Proquin XR product to wholesalers and retail pharmacies thatis subject to rights of return up to twelve months after productexpiration.  Given the Company’s limitedhistory of selling Proquin XR, the Company currently cannot reliably estimateexpected returns of the product at the time of shipment. Accordingly, theCompany defers recognition of revenue on product shipments of Proquin XR untilthe right of return no longer exists, which occurs at the earlier of the timeProquin XR units are dispensed through patient prescriptions or expiration ofthe right of return. The Company estimates patient prescriptions dispensedusing an analysis of third-party information, including third-party marketresearch data and information obtained from wholesalers with respect toinventory levels and inventory movement. As a result of this policy, theCompany has a deferred revenue balance of $1.4 million at September 30,2008 related to Proquin XR product shipments that have not been recognized asrevenue, which is net of wholesaler fees, retail pharmacy discounts and promptpayment discounts. The Company will recognize revenue upon the earlier to occurof prescription units dispensed or expiration of the right of return until itcan reliably estimate product returns, at which time the Company will record aone-time increase in net revenue related to the recognition of revenuepreviously deferred. In addition, the costs of manufacturing 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. Product sales allowances are based on amounts owed or to be claimedon the related sales. These estimates take into consideration the terms of theCompany’s agreements with customers, historical product returns, rebates ordiscounts taken, estimated levels of inventory in the distribution channel, theshelf life of the product, and specific known market events, such ascompetitive pricing and new product introductions. If actual future resultsvary, the Company may need to adjust these estimates, which could have aneffect on earnings in the period of adjustment. The Company’s product salesallowances include:

 

·                  Managed CareRebates – The Company offers rebates under contracts with certain managed carecustomers. The Company establishes an accrual equal to its estimates of futuremanaged care rebates attributable to sales and recognizes the estimated rebatesas a reduction of revenue in the same period the related revenue is recognized.The Company estimates its managed care rebates based on the terms of eachagreement, estimated levels of inventory in the distribution channel, andhistorical and expected future utilization of our product by the managed careorganization.

 

·                  ProductReturns – The Company estimates product returns on sales of GLUMETZA. TheCompany allows customers to return product that is within six months before andup to one year after its product expiration date.  The shelf life of the 500mg GLUMETZA is currently48 months from the date of tablet manufacture. On product launch in August 2006and through the second quarter of 2008, the shelf life of 500mg GLUMETZAproduct shipped by the Company was 36 months. 1000mg GLUMETZA tablets, whichbecame available in June 2008, currently have a shelf life of 24 monthsfrom the date of tablet manufacture. The Company estimates GLUMETZA productreturns based on an analysis of return rates of companies with products thathave similar characteristics and similar return policies within the metforminprescription market, trends in historical returns, shipments and prescriptionsand estimated channel inventory levels.

 

·                  Wholesalerand Retail Pharmacy Discounts – The Company offers discounts to certainwholesale distributors and retail pharmacies based on contractually determinedrates. The Company 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.

 

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**DEPOMED, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (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 productpricing, current rebates and changes in the level of discounts the Companyoffers that may affect the level of Medicaid discount, historical and estimatedfuture percentages of our product sold to Medicaid recipients, estimated levelsof inventory in the distribution channel, and third-party market data regardingprescription payor information.

 

·                  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 estimated wholesaler inventory levels, current contract prices andhistorical 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, theCompany entered into a settlement and license agreement with TevaPharmaceuticals USA, Inc. (Teva) in which the Company is entitled toreceive royalties from Teva on sales by Teva or its affiliates of genericGlucophage®XR in the United States, subject to a $2.5 million aggregate cap.The royalties are calculated as a percentage of sales by Teva of genericGlucophage XR in the United States, as reported by a third-party marketresearch company. The Company accrues royalties from Teva each quarter based onTeva’s sales of generic Glucophage XR reported by the third-party marketresearch company for that quarter. See Note 4 of the Notes to CondensedConsolidated Financial Statements for further information on the settlement andlicense agreement.

 

Royalties received underthe Company’s agreements with Biovail Laboratories s.r.l. (Biovail) and LG LifeSciences (LG) are recognized when the royalty payments are received as they arenot estimable.

 

The Company recognizedroyalties under its license agreement with Esprit Pharma (Esprit) based onEsprit’s sales of Proquin XR, net of any estimated returns, discounts, rebatesand chargebacks, subject to minimum annual royalties. The license agreementwith Esprit was terminated in July 2007.

 

·                  License Revenue- 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.

 

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**DEPOMED, INC.**

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

***(Unaudited)***

* *

***Recently Issued AccountingStandards***

* *

In December 2007,the FASB ratified the final consensuses in Emerging Issues Task Force (EITF)Issue No. 07-1, *Accounting forCollaborative Arrangements* (EITF 07-1), which requires certainincome 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.

 

Effective January 1,2008, the Company adopted EITF Issue No. 07-3, Accounting forNonrefundable Advance Payments for Goods or Services Received for Use in FutureResearch and Development Activities (EITF 07-3). EITF 07-3 requires thatnonrefundable advance payments for goods and services that will be used orrendered in future R&D activities pursuant to contractual arrangements bedeferred and recognized as expense in the period that the related goods aredelivered or services are performed. The adoption of EITF 07-3 did not have amaterial impact on the Company’s financial position, results of operations orcash flows.

 

**NOTE 2. CASH, CASH EQUIVALENTS AND MARKETABLESECURITIES**

 

 TheCompany considers all highly liquid investments with an original maturity (atdate of 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 September 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 September 30, 2008 (inthousands):

 
| ** **                                          | ** ** | **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              |       | $                       | 4,940      |                          | $          | (10            | )          | $ | — |   | $ | — |   | $ | 4,940 |   | $ | (10 | ) |
| U.S. corporate debt and commercial paper securities |       | 13,040                  |       | (255                          | )          | —         |       | — |   | 13,040 |   | (255 | ) |
| Total available-for-sale                            |       | $                       | 17,980     |                          | $          | (265           | )          | $ | — |   | $ | — |   | $ | 17,980 |   | $ | (265 | ) |

 

The gross unrealized losses above were causedby interest rate increases. No significant facts or circumstances have arisento indicate that there has been any deterioration in the creditworthiness ofthe issuers of the Company’s securities. Based on the Company’s review of thesesecurities, including the assessment of the duration and severity of theunrealized losses and the Company’s ability and intent to hold the investmentsuntil maturity, there were no material other-than-temporary impairments forthese securities at September 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:

 

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**DEPOMED, INC.**

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

***(Unaudited)***

* *

·                  Level1: Quotedprices in active markets for identical assets or liabilities.

 

·                  Level2: Inputsother than Level 1 that are observable, either directly or indirectly, such asquoted prices for similar assets or liabilities; quoted prices in markets thatare not active; or other inputs that are observable or can be corroborated byobservable market data for substantially the full term of the assets orliabilities.

 

·                  Level3: Unobservableinputs that are supported by little or no market activity and that aresignificant to the fair value of the assets or liabilities.

 

The adoption of FAS 157did not have a material impact on the Company’s financial position, results ofoperations or cash flows. In accordance with FAS 157, the following tablerepresents the Company’s fair value hierarchy for its financial assets measuredat fair value on a recurring basis as of September 30, 2008 (inthousands):

 
| ** **                             | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-----------|------------|
| Money market funds                     |       | $           | 48         |        | $          | —      |       | $         | —     |   | $ | 48 |   |
| Commercial paper                       |       | —      |       | 5,449       |       | —      |       | 5,449     |       |
| U.S. government agency debt securities |       | —      |       | 7,200       |       | —      |       | 7,200     |       |
| U.S. Treasury securities               |       | —      |       | 60,890      |       | —      |       | 60,890    |       |
| U.S. corporate debt securities         |       | —      |       | 11,691      |       | —      |       | 11,691    |       |
| Total                                  |       | $           | 48         |        | $          | 85,230      |       | $         | —     |   | $ | 85,278 |   |

 

In February 2007,the FASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities - Including an amendment of FASBStatement No. 115* (FAS 159), which provides a fair value optionelection that permits entities to irrevocably elect to measure financial assetsand liabilities (except for those that are specifically scoped out of theStatement) at fair value as the initial and subsequent measurement attribute,with changes in fair value recognized in earnings as they occur. FAS 159permits the fair value option election on an instrument-by-instrument basis atinitial recognition of an asset or liability or upon an event that gives riseto a new basis of accounting for that instrument.  The Company didnot elect to apply the fair value option to any of its financial assets orliabilities; therefore, there has been no impact on the Company’s financialposition, results of operations or cash flows.

 

**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 outstanding warrants are determined under the treasury stock method.Shares used in the computation on net income (loss) per common share are asfollows:

 
| ** **                        | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                  | ** ** | **2007**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
|                              |       |                                      |       |                                     |       |   |   |   |   |
| Weighted-average shares - basic   |       | 48,123,668                                |       | 47,630,945                               |       | 48,011,004 |   | 45,334,269 |   |
| Effect of dilutive securities:    |       |                                      |       |                                     |       |   |   |   |   |
| Stock options                     |       | —                                    |       | 120,599                                  |       | — |   | 290,949 |   |
| Warrants                          |       | —                                    |       | 34,790                                   |       | — |   | 176,024 |   |
| Weighted-average shares - diluted |       | 48,123,668                                |       | 47,786,334                               |       | 48,011,004 |   | 45,801,242 |   |

 

For the three and nine months ended September 30,2008, approximately 8.5 million common stock equivalent shares are not includedbecause their effect is anti-dilutive. For the three and nine months ended September 30,2007, approximately 7.7 million and 7.3 common stock equivalent shares are notincluded because their effect is anti-dilutive.

 

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**DEPOMED, INC.**

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

***(Unaudited)***

* *

**NOTE 4. LICENSE AND COLLABORATIVEARRANGEMENTS**

 

***Santarus, Inc.***

 

In July 2008, the Company entered into a promotion agreement withSantarus, Inc. (Santarus) granting Santarus exclusive rights to promoteGLUMETZA in the United States. Santarus paid the Company a $12 million upfrontfee, and based on the achievement of specified levels of annual GLUMETZA netproduct sales, Santarus may be required to pay the Company additional one-timesales milestones, totaling up to $16 million.

