##### Table of Contents





UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



FORM 10-K



ANNUAL AND
TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

(Mark One)

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

For the fiscal year ended December 31, 2009

OR

| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period
from                      to
                    .

Commission File No. 000-31135



INSPIRE PHARMACEUTICALS, INC.

(Exact Name of
Registrant as Specified in Its Charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 04-3209022                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|4222 Emperor Boulevard, Suite 200, Durham, North Carolina      |  | 27703-8466                          
|(Address of Principal Executive Offices)                       |  | (Zip Code)                          

(919)
941-9777

(Registrants telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

|                              |  |                                          
|----------------------------- |  | -----------------------------------------
|Title of Each Class           |  | Name of Each Exchange on Which
Registered
|Common Stock, $.001 par value |  | The Nasdaq Stock Market LLC              

Securities registered pursuant to Section 12(g) of the Act:     None

(Title of
Class)



Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes   ̈     No  x

Indicate by check mark if the
Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes   ̈    No  x

Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.    Yes  x    No   ̈

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not
be contained, to the best of Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant has submitted electronically and
posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit
and post such files).    Yes   ̈    No   ̈

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller
reporting company. See the definitions of large accelerated filer, accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one)

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

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the
Act).    Yes   ̈    No  x

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at
which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrants most recently completed second fiscal quarter.$235,170,141.

Indicate the number of shares outstanding of each of the Registrants classes of common stock, as of January 31, 2010.

|                              |  |                 
|----------------------------- |  | ----------------
|Class                         |  | Number of Shares
|Common Stock, $.001 par value |  | 82,350,770      

Documents
incorporated by reference

|                                                                                                                                                                                                                        |  |                        
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -----------------------
|Document Description                                                                                                                                                                                                    |  | 10-K Part III          
|Portions of the Registrants proxy statement to be filed pursuant to Regulation 14A within 120 days after Registrants fiscal year end of December 31, 2009 are
incorporated by reference into Part III of this report. |  | Items 10, 11, 12,13, 14









---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.

2009 FORM 10-K ANNUAL REPORT



TABLE OF CONTENTS



|           |  |                                                                                                                |  |   
|---------- |  | -------------------------------------------------------------------------------------------------------------- |  | --
|           |  | Page                                                                                                          
|PART I.    |  |                                                                                                                |  |   
|Item 1.    |  | Business.                                                                                                      |  | 1 
|Item 1A.   |  | Risk Factors.                                                                                                  |  | 21
|Item 1B.   |  | Unresolved Staff Comments                                                                                      |  | 43
|Item 2.    |  | Properties.                                                                                                    |  | 43
|Item 3.    |  | Legal Proceedings.                                                                                             |  | 43
|Item 4.    |  | Reserved.                                                                                                      |  | 43
|           |  |                                                                                                               
|PART II    |  |                                                                                                                |  |   
|Item 5.    |  | Market for the Companys Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. |  | 44
|Item 6.    |  | Selected Financial Data.                                                                                       |  | 46
|Item 7.    |  | Managements Discussion and Analysis of Financial Condition and Results of
Operations.                         |  | 47
|Item 7A.   |  | Quantitative and Qualitative Disclosures About Market Risk.                                                    |  | 65
|Item 8.    |  | Financial Statements and Supplementary Data.                                                                   |  | 66
|Item 9.    |  | Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure.                          |  | 66
|Item 9A.   |  | Controls and Procedures.                                                                                       |  | 67
|Item 9B.   |  | Other Information.                                                                                             |  | 68
|           |  |                                                                                                               
|PART III   |  |                                                                                                                |  |   
|Item 10.   |  | Directors, Executive Officers and Corporate Governance.                                                        |  | 69
|Item 11.   |  | Executive Compensation.                                                                                        |  | 69
|Item 12.   |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.                |  | 69
|Item 13.   |  | Certain Relationships and Related Transactions, and Director Independence.                                     |  | 69
|Item 14.   |  | Principal Accountant Fees and Services.                                                                        |  | 69
|           |  |                                                                                                               
|PART IV    |  |                                                                                                                |  |   
|Item 15.   |  | Exhibits and Financial Statements Schedules.                                                                   |  | 70
|SIGNATURES |  | 71                                                                                                            



We own or have rights to various trademarks, copyrights and trade names used in our business. AzaSite® is a trademark owned by InSite Vision Incorporated. Restasis®, Elestat®
and ProlacriaTMare trademarks owned by Allergan,
Inc. This report also includes trademarks, service marks and trade names of other companies.



---

##### Table of Contents

PART I



Item 1. Business.



Overview



We are a biopharmaceutical company focused on researching, developing and commercializing prescription
pharmaceutical products for ophthalmic and pulmonary diseases. Our goal is to build and commercialize a sustainable portfolio of innovative new products based on our technical and scientific expertise. The most advanced compounds in our clinical
pipeline are denufosol tetrasodium for cystic fibrosis and Prolacria for dry eye, both of which are in Phase 3 development, and AzaSitefor blepharitis, which is in Phase 2 development. We receive revenue related to the promotion of
AzaSitefor bacterial conjunctivitis, co-promotion of Elestat for allergic conjunctivitis and royalties on Restasis for dry eye. Our portfolio of products and product candidates include:



|                                   |  |                             |  |                                      |  |                                    
|---------------------------------- |  | --------------------------- |  | ------------------------------------ |  | -----------------------------------
|PRODUCTS AND PRODUCT CANDIDATES    |  | THERAPEUTIC AREA/INDICATION |  | COLLABORATIVE PARTNER (1)            |  | CURRENT STATUS IN THE UNITED STATES
|Products                           |  |                             |  |                                      |  |                                    
|                                   |  |                             | 
|AzaSite                            |  | Bacterial conjunctivitis    |  | InSite Vision                        |  | Promoting                          
|                                   |  |                             | 
|Elestat                            |  | Allergic conjunctivitis     |  | Allergan                             |  | Co-promoting                       
|                                   |  |                             | 
|Restasis                           |  | Dry eye disease             |  | Allergan                             |  | Receiving royalty                  
|                                   |  |                             | 
|Product Candidates in              |  |                             |  |                                      |  |                                    
|Clinical Development               |  |                             |  |                                      |  |                                    
|                                   |  |                             | 
|Denufosol tetrasodium              |  | Cystic fibrosis             |  | None                                 |  | Phase 3                            
|                                   |  |                             | 
|Prolacria (diquafosol tetrasodium) |  | Dry eye disease             |  | Allergan; Santen
Pharmaceutical      |  | Phase 3(2)                         
|                                   |  |                             | 
|AzaSite                            |  | Blepharitis                 |  | InSite Vision                        |  | Phase 2                            
|                                   |  |                             | 
|INS115644, INS117548               |  | Glaucoma                    |  | Wisconsin Alumni Research Foundation |  | Phase 1                            



|(1) | See Collaborative Agreements in this report for a detailed description of our agreements with these collaborative partners.
|--- | -----------------------------------------------------------------------------------------------------------------------------

|(2) | In January 2010, we announced that our Phase 3 clinical trial (Trial 03-113) did not meet its primary or secondary endpoints. See Product Candidates in Clinical
DevelopmentProlacria (diquafosol tetrasodium) for additional information on this product candidate.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We were incorporated as a Delaware corporation in October 1993 and commenced operations in March 1995. We are located in Durham, North
Carolina, adjacent to the Research Triangle Park.



1



---

##### Table of Contents

PRODUCTS



AzaSite



AzaSite (azithromycin ophthalmic solution) 1% is a topical anti-infective, in which azithromycin is formulated
into an ophthalmic solution utilizing DuraSite®, a novel ocular drug delivery system. Azithromycin is a
semi-synthetic antibiotic that is derived from erythromycin and since 1992, has been available via oral administration by Pfizer Inc. under the trade name Zithromax®. In April 2007, AzaSite was approved by the U.S. Food and Drug Administration, or FDA, for the treatment of bacterial conjunctivitis in adults and children
one year of age and older.



In February 2007, we
entered into a license agreement with InSite Vision Incorporated, or InSite Vision, pursuant to which we acquired exclusive rights to commercialize AzaSite for use in the treatment of human ocular or ophthalmic indications. The license
agreement grants us exclusive rights to develop, make, use, market, commercialize and sell AzaSitein the United States and Canada. We are obligated to pay InSite Vision royalties on net sales of AzaSite in the United States and
Canada. See Collaborative AgreementsInSite Vision Incorporated.



In August 2007, we launched AzaSite in the United States and are promoting it to eye care specialists. The manufacture and sale of AzaSite is protected in the United States under use and
formulation patents, the latest of which expires in March 2019. In addition, the sale of AzaSite is also protected in the United States under a use patent that we sub-licensed from Pfizer that expires in November 2018.



Market Opportunity. The U.S. single-entity ocular
antibiotic market was approximately $474 million for the 12 months ended December 31, 2009 according to data compiled from IMS Health. Total prescriptions for all branded products in the U.S. ocular antibiotic market were approximately
5.7 million for the 12 months ended December 31, 2009, which was relatively unchanged from the prior year according to data compiled from IMS Health.



Elestat



Elestat(epinastine HCl ophthalmic solution) 0.05% is a topical antihistamine developed by Allergan, Inc., or Allergan, for the
prevention of ocular itching associated with allergic conjunctivitis. Elestat was approved by the FDA in October 2003 and is indicated for adults and children at least three years old.



We receive co-promotion revenue from Allergan on its U.S. net
sales of Elestat. When a generic form of Elestator an over-the-counter form of epinastine ophthalmic solution is introduced into the market, our agreement with Allergan to co-promote Elestat will no longer be in effect, and our
revenues from sales of Elestat will be minimal. See Collaborative AgreementsAllergan, Inc.Elestat.



Subject to applicable law, competitors are permitted to submit to the FDA an Abbreviated New Drug Application, or ANDA, for a generic version
of Elestat, due to the expiration of the marketing exclusivity period for Elestat provided under the Hatch-Waxman Act on October 15, 2008. Notices have been received from four companies: Apotex, Inc., Cypress Pharmaceutical, Inc.,
Paddock Laboratories, Inc., and Sandoz Inc., advising that each company filed an ANDA for a generic version of Elestat. The date of submission of the first ANDA filing to the FDA Office of Generic Drugs was October 14, 2008, according to
the FDAs website (www.fda.gov).



We plan to
continue co-promoting and receiving co-promotion revenues onElestat sales during the FDAs review period of these ANDAs. According to an Office of Generic Drugs Update presentation made by Gary Buehler, Director, Office of Generic
Drugs, on February 16, 2010, at the GPhA Annual Meeting, the ANDA median approval time for the fiscal period ending September 30, 2009 was approximately 26.7 months. We do not know when the FDA will complete its review of the ANDAs relating to
a generic version of Elestat and we



2



---

##### Table of Contents

do not expect to be notified by any party prior to any approval. However, based upon our assessment, we believe it is likely that a generic form of epinastine may be launched in the second half
of 2010. See the risk factor entitled When a generic form of Elestat or an over-the-counter form of epinastine ophthalmic solution is introduced into the market, our agreement with Allergan to co-promote Elestat will no longer be in
effect, and our revenues from sales of Elestat will be minimalfor further discussion of the risk related to the ANDA filings.



Restasis



Restasis (cyclosporine ophthalmic emulsion) 0.05% is the first approved prescription product in the United States for the treatment of
dry eye disease. It is indicated to increase tear production in adults and children at least 16 years old whose tear production is presumed to be suppressed due to ocular inflammation associated with keratoconjunctivitis sicca, or dry eye disease.
Restasis was approved by the FDA in December 2002, and Allergan launched the product in the United States in April 2003.



In June 2001, we entered into an agreement with Allergan to develop and commercialize our product candidate, Prolacria (diquafosol
tetrasodium), for the treatment of dry eye disease. The agreement also provides that Allergan pay us royalties on net sales of Restasis. See Collaborative AgreementsAllergan, Inc.Restasis and Prolacria.



Following the expiration of a use patent in
August 2009, the manufacture and sale of Restasis is protected in the United States by a formulation patent that expires in May 2014.



Market Opportunity:Other than Restasis, the current treatments for dry eye disease in the eight major international
prescription pharmaceutical markets consist of artificial tear solutions and lubricant eye drops. Dry eye disease is associated with aging, environmental factors, autoimmune disorders and various medications. According to Allergan, dry eye disease
affects an estimated 21 million people in the United States. For the years ended December 31, 2009, 2008 and 2007, Allergan has recognized approximately $523 million, $444 million and $345 million, respectively, of revenue from net sales
of Restasis.



For a more detailed
discussion of the risks associated with these products, please see the Risk Factors located elsewhere in this report.



PRODUCT CANDIDATES IN CLINICAL DEVELOPMENT



Denufosol tetrasodium for the treatment of cystic fibrosis



Overview.We are developing denufosol tetrasodium as an inhaled product candidate for the treatment of
cystic fibrosis. Denufosol tetrasodium is a first-in-class ion channel regulator that addresses the underlying ion transport defect in the lungs of patients with cystic fibrosis. Denufosol is designed to enhance airway hydration and mucociliary
clearance through receptor-mediated mechanisms that increase chloride secretion, inhibit sodium absorption and increase ciliary beat frequency. These integrated pharmacological actions are important to restoring airway clearance, maintaining lung
function, and potentially delaying the progression of cystic fibrosis lung disease. We believe that our product candidate could be the first FDA-approved product that mitigates the underlying defect in the airways of patients with cystic fibrosis.
If approved, we expect denufosol to be an early intervention therapy for cystic fibrosis. This product candidate has been granted orphan drug status and fast-track review status by the FDA, and orphan drug status by the European Medicines Agency.



The manufacture and sale of denufosol tetrasodium
is protected in the United States under patents that have claims to the drug substance, the formulation, and method of use that expire in February 2017, subject to any applicable patent restoration that may extend protection up to an additional five
years from the date of expiration of the applicable patent, if any, for which restoration is sought.



3



---

##### Table of Contents

Development Status



TIGER 1:Our first Phase 3 clinical trial, TIGER-1 (Trial 08-108), with denufosol
tetrasodium inhalation solution for the treatment of cystic fibrosis was a 24-week, double-blind, placebo-controlled, randomized clinical trial comparing 60 mg of denufosol to placebo, administered three-times daily by jet nebulizer, in 352 patients
with mild cystic fibrosis lung disease (FEV1(Forced
Expiratory Volume in One Second) (in liters) 3 75% predicted normal) at clinical centers across North America. This portion of the clinical trial was followed by a 24-week denufosol-only open-label
extension, or OLE.



In June
2008, we announced top-line results from the 24-week placebo-controlled portion of the clinical trial. The clinical trial demonstrated statistical significance for its primary efficacy endpoint, which was the change in FEV1from baseline at the clinical trial endpoint (at 24 weeks or last
observation carried forward). Patients treated with denufosol had a statistically significant improvement in FEV1compared to placebo (45 milliliter treatment group difference in adjusted means, p = 0.047). On average, patients on
denufosol improved in FEV1relative to baseline whereas
patients on placebo remained essentially unchanged. Secondary endpoints were also evaluated during the placebo-controlled portion of TIGER-1. There was a trend in differences in FEF25%-75%(Forced Expiratory Flow 25%-75%), a measure of small airway function, favoring denufosol over placebo (87.5
milliliters/second treatment group difference, p = 0.072).



In October 2008, we presented new data at the North American Cystic Fibrosis Conference which indicate that patients who continued to receive denufosol for an additional 24 weeks during the OLE
experienced a progressive improvement in FEV1. Those patients
who received denufosol for 48 weeks during TIGER-1 experienced a mean change from baseline in FEV1of 115 ml at the end of the OLE, almost a two-and-a-half fold increase compared to the initial 48 ml increase at the end of the 24-week placebo-controlled portion of the trial.



The patients who crossed over from placebo
to denufosol at Week 24 also experienced improvements in FEV1when receiving denufosol during the OLE. In terms of observed means, these patients had a 78 ml increase from baseline, compared to a 16 ml increase at the end of the 24-week placebo-controlled portion of the trial. This differs from the 3 ml
adjusted mean for placebo at the 24-week study endpoint which also accounted for discontinuations.



A total of 315/352 (89%) patients completed the 24-week placebo-controlled phase of TIGER-1 and had the option to
participate in the OLE phase in which all patients received denufosol for an additional 24 weeks. All of the patients but one (n=314) entered the OLE extension. The objective of the OLE phase was to evaluate the long-term safety of denufosol
treatment among cystic fibrosis patients with FEV13 75% predicted normal. In the TIGER-1 trial, there was no evidence of adverse effects on growth, clinical laboratory values or vital sign assessments with long-term denufosol treatment. Denufosol was
well-tolerated over 48 weeks of dosing in the TIGER-1 trial.



The retention rate during the OLE phase was approximately 96%, with 302 patients completing the full 48 weeks. Twelve patients withdrew during the OLE phase, with only four withdrawals related to Adverse
Events, or AEs. In the OLE phase, the most commonly reported AEs, which included cough, condition aggravated and productive cough, were similar to those reported during the placebo-controlled phase. The incidence of Serious Adverse Events, or SAEs,
in the OLE phase was under 20% and the majority of SAEs were pulmonary exacerbations.



In TIGER-1, there were two definitions of pulmonary exacerbations in the protocol. Based on the primary protocol definition of an exacerbation as a patient experiencing at least four out of 12 defined
signs and symptoms regardless of treatment, the frequency of pulmonary exacerbations was 23% in both the placebo-controlled phase and the OLE phase. Based on the secondary protocol definition of an exacerbation as a patient requiring treatment with
IV antibiotics for a respiratory sign or symptom, the frequency of pulmonary exacerbations was 8% in the placebo-controlled phase and 13% in the OLE phase.



4



---

##### Table of Contents

TIGER 2:In February 2008, we initiated patient enrollment in
TIGER-2 (Trial 08-110), our second planned pivotal Phase 3 clinical trial, and in July 2008, we announced modifications to the clinical protocol for this ongoing clinical trial. As modified, the TIGER-2 clinical trial is a 48-week, double-blind,
placebo-controlled, randomized clinical trial comparing 60 mg of denufosol to placebo, administered three-times daily by jet nebulizer, in approximately 450 patients with FEV1greater than or equal to 75% and less than or equal to 110% of predicted normal. The primary efficacy endpoint is the
change from baseline in FEV1(in liters) at the 48-week trial
endpoint. Secondary endpoints include other lung function parameters, pulmonary exacerbations, requirements for concomitant cystic fibrosis medications and health related quality of life. Patients aged five years and older are eligible for
enrollment. The use of standard cystic fibrosis maintenance therapies is permitted during the trial. Hypertonic saline is not permitted to be used by those patients enrolled in the clinical trial.



We have approximately 100 participating clinical trial sites
across the United States, Canada, Australia and New Zealand and completed patient enrollment in November 2009. Top-line results from this clinical trial are expected in the first quarter of 2011.



Additionally, any patient who has successfully completed TIGER-2
may elect to participate in a follow-on, open-label denufosol-only trial (Trial 08-114) which will enable patients to continue receiving denufosol for up to 3 additional years. The original length of this extension study was 48 weeks, but this was
recently extended to 3 years to assess the potential disease-modifying effects of extended denufosol treatment on lung function over time. To date, more than 80% of the patients who have completed TIGER-2 have elected to enroll in this long-term
study.



Assuming the results of TIGER-2 are
positive, that we subsequently file a New Drug Application, or NDA, for denufosol with the FDA and that the FDA approves such NDA, we are targeting a potential U.S. commercial launch for denufosol in the 2012 timeframe.



Other:In 2006, we completed a 52-week inhalation
toxicology study in one animal species, and have submitted the final study report to the FDA. There were no signs of pulmonary or systemic toxicity at doses well above the Phase 3 clinical dose. In 2009, we completed the required two-year inhalation
carcinogenicity study in rats and the final study report confirms that there was no evidence of a carcinogenic effect with denufosol.



Estimated subsequent costs necessary to submit an NDA for denufosol for the treatment of cystic fibrosis are projected to be in the range of
$21 million to $28 million. This estimate includes completing TIGER-2 as well as conducting any additionally required toxicology studies and other ancillary studies, manufacturing denufosol for clinical trials, producing qualification lots
consistent with current Good Manufacturing Practices, or cGMP, standards, salaries for development personnel, other unallocated development costs and regulatory preparation and filing costs. These costs do not include the costs of pre-launch
inventory and any product approval milestones payable to Cystic Fibrosis Foundation Therapeutics, Inc., or CFFT. SeeCollaborative AgreementsCystic Fibrosis Foundation Therapeutics, Inc. These costs are
difficult to project and actual costs could be materially different from our estimate. For example, clinical trials and any other required studies may not proceed as planned, results from ongoing or future clinical trials may change our planned
development program, additional Phase 3 clinical trials may be necessary and an anticipated NDA filing could be delayed.



In addition to the activities and costs necessary to submit an NDA for denufosol, we are initiating pre-launch and franchise development
activities, including conducting market research, developing manufacturing plans, and expanding our clinical and scientific database on denufosol beyond the TIGER-1 and TIGER-2 pivotal trials. More specifically, these activities would include the
extension study (Trial 08-114) discussed above and development of a secondary supplier of denufosol. We expect the costs of these activities to be significant and will include approximately $8 million in remaining milestone payments due under our
technology license agreement with Yamasa Corporation. See Manufacturing and SupplyYamasa Corporation.



