** **

** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**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,  2007**                                                           |
|                                                                                                             |       |                                                                                                     |
| **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 000-23267**

 

**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 |
|------------------|--------|-----------------|

 

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated fileror a non-accelerated filer, as defined in Rule 12b-2 of the Exchange Act.

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

 

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 ofNovember 2, 2007 was 47,764,745.

 

 

----

 

**DEPOMED, INC.**

 
| ** **                                                                                                                           | **Page**   |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                                                 |       |
| **PART I  — FINANCIAL INFORMATION**                                                                                        | ** ** |
|                                                                                                                                 |       |
| Item 1. Condensed Consolidated Financial Statements:                                                                                 |       |
|                                                                                                                                 |       |
| Condensed Consolidated Balance Sheets at September 30,  2007 (unaudited) and December 31, 2006                                  | 3          |
|                                                                                                                                 |       |
| Condensed Consolidated Statements of Operations for  the three and nine-month periods ended September 30, 2007 and 2006  (unaudited) | 4          |
|                                                                                                                                 |       |
| Condensed Consolidated Statements of Cash Flows for  the nine-month periods ended September 30, 2007 and 2006 (unaudited)            | 5          |
|                                                                                                                                 |       |
| Notes to Condensed Consolidated Financial Statements                                                                                 | 6          |
|                                                                                                                                 |       |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                  | 14         |
|                                                                                                                                 |       |
| Item 3. Quantitative and Qualitative Disclosure About  Market Risk                                                                   | 25         |
|                                                                                                                                 |       |
| Item 4. Controls and Procedures                                                                                                      | 25         |
|                                                                                                                                 |       |
| **PART II  — OTHER INFORMATION**                                                                                           | ** ** |
|                                                                                                                                 |       |
| Item  1. Legal Proceedings                                                                                                           | 26         |
|                                                                                                                                 |       |
| Item  1A. Risk Factors                                                                                                               | 26         |
|                                                                                                                                 |       |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                                                 | 39         |
|                                                                                                                                 |       |
| Item 3. Defaults upon Senior Securities                                                                                              | 39         |
|                                                                                                                                 |       |
| Item 4. Submission of Matters to a Vote of Security  Holders                                                                         | 39         |
|                                                                                                                                 |       |
| Item  5. Other Information                                                                                                           | 39         |
|                                                                                                                                 |       |
| Item 6.  Exhibits                                                                                                                    | 40         |
|                                                                                                                                 |       |
| Signatures                                                                                                                           | 41         |

 

 

 

2

----

 

 

 

 

**PART I— FINANCIAL INFORMATION**

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

###### ** **

**DEPOMED, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

** (inthousands, except share and per share amounts)**

 
| ** **                                                                                                                                                                                                                                                                                   | ** ** | **September  30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                   | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| ** **                                                                                                                                                                                                                                                                                   | ** ** | **(Unaudited)**    | ** ** | **(1)**               |       |
| **ASSETS**                                                                                                                                                                                                                                                                                   | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                                                                                              |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                                    |       | $                  | 9,584      |                  | $          | 14,574 |   |
| Marketable securities                                                                                                                                                                                                                                                                        |       | 20,033             |       | 16,985                |       |
| Accounts receivable                                                                                                                                                                                                                                                                          |       | 3,045              |       | 7,127                 |       |
| Unbilled accounts receivable                                                                                                                                                                                                                                                                 |       | 11                 |       | 1,955                 |       |
| Inventories                                                                                                                                                                                                                                                                                  |       | 3,851              |       | 4,483                 |       |
| Prepaid and other current assets                                                                                                                                                                                                                                                             |       | 1,420              |       | 2,756                 |       |
| Total current assets                                                                                                                                                                                                                                                                         |       | 37,944             |       | 47,880                |       |
| Marketable securities                                                                                                                                                                                                                                                                        |       | 16,229             |       | 1,999                 |       |
| Property and equipment, net                                                                                                                                                                                                                                                                  |       | 1,860              |       | 2,541                 |       |
| Other assets                                                                                                                                                                                                                                                                                 |       | 197                |       | 197                   |       |
|                                                                                                                                                                                                                                                                                         |       | $                  | 56,230     |                  | $          | 52,617 |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY (DEFICIT)**                                                                                                                                                                                                                                     | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                                         |       |               |       |                  |       |
| Accounts payable                                                                                                                                                                                                                                                                             |       | $                  | 1,040      |                  | $          | 4,886 |   |
| Accrued compensation                                                                                                                                                                                                                                                                         |       | 1,510              |       | 1,818                 |       |
| Accrued clinical trial expense                                                                                                                                                                                                                                                               |       | 27                 |       | 726                   |       |
| Accrued promotion fee expense                                                                                                                                                                                                                                                                |       | 2,150              |       | 2,340                 |       |
| Other accrued liabilities                                                                                                                                                                                                                                                                    |       | 4,426              |       | 3,088                 |       |
| Deferred product sales                                                                                                                                                                                                                                                                       |       | 4,735              |       | 4,825                 |       |
| Deferred license revenue                                                                                                                                                                                                                                                                     |       | 1,454              |       | 4,600                 |       |
| Other current liabilities                                                                                                                                                                                                                                                                    |       | 56                 |       | 56                    |       |
| Total current liabilities                                                                                                                                                                                                                                                                    |       | 15,398             |       | 22,339                |       |
| Deferred license revenue, non-current portion                                                                                                                                                                                                                                                |       | 21,126             |       | 57,483                |       |
| Other long-term liabilities                                                                                                                                                                                                                                                                  |       | 42                 |       | 84                    |       |
| Commitments                                                                                                                                                                                                                                                                                  |       |               |       |                  |       |
| Shareholders’ equity (deficit):                                                                                                                                                                                                                                                         |       |               |       |                  |       |
| 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, 2007 and December 31,  2006, respectively, with an aggregate liquidation preference of $18,159 |       | 12,015             |       | 12,015                |       |
| Common stock, no par value, 100,000,000 shares authorized; 47,630,945  and 42,029,411 shares issued and outstanding at September 30, 2007 and  December 31, 2006, respectively                                                                                                          |       | 167,184            |       | 144,820               |       |
| Accumulated deficit                                                                                                                                                                                                                                                                          |       | (159,618           | )          | (184,111              | )          |
| Accumulated other comprehensive gain (loss)                                                                                                                                                                                                                                                  |       | 83                 |       | (13                   | )          |
| Total shareholders’ equity (deficit)                                                                                                                                                                                                                                                    |       | 19,664             |       | (27,289               | )          |
|                                                                                                                                                                                                                                                                                         |       | $                  | 56,230     |                  | $          | 52,617 |   |

----

(1) Derived from theaudited consolidated financial statements included in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2006.

 

See accompanying notes to CondensedConsolidated Financial Statements.

 

 

 

3

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**DEPOMED, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

** (inthousands, except share and per share amounts)**

**(Unaudited)**

 
| ** **                                                                          | ** ** | **Three  Months********Ended September 30****,** | ** ** | **Nine  Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                          | ** ** | **2007**                                         | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenue:                                                                            |       |                                             |       |                                 |       |   |   |   |   |
| Product sales                                                                       |       | $                                                | 3,832      |                                 | $          | — |   | $ | 7,666 |   | $ | 1,265 |   |
| Royalties                                                                           |       | 2,546                                            |       | 66                                   |       | 2,625 |   | 495 |   |
| License revenue                                                                     |       | 46,481                                           |       | 893                                  |       | 50,003 |   | 2,679 |   |
| Collaborative revenue                                                               |       | 1                                                |       | —                               |       | 3 |   | 75 |   |
| Total revenues                                                                      |       | 52,860                                           |       | 959                                  |       | 60,297 |   | 4,514 |   |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Costs and expenses:                                                                 |       |                                             |       |                                 |       |   |   |   |   |
| Cost of sales                                                                       |       | 724                                              |       | 320                                  |       | 1,598 |   | 1,445 |   |
| Research and development                                                            |       | 4,724                                            |       | 6,436                                |       | 19,425 |   | 18,888 |   |
| Selling, general and administrative                                                 |       | 8,483                                            |       | 7,328                                |       | 21,033 |   | 16,157 |   |
| Gain on termination of Esprit Pharma agreement                                      |       | (5,000                                           | )          | —                               |       | (5,000 | ) | — |   |
| Total costs and expenses                                                            |       | 8,931                                            |       | 14,084                               |       | 37,056 |   | 36,490 |   |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Income (loss) from operations                                                       |       | 43,929                                           |       | (13,125                              | )          | 23,241 |   | (31,976 | ) |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Interest and other income                                                           |       | 638                                              |       | 492                                  |       | 1,504 |   | 1,673 |   |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Net income (loss) before income taxes                                               |       | 44,567                                           |       | (12,633                              | )          | 24,745 |   | (30,303 | ) |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Provision for income taxes                                                          |       | (248                                             | )          | —                               |       | (252 | ) | — |   |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Net income (loss)                                                                   |       | 44,319                                           |       | (12,633                              | )          | 24,493 |   | (30,303 | ) |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Deemed dividend on preferred stock                                                  |       | (174                                             | )          | (165                                 | )          | (511 | ) | (500 | ) |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Net income (loss) applicable to common stock shareholders                           |       | $                                                | 44,145     |                                 | $          | (12,798 | ) | $ | 23,982 |   | $ | (30,803 | ) |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Basic net income (loss) applicable to common stock shareholders per  common share   |       | $                                                | 0.93       |                                 | $          | (0.31 | ) | $ | 0.53 |   | $ | (0.74 | ) |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Diluted net income (loss) applicable to common stock shareholders per  common share |       | $                                                | 0.92       |                                 | $          | (0.31 | ) | $ | 0.52 |   | $ | (0.74 | ) |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Shares used in computing basic net income (loss) per common share                   |       | 47,630,945                                       |       | 41,776,362                           |       | 45,334,269 |   | 41,382,662 |   |
|                                                                                |       |                                             |       |                                 |       |   |   |   |   |
| Shares used in computing diluted net income (loss) per common share                 |       | 47,786,334                                       |       | 41,776,362                           |       | 45,801,242 |   | 41,382,662 |   |
|                                                                                     |            |                                                  |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |

** **

** **

See accompanying notes to Condensed Consolidated Financial Statements.

 

 

4

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**DEPOMED, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

** (inthousands)**

**(Unaudited)**

 

 
| ** **                                                                            | ** ** | **Nine  Months Ended September 30,** | ** ** |     |
|---------------------------------------------------------------------------------------|------------|--------------------------------------|------------|----------|
| ** **                                                                            | ** ** | **2007**                             | ** ** | **2006** | ** ** |   |
| **Operating Activities**                                                              |       |                                 |       |     |   |   |
| Net income (loss)                                                                     |       | $                                    | 24,493     |     | $ | (30,303 | ) |
| Adjustments to reconcile net income (loss) to net cash used in  operating activities: |       |                                 |       |     |   |   |
| Depreciation and amortization                                                         |       | 687                                  |       | 1,069    |   |   |
| Employee and director stock-based compensation                                        |       | 1,430                                |       | 1,896    |   |   |
| Stock-based compensation related to consultants                                       |       | 42                                   |       | —   |   |   |
| Changes in assets and liabilities:                                                    |       |                                 |       |     |   |   |
| Accounts receivable                                                                   |       | 6,026                                |       | (4,847   | ) |   |
| Inventories                                                                           |       | 632                                  |       | (1,480   | ) |   |
| Prepaid and other current assets                                                      |       | 1,336                                |       | (1,525   | ) |   |
| Other assets                                                                          |       | —                               |       | 32       |   |   |
| Accounts payable and other accrued liabilities                                        |       | (3,440                               | )          | 6,262    |   |   |
| Accrued compensation                                                                  |       | (307                                 | )          | (62      | ) |   |
| Royalty advances                                                                      |       | —                               |       | 619      |   |   |
| Deferred revenue                                                                      |       | (39,593                              | )          | 3,063    |   |   |
| Net cash (used in) operating activities                                               |       | (8,694                               | )          | (25,276  | ) |   |
|                                                                                  |       |                                 |       |     |   |   |
| **Investing Activities**                                                              |       |                                 |       |     |   |   |
| Purchases of property and equipment                                                   |       | (137                                 | )          | (669     | ) |   |
| Purchases of marketable securities                                                    |       | (38,677                              | )          | (20,072  | ) |   |
| Maturities of marketable securities                                                   |       | 21,626                               |       | 37,240   |   |   |
| Sales of marketable securities                                                        |       | —                               |       | 1,497    |   |   |
| Net cash (used in) provided by investing activities                                   |       | (17,188                              | )          | 17,996   |   |   |
|                                                                                  |       |                                 |       |     |   |   |
| **Financing Activities**                                                              |       |                                 |       |     |   |   |
| Proceeds from issuance of common stock                                                |       | 20,892                               |       | 2,463    |   |   |
| Net cash provided by financing activities                                             |       | 20,892                               |       | 2,463    |   |   |
|                                                                                  |       |                                 |       |     |   |   |
| Net (decrease) in cash and cash equivalents                                           |       | (4,990                               | )          | (4,817   | ) |   |
| Cash and cash equivalents at beginning of period                                      |       | 14,574                               |       | 7,566    |   |   |
| Cash and cash equivalents at end of period                                            |       | $                                    | 9,584      |     | $ | 2,749 |   |
|                                                                                       |            |                                      |            |          |  |  |  |  |  |

 

See accompanying notes to Condensed Consolidated Financial Statements.