 

Santarus began promotion of GLUMETZA in October 2008. Santarus isrequired to meet certain minimum promotion obligations during the term of theagreement, and required to make certain minimum marketing, advertising, medicalaffairs and other commercial support expenditures. The Company will continue torecord revenue from the sales of GLUMETZA product and, beginning in October 2008,will pay Santarus a fee ranging from 75% to 80% of the gross margin earned fromnet sales of GLUMETZA product in the United States.

 

Santarus is responsible for all costs associated with its sales forceand for all other marketing expenses associated with its promotion of GLUMETZAproduct. Depomed is responsible for overseeing product manufacturing andsupply. A joint commercialization committee has been formed to oversee andguide the strategic direction of the GLUMETZA alliance.

 

Pursuant to the terms of the promotion agreement, Depomed retains theoption to co-promote GLUMETZA product in the future to obstetricians andgynecologists. The promotion agreement will continue in effect until theexpiration of the last-to-expire patent or patent application with a validclaim in the territory covering a GLUMETZA product, unless terminated sooner.

 

The Company is recognizing the $12.0 million upfront payment ratablyuntil November 2021, which represents the estimated length of time theCompany’s obligations exist under the arrangement related to promotion fees itis obligated to pay Santarus.  For thethree months ended September 30, 2008, the Company recognized $0.2 millionin license revenue related to the amortization of the upfront payment.

 

***Settlementwith 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 XRproduct in the United States.  The $7.5million one-time payment received by the Company was recognized as a gain onlitigation settlement within operating income during the second quarter of2008.

 

The Company also receives ongoing royaltypayments from Teva on sales by Teva (including IVAX) of generic Glucophage XRin the United States, which is calculated as a percentage of sales, as reportedby a third-party market research company.  The royalty is subject to a$2.5 million aggregate cap.  For thethree and nine months ended September 30, 2008, the company recognized$0.4 million and $0.8 million in royalty revenue related to this arrangement,respectively.

 

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**DEPOMED, INC.**

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

***(Unaudited)***

* *

**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 provided the Companywith a $15.0 million credit facility. The credit facility was available in upto three tranches.  The first tranche of$3.8 million was advanced to the Company upon the closing of the loanagreement.  The second tranche of $5.6million was advanced to the Company in July 2008. The third tranche of$5.6 million was not drawn and is no longer available to the Company, and GECCand Oxford waived the 2% unused line fee related to the unused portion of thecredit facility.

 

The Company is required to pay interest onthe first tranche for the first six months at an interest rate of 11.59%.  Thereafter, the Company will be required topay the principal on the first tranche, plus interest at such rate, in 30 equalmonthly installments. The second tranche is interest-only through December 31,2008, with principal and interest payable thereafter in 30 equal monthlyinstallments at an interest rate of 11.59%.

 

 TheCompany has the right to voluntarily prepay any tranches received under thefacility, in full or in part. Upon any voluntary prepayment of any of thetranches, the Company will be required to pay the lenders, a prepayment premiumequal to: (i) 5% on such prepayment amount, if such prepayment is madewithin 14 months after the closing date, (ii) 4% on such prepaymentamount, if such prepayment is made more than 14 months after the closing datebut within 29 months after the closing date, and (ii) 3% on suchprepayment amount, if such prepayment is made more than 29 months after theclosing date, but on or before the maturity date of the respective tranche.

 

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

 

The credit facility contains affirmativeand negative covenants with which the Company must comply with, and imposesrestrictions with regards to additional indebtedness, liens, variousfundamental changes (including mergers and acquisitions), payments,investments, transactions with affiliates, and other limitations customary insecured credit facilities. The Company was in compliance with such covenants asof September 30, 2008.

 

**NOTE6.  STOCK-BASED COMPENSATION**

 

The following table presents stock-based compensationexpense recognized under FAS 123(R) for stock options, stock awards andthe Company’s employee stock purchase program (ESPP) in the Company’sconsolidated statements of operations (in thousands):

 
| ** **                                  | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                  | ** ** | **2008**                                  | ** ** | **2007**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                        |       |                                      |       |                                     |       |   |   |   |   |
| Cost of sales                               |       | $                                         | 7          |                                     | $          | 6 |   | $ | 17 |   | $ | 16 |   |
| Research and development expense            |       | 171                                       |       | 134                                      |       | 552 |   | 542 |   |
| Selling, general and administrative expense |       | 551                                       |       | 277                                      |       | 1,380 |   | 914 |   |
| Total                                       |       | $                                         | 729        |                                     | $          | 417 |   | $ | 1,949 |   | $ | 1,472 |   |

 

At September 30, 2008, Depomed had $4.7 millionof total unrecognized compensation expense, net of estimated forfeitures,related to stock option grants that will be recognized over an average vestingperiod of 2.0 years.

 

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**DEPOMED, INC.**

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

***(Unaudited)***

* *

**NOTE7.  COMPREHENSIVE INCOME (LOSS)**

 

Total comprehensive income (loss) for thethree and nine months ended September 30, 2008 and 2007 approximates netincome (loss) and includes unrealized gains and losses on marketablesecurities.

 

**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):

 

| ** **      | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------|------------|-----------------------------|------------|----------------------------|------------|
| Raw materials   |       | $                           | 295        |                       | $          | 837 |   |
| Work-in-process |       | —                      |       | 419                        |       |
| Finished goods  |       | 2,659                       |       | 1,184                      |       |
| Deferred costs  |       | 54                          |       | 823                        |       |
| Total           |       | $                           | 3,008      |                       | $          | 3,263 |   |

 

At September 30, 2008, deferred costsrepresent the costs of Proquin XR product shipped for which recognition ofrevenue has been deferred. At December 31, 2007, deferred costsrepresented the costs of both GLUMETZA and Proquin XR product shipped for whichrecognition of revenue has been deferred. Beginning in the third quarter of 2008, the Company began recognizingrevenue on GLUMETZA product at the time of shipment and no longer has deferredcosts for GLUMETZA at September 30, 2008 (See Note 1 of the Notes toCondensed Consolidated Financial Statements for further discussion).

 

**NOTE 9.SHAREHOLDERS’ EQUITY**

 

***Series A Preferred Stock***

 

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

 

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**DEPOMED, INC.**

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

**(Unaudited)**

** **

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 anincrease in 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 warrant wasconvertible into shares of the Company’s common stock during the period betweenJanuary 2006 and January 2009. The conversion price of the warrantinitially was $7.12, which was equal to the Series A Preferred Stockconversion price in effect as of January 20, 2006. The conversion price ofthe warrant decreased by approximately 4.8% per year during the conversionperiod, such that the number of shares of the Company’s common stock issuableupon conversion of the warrant increased by approximately 5.1% per year. Theconversion of the warrant could 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 could be surrendered in exchangefor common stock for an additional three years through January 20, 2009.As long as the Series A Preferred Stock remained outstanding, the numberof shares into which the warrant could be converted increased as the conversionprice of the warrant decreased resulting in additional deemed dividends on the Series APreferred Stock. For the three and nine months ended September 30, 2008,the Company recognized Series A Preferred Stock deemed dividends ofapproximately $183,000 and $538,000, respectively, attributable to thebeneficial conversion feature from the accrued dividends and decreasing warrantprice.

 

Asof September 30, 2008, there were 18,158 shares of Series A PreferredStock outstanding with an aggregate liquidation preference of approximately$18.2 million. The warrant was convertible into 2,913,807 shares of the Company’scommon stock at a conversion price of $6.23 as of September 30, 2008.

 

InOctober 2008, the holder of the Series A Preferred Stock and warrantexercised its warrant to acquire shares of the Company’s common stock bysurrendering its 18,158 shares of Series A Preferred Stock in exchange for2,914,526 shares of the Company’s common stock. The warrant was exercised inaccordance with its terms and without any cash payment to the company, andtogether with surrender of the Series A Preferred Stock, was convertibleinto the Company’s common stock at a conversion price of $6.23 per share on thedate of exercise.

 

***Option Exercises***

 

Duringthe three and nine months ended September 30, 2008, employees andconsultants exercised options to purchase 27,667 and 30,614 shares of theCompany’s common stock with net proceeds to the Company of approximately$73,000 and $80,000.

 

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**DEPOMED, INC.**

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

**(Unaudited)**

** **

***Employee Stock Purchase Plan***

 

In May 2008, the Company sold 84,308 shares under the ESPP. Theshares were purchased at a weighted average exercise price of $2.47 withproceeds 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 asPresident, Chief Executive Officer and Chairman of the Company.  Dr. Fara continued to serve as a memberof the Company’s Board of Directors through the 2008 Annual Meeting.  The Company entered into a consultingagreement with Dr. Fara, pursuant to which Dr. Fara will provideconsulting services to the Company through December 31, 2009. From August 2007through December 31, 2008, the Company will pay Dr. Fara $20,833 permonth for his consulting services, and will reimburse Dr. Fara for COBRAand life insurance premiums. Dr. Fara will be paid on an hourly basis forconsulting services provided in 2009. For the three and nine months ended September 30,2008, the Company incurred expense of approximately $62,000 and $187,000,respectively, associated with this consulting agreement.

 

During the period of his consultancy, Dr. Fara will continue tovest in all of his currently unvested stock options, and his vested stockoptions will remain exercisable. For the three and nine months ended September 30,2008, the Company recognized approximately $101,000 and $173,000, respectively,in stock compensation expense associated with these awards. In the event of achange in control of the Company, as defined by the Company’s 2004 EquityIncentive Plan, all of Dr. Fara’s unvested options will fully vest, andany remaining monthly payments for consulting under the agreement will beaccelerated.

 

***John F. Hamilton***

 

In October 2007, John F. Hamilton retired from his position asVice President, Finance and Chief Financial Officer of the Company.  The Company entered into a consultingagreement with Mr. Hamilton, pursuant to which Mr. Hamilton providedconsulting services to the Company through October 10, 2008. From October 10,2007 through October 10, 2008, the Company paid Mr. Hamilton $25,667per month for his consulting services. For the three and nine months ended September 30,2008, the Company incurred expense of approximately $77,000 and $231,000,respectively, associated with this consulting agreement.