5



---

##### Table of Contents

We currently plan to retain commercial rights for denufosol for the treatment of cystic
fibrosis in North America. We continue to seek a corporate partner to develop and commercialize this product candidate outside of North America.



Market Opportunity.The current commercially available therapeutic approaches to address cystic fibrosis mainly treat the
complications of the disease and are aimed at reducing respiratory infections and breaking up thickened mucous secretions that cause airflow obstruction and harbor bacteria. For example, TOBIis an inhaled antibiotic that treats lung
infections and Pulmozymeis an inhaled protein that breaks up excessive DNA in mucus that reduces the thickness and tackiness of the respiratory secretions. While both products are approved for the management of cystic fibrosis, neither
product is designed to address the underlying ion-transport defect, which results in dehydrated mucus and severely impaired mucociliary clearance.



According to the U.S. Cystic Fibrosis Foundation, there are approximately 30,000 cystic fibrosis patients in the United States, and
approximately 70,000 cystic fibrosis patients worldwide. Based on data compiled and reported by IMS Health as of December 31, 2009, annual sales in the United States of the two prescription pharmaceutical products to treat cystic fibrosis lung
disease,Pulmozyme and TOBI, were approximately $328 million and $242 million, respectively, and represented approximately two-thirds of annual world-wide sales of these two products.



Prolacria (diquafosol tetrasodium) for the treatment of dry eye disease



Overview.Diquafosol tetrasodium is a dinucleotide which functions as an agonist at the P2Y2receptor and is being developed for the treatment of dry eye disease. Prolacria, the proposed U.S. tradename for diquafosol tetrasodium ophthalmic solution 2%, is designed to stimulate the release
of three components of natural tearsmucin, lipids and fluid. The manufacture and sale of Prolacria is protected in the United States under drug substance and formulation patents that expire in July 2016, as well as under use patents
that expire in February 2017, subject to any applicable patent restoration that may extend protection up to an additional five years from the date of expiration of the applicable patent, if any, for which restoration is sought.



Under our agreement with Allergan, we are responsible for the
development of Prolacria in the United States, and Allergan is responsible for the commercialization of Prolacria in the United States. If we receive FDA approval and Prolacriais launched, we expect to co-promote this product.
Pursuant to this agreement, Allergan is responsible for obtaining regulatory approval and for commercializing diquafosol tetrasodium in Europe and elsewhere globally with the exception of Asia. See Collaborative
AgreementsAllergan, Inc.Restasis and Prolacria.



Development Status.In June 2003, we filed an NDA with the FDA for Prolacria for the treatment of dry eye disease. We received approvable letters from the FDA in December 2003 and December
2005. In September 2008, we submitted a clinical protocol and request for Special Protocol Assessment, or SPA, to the FDA for a pivotal Phase 3 environmental trial with Prolacria. During 2009, we reached agreement with the FDA on the design
of a Phase 3 clinical trial forProlacria,and completed the trial.



In January 2010, we announced that this Phase 3 clinical trial (Trial 03-113) did not meet its primary endpoint (p = 0.526) or its secondary endpoint (p = 0.368). Given the complexity of this program and
the large database of information we have, we are working closely with our partner, Allergan, to determine potential next steps for the program.



Due to the uncertainty of the future of this program, we are currently unable to reasonably project the future dates and costs associated
with additional clinical trials or other work which would be necessary to amend our NDA submission for Prolacria and resubmit the application for commercial approval in the United States.



6



---

##### Table of Contents

Our partner, Santen Pharmaceutical Co., Ltd., or Santen, is currently developing a different
formulation of diquafosol tetrasodium, which it refers to as DE-089, in Japan. Our agreement with Santen allows Santen to develop diquafosol tetrasodium for the therapeutic treatment of ocular surface diseases, such as dry eye disease, in Japan and
nine other Asian countries, and provides for certain milestone payments to be paid to us upon achievement of development milestones by Santen. In May 2008, Santen filed an application for manufacturing and marketing approval of DE-089 with the
Japanese Ministry of Health, Labor, and Welfare (the Japanese equivalent of the FDA), which is pending review. See Collaborative AgreementsSanten Pharmaceutical Co., Ltd.



AzaSite for the treatment of blepharitis



Overview. Blepharitis is an ocular disease characterized
by inflammation of the lid margin that is common, complex, and has a multi-factorial etiology. Blepharitis coexists with other common ocular surface conditions and is often under-diagnosed and misdiagnosed in general clinical practice. Blepharitis
can be subdivided into two categories: anterior and posterior blepharitis. Although they are distinct diseases, they can overlap. Anterior blepharitis is generally associated with the presence of bacteria, lid debris and/or sebaceous gland activity
and is most often an acute disease. Posterior blepharitis is almost always associated with dysfunctional meibomian glands or altered meibomian gland secretions and is generally considered a chronic disease.



Our market research and input from eye care specialists suggests
that blepharitis is an under-diagnosed and under-treated disease. Survey data published in The Ocular Surface and funded by Inspire indicated that 15 percent of adults reported having at least one of the three symptoms that clinicians associate with
anterior blepharitis at least half of the time in the previous 12 months. Based on the overall U.S. adult population of 232 million, this implies potentially as many as 34 million adults might have suffered from some form of blepharitis
over such time frame. Currently, there are no FDA-approved prescription pharmaceutical products indicated for the treatment of this disease. Patients currently manage the acute and often chronic effects of blepharitis with the use of warm
compresses, lid hygiene, topical antibiotic ointments and, when exacerbated, with topical steroids or oral antibiotics.



Development Status. During 2008, we conducted a series of Phase 4 clinical trials with AzaSite evaluating the safety and
efficacy of AzaSite in ocular conditions, such as blepharitis. In late 2008, we sought input from numerous medical experts and evaluated our Phase 4 data along with market research on the prevalence and awareness of the disease to evaluate
AzaSites potential opportunity as it relates to the treatment of blepharitis. In addition, we had preliminary discussions with the FDA on potential regulatory pathways. Based on preliminary information gathered, we decided to pursue a
Phase 2 program to study AzaSite for the treatment of blepharitis.



In May 2009, we initiated Phase 2 work which consisted of two randomized, vehicle-controlled clinical trials that enrolled approximately 600 patients with anterior blepharitis. Trial 044-101 included a
two-week treatment period with a two-week follow-up period and Trial 044-102 included a four-week treatment period with a four-week follow-up period. Patients were randomized to AzaSite or the DuraSite vehicle and received one drop in
each eye twice-a-day for the first two days, then one drop in each eye daily for the remainder of the treatment period. All patients in the trials performed lid hygiene using commercially available lid scrubs once daily for the duration of the
trials.



In March 2010, we announced the results
of these two trials. In the four-week trial, improvements for AzaSite compared to vehicle were achieved for a number of blepharitis signs and symptoms at various time points with p-values £ 0.05,
but statistical significance was not achieved for the primary endpoint of mean lid margin hyperemia. In the two-week trial, there were no statistically significant improvements for AzaSite compared to vehicle, including for the primary
endpoint of clearing of lid debris. In both trials, the AzaSite treatment group and the vehicle treatment group showed statistically significant improvements relative to baseline for all measured signs and symptoms of blepharitis.
Additionally, AzaSite was well-tolerated in both trials.



7



---

##### Table of Contents

We will conduct additional clinical work to continue pursuing a potential indication for
treatment of anterior and posterior forms of blepharitis.



Given the limited data available and the early stage of development of this program, we are currently unable to reasonably project the future dates and costs associated with clinical trials or a prospective NDA filing for this program.
Additionally, since there are no prescription pharmaceutical products indicated for the treatment of blepharitis, we are unable to provide U.S. market opportunity data.



Glaucoma product candidates



Overview.In November 2004, we licensed technology for use in developing and commercializing new treatments for glaucoma
from Wisconsin Alumni Research Foundation, or WARF. See Collaborative AgreementsWisconsin Alumni Research Foundation. In relation to this technology, we are evaluating new and existing compounds that are active in
disrupting the acto-cytoskeleton of the trabecular meshwork as potential treatments for glaucoma. Our scientific hypothesis is that the mechanism of action may result in reduction of intraocular pressure, or IOP, by affecting the primary outflow
pathway for aqueous humor.



Development Status.In the first quarter of 2007, we initiated a Phase 1 proof-of-concept placebo-controlled, dose-ranging clinical trial (Trial 032-101) for INS115644, the first compound in a series of compounds, in glaucoma patients to evaluate the safety and
tolerability of INS115644, as well as changes in IOP. In September 2008, we initiated a Phase 1 proof-of-concept placebo-controlled, dose-ranging clinical trial (Trial 037-101) for a second compound, referred to as INS117548, to evaluate the safety,
tolerability and IOP-lowering effects of INS117548 in approximately 80 subjects with early stage glaucoma or ocular hypertension.



In September 2009, we announced top-line results of these trials. In Trial 032-101 with INS115644, a Latrunculin B formulation, we observed
dose-dependent IOP-lowering effects and the compound was well-tolerated. Trial 037-101 with INS117548, which is one of a series of Rho kinase molecules we have developed, showed mild IOP-lowering effects but had some dose-related tolerability
issues, specifically with ocular discomfort such as burning and stinging. We are in the process of evaluating next steps for the overall glaucoma program, based on our clinical and preclinical data, expert opinions and resource availability.



Due to the uncertainty of the future of this
program, and given the limited data available and the early stage of development of this program, we are currently unable to reasonably project the future dates and costs associated with clinical trials or a prospective NDA filing for either of
these product candidates.



Market
Opportunity. The current market for treatment of glaucoma, the largest market in ophthalmic pharmaceuticals, is approximately $2.2 billion in annual sales in the United States based on data compiled and reported by IMS Health as of
December 31, 2009.



For a discussion of the
risks associated with our development programs, please see the Risk Factors located elsewhere in this report.



Additional information about the costs and expenses associated with all of our research and development programs is discussed below in
Managements Discussion and Analysis of Financial Condition and Results of OperationsResults of OperationsYears Ended December 31, 2009, 2008 and 2007Costs and Expenses.



Collaborative Agreements



Allergan, Inc.Elestat



In December 2003, we entered into an agreement with Allergan to
co-promote Elestat in the United States. Under the agreement, we have the responsibility for promoting and marketing Elestat to ophthalmologists, optometrists and allergists in the United States and paying the associated costs. We
receive co-promotion revenue



8



---

##### Table of Contents

from Allergan on its U.S. net sales of Elestat. Allergan records sales of Elestat and is responsible for supply chain management, managed health care, customer order processing and
regulatory compliance, as well as any international marketing and selling activities.



TheElestat co-promotion agreement provides that unless earlier terminated, the term of such agreement will be in effect until the earlier of (i) the approval and launch of the first generic
epinastine product after expiration of the FDA exclusivity period coveringElestat in the United States, or (ii) the approval and launch of the first over-the-counter epinastine product after expiration of the listing ofElestat
in the FDAs Orange Book. Following the termination of such co-promotion agreement, we will no longer have rights to co-promoteElestat. We will be entitled to receive post-termination payments from Allergan, based on any remaining net
sales ofElestat for a period of 36 months. During the three successive 12-month periods immediately following the termination of the agreement, Allergan will be obligated to pay to us 20%, 15% and 10%, respectively, on any net sales ofElestat in the United States. See ProductsElestat for a discussion of the filing of ANDAs by various pharmaceutical companies relating to generic forms of Elestat.



Either Allergan or we may terminate the agreement in the event
of a material breach of the agreement by the other or in the event of the others insolvency. Allergan can terminate the agreement upon a change of control where we become an affiliate of a direct competitor of Allergan as that term is defined
in the agreement. We can terminate the agreement in the event that Elestat is withdrawn from the market for more than 90 days.



Allergan, Inc.Restasis and Prolacria



In June 2001, we entered into a joint license, development and marketing agreement with Allergan to develop and
commercialize our product candidate, Prolacria, for the treatment of dry eye disease. The agreement also provided us with revenue on net sales of Allergans Restasis.



Under the terms of the agreement, Allergan obtained an exclusive license to develop and commercialize
Prolacriaworldwide, with the exception of Japan and nine other Asian countries covered by our agreement with Santen. In return, we are entitled to receive revenue from Allergan on net sales of Restasis and Prolacria, if any,
worldwide, excluding most larger Asian markets. Under this agreement, we have received up-front and milestone payments of $11 million related to our development of Prolacriaand will be entitled to receive up to an additional $28 million in
milestone payments assuming the successful completion of all remaining milestones under this agreement. If we receive FDA approval and Prolacriais launched, we expect to begin to co-promote this product in the United States.



We have established a joint development committee with Allergan
to oversee the joint development program and a joint commercialization committee to establish the broad strategies and manage the relationship. Under the terms of the agreement, we provide bulk active drug substance while Prolacriais in
development and Allergan is responsible for obtaining or manufacturing all of its bulk active drug substance requirements for commercial supply of the product.



We are responsible for conducting, in collaboration with Allergan, the Phase 3 clinical trials needed to file a U.S. NDA for
Prolacria. Allergan is responsible for all other development activities under the agreement, including all development and regulatory activities needed for potential approval outside the United States and in its territories, and for ex-U.S.
regulatory submissions, filings, and approvals relating to products. In addition, Allergan is responsible for all commercial costs except for the cost of our sales force in the United States. Allergan is required to use commercially reasonable
efforts to conduct these development activities, seek ex-U.S. regulatory approvals and market and sell Prolacria.



The revenue that we receive on the net sales of Restasis is based upon a percentage of net sales of Restasis in the United States, and
upon a percentage of net sales of Restasis outside the United States, except in Japan and nine other Asian countries covered by our agreement with Santen.



9



---

##### Table of Contents

In December 2008, we amended our agreement with Allergan such that we
ceased co-promoting Restasis as of December 31, 2008. Notwithstanding the fact that we are no longer co-promoting Restasis, Allergan remains obligated to pay us royalties in relation to sales of Restasisat the rates in
effect prior to the December 2008 amendment.



Unless earlier terminated pursuant to other terms of the agreement, the agreement will expire as to each product (Restasis or Prolacria, as the case may be) in each applicable country on the later of (i) the 10th
anniversary of the first commercial sale of such product in the applicable country, or (ii) the date on which the sale of such product ceases to be covered by any claim of any applicable Inspire or Allergan patent. The agreement will expire in
its entirety upon the expiration of the agreement with respect to all products in all countries as described in the previous sentence. Either Allergan or we may terminate the agreement in the event of a material breach of the agreement. In addition,
we have the right to terminate the agreement by giving 180 days prior notice if we determine, subject to the joint commercialization committees review and arbitration, that Allergan has not made reasonably sufficient progress in the
commercialization of our product. If Allergan breaches the agreement, becomes insolvent or we terminate for failure to make progress with the commercialization of our product, Allergans license will terminate and Allergan must provide us
with all data and information relating to our product and must assign or permit us to cross-reference all regulatory filings and approvals.



In the event that the joint development committee decides to terminate the development program for Prolacria, and any other Inspire
product under development pursuant to the agreement, and we do not within six months of the termination of the development program fulfill our obligations under the co-promotion provisions for Restasis, including providing 20% of the budgeted
sales force for Restasis, the royalty that we receive on net sales of Restasis, both with respect to sales in the United States and elsewhere, will be reduced by 30%.



Cystic Fibrosis Foundation Therapeutics, Inc.



In October 2002, we entered into a study funding agreement with
the CFFT, a non-profit drug development affiliate of the Cystic Fibrosis Foundation, for the funding of one Phase 2 clinical trial for denufosol for the treatment of cystic fibrosis. Under the agreement, the CFFT provided the majority of funding of
external costs for one Phase 2 clinical trial of denufosol, which we completed in April 2004, in exchange for post-commercialization development and sales milestone payments. If denufosol ultimately receives FDA approval for the treatment of cystic
fibrosis, we would be obligated to pay a development milestone to the CFFT, calculated as a multiple of the clinical trial costs incurred by the CFFT. In addition, we would be obligated to pay a sales milestone if the product candidate achieves a
specified aggregate sales volume in the first five years following product approval. The development milestone is currently estimated to be approximately $12 million, payable over five years, and the sales milestone would be an additional $4
million, payable over two years. The agreement will terminate no later than the expiration of all payment obligations under the agreement. Either the CFFT or we may terminate the agreement if the other materially breaches the agreement.



InSite Vision Incorporated



In February 2007, we entered into a license agreement with
InSite Vision pursuant to which we acquired exclusive rights to commercialize AzaSite, as well as other potential topical anti-infective products containing azithromycin as the sole active ingredient for use in the treatment of human ocular
or ophthalmic indications. The license agreement also grants us exclusive rights to develop, make, use, market, commercialize and sell each product in the United States and Canada. We are currently responsible for all regulatory obligations and
strategies relating to the further development and commercialization of a product in the United States and Canada.



Pursuant to the license agreement, we paid InSite Vision an upfront license fee of $13.0 million and an additional $19.0 million milestone
related to FDA approval of AzaSite. In addition, we paid a 20% royalty for the first two years of commercialization and in July 2009 began paying a 25% royalty on net sales of AzaSite in the



10



---

##### Table of Contents

United States and Canada, which will continue for the duration of the agreement. We are obligated to pay royalties under the agreement for the longer of (i) 11 years from the launch of the
subject product and (ii) the period during which a valid claim under a patent licensed from InSite Vision covers a subject product. Under the terms of the agreement, our obligation to pay royalties to InSite Vision is subject to pre-determined
minimum annual royalty payments. The determination of whether or not we will owe any such payments is based upon the amount of royalties accrued over a 12-month royalty period. There are five successive 12-month minimum royalty periods, the second
of which commenced on October 1, 2009.



Contemporaneously with the license agreement, InSite Vision entered into an exclusive license agreement with Pfizer for certain Pfizer patent rights relating to the treatment of ocular infection with azithromycin for certain products. Under
the terms of our license agreement with InSite Vision, we obtained from InSite Vision a sublicense to such Pfizer patent rights, in addition to the license to the InSite Vision patent rights, subject to certain limitations. Also, Inspire and Pfizer
entered into a related agreement that provides for the continuation of our sublicense rights under the Pfizer patent rights upon a termination of the license agreement between InSite Vision and Pfizer. The agreement between us and Pfizer also
provides an opportunity to cure any breaches by InSite Vision of the license agreement between InSite Vision and Pfizer and the opportunity to maintain and enforce such Pfizer patent rights under certain circumstances.



Santen Pharmaceutical Co., Ltd.



In December 1998, we entered into a development, license and
supply agreement with Santen for the development of diquafosol tetrasodium for the therapeutic treatment of ocular surface diseases, such as dry eye disease, in Asia. Under the agreement, we granted Santen an exclusive license to develop and market
diquafosol tetrasodium for ocular surface diseases in Japan, China, South Korea, the Philippines, Thailand, Vietnam, Taiwan, Singapore, Malaysia and Indonesia.



We established a coordinating committee to review and evaluate Santens progress in the development and commercialization of
potential products. Santen is responsible for all development, regulatory submissions, filings and approvals, and all marketing of potential products in its territory. We are obligated to supply Santen with all its requirements of diquafosol
tetrasodium in bulk drug substance form for all preclinical studies, clinical trials and commercial requirements at agreed-upon prices. However, we do not have manufacturing expertise or capability, and we do not have an agreement with any third
party for the manufacture of diquafosol tetrasodium in bulk drug substance form for the commercial requirements of Santens product, if approved. See below and Risk FactorsThe third-party vendor that manufactures denufosol and
the API related to both Prolacria and Santens DE-089 does not have the capacity to manufacture the projected commercial quantities of API for these products, if any is approved.



Under the terms of the agreement, we received an up-front equity
investment of $1.5 million in exchange for shares of our preferred stock in December 1998, that were subsequently converted into shares of our common stock. We have received total milestone payments of $3.0 million based on the achievement of
certain regulatory work and the completion of Phase 3 clinical testing of diquafosol tetrasodium in Japan by Santen, which Santen refers to as DE-089. If all milestones are achieved, we could receive up to an additional $1.75 million. We are
eligible to receive royalties on net sales of DE-089 if it is approved for commercialization and launched in Santens licensed territories.



The agreement will terminate when all patents licensed under the agreement have expired. Either Santen or we may terminate the agreement if
the other materially breaches the agreement. In addition, we have the right to terminate the agreement at any time if we determine, subject to the coordinating committees review and arbitration, that Santen has not made reasonably sufficient
progress in the development or commercialization of potential products. If Santen breaches the agreement, or if we terminate the agreement because Santen has not made sufficient progress, Santens license will terminate. Santen will provide us
with all data and information relating to our products, and will assign or permit us to cross-reference all regulatory filings and approvals. If we



11



---

##### Table of Contents

are unable to supply Santen with the API for its DE-089 product, Santen may elect to manufacture (or have manufactured) the quantity of API that we fail to supply or to assume full responsibility
for supply of the API. In such event, Santen will receive a manufacturing license from us. In the event that we are in material breach of our material contractual obligations regarding supply of API, other remedies available under law or in equity
will apply.



Wisconsin Alumni Research
Foundation



In November 2004, we licensed
technology for use in developing and commercializing new treatments for glaucoma from WARF. Under the terms of the agreement, we paid an upfront licensing payment of $150,000 in 2004 upon execution of the agreement and a $50,000 milestone payment
related to the filing of an Investigational New Drug Application, or IND, for our glaucoma program in 2006. We are obligated for additional contingent payments of up to an aggregate of $1.8 million upon the achievement of development milestones, and
royalties on sales of any regulatory approved product utilizing the licensed patents.