 

 

5

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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 are normallyrequired by U.S. generally accepted accounting principles have been condensedor omitted pursuant to such rules and regulations. In the opinion of theCompany’s management, the accompanying interim unaudited condensed consolidatedfinancial statements include all adjustments (consisting only of normalrecurring adjustments) necessary for a fair presentation of the information forthe periods presented. The results for the interim period ended September 30,2007 are not necessarily indicative of results to be expected for the entireyear ending December 31, 2007 or future operating periods.

 

The balance sheet as of December 31, 2006 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 endedDecember 31, 2006 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(revised 2004), *Share-Based Payment* (FAS 123(R)),as interpreted by SEC Staff Accounting Bulletin No. 107 (SAB 107), usingthe modified 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 OpinionNo. 25, *Accounting for Stock Issued to Employees*(APB No. 25).**FAS 123(R) requires companies torecognize the cost of employee and director services received in exchange forawards of equity instruments, based on the grant-date fair value of thoseawards, 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 afterJanuary 1, 2006. Compensation expense for stock-based awards granted priorto implementation that were unvested and outstanding as of January 1, 2006is recognized over the requisite service period based on the grant-date fairvalue of 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. Under the modifiedprospective transition method of implementation, no restatement of priorperiods has been made. See Note 4 of the Notes to Condensed ConsolidatedFinancial Statements for further information regarding Depomed’s stock-basedcompensation expense.

 

6

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* *

***Revenue Recognition***

 

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.

 

The Company sells GLUMETZA product to wholesalers andretail pharmacies that is subject to rights of return up to twelve months afterproduct expiration. Given the limited sales history of GLUMETZA, the Companycurrently cannot reliably estimate expected returns of the product at the timeof shipment. Accordingly, the Company defers recognition of revenue on productshipments of GLUMETZA until the right of return no longer exists, which occursat the earlier of the time GLUMETZA units are dispensed through patientprescriptions or expiration of the right of return. The Company estimatespatient prescriptions dispensed using an analysis of third-party information,including third-party market research data, information obtained from wholesalerswith respect to inventory levels and out-movement and retail pharmacyre-stocking activity. As a result of this policy, the Company has a deferredrevenue balance of $4.7 million at September 30, 2007 related to GLUMETZAproduct shipments that have not been recognized as revenue, which is net ofestimated patient support program discounts, wholesaler fees, prompt paymentdiscounts, chargebacks and Medicaid rebates. The Company will recognize revenueupon the earlier of prescription units dispensed or expiration of the right ofreturn until it can reliably estimate product returns, at which time theCompany will record a one-time increase in net revenue related to therecognition of revenue previously deferred. In addition, the costs ofmanufacturing GLUMETZA associated with the deferred revenue are recorded asdeferred costs, which are included in inventory, until such time the deferredrevenue is recognized.

 

Productsales revenue related to the Company’s supply agreement with Esprit Pharma,Inc. (Esprit) was recognized after the expiration of a 30-day period in whichEsprit was entitled to reject product that did not meet agreed-uponspecifications. The supply agreement with Esprit was terminated in July 2007.See Note 6 for additional information with respect to this terminationagreement.

 

Royaltiesare recognized as earned in accordance with the contract terms when royaltiesfrom licensees can be reliably measured and collectibility is reasonablyassured. Royalties received under the Company’s agreements with BiovailLaboratories s.r.l. (Biovail) and LG Life Sciences (LG) are recognized when theroyalty payments are received as they are not estimable.

 

TheCompany recognized royalties under its license agreement with 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. See Note 6 for additional informationwith respect to this termination agreement.

 

Revenue from license arrangements is recognized whenthe Company has substantially completed its obligations under the terms of thearrangement and the Company’s remaining involvement is inconsequential andperfunctory. If the Company has significant continuing involvement under suchan arrangement, license fees are deferred and recognized over the estimatedperformance period. License fee payments received in excess of amounts earnedare classified as deferred revenue until earned.

 

Collaborative revenue recognized relates to servicesrendered in connection with collaborative arrangements and the achievement ofmilestones under such arrangements. Revenue related to collaborative agreementswith corporate partners is recognized as the expenses are incurred under eachcontract. The Company is required to perform services as specified in eachrespective agreement and the Company is reimbursed based on the costs incurredon each specific contract. Nonrefundable substantive milestone payments arerecognized pursuant to collaborative agreements upon the achievement ofspecified milestones where no further obligation to perform exists underthat milestone provision of the arrangement and when collectibility isreasonably assured.

 

7

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

 

 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 cashand cash equivalents at amortized cost, which approximates the 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 income (loss) withinshareholders’ equity. The Company uses the specific identification method todetermine the amount of realized gains or losses on sales of marketablesecurities. Realized gains or losses have been insignificant and are includedin “interest and other income” in the condensed consolidated statement ofoperations. As of September 30, 2007, the individual contractual period for allavailable-for-sale debt securities 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, 2007 (in thousands):

 
| ** **                      | ** ** | **Less than 12 months** | ** ** | **12 months or greater**      | ** ** | **Total**      | ** ** |
|---------------------------------|------------|-------------------------|------------|-------------------------------|------------|----------------|------------|
| **U.S. Debt Securities**        | ** ** | **Fair Value**          | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** |
| U.S. government debt securities |       | $                       | —     |                          | $          | —         |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| U.S. corporate debt securities  |       | 7,983                   |       | (5                            | )          | —         |       | — |   | 7,983 |   | (5 | ) |
| Total available-for-sale        |       | $                       | 7,983      |                          | $          | (5             | )          | $ | — |   | $ | — |   | $ | 7,983 |   | $ | (5 | ) |
|                                 |            |                         |            |                               |            |                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The gross unrealized losses above werecaused by interest rate increases. No significant facts or circumstances havearisen to indicate that there has been any deterioration in thecreditworthiness of the issuers of the Company’s securities. Based on theCompany’s review of these securities, including the assessment of the durationand severity of the unrealized losses and the Company’s ability and intent tohold the investments until maturity, there were no other-than-temporaryimpairments for these securities at September 30, 2007.

 

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

 

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

 
| ** **                        | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                        | ** ** | **2007**                             | ** ** | **2006**                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Weighted-average shares - basic   |       | 47,630,945                           |       | 41,776,362                          |       | 45,334,269 |   | 41,382,662 |   |
| Effect of dilutive securities:    |       |                                 |       |                                |       |   |   |   |   |
| Stock options                     |       | 120,599                              |       | —                              |       | 290,949 |   | — |   |
| Warrants                          |       | 34,790                               |       | —                              |       | 176,024 |   | — |   |
| Weighted-average shares - diluted |       | 47,786,334                           |       | 41,776,362                          |       | 45,801,242 |   | 41,382,662 |   |

 

For the three and nine months endedSeptember 30, 2007, approximately 7.7 million and 7.3 million common stockequivalent shares are not included because their effect is anti-dilutive. Forthe three and nine months ended September 30, 2006, approximately 10.1 millioncommon stock equivalent shares are not included because their effect isanti-dilutive.

 

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**NOTE 4. STOCK-BASEDCOMPENSATION**

 

The Company adopted FAS 123(R) on January 1, 2006as described in Note 1 of the Notes to Condensed Consolidated FinancialStatements. The following table presents stock-based compensation expenserecognized under FAS 123(R) for stock options and the Company’s employee stockpurchase program (ESPP) in the Company’s condensed consolidated statements ofoperations (in thousands):

 
| ** **                                  | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                  | ** ** | **2007**                             | ** ** | **2006**                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Cost of sales                               |       | $                                    | 6          |                                | $          | 3 |   | $ | 16 |   | $ | 3 |   |
| Research and development expense            |       | 134                                  |       | 239                                 |       | 542 |   | 728 |   |
| Selling, general and administrative expense |       | 277                                  |       | 437                                 |       | 914 |   | 1,165 |   |
| Total                                       |       | $                                    | 417        |                                | $          | 679 |   | $ | 1,472 |   | $ | 1,896 |   |

 

At September 30, 2007, Depomed had $6.0 million oftotal unrecognized compensation expense, net of estimated forfeitures, relatedto stock option plans that will be recognized over an average vesting period of2.5 years.

 

**NOTE 5. COMPREHENSIVEINCOME (LOSS)**

 

Total comprehensive income (loss) for thethree and nine months ended September 30, 2007 and 2006 approximates net income(loss) and includes unrealized gains and losses on marketable securities.

 

**NOTE 6. COLLABORATIVEARRANGEMENTS AND CONTRACTS**

 

***Esprit Pharma***

 

In July 2005, the Company entered into an exclusive license agreementwith Esprit to market and distribute ProQuin XR in the United States. Theagreement was amended in July 2006. In connection with the license agreement,the Company also entered into a related supply agreement with Esprit, pursuantto which the Company supplied commercial quantities of ProQuin XR to Esprit.

 

The license agreement obligated Esprit to pay the Company $50.0 millionin license fees, of which $30.0 million was paid in July 2005 and $10.0 millionwas paid in December 2006. The remaining $10.0 million was due in July 2007.The license fee payments received were scheduled to be recognized as revenueratably until June 2020, which represented the length of time that the Companywas obligated to manufacture ProQuin XR for Esprit or its licensees.

 

The license agreement also provided for royalty payments by Esprit tothe Company of 15 percent to 25 percent of ProQuin XR net sales, based onescalating net sales and subject to certain minimum royalty amounts. Esprit’sminimum royalty obligation for 2007 was $5.0 million, and in subsequent yearswas $5.0 million per year, subject to annual increases in the consumer priceindex beginning in 2008.

 

In July 2007, the Company entered into a terminationand assignment agreement with Esprit terminating the exclusive licenseagreement and related supply agreement. Upon entering into the termination andassignment agreement, the marketing and distribution rights in the UnitedStates for ProQuin XR reverted back to the Company and Esprit paid the Company$17.5 million, representing (i) a $10.0 million payment in respect of the finallicense payment that would have been due to the Company in July 2007 under thelicense agreement; (ii) a $2.5 million payment in respect of a pro-ratedportion of minimum royalties for 2007 under the license agreement; and (iii) a$5.0 million termination fee. Esprit has no future royalty obligations to theCompany.

 

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As a result of termination of the license and supplyagreements with Esprit, the Company no longer has continuing obligations toEsprit. Accordingly, all deferred revenue related to license fees previouslyreceived from Esprit was fully recognized as revenue in July 2007, resulting inrecognition of approximately $36.1 million of license revenue. In addition, thefinal $10 million payment received in July 2007 was fully recognized as licenserevenue on receipt, resulting in total recognition of $46.1 million of licenserevenue in the third quarter of 2007. The royalty payment of $2.5 million wasrecognized as royalty revenue and the $5.0 million termination fee has beenclassified as a gain within operating income in the third quarter of 2007.

 

***Watson Pharmaceuticals***

 

In July 2007, the Company entered into a promotionagreement with Watson Pharmaceuticals (Watson) granting Watson a co-exclusiveright to promote ProQuin XR to the urology specialty and to long-term carefacilities in the United States. In September 2007, the agreement was amendedto also grant Watson a co-exclusive right to promote ProQuin XR to theobstetrics/gynecology (ob/gyn) specialty. Watson is required to deliver aminimum number of annual sales detail calls and maintain a sales force of aminimum size. Watson will receive a promotion fee equal to an agreed uponportion of gross margin attributable to the urology and ob/gyn specialties andlong-term care facilities above an agreed upon baseline level. The Company isresponsible for the manufacture and distribution of ProQuin XR. Each partybears all of its own personnel and other costs, including marketing expenses. Theterm of the promotion agreement is three years, with up to two additional one-yearrenewal periods at the election of Watson, and subject to early terminationunder certain circumstances. The Company has retained the right to promoteProQuin XR to physicians outside the urology, ob/gyn and long-term caremarkets, either directly or through third parties. The Company re-launchedProQuin XR and Watson commenced promotion in October 2007.