 

**NOTE 11.INCOME TAXES**

 

The Company adopted the provisions of FIN 48 on January 1,2007. As of December 31, 2007 and September 30, 2008, the Company had$2.9 million and $3.0 million of unrecognized tax benefits, which is nettedagainst deferred tax assets and is fully offset by a valuation allowance.  All tax years since inception remain open toexamination by the Internal Revenue Service and the California Franchise TaxBoard until such time the Company’s net operating losses and credits are eitherutilized or expire. Interest and penalties, if any, related to unrecognized taxbenefits, would be recognized as income tax expense by the Company. As of thedate of adoption of FIN 48, the Company did not have any accrued interestor penalties associated with unrecognized tax benefits.  The Company does not foresee any materialchanges to unrecognized tax benefits within the next twelve months.

 

**NOTE 12.SUBSEQUENT EVENTS**

 

***Series A Preferred Stock***

 

InOctober 2008, the holder of the Series A Preferred Stock and relatedwarrant exercised its warrant to acquire shares of the Company’s common stockby surrendering its 18,158 shares of Series A Preferred Stock in exchangefor 2,914,526 shares of the Company’s common stock. The warrant was exercisedin accordance with its terms and without any cash payment to the company, andtogether with surrender of the Series A Preferred Stock, was convertibleinto the Company’s common stock at a conversion price of $6.23 per share on thedate of exercise. See Note 9 of the Notes to Condensed Consolidated FinancialStatements for further information regarding the Series A Preferred Stockand related warrant.

 

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**ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

### **FORWARD-LOOKINGINFORMATION**

### ** **

Statements made in this “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and elsewhere in this QuarterlyReport on Form 10-Q that are not statements of historical fact areforward-looking statements within the meaning of Section 27A of theSecurities 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 differmaterially from those discussed in, or implied by, these forward-lookingstatements. Forward-looking statements are identified by words such as “believe,”“anticipate,” “expect,” “intend,” “plan,” “will,” “may” and other similarexpressions.  In addition, any statementsthat refer to expectations, projections or other characterizations of futureevents or circumstances are forward-looking statements. Forward-lookingstatements include, but are not necessarily limited to, those relating to:

 

·                  ourability to find development and commercialization partners for DM-1796 andDM-5689 (both formerly referred to as Gabapentin GR®) and otherproduct candidates;

 

·                  resultsand timing of our clinical trials, including the results of our DM-1796 andDM-5689 trials;

 

·                  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 conditionsto differ from those anticipated by these and other forward-looking statementsinclude those more 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.

 

**ABOUT DEPOMED**

 

Depomed is a specialty pharmaceutical company focusedon the development and commercialization of differentiated products thataddress large and growing markets and are based on proprietary oral drugdelivery technologies.  In 2004, weannounced our determination to evolve from a solely product development focusedcompany to an integrated specialty pharmaceutical company, with sales and marketingof our own products.  Preliminarystaffing for these activities began in 2005. In 2006 and 2007, we enhanced our internal sales and marketingcapabilities through the hiring of additional sales and marketing employees andthe 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 commercialize in the United States withSantarus, Inc. (Santarus). Proquin® XR (ciprofloxacinhydrochloride extended release tablets) is a once-daily treatment foruncomplicated urinary tract infections that we commercialize in the UnitedStates with Watson Pharma (Watson).

 

We have a three-pronged approach to productdevelopment designed to optimize the use and value of our drug deliverytechnologies, while managing the costs and risks associated with developing andcommercializing pharmaceutical products. We develop products for our ownaccount that are designed to compete in large growing markets and that can behighly 

 

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differentiated from immediate release versions of thecompounds upon which they are based. Second, we selectively enter intocollaborative partnerships with other companies where the unique capabilitiesof our technology can provide superior value to a partner’s compound, resultingin significantly greater value for Depomed than a traditional fee-for-servicearrangement. Third, we enter into arrangements that enable our technology to beapplied by other companies to a greater number of compounds than ourinfrastructure can support, so as to derive additional value from ourtechnology. In the future, we plan to commercialize our proprietary products,relying on partners to cover the large primary care audiences, whilemaintaining co-promotion and distribution rights in order to be in a positionto create our own sales force when appropriate, thereby increasing the value tous of our products, and our control over them.

 

Our most advanced product candidates in developmentare DM-1796 and DM-5689 (both formerly referred to as Gabapentin GR), extendedrelease forms of gabapentin.  We haveinitiated two Phase 3 trials with respect to DM-5689 for the treatment ofmenopausal hot flashes. We have also completed a Phase 3 clinical trial withrespect to DM-1796 for the treatment of postherpetic neuralgia (PHN), and haveinitiated a second Phase 3 trial for the same indication.  In addition, we have other product candidatesin earlier stages of development.

 

The following table summarizes our marketed products,and our product pipeline.

 
| **Marketed Products**                                   |
|---------------------------------------------------------|
|                                                    |   |   |   |   |
| **Product**                                             | ** ** | **Indication** | ** ** | **Status** |
| ** **                                              | ** ** | ** ** | ** ** | ** ** |
| 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**                                   |
| ** **                                              | ** ** | ** ** | ** ** | ** ** |
| DM-1796 

*Formerly referred to as Gabapentin GR®* |   | Postherpetic neuralgia |   | Second Phase 3 study underway. |
|                                                    |   |   |   |   |
| DM-5689 

*Formerly referred to as Gabapentin GR®* |   | Menopausal hot flashes |   | Phase 3 studies underway (Breeze 1 and Breeze 2). |
|                                                    |   |   |   |   |
| DM-3458 

*Formerly referred to as Omeprazole*          |   | Gastroesophageal reflux disease |   | Proof of concept studies completed. |
|                                                    |   |   |   |   |
| DM-1992 

*Formerly referred to as Levodopa/Carbidopa*  |   | Parkinson’s disease |   | Preclinical development ongoing. |
|                                                    |   |   |   |   |
| One undisclosed compound                                |   | Confidential |   | Preclinical development ongoing. |

 

Our intellectual property positionincludes twelve issued patents and sixteen patent applications pending in theUnited States.

 

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

 

·                  In September 2008, we enrolledand dosed the first patient in Breeze 1, the first of two pivotal Phase 3clinical trials in our registration program for DM-5689 for the treatment ofmenopausal hot flashes.

 

·                  In July 2008, we entered into apromotion agreement with Santarus, Inc. (Santarus) granting Santarusexclusive rights to promote GLUMETZA in the United States, and we received a$12 million upfront fee from Santarus.

 

·                  In July 2008, we were awarded amodest preclinical grant by The Michael J. Fox Foundation under the foundation’sTherapeutics Development Initiative 2008 Program related to our DM-1992program.

 

·                  In July 2008, the MedicalProducts Agency in Sweden approved the Marketing Authorization for Proquin XR,which is licensed by Rottapharm/Madaus in Europe.

 

·                  In July 2008, we drew anadditional $5.6 million under our credit facility with General Electric CreditCompany and Oxford Finance Corporation.

 

·                  Revenue for the three months ended September 30,2008 was $14.1 million, compared to $52.9 million for the three months ended September 30,2007.  Revenue for the three months endedSeptember 30, 2008 included a one-time increase of $6.3 million in productsales related to previously deferred revenue, net of estimated product returns,contractual allowances and discounts. Revenue for the three months ended September 30, 2007 included aone-time recognition of $48.6 million associated with the termination of ourEsprit Pharma license and supply agreements.

 

·                  Operating expenses for the threemonths ended September 30, 2008 were $12.2 million compared to $8.2million for the three months ended September 30, 2007.  Operating expenses for the three months endedSeptember 30, 2007 included a one-time gain of $5.0 million related to thetermination of our agreements with Esprit Pharma, which had the effect ofreducing operating expenses for that period.

 

·                  Cash, cash equivalents and marketablesecurities were $85.5 million as of September 30, 2008 compared to $69.5million as of December 31, 2007.

 

**RECENT PRODUCT DEVELOPMENTS**

 

***MARKETED PRODUCTS***

 

***GLUMETZA®***

 

*Santarus, Inc.* In July 2008,we entered into a promotion agreement with Santarus granting Santarus exclusiverights to promote GLUMETZA in the United States. Santarus paid us a $12.0million upfront fee, and based on the achievement of specified levels of annualGLUMETZA net product sales, Santarus may be required to pay us additionalone-time sales milestones, totaling up to $16.0 million.

 

Santarus began promotion of GLUMETZA in October 2008. Santarus isrequired to meet certain minimum promotion obligations during the term of theagreement, and required to make certain minimum marketing, advertising, medicalaffairs and other commercial support expenditures. We 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 is responsible for all costs associated with its sales forceand for all other marketing expenses associated with its promotion of GLUMETZAproduct. We are responsible for overseeing product manufacturing and supply. Ajoint commercialization committee has been formed to oversee and guide thestrategic direction of the GLUMETZA alliance.

 

Pursuant to the terms of the promotion agreement, we retain the optionto co-promote GLUMETZA product in the future to obstetricians andgynecologists. The promotion agreement will continue in effect until theexpiration of the last-to-expire patent or patent application with a validclaim in the territory covering a GLUMETZA product, unless terminated sooner.

 

*Contract Sales Organization*. In February 2008, weentered into a professional detailing services agreement with Publicis SellingServices (Publicis) pursuant to which approximately 33 part-time Publicis salesrepresentatives detailed GLUMETZA to physicians.  The arrangement with Publicis ended in September 2008.

 

*1000mg Formulation*. In December 2007, the FDA approved the 1000mg formulation formarketing in the United States.  In June 2008,we began selling the 1000mg 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***

 

## ***DM-1796 (formerly known as Gabapentin GR) forPostherpetic Neuralgia***

## * *

In March 2008, we initiated dosing of the firstpatient in a second Phase 3 clinical trial for DM-1796 for PHN.  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 ofDM-1796 dosed once daily. The study is being conducted at sites in the UnitedStates and Russia.

 

The primary objective of the study is to assess theefficacy of DM-1796 in reducing the pain associated with PHN, measured frombaseline pain scores to the end of a ten-week treatment period on the basis ofthe Likert pain scale.  Secondary objectives include an assessment ofchanges from baseline in sleep interference, and additional patient andclinician 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.