We will design and fund all future research, development, testing, regulatory filings and potential marketing activities related to any product candidate under development or product developed from the
license. Unless terminated earlier, the agreement will expire on a country-by-country basis upon the expiration of the patents in such country. The U.S. government may have limited rights in some of this patented technology. WARF may terminate the
license if we fail to make timely payment of any amount due to WARF under the agreement or commit a material breach of any material covenant contained in the agreement, subject to our right to cure.



Research and Development



Since our inception, we have made substantial investments in
research and development. During the years ended December 31, 2009, 2008 and 2007, our research and development expenses were $51.1 million, $44.6 million and $53.4 million, respectively. In February 2009, we eliminated our early preclinical
and molecule discovery activities and refocused our resources on the development of existing later-stage clinical programs and commercially available products.



In addition to internal resources, we collaborate with external contract research organizations that allow us to perform development
activities, including toxicology, pharmacokinetics, toxicokinetics, and other studies required for NDA regulatory submissions, with a limited number of staff. We routinely present our scientific research at eye care and pulmonary conferences and in
peer-reviewed publications.



For more information
about our research and development costs and expenses, see Managements Discussion and Analysis of Financial Conditions and Results of OperationsResearch and Development Expenses.



Sales and Marketing



We currently employ approximately 90 territory managers to
provide us with national U.S. sales coverage for AzaSiteand Elestat. We also have marketing, managed care, training and operation groups to support our commercialization efforts. Our sales and marketing organization focuses its
promotional activities for AzaSiteandElestaton eye care specialists.



We intend to establish corporate partnering, licensing or other arrangements for the marketing and sale of selected product candidates that we develop, especially outside of North America. We do not
intend to develop commercial operations outside of North America.



We believe our commercial operations provides us with the foundation to leverage opportunities to market and sell other products we are developing, or products that we may in-license or otherwise acquire,
and to maximize their commercial value in the United States.



12



---

##### Table of Contents

Compliance



We conduct our business in an ethical, fair, honest and lawful manner. We act responsibly, respectfully and with integrity in our
relationships with patients, health care professionals, providers, governments, regulatory entities, customers, stockholders, suppliers and vendors.



We have designated a Chief Compliance Officer who reports to the Chief Executive Officer and the Chairperson of the Audit Committee of the
Board of Directors. Among other duties, this officer oversees compliance training, education, auditing and monitoring; enforces disciplinary guidelines for any infractions of our Comprehensive Compliance Program; implements new policies and
procedures; responds to any detected issues; and undertakes corrective action procedures. The Chief Compliance Officer provides updates to senior management, the Audit Committee of the Board of Directors, and to the full Board of Directors. Our
controls address compliance matters relating to requirements and entities that govern public pharmaceutical companies including, but not limited to the following: federal and state law, such as the Sarbanes-Oxley Act of 2002 and the U.S. Foreign
Corrupt Practices Act of 1977; NASDAQ listing requirements; the Financial Industry Regulatory Authority; the Securities and Exchange Commission; the Food and Drug Administration; the United States Department of Health and Human Services; and the
Office of Inspector General, along with voluntary industry standards developed by the Pharmaceutical Research and Manufacturers of America. Our standard operating procedures are designed to provide a framework for corporate governance in accordance
with ethical standards and legal best practices. Our codes and policies that have been implemented include, but are not limited to, Code of Conduct and Business Ethics; Whistleblower Policy; and Code of Conduct: Promotional Interactions with Health
Care Professionals.



Manufacturing and Supply



We rely on single source manufacturers for our commercial
products and product candidates. Allergan is responsible for the manufacturing of both Restasisand Elestat and relies on single source manufacturers for the active pharmaceutical ingredients, or APIs, in both products. We rely on
InSite Vision for supply of the active pharmaceutical ingredient for AzaSite, which InSite Vision obtains from a single source manufacturer. We are responsible for the remaining finished product manufacturing of AzaSite, for which we
rely on a single source manufacturer. Additionally, we rely upon a single third party to provide distribution services for AzaSite.



We rely upon one vendor as the sole manufacturer of the supply of active pharmaceutical ingredients for both Prolacriaand denufosol;
however, we have initiated development of a secondary supplier for denufosol. See Risk FactorsReliance on a single party to manufacture and supply either finished product or the bulk active pharmaceutical ingredients for a product or
product candidates could adversely affect us and The third-party vendor that manufactures denufosol and the API related to bothProlacriaand Santens DE-089 does not currently have the capacity to manufacture the
projected commercial quantities of API for all these products, if approved.



We conduct qualification and routine audits of our contract manufacturers. These contract manufacturers are identified in our regulatory agency filings, such as with the FDA, and are subject to regulatory
agency inspections. We also attempt to stay informed on the financial condition of contract manufacturers and their status with regulatory agencies.



The manufacture of our products and product candidates is based, in part, on technology that we believe to be proprietary to our contract
manufacturers or our collaborative partners. Such manufacturers may not abide by the limitations or confidentiality restrictions in agreements with us. In addition, any such manufacturer may develop process technology related to the manufacture of
our compounds that such supplier owns either independently or jointly with us. This would increase our reliance on such manufacturer or require us to obtain a license from such manufacturer in order to have our products manufactured using such
technology.



13



---

##### Table of Contents

Catalent Pharma Solutions



In September 2007, we entered into a long term manufacturing
services agreement with Catalent Pharma Solutions, LLC, or Catalent, for the manufacture of the finished product AzaSite, pursuant to which Catalent agreed to manufacture AzaSite to Inspires specifications for a period of six
years. Under the agreement, we agreed to purchase from Catalent on an annual basis a specified minimum number of units (each unit consists of 2.5 milliliters) of AzaSitefor the first four years at a per unit price that is specified in the
contract. Either party may terminate the agreement upon 60 days prior written notice if the other party materially breaches the agreement. However, if we fail to make payments to Catalent within 15 days after such payments are due, Catalent
may terminate the agreement or Catalent may cease performing under the agreement until all of the outstanding payments are brought current. We may terminate the agreement if a force majeure event prevents Catalent from fully performing its
obligations under the agreement for a period of 120 days. In addition, following the conclusion of the third contract year, the agreement may be terminated on 12 months notice by us or on 24 months notice by Catalent.



InSite Vision



In February 2007, we entered into a supply agreement with
InSite Vision for the active pharmaceutical ingredient, azithromycin. Previously, InSite Vision entered into a third-party supply agreement for the production of azithromycin. Under the supply agreement, InSite Vision agreed to supply our
requirements of azithromycin, pursuant to certain forecasting and ordering procedures. The initial term of the supply agreement is until 2012, subject to certain customary termination provisions, such as termination for material breach of the
agreement. Either we or InSite Vision may terminate the supply agreement upon 180 days notice to the other party. After 2012, the supply agreement automatically renews for successive three-year periods unless terminated pursuant to such termination
provisions. The supply agreement requires that InSite Vision produce for us a specified stockpile of azithromycin.



Yamasa Corporation



Effective September 25, 2009, we entered into a Technology License Agreement for the Manufacture of Denufosol with Yamasa Corporation.
During our denufosol development program, Yamasa has manufactured all of the denufosol used by Inspire in its related clinical trials. The purpose of the technology agreement is to facilitate the transfer of the current denufosol manufacturing
technology, including intellectual property, to an additional manufacturer and thus enable a two-supplier strategy for denufosol.



Pursuant to the terms and conditions of the technology agreement, Yamasa granted to Inspire an exclusive, worldwide, royalty-free right and
license to use, make, have made and sell denufosol and any pharmaceutical formulation containing denufosol as an active pharmaceutical ingredient, under certain intellectual property developed by Yamasa. During the term of the technology agreement,
Inspire may designate a single manufacturer (in addition to Yamasa) to use the rights licensed from Yamasa at any given time.



In consideration of the grant of rights under the technology agreement, in October 2009, Inspire paid Yamasa three hundred million Japanese
Yen (¥ 300,000,000), which was approximately $3.3 million at the prevailing exchange rate. Additionally, Inspire shall pay Yamasa (i) three hundred million Yen (¥ 300,000,000) within thirty (30) days after the receipt of a process
validation report by December 31, 2010 following the successful completion of three validation batches; and (ii) four hundred million Yen (¥ 400,000,000) within thirty (30) days after both (a) the acceptance of a pre-approval
inspection of denufosol at Yamasa by the FDA, and (b) the approval of a New Drug Application of a formulated denufosol drug product at Inspire by the FDA.



14



---

##### Table of Contents

Patents and Proprietary Rights



We believe that the proprietary protection of our product candidates, processes and know-how is important to
the success of our business. We file and prosecute patents covering our proprietary technology and, if warranted, will defend our patents and proprietary technology. We seek trademark protection in the United States and foreign countries, as
appropriate. We also rely upon trade secrets, know-how, continuing technological innovation and licensing opportunities to develop and maintain our competitive position.



As of February 28, 2010, our patent estate included approximately 70 U.S. patents that we own or co-own and approximately
20 U.S. patents that we have licensed, as well as over 160 counterpart patents in countries other than the United States. Our issued patents and pending patent applications in the United States include composition of matter coverage on a number
of different structural families of compounds as well as related formulation and use coverage. The actual protection afforded by a patent varies from country to country and depends upon many factors, including the type of patent, the scope of its
coverage and the availability of legal remedies in a particular country.



Below is a summary of certain patent information, as of February 28, 2010, relating to our commercial products as well as product candidates that are in Phase 3 development. The
information relating to the products listed below reflects those patents listed in the FDAs Orange Book: Approved Drug Products with Therapeutic Equivalence Evaluations, with respect to such product. The information relating to
Prolacria represents those patents listed in our NDA filed with respect to such candidate and the information regarding denufosol tetrasodium reflects the U.S. patents that we own and consider to be particularly important to the
protection of such candidate. In addition to the patents reflected in the table, for some of these product candidates we have other patents that cover a particular form or composition or relate to manufacturing methods, as well
as pending patent applications. These issued patents and any patents issued in relation to a pending applications, could provide additional or a longer period of protection.



|                                   |  |                                   |  |                                     |  |                         |  |                                    
|---------------------------------- |  | --------------------------------- |  | ----------------------------------- |  | ----------------------- |  | -----------------------------------
|PRODUCTS AND PRODUCT CANDIDATES    |  | NUMBER OFSPECIFIEDPATENTS IN U.S. |  | TYPES OF PATENTSIN U.S.             |  | PATENT OWNERIN U.S.     |  | RANGE OF U.S.PATENTEXPIRATION
DATES
|Products                           |  |                                   |  |                                     |  |                         |  |                                    
|                                   |  |                                   |  |                                    
|AzaSite                            |  | 5                                 |  | Use and Formulation Patents         |  | InSite Vision/Pfizer(1) |  | November 2018  March 2019         
|                                   |  |                                   |  |                                    
|Elestat                            |  | N/A(2)                            |  | N/A(2)                              |  | N/A                     |  | N/A                                
|                                   |  |                                   |  |                                    
|Restasis                           |  | 1                                 |  | Formulation                         |  | Allergan(1)             |  | May 2014                           
|                                   |  |                                   |  |                                    
|Product Candidates                 |  |                                   |  |                                     |  |                         |  |                                    
|in Phase 3 Clinical                |  |                                   |  |                                     |  |                         |  |                                    
|Development                        |  |                                   |  |                                     |  |                         |  |                                    
|                                   |  |                                   |  |                                    
|Denufosol tetrasodium              |  | 6                                 |  | Drug substance, Formulation and Use |  | Inspire                 |  | February 2017(3)                   
|                                   |  |                                   |  |                                    
|Prolacria (diquafosol tetrasodium) |  | 8                                 |  | Drug substance, Formulation and Use |  | Inspire                 |  | July 2016  February 2017(3)       



|(1) | In-licensed to Inspire
|--- | ----------------------

|(2) | See ProductElestat for a discussion of the expiration of market exclusivity under the Hatch-Waxman Act.
|--- | ----------------------------------------------------------------------------------------------------------

|(3) | Subject to any applicable patent restoration that may extend protection up to an additional five years from the date of expiration of the applicable patent, if any, for
which restoration is sought.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



15



---

##### Table of Contents

We seek patent protection for our proprietary technology and products in the United States
and Canada and in key commercial European and Asia/Pacific countries and other major commercial sectors of the world, as appropriate. We have in-licensed patents related to AzaSite in Canada, and have received patents related to denufosol
tetrasodium and diquafosol tetrasodium in Canada, Europe, Australia, New Zealand and other Asia/Pacific countries. See Collaborative AgreementsAllergan, Inc.Restasis and Prolacria and Collaborative
AgreementsSanten Pharmaceutical Co., Ltd. for additional discussion of responsibilities for diquafosol tetrasodium development and potential commercialization outside of the United States.



Competition



Many pharmaceutical and biotechnology companies engage in
research and development to commercialize products to treat allergic conjunctivitis, bacterial conjunctivitis, cystic fibrosis, dry eye disease, blepharitis, glaucoma, and other diseases that we are researching. We compete with these companies for
funding, access to licenses, personnel, third-party collaborators and product development. However, most large pharmaceutical and biotechnology companies have significantly larger intellectual property estates, substantially greater financial,
marketing, sales, distribution and technical resources and greater capabilities and experience in preclinical and clinical development, sales, marketing, manufacturing and regulatory affairs than we do. The introduction of new products or the
development of new processes by competitors or new information about existing products may result in price reductions or product replacements, even for products protected by patents.



The following treatments compete, or may compete, with our products and product candidates, as applicable:



Allergic
Conjunctivitis. There are multiple therapies available to treat or prevent allergic conjunctivitis. The primary products that Elestat competes with are Patanol® and PatadayTM, both by Alcon, Inc.; Zaditor® by Novartis and its related
generic; and Optivar® by Meda Pharmaceuticals and its related generic. Patanoland Patadaycurrently have the majority of the prescriptions in the allergic conjunctivitis market. Additionally, in September 2009, the FDA approved BepreveTM, by ISTA Pharmaceuticals, Inc., and the product was
launched in late 2009.



Bacterial Conjunctivitis. The current prescription ocular anti-infective treatments for bacterial conjunctivitis that compete with AzaSiteinclude single-entity antibiotics Vigamox® and Ciloxan®, both by Alcon; Zymar® and Ocuflox®, both by Allergan; Quixin®and Iquix®, both by Vistakon Pharmaceuticals, LLC; and Besivance® by Bausch & Lomb, Inc. and combination products such as Zylet®by Bausch & Lomb, Inc.; and TobraDex®by Alcon. In addition, there are several generics used to treat bacterial conjunctivitis, which include erythromycin, gentamycin and tobramycin.



Cystic Fibrosis.There are two
products approved in the United States specifically for the treatment of complications of cystic fibrosis lung disease: Pulmozyme®, by Genentech, Inc., an agent designed to break up thickened airway secretions, and TOBI®, by Novartis, an inhaled antibiotic. Additionally, in February 2010, the FDA approved Cayston® (aztreonam for inhalation), an inhaled antibiotic, by Gilead Sciences, Inc. Academic groups have completed at least one clinical trial that demonstrated clinical
benefit of hypertonic saline. At least one clinical trial has been completed that demonstrated clinical benefit with Zithromax®, by Pfizer, Inc., an oral antibiotic. In addition, the following products for the treatment of cystic fibrosis are in Phase 3 development: BronchitolTMby
Pharmaxis and VX-770 by Vertex Pharmaceuticals, Inc.



Dry Eye Disease.The current prescription and non-prescription treatments for dry eye disease include Restasis by Allergan; artificial tear solutions and lubricant eye drops. In addition to
our development program for Prolacria, we are aware of several other companies that are developing products for the treatment of dry eye disease.



16



---

##### Table of Contents

Governmental Regulation



The research, development, testing, manufacture, promotion, marketing and distribution of human therapeutic
products are extensively regulated by governmental authorities in the United States and other countries. The FDA regulates drugs products in the United States and similar regulatory agencies exist in other countries. The steps ordinarily required
before a new drug may be marketed in the United States, which are similar to steps required in most other countries, include:



| |  |  | Preclinical laboratory tests, preclinical studies in animals and formulation studies and the submission to the FDA of an IND prior to beginning
clinical trials for a new drug;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Adequate and well-controlled clinical trials to establish the safety and efficacy of the drug for each indication;
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | The submission of an NDA to the FDA; and
| | - |  | ----------------------------------------



| |  |  | FDA review and approval of the NDA before any commercial sale or shipment of the drug.
| | - |  | --------------------------------------------------------------------------------------



Preclinical tests include laboratory evaluation of product
toxicity and formulation, as well as animal studies. The results of preclinical testing are submitted to the FDA as part of an IND. A 30-day waiting period after the filing of each IND is required before the commencement of clinical testing in
humans. At any time during this 30-day period or later, the FDA may place a clinical hold and halt proposed or ongoing clinical trials for any one of several conditions that are set out in regulations, and the clinical trial may not resume until the
FDA withdraws its hold on the clinical trials. Moreover, positive results of preclinical tests will not necessarily indicate positive results in clinical trials.



Clinical trials to support NDAs are typically conducted in three sequential phases, but the phases may overlap.



Phase 1During Phase 1, the
initial introduction of the drug into healthy volunteers, the drug is tested to assess metabolism, pharmacokinetics and pharmacological actions and safety, including side effects associated with increasing doses.



Phase 2Phase 2 usually involves studies in
a limited patient population to: (1) assess the efficacy of the drug in specific, targeted indications; (2) assess dosage tolerance and optimal dosage; and (3) identify possible adverse effects and safety risks.



Phase 3If a compound is found to be
potentially effective and to have an acceptable safety profile in Phase 2 evaluations, Phase 3 clinical trials, also called pivotal studies, major studies or advanced clinical trials, are undertaken to further demonstrate clinical efficacy and to
further test for safety within an expanded patient population at geographically dispersed clinical trial sites. In general, the FDA requires that at least two adequate and well-controlled Phase 3 clinical trials be conducted.



After successful completion of the required clinical testing,
generally an NDA is submitted. The FDA may request additional information before accepting an NDA for filing, in which case the application must be resubmitted with the additional information. Once the submission has been accepted for filing, the
FDA has 180 days to review the application and respond to the applicant. The review process is often significantly extended by FDA requests for additional information or clarification. The FDA may refer the NDA to an appropriate advisory committee
for review, evaluation and recommendation as to scientific issues relevant to whether the application should be approved, but the FDA is not bound by the recommendation of an advisory committee.



Based on its review of the NDA and associated support, such as
the results from inspections of manufacturing and clinical sites, the FDA will either approve or refuse to approve the NDA, unless the FDA evaluation is inconclusive, in which case the FDA will issue a complete response letter. The
complete response letter replaced the FDAs approvable and non-approvable letters on August 11, 2008. A complete response letter will state that the FDA cannot approve the NDA in its present form and, usually, will
describe all of the



17



---

##### Table of Contents

specific deficiencies that the FDA has identified in the application. The complete response letter, when possible, will include the FDAs recommended actions to place the application in a
condition for approval. Deficiencies can be minor (e.g., labeling changes) or major (e.g., requiring additional clinical trials). A complete response letter may also be issued before the FDA conducts the required facility inspection
and/or reviews labeling, leaving the possibility that additional deficiencies in the original NDA could be subsequently cited. An applicant receiving a complete response letter is permitted to resubmit the NDA addressing the identified deficiencies
(in which case a new two or six month review cycle will begin), or withdraw the NDA. The FDA may consider a failure to take action within one year of a complete response letter to be a request to withdraw, unless the applicant has requested an
extension of time in which to resubmit. If the FDA approves an NDA, the marketing of the drug product will be limited to the particular disease states and conditions of use that are described in the product label.



We and all of our contract manufacturers are also required to
comply with the applicable FDA cGMP regulations during clinical development and to ensure that the product can be consistently manufactured to meet the specifications submitted in an NDA. The cGMP regulations include requirements relating to product
quality as well as the corresponding maintenance of records and documentation. Manufacturing facilities must be approved by the FDA before they can be used to manufacture our products. Based on an inspection, the FDA determines whether manufacturing
facilities are in compliance with applicable regulations. Manufacturing facilities in non-U.S. countries that are utilized to manufacture drugs for distribution into the United States are subject to inspection by the FDA. Additionally, failure to
comply with local regulatory requirements could affect production and availability of product in relevant markets.



We must also comply with multiple governmental requirements and best practices associated with the marketing, sale and distribution of our
products and product samples. These include, but are not limited to, compliance with federal and state reporting laws; review, approval and distribution of product promotional materials; review and monitoring of promotional and educational programs;
interactions with health care providers; and distribution of product samples.



With regard to AzaSite, we are responsible for monitoring the safety of the product, reporting adverse events, and taking corrective actions as necessary. In addition, we enter into contracts with
managed care organizations for both private and government programs, including Medicare Part D and also directly with state and federal governments for certain programs, including Medicaid programs.