 

***LGLife Sciences***

 

InJanuary 2007, the Company and LG Life Sciences amended the parties’ license anddistribution agreement, originally entered into in August 2004, as amended inNovember 2006. The amendment grants LG a license to certain of the Company’sintellectual property rights to manufacture LG’s version of Glumetza, Novamet GR (extended releasemetformin tablets), in exchange for royalties on net sales of Novamet GR inKorea, and to remove the provisions of the original agreement providing for thesupply of 500mg Novamet GR tablets by the Company to LG. The Company received a$0.6 million upfront license fee in August 2004 and a $0.5 million milestonepayment in November 2006 with respect to LG’s approval to market Novamet GR inthe Republic of Korea that were originally deferred and amortized as revenueover the estimated length of time the Company was obligated to provideassistance in development and manufacturing. Under the amended agreement, theCompany no longer has continuing performance obligations to LG that are otherthan inconsequential or perfunctory and accordingly, the remaining $0.9 millionof previously deferred revenue was recognized as license revenue in the firstquarter of 2007.

 

***Biovail***

 

InFebruary 2007, the Company entered into a license and development agreementwith Biovail granting Biovail an option to license the AcuForm drug deliverytechnology to develop and commercialize up to two pharmaceutical products.Pursuant to the agreement, Biovail paid the Company an upfront fee of $0.5million in February 2007, and is contingently obligated to pay the Companyadditional fees related to the exercise of the license option, the initiationof the first Phase 3 trial for each product and upon receipt of U.S. regulatoryapproval for each product. The agreement also requires that Biovail makeroyalty payments to the Company on net commercial sales of any productdeveloped under the agreement. As the Company has no continuing obligations toBiovail under the agreement that are other than inconsequential or perfunctory,the $0.5 million upfront license fee was recognized as license revenue in thefirst quarter of 2007.

 

Alsoin February 2007, the Company amended its stock purchase agreement with Biovailoriginally entered into in May 2002. The amended stock purchase agreementremoved Biovail’s observer rights at the Company’s board of directors meetingsand removed the right of first negotiation in favor of Biovail with respect toacquisition transactions involving the Company.

 

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**NOTE 7. RELATEDPARTY TRANSACTIONS**

 

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

 

InAugust 2007, John W. Fara, Ph.D. retired from his positions as President, ChiefExecutive Officer and Chairman of the Company. Dr. Fara will continue to serveas a member of the Company’s Board of Directors. The Company entered into aconsulting agreement 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 per month forhis consulting services, and will reimburse Dr. Fara for COBRA and life insurancepremiums. Dr. Fara will be paid on an hourly basis for consulting servicesprovided in 2009. For the three months ended September 30, 2007, the Companyincurred expense of approximately $27,000 associated with this consultingagreement.

 

During the period of his consultancy, Dr. Fara willcontinue to vest in all of his currently unvested stock options, and his vestedstock options will remain exercisable. For the three months ended September 30,2007, the Company recognized approximately $12,000 in stock compensationexpense associated with these awards.

 

In the event of a change in control of the Company, asdefined by the Company’s 2004 Equity Incentive Plan, all of Dr. Fara’s unvestedoptions will fully vest, and any remaining monthly payments for consultingunder the agreement will be accelerated.

 

**NOTE 8. REDUCTIONIN FORCE**

 

InSeptember 2007, the Company reduced its workforce by 25 employees, orapproximately 25% of its full-time staff, to conserve cash and align itsworkforce with its anticipated staffing needs. The total cost of the workforcereduction is expected to be $672,000, which consists of cash payments forseverance, medical insurance and outplacement services and was recognized asexpense during the three months ended September 30, 2007. Severance expense of$451,000 and $221,000 was recognized in research and development expense andselling, general and administrative expense, respectively, for the three monthsended September 30, 2007. The following table summarizes the severance expenseactivity during the three months ended September 30, 2007 (in thousands):

|                                               |   |   |   |
|----------------------------------------------------|--------|--------|--------|
| Severance expense accrued                          |   | $      | 672    |   |
| Cash payments                                      |   | (392   | )      |
| Accrued severance balance as of September 30, 2007 |   | $      | 280    |   |

 

The severance accrual as of September 30, 2007 isexpected to be paid in the fourth quarter of 2007.

 

**NOTE 9.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, 2007** | ** ** | **December 31, 2006** | ** ** |
|-----------------|------------|------------------------|------------|----------------------------|------------|
| Raw materials   |       | $                      | 980        |                       | $          | 1,343 |   |
| Work-in-process |       | 272                    |       | 1,387                      |       |
| Finished goods  |       | 1,961                  |       | 970                        |       |
| Deferred costs  |       | 638                    |       | 783                        |       |
| Total           |       | $                      | 3,851      |                       | $          | 4,483 |   |

 

Deferred costs represent the costs ofGLUMETZA product shipped for which recognition of revenue has been deferred.

 

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**NOTE 10.SHAREHOLDERS’ EQUITY (DEFICIT)**

 

***Registered Direct Equity Offering***

 

In April 2007, the Company completed a registered direct offering of 5,300,000shares of common stock with selected institutional investors. The shares weresold at a price of approximately $3.78 per share, with net proceeds totalingapproximately $20.0 million.

 

***Series A Preferred Stock***

 

TheSeries A Preferred Stock accrued a dividend of 7% per annum, compoundedsemi-annually and payable in shares of Series A Preferred Stock. TheSeries A Preferred Stock was convertible at anytime betweenJanuary 2002 and January 2006 into the Company’s common stock. Theoriginal conversion price of the Series A Preferred Stock was $12.00;however, as a result of the Company’s March 2002 and October 2003financings, the conversion price had been adjusted to $9.51 per share. InDecember 2004, the Company entered into an agreement with the Series APreferred shareholder to resolve a misunderstanding between the Company and theshareholder relating primarily to prior adjustments to the conversion price ofthe Series A Preferred Stock. Pursuant to the agreement, among othermatters, the Company agreed to adjust the conversion price to $7.50 per share.The Company and the shareholder also agreed to binding interpretations ofcertain other terms related to the Series A Preferred Stock conversionprice.

 

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 preferred shareholder.However, an anti-dilution provision ofthe Series A Preferred Stock was triggered by the Company’sJanuary 2005 financing, which adjusted the conversion price of theSeries A Preferred Stock to $7.12. As a result of the adjustedconversion price and an increase in the amount of common stock issuable uponconversion of the Series A Preferred Stock due to additional accumulateddividends, the Series A Preferred Stock now contains a “beneficialconversion feature” subject to recognition pursuant to Issue No. 98-5.

 

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

 

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TheSeries A Preferred Stock accrued dividends through January 20, 2006,which is the date the warrant initially became exercisable. As a result of theissuance of the warrant, the preferred stock may be surrendered in exchange forcommon stock for an additional three years through January 20, 2009. Aslong as the Series A Preferred Stock remains outstanding, the number ofshares into which the warrant can be converted increases as the conversionprice of the warrant decreases resulting in additional deemed dividends on theSeries A Preferred Stock. For the three and nine months ended September30, 2007, the Company recognized Series A Preferred Stock deemed dividendsof approximately $0.2 and $0.5 million, respectively, attributable to thebeneficial conversion feature from the accrued dividends and decreasing warrantprice. The Company will continue to recognize Series A Preferred Stockdeemed dividends until the earlier of, the time the Series A PreferredStock is surrendered or until January 2009.

 

Asof September 30, 2007, 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 2,773,402 shares of the Company’scommon stock at a conversion price of $6.55 as of September 30, 2007.

 

***Option Exercises***

 

There were no options exercised by employees and consultants during thethree months ended September 30, 2007. Employees and consultants exercisedoptions to purchase 226,472 shares of the Company’s common stock with netproceeds to the Company of approximately $0.7 million during the nine monthsended September 30, 2007.

 

***Employee Stock Purchase Plan***

 

In May 2007, the Company sold 72,217 shares under the ESPP. The shareswere purchased at a weighted average exercise price of $3.09 with proceeds ofapproximately $0.2 million.

 

**NOTE 11.INCOME TAXES**

 

In July 2006, the Financial Accounting Standards Board, or FASB, issuedFASB Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes - an interpretation of FASB Statement No. 10* (FIN48). FIN 48 clarifies the accounting for uncertainty in income taxes recognizedin an entity’s financial statements. Tax positions are evaluated forrecognition using a more-likely-than-not threshold, and those tax positionsrequiring recognition are measured as the largest amount of tax benefit that isgreater than 50 percent likely of being realized upon ultimate settlement witha taxing authority that has full knowledge of all relevant information. FIN 48is effective for fiscal years beginning after December 15, 2006.

 

The Company adopted the provisions of FIN 48 on January 1,2007. As of January 1, 2007 and September 30, 2007, the Company had$2.3 million and $2.9 million of unrecognized tax benefits, which isnetted against deferred tax assets and is fully offset by a valuationallowance. Upon adoption of FIN 48, no adjustment was made to the Company’sliability for uncertain tax positions or the Company’s beginning accumulateddeficit balance. The adoption of FIN 48 did not have a material impact onthe Company’s financial statements, results of operations or cash flows.

 

All tax years since inception remain open to examination by theInternal Revenue Service and the California Franchise Tax Board until such timethe Company’s net operating losses and credits are either utilized or expire.Interest and penalties, if any, related to unrecognized tax benefits, would berecognized as income tax expense by the Company. As of the date of adoption ofFIN 48, the Company did not have any accrued interest or penaltiesassociated with unrecognized tax benefits. The Company does not foresee any materialchanges to unrecognized tax benefits within the next twelve months.

 

**NOTE 12.SUBSEQUENT EVENTS**

 

***King Pharmaceuticals***

 

In October 2007, the Company terminated its promotionagreement with King Pharmaceuticals (King) related to the marketing of GLUMETZAin the United States. Pursuant to the termination agreement, King paid theCompany $29.9 million in termination and other fees, and will fulfill itsGLUMETZA promotion obligations through December 31, 2007. Beginning in thefourth quarter of 2007, the Company is no longer obligated to pay Kingpromotion fees on sales of GLUMETZA in the United States.

 

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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 the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended. We have based these forward-looking statements on our currentexpectations and projections about future events. Our actual results coulddiffer materially 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 statements that refer to expectations,projections or other characterizations of future events or circumstances areforward-looking statements. Forward-looking statements include, but are notnecessarily limited to, those relating to:

 

•    ourability to obtain development and marketing partners for Gabapentin GRTM andother product candidates;

•    resultsand timing of our clinical trials, including the results of Gabapentin GRtrials and publication of those results;

•    thefuture commercialization of GLUMETZATM in the United States, and our ability tofind a new marketing partner for GLUMETZA in the United States;

•    thesuccess of ProQuin® XR in the United States, and the success of our collaborative arrangement with WatsonPharmaceuticals with respect to ProQuin XR;

•    marketacceptance of GLUMETZA and ProQuin XR;

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

•    ourability to raise additional capital; 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. 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. ProQuinXR (ciprofloxacin hydrochloride extended release tablets) is a once-dailytreatment for uncomplicated urinary tract infections that we jointlycommercialize in the United States with Watson Pharmaceuticals.

 

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 differentiated from immediate release versions of the compounds uponwhich they are based. Second, we selectively enter into collaborativepartnerships with other companies where the unique capabilities of ourtechnology can provide superior value to a partner’s compound, resulting insignificantly 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.

 

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Our most advanced product candidate is Gabapentin GR,an extended release form of gabapentin. In July 2007, we announced that theprimary endpoint of our Phase 3 clinical trial for the treatment ofpostherpetic neuralgia (PHN) was not achieved with statistical significance.****We have also completed and announced positive results of aPhase 2 clinical trial for the treatment of diabetic peripheral neuropathy(DPN), and initiated a Phase 2 clinical trial for the treatment of menopausalhot flashes. Additionally, we have other product candidates in earlier stagesof development, including a treatment for gastroesophageal reflux disease(GERD).

 

Ourintellectual property position includes nine issued patents and twelve patentapplications pending in the United States.