 

## ***DM-5689 (formerly known as Gabapentin GR) forMenopausal Hot Flashes***

## * *

 In February 2008,we announced positive results of our Phase 2 trial for DM-5689 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 DM-5689 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 DM-5689 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 stableDM-5689 dose for five weeks at an initial dose, followed by five weeks on astable, 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*. DM-5689 demonstrated a reduction in themean frequency of moderate to severe hot flashes, and in the mean total dailyseverity 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. *DM-5689was 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. * Our Phase 3 registration program forDM-5689 in menopausal hot flashes includes two randomized, double-blind,placebo-controlled studies of approximately 540 patients per study, Breeze 1and Breeze 2. In September 2008, we enrolled and dosed the first patientin Breeze 1, and in October 2008, we enrolled and dosed the first patientin Breeze 2.  In each study, patients will be randomized into threetreatment arms:  (i) placebo; (ii) 1200mg of DM-5689 dosed oncedaily; or (iii) a total dose of 1800mg of DM-5689 dosed 600mg in themorning and 1200mg in the evening.

 

The treatment duration of the Breeze 1 study will be six months, withprimary efficacy endpoints assessed at 4 and 12 weeks. Persistence of efficacywill be assessed at 6 months as one of the secondary endpoints. The treatmentduration in the second study, Breeze 2, will be three months, with assessmentof efficacy at 4 and 12 weeks only.

 

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. Various secondary efficacy endpoints will be measured as well.

 

***OTHERRESEARCH AND DEVELOPMENT AND COLLABORATIVE PROGRAMS***

 

*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.

 

***OTHEREVENTS***

 

*Patent LawsuitSettlement**. *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.6,340,475 and 6,635,280 (the Asserted Patents)) by IVAX’s extended releasemetformin hydrochloride tablets.

 

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Pursuant to the settlement Agreement: (a) the parties dismissed and released all claims associated withthe litigation; (b) we received a one-time payment of $7.5 million in April 2008;(c) we granted Teva a non-exclusive license to the Asserted Patents(including IVAX) to continue to market its generic Glucophage® XR(metformin hydrochloride extended release tablets) product in the United Statesunder the Asserted Patents; and (d) we will receive ongoing royaltypayments from Teva on sales by Teva (including IVAX) of generic Glucophage XRin the United States.  The royalty is subject to a $2.5 million aggregatecap.

 

*Credit Facilit**y. *In June 2008, we entered into a $15.0 millionsecured credit facility with General Electric Capital Corporation (GECC) andOxford Finance Corporation (Oxford).  Thecredit facility is described 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 “***RevenueRecognition***” and “***Stock-Based Compensation***”,there have been no changes to our critical accounting policies since we filedour 2007 Annual Report on Form 10-K with the Securities and ExchangeCommission on March 12, 2008. For a description of our critical accountingpolicies, please refer to our 2007 Annual Report on Form 10-K.

 

***Revenue Recognition***

 

We recognize revenue from the sale of our products,license fees and royalties earned on license agreements and collaborativearrangements. 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 ispersuasive evidence that an arrangement exists, delivery has occurred and titlehas passed, the price is fixed or determinable and we are reasonably assured ofcollecting the resulting receivable.

 

We sell GLUMETZA product to wholesalers and retailpharmacies that is subject to rights of return within a period beginning six monthsprior to, and ending twelve months following product expiration. We beganshipping GLUMETZA product to customers in the third quarter of 2006. Prior tothe third quarter of 2008, we were unable to reasonably estimate expectedreturns of the product at the time of shipment, and therefore, deferred revenueon product shipments of GLUMETZA until the product was dispensed throughpatient prescriptions. The quantity of prescription units dispensed wasestimated based on analysis of third-party information, including third-partymarket research data and information obtained from wholesalers with respect toinventory levels and inventory movement. Based on the shipment trends,prescription trends and product returns history for GLUMETZA over two yearsthrough the third quarter of 2008 and based on an analysis of return rates ofcompanies with products that have similar characteristics and similar returnpolicies within the metformin prescription market, we concluded that we had theinformation needed to reasonably estimate product returns during the thirdquarter of 2008. Beginning in the third quarter of 2008, we began recognizingrevenue for GLUMETZA sales as revenue at the time of shipment to its customers.Consequently, for the quarter ended September 30, 2008, we recognized aone time increase of $6.3 million in net product sales of GLUMETZA,representing product sales previously deferred, net of estimated productreturns, managed care and Medicaid rebates, wholesaler and retail pharmacy feesand discounts, chargebacks and prompt payment discounts. Deferred costs relatedto shipments of GLUMETZA previously deferred were also recognized to cost ofsales. This change resulted in a one-time $5.3 million reduction of net lossfor the third quarter of 2008. Revenues from GLUMETZA product sales arerecorded net of estimated product returns, managed care rebates, wholesaler andretail pharmacy fees and discounts, prompt payment discounts, patient supportprograms, chargebacks, and Medicaid rebates. These gross-to-net salesadjustments are recognized in the same period the related revenue is recognizedand are based on estimates of the amounts earned or to be claimed on therelated sales.

 

We obtained the rights back from Esprit Pharma(Esprit) to market Proquin XR product in July 2007, and began sellingProquin XR to wholesalers and retail pharmacies in October 2007. Given ourlimited history of selling Proquin XR, we currently cannot reliably estimateexpected returns of the product at the time of shipment. Accordingly, we deferrecognition of revenue on product shipments of Proquin XR until the right ofreturn no longer exists, which occurs at the earlier of the time Proquin XRunits are dispensed through patient prescriptions or expiration of the right ofreturn. We estimate patient prescriptions dispensed using an analysis ofthird-party information, including third-party market research data andinformation obtained from wholesalers with respect to inventory levels andinventory movement. We have not had significant 

 

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history estimating the number of patient prescriptions dispensed for ProquinXR. If we underestimate or overestimate patient prescriptions dispensed for agiven period, adjustments to revenue may be necessary in future periods. Wehave a deferred revenue balance of $1.4 million at September 30, 2008related to Proquin XR product shipments that have not been recognized asrevenue, which is net of wholesaler and retail pharmacy fees and discounts and promptpayment discounts. We will recognize revenue for Proquin XR upon the earlier ofprescription units dispensed or expiration of the right of return until we canreliably estimate product returns, at which time we will record a one-timeincrease in net revenue related to the recognition of revenue previouslydeferred. In addition, the costs of manufacturing Proquin XR associated withthe deferred revenue are recorded as deferred costs, which are included ininventory, until such time the deferred revenue is recognized. Revenues fromProquin XR product sales are recorded net of estimated wholesaler and retailpharmacy fees and discounts, prompt payment discounts, chargebacks and Medicaidrebates. These gross-to-net sales adjustments are recognized in the same periodthe related revenue is recognized and are based on estimates of the amountsearned or to be claimed on the related sales.

 

We believe our estimates related to gross-to-net salesadjustments for wholesaler and retail pharmacy fees and discounts, promptpayment discounts, patient support programs and chargebacks do not have a highdegree of estimation complexity or uncertainty as the related amounts aresettled within a relatively short period of time.  We believe that estimated product returnallowances and estimated rebates for GLUMETZA require a high degree of judgmentand are subject to change based on our experience and certain quantitative andqualitative factors.

 

Beginning in the third quarter of 2008, we beganrecognizing GLUMETZA product sales at time title transfers to our customer, andprovide for an estimate of future product returns at that time. Based on ananalysis of return rates of companies with products that have similarcharacteristics and similar return policies within the metformin prescriptionmarket, our historical returns, shipment trends, prescription trends andestimated distribution channel inventory levels, we develop an estimate of thequantity of product in the distribution channel which may be subject to productreturn.  As of September 30, 2008,the Company’s allowance for GLUMETZA product returns was approximately $1.1million.

 

Our rebate accruals for GLUMETZA are based ondefinitive contractual agreements after the dispensing of the product to amedical benefit plan participant. Rebates are accrued at the time of sale, andtypically are paid out several months after the sale. We estimate rebates basedon current and future patient usage, the applicable contractual rebate rateamounts, and our estimates of the quantity of product in the channel.

 

Our product sales allowances and related accruals areevaluated each reporting period and adjusted when trends or significant eventsindicate that a change in estimate is appropriate. Such changes in estimatecould materially affect our results of operations of financial position.  As of September 30, 2008, the Companyhad accruals related to product sales allowances of $3.1 million, whichincludes accrued estimates of product returns, managed care rebates, wholesalerand retail pharmacy discounts and fees, patient support programs, chargebacks,and Medicaid rebates.

 

Revenue from license arrangements, including licensefees creditable against future royalty obligations (if any), of the licensee,is recognized when an arrangement is entered into if we have substantiallycompleted our obligations under the terms of the arrangement and our remaininginvolvement is inconsequential and perfunctory. If we have significantcontinuing involvement under such an arrangement, license fees are deferred andrecognized over the estimated performance period. License fee payments receivedin excess of amounts earned are classified as deferred revenue until earned.

 

***Stock-Based Compensation***

 

As of January 1, 2006, we began accounting forstock-based compensation in accordance with Statement of Financial AccountingStandards No. 123 (revised 2004), *Share-Based Payment*(FAS 123(R)), using the modified prospective transition method. We use theBlack-Scholes option valuation model to estimate the fair value of stockoptions and Employee Stock Purchase Plan (ESPP) shares. The Black-Scholes modelrequires the input of highly subjective assumptions. The most significantassumptions are our estimates of the expected volatility and the expected termof the award. For our volatility assumption, we use the historical volatilityof our common stock over the expected term of the options.

 

On adoption of FAS 123(R), we concluded that ourhistorical share option exercise experience did not provide a reasonable basisupon which to estimate expected term and estimated the expected term of optionsgranted by taking the average of the vesting term and the contractual term ofthe option, as illustrated by the simplified method in SEC Staff AccountingBulletin (SAB) No. 107 (SAB 107). SAB 107 allowed for use of the simplified method to estimate expectedterm through December 31, 2007, and we used the simplified method toestimate the expected term for fiscal years 2006 and 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.However, we elected to no longer utilize the simplified method 

 

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after December 31, 2007. At January 1, 2008,we concluded 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 ateach grant date and, as a result, we are likely to change our valuationassumptions used to value employee stock-based awards granted in futureperiods. FAS 123(R) requires that employee and director stock-basedcompensation costs be recognized over the vesting period of the award, and wehave elected to use the straight-line attribution method.

 

FAS 123(R) requires forfeitures to be estimatedat the time of grant and revised, if necessary, in subsequent periods if actualforfeitures differ from those estimates. We estimated forfeitures based onhistorical experience. Prior to the adoption of FAS 123(R), pro formainformation required under FAS 123 included forfeitures as they occurred.