Outside the United States, our ability to market our products
will also depend on our receipt of marketing authorizations from the appropriate regulatory authorities, as well as the efforts of our collaborative partners to obtain authorizations. The requirements governing the conduct of clinical trials and
marketing authorization vary widely from country to country. At present, foreign marketing authorizations are applied for at a national level, although within the European Union procedures are available to companies seeking to market a product in
more than one member state. If the regulatory authority is satisfied that adequate evidence of safety, quality and efficacy has been presented, a marketing authorization will be granted. Foreign regulatory approval processes, including those in
Europe and Japan, involve risks similar to those associated with obtaining FDA marketing approval.



Health Care Reform Measures and Third-Party Reimbursement



The efforts of governments and third-party payors to contain or reduce the cost of health care will continue to affect the business and
financial condition of drug companies. In both the United States and some foreign jurisdictions, there have been a number of legislative and regulatory changes to the health care system adopted in recent years that could affect our ability to sell
our products profitably, and additional changes could be adopted in the future. For instance, in the United States, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 established a voluntary Medicare outpatient
prescription drug benefit under Part D of the Social Security Act. The program, which went into effect January 1, 2006, is administered by the Centers for



18



---

##### Table of Contents

Medicare & Medicaid Services, or CMS, within the Department of Health and Human Services, or HHS, and is implemented and operated by private sector Part D plan sponsors. Under the
Part D program, each participating drug plan is permitted by regulation to develop and establish its own unique drug formulary that may exclude certain drugs from coverage and impose prior authorization and other coverage restrictions, and negotiate
payment levels with drug manufacturers that may be lower than reimbursement levels available through private health plans or other payers. Moreover, beneficiary co-insurance requirements can vary, in turn influencing which products are
recommended by physicians and selected by patients. CMS has issued extensive regulations and other subregulatory guidance documents to assist Part D plan sponsors with implementing the new benefit. Moreover, the HHS Office of Inspector General
has issued regulations and other guidance in connection with the program. The federal government continues to issue guidance and regulations regarding the obligations of Part D sponsors on an ongoing basis.



Allergan is responsible for the implementation of the Medicare
Part D program as it relates to RestasisandElestat and has contracted with Part D plan sponsors to cover such drugs under the Part D benefit. We are responsible for contracting with Part D plan sponsors with respect to
AzaSite. There is no assurance that any drug that we co-promote or sell will be covered by drug plans participating under the Medicare Part D program or, if covered, what the terms of any such coverage will be, or that the drugs will be
reimbursed at amounts that reflect current or historical payment levels. Our results of operations could be materially adversely affected by coverage or reimbursement changes resulting from the Medicare prescription drug program, including changes
in Part D formularies or prices negotiated with Part D drug plans. To the extent that private insurers or managed care programs follow Medicare coverage and payment developments, the adverse effects of lower Medicare payments may be magnified
by private insurers adopting similar lower payment. In addition, health care reform legislation in the United States and in foreign countries, along with other federal or state prescription drug reimbursement and coverage policies, may be
enacted or adopted in the future that could further lower payment for our products.



A number of federal and state proposals to reform the health care system have been considered in recent years, and legislation currently is being debated that could impact reimbursement and coverage for
prescription drugs. In particular, both the U.S. House of Representatives and Senate approved major health reform plans in late 2009 that would, among many other things: increase Medicaid drug rebate amounts paid by manufacturers and expand the
drugs that are subject to such rebates, generally require drug manufacturers to provide a discount on brand-name prescriptions filled in the Medicare Part D coverage gap, expand comparative effectiveness research programs, and expand
disclosure requirements regarding drug manufacturer financial arrangements with referring physicians. In addition, the House version of the bill would establish a public health insurance program to compete with private insurance companies, which
could increase competitive pressures in the private insurance market that ultimately could impact prescription drug reimbursement. The House bill also would require the HHS Secretary to negotiate Medicare Part D drug prices directly with
pharmaceutical manufacturers, and it would bar agreements between brand name and generic drug manufacturers that delay competition from generic drugs. The Senate bill would impose a $2.3 billion annual fee on the pharmaceutical manufacturing sector,
generally allocated according to market share. To date Congress has not reached agreement on a single reform plan, so it is uncertain at this time whether a bill will be enacted in the near future and, if so, the scope of the provisions that will be
included or the impact on us. There can be no assurances, however, that enactment of health reform legislation would not have an impact on reimbursement and/or coverage of our products. Likewise, the potential for adoption of health care reform or
other cost-control proposals on a state-by-state basis could impact our reimbursement levels and require us to develop state-specific marketing and sales approaches.



Sales of prescription drugs depend significantly on the availability of reimbursement to the consumer and/or
provider from third-party payors, such as government health programs and private insurance plans. These third-party payors frequently require that drug companies provide predetermined discounts or rebates from list prices, and they are increasingly
challenging the prices for medical products and services. Third-party payors may not consider our products to be cost effective and may not reimburse the consumer sufficiently to allow us, and/or our collaborators, to sell our products on a
profitable basis. In addition, an increasing emphasis on managed care



19



---

##### Table of Contents

in the United States continues to increase pressure on drug pricing. Additional legislative or regulatory proposals or changes in managed care practices may be adopted that may have an adverse
effect on our business and our financial condition, including our profits.



Employees



As of January 31,
2010, we had approximately 240 full-time and part-time employees. In addition, we utilize interns, outside contractors and consultants as needed. Our future success will depend in large part upon our ability to attract and retain highly qualified
personnel. Our employees are not represented by any collective bargaining agreements, and we have never experienced a work stoppage. Employees are required to execute confidentiality and assignment of intellectual property agreements.



Available Information



Our Internet site is located at www.inspirepharm.com. Copies of
our reports filed pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports may
be accessed from our website, free of charge, as soon as reasonably practicable after we electronically file such reports with, or furnish such reports to, the Securities and Exchange Commission, or SEC. Please note that the information contained on
our website is not incorporated by reference into our reports that are filed with the SEC. The public may read or copy any materials we file with the SEC at the SECs Public Reference Room at 100 F Street NE, Room 1580, Washington D.C. 20549.
The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers
that file electronically with the SEC. The address of that site is www.sec.gov.



20



---

##### Table of Contents

Item 1A. Risk Factors.



RISK FACTORS



An investment in our common stock involves a substantial risk of
loss. You should carefully read this entire report and should give particular attention to the following risk factors. You should recognize that other significant risks may arise in the future, which we cannot foresee at this time. Also, the risks
that we now foresee might affect us to a greater or different degree than expected. There are a number of important factors that could cause our actual results to differ materially from those indicated by any forward-looking statements in this
report. These factors include, without limitation, the risk factors listed below and other factors presented throughout this report and any other reports filed by us with the SEC.



Risks Related to Product Commercialization



Failure to adequately market and commercializeAzaSitewill negatively impact our revenues.



The commercial success of AzaSite
will depend on a number of factors, including:



| |  |  | Acceptance by patients and physicians;
| | - |  | --------------------------------------



| |  |  | Effectiveness of our sales and marketing efforts;
| | - |  | -------------------------------------------------



| |  |  | Ability to differentiate AzaSiterelative to our competitors products;
| | - |  | ----------------------------------------------------------------------



| |  |  | Ability to further develop clinical information to support AzaSite;
| | - |  | -------------------------------------------------------------------



| |  |  | Market satisfaction with existing alternative therapies;
| | - |  | --------------------------------------------------------



| |  |  | Perceived efficacy relative to other available therapies;
| | - |  | ---------------------------------------------------------



| |  |  | Disease prevalence;
| | - |  | -------------------



| |  |  | Cost of treatment;
| | - |  | ------------------



| |  |  | Pricing and availability of alternative products, including generic or over-the-counter products;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | Marketing and sales activities of competitors;
| | - |  | ----------------------------------------------



| |  |  | Shifts in the medical community to new treatment paradigms or standards of care;
| | - |  | --------------------------------------------------------------------------------



| |  |  | Relative convenience and ease of administration;
| | - |  | ------------------------------------------------



| |  |  | The manufacturers successful sustaining of manufacturing capability; and
| | - |  | -------------------------------------------------------------------------



| |  |  | Our ability to enter into managed care and governmental agreements on favorable terms.
| | - |  | --------------------------------------------------------------------------------------



We are responsible for all aspects of the commercialization of
this product, including the determination of formularies upon which AzaSite is listed, manufacturing, distribution, marketing and sales. The determination of formularies upon which AzaSiteis listed, the discounts and pricing under
such formularies, as well as the amount of time it takes for us to obtain favorable formulary status under various plans will impact our commercialization efforts.Additionally, inclusion on certain formularies requires significant price
concessions through rebate programs that impact the level of revenue that we receive. The need to give price concessions can be particularly acute where competing products are listed on the same formulary, such as the area of bacterial
conjunctivitis. If AzaSite is not successfully commercialized, our revenues will be limited.



Under our agreement with InSite Vision, we are obligated to make pre-determined minimum annual royalty payments to InSite Vision. To the
extent annual royalty payments actually paid to InSite Vision on our sales of AzaSite are less than the minimum annual royalty amounts established under our agreement with InSite Vision,



21



---

##### Table of Contents

we are obligated to pay the difference. In the event we are required to make annual minimum royalty payments, our profits with respect to AzaSite, if any, will be decreased or any losses
with respect to the product will be increased. Such circumstances may result in us ceasing our commercialization of AzaSiteand terminating our agreement with InSite Vision.



IfRestasisis not successfully commercialized by Allergan, our revenues will be negatively impacted.



Allergan is responsible for commercializing
Restasis. Accordingly, our revenues on the net sales of Restasis are dependent on the actions and success of Allergan, over whom we have no control.



Following the expiration of a use patent in August 2009, the manufacture and sale of Restasis is
protected in the United States by a formulation patent that expires in May 2014. While a formulation patent may afford certain limited protection, a competitor may attempt to gain FDA approval for a cyclosporine product using a different
formulation. Furthermore, following the expiration of the formulation patent in 2014, a generic form of Restasis could be introduced into the market. If and when Restasis experiences competition from a cyclosporine product, including
generics, our revenues attributable to Restasis may be significantly impacted.



Other factors that could affect the commercialization of Restasis include:



| |  |  | Extent and effectiveness of Allergans sales and marketing efforts;
| | - |  | -------------------------------------------------------------------



| |  |  | Satisfaction with existing alternative therapies, including generic or over-the-counter products;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | Perceived efficacy relative to other available therapies;
| | - |  | ---------------------------------------------------------



| |  |  | Changes in, or the levels of, third-party reimbursement of product costs;
| | - |  | -------------------------------------------------------------------------



| |  |  | Coverage and reimbursement under Medicare Part D, state government sponsored plans and commercial plans;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | Cost of treatment;
| | - |  | ------------------



| |  |  | Development and FDA approval of competing dry eye products; and
| | - |  | ---------------------------------------------------------------



| |  |  | Shifts in the medical community to new treatment paradigms or standards of care.
| | - |  | --------------------------------------------------------------------------------



When a generic form ofElestator an over-the-counter
form of epinastine ophthalmic solution is introduced into the market, our agreement with Allergan to co-promoteElestatwill no longer be in effect, and our revenues from sales ofElestatwill be minimal.



Our Elestat co-promotion agreement
with Allergan provides that unless earlier terminated, the term of such agreement will be in effect until the earlier of (i) the approval and launch of the first generic epinastine product after expiration of the FDA exclusivity period
coveringElestat in the United States, or (ii) the approval and launch of the first over-the-counter epinastine product after expiration of the listing ofElestat in the FDA publication Approved Drug Products with Therapeutic
Equivalence (commonly called the Orange Book). Following the termination of the co-promotion agreement, we will no longer have rights to co-promoteElestat. We will be entitled to receive post-termination payments from Allergan,
based on any remaining net sales ofElestat for a period of 36 months. During the three successive 12-month periods immediately following the termination of the agreement, Allergan will be obligated to pay to us 20%, 15% and 10%,
respectively, on any net sales ofElestat in the United States.



Subject to applicable law, competitors are permitted to submit to the FDA an ANDA for a generic version of Elestat, due to the expiration of the marketing exclusivity period for Elestat
provided under the Hatch-Waxman Act on October 15, 2008.



We have been notified that Boehringer Ingelheim and Allergan received notices of Paragraph IV certifications from Apotex, Inc., Cypress Pharmaceutical, Inc., Paddock Laboratories, Inc. and Sandoz Inc.



22



---

##### Table of Contents

advising that each company filed an ANDA for a generic version of Elestat. Each ANDA notice alleges that the method of treatment patent related to Elestat is invalid, unenforceable
and/or will not be infringed by the respective ANDA applicants manufacture, use, sale, or offer for sale of the drug for which the ANDA was submitted. The date of submission of the first filing to the FDA Office of Generic Drugs was
October 14, 2008, according to the FDAs website (www.fda.gov). In response thereto, Boehringer Ingelheim has filed a statutory disclaimer of all the claims contained in such patent, and accordingly, such patent is unenforceable.



The FDAs review of an ANDA is a
confidential process between the FDA and the applicable ANDA filer. We do not expect to be informed by the FDA, any ANDA filer or any other party regarding the status or timing of the review relating to any of the ANDA filings pertaining to a
generic form of Elestat. The FDA may complete its review of the filed ANDAs at any time. As a result, we expect to be required to stop the co-promotion of Elestat with little, if any, advance notice. We believe it is likely that a
generic form of epinastine may be launched in the second half of 2010. The loss of co-promotion revenue from Elestat will significantly impact our results of operations and cash flows.



If we do not successfully market and promoteElestat,
our revenues will be negatively impacted.



Notwithstanding the expected termination of the Elestat agreement upon the launch of a generic form of Elestat, our present revenues depend, in part, upon the continued acceptance of Elestat by eye care professionals,
allergists and patients. Other factors that could affect the commercialization of Elestat include:



| |  |  | Satisfaction with existing alternative therapies, including therapies requiring only one dose per day;
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | Decreases in the size of the market for topical allergic conjunctivitis products;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | Extent and effectiveness of our sales and marketing efforts;
| | - |  | ------------------------------------------------------------



| |  |  | Changes in, or the levels of, third-party reimbursement of product costs;
| | - |  | -------------------------------------------------------------------------



| |  |  | Coverage and reimbursement under Medicare Part D, state government sponsored plans and commercial plans;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | Pricing and availability of alternative products, including generic or over-the-counter products; and
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | Marketing and sales activities of competitors.
| | - |  | ----------------------------------------------



We rely on third parties to distribute and sell our products and those third parties may not perform.



We are dependent on third parties to perform or assist us in
the distribution or sale of AzaSite, and are dependent on third parties, primarily Allergan, to perform or assist us in the distribution and sale ofElestat. We rely on the services of a single source, third-party distributor to
deliver AzaSite to our customers. In addition to the physical storage and distribution of AzaSite, this third-party distributor maintains and provides us with information and data with regard to our inventory, AzaSiteorders,
billings and receivables, chargebacks and returns, among others, on which our accounting estimates are based. If third parties do not successfully carry out their contractual duties in maximizing the commercial potential of our products, we may be
required to hire or expand our own staff and sales force to compete successfully, which may not be possible. If third parties or Allergan do not perform, or assist us in performing these functions, or if there is a delay or interruption in the
distribution of our products, it could have an adverse effect on product revenue, accounting estimates and our overall operations.



23



---

##### Table of Contents

We depend on three pharmaceutical wholesalers for the vast majority of ourAzaSitesales in the United States, and the loss of any of these wholesalers would negatively impact our revenues.



The prescription drug wholesaling industry in the United States is highly concentrated, with a vast majority of all sales made by three major
full-line companies: Cardinal Health, McKesson Corporation and AmerisourceBergen. Greater than 85% of our AzaSiterevenues come from sales to these three companies. The loss of any of these wholesalers could have a negative impact on our
commercialization of AzaSite.



It is also
possible that these wholesalers, or others, could decide to change their policies and fees in the future. This could result in or cause us to incur higher product distribution costs, lower margins or the need to find alternative methods of
distributing our products. Such alternative methods may not be economically or administratively feasible.



Risks Related to Manufacture and Supply



If we are unable to contract with third parties for the manufacture of active pharmaceutical ingredients required for preclinical testing, for the
manufacture of drug products for clinical trials, for the large-scale manufacture of any approved products, or for the manufacture of related devices, we may be unable to develop or commercialize our drug products.



The manufacturing of sufficient quantities of new products or
product candidates is a time-consuming and complex process. We have no experience or capabilities to conduct the manufacture of any of our product candidates. In order to successfully commercialize AzaSite and continue to develop our product
candidates, we need to contract or otherwise arrange for the necessary manufacturing services. There are a limited number of manufacturers that operate under the FDAs cGMP regulations capable of manufacturing for us or our collaborators. We
depend upon third parties for the manufacture of active pharmaceutical ingredients, finished drug products for clinical trials, and for the manufacture of AzaSite. We expect to depend upon third parties for the large-scale manufacture of
commercial quantities of any other approved product. This dependence may adversely affect our ability to develop and deliver such products on a timely and competitive basis. Similarly, our dependence on our partners to arrange for their own
supplies of finished drug products may adversely affect our operations and revenues. If we, or our partners, are unable to engage or retain third-party manufacturers on a long-term basis or on commercially acceptable terms, our products may not be
commercialized as planned, and the development of our product candidates could be delayed.



Under our agreement with the manufacturer of AzaSite, we are required to purchase a minimum number of units of AzaSite annually, regardless of our ability to sell AzaSite. If we are
unable to sell the AzaSite that we are required to purchase, our inventory of the product will increase and the shelf life of the inventory will be adversely impacted. In such circumstances, we may be required to make price concessions to
sell short-dated product or write-off and dispose of expired product, which may have an adverse affect on our AzaSite profitability.



The manufacturing processes for our product candidates have not been validated at the scale required for commercial sales. Delays in scale-up
to commercial quantities and any change at the site of manufacture could delay clinical trials, regulatory submissions and ultimately the commercialization of our products. In addition, manufacturing facilities are subject to an FDA inspection to
confirm cGMP compliance prior to a product candidates potential NDA approval as well as ongoing post-approval FDA inspections to ensure continued compliance with cGMP regulations, over which we have no control.



We depend upon a third-party vendor to manufacture the nebulizer
used with denufosol with whom we have no supply agreement. This vendor is responsible for managing the manufacturing process of the nebulizer in accordance with all applicable regulatory requirements. Any manufacture or regulatory compliance
problems



24



---

##### Table of Contents

related to the manufacture of this device or any failure on the part of the manufacturer to supply the device (including discontinuation of the nebulizer) could delay product development or
adversely affect regulatory approvals of denufosol.



Reliance
on a single party to manufacture and supply either finished product or the bulk active pharmaceutical ingredients for a product or product candidates could adversely affect us.



Under our agreements with Allergan, Allergan is responsible for the manufacture and supply of RestasisandElestat. Allergan relies upon an arrangement with a single third party for the manufacture and supply of active pharmaceutical ingredients, or APIs, for each of Restasisand Elestat. Allergan then completes the
manufacturing process to yield finished product.



Under our supply agreement with InSite Vision, InSite Vision is responsible for supplying us with azithromycin, the API used in AzaSite. InSite Vision, in turn, relies upon an arrangement with a single third party for the manufacture
and supply of such API. We are responsible for producing the finished product form of AzaSite, which is currently manufactured by a single party. There can be no assurance that such manufacturer will be able to continue to produce sufficient
quantities of finished product in a timely manner to support the commercialization of AzaSite.



In the event a third-party manufacturer is unable to supply Allergan or InSite Vision (as the case may be), if such supply is unreasonably
delayed, or if Allergan or our finished product contract partner are unable to complete the manufacturing cycle, sales of the applicable product could be adversely impacted, which would result in a reduction in any applicable product revenue. In
addition, if Allergan or the third-party manufacturers do not maintain cGMP compliance, the FDA could require corrective actions or take enforcement actions that could affect production and availability of the applicable product, thus adversely
affecting sales.



In addition, we rely upon supply
agreements with third parties for the manufacture and supply of the bulk APIs for our product candidates for purposes of preclinical testing and clinical trials. We presently depend upon one vendor as the sole manufacturer of our supply of APIs for
both Prolacriaand denufosol. We have entered into an agreement with such manufacturer to facilitate the transfer of the current denufosol manufacturing technology, including intellectual property, to an additional manufacturer and thus
enable a two-supplier strategy for denufosol. However, we have not yet entered into an agreement with a secondary supplier for denufosol. Delays in any aspect of implementing the manufacturing process could cause significant development delays and
increased costs.



It would be time consuming and
costly to identify and qualify new sources for manufacture of APIs or finished products. If our vendors were to terminate our arrangement or fail to meet our supply needs we might be forced to delay our development programs and/or be unable to
supply products to the market, which could delay or reduce revenues and result in loss of market share.



The third-party vendor that manufactures denufosol and the API related to bothProlacriaand Santens DE-089 does not presently have the capacity to manufacture the projected
commercial quantities of API for these products, if any is approved.



Yamasa Corporation manufacturers the clinical supplies of denufosol, and the API (i.e.diquafosol) for Prolacria and Santens DE-089. We do not believe that Yamasa presently has the
capacity to manufacture the projected commercial quantities of denufosol, or the API for Prolacria and Santens DE-089. Although we have agreements with Yamasa for the manufacture of clinical quantities, we do not have agreements
with Yamasa for commercial supplies of denufosol or diquafosol and we are in the process of working to establish those agreements. We may not be able to enter into such agreements on commercially acceptable terms, if at all.