 

***Significant Developments for the Quarter Ended September 30,2007***

 

•             InJuly 2007, we announced the results of our Phase 3 clinical trial forGabapentin GR for the treatment of PHN. The primary endpoint in the study wasnot achieved with statistical significance for either active treatment regimen,as compared to placebo, over the ten-week treatment period. However, importantsecondary endpoints related to efficacy were achieved with statisticalsignificance relative to placebo, and the incidence of certain adverse eventsassociated with gabapentin was relatively low.

•             InJuly 2007, we terminated our license and supply arrangements with Esprit Pharmarelated to ProQuin XR, and the marketing and distribution rights in the UnitedStates for ProQuin XR were transferred back to us. We received $17.5 million inpayments pursuant to the termination agreement.

•             InJuly 2007, we entered into a promotion agreement with Watson Pharmaceuticalsgranting Watson a co-exclusive right to promote ProQuin XR to the urologyspecialty and long-term care facilities in the United States. In September2007, we amended the agreement and additionally granted Watson a co-exclusiveright to promote ProQuin XR to the ob/gyn specialty.

•             InAugust 2007, Dr. John W. Fara retired from his positions as our Chairman,President and Chief Executive Officer of the Company. Dr. Fara will continue toserve the Company as a director and a consultant.

•             InAugust 2007, Carl A. Pelzel was appointed as the Company’s President and ChiefExecutive Officer, and Craig R. Smith, M.D., was appointed Chairman of theBoard of Directors.

•             InAugust 2007, we announced the results of a Phase 2apharmacokinetic/pharmacodynamic proof-of-concept study of patients sufferingwith nocturnal acid breakthrough (NAB) associated with GERD.

•             InSeptember 2007, we completed patient enrollment on a Phase 2 trial forGabapentin GR for the treatment of menopausal hot flashes.

•             InSeptember 2007, we implemented a reduction in force affecting approximatelyone-fourth of our employees.

•             Revenuesfor the three months ended September 30, 2007 were $52.9 million, and included$48.6 million associated with the termination of our Esprit license and supplyagreements, compared to $1.0 million for the three months ended September 30,2006.

•             Operatingexpenses for the three months ended September 30, 2007 were $8.2 million andincluded a $5.0 million gain on termination of our Esprit license and supplyagreements, compared to operating expenses of $13.8 million for the threemonths ended September 30, 2006.

•             Cash,cash equivalents and marketable securities were $45.8 million as of September30, 2007, compared to $33.6 million as of December 31, 2006.

 

***Other Recent Developments***

 

•             InOctober 2007, John F. Hamilton retired as our Vice President, Finance and ChiefFinancial Officer, and Tammy L. Cameron, our Corporate Controller, wasappointed as our principal accounting and financial officer on an interimbasis.

•             InOctober 2007, we terminated our promotion agreement with King Pharmaceuticalsrelated to GLUMETZA. Pursuant to the termination agreement, King paid us $29.9million in termination and other fees, and will fulfill its GLUMETZA promotionobligations through December 31, 2007.

 

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**RECENTPRODUCT DEVELOPMENTS**

 

***MARKETED PRODUCTS***

 

***GLUMETZATM***

 

*King Pharmaceuticals*. InOctober 2007, we terminated our promotion agreement with King related toGLUMETZA. Pursuant to the termination agreement, King paid us $29.9 million intermination and other fees, and will fulfill its GLUMETZA promotion obligationsthrough December 31, 2007. We have no obligation to pay King promotion fees onsales of GLUMETZA for periods after September 30, 2007. We are in discussionswith potential marketing partners for GLUMETZA in the United States.

 

In April 2007, we submitted a prior approval supplement to the FDAcovering a 1000mg tablet strength of GLUMETZA seeking approval to market theproduct in the United States.  In August 2007, we received an approvableletter from the FDA in response to the prior approval supplement.  Theconditions to approval set forth in the letter relate primarily to manufacturing,and we are working with Biovail to resolve them. We expect that the conditionswill be satisfied, and the 1000mg GLUMETZA to be commercially available in thesecond quarter of 2008.

 

***ProQuin® XR***

 

*Esprit Pharma*. In July 2007,we entered into a termination and assignment agreement with Esprit terminatingthe exclusive license and marketing agreement originally entered into in July2005 and subsequently amended in July 2006, in which we previously grantedEsprit ProQuin XR marketing and distribution rights in the United States. Therelated supply agreement entered into in July 2005 and co-promotion agreemententered into in July 2006 were also terminated.

 

Upon entering into the termination and assignmentagreement, the marketing and distribution rights in the United States forProQuin XR were transferred back to us and Esprit paid us $17.5 millionrepresenting (i) a $10.0 million payment in respect of the final licensepayment that would have been due to us in July 2007 under the exclusive licenseand marketing agreement; (ii) a $2.5 million payment in respect to a pro-ratedportion minimum royalties for 2007; and (iii) a $5.0 million termination fee.The termination and assignment agreement removed Esprit’s future minimumroyalty obligations to us.

 

Under the termination and assignment agreement, Espritis responsible for all returns and rebates associated with ProQuin XR productdistributed by Esprit.

 

*Watson Pharmaceuticals*. InJuly 2007, we entered into a promotion agreement with Watson granting Watson aco-exclusive right to promote ProQuin XR to the urology specialty and long-termcare facilities in the United States. In September 2007, we amended theagreement to also grant Watson a co-exclusive right to promote ProQuin XR tothe ob/gyn specialty. Watson is required to deliver a minimum number of annualsales detail calls and maintain a sales force of a minimum size. Watson willreceive a promotion fee equal to an agreed upon portion of gross marginattributable to the urology and ob/gyn specialties and long-term carefacilities above an agreed upon baseline level. We will be responsible for themanufacture and distribution of ProQuin XR. Each party will bear all of its ownpersonnel and other costs, including marketing expenses. The term of the PromotionAgreement is three years, subject to early termination in certaincircumstances, with up to two additional one-year renewal periods at theelection of Watson. We have retained the right to promote ProQuin XR tophysicians outside the urology and ob/gyn specialties and long-term caremarkets, either directly or through third parties. We and Watson re-launchedProQuin XR in October 2007.

 

*Madaus*.In November 2005, we entered into a distributionand supply agreement for ProQuin XR in Europe with a privately owned specialtypharmaceutical company, Madaus S.r.l., who was acquired by Rottapharm in June2007. Under the terms of the agreement, we granted an exclusive right to Madausfor the commercialization of ProQuin XR in Europe and agreed to supply Madaus withcommercial quantities of ProQuin XR tablets in bulk form.  InMarch 2006, Madaus filed a Marketing Authorization Application for ProQuinXR with the Medical Products Agency in Sweden.  We assisted Madaus with aresponse to comments and questions on the Marketing Authorization Applicationthat Madaus received in May 2007.  Madaus submitted its response to theSwedish Medical Products Agency’s questions and comments in August 2007. We anticipate that the Medical Products Agency will act on the response submittedby Madaus before the end of the first quarter of 2008.

 

16

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***PRODUCT CANDIDATES***

 

## ***Gabapentin GRTM***

 

*Postherpetic Neuralgia*. InMay 2006, we initiated a Phase 3 clinical trial for Gabapentin GR for thetreatment of PHN. The study was a randomized, double-blind, placebo-controlledstudy of approximately 400 PHN patients. The study was fully enrolled in March2007. Patients in the study were randomized into three treatment arms: placebo,a total daily dose of 1800mg of Gabapentin GR dosed once daily, and a totaldaily dose of 1800mg of Gabapentin GR dosed twice daily.

 

The primary objective of the study was to assess theefficacy of Gabapentin GR in reducing the pain associated with PHN, measuredfrom baseline pain scores to the end of a ten-week treatment period on thebasis of the Likert pain scale. Secondary objectives include an assessment ofchanges from baseline in sleep interference, and additional patient andclinician assessments of pain and quality of life.

 

In July 2007, we announced the primary endpoint wasnot achieved with statistical significance for either active treatment regimen,as compared to placebo, over the ten-week treatment period. The mean reductionsin average daily pain scores from baseline to end of study were 1.83(once-daily), 1.72 (twice-daily) and 1.43 (placebo). However, statisticalsignificance relative to placebo was achieved in each of the first seven weeksfor the once-daily treatment arm and in each of the first four weeks for thetwice-daily treatment arm using the "baseline observation carriedforward" statistical analysis applied to the primary endpoint in thestudy.

 

The secondary endpoints of sleep interference,Clinical Global Impression of Change (CGIC), a scale used by physicians foroverall assessment of patient improvement, and Patient Global Impression ofChange (PGIC), a scale used by patients to report their overall assessment ofchange, were all statistically significant for the once-daily treatmentcompared to placebo over the ten week study period. Sleep interference scoreswere reduced by 2.01 points with Gabapentin GR compared to -1.39 with placebo(p=0.014). Physicians reported that 48.0% of patients taking Gabapentinonce-daily were “very much improved” or “much improved” compared to 27.1% ofthe patients who received placebo (p<0.001), as measured by the CGIC.Similar results were observed for the PGIC in the once-daily and placebo arms(p=0.009).

 

We are pursuing discussions with potential developmentand marketing partners for Gabapentin GR for PHN. In November 2007, we plan tosubmit to the FDA a special protocol assessment related to a new Phase 3clinical trial in PHN for Gabapentin GR. Under the FDA’s special protocolassessment procedures, the FDA will evaluate within 45 days certain protocolsfor clinical trials to assess whether they are adequate to meet scientific andregulatory requirements necessary to support an approval. We believe thatobtaining the FDA’s input on the details of a proposed modified protocol designbefore starting a further study will provide valuable guidance for the efficacydemonstration needed for an NDA filing for Gabapentin GR for the PHNindication.

 

*Menopausal Hot Flashes*. InApril 2007, we commenced a Phase 2 study of Gabapentin GR for the treatment ofmenopausal hot flashes assessing the relationship between various doses anddosing schedules of Gabapentin GR and the safety and efficacy of theformulation of Gabapentin GR for the treatment of menopausal hot flashes. InSeptember 2007, we completed patient enrollment in the trial and expect toreport top-line data from the study in the first quarter of 2008. The study isa double-blind, placebo-controlled, multi-center trial of 124 menopausal womenexperiencing recurrent, moderate to severe hot flashes. The primary endpointsof the trial are the frequency and severity of hot flashes, relative tobaseline. Secondary endpoints include, among others, the efficacy of GabapentinGR relative to placebo based on changes from baseline to the end of eachtreatment period, average daily frequency and severity score of hot flashes andsleep quality.

 

***GastroesophagealReflux Disease Program***

 

In 2006, we conducted a Phase 1 study of the GERDtreatment omeprazole, a generic proton pump inhibitor, designed to provide uswith insight into our formulation strategy for our GERD program.  We havealso conducted two proof-of-concept studies related to our GERD program. In the initial study, we determined that our gastric retentive omeprazoletablet can predictably deliver omeprazole approximately four hours afteringestion.

 

In August 2007, we announced the results of the secondstudy. The Phase 2a pharmacokinetic/pharmacodynamic proof-of-concept studydemonstrated the potential clinical advantages of the delivery of omeprazole intwo evening pulses to patients suffering with nocturnal acid breakthrough, orNAB, associated with GERD.

 

17

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The objective of the study was to determine if thedelivery of a dose of omeprazole with dinner and a second dose four hours afterdinner would reduce the incidence of NAB, which typically occurs in the lateevening and early morning hours. The study was an open label crossover studythat involved 16 patients with at least three months history of GERD withrecurrent nighttime acid reflux while taking omeprazole or any other protonpump inhibitor. Fourteen of the 16 patients completed each of two treatmentarms. In the proof-of-concept arm of the study, patients received 20 mg ofomeprazole with dinner followed by a second 20 mg dose four hours later, inorder to simulate a two pulse delivery mechanism. In the comparative arm of thestudy, patients received 40 mg of omeprazole 30 minutes before dinner.

 

Five patients who received the two pulses ofomeprazole did not have clinically meaningful blood levels of the drugassociated with the first pulse and therefore did not provide useful data forthis trial, because the study objective was to evaluate a two pulse delivery ofthe drug. These patients received the commercially available formulation ofomeprazole known as Prilosec®. It is not known why these patients did notachieve blood levels with Prilosec.