 

### **RESULTS OF OPERATIONS**

### ** **

*Three and NineMonths Ended September 30, 2008 and 2007*

* *

### **Revenue**

### ** **

Total revenues aresummarized in the following table (in thousands):

 
| ** **                      | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Product sales:                  |       |                                                     |       |                                                    |       |   |   |   |   |
| GLUMETZA                        |       | $                                                        | 12,923     |                                                    | $          | 3,832 |   | $ | 23,494 |   | $ | 7,666 |   |
| Proquin XR                      |       | 88                                                       |       | —                                                  |       | 262 |   | — |   |
| Total product sales             |       | 13,011                                                   |       | 3,832                                                   |       | 23,756 |   | 7,666 |   |
|                            |       |                                                     |       |                                                    |       |   |   |   |   |
| Royalties:                      |       |                                                     |       |                                                    |       |   |   |   |   |
| GLUMETZA                        |       | 100                                                      |       | 46                                                      |       | 283 |   | 125 |   |
| Proquin XR                      |       | —                                                   |       | 2,500                                                   |       | — |   | 2,500 |   |
| Teva                            |       | 416                                                      |       | —                                                  |       | 777 |   | — |   |
| Total royalties                 |       | 516                                                      |       | 2,546                                                   |       | 1,060 |   | 2,625 |   |
|                            |       |                                                     |       |                                                    |       |   |   |   |   |
| License revenue:                |       |                                                     |       |                                                    |       |   |   |   |   |
| GLUMETZA                        |       | 584                                                      |       | 364                                                     |       | 1,311 |   | 1,996 |   |
| Proquin XR                      |       | —                                                   |       | 46,117                                                  |       | — |   | 47,507 |   |
| AcuForm technology         |       | —                                                   |       | —                                                  |       | — |   | 500 |   |
| Total license revenue           |       | 584                                                      |       | 46,481                                                  |       | 1,311 |   | 50,003 |   |
|                            |       |                                                     |       |                                                    |       |   |   |   |   |
| Collaborative and other revenue |       | —                                                   |       | 1                                                       |       | — |   | 3 |   |
|                            |       |                                                     |       |                                                    |       |   |   |   |   |
| Total revenues                  |       | $                                                        | 14,111     |                                                    | $          | 52,860 |   | $ | 26,127 |   | $ | 60,297 |   |

 

***Productsales***

 

As noted above under “**CRITICAL ACCOUNTING POLICIES – *Revenue Recognition***”, beginning in the third quarter of 2008, webegan to recognize GLUMETZA product sales at time title transfers to ourcustomer, and provide for an estimate of future product returns at thattime.  This resulted in a one-timeincrease for the three and nine months ended September 30, 2008, of $6.3million in net product sales of GLUMETZA, representing product sales previouslydeferred, net of estimated product returns, managed care and Medicaid rebates,wholesaler and retail pharmacy fees and discounts, chargebacks and promptpayment discounts. GLUMETZA product sales also increased for the three and ninemonths ended September 30, 2008 as compared to the three and nine monthsended September 30, 2007 from an additional year of promotional andmarketing efforts related to GLUMETZA, as GLUMETZA was launched in September 2006.In October

 

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2007, we terminated our promotion agreement related toGLUMETZA with King and King’s promotion obligations ended in December 2007.From February 2008 through September 2008, we promoted GLUMETZAthrough a contract sales organization, as we did not have an established salesorganization. Product sales for GLUMETZA relative to its current runrate willdepend on the success of our promotion partner, Santarus, who commencedpromotion of GLUMETZA in October 2008.

 

In October 2007, were-launched Proquin XR with Watson, and began selling to wholesalers and retailpharmacies. We defer recognition of revenue on product shipments of Proquin XRuntil the right of return no longer exists, which occurs at the earlier of thetime Proquin XR units are dispensed through patient prescriptions or expirationof the right of return. At September 30, 2008, we have a deferred revenuebalance, which is classified as a liability on the consolidated balance sheet,of $1.4 million associated with the deferral of revenue on Proquin XRproduct shipments, which is net of estimated wholesaler fees, retail pharmacydiscounts, stocking allowances and prompt payment discounts.

 

***Royalties***

 

GLUMETZA royalties relateto royalties we received from Biovail based on net sales of GLUMETZA in Canadaand royalties we received from LG based on net sales of LG’s version ofGLUMETZA, Novamet GR, in Korea. We began receiving royalties from Biovail inthe first quarter of 2006 and from LG in the first quarter of 2007.

 

In April 2008, weentered into a settlement and license agreement with Teva related to the patentinfringement lawsuit against Teva affiliates IVAX Corporation and IVAXPharmaceuticals, Inc. we initiated in January 2006 related to Teva’sgeneric Glucophage XR tablets. In connection with the settlement and licenseagreement we may receive up to $2.5 million in future royalties on Teva’sgeneric Glucophage XR product in the United States. For the three and ninemonths ended September 30, 2008, we recognized $0.4 and $0.8 million,respectively, in royalty revenue related to this arrangement.

 

In July 2007, we terminatedour license agreement with Esprit, and Esprit paid us $2.5 million inroyalties, representing a pro-rated amount of minimum royalties that would havebeen due to us under the original agreements.

 

***Licenserevenue***

 

Licenserevenue for the three and nine months ended September 30, 2008 consistedprimarily of license revenue recognized from the $25.0 million upfront licensefee received from Biovail in July 2005 and from the $12.0 million upfrontfee received from Santarus in July 2008. We are recognizing the $25.0million upfront license fee payment from Biovail as revenue ratably until October 2021,which represents 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. We are recognizing the $12.0 millionupfront payment from Santarus as revenue ratably until October 2021, whichrepresents the estimated length of time our obligations exist under thearrangement related to promotion fees we are obligated to pay Santarus forGLUMETZA in the United States.

 

License revenue for thethree and nine months ended September 30, 2007 consisted primarily ofrevenue recognized related to our agreements with Biovail for GLUMETZA and ouragreements with Esprit Pharma for Proquin XR. License revenue for the ninemonths ended September 30, 2007 consisted of revenue recognized related tothe Biovail agreements for GLUMETZA, the Esprit Pharma agreements for ProquinXR, the LG Life Sciences agreement for GLUMETZA, and the Biovail agreementrelated to our AcuForm drug delivery 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,resulting in total recognition of $46.1 million of license revenue related toour agreements with Esprit in the third quarter of 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 

 

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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 of Sales**

 

Cost of sales consists of costs of the activepharmaceutical ingredient, contract manufacturing and packaging costs,inventory write-downs, product quality testing, internal employee costs relatedto the manufacturing process, distribution costs and shipping costs related toour product sales. Total cost of sales for the three and nine months ended September 30,2008, as compared to the prior year, was as follows (in thousands):

 
| ** **    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **    | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Cost of sales |       | $                                                        | 2,396      |                                                    | $          | 724 |   | $ | 4,567 |   | $ | 1,598 |   |
|               |            |                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |

 

Cost of sales for the three and nine months ended September 30,2008 and 2007 relates primarily to costs associated with the sale of GLUMETZAand Proquin XR. Cost of sales increased in 2008 over 2007 primarily as a resultof an increase in GLUMETZA product sales. As noted above under “**CRITICAL ACCOUNTING POLICIES – *RevenueRecognition***”,beginning in the third quarter of 2008, we began to recognize GLUMETZAproduct sales at time title transfers to our customer. This resulted in aone-time increase of approximately $1.0 million in costs of sales during thethree and nine months ended September 30, 2008. During the three and ninemonths ended September 30, 2008, cost of sales also included approximately$0.3 million and $0.6 million, respectively, in inventory write-downs relatedto slow moving Proquin XR inventory that we expect will not be sold prior toits expiration date.

 

The costs of manufacturing associated with deferredrevenue on Proquin XR product shipments are recorded as deferred costs, whichare included 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 drug andthe requirements and level of participation, if any, by potential partners. Aspotential 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 nine months ended September 30,2008, as compared to the prior year, was as follows (in thousands):

 
| ** **                        | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Research and development expense  |       | $                                                        | 6,998      |                                                    | $          | 4,724 |   | $ | 17,748 |   | $ | 19,425 |   |
| Dollar change from prior year     |       | 2,274                                                    |       |                                                    |       | (1,677 | ) |   |   |
| Percentage change from prior year |       | 48.1                                                     | %          |                                                    |       | (8.6 | )% |   |   |
|                                   |            |                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |

 

The increase in research and development expense forthe three months ended September 30, 2008 as compared to the three monthsended September 30, 2007 was primarily due to higher clinical researchorganization expenses with the commencement of Breeze 1, the first of our twoPhase 3 clinical trials for DM-5689 for the treatment of menopausal hot flashesand our ongoing second Phase 3 trial for DM-1796 for the treatment ofpostherpetic neuralgia.

 

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The decrease in research and development expense forthe nine months ended September 30, 2008 as compared to the nine monthsended September 30, 2007 was primarily due to lower clinical researchorganization expenses related to our first Phase 3 clinical trial for DM-1796for the treatment of postherpetic neuralgia, which was completed in the firsthalf of 2007, and also due to lower headcount as a result of the implementationof a reduction in force in September 2007.

 

In October 2008, we enrolled and dosed the firstpatient in Breeze 2, our second Phase 3 clinical trial for DM-5689 for thetreatment of menopausal hot flashes and expect research and development expenseto increase in fourth quarter of 2008.

 

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 September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                              | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| DM-1796                                 |       | $                                                        | 2,238      |                                                    | $          | 2,544 |   | $ | 9,426 |   | $ | 12,653 |   |
| DM-5689                                 |       | 2,319                                                    |       | 842                                                     |       | 4,559 |   | 2,778 |   |
| Other projects                          |       | 2,441                                                    |       | 1,338                                                   |       | 3,763 |   | 3,994 |   |
| Total research and development expenses |       | $                                                        | 6,998      |                                                    | $          | 4,724 |   | $ | 17,748 |   | $ | 19,425 |   |

 

**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 September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                          | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Selling, general and administrative |       | $                                                        | 5,250      |                                                    | $          | 8,483 |   | $ | 16,998 |   | $ | 21,033 |   |
| Dollar change from prior year       |       | (3,233                                                   | )          |                                                    |       | (4,035 | ) |   |   |
| Percentage change from prior year   |       | (38.1                                                    | )%         |                                                    |       | (19.2 | )% |   |   |
|                                     |            |                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |

 

The decrease in selling,general and administrative expense for the three and nine months ended September 30,2008 as compared to the three and nine months ended September 30, 2007,was primarily due to a decrease in legal expenses related to our litigationwith IVAX and a decrease in promotion fee expense, as we and King terminatedour promotion agreement in October 2007, and we no longer are required topay King promotion 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 andadministrative expense to increase in the fourth quarter of 2008.