25



---

##### Table of Contents

We are in discussions with another manufacturer for the purpose of establishing a secondary
source of commercial supply for denufosol. To facilitate this second manufacturer, we entered into an agreement with Yamasa to acquire access to its manufacturing know-how and processes related to denufosol. Technical transfer of manufacturing
capabilities, however, can be difficult. Also, we may not be able to enter into secondary supply arrangements on commercially acceptable terms, if at all. A failure to achieve sufficient commercial supply of denufosol could result in a delay in the
launch of the candidate. Furthermore, if the candidate is approved, and depending on market acceptance and other competitive factors, a failure to achieve sufficient commercial supply potentially could adversely affect product sales.



In May 2008, Santen filed an application for manufacturing and
marketing approval of DE-089 with the Japanese Ministry of Health, Labor, and Welfare, which is pending review. Subject to the terms of our agreement with Santen, we are required to supply Santen with its API requirements for DE-089 for commercial
use. We do not have manufacturing expertise, capabilities or facilities, and rely on Yamasa to manufacture this API. We are currently in discussions with Yamasa to further assess its ability to increase capacity for the production of the API
for DE-089. If Yamasa is unable to timely produce sufficient commercial quantities of the API for each of DE-089 and Prolacria, the launch of each such product candidate following approval, if any, could be delayed. Furthermore, if
either DE-089 orProlacria is approved, and depending on market acceptance and other competitive factors, an insufficient supply of the API for such product following its launch potentially could adversely affect product sales. A
reduction in sales likely would reduce royalty income to us associated with each of DE-089 and Prolacria. If we are unable to supply Santen with its API requirements for DE-089 pursuant to the terms of our agreement, Santen may pursue
legal or equitable remedies against us.



Risks
Related to Product Development



If the FDA does not
conclude that our product candidates meet statutory requirements for safety and efficacy, we will be unable to obtain regulatory approval for marketing in the United States.



We have to conduct significant development activities, non-clinical and clinical tests and obtain regulatory
approval before our product candidates can be commercialized. Product candidates that may appear to be promising at early stages of development may not successfully reach the market for a number of reasons. The results of preclinical and clinical
testing of our product candidates under development may not necessarily indicate the results that will be obtained from later or more extensive testing. Additionally, companies in the pharmaceutical and biotechnology industries, including us, have
suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier clinical trials. Our ongoing clinical trials might be delayed or halted for various reasons, including:



| |  |  | The measure of efficacy of the drug is not statistically significant compared to placebo;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | Patients experience severe side effects or serious adverse events during treatment;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | Patients die during the clinical trial because their disease is too advanced or because they experience medical problems that may or may not relate to
the drug being studied;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Patients do not enroll in the clinical trials at the rate we expect;
| | - |  | --------------------------------------------------------------------



| |  |  | We decide to modify the drug or the clinical trial protocol during testing;
| | - |  | ---------------------------------------------------------------------------



| |  |  | Our commercial partners, or future commercial partners, delay, amend or change our development plan or strategy; and
| | - |  | --------------------------------------------------------------------------------------------------------------------



| |  |  | We allocate our limited financial and other resources to other clinical and preclinical programs.
| | - |  | -------------------------------------------------------------------------------------------------



Changes in regulatory policy or new regulations as well as
clinical investigator misconduct could also result in delays or rejection of our applications for approval of our product candidates. Clinical investigator misconduct that raises questions about the integrity of data in one or more applications
(e.g., fraud, bribery, omission of a



26



---

##### Table of Contents

material fact, gross negligence) could be used by the FDA as grounds to suspend substantive scientific review of all pending marketing applications until the data in question have successfully
undergone a validity assessment. Product candidates that fail validity assessments must be withdrawn from FDA review or, if the drug is an approved, marketed product, such product must be removed from the market.



Additionally, the introduction of our products in foreign
markets will subject us to foreign regulatory clearances, the receipt of which may be unpredictable, uncertain and may impose substantial additional costs and burdens which we or our partners in such foreign markets may be unwilling or unable to
fund. As with the FDA, foreign regulatory authorities must be satisfied that adequate evidence of safety and efficacy of the product has been presented before marketing authorization is granted. The foreign regulatory approval process includes all
of the risks associated with obtaining FDA marketing approval. Approval by the FDA does not ensure approval by other regulatory authorities, nor does approval by any foreign regulatory authority ensure approval by the FDA.



Since some of our clinical candidates utilize new or different mechanisms of
action and in some cases there may be no regulatory precedents, conducting clinical trials and obtaining regulatory approval may be difficult, expensive and prolonged, which would delay any commercialization of our products.



To complete successful clinical trials, our product candidates
must demonstrate safety and provide substantial evidence of efficacy. The FDA generally evaluates efficacy based on the statistical significance of a product candidate meeting predetermined clinical endpoints. The design of clinical trials to
establish meaningful endpoints is done in collaboration with the FDA prior to the commencement of clinical trials. We establish these endpoints based on guidance from the FDA, including FDA guidance documents applicable to establishing the efficacy,
safety and tolerability measures required for approval of products. However, since some of our product candidates utilize new or different mechanisms of action, the FDA may not have established guidelines for the design of our clinical trials and
may take longer than average to consider our product candidates for approval. The FDA could change its view on clinical trial design and establishment of appropriate standards for efficacy, safety and tolerability and require a change in clinical
trial design, additional data or even further clinical trials before granting approval of our product candidates. We could encounter delays and increased expenses in our clinical trials if the FDA concludes that the endpoints established for a
clinical trial do not adequately predict a clinical benefit.



We are developing denufosol as an inhaled product candidate for the treatment of cystic fibrosis. Denufosol tetrasodium is a first-in-class ion channel regulator that addresses the underlying ion
transport defect in the lungs of patients with cystic fibrosis. The FDA has not published guidance on the drug approval process associated with such a product candidate. Furthermore, we are not aware of any FDA-approved product that addresses the
underlying ion transport defect in the lungs of patients with cystic fibrosis. We cannot predict or guarantee the outcome or timing of our Phase 3 program for denufosol for cystic fibrosis. A significant amount of work will be required to advance
denufosol through clinical testing, including satisfactory completion of additional clinical trials and other studies. We may later decide to change the focus or timing of our Phase 3 program. Our TIGER-2 clinical trial for denufosol for cystic
fibrosis may not be successful or unexpected safety concerns may emerge that would negatively change the risk/benefit profile for this product candidate.



We have initiated a Phase 2 development program to evaluate the use of AzaSite for the treatment of blepharitis. The FDA has not
published guidelines on the approval of a product for the treatment of blepharitis. Furthermore, to date, no prescription product has been approved by the FDA for the treatment of blepharitis. The FDA may require that we evaluate the product in
relation to different primary and/or secondary clinical endpoints than those being used presently. This may require us to undertake additional Phase 2 clinical trials, which could lead to increased costs and program delays.



27



---

##### Table of Contents

The FDA has not published guidelines on the approval of a product for the treatment of dry
eye disease. In order to gain approval, it will be necessary to undertake at least one additional Phase 3 clinical trial in support of our NDA for Prolacria.There can be no guarantee that any such additional clinical trial would be
successful or that the FDA would approve Prolacria even if such additional clinical trial was successful.



We may need to develop alternate dosing regimens for our product candidates.



In order to achieve broad market acceptance of our product candidates, we may need to develop, alone or with
others, alternate dosing regimens and methods for administering our products. For example, in our current clinical trials, denufosol for the treatment of cystic fibrosis is administered by a standard nebulizer three times per day, but clinical data
from our TIGER-1 clinical trial indicated that patients in that study administered the drug only 2.7 times per day, on average. Patients may prefer a smaller, more portable device or less frequent dose administration. In addition, we intend that
Prolacria will be applied from a vial containing a single days dosage of non-preserved medication. Patients may prefer to purchase preserved medication for multiple doses. Neither we nor Allergan have established a plan to develop a
multi-dose formulation.



Similar challenges may
exist in identifying and developing appropriate and convenient dosing and methods of administration for our other product candidates. If the number of doses, or the method of dosing, is not convenient, patients may not use our product. Furthermore,
if patients use our products at a dosing level that is less than the dosing level tested in our clinical trials, the drug may not be efficacious or may be less efficacious. In such cases, the patient may look for alternative therapies.



Estimated development costs are difficult to project and may change
frequently prior to regulatory approval.



The
number and type of studies that may be required by the FDA, or other regulatory authorities, for a particular compound are based on the compounds clinical profile compared to existing therapies for the targeted patient population. While all
new compounds require standard regulated phases of testing, the actual type and scope of testing can vary significantly among different product candidates and as a result, creates additional complexity when estimating program costs. Factors that
affect the costs of a clinical trial include:



| |  |  | The number of patients required to participate in clinical trials to demonstrate statistical significance for a drugs safety and efficacy and the
number and geographical location of clinical trial sites necessary to enroll such patients;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The time required to enroll the targeted number of patients in clinical trials, which may vary depending on the size and availability of the targeted
patient population and the perceived benefit to the clinical trial participants; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The number and type of required laboratory tests supporting clinical trials.
| | - |  | ----------------------------------------------------------------------------



Additionally, ongoing development programs and associated costs
are subject to frequent, significant and unpredictable changes due to a number of factors, including:



| |  |  | Data collected in preclinical or clinical trials may prompt significant changes, delays or enhancements to an ongoing development program;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Commercial partners and the underlying contractual agreements may require additional or more involved clinical or preclinical activities;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The FDA or other regulatory authorities may direct the sponsor to change or enhance its ongoing development program based on developments in the
testing of similar compounds or related compounds;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Unexpected regulatory requirements, changes in regulatory policy or review standards, or interim reviews by regulatory agencies may cause delays or
changes to development programs; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



28



---

##### Table of Contents

| |  |  | Anticipated manufacturing costs may change significantly due to necessary changes in manufacturing processes, variances from anticipated manufacturing
process yields or changes in the cost and/or availability of starting materials, and other costs to ensure the manufacturing facility is in compliance with cGMP requirements and is capable of consistently producing the product candidate in
accordance with established specifications submitted to the FDA.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The occurrence of any of these factors may result in significant disparities in total costs required to complete the respective development programs.



Clinical trials may take longer to complete and cost more than we expect,
which would adversely affect our ability to commercialize product candidates and achieve profitability.



Clinical trials are expensive and are often lengthy. They require appropriate identification of optimal treatment regimens and relevant
patient population, adequate supplies of drug product, and sufficient patient enrollment. Patient enrollment is a function of many factors, including:



| |  |  | The size and availability of the relevant patient population;
| | - |  | -------------------------------------------------------------



| |  |  | The nature of the protocol;
| | - |  | ---------------------------



| |  |  | The proximity of patients to clinical sites;
| | - |  | --------------------------------------------



| |  |  | The eligibility criteria for the clinical trial; and
| | - |  | ----------------------------------------------------



| |  |  | The perceived benefit of participating in a clinical trial.
| | - |  | -----------------------------------------------------------



Delays in patient enrollment can result in increased costs and longer development times. Even if we
successfully complete clinical trials, we may not receive regulatory approval for the product candidate. In addition, if the FDA or foreign regulatory authorities require additional clinical trials, we could face increased costs and significant
development delays.



We are conducting portions of
our TIGER-2 clinical trial in Canada, Australia and New Zealand and are therefore subject to the risks and uncertainties of doing business internationally. Disruptions in communication and transportation, changes in governmental policies, and
currency exchange rates, among other factors, may affect the time and costs required to complete these clinical trials.



If we fail to reach milestones or to make annual minimum payments or otherwise breach our obligations under our license agreements, our licensors may
terminate our agreements with them.



If we
fail to meet payment obligations, performance milestones relating to the timing of regulatory filings, development and commercial diligence obligations, fail to make milestone payments in accordance with applicable provisions, or fail to pay the
minimum annual payments under our respective licenses, our licensors may terminate the applicable license. As a result, our development of the respective product candidate or commercialization of the product would cease.



Risks Related to Governmental Regulation



Failure to comply with all applicable regulations, including those that
require us to obtain and maintain governmental approvals for our product candidates, may result in fines, corrective actions, administrative sanctions and restrictions, including the withdrawal of a product from the market.



Pharmaceutical companies are subject to significant regulation
by a number of local, state, and federal governmental agencies, including the FDA. Such regulations and their authorizing statutes are amended from time to time. There are laws and regulations that govern areas including financial controls, clinical
trials, testing, manufacturing, labeling, safety, packaging, shipping, distribution, post-approval safety surveillance, marketing, and promotion of pharmaceuticals, including those governing interactions with prescribers and health care



29



---

##### Table of Contents

professionals in a position to prescribe, recommend, or arrange for the provision of our products. Failure to comply with applicable regulatory requirements could, among other things, result in
warning letters, fines, corrective actions, administrative sanctions, suspensions or delays of product manufacture or distribution or both, product recalls, delays in marketing activities and sales, withdrawal of marketing approvals, and civil or
criminal sanctions including seizure of product, court-ordered injunction, and possible exclusion from eligibility for federal government contracts payment of our products by Medicare, Medicaid, and other third-party payors.



After initial regulatory approval, the manufacturing and
marketing of drugs, including our products, are subject to continuing FDA and foreign regulatory review. The FDA requires drug manufacturers and distributors to monitor the safety of a drug after it is approved and marketed. We are required to
document and investigate reports of adverse events and report serious adverse events to the FDA. Additionally, the FDA encourages health professionals to report significant adverse events associated with products. The FDA may require additional
clinical studies, known as Phase 4 studies, to evaluate product safety effects. In addition to studies required by the FDA after approval, we may conduct our own Phase 4 studies to explore the use of the approved drug product for treatment of new
indications or to broaden our knowledge of the product. The subsequent discovery of previously unknown problems with a products safety or efficacy as a result of these studies or as reported in their prescribed use may result in restrictions
through labeling changes or withdrawal of the product from the market.



The FDA periodically inspects drug manufacturing facilities to ensure compliance with applicable cGMP regulations. Failure to comply with statutory and regulatory requirements subjects the manufacturer to
possible legal or regulatory action, such as suspension of manufacturing, seizure of product or court-ordered injunction, which could include mandatory recall of a product. Before taking such actions, the FDA may first issue one or more notices of
compliance deficiencies. Such notices include inspectional observations on Form FDA-483, warning letters, and other untitled written correspondence; however, the FDA may also take action without such notice in situations of egregious noncompliance
or where public safety is at risk. The FDA may also request us to take actions voluntarily or we may initiate actions ourselves such as recalls or suspension of manufacturing to ensure compliance with cGMP regulations.



Additional authority to take post-approval actions was given to
the FDA under the FDA Amendments Act of 2007. The FDA is authorized to revisit and change its prior determinations if new information raises questions about our products safety profile. The FDA is authorized to impose additional post-marketing
requirements which could result in actions such as requiring additional studies, corrective actions, fines, withdrawal of marketing approval, or any combination of such actions.



In its regulation of advertising, the FDA may issue correspondence to pharmaceutical companies alleging that
its advertising, promotional materials or activities are false or misleading. Pharmaceutical advertising and promotional activity must be true, fairly balanced between benefits and risks, provide adequate risk information, and be within the labeled
indications. Drug manufacturers are prohibited from promoting a product for any use that is not on the approved labeling; however, healthcare professionals are free to use the product for any use that, in the judgment of the healthcare professional,
may be appropriate for any individual patient. The FDA has the power to impose a wide array of sanctions on companies for advertising practices that it concludes is false or misleading, and, if we were to receive correspondence from the FDA alleging
such practices, it may be necessary for us to:



| |  |  | Incur substantial expenses, including fines, penalties, legal fees and costs to conform to the FDAs limits on such promotion;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | Change our methods of marketing, promoting and selling products;
| | - |  | ----------------------------------------------------------------



| |  |  | Take corrective action, which could include placing advertisements or sending letters to physicians correcting statements made in previous
advertisements or promotions; or
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Disrupt the distribution of products and stop sales until we are in compliance with the FDAs interpretation of applicable laws and regulations.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



30



---

##### Table of Contents

Medicare prescription drug coverage legislation and future legislative or regulatory reform of the health
care system may affect our or our partners ability to sell products profitably.



In both the United States and some foreign jurisdictions, there have been a number of legislative and regulatory changes to the health care system that could affect our ability to sell our products
profitably. In the United States, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 established a voluntary Medicare outpatient prescription drug benefit under Part D of the Social Security Act. The program, which
went into effect January 1, 2006, is administered by the Centers for Medicare & Medicaid Services within the Department of Health and Human Services and is implemented and operated by private sector Part D plan sponsors. Each
participating drug plan is permitted by regulation to develop and establish its own unique drug formulary that may exclude certain drugs from coverage and impose prior authorization and other coverage restrictions, and negotiate payment levels with
drug manufacturers that may be lower than reimbursement levels available through private health plans or other payers. Moreover, beneficiary co-insurance requirements can vary, which could influence which products are recommended by physicians and
selected by patients. The federal government can be expected to continue to issue guidance and regulations regarding the obligations of Part D sponsors under the program.



Allergan is responsible for the implementation of the Medicare Part D program as it relates to Restasisand
Elestat and has contracted with Part D plan sponsors to cover such drugs under the Part D benefit. We are responsible for contracting with Part D plan sponsors with respect toAzaSite. There is no assurance that any drug that we
co-promote or sell will be covered by drug plans participating under the Medicare Part D program or, if covered, what the terms of any such coverage will be, or that the drugs will be reimbursed at amounts that reflect current or historical payment
levels. Our results of operations could be materially adversely affected by the reimbursement changes emerging from Medicare prescription drug coverage legislation or from changes in the formularies or price negotiations with Part D drug plans. To
the extent that private insurers or managed care programs follow Medicare coverage and payment developments, the adverse effects of lower Medicare payment may be magnified by private insurers adopting similar lower payment.



Our products also can be impacted by state and federal
legislative and regulatory changes in Medicaid reimbursement policy and in mandated levels of Medicaid drug rebates paid by pharmaceutical manufacturers. Congress is considering proposals as part of health reform that would increase the drug rebate
level paid by pharmaceutical manufacturers to Medicaid for brand-name drugs and make other changes that could result in larger pharmaceutical manufacturer rebate obligations. Likewise, many states are facing serious budgetary pressures
that could lead to adoption of cost-containment measures, including provisions aimed at reducing Medicaid drug prices. There can be no assurances that new federal or state policies will not increase our rebate obligation or lower Medicaid
reimbursement levels for our products.



New
federal or state drug payment changes or health care reforms in the United States and in foreign countries may be enacted or adopted in the future that could further lower payment for our products. In particular, both the U.S. House of
Representatives and Senate approved major health reform plans in late 2009. In addition to increasing Medicaid drug rebate obligations, the legislation generally would require drug manufacturers to provide a discount on brand-name prescriptions
filled in the Medicare Part D coverage gap; expand comparative effectiveness research programs, and expand disclosure requirements regarding drug manufacturer financial arrangements with referring physicians. The House version of the
bill also would establish a public health insurance program to compete with private insurance companies, which could increase competitive pressures in the private insurance market that ultimately could impact prescription drug reimbursement. The
House bill also would require the HHS Secretary to negotiate Medicare Part D drug prices directly with pharmaceutical manufacturers, and it would bar agreements between brand name and generic drug manufacturers that delay competition from generic
drugs. The Senate bill would impose a $2.3 billion annual fee on the pharmaceutical manufacturing sector, generally allocated according to market share. To date Congress has not reached agreement on a single reform plan, so it is uncertain at this
time whether a bill will be enacted in the near future and, if so, the scope of the provisions that will be included or the impact on us. There can be no



31



---

##### Table of Contents

assurances, that enactment of health reform legislation would not have an adverse impact on reimbursement and/or coverage of our products. Likewise, the potential for adoption of health care
reform or other cost-control proposals on a state-by-state basis could impact our reimbursement levels and require us to develop state-specific marketing and sales approaches.



Congress also has enacted the American Recovery and Reinvestment Act, which included a major expansion of
federal efforts to compare the effectiveness of different medical treatments, including pharmaceuticals, which eventually could impact Medicare and private payer coverage and payment policies. The federal government may consider additional proposals
that could lead to reimbursement constraints and restrictions on access to certain products. We cannot predict the outcome of such initiatives, and it is difficult to predict the impact on our business of future legislative and regulatory changes.



We are subject to fraud and abuse and similar
government laws and regulations, and a failure to comply with such laws and regulations, or an investigation into our compliance with such laws and regulations, or a failure to prevail in any litigation related to noncompliance, could harm our
business.



We are subject to multiple state
and federal laws pertaining to health care fraud and abuse. Pharmaceutical pricing, sales, and marketing programs and arrangements, and related business practices in the health care industry generally are under increasing scrutiny from federal and
state regulatory, investigative, prosecutorial, and administrative entities. Many health care laws, including the federal and state anti-kickback laws and federal and state statutory and common law false claims laws, have been construed broadly
by the courts and permit government entities to exercise considerable discretion. In the event that any of these government entities believed that wrongdoing had occurred, one or more of them could institute civil, administrative, or criminal
proceedings which, if instituted and resolved unfavorably, could subject us to substantial fines, penalties, and injunctive and administrative remedies, including exclusion from government reimbursement programs. We cannot predict whether
investigations or enforcement actions would affect our marketing or sales practices. Any such result could have a material adverse impact on our results of operations, cash flows, financial condition, and our business. Such investigations
and enforcement actions could be costly, divert managements attention from our business, and result in damage to our reputation. We cannot guarantee that measures that we have taken to prevent violations, including our corporate
compliance program, will protect us from future violations, lawsuits or investigations by governmental entities or private whistleblowers. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting
our rights, those actions could have a significant negative impact on our business, including the imposition of significant fines or other sanctions.