 

In the nine patients whodid achieve blood levels from both doses of omeprazole, and thus provideduseful data for the two pulse concept tested in the trial, none experiencedNAB. In the 40 mg single dose treatment arm, three patients experienced NAB.All three of these patients had blood levels of omeprazole fall to undetectablelevels between 2 a.m. and 3 a.m.. Results from both arms of the study thereforedemonstrate the need to maintain adequate blood levels of omeprazole in orderto inhibit NAB.

 

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

 

*Supernus*. In September 2006,we entered into a collaboration agreement with Supernus Pharmaceuticals, Inc.to develop through a Phase 1 study a product candidate leveraging our AcuFormdrug delivery technology. The cost and ownership of the program will be sharedbetween the parties equally. We continue to participate with Supernus on thiscollaborative program.

 

**CRITICAL ACCOUNTING POLICIES**

 

Critical accounting policies are those that requiresignificant judgment and/or estimates by management at the time that thefinancial statements are prepared such that materially different results mighthave been reported if other assumptions had been made. We consider certainaccounting policies related to revenue recognition, accrued liabilities andstock-based compensation to be critical policies. There have been no changes toour critical accounting policies since we filed our 2006 Annual Report on Form 10-Kwith the Securities and Exchange Commission on March 16, 2007. For adescription of our critical accounting policies, please refer to our 2006Annual Report on Form 10-K.

 

18

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### **RESULTS OF OPERATIONS**

### ** **

*Three and NineMonths Ended September 30, 2007 and 2006*

* *

### **Revenue**

### ** **

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

 

| ** **            | ** ** | **Three  Months Ended September 30,** | ** ** | **Nine  Months Ended September 30,** | ** ** |
|-----------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **            | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Product sales:        |       |                                  |       |                                 |       |   |   |   |   |
| GLUMETZA              |       | $                                     | 3,832      |                                 | $          | — |   | $ | 7,666 |   | $ | — |   |
| ProQuin XR            |       | —                                |       | —                               |       | — |   | 1,265 |   |
| Total product sales   |       | 3,832                                 |       | —                               |       | 7,666 |   | 1,265 |   |
|                  |       |                                  |       |                                 |       |   |   |   |   |
| Royalties:            |       |                                  |       |                                 |       |   |   |   |   |
| GLUMETZA              |       | 46                                    |       | 9                                    |       | 125 |   | 107 |   |
| ProQuin XR            |       | 2,500                                 |       | 57                                   |       | 2,500 |   | 388 |   |
| Total royalties       |       | 2,546                                 |       | 66                                   |       | 2,625 |   | 495 |   |
|                  |       |                                  |       |                                 |       |   |   |   |   |
| License revenue:      |       |                                  |       |                                 |       |   |   |   |   |
| GLUMETZA              |       | 364                                   |       | 382                                  |       | 1,996 |   | 1,146 |   |
| ProQuin XR            |       | 46,117                                |       | 511                                  |       | 47,507 |   | 1,533 |   |
| AcuForm technology    |       | —                                |       | —                               |       | 500 |   | — |   |
| Total license revenue |       | 46,481                                |       | 893                                  |       | 50,003 |   | 2,679 |   |
|                  |       |                                  |       |                                 |       |   |   |   |   |
| Collaborative revenue |       | 1                                     |       | —                               |       | 3 |   | 75 |   |
|                  |       |                                  |       |                                 |       |   |   |   |   |
| Total revenues        |       | $                                     | 52,860     |                                 | $          | 959 |   | $ | 60,297 |   | $ | 4,514 |   |

 

***Product sales***

 

The GLUMETZA product thatwe began selling to wholesalers and retail pharmacies in September 2006 issubject to rights of return of up to twelve months after product expiration.Given the limited sales history of GLUMETZA and return privileges, we currentlycannot reliably estimate expected returns of the product at the time ofshipment. We defer recognition of revenue on product shipments of GLUMETZAuntil the right of return no longer exists, which occurs at the earlier of thetime GLUMETZA units are dispensed through patient prescriptions or expirationof the right of return. We estimate the volume of prescription units dispensedby pharmacies based on an analysis of third-party information, includingthird-party market research data, information obtained from certain wholesalerswith respect to inventory levels and out-movement and retail pharmacyre-stocking activity. For the three and nine months ended September 30, 2007,we recognized approximately $3.8 million and $7.7 million of product sales ofGLUMETZA, respectively, which is net of estimated patient support programdiscounts, wholesaler fees, stocking allowances, prompt payment discounts,chargebacks and Medicaid rebates. We have deferred recognition of revenue onGLUMETZA product shipments to customers which we estimate have not beendispensed through patient prescriptions. At September 30, 2007, we have a deferredrevenue balance, which is classified as a liability on the consolidated balancesheet, of $4.7 million associated with the deferral of revenue on GLUMETZAproduct shipments, which is net of estimated patient support program discounts,wholesaler fees, stocking allowances, prompt payment discounts, chargebacks andMedicaid rebates.

 

ProQuin XR product salesin 2006 relate to our supply agreement with Esprit. We began supplying Espritwith commercial quantities of ProQuin XR in the fourth quarter of 2005, and in2007, there were no sales pursuant to the supply agreement. We terminated thelicense and supply agreements in July 2007 and the marketing and distributionrights in the United States for ProQuin XR reverted back to us. In October2007, we re-launched ProQuin XR with Watson and expect to begin recognizingproduct sales as revenue in the fourth quarter of 2007.

 

19

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***Royalties***

 

In July 2007, weterminated our license agreement with Esprit that provided for royalty paymentsby Esprit to us on ProQuin XR net sales in the United States. Under thetermination and assignment agreement related to our license and supplyagreements, Esprit paid us $2.5 million in royalties in July 2007, which wasrecognized as royalty revenue in the third quarter of 2007. Esprit is no longerobligated to pay us royalties on ProQuin XR sales.

 

GLUMETZA royalties forthe three and nine months ended September 30, 2007 relate to royalties wereceived from Biovail based on net sales of GLUMETZA in Canada and royalties wereceived from LG based on net sales of LG's version of GLUMETZA, Novamet GR, inKorea. In July 2007, the royalty payable by Biovail was increased to tenpercent on Canadian net sales of the 500mg GLUMETZA. We began receivingroyalties from LG in the first quarter of 2007.

 

***License revenue***

 

Our license agreementwith Esprit for ProQuin XR provided for $50.0 million in license fees fromEsprit. We received $30.0 million in license fees in July 2005 and anadditional $10.0 million in December 2006. The final $10.0 million installmentwas due in July 2007. The first $40.0 million in license fees received wererecognized as revenue ratably commencing on our receipt of the fees throughJune 2020, which represented the length of time we were obligated tomanufacture ProQuin XR under our ProQuin XR supply agreement with Esprit. InJuly 2007, we and Esprit terminated the license and supply agreements.

 

As a result of the termination of our agreements withEsprit, we no longer have continuing obligations to Esprit. Accordingly, alldeferred revenue related to license fees previously received from Esprit wasfully recognized as revenue in July 2007, resulting in recognition ofapproximately $36.1 million of license revenue. In addition, the final $10million payment received in July 2007 was fully recognized as license revenueon receipt, resulting in total recognition of $46.1 million of license revenuerelated to our agreements with Esprit during the third quarter of 2007.

 

We received $25.0 millionin GLUMETZA license fees from Biovail in July 2005. We are recognizing the$25.0 million license fee payment as revenue ratably until February 2023, whichrepresents the estimated length of time our obligations exist under thearrangement related to royalties we are obligated to pay Biovail on net salesof GLUMETZA in the United States and for our obligation to use Biovail as oursole supplier of the 1000mg GLUMETZA, should the 1000mg GLUMETZA obtainapproval in the United States.

 

Wereceived a $0.6 million upfront license fee from LG in August 2004 and a $0.5million milestone payment received in November 2006 with respect to LG’sapproval to market Novamet GR in the Republic of Korea. These payments wereoriginally deferred and amortized as license revenue over the estimated lengthof time we were obligated to provide assistance in development andmanufacturing. In January 2007, we amended our agreement with LG, granted LG alicense to certain of the Company’s intellectual property rights to manufacturethe 500mg Novamet GR in exchange for royalties on net sales of Novamet GR inKorea, and removed the provisions of the original agreement providing for thesupply of 500mg Novamet GR tablets by us to LG. Under the amended agreement, weno longer have continuing performance obligations that are other thaninconsequential or perfunctory to LG. Accordingly, the remaining $0.9 millionof previously deferred revenue was recognized as license revenue in the firstquarter 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 commercialize up totwo pharmaceutical products. We have no continuing performance obligations thatare other than inconsequential or perfunctory under the agreement. Accordingly,we have recognized the entire upfront license fee as revenue in the firstquarter of 2007.

 

20

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**Cost of Sales**

 

Cost of sales consists of costs of the activepharmaceutical ingredient, contract manufacturing and packaging costs, productquality testing, internal employee costs related to the manufacturing process,distribution costs and shipping costs related to our product sales. Total costof sales for the three and nine months ended September 30, 2007, as compared tothe prior year, was as follows (in thousands):

 

| ** **    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **    | ** ** | **2007**                             | ** ** | **2006**                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Cost of sales |       | $                                    | 724        |                                | $          | 320 |   | $ | 1,598 |   | $ | 1,445 |   |
|               |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |

 

Cost of sales for the three and nine months endedSeptember 30, 2007 relates primarily to costs associated with the sale ofGLUMETZA. Costs of sales for the three and nine months ended September 30, 2006relates primarily to costs associated with the supply of ProQuin XR to Esprit.The costs of manufacturing associated with deferred revenue on GLUMETZA productshipments are recorded as deferred costs, which are included in inventory, untilsuch time the deferred revenue is recognized.

 

**Research and Development Expense**

 

Our research anddevelopment expenses currently include costs for scientific personnel,supplies, equipment, outsourced clinical and other research activities,consultants, depreciation, facilities and utilities. The scope and magnitude offuture research and development expenses cannot be predicted at this time forour product candidates in the early phases of research and development, as itis not possible to determine the nature, timing and extent of clinical trialsand studies, the FDA’s requirements for a particular drug and the requirementsand level of participation, if any, by potential partners. As potentialproducts proceed through the development process, each step is typically moreextensive, and therefore more expensive, than the previous step. Success indevelopment therefore, generally results in increasing expenditures untilactual product launch. Total research and development expense for the three andnine months ended September 30, 2007, as compared to the prior year, was asfollows (in thousands):

 

| ** **                        | ** ** | **Three  Months Ended September 30,** | ** ** | **Nine  Months Ended September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Research and development expense  |       | $                                     | 4,724      |                                 | $          | 6,436 |   | $ | 19,425 |   | $ | 18,888 |   |
| Dollar change from prior year     |       | (1,712                                | )          |                                 |       | 537 |   |   |   |
| Percentage change from prior year |       | (26.6                                 | )%         |                                 |       | 2.8 | % |   |   |
|                                   |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

The decrease in research and development expense forthe three months ended September 30, 2007 as compared to the three months endedSeptember 30, 2006 was primarily due to lower outside contract service expensesrelated to the completion of the Phase 3 clinical trial for Gabapentin GR forthe treatment of postherpetic neuralgia which was completed in the first halfof 2007.

 

The increase in research and development expense forthe nine months ended September 30, 2007 as compared to the nine months endedSeptember 30, 2006 was primarily due to higher outside contract serviceexpenses for our clinical trial expenses related to our Phase 2 clinical trialfor Gabapentin GR for the treatment of menopausal hot flashes and costsassociated with our Phase 2a proof-of-concept GERD formulation studies.

 

We may decide to commence one or more additional Phase3 trials for Gabapentin GR for the treatment of postherpetic neuralgia ormenopausal hot flashes either alone or with a collaborative partner, which mayresult in increased research and development expense in future periods.

 

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**Selling, General and AdministrativeExpense**

 

Selling, general andadministrative expenses primarily consist of personnel expenses to support ouroperating activities, marketing and promotion expenses associated withGLUMETZA, facility costs and professional expenses, such as legal andaccounting fees. Total selling, general and administrative expenses, ascompared to the prior year, were as follows (in thousands):

 

| ** **                          | ** ** | **Three  Months Ended September 30,** | ** ** | **Nine  Months Ended September 30,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                          | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Selling, general and administrative |       | $                                     | 8,483      |                                 | $          | 7,328 |   | $ | 21,033 |   | $ | 16,157 |   |
| Dollar change from prior year       |       | 1,155                                 |       |                                 |       | 4,876 |   |   |   |
| Percentage change from prior year   |       | 15.8                                  | %          |                                 |       | 30.2 | %  |   |   |
|                                     |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

The increase in selling,general and administrative expense for the three months ended September 30,2007 as compared to the three months ended September 30, 2006 was primarily dueto $2.1 million in promotion fees due to King under the promotion agreement forGLUMETZA, which was launched in September 2006, offset by decreases of $0.6million in marketing expenses related to GLUMETZA and $0.2 million related tostock-based compensation.