 

**Gain on Litigation 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.

 

**Gain on Termination ofEsprit Pharma Agreement**

** **

Inconjunction with the termination and assignment agreement entered into withEsprit in July 2007, we received a $5.0 million termination payment fromEsprit, which has been classified as a gain within operating income for thethree and nine months ended September 30, 2007.

 

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**Interest Income and Expense**

 
| ** **                    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **(in thousands)**       | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Interest and other income     |       | $                                                        | 515        |                                                    | $          | 638 |   | $ | 1,871 |   | $ | 1,504 |   |
| Interest expense              |       | (249                                                     | )          | —                                                  |       | (254 | ) | — |   |
| Net interest income (expense) |       | 266                                                      |       | 638                                                     |       | 1,617 |   | 1,504 |   |
|                               |            |                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |

 

Interest and other income decreased during the three months ended September 30,2008 as compared to the corresponding period in 2007 as a result of lowerinterest rates on our investments. Interest and other income increased duringthe nine months ended September 30, 2008 as compared to the correspondingperiod in 2007 as a result of higher investment balances.

 

Interest expense relates to interest on the credit facility we enteredinto in June 2008 with General Electric Capital Corporation and OxfordFinance Corporation.

 

**LIQUIDITYAND CAPITAL RESOURCES**

** **
| **(in thousands)**                          | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Cash, cash equivalents and marketable securities |       | $                            | 85,452     |                        | $          | 69,523 |   |
|                                                  |            |                              |            |                             |            |  |  |

 

Sinceinception through September 30, 2008, we have financed our productdevelopment efforts and operations primarily from private and public sales ofequity securities and from license and termination fees from collaborative andlicense partners.

 

In December 2006, we entered into a common stockpurchase agreement with Azimuth Opportunity, Ltd., pursuant to which Azimuth iscommitted to purchase, from time to time and at our sole discretion, up to thelesser of (a) $30.0 million of our common stock, or (b) 8,399,654shares of common stock. In August 2008, the agreement was amended and theterm of the agreement was extended until December 2010. Sales to Azimuthunder the agreement, if any, will be made at a price equal to the averageclosing price of our common stock over a given pricing period, minus a discountranging from approximately 3.8% to 6.4%, which varies based on a thresholdprice set by us. Upon each sale of the our common stock to Azimuth under theagreement, we have also agreed to pay Reedland Capital Partners a placement feeequal to approximately 1.1% of the aggregate dollar amount of common stockpurchased by Azimuth. Azimuth is not required to purchase our common stock whenthe price of our common stock is below $2 per share. As of September 30,2008, we have not sold any common stock to Azimuth under this common stockpurchase agreement.

 

InJune 2008, we entered into a credit facility with GECC and Oxford. Thecredit facility was available in up to three tranches.  The first tranche of $3.8 million wasadvanced to 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 was not drawn and itis no longer available to us, and GECC and Oxford waived the 2% unused linefee.

 

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%. As of September 30, 2008, totaladvances on the credit facility were $9.4 million at an interest rate of11.59%.

 

Our obligations under the Loan Agreement are secured by interests inall of our personal property, and proceeds from any intellectual property, butnot by our intellectual property.  Theloan agreement contains conditions precedent that must be satisfied prior toany borrowing 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 September 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.

 

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Asof September 30, 2008, we have accumulated net losses of $139.0 million.We expect to continue to incur operating losses for the remainder of 2008. Weanticipate that our existing capital resources will permit us to meet ourcapital and operational requirements through at least the end of 2009. We basethis expectation on our current operating plan, which may change as aresult of many factors.

 

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

 

·          sales of our marketed products;

·          expenditures related to our commercializationand development efforts;

·          financial terms of definitive licenseagreements or other commercial agreements we enter into, if any;

·          results of research and development efforts;

·          changes in the focus and direction of ourresearch and development programs;

·          technological advances;

·          results of clinical testing, requirements ofthe FDA and comparable foreign regulatory agencies; and

·          acquisitions or investment in complimentarybusinesses, products or technologies.

 

We will need substantialfunds of our own or from third parties to:

 

·          conduct research and development programs;

·          conduct preclinical and clinical testing; and

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

 

Our existing capitalresources may not be sufficient to fund our operations until such time aswe may be able to generate sufficient revenues to support our operations.We have limited credit facilities and, except for the common stock purchaseagreement with Azimuth, we have no other committed sources of capital. To theextent that our capital resources are insufficient to meet our future capitalrequirements, we will have to raise additional funds through the sale of ourequity securities or from development and licensing arrangements to continueour development programs. We may be unable to raise such additionalcapital on favorable terms, or at all. If we raise additional capital by sellingour equity or convertible debt securities, the issuance of such securitiescould result in dilution of our shareholders’ equity positions. If adequatefunds 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 raiseadditional capital would have a material adverse effect on our company.

 

### **Cash Flows from OperatingActivities**

### ** **

Cash provided by operating activities during the ninemonths ended September 30, 2008 was approximately $7.2 million, comparedto cash used in operating activities of approximately $8.7 million for the ninemonths ended September 30, 2007. The increase in cash provided by operating activities for the ninemonths ended September 30, 2008 as compared to cash used in operatingactivities nine months ended September 30, 2007 was primarily due toreceipt of the $12.0 million upfront payment from Santarus.

 

**Cash Flows from Investing Activities**

 

Net cash used in investing activities during the ninemonths ended September 30, 2008 was approximately $16.8 million andconsisted primarily of a net increase in marketable securities. Cash used ininvesting activities during the nine months ended September 30, 2007 wasapproximately $17.2 million and consisted primarily of a net increase inmarketable securities.

 

**Cash Flows from Financing Activities**

 

Cash provided byfinancing activities during the nine months ended September 30,2008 was approximately $9.4 million compared tocash provided by financing activities of approximately $20.9 million for thesame period in 2007. For the nine months ended September 30, 2008, cash provided by financing activities primarilyconsisted of proceeds from our credit

 

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facility. For the ninemonths ended September 30, 2007, cashprovided by financing activities consisted of $20.0 million in proceedsfrom our registered direct offering in April 2007 and $0.9 million in cashproceeds from exercises of stock options and our ESPP.

 

**Contractual Obligations**

 

As of September 30, 2008, our aggregate contractual obligationsare as shown in the following table (in thousands):

 
| ** **                 | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **Total** | ** ** |
|----------------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|-----------|------------|
| Operating leases           |       | $                               | 1,543      |               | $          | 3,238              |       | $         | 549        |   | $ | 5,330 |   |
| Related party arrangements |       | 79                              |       | —             |       | —             |       | 79        |       |
| Purchase commitments       |       | 3,679                           |       | —             |       | —             |       | 3,679     |       |
|                       |       | $                               | 5,301      |               | $          | 3,238              |       | $         | 549        |   | $ | 9,088 |   |

 

At September 30,2008, we had non-cancelable purchase orders and minimum purchase obligations ofapproximately $0.7 million under our manufacturing agreement with PatheonPuerto Rico, Inc. for the manufacture of the 500mg GLUMETZA and $0.4million under our supply agreement with Biovail for the supply of the 1000mgGLUMETZA. We also had a non-cancelable purchase order to purchase in December 2008approximately $2.6 million of gabapentin, the active ingredient in both DM-1796and DM-5689, from a third-party supplier. The amounts disclosed only representminimum purchase requirements. Actual purchases are expected to exceed theseamounts.

 

We have a consultingarrangement with John W. Fara, Ph.D., our former Chairman, President and ChiefExecutive and former member of the Company’s Board of Directors and areobligated to pay Dr. Fara $62,000 for consulting services for theremainder of 2008. We also had a consulting arrangement with John F. Hamilton,our former Vice President, Finance and Chief Financial Officer and paid Mr. Hamilton$17,000 for consulting services through October 2008.

 

The contractualobligations reflected in this table exclude $3.0 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.

 

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

 

There have been nosignificant changes in our market risk compared to the disclosures in Item 7Aof our Annual Report on Form 10-K for the year ended December 31,2007.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

***Evaluation of Disclosure Controlsand Procedures***

 

An evaluation was performedunder the supervision and with the participation of our management, includingthe Company’s President and Chief Executive Officer along with its interimprincipal accounting and financial officer, of the effectiveness of the designand operation of our disclosure controls and procedures as of the end of theperiod covered by this quarterly report. Based on that evaluation, ourmanagement, including the Company’s President and Chief Executive Officer alongwith its interim principal accounting and financial officer, concluded that ourdisclosure controls and procedures were effective.

 

We review and evaluate thedesign and effectiveness of our disclosure controls and procedures on anongoing basis to improve our controls and procedures over time and to correctany deficiencies that we may discover in the future. Our goal is to ensurethat our senior management has timely access to all material financial andnon-financial information concerning our business. While we believe the presentdesign of our disclosure controls and procedures is effective to achieve ourgoal, future events affecting our business may cause us to significantlymodify our disclosure controls and procedures.

 

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***Changes in Internal Controls***

 

There were no changes inour internal controls over financial reporting during the quarter ended September 30,2008 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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** **

**PART II – OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

***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 24 months. In October 2008,the court issued a ruling requiring that Apotex present its evidence in thecase by mid-January 2009, and that Biovail present its evidence by mid-April 2009. Anadverse outcome in this matter could substantially weaken our Canadianintellectual property.

 

**ITEM 1A. RISK FACTORS**

 

The risk factors presentedbelow amend and restate the risk factors previously disclosed in our AnnualReport on Form 10-K for the year ended December 31, 2007.