Congress also is considering new and expanded federal fraud authorities as part of health reform legislative efforts. We cannot predict at
this time whether health reform legislation will be enacted and, if so, the extent of new fraud authorities that would be adopted, if any, or the potential impact on our business.



Failure to adequately ensure compliance with applicable laws and regulations may subject us to whistleblower and government
actions.



In recent years, pharmaceutical
companies have been the targets of extensive whistleblower actions in which the person bringing the action alleges violations of the federal civil False Claims Act or its state equivalent, including allegations that manufacturers aided and abetted
in the submission of false claims. These actions have focused on such areas as pricing practices, off-label product promotion, sales and marketing practices, and improper relationships with physicians and other health care professionals, among
others. If our relationships with health care professionals and/or our promotional or other activities fail to comply with applicable laws, regulations or guidelines, we may be subject to warnings from, or enforcement action by, regulatory and other
federal or state governmental authorities. The potential ramifications are far-reaching if there are areas identified as out of compliance by regulatory agencies and governmental authorities including, but not limited to, significant financial
penalties, manufacturing and clinical trial consent decrees, commercialization restrictions, exclusion from government programs, product recalls or seizures, the imposition of corporate integrity



32



---

##### Table of Contents

agreements and deferred prosecution agreements, or other restrictions and litigation. Furthermore, there can be no assurance that we will not be subject to a whistleblower or other state or
federal investigative or enforcement action at some time in the future. Even an unsuccessful challenge to our operations or activities could prove costly and divert managements attention.



Risks Associated with Our Business and Industry



If we do not receive timely regulatory approvals of our
product candidates and successfully launch such products, we may need substantial additional funds to support our expanding capital requirements.



We have used substantial amounts of cash to fund our research and development and commercial activities. Our operating expenses were
approximately $129.8 million and $120.2 million for the years ended December 31, 2009 and 2008, respectively. Our cash, cash equivalents and investments totaled approximately $129.1 million on December 31, 2009. Based on current operating
plans, we expect our cash and investments to provide liquidity beyond 2010.



We expect that our capital and operating expenditures will continue to exceed our revenue over the next several years as we conduct our research and development and commercial activities. Many factors
will influence our future capital requirements, including:



| |  |  | The number, breadth and progress of our research and development programs;
| | - |  | --------------------------------------------------------------------------



| |  |  | The level of activities relating to commercialization of our products;
| | - |  | ----------------------------------------------------------------------



| |  |  | The ability to attract collaborators for our products and establish and maintain those relationships;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | Achievement of milestones under our existing or future collaborations and licensing agreements;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | Progress by our collaborators with respect to the development of product candidates;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | Competing technological and market developments;
| | - |  | ------------------------------------------------



| |  |  | The timing and terms of any business development activities;
| | - |  | ------------------------------------------------------------



| |  |  | The timing and amount of debt repayment requirements;
| | - |  | -----------------------------------------------------



| |  |  | The costs involved in defending any litigation claims against us;
| | - |  | -----------------------------------------------------------------



| |  |  | The costs involved in responding to government, the Financial Industry Regulatory Authority, Inc., or other applicable investigations against us; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The costs involved in enforcing patent claims and other intellectual property rights.
| | - |  | -------------------------------------------------------------------------------------



In addition, our capital requirements will depend upon:



| |  |  | The level of sales generated for AzaSite, Restasis and Elestat;
| | - |  | ---------------------------------------------------------------



| |  |  | The receipt of revenue from Allergan on net sales of Restasisand Elestat;
| | - |  | -------------------------------------------------------------------------



| |  |  | The receipt of revenue from wholesalers and other customers on net sales of AzaSite;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | The receipt or payment of milestone payments under our current collaborative agreements and any future collaborations;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | The ability to obtain approval from the FDA for our product candidates; and
| | - |  | ---------------------------------------------------------------------------



| |  |  | Payments from existing and future collaborators.
| | - |  | ------------------------------------------------



In the event that we do not receive timely regulatory approvals, we may need substantial additional funds to
fully develop, manufacture, market and sell all of our other potential products and support our on-going product



33



---

##### Table of Contents

commercialization and co-promotion efforts. We may seek such additional funding through public or private equity offerings and debt financings. Additional financing may not be available when
needed. If available, such financing may not be on terms favorable to us or our stockholders. Our stockholders ownership will be diluted if we raise additional capital by issuing equity securities. If we are required to raise funds through
future collaborations and licensing arrangements, we may have to give up rights to our technologies or product candidates or grant licenses on unfavorable terms. If adequate funds are not available, we would have to scale back or terminate research
programs and product development and we may not be able to successfully commercialize any product candidate.



Our co-promotion and royalty revenues are based, in part, upon Allergans revenue recognition policy and other accounting policies over which we have limited or no control.



We recognize co-promotion revenue based on Allergans net
sales of Elestatand royalty revenue based on Allergans net sales of Restasis,as defined in the co-promotion agreements and as reported to us by Allergan. Accordingly, our co-promotion and royalty revenues are based upon
Allergans revenue recognition policy and other accounting policies over which we have limited or no control and the underlying terms of our co-promotion agreements. Allergans filings with the SEC indicate that Allergan maintains
disclosure controls and procedures in accordance with applicable laws, which are designed to provide reasonable assurance that the information required to be reported by Allergan in its Exchange Act filings is reported timely and in accordance with
applicable laws, rules and regulations. We are not entitled to review Allergans disclosure controls and procedures. All of our co-promotion and royalty revenues are currently derived from Allergans net sales of Restasisand
Elestat as reported to us by Allergan. We are unable to provide complete assurance that Allergan will not revise reported revenue amounts in the future. If Allergans reported revenue amounts were inaccurate, it could have a material
impact on our financial statements, including financial statements for previous periods.



Revenues in future periods could vary significantly and may not cover our operating expenses.



Our revenues may fluctuate from period to period due in part to:



| |  |  | The timing of the introduction of a generic form of Elestat;
| | - |  | ------------------------------------------------------------



| |  |  | Fluctuations in future sales of AzaSite, Restasisand Elestat due to competition, the intensity of an allergy season, disease
prevalence, manufacturing difficulties, reimbursement and pricing under commercial or government plans, seasonality, or other factors that affect the sales of a product;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Deductions from gross sales relating to estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates
and other allocated costs;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The duration of market exclusivity ofAzaSite and Restasis;
| | - |  | ----------------------------------------------------------



| |  |  | The timing of approvals, if any, for other possible future products;
| | - |  | --------------------------------------------------------------------



| |  |  | The progress toward and the achievement of developmental milestones by us or our partners;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | The initiation of new contractual arrangements with other companies; and
| | - |  | ------------------------------------------------------------------------



| |  |  | The failure or refusal of a collaborative partner to pay royalties or milestone payments.
| | - |  | -----------------------------------------------------------------------------------------



Inventory levels of AzaSite held by wholesalers can also
cause our operating results to fluctuate unexpectedly. Although we attempt to monitor wholesaler inventory of our products, we rely upon information provided by third parties to quantify the inventory levels maintained by wholesalers. In addition,
we and the wholesalers may not be effective in matching inventory levels to end-user demand. Significant differences between actual and estimated inventory levels and product demand may result in inadequate or excessive (1) inventory
production, (2) product supply in distribution channels, (3) product availability at the retail level, and (4) unexpected increases or decreases in orders from our major customers. Any of these events may cause our revenues to
fluctuate significantly from quarter to quarter, and in some cases may cause our operating results for a particular quarter to be below expectations.



34



---

##### Table of Contents

If we are unable to make the scheduled principal and interest payments on our term loan facility or
maintain minimum liquidity levels or compliance with other debt covenants as defined in the loan and security agreement, we may default on our debt.



Our $60.0 million term loan facility is collateralized by substantially all of our assets, except for our intellectual property, but
including all accounts, license and royalty fees and other revenues and proceeds arising from our intellectual property. Under the agreement, we are required to maintain minimum liquidity levels based on the balance of the outstanding advances. The
agreement also includes a subjective acceleration clause that provides our lenders with the ability to accelerate repayment, even if we are in compliance with all conditions of the agreement, upon a material adverse change to our business,
properties, assets, financial condition or results of operations. The agreement may affect our operations in several ways, including the following:



| |  |  | A portion of our cash flow from operations will be dedicated to the payment of the principal and interest on our indebtedness;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our future cash flow may be insufficient to meet our required principal and interest payments;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | We may need to raise additional capital in order to remain in compliance with the loan covenants;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | Our ability to enter into certain transactions (including incurrences of indebtedness) may be limited; and
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | We may need to delay or reduce planned expenditures for clinical trials as well as other development and commercial activities if our current
operations are not sufficient enough to service our debt.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Events of default under the loan and security agreement are not limited to, but include the following:



| |  |  | Payment default;
| | - |  | ----------------



| |  |  | Covenant default;
| | - |  | -----------------



| |  |  | A material adverse change in our business operations;
| | - |  | -----------------------------------------------------



| |  |  | Breach of our agreements with Allergan; and
| | - |  | -------------------------------------------



| |  |  | Judgments against us over a specified dollar amount.
| | - |  | ----------------------------------------------------



In case of an uncured default, the following actions may be taken against us by the lending institutions:



| |  |  | All outstanding obligations associated with the term loan facility would be immediately due and payable;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | Any of our balances and deposits held by the lending institutions would be applied to the obligation;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | Balances and accounts at other financial institutions could be held or exclusive control could be transferred to the lending institutions;
and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | All collateral, as defined in the agreement, could be seized and disposed of.
| | - |  | -----------------------------------------------------------------------------



If we continue to incur operating losses for a period longer than
anticipated, or in an amount greater than anticipated, we may be unable to continue our operations.



We have experienced significant losses since inception. We incurred net operating losses of approximately $40.0 million and $51.6 million for
the years ended December 31, 2009 and 2008, respectively. As of December 31, 2009, our accumulated deficit was approximately $400.4 million. We currently expect to incur operating losses over the next several years. We expect that losses
will fluctuate from quarter to quarter and that such fluctuations may be substantial. Such fluctuations will be affected by the timing and level of the following:



| |  |  | Commercialization activities to support AzaSiteand Elestat;
| | - |  | -----------------------------------------------------------



| |  |  | Revenues from Restasis;
| | - |  | -----------------------



| |  |  | Regulatory approvals of our product candidates;
| | - |  | -----------------------------------------------



35



---

##### Table of Contents

| |  |  | Patient demand for our products and any licensed products;
| | - |  | ----------------------------------------------------------



| |  |  | Payments to and from licensors and corporate partners;
| | - |  | ------------------------------------------------------



| |  |  | Research and development activities;
| | - |  | ------------------------------------



| |  |  | Investments in new technologies and product candidates; and
| | - |  | -----------------------------------------------------------



| |  |  | The costs involved in defending any litigation claims against, or government investigations of, us.
| | - |  | ---------------------------------------------------------------------------------------------------



To achieve and sustain profitable operations, we must, alone or
with others, develop successfully, obtain regulatory approval for, manufacture, introduce, market and sell our products. The time frame necessary to achieve market success is long and uncertain. We may not generate sufficient product revenues to
become profitable or to sustain profitability. If the time required to achieve profitability is longer than we anticipate, we may not be able to continue our operations.



The current stock market and credit market conditions are extremely volatile and unpredictable. It is difficult to predict whether these
conditions will continue or worsen, and, if so, whether the conditions would impact us and whether such impact could be material.



We have exposure to many different industries and counterparties, including commercial banks, investment banks and customers (which include
wholesalers, managed care organizations and governments) that may be unstable or may become unstable in the current economic environment. Any such instability may impact these parties ability to fulfill contractual obligations to us or they
might limit or place burdensome conditions upon future transactions with us. Customers may also reduce spending during times of economic uncertainty. Also, it is possible that suppliers may be negatively impacted. If such events were to occur, there
could be a resulting material and adverse impact on our operations and results of operations.



We may decide to access the equity or debt markets to meet capital or liquidity needs. However, the constriction and volatility in these markets may restrict our future flexibility to do so when such
needs arise. Further, recent economic conditions have resulted in severe downward pressure on the stock and credit markets, which could reduce the return available on invested corporate cash, which if severe and sustained could have a material and
adverse impact on our results of operations and cash flows.



Our dependence on collaborative relationships may lead to delays in product development, lost revenues and disputes over rights to technology.



Our business strategy depends to some extent upon the formation of research collaborations, licensing and/or marketing arrangements. We
currently have collaboration agreements with several collaborators, including Allergan, InSite Vision and Santen. The termination of any collaboration will result in the loss of any unmet development or commercial milestone payments, may lead to
delays in product development and disputes over technology rights, and may reduce our ability to enter into collaborations with other potential partners. In the event we breach an agreement with a collaborator, the collaborator is entitled to
terminate our agreement with them in the event we do not cure the breach within a specified period of time, which is typically 60 or 90 days from the notice date. With respect to the Allergan collaboration, in the event we become an affiliate of a
third party that manufactures, markets or sells any then currently promoted prescription ophthalmic product, Allergan will have the right to terminate our Elestat co-promotion agreement, which right must be exercised within 3 months of the
occurrence of such event. If we do not maintain our current collaborations, or establish additional research and development collaborations or licensing arrangements, it will be difficult to develop and commercialize potential products. Any future
collaborations or licensing arrangements may not be on terms favorable to us.



Our current or any future collaborations or licensing arrangements ultimately may not be successful. Under our current strategy, and for the foreseeable future, we do not expect to develop or market
products outside North



36



---

##### Table of Contents

America without a collaborative partner or outside our therapeutic areas of focus. We are currently pursuing the out-licensing of certain rights related to our cystic fibrosis program. We may be
unsuccessful in out-licensing this program or we may be forced to out-license this program on terms that are not favorable to us.



It may be necessary in the future for us to obtain additional licenses to avoid infringement of third-party patents. Additionally, we may
enter into license arrangements with other third parties as we build our product portfolio. We do not know the terms on which such licenses may be available, if at all.



We will continue to depend on collaborators and contractors for the preclinical study and clinical development of therapeutic
products and for manufacturing and marketing of potential products. Our agreements with collaborators typically allow them some discretion in electing whether to pursue such activities. If any collaborator were to breach or terminate its agreement
with us or otherwise fail to conduct collaborative activities in a timely and successful manner, the clinical development or commercialization of product candidates or research programs would be delayed or terminated. Any delay or termination in
clinical development or commercialization would delay or eliminate potential product revenues relating to our product candidates.



Disputes may arise in the future over the ownership of rights to any technology developed with collaborators. These and other possible
disagreements between us and our collaborators could lead to delays in the collaborative development or commercialization of products. Such disagreements could also result in litigation or require arbitration to resolve.



Failure to hire and retain key personnel may hinder our product development
programs and our business efforts.



We depend
on the principal members of management and scientific staff, including Adrian Adams, our President and Chief Executive Officer and a director, and Thomas R. Staab, II, our Chief Financial Officer and Treasurer. If these people leave us, we may have
difficulty conducting our operations. Other than Mr. Adams, with whom we have an employment agreement, we have not entered into agreements with any other officers or any other members of our management and scientific staff that bind them to a
specific period of employment. Our future success will depend in part on our ability to attract, hire or appoint, and retain additional personnel skilled or experienced in the pharmaceutical industry. There is significant competition for such
qualified personnel and we may not be able to attract and retain such personnel.



We may not be able to successfully compete with other biotechnology companies and established pharmaceutical companies.



The biotechnology and pharmaceutical industries are intensely competitive and subject to rapid and significant
technological change. There are many companies seeking to develop products for the same indications that we are working on. Our competitors in the United States and elsewhere are numerous and include, among others, major multinational pharmaceutical
and chemical companies and specialized biotechnology firms.



Most of these competitors have greater resources than we do, including greater financial resources, larger research and development staffs and more experienced marketing and manufacturing organizations.
In addition, most of our competitors have greater experience than we do in conducting clinical trials and obtaining FDA and other regulatory approvals. Accordingly, our competitors may succeed in obtaining FDA or other regulatory approvals for
product candidates more rapidly than we do. Companies that complete clinical trials, obtain required regulatory approvals, and commence commercial sale of their drugs before we do may achieve a significant competitive advantage, including patent and
FDA marketing exclusivity rights that would delay our ability to market products. Drugs resulting from our research and development efforts, or from our joint efforts with our collaborative partners, may not compete successfully with
competitors existing products or products under development.



37



---

##### Table of Contents

Our competitors may also develop technologies and drugs that are safer, more effective, or
less costly than any we are developing or which would render our technology and future drugs obsolete and non-competitive. In addition, alternative approaches, such as gene therapy, in treating diseases that we have targeted, such as cystic
fibrosis, may make our product candidates obsolete.



If our
intellectual property protection is inadequate, the development and any possible sales of our product candidates could suffer or competitors could force our products completely out of the market.



Our business and competitive position depends on our ability to
continue to develop and protect our products and processes, proprietary methods and technology and to prevent others from infringing on our patents, trademarks and other intellectual property rights. Upon the expiration or loss of patent protection
for a product, we or our applicable collaborative partners may lose a significant portion of sales of that product in a short period of time as other companies manufacture generic forms of the previously protected product or manufacture similar
products at lower cost, without having had to incur significant research and development costs in formulating the product. Therefore, our future financial success may depend in part on our and our partners obtaining patent protection for
technologies incorporated into our products. We cannot assure that such patents will be issued, or that any existing or future patents will be of commercial benefit. In addition, it is impossible to anticipate the breadth or degree of protection
that any such patents will afford, and we cannot assure that any such patents will not be successfully challenged in the future. If we are unsuccessful in obtaining or preserving patent protection, or if any of our products rely on unpatented
proprietary technology, we cannot assure that others will not commercialize products substantially identical to those products. We also believe that the protection of our trademarks is an important factor in product recognition and in our ability to
maintain or increase market share. If we do not adequately protect our rights in our various trademarks from infringement, their value to us could be lost or diminished, seriously impairing our competitive position. Moreover, the laws of certain
foreign countries do not protect our intellectual property rights to the same extent as the laws of the United States.



Certain of our patents are use patents containing claims covering methods of treating disorders and diseases by administering therapeutic
chemical compounds. Use patents may provide limited protection for commercial efforts in the United States, but may afford a lesser degree of protection, if any, in other countries due to their patent laws. Besides our use patents, we have patents
and patent applications covering compositions (new chemical compounds), pharmaceutical formulations and processes for manufacturing our new chemical compounds. Many of the chemical compounds included in the claims of our use patents and process
applications were known in the scientific community prior to our patent applications. None of our composition patents or patent applications covers these previously known chemical compounds, which are in the public domain. As a result, competitors
may be able to commercialize products that use the same previously known chemical compounds used by us for the treatment of disorders and diseases not covered by our use patents. Such competitors activities may reduce our revenues.



Third parties may challenge, invalidate or circumvent our
patents and patent applications relating to our products, product candidates or technologies at any time. If we must defend a patent suit, or if we choose to initiate a suit to have a third-party patent declared invalid, we may need to make
considerable expenditures of money and management time in litigation. We believe that there is significant litigation in the pharmaceutical and biotechnology industry regarding patent and other intellectual property rights. A patent does not provide
the patent holder with freedom to operate in a way that infringes the patent rights of others. We may be accused of patent infringement at any time. A judgment against us in a patent infringement action could cause us to pay monetary damages,
require us to obtain licenses, or prevent us from manufacturing or marketing the affected products. In addition, we may need to initiate litigation to enforce our proprietary rights against others. Initiation of litigation may result in considerable
expenditures of money and management time and may result in our patents being declared invalid. Further, we may need to participate in interference proceedings in the U.S. Patent and Trademark Office, or USPTO, to determine the priority of invention
of any of our technologies.



38



---

##### Table of Contents

Our ability to develop sufficient patent rights in our pharmaceutical, biopharmaceutical and
biotechnology products to support commercialization efforts is uncertain and involves complex legal and factual questions. For instance, the USPTO examiners may not allow our claims in examining our patent applications. If we have to appeal a
decision to the USPTOs Appeals Board for a final determination of patentability, we could incur significant legal fees. Lengthy and uncertain patent prosecutions, including the utilization of the appeals process, can add uncertainty, delay and
expense to the process of obtaining intellectual property rights for our products, and as such may add delay and uncertainty to the development program for any such product.



Use of our products may result in product liability claims for which we may not have adequate insurance coverage.



Manufacturing, marketing and sale of our
products or conducting clinical trials of our product candidates may expose us to liability claims from the use of those products and product candidates. Product liability claims could result in the imposition of substantial liability on us, a
recall of products, or a change in the indications for which they may be used. Although we carry product liability insurance and clinical trial liability insurance, we, or our collaborators, may not maintain sufficient insurance to cover these
potential claims. We do not have the financial resources to self-insure and it is unlikely that we will have these financial resources in the foreseeable future. If we are unable to protect against potential product liability claims adequately, we
may find it difficult or impossible to continue to commercialize our products or the product candidates we develop. If claims or losses exceed our liability insurance coverage, we may go out of business.



Insurance coverage is increasingly more costly and difficult to obtain or
maintain.