 

The increase in selling,general and administrative expense for the nine months ended September 30, 2007as compared to the nine months ended September 30, 2006 was primarily due to anincrease of $3.0 million in promotion fees due to King under the promotionagreement for GLUMETZA, $0.7 million in marketing costs associated withGLUMETZA, and $1.4 million increase in legal fees resulting from our patentinfringement case against IVAX, offset by a decrease of $0.3 million related tostock-based compensation.

 

We are no longer obligated to pay King promotion feesrelated to sales of GLUMETZA. Accordingly, selling, general and administrativeexpenses may decrease in the fourth quarter of 2007.

 

**Gain on Termination of Esprit Pharma Agreement**

 

In conjunction with thetermination and assignment agreement entered into with Esprit in July 2007, wereceived a $5.0 million termination payment from Esprit, which has beenclassified as a gain within operating income for the three months endedSeptember 30, 2007.

 

**Interest and Other Income**

 

| ** **                        | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| **(in thousands)**                | ** ** | **2007**                             | ** ** | **2006**                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Interest and other income         |       | $                                    | 638        |                                | $          | 492 |   | $ | 1,504 |   | $ | 1,673 |   |
| Dollar change from prior year     |       | 146                                  |       |                                |       | (169 | )  |   |   |
| Percentage change from prior year |       | 29.7                                 | %          |                                |       | (10.1 | )%  |   |   |
|                                   |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |

 

Interest and other income increased during the three months endedSeptember 30, 2007 as compared to the corresponding period in 2006 due tohigher investment balances in the three months ended September 30, 2007 as aresult of receipt of $17.5 million from Esprit in July 2007. Interest and otherincome decreased during the nine months ended September 30, 2007 as compared tothe corresponding periods in 2006 as a result of lower investment balances in2007.

 

**LIQUIDITYAND CAPITAL RESOURCES**

** **

| **(in thousands)**                               | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| Cash, cash equivalents and marketable securities |       | $                      | 45,846     |                  | $          | 33,558 |   |
|                                                  |            |                        |            |                       |            |  |  |

 

Sinceinception through September 30, 2007, we have financed our product developmentefforts and operations primarily from private and public sales of equitysecurities and receipts of upfront license and termination fees fromcollaborative and license partners.

 

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InDecember 2006, we entered into a common stock purchase agreement with AzimuthOpportunity, Ltd., pursuant to which Azimuth is committed to purchase, fromtime to time and at our sole discretion, up to the lesser of (a) $30.0 millionof our common stock, or (b) 8,399,654 shares of common stock. Sales to Azimuthunder the agreement, if any, will occur over a 24-month term and will be madeat a price equal to the average closing price of our common stock over a givenpricing period, minus a discount ranging from approximately 3.8% to 6.4%, whichvaries based on a threshold price set by us. Upon each sale of the our commonstock to Azimuth under the agreement, we have also agreed to pay ReedlandCapital Partners a placement fee equal to approximately 1.1% of the aggregatedollar amount of common stock purchased by Azimuth. Azimuth is not required topurchase our common stock when the price of our common stock is below $2 pershare. As of September 30, 2007, we have not sold any common stock to Azimuthunder this common stock purchase agreement.

 

In April 2007, we completed a registered direct offering of 5,300,000shares of common stock with institutional investors. The shares were sold at aprice of approximately $3.78 per share, with net proceeds totalingapproximately $20.0 million.

 

InJuly 2007, Esprit paid us $17.5 million in connection with the termination ofthe license and supply agreement.

 

InOctober 2007, King paid us $29.9 million in connection with the termination ofour GLUMETZA promotion agreement with King.

 

Asof September 30, 2007, we have accumulated net losses of $159.6 million. Weexpect to continue to incur operating losses in 2008. We anticipate that ourexisting capital resources will permit us to meet our capital and operationalrequirements through at least the end of 2008. We base this expectation on ourcurrent operating plan, which may change as a result of many factors.

** **

Our cash needsmay also vary materially from our current expectations because of numerousfactors, including:

•   salesof our marketed products;

•   expendituresrelated to our commercialization and development efforts;

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

•   resultsof research and development efforts;

•   resultsof our litigation against IVAX;

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

•   technologicaladvances;

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

•   acquisitionsor investment in complimentary businesses, products or technologies.

Wewill need substantial funds of our own or from third parties to.

•   conductresearch and development programs;

•   conductpreclinical and clinical testing; and

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

 

23

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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 byselling our equity or convertible debt securities, the issuance of suchsecurities could result in dilution of our shareholders’ equity positions. Ifadequate funds are not available we may have to:

 

•   delay,postpone or terminate clinical trials;

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

•   obtainfunds through entering into collaboration agreements on unattractive terms.

 

The inability to raiseadditional capital would have a material adverse effect on our company.

** **

### **Cash Flows from OperatingActivities**

### ** **

Cash used in operating activities during the nine monthsended September 30, 2007 was approximately $8.7 million, compared to cash usedin operating activities of approximately $25.3 million during the nine monthsended September 30, 2006. During the nine months ended September 30, 2007 cashused in operating activities was primarily due to our net income adjusted forstock-based compensation, depreciation expense and movements in workingcapital, including recognition of previously deferred revenue. During the ninemonths ended September 30, 2006 cash used in operating activities was primarilydue to our net loss adjusted for stock-based compensation, depreciation expenseand movements in working capital. The decrease in cash used in operatingactivities for the nine months ended September 30, 2007 as compared to theprior year was primarily due to receipt of the $17.5 million in payments fromEsprit on termination of the license and supply agreements for ProQuin XR.

 

**Cash Flows from Investing Activities**

 

Cash used in investing activities during the nine monthsended September 30, 2007 was approximately $17.2 million and consisted of a$17.1 million net increase in marketable securities. Net cash provided byinvesting activities during the nine months ended September 30, 2006 wasapproximately $18.0 million and consisted of an $18.7 million net decrease inmarketable securities offset by $0.7 million in purchases of laboratory andoffice equipment.

 

**Cash Flows from Financing Activities**

 

Cash provided byfinancing activities during the nine months ended September30, 2007 was approximately $20.9 millioncompared to cash provided by financing activities of approximately $2.5 millionfor the same period in 2006. In the nine months ended September 30, 2007, the amount consisted of $20.0 million inproceeds from our registered direct offering in April 2007 and $0.9million in cash proceeds from exercises ofstock options and our ESPP. In the nine months ended September 30, 2006, the amount consisted primarily of cash proceedsfrom the exercises of warrants and stock options.

** **

**Contractual Obligations**

 

As of September 30, 2007, our aggregate contractual obligations are asshown in the following table (in thousands):

 

| ** **       | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **More than 3 years** | ** ** | **Total** | ** ** |
|------------------|------------|-----------------------|------------|---------------|------------|-----------------------|------------|-----------|------------|
| Operating leases |       | $                     | 1,374      |          | $          | 1,238                 |       | $         | 9          |   | $ | 2,621 |   |
|                  |            |                       |            |               |            |                       |            |           |            |  |  |  |  |

 

The contractual obligations reflected in thistable exclude $3.5 million of contingent milestone payments we may be obligatedto pay in the future under our sublicense agreement with PharmaNova. Thesepayments relate to various milestones for the product candidate under thesublicense agreement, including dosing of the first patient in any Phase 3trial, submission to the FDA of an NDA, and FDA approval of an NDA. The tableabove also excludes any future royalty payments we may be required to pay onproducts we have licensed or any promotion fees associated with our promotionagreement with Watson.

 

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**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 31,2006.

** **

**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 along with its interimprincipal accounting and financial officer, concluded that our disclosurecontrols 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 and non-financialinformation concerning our business. While we believe the present design of ourdisclosure controls and procedures is effective to achieve our goal, futureevents affecting our business may cause us to significantly modify ourdisclosure controls and procedures.

 

***Changes in Internal Controls***

 

There were no changes inour internal controls over financial reporting during the quarter endedSeptember 30, 2007 that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

 

 

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**PART II — OTHER INFORMATION**

 

**ITEM 1.LEGAL PROCEEDINGS**

 

We are involved in legal proceedings relating to someof our intellectual property rights.  In January 2006, we filed acomplaint against IVAX Corporation in the U.S. District Court for the NorthernDistrict of California for infringement of U.S. Patent Nos. 6,340,475 and6,635,280, both of which we own. The patents relate to our AcuFormdelivery technology. The complaint alleges infringement of our patents by IVAX’sextended release metformin hydrochloride tablets.  In April 2006, IVAXfiled an answer and counterclaim, in which it alleged that the patents in thesuit are not infringed by IVAX and are invalid and unenforceable. In December2006, the court issued an order construing certain of the claim terms appearingin the patents.  Fact and expert discovery in the case issubstantially complete. In September 2007, we submitted a motionfor summary judgment of infringement. In October 2007, IVAX submittedmotions for summary judgment of invalidity, inequitable conduct, lackof willfulness, and for construction of a claim term appearing in thepatents.  A consolidated hearing on the parties’ summary judgment motionsis scheduled for November 20, 2007. The court has not set a trial date.

 

**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, 2006.

 

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 and presentedelsewhere by our management from time to time. See “Part I, Item2—Forward-Looking Information.”

 

**Our recent Phase 3 trial for Gabapentin GR failedto meet the primary efficacy endpoint and there can be no assurance thisproduct will be approved.**

 

In July 2007, we announcedthat our drug candidate Gabapentin GR failed to meet the primary efficacyendpoint in a Phase 3 trial for the treatment of postherpetic neuralgia(PHN).  We expect that one or moreadditional clinical trials will be required to obtain marketing approval in theUnited States for the product for the PHN indication.  We are pursuing discussions with potentialdevelopment and marketing partners related to the continued development ofGabapentin GR for PHN.  However, we maynot secure a development and marketing arrangement on terms favorable to us, orat all.  In that event, we must considerconducting one or more additional clinical trials alone.

 

We intend to submit aprotocol for a Phase 3 registration trial for Gabapentin GR to the FDA for aspecial protocol assessment, or SPA, pursuant to which the FDA will assesswhether the protocol is adequate to meet the scientific and regulatoryrequirements necessary to support marketing approval of Gabapentin GR forPHN.  In connection with the assessment, we may decide, or the FDA mayrequire us, to modify the protocol by, for example, changing the proposedprimary endpoint, the size of the study or otherwise, which may result in adelay in the completion of the trial.

 

If we conduct additional trials,we will incur significant additional expenses and will not know for at leastone to two years whether the drug is safe and effective such that it could beapproved for marketing.  Even if thesetrials are successful, the approval date for the drug is likely to besignificantly delayed, which means that we would not receive revenue from drugsales for a number of years, if at all. If we decide to abandon the further development of Gabapentin GR forPHN, our commercial prospects may be adversely affected.

 

 

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**We have terminated our promotionarrangement with King Pharmaceuticals related to GLUMETZA in the United States,and have not yet identified a new commercialization partner for the product.**

 

In June 2006, we entered into a promotion agreementwith King Pharmaceuticals pursuant to which King promoted GLUMETZA in theUnited States through its sales force. In October 2007, following a strategic shift in focus by King toward itsneuroscience and hospital/acute care business, we and King terminated thepromotion agreement.  Pursuant to thetermination of the promotion agreement, we received payments from King ofapproximately $29.9 million, and King will continue detailing GLUMETZA throughDecember 31, 2007.

 

We are seeking a new marketing partner forGLUMETZA.  However, we have not yetidentified a new marketing partner and we may not succeed in entering into amarketing arrangement for GLUMETZA on favorable terms, or at all.  We have not yet established a sales force, orcontracted with a third party to act as our sales force, and we do not haveimmediate plans to do so.  Accordingly,the success of GLUMETZA will depend in large part on our ability to identifyand enter into a marketing arrangement with a new partner.  Even if we enter into a new marketingarrangement for GLUMETZA, it may not be successful.  Any failure to successfully commercializeGLUMETZA could have a material adverse effect on our business, financialconditions, results of operations and cash flows.