 

The following factors, alongwith those described 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 prior Phase 3 trial for DM-1796 failed to meetthe primary efficacy endpoint and there can be no assurance this product willbe approved.**

 

In July 2007, weannounced that our drug candidate DM-1796 failed to meet the primary efficacyendpoint in a Phase 3 trial for postherpetic neuralgia (PHN).  In March 2008, we initiated anotherPhase 3 registration trial for the product for the PHN indication.  We are pursuing discussions with potentialdevelopment and marketing partners related to the continued development ofDM-1796 for PHN.  However, we may notsecure a development and marketing arrangement on terms favorable to us, or atall.

 

We submitted to the FDA aprotocol for a Phase 3 registration trial for DM-1796 to the FDA for a specialprotocol assessment, or SPA, pursuant to which we requested that the FDA assesswhether the protocol is adequate to meet the scientific and regulatoryrequirements necessary to support marketing approval of DM-1796 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 approve DM-1796for PHN for marketing even if we meet the primary endpoint in our current Phase3 trial.

 

We will incur significantadditional expenses and will not know for at least one to two years whether thedrug is safe and effective 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 DM-5689 formenopausal hot flashes is safe and effective. If our clinical trials of DM-5689 for menopausal hot flashes do notdemonstrate safety and efficacy, or if the clinical trials are delayed orterminated, our business will be harmed.**

 

Togain regulatory approval from the FDA to market DM-5689 for menopausal hotflashes, our planned Phase 3 registration trials must demonstrate the safetyand efficacy of the product candidate. Clinical development is a long, expensive and uncertain process and issubject to delays.  The results of ourPhase 2 clinical trial are not necessarily 

 

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indicativeof the results we will obtain in later clinical trials.  Accordingly, future clinical trials may notdemonstrate that DM-5689 is effective for menopausal 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 DM-5689 for menopausal hot flashes and would require us tocommit significant additional financial resources. Even after we conduct theseadditional clinical trials, we may not receive regulatory approval to marketthe product.

 

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

 

·      negative or inconclusive results;

·      slow patient enrollment or patient noncompliance with the protocol;

·      adverse medical events or side effects among patients during theclinical trials;

·      FDA inspections of our clinical operations; and

·      real or perceived lack of effectiveness orsafety 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 promotionagreement with Santarus, Inc. pursuant to which Santarus will promoteGLUMETZA in the United States through its sales force beginning in the fourthquarter of 2008. Under the agreement, in exchange for promotion fees, Santarusis required to market and promote GLUMETZA to physicians in the United States,to deliver annual detail calls to potential GLUMETZA prescribers, and tomaintain a sales force of a minimum size.  Although we have retainedrights to promote GLUMETZA to obstetricians/gynecologists, or ob/gyns, and toretain revenues from incremental sales generated by ob/gyns, we call upon,ob/gyns generally do not prescribe significant amounts of metforminproducts.  In addition, we do not haveany immediate plans to establish a sales force, or contract with a third partyto act as our sales force, for the purpose of exercising our GLUMETZAco-promotion rights.  Accordingly, thesuccess of the commercialization of GLUMETZA will depend in large part on Santarus’marketing and promotion efforts.  Factorsthat may affect the success of our promotion arrangement with Santarus includethe following:

 

·      Santarus may acquire or develop alternativeproducts;

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

·      Santarus may in the future choose to devotefewer resources to GLUMETZA;

·      GLUMETZA may fail to achieve greater marketacceptance; and

·      Santarus may fail to comply with itsobligations under our promotion agreement.

 

Any of the preceding factors could affectSantarus’ commitment to the collaboration, which, in turn, could adverselyaffect the 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.

 

**The development of drug candidates is inherentlyuncertain and we cannot be certain that any of our product candidates will beapproved for marketing or, if approved, will achieve market acceptance.**

 

We have the following programsin clinical development: DM-1796 for neuropathic pain and DM-5689 formenopausal hot flashes. We also have other product candidates in earlier stagesof development.

 

Our own product candidates and those of ourcollaborative partners are subject to the risk that any or all of them may befound to be ineffective or unsafe, or otherwise may fail to receivenecessary regulatory clearances.  Additionally, clinical trial results inearlier trials may not be indicative of results that will be obtained insubsequent larger trials, as was the case with the Phase 3 trial for DM-1796for the treatment of postherpetic neuralgia that we completed in 2007.

 

We are unable to predict whether any of these productcandidates will receive regulatory clearances or be successfully manufacturedor marketed.  Further, due to theextended testing and regulatory review process required before marketingclearance can be obtained, the time frames for commercialization of anyproducts are long and uncertain.  Even ifthese other product candidates receive regulatory clearance, our productsmay not achieve or maintain market acceptance. Also, 

 

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substantially all of our product candidates use the AcuForm technology.  If it is discovered that the AcuForm technologycould have adverse effects or other characteristics that indicate it isunlikely to be effective as a delivery system for drugs or therapeutics, ourproduct development efforts and our business would be significantly harmed.

 

**We****depend on WatsonPharmaceuticals for the successful commercialization of Proquin XR in theUnited States.**

 

In July 2007, we granted Watson Pharmaceuticalsco-exclusive marketing rights to Proquin XR in the United States for the urology specialty and long-term caresales channels. In September 2007, we expanded our promotion arrangementwith Watson to include the ob/gyn specialty as well. As described above, we donot have a permanent commercial sales force and do not, for the foreseeablefuture, expect to have the resources to successfully promote Proquin XR on ourown. Accordingly, we will depend on Watson to successfully promote this drug. Ourprior marketing partner for Proquin XR, Esprit Pharma, was unable tosuccessfully commercialize Proquin XR following its initial launch in November 2005.As a result, we and Esprit agreed to terminate the license in July 2007.Through the third quarter of 2008, Proquin XR product sales have been low. Itis possible that Proquin XR product sales will remain relatively low, whichunder the provisions of the promotion agreement could lead to an earlytermination of the agreement. If Watson fails to successfully commercializeProquin XR, our business, financial condition and results of operations may bematerially and adversely affected.

 

**We have limited in-house sales andmarketing resources, which we will require in order to successfully co-promoteGLUMETZA and Proquin XR through our own sales force.**

 

Although we have the rights to promote GLUMETZA and ProquinXR through our own sales force, or through third parties, we have no salesforce and 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.

 

**We are responsible for thedistribution of GLUMETZA and Proquin XR, and we have limited experience withdistribution of pharmaceutical products.**

 

We are responsible for the distribution of GLUMETZAand Proquin XR in the United States.  Ourin-house commercial 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 key personnel.  The efforts of third parties with whom wecontract 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.

 

**We depend on our marketing partnersfor the successful commercialization of GLUMETZA in Canada and Korea, and ofProquin XR in Europe.**

 

We have licensed exclusive marketing rights to the500mg GLUMETZA in Canada 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 facilitywith Oxford Finance Corporation and General Electric Capital Corporation in June 2008.  We have drawn $9.4 million under the facilityand will not make any further draws under the facility. The credit facility issecured by a pledge of all of our assets other than intellectual property, andcontains a variety of 

 

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operational covenants,including limitations 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 will need to be repaid, which creates additionalfinancial risk for our company, particularly if our business, or prevailingfinancial market conditions, are not conducive to paying off or refinancing ouroutstanding debt obligations. Furthermore, our failure to comply with thecovenants in the credit facility could result in an event of default that, ifnot cured or waived, could result in the acceleration of all or a substantialportion of our debt, which could have a material adverse effect on our cashposition 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 sufficientto fund our operations until such time as we may be able to generate sufficientrevenues to support our operations.  Wehave limited credit facilities and, except for our common stock purchaseagreement with Azimuth, we have no other committed sources of capital.  Our late stage clinical development programswill require considerable financial resources, and we may not be successful inentering into development and marketing arrangements in which a collaborativepartner will pay for the costs of those programs. To the extent that ourcapital resources are insufficient to meet our future capital requirements, wewill have to raise additional funds through the sale of our equity securitiesor from development and licensing arrangements to continue our developmentprograms. We may be unable to raise such additional capital on favorable terms,or at all. If we raise additional capital by selling our equity or convertibledebt securities, the issuance of such securities could result in dilution ofour shareholders’ equity positions. If adequate funds are not available we mayhave 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.

 

Someeconomists are now predicting that the United States economy, and possibly theglobal economy, may enter into a prolonged downturn or recession as a result ofrecent economic events, including the deterioration of the credit and capital marketsand related financial crisis.  Though theultimate effect of these developments cannot be predicted, they may have amaterial adverse effect on our liquidity and financial condition and ourability to raise additional funds, whether pursuant to our existing or futurefinancing arrangements.  In addition, ifthese developments negatively impact the ability of our collaborative partnersto develop, manufacture, promote or commercialize our products and productcandidates, our revenues may suffer and our business, financial condition andresults of operations could be materially and adversely affected.  Similarly, any negative impact of an economicdownturn or recession on our potential collaborative partners could adverselyaffect the terms on which collaborative partnerships may be available to us, ifat all.

 

**We are expecting operating losses in the future.**

 

To date, we have recorded revenues from license fees,product sales, royalties, collaborative research and development arrangementsand feasibility studies.  For the ninemonths ended September 30, 2008, we recorded total revenues of $26.1million and for the years ended December 31, 2007, 2006 and 2005, werecorded total revenue of $65.6 million, $9.6 million, and $4.4 million,respectively. For the nine months ended September 30, 2008, we incurred anet loss of $4.1 million and for the years ended December 31, 2006 and2005 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. However, as we continue our research and development efforts,preclinical testing and clinical trial activities, we anticipate that we willincur operating losses for the remainder of 2008.  Therefore, we expect our cumulative losses toincrease. These losses, among other things, have had, and we expect that theywill continue to have, an adverse impact on our total assets, shareholders’equity and working capital.

 

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

 

The following factors will affect our operatingresults and may result in a material adverse effect on our stock price:

 

·      results of clinical trials for our product candidates;

·      announcements regarding development plans for our drug candidates,including DM-1796 and DM-5689;

·      the degree of commercial success of GLUMETZA and Proquin XR;

·      regulatory actions;

·      adverse events related to our products, including recalls;

·      interruptions of manufacturing or supply;

 

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·      results of litigation;

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

·      variations in revenues obtained from collaborative agreements, includingmilestone payments, royalties, license fees and other contract revenues;

·      decisions by collaborative partners to proceed or not to proceed withsubsequent phases of a collaboration or program;

·      market acceptance of the AcuForm technology;

·      adoption of new technologies by us or our competitors;

·      the introduction of new products by our competitors;

·      manufacturing costs and difficulties;

·      third-party reimbursement policies; and

·      the status of our compliance with the provisions of the Sarbanes-OxleyAct of 2002.