While we currently have insurance
for our business, property, directors and officers, and our products, insurance is increasingly more costly and narrower in scope, and we may be required to assume more risk in the future. If we are subject to claims or suffer a loss or damage in
excess of our insurance coverage, we will be required to share that risk in excess of our insurance limits. If we are subject to claims or suffer a loss or damage that is outside of our insurance coverage, we may incur significant uninsured costs
associated with loss or damage that could have an adverse effect on our operations and financial position. Furthermore, any claims made on our insurance policies may impact our ability to obtain or maintain insurance coverage at reasonable costs or
at all.



Risks Related to Our Stock



Our common stock price has been volatile and your
investment in our stock may decline in value.



The market price of our common stock has been volatile. These fluctuations create a greater risk of capital losses for our stockholders as compared to less volatile stocks. Factors that have caused volatility and could cause additional
volatility in the market price of our common stock include among others:



| |  |  | Announcements made by us concerning results of clinical trials with our product candidates;
| | - |  | -------------------------------------------------------------------------------------------



| |  |  | Announcements regarding the commercialization of AzaSite;
| | - |  | ---------------------------------------------------------



| |  |  | Announcements regarding FDA approval of Prolacria, denufosol or any of our product candidates;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | Market acceptance and market share of AzaSite, Restasisand Elestat;
| | - |  | -------------------------------------------------------------------



| |  |  | The timing of the introduction of a generic form of Elestat;
| | - |  | ------------------------------------------------------------



| |  |  | Duration of market exclusivity of AzaSiteand Restasis;
| | - |  | ------------------------------------------------------



| |  |  | Volatility in other securities including pharmaceutical and biotechnology securities;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | Changes in government regulations;
| | - |  | ----------------------------------



39



---

##### Table of Contents

| |  |  | Regulatory actions and/or investigations;
| | - |  | -----------------------------------------



| |  |  | Changes in the development priorities of our collaborators that result in changes to, or termination of, our agreements with such collaborators;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Developments concerning proprietary rights including patents by us or our competitors;
| | - |  | --------------------------------------------------------------------------------------



| |  |  | Variations in our operating results;
| | - |  | ------------------------------------



| |  |  | FDA approval of other treatments for the same indication as any one of our product candidates;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | Business development activities; and
| | - |  | ------------------------------------



| |  |  | Litigation.
| | - |  | -----------



Extreme price and volume fluctuations occur in the stock market from time to time that can particularly affect the prices of biotechnology
companies. These extreme fluctuations are sometimes unrelated to the actual performance of the affected companies.



Warburg is able to exercise substantial control over our business.



Warburg Pincus Private Equity IX, L.P., or Warburg, holds 22,907,488 shares of our common stock, which
represented approximately 28% of our outstanding common stock as of January 31, 2010. Warburg and its affiliates may acquire the lesser of: (x) 32.5% of our voting securities on a fully diluted basis and (y) 34.9% of our then
outstanding voting securities, without triggering the provisions of our stockholder rights plan. Warburg has the right to designate one person for election to our Board of Directors for so long as Warburg owns a significant percentage of our
securities. Pursuant to this right, Jonathan S. Leff serves as a Class C member of the Board of Directors. Pursuant to a Securities Purchase Agreement, dated July 17, 2007, for so long as Warburg owns at least 10% of the shares of common stock
issued upon the exchange of Exchangeable Preferred Stock it acquired in July 2007, it will have subscription rights to acquire a pro rata amount of future issuances of equity securities by us, subject to certain exceptions. As a result of the
foregoing, Warburg is able to exercise substantial influence over our business, policies and practices.



Our existing principal stockholders hold a substantial amount of our common stock and may be able to influence significant corporate decisions, which may conflict with the interest of other
stockholders.



As of January 31, 2010,
our current 5% and greater stockholders (which includes Warburg) and their affiliates beneficially owned approximately 42% of our outstanding common stock. These stockholders, if they act together, may be able to influence the outcome of matters
requiring approval of the stockholders, including the election of our directors and other corporate actions such as:



| |  |  | a merger or corporate combination with or into another company;
| | - |  | ---------------------------------------------------------------



| |  |  | a sale of substantially all of our assets; and
| | - |  | ----------------------------------------------



| |  |  | amendments to our certificate of incorporation.
| | - |  | -----------------------------------------------



The decisions of these individual stockholders may conflict with our interests or those of our other
stockholders.



Future sales and issuances of securities may
dilute the ownership interests of our current stockholders and cause our stock price to decline.



Future sales of our common stock by current stockholders into the public market could cause the market price of our stock to fall. As of
January 31, 2010, there were 82,350,770 shares of our common stock outstanding. In addition, after deducting the $115 million of common stock sold in August 2009, we retain the



40



---

##### Table of Contents

ability to issue and may in the future issue, up to an additional $15 million of securities, including common stock, preferred stock, debt securities, depositary shares and securities warrants,
from time to time at prices and on terms to be determined at the time of sale remaining under an active shelf registration statement, which we filed with the SEC on March 9, 2007. Furthermore, we may from time to time issue securities in
relation to a license arrangement, collaboration, merger or acquisition.



Up to 16,178,571 shares of our common stock are issuable upon the release of restricted stock units and/or exercise of stock options that have been, or stock options, stock appreciation rights, stock
awards and restricted stock units that may be, issued pursuant to our Amended and Restated 1995 Stock Plan, our Amended and Restated 2005 Equity Compensation Plan and the Executive Employment Agreement, dated February 18, 2010, between Inspire
and Mr. Adams. The shares underlying existing stock options and restricted stock units and possible future stock options, stock appreciation rights and stock awards have been registered pursuant to registration statements on Form S-8.



If some or all of such shares are sold or
otherwise issue into the public market over a short period of time, our current stockholders ownership interests may be diluted and the value of all publicly traded shares is likely to decline, as the market may not be able to absorb those
shares at then-current market prices. Additionally, such sales and issuances may make it more difficult for us to sell equity securities or equity-related securities in the future at a time and price that our management deems acceptable, or at all.



Our Rights Agreement, the provisions of our Change in Control
Severance Benefit Plans, the anti-takeover provisions in our Amended and Restated Certificate of Incorporation, as amended, and Amended and Restated Bylaws, standstill agreements, and our right to issue preferred stock, may discourage a third party
from making a take-over offer that could be beneficial to us and our stockholders and may make it difficult for stockholders to replace our Board of Directors and effect a change in our management if they desire to do so.



In October 2002, we entered into a Rights Agreement with
Computershare Trust Company. The Rights Agreement could discourage, delay or prevent a person or group from acquiring 15% or more of our common stock. The Rights Agreement provides that if a person acquires 15% or more of our common stock without
the approval of our Board of Directors, all other stockholders will have the right to purchase securities from us at a price that is less than its fair market value, which would substantially reduce the value of our common stock owned by the
acquiring person. As a result, our Board of Directors has significant discretion to approve or disapprove a persons efforts to acquire 15% or more of our common stock. In connection with the transaction with Warburg, we and Computershare
entered into a First Amendment to Rights Agreement which provides that Warburg and its affiliates will be exempt from the definition of an Acquiring Person under the Rights Agreement, unless Warburg or certain of its affiliates becomes
the beneficial owner of the lesser of: (x) 32.5% of our voting securities on a fully diluted basis and (y) 34.9% of our then outstanding voting securities. In addition to Warburgs ability to exercise substantial control over our
business, the First Amendment to Rights Agreement could further discourage, delay or prevent a person or group from acquiring 15% or more of our common stock. As part of the same transaction with Warburg, we entered into a standstill agreement,
dated July 20, 2007, pursuant to which Warburg and certain of its affiliates agreed for three years not to increase their holdings of our common stock beyond the levels described above in the First Amendment to Rights Agreement. On
August 4, 2009, we amended the standstill agreement to extend its term until August 4, 2012.



Our employees are covered under Change in Control Severance Benefit Plans which provide severance benefits in the event of a change of
control that occurs prior to July 8, 2010, and in the event they are terminated after a change in control occurring on or after July 8, 2010. In addition, Mr. Adams Executive Employment Agreement provides for severance benefits
in the event of a change of control. These arrangements would increase the acquisition costs to a purchasing company that triggers the change in control provisions and as a result, may discourage, delay or prevent a change in control.



41



---

##### Table of Contents

Our Amended and Restated Certificate of Incorporation, as amended, and Amended and Restated
Bylaws contain provisions which could discourage, delay or prevent a third party from acquiring shares of our common stock or replacing members of our Board of Directors. Our Amended and Restated Certificate of Incorporation, as amended, allows our
Board of Directors to issue shares of preferred stock. Our Board of Directors can determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. As a result, our Board of Directors
could make it difficult for a third party to acquire a majority of our outstanding voting stock. Since management is appointed by the Board of Directors, any inability to effect a change in the Board of Directors may result in the entrenchment of
management.



Our Amended and Restated Certificate
of Incorporation, as amended, also provides that the members of the Board will be divided into three classes. Each year, the terms of approximately one-third of the directors will expire. Our Amended and Restated Bylaws include director nomination
procedures and do not permit our stockholders to call a special meeting of stockholders. The staggering of directors terms of office, the director nomination procedures and the inability of stockholders to call a special meeting may make it
difficult for stockholders to remove or replace the Board of Directors should they desire to do so. The director nomination requirements include a provision that requires stockholders give advance notice to our Secretary of any nominations for
director or other business to be brought by stockholders at any stockholders meeting. Our directors may be removed from our Board of Directors only for cause. These provisions may discourage, delay or prevent changes of control or management,
either by third parties or by stockholders seeking to change control or management.



In the ordinary course of our business, from time to time we discuss possible collaborations, licenses and other transactions with various third parties, including pharmaceutical companies and
biotechnology companies. When we deem it appropriate, we enter into standstill agreements with such third parties in relation to the discussions. These standstill agreements, several of which are currently in force, typically prohibit such parties
from acquiring our securities for a period of time.



We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. Under these provisions, if anyone becomes an interested stockholder, we may not enter a business
combination with that person for three years without special approval, which could discourage a third party from making a take-over offer and could delay or prevent a change of control. For purposes of Section 203, interested
stockholder means, generally, someone owning 15% or more of our outstanding voting stock or an affiliate of ours that owned 15% or more of our outstanding voting stock during the past three years, subject to certain exceptions as described in
Section 203. In connection with our prior sale of stock to Warburg, we agreed to waive Warburgs acquisition of securities from the provisions of Section 203 of the Delaware General Corporation Law.



FORWARD LOOKING STATEMENTS



This annual report on Form 10-K, including the documents that we
incorporate by reference, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, that are
subject to the safe harbor created by those sections. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These statements
are often, but not always, made through the use of words or phrases such as anticipate, estimate, plan, project, continuing, believe, expect, future and
intend and similar expressions to identify forward-looking statements. There are a number of important factors that could cause our actual results to differ materially from those indicated by any forward-looking statements, including,
without limitation, the risk factors listed above and those relating to product development, revenue and earnings expectations, intellectual property rights and litigation, competitive products, results of clinical trials, the need for additional
research and testing,



42



---

##### Table of Contents

delays in manufacturing, funding and the timing and content of decisions made by regulatory authorities, including the FDA and other factors presented throughout this annual report and any other
documents filed by us with the SEC.



In light of
these assumptions, risks and uncertainties, the results and events discussed in the forward-looking statements contained in this annual report on Form 10-K or in any document incorporated by reference might not occur. Stockholders are cautioned not
to place undue reliance on the forward-looking statements, which speak only of the date of this report or the date of the document incorporated by reference in this document. We are not under any obligation, and we expressly disclaim any obligation,
to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. All subsequent forward-looking statements attributable to us or to any person acting on our behalf are expressly qualified in
their entirety by the cautionary statements contained or referred to in this section.



Item 1B. Unresolved Staff Comments



On December 10, 2009, we received a comment letter from the staff of the SEC with respect to our Form 10-K for the fiscal year
ended December 31, 2008 and our Proxy Statement filed March 26, 2009. We responded to the SECs comments on February 1, 2010, and received two follow-up comments from the SEC on March 11, 2010, regarding a tabular summary of
various patent information and asking for confirmation that the Compensation Discussion and Analysis to be contained in our upcoming proxy statement will discuss the factors considered by our Compensation Committee in evaluating the portion of the
bonuses to our named executive officers that were based on individual contributions. On March 12, 2010, we submitted a response to the SEC that we believe addresses their comments. However, this has not been confirmed by the SEC.



Item 2. Properties.



We lease contiguous administrative and laboratory facilities
that comprise approximately 51,000 square feet in Durham, North Carolina, which is adjacent to the Research Triangle Park. The various leases underlying our facilities expire in January 2011 and are renewable. We believe our facilities are adequate
to meet our current operational needs. In addition, we lease approximately 500 square feet of administrative space as a sales office in Dallas, Texas.



Item 3. Legal Proceedings.



Not applicable.



Item 4. Reserved.



43



---

##### Table of Contents

PART II



Item 5. Market for the Companys Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities.



Our common stock has been traded on the Nasdaq National Market, and later the Nasdaq Global Market, under the symbol ISPH since August 3, 2000. The following table sets forth, for the calendar periods indicated, the range
of high and low sale prices for our common stock on the Nasdaq Global Market:



|               |  |      |      |     |   |     
|-------------- |  | ---- | ---- | --- | - | ----
|2008           |  | High |      | Low
|First Quarter  |  | $    | 6.09 |     | $ | 3.59
|Second Quarter |  | $    | 6.75 |     | $ | 2.89
|Third Quarter  |  | $    | 4.70 |     | $ | 3.21
|Fourth Quarter |  | $    | 4.08 |     | $ | 1.68
|               |  |     
|2009           |  | High |      | Low
|First Quarter  |  | $    | 4.21 |     | $ | 2.59
|Second Quarter |  | $    | 5.70 |     | $ | 3.52
|Third Quarter  |  | $    | 6.54 |     | $ | 4.33
|Fourth Quarter |  | $    | 6.07 |     | $ | 4.36



As of January 31, 2010, there were 50 record stockholders and approximately 5,600 beneficial stockholders of our common stock. As of
January 29, 2010, the last sale price reported on the Nasdaq Global Market for our common stock was $5.51 per share.



We have not paid or declared dividends on our common stock since our inception and do not plan to pay dividends on our common stock in the
foreseeable future. Any earnings that we may realize will be retained to finance our growth.



See Part IIIItem 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters for certain equity compensation plan information.



44



---

##### Table of Contents

RELATIVE STOCK PERFORMANCE



The graph below compares Inspire Pharmaceuticals, Inc.s
cumulative 5-year total stockholder return on common stock with the cumulative total returns of the NASDAQ Composite index and the NASDAQ Biotechnology index. The graph tracks the performance of a $100 investment in our common stock and in each of
the indexes (with the reinvestment of all dividends) from December 31, 2004 to December 31, 2009.



LOGO



|                              |  |                          |        |          |   |          |  |          |        |          |   |          |  |   |        |  |   |       
|----------------------------- |  | ------------------------ | ------ | -------- | - | -------- |  | -------- | ------ | -------- | - | -------- |  | - | ------ |  | - | ------
|                              |  | Cumulative Total Returns
|                              |  | 12/31/04                 |        | 12/31/05 |   | 12/31/06 |  | 12/31/07 |        | 12/31/08 |   | 12/31/09
|Inspire Pharmaceuticals, Inc. |  | $                        | 100.00 |          | $ | 30.29    |  | $        | 37.87  |          | $ | 35.66    |  | $ | 21.47  |  | $ | 32.92 
|NASDAQ Composite              |  |                          | 100.00 |          |   | 101.33   |  |          | 114.01 |          |   | 123.71   |  |   | 73.11  |  |   | 105.61
|NASDAQ Biotechnology          |  |                          | 100.00 |          |   | 117.54   |  |          | 117.37 |          |   | 121.37   |  |   | 113.41 |  |   | 124.58



The comparisons in the graph are required by the SEC and are not intended to forecast or be indicative of possible future performance of our
common stock.



45



---

##### Table of Contents

Item 6. Selected Financial Data.



The selected statement of operations data and balance sheet
data with respect to the years ended December 31, 2009, 2008, 2007, 2006 and 2005 set forth below are derived from our financial statements. The selected financial data set forth below should be read in conjunction with Managements
Discussion and Analysis of Financial Condition and Results of Operations contained in Item 7 below, and our financial statements and the notes thereto appended to this annual report. Historical results are not necessarily indicative of
our future results.



|                                                                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|------------------------------------------------------------------------------------------------- |  | ---------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                                                                                                  |  | (in thousands, except per share amounts) |        
|                                                                                                  |  | Year Ended December 31,                  |        
|                                                                                                  |  | 2009                                     |         |   | 2008 |   |         | 2007 |  |   | 2006    |   |  | 2005 |        
|Statement of Operations Data:                                                                     |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Revenue                                                                                           |  | $                                        | 92,159  |   |      | $ | 70,498  |      |  | $ | 48,665  |   |  | $    | 37,059  |   |  | $ | 23,266  |  
|                                                                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Operating expenses:                                                                               |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Cost of sales                                                                                     |  |                                          | 11,271  |   |      |   | 6,412   |      |  |   | 1,622   |   |  |      |        |   |  |   |        |  
|Research and development                                                                          |  |                                          | 51,134  |   |      |   | 44,637  |      |  |   | 53,391  |   |  |      | 42,537  |   |  |   | 23,566  |  
|Selling and marketing                                                                             |  |                                          | 49,304  |   |      |   | 54,568  |      |  |   | 45,543  |   |  |      | 25,265  |   |  |   | 23,223  |  
|General and administrative                                                                        |  |                                          | 16,053  |   |      |   | 14,540  |      |  |   | 13,986  |   |  |      | 15,880  |   |  |   | 12,004  |  
|Restructuring                                                                                     |  |                                          | 2,014   |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|                                                                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total operating expenses                                                                          |  |                                          | 129,776 |   |      |   | 120,157 |      |  |   | 114,542 |   |  |      | 83,682  |   |  |   | 58,793  |  
|                                                                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Loss from operations                                                                              |  |                                          | (37,617 | ) |      |   | (49,659 | )    |  |   | (65,877 | ) |  |      | (46,623 | ) |  |   | (35,527 | )
|Other income/(expense), net                                                                       |  |                                          | (2,359  | ) |      |   | (1,944  | )    |  |   | 2,137   |   |  |      | 4,508   |   |  |   | 3,680   |  
|                                                                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net loss                                                                                          |  | $                                        | (39,976 | ) |      | $ | (51,603 | )    |  | $ | (63,740 | ) |  | $    | (42,115 | ) |  | $ | (31,847 | )
|                                                                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Non-cash deemed dividend related to beneficial conversion feature of exchangeable preferred stock |  |                                          |        |   |      |   |        |      |  |   | (8,285  | ) |  |      |        |   |  |   |        |  
|                                                                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net loss attributable to common stockholders                                                      |  | $                                        | (39,976 | ) |      | $ | (51,603 | )    |  | $ | (72,025 | ) |  | $    | (42,115 | ) |  | $ | (31,847 | )
|                                                                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net loss per common sharebasic and diluted                                                       |  | $                                        | (0.60   | ) |      | $ | (0.91   | )    |  | $ | (1.61   | ) |  | $    | (1.00   | ) |  | $ | (0.76   | )
|                                                                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Common shares used in computing weighted average common shares outstandingbasic and diluted      |  |                                          | 66,797  |   |      |   | 56,609  |      |  |   | 44,763  |   |  |      | 42,227  |   |  |   | 42,101  |  



|                                               |  |                |         |      |   |         |  |      |         |      |   |         |  |   |        
|---------------------------------------------- |  | -------------- | ------- | ---- | - | ------- |  | ---- | ------- | ---- | - | ------- |  | - | -------
|                                               |  | (in thousands)
|                                               |  | December, 31  
|                                               |  | 2009           |         | 2008 |   | 2007    |  | 2006 |         | 2005
|Balance Sheet Data:                            |  |                |         |      |   |         |  |      |         |      |   |         |  |   |        
|Cash, cash equivalents and investments         |  | $              | 129,099 |      | $ | 72,966  |  | $    | 139,724 |      | $ | 102,281 |  | $ | 122,323
|Trade receivables, net                         |  |                | 22,682  |      |   | 16,544  |  |      | 12,974  |      |   | 8,245   |  |   | 4,898  
|Inventories, net                               |  |                | 1,717   |      |   | 689     |  |      | 1,280   |      |   |        |  |   |       
|Working capital                                |  |                | 85,412  |      |   | 52,512  |  |      | 107,651 |      |   | 89,655  |  |   | 99,265 
|Total assets                                   |  |                | 178,770 |      |   | 114,224 |  |      | 180,503 |      |   | 116,699 |  |   | 132,446
|Deferred revenue                               |  |                |        |      |   |        |  |      | 371     |      |   |        |  |   |       
|Debt obligations, including current portion(1) |  |                | 25,175  |      |   | 43,605  |  |      | 57,701  |      |   | 21,357  |  |   | 1,392  
|Total stockholders equity                     |  |                | 119,168 |      |   | 44,387  |  |      | 91,693  |      |   | 78,371  |  |   | 118,689
|Shares of common stock outstanding             |  |                | 82,346  |      |   | 56,672  |  |      | 56,501  |      |   | 42,238  |  |   | 42,211 



|(1) | Includes capital leases.
|--- | ------------------------



46



---

##### Table of Contents

Item 7. Managements Discussion and Analysis of Financial Condition
and Results of Operations.