 

**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 right to co-promote GLUMETZA andProQuin XR through our own sales force, or through third parties, we have nosales force and limited marketing and sales staff.  The success of our own promotion efforts forGLUMETZA, ProQuin XR and any other product candidates that receive regulatoryapproval that we choose to market or co-market will require that wesubstantially enhance our in-house marketing and sales force with technicalexpertise, or make arrangements with third parties to perform theseservices for us.  The development of theinfrastructure associated with these activities involves substantial resources,and considerable attention of our management and key personnel. To the extentthat we 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****depend on WatsonPharmaceuticals for the successful commercialization of ProQuin XR in theUnited States.**

 

In July 2007, we granted Watson Pharmaceuticals theco-exclusive marketing rights to ProQuin XR in the United States for urology specialty and long-term caresales channels. In September 2007, we expanded our promotion arrangement withWatson to include the ob/gyn specialty as well. As described above, we do nothave a commercial sales force and do not, for the foreseeable future, expect tohave the resources to successfully promote ProQuin XR on our own.  Accordingly, we will depend on Watson tosuccessfully promote this drug.  Ourprior marketing partner for ProQuin XR, Esprit Pharma, was unable tosuccessfully commercialize ProQuin XR following its initial launch in November2005.  As a result, we and Esprit agreedto terminate the license in July 2007. It is possible that Watson could also have similar difficultiescommercializing ProQuin XR.  If Watsonfails to successfully commercialize ProQuin XR, our business, financialcondition and results of operations may be materially and adversely affected.

 

**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 keypersonnel.  The efforts of third partieswith whom we contract for distribution of our products may not besuccessful.  Any failure on our part tosuccessfully develop distribution capabilities could cause delays in productsales and incur increased costs.

 

 

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**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, who was acquiredby Rottapharm in June 2007, related to the commercialization of ProQuin XR inEurope. If Biovail fails to successfully commercialize GLUMETZA in Canadaand/or LG fails to successfully commercialize Novamet GR in Korea, our businessand future revenues may be adversely affected.

 

**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 thefollowing programs in clinical development:Gabapentin GR for postherpeticneuralgia, Gabapentin GR for diabetic peripheralneuropathy, Gabapentin GRfor the treatment of hot flashes associated with menopause and omeprazole for the treatment of gastroesophagealreflux disease.  We also have other product candidates in earlier stages of development.

 

Our own product candidates and those of ourcollaborative partners are subject to the risk that any or all of them arefound to be ineffective or unsafe, or otherwise may fail to receive necessaryregulatory 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 our recently completed Phase 3trial for Gabapentin GR for the treatment of postherpetic neuralgia.

 

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, substantially all ofour product candidates use the AcuForm technology.  If it is discovered that theAcuForm technology could have adverse effects or other characteristicsthat indicate it is unlikely to be effective as a delivery system for drugs ortherapeutics, our product development efforts and our business would besignificantly harmed.

 

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

 

To date, we have recorded limited revenues fromlicense fees, product sales, royalties, collaborative research and developmentarrangements and feasibility studies. For the nine months ended September 30,2007, we recorded total revenues of $60.3 million, and for the years endedDecember 31, 2006, 2005 and 2004, we recorded total revenue of $9.6million, $4.4 million and $0.2 million, respectively. For the nine months endedSeptember 30, 2007, we have recorded net income of $24.5 million, and for theyears ended December 31, 2006, 2005 and 2004 we incurred net losses of$39.7 million, $24.5 million and $26.9 million, respectively. The terminationof our license agreement with Esprit in July 2007, including the acceleratedrecognition of previously deferred revenue under the arrangement, andtermination fees received associated with the termination of our promotion agreementwith King are expected to allow us to be profitable in 2007. However, as wecontinue our research and development efforts, preclinical testing and clinicaltrial activities, we anticipate that we will incur operating losses in fiscalyear 2008. Therefore, we expect our cumulative losses to increase. Theselosses, among other things, have had, and we expect that they will continue tohave, an adverse impact on our total assets, shareholders’ equity and workingcapital.

 

 

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**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 Gabapentin GR;

•                  the degree of commercial success of ProQuin XR and GLUMETZA;

•                  regulatory actions;

•                  adverse events related to our products, including recalls;

•                  interruptions of manufacturing or supply;

•                  results of litigation, including our pending litigation against IVAXCorporation;

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

•                  variations in revenues obtained from collaborative agreements,including milestone payments, royalties, license fees and other contractrevenues;

•                  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 ofthe Sarbanes-Oxley Act of 2002.

 

          As a result of these factors, ourstock price may continue to be volatile and investors may be unable to selltheir shares at a price equal to, or above, the price paid. Additionally, anysignificant drops in our stock price, such as the one we experienced followingthe announcement of our Gabapentin GR Phase 3 trial results, 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.

 

 

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**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 collaborationagreement for development of product candidates through the feasibility phasewith New River Pharmaceuticals, a company acquired by Shire Pharmaceuticals,Inc., and we have a collaboration arrangement with Patheon, Inc. related to thepotential development of product candidates for third parties.  We also have a collaboration agreement withSupernus, Inc. providing for the development of a product candidate throughfeasibility, with the possibility to enter into a definitive agreementproviding for the further development of the product candidate, by either orboth parties.  In addition, we have inthe past and may in the future enter into other collaborativearrangements, some of which have been based on less definitive agreements, suchas memoranda of understanding, material transfer agreements, options orfeasibility agreements.  We may notexecute definitive agreements formalizing these arrangements.  Collaborative relationships are generallycomplex and may give rise to disputes regarding the relative rights,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 future collaborative arrangementson acceptable terms, which would harm our ability to develop and commercializeour current and potential future products. Further, even if we do enter intocollaboration arrangements, it is possible that our collaborative partnersmay not choose to develop and commercialize products using theAcuForm technology. Other factors relating to collaborations thatmay adversely affect the commercial success of our products include:

 

•                  any paralleldevelopment by a collaborative partner of competitive technologies or products;

•                  arrangementswith collaborative partners that limit or preclude us from developing productsor technologies;

•                  prematuretermination of a collaboration agreement; or

•                   failureby a collaborative partner to devote sufficient resources to the developmentand commercial sales of products using the AcuForm technology.

 

Generally, our collaborative arrangements do not restrict ourcollaborative partners from competing with us or restrict their ability tomarket or sell competitive products. Our current and any future collaborativepartners may pursue existing or other development-stage products oralternative technologies in preference to those being developed incollaboration with us. Our collaborative partners may also terminate theircollaborative relationships with us or otherwise decide not to proceed withdevelopment and commercialization of our products.

 

 

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**Wemay be unable to protect our intellectual property and may be liablefor infringing the intellectual property of others.**

 

Our success will depend in part on our ability to obtain and maintainpatent protection for our technologies and to preserve our trade secrets. Ourpolicy is to seek to protect our proprietary rights, by, among other methods,filing patent applications in the United States and foreign jurisdictions tocover certain aspects of our technology. We currently hold nine issued patents,and have fourteen patent applications pending in the United States.  In addition, we are preparing patentapplications relating to our expanding technology for filing in the UnitedStates and abroad.  We have also appliedfor patents in numerous foreign countries. Some of those countries have grantedour applications 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 and to make commercial sales ofproducts using our technologies also depends on not infringing others’ patentsor other intellectual property rights. We are not aware of any intellectualproperty 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, weare aware that patents issued to third parties relating to sustained releasedrug formulations or particular pharmaceutical compounds could in the future beasserted against us, although we believe that we do not infringe any validclaim of any patents.  If claimsconcerning any of our products were to arise and it was determined that theseproducts infringe a third party’s proprietary rights, we could be subject tosubstantial damages for past infringement or be forced to stop or delay ouractivities with respect to any infringing product, unless we can obtain alicense, or we may have to redesign our product so that it does not infringeupon others’ patent rights, which may not be possible or could requiresubstantial funds or time.  Such alicense may not be available on acceptable 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.  In addition, any public announcements relatedto litigation or interference proceedings initiated or threatened against us,even if such claims are without merit, could cause our stock price to decline.

 

From time to time, we may become aware ofactivities by third parties that may infringe our patents.  Infringement by others of our patents mayreduce our market shares (if a related product is approved) and, consequently,our potential future revenues and adversely affect our patent rights if we donot take appropriate enforcement action. We may need to engage in litigation in the future to enforce any patentsissued or licensed to us or to determine the scope and validity of third-party proprietary rights.  Our issued or licensed patents may not beheld valid by a court of competent jurisdiction. Whether or not the outcome oflitigation is favorable to us, defending a lawsuit takes significant time, maybe expensive and may divert management attention from other business concerns.We may also be required to participate in interference proceedings declared bythe United States Patent and Trademark Office for the purpose of determiningthe priority of inventions in connection with our patent applications or otherparties’ patent applications. Adverse determinations in litigation orinterference proceedings could require us to seek licenses which may not beavailable on commercially reasonable terms, or at all, or subject us tosignificant liabilities to third parties. If we need but cannot obtain a license, we may be prevented frommarketing the affected product.

 

In January 2006, we filed a complaintagainst IVAX Corporation in federal court for infringement of two of our U.S.patents related to the AcuForm delivery technology.  The complaint alleged infringement of ourpatents by IVAX’s extended release metformin hydrochloride tablet. Although weintend to vigorously enforce our intellectual property rights, there can be noassurance that we will be successful in our litigation against IVAX. If one ormore of our patents is declared invalid or key claims are disallowed, thepatent protection for our products and product candidates could besubstantially weakened and our business and business prospects could beseverely impacted.

 

 

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**Ourlicensed patent covering the use of gabapentin to treat hot flashes associatedwith menopause is a method-of-use patent, which increases the risk thatprescriptions for gabapentin to treat hot flashes in menopausal women could bewritten for, or filled with, generic gabapentin.**

 

** **We have anexclusive sublicense from PharmaNova, Inc. to a patent held by the Universityof Rochester to develop and commercialize in the United States a gabapentin productfor the treatment of hot flashes associated with menopause.  Because a method-of-use patent, such as thepatent we have sublicensed from PharmaNova, covers only a specified use of aparticular compound, not a particular composition of matter, we cannot preventothers from commercializing gabapentin. Accordingly, physicians could prescribe another manufacturer’sgabapentin to treat hot flashes in menopausal women rather than Gabapentin GR,or pharmacists could seek to fill prescriptions for Gabapentin GR with anothermanufacturer’s gabapentin.  Although anysuch “off-label” use would violate our licensed patent, effectively monitoringcompliance with our licensed patent may be difficult and costly.

 

**Itis difficult to develop a successful product. If we do not develop a successfulproduct we may not be able to raise additional funds.**

 

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 foreignregulatory authorities.

 

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 inpreclinical or early-stage clinical studies do not demonstrate efficacy inlater-stage, larger scale clinical 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 healthplans.

 

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 and wouldmake it difficult for us to raise financing on favorable terms, if at all.

 

 

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**Ifwe do not achieve our projected development and commercialization goals in thetimeframes we announce and expect, the commercialization of our productcandidates may be delayed and our business will be harmed and our stock pricemay decline.**

 

For planning purposes, we estimate thetiming of the accomplishment of various scientific, clinical, regulatory andother product development and commercialization goals.  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, or the initiation of other clinicalprograms. 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 availablecapital resources;

•                  the efforts ofour marketing partners with respect to the commercialization of our products;

•                  the rate ofprogress, costs and results of our clinical trial and research and developmentactivities, including the extent of scheduling conflicts with participatingclinicians and clinical institutions and our ability to identify and enrollpatients who meet clinical trial eligibility criteria;

•                  our receipt ofapprovals by the FDA and other regulatory agencies and the timing thereof;

•                  other actions byregulators;

•                  our ability toaccess sufficient, reliable and affordable supplies of components used in themanufacture of our product candidates, including materials for our AcuFormtechnology; and

•                  the costs of ramping up and maintainingmanufacturing operations, as necessary.

 

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

 

**Wedepend on clinical investigators and clinical sites to enroll patients in ourclinical trials and other third parties to manage the trials and to performrelated data collection and analysis, and, as a result, we may face costs anddelays outside of our control.**

 

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

 

Our agreements with clinical investigatorsand clinical sites for clinical testing and for trial management services placesubstantial responsibilities on these parties, which could result in delays in,or termination of, our clinical trials if these parties fail to perform asexpected. For example, if any of our clinical trial sites fail to comply withFDA-approved good clinical practices, we may be unable to use the data gatheredat those sites. If these clinical investigators, clinical sites or other thirdparties do not carry out their contractual duties or obligations or fail tomeet expected deadlines, or if the quality or accuracy of the clinical datathey obtain is compromised due to their failure to adhere to our clinicalprotocols or for other reasons, our clinical trials may be extended, delayed orterminated, and we may be unable to obtain regulatory approval for, orsuccessfully commercialize, our product candidates.