 

As a result of these factors, our stock price maycontinue to be volatile and investors may be unable to sell their shares at aprice equal to, or above, the price paid. Additionally, any significant dropsin our stock price, such as the one we experienced following the announcementof our DM-1796 Phase 3 trial results in July 2008, could give rise toshareholder lawsuits, which are costly and time consuming to defend against andwhich may adversely affect our ability to raise capital while the suits arepending, even if the suits are ultimately resolved our favor.

 

**Our collaborative arrangementsmay give rise to disputes over commercial terms, contract interpretationand ownership of our intellectual property and may adversely affect thecommercial success of our products.**

 

We currently have a collaboration arrangement withPatheon, Inc. related to the potential development of product candidatesfor third parties.  We also have adevelopment collaboration agreement with Supernus, Inc. providing for thedevelopment of a product candidate through feasibility.  However, neither we nor Supernus intend tofurther develop the product candidate. In addition, we have in the past and may in the future enter intoother collaborative arrangements, some of which have been based on lessdefinitive agreements, such as memoranda of understanding, material transferagreements, options or feasibility agreements. We may not execute definitive agreements formalizing thesearrangements.  Collaborative relationshipsare generally complex and may give rise to disputes regarding the relativerights, obligations and revenues of the parties, including the ownership ofintellectual property and associated rights and obligations, especially whenthe applicable collaborative provisions have not been fully negotiated anddocumented. Such disputes can delay collaborative research, development orcommercialization of potential products, and can lead to lengthy, expensivelitigation or arbitration. The terms of collaborative arrangementsmay also limit or preclude us from developing products or technologiesdeveloped pursuant to such collaborations. Additionally, the collaboratorsunder these arrangements might breach the terms of their respective agreementsor fail to prevent infringement of the licensed patents by third parties.Moreover, negotiating collaborative arrangements often takes considerablylonger to conclude than the parties initially anticipate, which could cause usto enter into less favorable agreement terms that delay or defer recovery ofour development costs and reduce the funding available to support key programs.

 

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 a collaborativepartner of competitive technologies or products;

·      arrangements with collaborative partners thatlimit or preclude us from developing products or technologies;

·      premature termination of a collaborationagreement; or

·      failure by a collaborative partner to devotesufficient resources to the development and commercial sales of products usingthe 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. 

 

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Our collaborative partners may also terminate their collaborativerelationships with us or otherwise decide not to proceed with development andcommercialization 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.

 

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 to significantliabilities to third parties.  If we need but cannot obtain a license, wemay 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 

 

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amethod-of-use patent, such as the patent we have sublicensed from PharmaNova,covers only a specified use of a particular compound, not a particularcomposition of matter, we cannot prevent others from commercializinggabapentin.  Accordingly, physicianscould prescribe another manufacturer’s gabapentin to treat hot flashes inmenopausal women rather than DM-5689, or pharmacists could seek to fillprescriptions for DM-5689 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 wedo not develop a successful product, our financial position and liquidity willbe adversely affected.**

 

The drug development process is costly, time-consumingand subject to unpredictable delays and failures. Before we or others makecommercial sales of products using the AcuForm technology, other thanGLUMETZA and Proquin XR, we, our current and any future collaborative partnerswill need to:

 

·      conduct preclinical and clinical tests showing that these products aresafe and effective; and

·      obtain regulatory approval from the FDA or foreign regulatoryauthorities.

 

We will have to curtail, redirect or eliminate ourproduct development programs if we or our collaborative partners find that:

 

·      the AcuForm technology has unintended or undesirable side effects;or

·      product candidates that appear promising in preclinical or early-stageclinical studies do not demonstrate efficacy in later-stage, larger scaleclinical trials.

 

Even when or if our products obtain regulatoryapproval, successful commercialization requires:

 

·      market acceptance;

·      cost-effective commercial scale production; and

·      reimbursement under private or governmental health plans.

 

Any material delay or failure in the governmentalapproval process and/or the successful commercialization of our potentialproducts would adversely impact our financial position and liquidity.

 

**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 our expectationsregarding the commercial launchof our products by us or our licensees, and the commencement or completion ofscientific studies and clinical trials and the submission of regulatoryfilings.  From time to time, we maypublicly announce the expected timing of some of these milestones, such as thecompletion of an ongoing clinical trial, the initiation of other clinicalprograms, or the commercial launch of products. All of these milestones are based on a variety of assumptions.  The actual timing of these milestones canvary considerably from our estimates depending on numerous factors, some ofwhich are beyond our control, including:

 

·      our available capital resources;

·      the efforts of our marketing partners withrespect to the commercialization of our products;

·      the rate of progress, costs and results of ourclinical trial and research and development activities, including the extent ofscheduling conflicts with participating clinicians and clinical institutionsand our ability to identify and enroll patients who meet clinical trialeligibility criteria;

·      our receipt of approvals by the FDA and otherregulatory agencies and the timing thereof;

·      other actions by regulators;

 

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

·      the costs of ramping up and maintainingmanufacturing 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 theclinical sites that conduct the clinical testing may devote to our clinicaltrials.  If our clinical investigatorsand clinical sites fail to enroll a sufficient number of patients in ourclinical trials or fail to enroll them on our planned schedule, we will beunable to complete these trials or to complete them as planned, which coulddelay or prevent us from obtaining regulatory approvals for our productcandidates.

 

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

 

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

 

All marketing activities associated with GLUMETZA andProquin XR, as well as marketing activities related to any other products forwhich we obtain regulatory approval, will be subject to numerous federal andstate laws governing the marketing and promotion of pharmaceutical products.The FDA regulates post-approval promotional labeling and advertising to ensurethat they conform to statutory and regulatory requirements. In addition toFDA restrictions, 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 

 

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alleging that certain marketing activities caused false claims forprescription drugs to be submitted to federal programs. Many states havesimilar statutes or regulations, which apply to items and services reimbursedunder Medicaid and other state programs, or, in some states, regardless of thepayer. If we, or our collaborative partners, fail to comply with applicable FDAregulations or other laws or regulations relating to the marketing of ourproducts, we could be subject to criminal prosecution, civil penalties, seizureof products, injunction, and exclusion of our products from reimbursement undergovernment programs, as well as other regulatory actions against our productcandidates, our collaborative partners or 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 United States,we and our collaborative partners, including Madaus, are subject to numerousand varying foreign regulatory requirements, implemented by foreign healthauthorities, governing the design and conduct of human clinical trials andmarketing 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 areunable to obtain acceptable prices or adequate reimbursement for our productsfrom third-party payers, 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 administration authorities;

·      private health insurers;

·      health maintenance organizations;

·      pharmacy benefit management companies; and

·      other healthcare-related organizations.

 

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

 

Federal and 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.

 

**We may beunable to compete successfully in the pharmaceutical product and drug deliverysystem 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.

 

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Bayer Corporation developeda once-daily ciprofloxacin product for the treatment of urinary tractinfections, which is currently marketed by Schering-Plough Corporation. Thereare also 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 forepileptic seizures and for postherpetic pain. Pfizer’s basic U.S. patentsrelating to Neurontin have expired, and numerous companies have receivedapproval to market generic versions of the immediate release product. Inaddition, Pfizer has developed  Lyrica®(pregabalin), which has been approved for marketing in the United States andthe 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. is our sole supplier for tablets of the500mg strength of GLUMETZA pursuant to a supply agreement we entered into withMOVA Pharmaceuticals in December 2006. Biovail is our sole supplier for the 1000mg formulation GLUMETZA.  We will be unable to manufacture GLUMETZA ina timely manner if we are unable to obtain GLUMETZA 500mg tablets from ourcontract manufacturer, active pharmaceutical ingredient from suppliers, orexcipient suppliers, or GLUMETZA 1000mg tablets from Biovail.

 

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 XR fromUquifa Mexico, S.A., a sole supplier to us, on a purchase order basis. We willalso be responsible for the manufacture of bulk Proquin XR tablets to Madausfor the European market, if the product is approved for marketing in Europeanjurisdictions.  We intend to purchaseProquin XR tablets from Patheon, Puerto Rico, Inc. for that purpose. If weare unable, for whatever reason, to obtain the active pharmaceutical ingredientor Proquin XR tablets from our contract manufacturers, we may be unable tomanufacture Proquin XR in a timely manner, if at all.

 

Although we have obtained clinical batches of DM-1796and DM-5689 from a contract manufacturer, we currently have no long-term supplyarrangement with respect to DM-1796 and DM-5689.  Any failure to obtain clinical supplies ofDM-1796 and DM-5689 could adversely affect these clinical development programs.

 

**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.

 

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**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 product liability insurance for futuretrials;

·      we may be unable to obtain product liability insurance for futureproducts;

·      we may be unable to maintain product liability insurance onacceptable terms;

·      we may be unable to secure increased coverage as thecommercialization of the AcuForm technology proceeds; or

·      our insurance may not provide adequate protection againstpotential 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 and resultsof 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; we have not yetreplaced our Chief Financial Officer 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.

 

**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.

 

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**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 2002requires companies to conduct a comprehensive evaluation of their internalcontrol over financialreporting.  At the end of each fiscalyear, we must perform an evaluation of our internal control over financialreporting, include in our annual report the results of the evaluation, and haveour external auditors publicly attest to such evaluation.  If material weaknesses were found in ourinternal controls in the future, if we fail to complete future evaluations ontime, or if our external auditors cannot attest to our future evaluations, wecould fail to meet our regulatory reporting requirements and be subject toregulatory scrutiny and a loss of public confidence in our internal controls,which could have an adverse effect on our stock price.

 

**Businessinterruptions could limit our 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 forlosses that occur. A significant business interruption could result in lossesor damages incurred by us and require us to cease or curtail our operations.

 

**ITEM 2.**** ****UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

Not applicable.

 

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

 

Not applicable.

 

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

 

Not applicable.

 

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

 

Not applicable.

 

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**ITEM 6. EXHIBITS**

 
|   | (a)    | Exhibits |   |                                                                                                              |
|--------|--------|----------|--------|-------------------------------------------------------------------------------------------------------------------|
|   |   | 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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##### **SIGNATURES**

##### ** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
| Date: November 7, 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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