 

 

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**If we areunable to obtain or maintain regulatory approval, we will be limited in ourability to commercialize our products, and our business will be harmed.**

 

The regulatory process is expensive and time consuming. Even afterinvesting significant time and expenditures on clinical trials, we may notobtain regulatory approval of our product candidates. Data obtained fromclinical trials are susceptible to varying interpretations, which could delay,limit or prevent regulatory approval, and the FDA may not agree with ourmethods of clinical data analysis or our conclusions regarding safety and/orefficacy. 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, once regulatoryapproval is obtained, a marketed product and its manufacturer are subject tocontinual review. The discovery of previously unknown problems with a productor manufacturer may result in restrictions on the product, manufacturer ormanufacturing facility, including withdrawal of the product from the market.Manufacturers of approved products are also subject to ongoing regulation,including compliance with FDA regulations governing current Good ManufacturingPractices (cGMP). Failure to comply with manufacturing regulations can resultin, among other things, warning letters, fines, injunctions, civil penalties,recall or seizure of products, total or partial suspension of production,refusal of the government to renew marketing applications and criminalprosecution.

 

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

 

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

 

**Theapproval process outside the United States is uncertain and may limit ourability to develop, manufacture and sell our products internationally.**

 

To market any of our products outside of the United States, we and ourcollaborative partners, including Madaus, are subject to numerous and varyingforeign regulatory requirements, implemented by foreign health authorities,governing the design and conduct of human clinical trials and marketingapproval for drug products. The approval procedure varies among countries andcan involve additional testing, and the time required to obtain approval maydiffer from that required to obtain FDA approval. The foreign regulatoryapproval process includes all of the risks associated with obtaining FDAapproval set forth above, and approval by the FDA does not ensure approval bythe health authorities of any other country, nor does the approval by foreignhealth authorities ensure approval by the FDA.

 

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

 

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

•                  governmenthealth administration authorities;

•                  private healthinsurers;

•                  healthmaintenance organizations;

•                  pharmacy benefitmanagement companies; and

•                  other healthcare-relatedorganizations.

 

If reimbursement is not available for our products or productcandidates, demand for these products may be limited. Further, any delay inreceiving approval for reimbursement from third-party payers would have anadverse effect on our future revenues. Third-party payers are increasinglychallenging the price and cost-effectiveness of medical products and services.Significant uncertainty exists as to the reimbursement status of newly approvedhealthcare products, including pharmaceuticals. Our products may not beconsidered 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 and foreigngovernments continue to propose and pass new legislation designed to contain orreduce the cost of healthcare. Existing regulations affecting pricing may alsochange before many of our product candidates are approved for marketing. Costcontrol initiatives could decrease the price that we receive for any product wemay develop.

 

**Wemay be unable to compete successfully in the pharmaceutical product and drugdelivery system industries.**

 

Othercompanies that have oral drug delivery technologies competitive with theAcuForm technology include Bristol-Myers Squibb, IVAX Corporation (asubsidiary of TEVA Pharmaceutical Industries, Ltd.), ALZA Corporation (asubsidiary of Johnson & Johnson), SkyePharma plc, Biovail Corporation,Flamel Technologies S.A., Ranbaxy Laboratories, Ltd., KosPharmaceuticals, Inc., Intec Pharma and Alpharma, Inc., all of whichdevelop oral tablet products designed to release the incorporated drugs overtime. Each of these companies has patented technologies with attributesdifferent from ours, and in some cases with different sites of delivery to thegastrointestinal 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., MylanLaboratories, Inc. and Teva Pharmaceutical Industries, Ltd. have receivedFDA approval for and are selling a controlled-release metformin product.

 

BayerCorporation developed a once-daily ciprofloxacin product for the treatment ofurinary tract infections, which is currently marketed by Schering-PloughCorporation. There may be other companies developing products competitivewith GLUMETZA and ProQuin XR of which we 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 a new product, LyricaTM (pregabalin), which hasbeen approved for marketing in the U.S. and the European Union.

 

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

 

 

 

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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.

 

**Wedepend on third parties who are single source suppliers to manufacture ProQuinXR, GLUMETZA and our other product candidates. If these suppliers are unable to manufacture ProQuin XR, GLUMETZA or ourproduct candidates, our business will be harmed.**

 

We are responsible for the supply and distribution of GLUMETZA, andMOVA Pharmaceuticals, a subsidiary of Patheon, Inc., is our sole supplier fortablets of the 500mg strength of GLUMETZA pursuant to a supply agreement weentered into with MOVA Pharmaceuticals in December 2006. If approved, Biovailwill be our sole supplier for the new formulation of 1000mg GLUMETZA.  We will be unable to manufacture GLUMETZA ina timely manner if we are unable to obtain GLUMETZA 500mg tablets from ourcontract manufacturer or active pharmaceutical ingredient from suppliers, orGLUMETZA 1000mg tablets from Biovail.

 

We are also responsible for supply and distribution of ProQuin XR.  For the manufacture of ProQuin XR tablets, wehave entered into an agreement with MOVA Pharmaceuticals, as our sole supplier.We purchase the active ingredient for ProQuin XR from Uquifa Mexico, S.A., asole supplier to us, on a purchase order basis. We will also be responsible forthe manufacture of bulk ProQuin XR tablets to Madaus for the European market,if the product is approved for marketing in European jurisdictions.  We intend to purchase ProQuin XR tablets fromMOVA Pharmaceuticals for that purpose. If we are unable, for whatever reason,to obtain the active pharmaceutical ingredient or ProQuin XR tablets from ourcontract manufacturers, we may be unable to manufacture ProQuin XR in a timelymanner, if at all.

 

Although we have obtained clinical batches of Gabapentin GR from acontract manufacturer, we currently have no long-term supply arrangement withrespect to Gabapentin GR.  Any failure toobtain clinical supplies of Gabapentin GR could adversely affect our GabapentinGR clinical development programs.

 

**Wecould become subject to product liability litigation and may not haveadequate insurance to cover product liability claims.**

 

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 2007 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.

 

 

 

 

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**If wechoose to acquire new and complementary businesses, products or technologies,we may be unable to complete these acquisitions or to successfully integratethem in a cost effective and non-disruptive manner.**

 

Our success depends on our ability to continually enhance and broadenour product offerings in response to changing customer demands, competitivepressures and technologies. Accordingly, we may in the future pursue theacquisition of complementary businesses, products or technologies instead ofdeveloping them ourselves. We have no current commitments with respect to anyacquisition or such investment. We do not know if we would be able to successfullycomplete any acquisitions, or whether we would be able to successfullyintegrate any acquired business, product or technology or retain any keyemployees. Integrating any business, product or technology we acquire could beexpensive and time consuming, disrupt our ongoing business and distract ourmanagement. If we were to be unable to integrate any acquired businesses,products or technologies effectively, our business would suffer. In addition,any amortization or charges resulting from the costs of acquisitions could harmour operating results.

 

**If welose our key personnel or are unable to attract and retain key management andoperating personnel, we may be unable to pursue our product developmentand commercialization efforts.**

 

          Our success is dependent in large partupon the continued services of our President and Chief Executive Officer, CarlA. Pelzel, and other members of our executive management team, and on ourability to attract and retain key management and operating personnel. We do nothave agreements with Mr. Pelzel or any of our other executive officers thatprovide for their continued employment with us. Our former Chairman, President and Chief Executive Officer retired in August2007, and our Chief Financial Officer retired in October 2007.  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.

 

**We have implemented certain anti-takeover provisions.**

 

          Certain provisions of our articles ofincorporation and the California General Corporation Law could discourage athird party from acquiring, or make it more difficult for a third party toacquire, control of our company without approval of our board of directors.These provisions could also limit the price that certain investors might bewilling to pay in the future for shares of our common stock. Certain provisionsallow the board of directors to authorize the issuance of preferred stock withrights superior to those of the common stock. We are also subject to theprovisions of Section 1203 of the California General Corporation Law whichrequires a fairness opinion to be provided to our shareholders in connectionwith their consideration of any proposed “interested party” reorganizationtransaction.

 

          We have adopted a shareholder rightsplan, commonly known as a “poison pill”. The provisions described above, ourpoison pill and provisions of the California General Corporation Law maydiscourage, delay or prevent a third party from acquiring us.

 

**Increasedcosts associated with corporate governance compliance may significantly impactour results of operations.**

 

 Changinglaws, regulations and standards relating to corporate governance, publicdisclosure and compliance practices, including the Sarbanes-Oxley Act of 2002,new SEC regulations and Nasdaq Global Market rules, are creating uncertaintyfor companies 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 us to attract andretain qualified members of our board of directors, or qualified executiveofficers.  We are presently evaluatingand monitoring regulatory developments and cannot estimate the timing ormagnitude 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.

 

 

 

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**If we sellshares of our common stock under our equity line of credit arrangement or inother future financings, existing common shareholders will experience immediatedilution and, as a result, our stock price may go down.**

 

We may from time to time issue additional shares of common stock at adiscount from the current trading price of our common stock.  As a result, our existing common shareholderswill experience immediate dilution upon the purchase of any shares of our commonstock sold at such discount.  For example,in December 2006, we entered into a common stock purchase agreement withAzimuth Opportunity Ltd., pursuant to which we may sell shares of common stockat a discount to the prevailing market price ranging from approximately 3.8% to6.4%, excluding an additional placement agent fee of approximately 1.1% payableby us on the gross offering proceeds. In addition, as other capital raisingopportunities present themselves, we may enter into financing or similararrangements in the future, including the issuance of debt securities,preferred stock or common stock. If we issue common stock or securitiesconvertible into common stock, our common shareholders will experience dilutionand this dilution will be greater if we find it necessary to sell securities ata discount to prevailing market prices.

 

**Ifwe are unable to satisfy regulatory requirements relating to internal controls,our stock price could suffer.**

 

          Section 404 of the Sarbanes-Oxley Actof 2002 requires companies to conduct a comprehensive evaluation of theirinternal control 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.

 

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

 

Our operations are vulnerable to damage or interruption from computerviruses, human error, natural disasters, telecommunications failures,intentional acts of vandalism and similar events. In particular, our corporateheadquarters are located in theSan Francisco Bay area, which has a history of seismic activity. We have notestablished a formal disaster recovery plan, and our back-up operations and ourbusiness interruption insurance may not be adequate to compensate us for lossesthat occur. A significant business interruption could result in losses ordamages incurred by us and require us to cease or curtail our operations.

 

 

 

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

 

Not applicable.

 

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

 

Not applicable.

 

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

 

Not applicable.

 

**ITEM 5.                OTHER INFORMATION**

 

Not applicable.

 

 

 

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**ITEM 6.EXHIBITS**

 
| (a)    |   | Exhibits            |   |                                                                                                               |
|--------|--------|---------------------|--------|--------------------------------------------------------------------------------------------------------------------|
|   |   | 10.1                |   | Termination and  Assignment Agreement, dated July 5, 2007, between the Company and Esprit  Pharma                  |
|   |   | 10.2  (+) |   | Amended  Promotion Agreement, dated September 21, 2007, between the Company and Watson  Pharmaceuticals            |
|   |   | 10.3  (1) |   | Consulting  Agreement, dated August 24, 2007, between the Company and John W. Fara, Ph.D.                          |
|   |   | 10.4  (1) |   | Offer Letter,  dated August 24, 2007, between the Company and Carl A. Pelzel                                       |
|   |   | 10.5  (1) |   | Amendment No. 1  to Management Continuity Agreement, dated August 24 2007, between the Company  and Carl A. Pelzel |
|   |   | 10.6  (2) |   | Consulting  Agreement, dated October 10, 2007, between the Company and John Hamilton                               |
|   |   | 10.7  (2) |   | Letter  Agreement, dated October 10, 2007, between the Company and John Hamilton                                   |
|   |   | 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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(+)   Confidentialtreatment requested.

(1)   Incorporatedby reference to the Company’s Form 8-K filed with the SEC on August 27, 2007.

(2)   Incorporatedby reference to the Company’s Form 8-K filed with the SEC on October 11, 2007.

 

 

 

 

 

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##### **SIGNATURES**

##### ** **

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

 

 
| Date: November 8,  2007 | 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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