Cautionary Statement



The discussion below contains
forward-looking statements regarding our financial condition and our results of operations that are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted within the United States,
as well as projections for the future. The preparation of these financial statements requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. We evaluate our estimates on an ongoing basis. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. The results of our
estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.



We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. We are subject to risks
common to biopharmaceutical companies, including risks inherent in our research, development and commercialization efforts, clinical trials, uncertainty of regulatory actions and marketing approvals, reliance on collaborative partners, enforcement
of patent and proprietary rights, the need for future capital, competition associated with products, potential competition associated with our product candidates and retention of key employees. In order for any of our product candidates to be
commercialized, it will be necessary for us, or our collaborative partners, to conduct clinical trials, demonstrate efficacy and safety of the product candidate to the satisfaction of regulatory authorities, obtain marketing approval, enter into
manufacturing, distribution and marketing arrangements, obtain market acceptance and adequate reimbursement from government and private insurers. We cannot provide assurance that we will generate significant revenues or achieve and sustain
profitability in the future. In addition, we can provide no assurance that we will have sufficient funding to meet our future capital requirements. Statements contained in Managements Discussion and Analysis of Financial Condition and Results
of Operations which are not historical facts are, or may constitute, forward-looking statements. Forward-looking statements involve known and unknown risks that could cause our actual results to differ materially from expected results. The most
significant known risks are discussed in the section entitled Risk Factors. Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity,
performance or achievements.



Our revenues are
difficult to predict and depend on numerous factors. The effectiveness of our ability and the ability of third parties on which we rely to help us manufacture, distribute and market AzaSite;physician and patient acceptance of AzaSite;
competitor response to AzaSite;as well as discounts, pricing and coverage on governmental and commercial formularies; are all factors, among others, that will impact the level of revenue recorded for AzaSite in subsequent periods.
Through the year ended December 31, 2008, we actively promoted both Restasisand Elestat through our commercial organization. As of January 1, 2009, we are no longer responsible for the co-promotion of Restasis, but we
continue to receive royalties on Allergans net sales of Restasis. Our co-promotion and royalty revenues are based upon Allergans revenue recognition policy and other accounting policies, over which we have limited or no control,
and on the underlying terms of our co-promotion agreements. Our co-promotion and royalty revenues are impacted by the number of governmental and commercial formularies upon which Restasis and Elestat are listed, the discounts and
pricing under such formularies, as well as the estimated and actual amount of rebates, all of which are managed by Allergan. Other factors that are difficult to predict and that impact our co-promotion and royalty revenues are the extent and
effectiveness of Allergans sales and marketing efforts, our sales and marketing efforts, coverage and reimbursement under Medicare Part D and Medicaid programs, and the sales and marketing activities of competitors. Additionally, our ability
to receive revenues on future sales of AzaSite, Restasis and Elestat are dependent upon the duration of market exclusivity and strength of patent protection. Revenues related to development activities are dependent upon the
progress toward and the achievement of developmental milestones by us or our collaborative partners.



47



---

##### Table of Contents

Our operating expenses are also difficult to predict and depend on several factors. Cost of
sales related to AzaSite contain variable and fixed cost components. Research and development expenses, including expenses for development milestones, drug manufacturing, and clinical research activities, depend on the ongoing requirements of
our development programs, completion of business development transactions, availability of capital and direction from regulatory agencies, which are difficult to predict. Management may in some cases be able to control the timing of research and
development expenses, in part by accelerating or decelerating clinical development activities, but many of these expenditures will occur irrespective of whether our product candidates are approved when anticipated or at all. We have incurred and
expect to continue to incur significant selling and marketing expenses to commercialize our products. Again, management may in some cases be able to control the timing and magnitude of these expenses.



As a result of these factors, we believe that period to period
comparisons are not necessarily meaningful and you should not rely on them as an indication of future performance. Due to all of the foregoing factors, it is possible that our operating results will be below the expectations of market analysts and
investors. In such event, the prevailing market price of our common stock could be materially adversely affected.



Overview



We are a biopharmaceutical company focused on researching, developing and commercializing prescription pharmaceutical products for ophthalmic
and pulmonary diseases. Our goal is to build and commercialize a sustainable portfolio of innovative new products based on our technical and scientific expertise. The most advanced compounds in our clinical pipeline are denufosol tetrasodium for
cystic fibrosis and Prolacria for dry eye, both of which are in Phase 3 development, and AzaSitefor blepharitis, which is in Phase 2 development. We receive revenue related to the promotion of AzaSitefor bacterial
conjunctivitis, co-promotion of Elestat for allergic conjunctivitis and royalties on Restasis for dry eye.



In February 2007, we signed an exclusive licensing agreement with InSite Vision for the U.S. and Canadian commercialization rights of
AzaSitefor the treatment of bacterial conjunctivitis. In April 2007, AzaSite was approved by the FDA for the treatment of bacterial conjunctivitis in adults and children one year of age and older. In August 2007, we launched
AzaSite in the United States and are promoting it to eye care specialists.



In 2004, we launched Elestat for the treatment of allergic conjunctivitis and began co-promoting Restasis for the treatment of dry eye disease. In December 2008, we amended our agreement
with Allergan and terminated our co-promotion responsibilities related to Restasis. Under agreements with Allergan, we receive revenue based upon Allergans net sales of these products.



See Part IItem 1. Business of this report for a full
discussion of our agreements with InSite Vision, Allergan and other significant collaborative agreements, as well our other product candidates in clinical development.



We have incurred significant operating losses since our inception and, as of December 31, 2009, we had an accumulated
deficit of $400.4 million. Revenue from sales of AzaSite, Restasis and Elestatdid not exceed our total operating expenses in 2009. We expect to incur operating losses for the next several years. We have financed our operations through
the sale of equity securities, including private sales of preferred stock and public offerings of common stock, debt, and with revenue from corporate partnerships, including co-promotion and royalty revenue. We operate as a single business segment
and do not have any foreign operations.



Critical Accounting Policies and Estimates



The accompanying discussion and analysis of our financial condition and results of operations are based upon our financial statements and the related disclosures, which have been prepared in accordance
with generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and



48



---

##### Table of Contents

judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates, judgments and the
policies underlying these estimates on a periodic basis, as situations change and regularly discuss financial events, policies, and issues with members of our audit committee and our independent registered public accounting firm. In addition,
recognition of revenue from product co-promotion and earned royalties is affected by certain estimates and judgments made by Allergan on which we rely when recording this revenue. We routinely evaluate our estimates and policies regarding revenue
recognition, product returns, rebates and incentives, inventory and manufacturing, taxes, stock-based compensation, research and development, marketing and other expenses and any associated liabilities.



We believe the following policies to be the most critical to an
understanding of our financial condition and results of operations because they require us to make estimates and judgments about matters that are inherently uncertain.



Revenue Recognition



We record all of our revenue from: (1) sales of AzaSite; (2) product co-promotion activities and earned royalties; and
(3) collaborative research agreements when realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: 1) persuasive evidence of an arrangement exists; 2) delivery has occurred or
services have been rendered; 3) the sellers price to the buyer is fixed or determinable; and 4) collectibility is reasonably assured.



Product Revenues



We recognize revenue for sales of AzaSite when title and substantially all the risks and rewards of ownership have transferred to the
customer, which generally occurs on the date of shipment, with the exception of transactions whereby product stocking incentives were offered approximately one month prior to the products August 13, 2007 launch. In the United States, we
sell AzaSite to wholesalers and distributors, who, in turn, sell to pharmacies and federal, state and commercial health care organizations.



Sales deductions consist of statutory rebates to state Medicaid, Medicare and other government agencies, contractual rebates with commercial
managed care organizations, wholesaler chargebacks, sales discounts (including trade discounts and distribution service fees), allowances for coupon and voucher programs and product returns. These deductions are recorded as reductions to revenue
from AzaSite in the same period as the related sales with estimates of future utilization derived from historical experience adjusted to reflect known changes in the factors that impact such reserves.



We utilize data from external sources to help us estimate our
gross-to-net sales adjustments as they relate to the recognition of revenue for AzaSite sold. External sourced data includes, but is not limited to, information obtained from certain wholesalers with respect to their inventory levels and
sell-through to customers, targeted surveys as well as data from IMS Health, a third-party supplier of market research data to the pharmaceutical industry. We also utilize this data to help estimate and identify prescription trends and patient
demand, as well as product levels in the supply chain.



We account for these sales deductions in accordance with the Financial Accounting Standards Board, or FASB, authoritative guidance on revenue recognition when consideration is given by a vendor to a customer as well as when the right of
return exists.



We have categorized and described
more fully, the following significant sales deductions, all of which involve estimates and judgments which we consider to be critical accounting estimates, and require us to use information from external sources.



49



---

##### Table of Contents

Rebates and Chargebacks



Statutory rebates to state Medicaid agencies and Medicare and
contractual rebates to commercial managed care organizations are based on statutory or negotiated discounts to the selling price. As it can take up to nine months or more for information to be received on actual usage of AzaSite in
managed care and Medicaid and other governmental programs as well as on the total discounts to be reimbursed, we maintain reserves for amounts payable under these programs relating to AzaSite sales.



Chargebacks claimed by wholesalers are based on the
differentials between product acquisition prices paid by wholesalers and lower government contract pricing paid by eligible customers covered under federally qualified programs.



The amount of the reserve for rebates and chargebacks is based on multiple qualitative and quantitative
factors, including the historical and projected utilization levels, historical payment experience, changes in statutory laws and interpretations as well as contractual terms, product pricing (both normal selling prices and statutory or negotiated
prices), changes in prescription demand patterns and utilization of our product through private or public benefit plans, and the levels of AzaSite inventory in both the wholesale and retail distribution channel. Other factors that we may
consider, if determined relevant would include price changes from competitors and introductions of generics and/or competitive new products. We acquire prescription utilization data from IMS Health, a third-party supplier of market research data to
the pharmaceutical industry. We apply these multiple factors, the quantitative historical data along with other qualitative aspects, such as managements judgment regarding future utilization trends, to the respective periods sales of
AzaSite to determine the rebate accrual and related expense. We update our estimates and assumptions each period and record any necessary adjustments to our reserves. Settlements of rebates and chargebacks typically occur within nine months
from point of sale. To the extent actual rebates and chargebacks differ from our estimates, additional reserves may be required or reserves may need to be reversed, either of which would impact current period product revenue. As of December 31,
2009 and 2008, reserves for rebates and chargebacks were $3.5 million and $783,000, respectively.



Discounts and Other Sales Incentives



Discounts and other sales incentives consist of the following:



| |  |  | Prompt pay discountsPrompt payment discounts are offered to all wholesalers in return for payment within 30 days following the invoice
date. We record sales of AzaSite net of the discount amount based on historical experience. We adjust the reserve at the end of each reporting period to approximate the percentage discount applicable to the outstanding gross accounts
receivable balances.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Inventory Management Agreement (IMA) FeesPer contractual agreements with our largest wholesalers (which collectively
represented over 85% of 2009 AzaSite sales), we provide an IMA fee based on a percentage of their purchases of AzaSite. The IMA fee rates are set forth in the individual contracts. We track sales to these wholesalers each period and
accrue a liability relating to the unpaid portion of these fees by applying the contractual rates to such sales.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Product coupons and vouchersProduct coupons and vouchers offer patients the ability to receive free or discounted product through their
pharmacy or prescribing physician, to whom we provide an inventory of coupons or vouchers as applicable. We use a third-party administrator who invoices us on a periodic basis for the cost of coupons and vouchers redeemed in the period. We base our
estimates on the historical coupon and voucher redemption rate of similar programs.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As of December 31, 2009 and 2008, reserves for discounts and other sales incentives were $889,000 and $519,000, respectively.



50



---

##### Table of Contents

Product Returns



At the time of sale of AzaSite, we record product returns allowances based on our estimate of the
portion of sales that will be returned by our customers in the future. The return allowances are established in accordance with our return policy. Our return goods policy generally allows for returns of AzaSite within an 18-month period, from
six months prior to the expiration date and up to 12 months following the expiration date, but may differ from customer to customer, depending on certain factors. Future estimated returns of AzaSite are based primarily on the return data for
comparative products and our own historical experience with AzaSite. Historical returns data on AzaSite is analyzed on a specific production lot basis. In determining our return allowance we also consider other relevant factors,
including:



| |  |  | Levels of inventory in the distribution channel and any significant changes to these levels
| | - |  | -------------------------------------------------------------------------------------------



| |  |  | Estimated expiration date or remaining shelf life of inventory in the distribution channel
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | Current and projected demand of AzaSite that could be impacted by introductions of generic products and/or introductions of competitive new
products; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Competitive product recalls and/or discontinuances
| | - |  | --------------------------------------------------



Our estimates of the level of AzaSite inventory in the distribution channel is based on inventory data
provided by wholesalers; and third-party prescription data. As of December 31, 2009 and 2008, reserves for returns of AzaSite were $1.5 million and $701,000, respectively.



The following table reflects the gross to net sales accruals and the balance in the related allowance accounts
for the years ended December 31, 2009, 2008 and 2007.



|                                                 |  |                            |           |                               |   |                             |  |   |                  |   |  |                       |            |   |  |   |          
|------------------------------------------------ |  | -------------------------- | --------- | ----------------------------- | - | --------------------------- |  | - | ---------------- | - |  | --------------------- | ---------- | - |  | - | ---------
|                                                 |  | Balance atBeginning ofYear |           | Related toCurrent PeriodSales |   | Related toPrior PeriodSales |  |   | Credits/Payments |   |  | Balance atEnd of Year
|Year Ended December 31, 2009                     |  |                            |           |                               |   |                             |  |   |                  |   |  |                       |            |   |  |   |          
|Reserve for Rebates and Chargebacks              |  | $                          | 783,000   |                               | $ | 6,015,000                   |  | $ | 188,000          |   |  | $                     | (3,498,000 | ) |  | $ | 3,488,000
|Reserve for Discounts and Other Sales Incentives |  |                            | 519,000   |                               |   | 3,328,000                   |  |   |                  |   |  |                       | (2,958,000 | ) |  |   | 889,000  
|Allowance for Returns                            |  |                            | 701,000   |                               |   | 1,259,000                   |  |   | 301,000          |   |  |                       | (738,000   | ) |  |   | 1,523,000
|                                                 |  |                            |           |                               |   |                             |  |   |                  |   |  |                       |            |   |  |   |          
|Total Sales Deductions Accruals                  |  | $                          | 2,003,000 |                               | $ | 10,602,000                  |  | $ | 489,000          |   |  | $                     | (7,194,000 | ) |  | $ | 5,900,000
|                                                 |  |                            |           |                               |   |                             |  |   |                  |   |  |                       |            |   |  |   |          
|Year Ended December 31, 2008                     |  |                            |           |                               |   |                             |  |   |                  |   |  |                       |            |   |  |   |          
|Reserve for Rebates and Chargebacks              |  | $                          | 149,000   |                               | $ | 1,501,000                   |  | $ | (7,000           | ) |  | $                     | (860,000   | ) |  | $ | 783,000  
|Reserve for Discounts and Other Sales Incentives |  |                            | 89,000    |                               |   | 1,394,000                   |  |   |                  |   |  |                       | (964,000   | ) |  |   | 519,000  
|Allowance for Returns                            |  |                            | 95,000    |                               |   | 661,000                     |  |   | 16,000           |   |  |                       | (71,000    | ) |  |   | 701,000  
|                                                 |  |                            |           |                               |   |                             |  |   |                  |   |  |                       |            |   |  |   |          
|Total Sales Deductions Accruals                  |  | $                          | 333,000   |                               | $ | 3,556,000                   |  | $ | 9,000            |   |  | $                     | (1,895,000 | ) |  | $ | 2,003,000
|                                                 |  |                            |           |                               |   |                             |  |   |                  |   |  |                       |            |   |  |   |          
|Year Ended December 31, 2007                     |  |                            |           |                               |   |                             |  |   |                  |   |  |                       |            |   |  |   |          
|Reserve for Rebates and Chargebacks              |  | $                          |          |                               | $ | 154,000                     |  | $ |                 |   |  | $                     | (5,000     | ) |  | $ | 149,000  
|Reserve for Discounts and Other Sales Incentives |  |                            |           |                               |   | 270,000                     |  |   |                  |   |  |                       | (181,000   | ) |  |   | 89,000   
|Allowance for Returns                            |  |                            |           |                               |   | 118,000                     |  |   |                  |   |  |                       | (23,000    | ) |  |   | 95,000   
|                                                 |  |                            |           |                               |   |                             |  |   |                  |   |  |                       |            |   |  |   |          
|Total Sales Deductions Accruals                  |  | $                          |          |                               | $ | 542,000                     |  | $ |                 |   |  | $                     | (209,000   | ) |  | $ | 333,000  
|                                                 |  |                            |           |                               |   |                             |  |   |                  |   |  |                       |            |   |  |   |          



Immediately preceding the launch of AzaSite, we offered wholesalers stocking incentives that allowed for extended payment terms, product discounts, and guaranteed sale provisions (collectively,
special terms). These special terms were only offered during a specified time period of approximately one month prior to the August 13, 2007 launch of AzaSite. Any sales of AzaSite made under these special term
provisions were



51



---

##### Table of Contents

accounted for using a consignment model since substantially all the risks and rewards of ownership did not transfer upon shipment. Under the consignment model, we did not recognize revenue upon
shipment of AzaSite purchased with the special terms, but recorded deferred revenue at gross invoice sales price, less all appropriate discounts and rebates, and accounted for AzaSite inventory held by the wholesalers as consignment
inventory. We recognized the revenue from these sales with special terms at the earlier of when the inventory of AzaSite held by the wholesalers was sold through to the wholesalers customers or when such inventory of AzaSite was
no longer subject to these special terms. At December 31, 2007, we had net deferred revenue of $371,000 related to sales of AzaSite considered consignment, which was fully recognized in the three months ended March 31, 2008. All
sales subsequent to this specified launch time period include return rights and pricing that are customary in the industry, as discussed above.



Product Co-promotion and Royalty Revenues



We recognize co-promotion revenue based on net sales of Elestat and royalty revenue based on net sales of Restasis, as defined
in the co-promotion agreements, and as reported to us by Allergan. Through the year ended December 31, 2008, we actively promoted both Restasisand Elestat through our commercial organization. As of January 1, 2009, we are no
longer responsible for the co-promotion of Restasis, but we continue to receive royalties on Allergans net sales of Restasis. Our co-promotion and royalty revenues are based upon Allergans revenue recognition policy and
other accounting policies over which we have limited or no control and on the underlying terms of our co-promotion agreements. Allergan recognizes revenue from product sales when goods are shipped and title and risk of loss transfers to the
customer. The co-promotion agreements provide for gross sales to be reduced by estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs as defined in the agreements,
all of which are determined by Allergan and are outside our control. We record a percentage of Allergans reported net sales to us for Elestat and Restasis,as co-promotion revenue and royalty revenue, respectively. We receive
monthly net sales information from Allergan and perform analytical reviews and trend analyses using prescription information that we receive from IMS Health. In addition, we exercise our audit rights under the contractual agreements with Allergan to
annually perform an examination of Allergans sales records of both Restasisand Elestat. We make no adjustments to the amounts reported to us by Allergan other than reductions in net sales to reflect the incentive programs
managed by us. We offer and manage certain incentive programs associated withElestat, which are utilized by us in addition to those programs managed by Allergan. We reduce co-promotion revenue from net sales of Elestat by estimating
the portion of sales that are subject to these incentive programs based on information reported to us by our third-party administrator of the incentive programs. The rebates associated with the programs we manage represent an insignificant amount,
as compared to the rebate and discount programs administered by Allergan and as compared to our aggregate co-promotion and royalty revenue. Under the co-promotion agreement for Elestat, we are obligated to meet predetermined minimum calendar
year net sales target levels. If the annual minimum is not achieved, we record revenues using a reduced percentage of net sales based upon our level of achievement of the predetermined calendar year net sales target levels. Amounts receivable from
Allergan in excess of recorded co-promotion revenue are recorded as deferred revenue. Calendar year 2009 was the last year in which there is a minimum annual net sales target level for Elestatunder the co-promotion agreement.



Collaborative Research and Development Revenues



We recognize revenue under our collaborative
research and development agreements when we have performed services under such agreements or when we or our collaborative partner have met a contractual milestone triggering a payment to us. We recognize revenue from our research and development
service agreements ratably over the estimated service period as related research and development costs are incurred and the services are substantially performed. Upfront non-refundable fees and milestone payments received at the initiation of
collaborative agreements for which we have an ongoing research and development commitment are deferred and recognized ratably over the period in which the services are substantially performed. This period, if not defined in the collaborative
agreement, is based on estimates by management and the progress towards



52



---

##### Table of Contents

agreed upon development events as set forth in our collaborative agreements. These estimates are subject to revision as our development efforts progress and we gain knowledge regarding required
additional development. Revisions in the commitment period are made in the period that the facts related to the change first become known. If the estimated service period is subsequently modified, the period over which the upfront fee or revenue
related to ongoing research and development services is modified on a prospective basis. We are also entitled to receive milestone payments under our collaborative research and development agreements based upon the achievement of agreed upon
development events that are substantively at-risk by our collaborative partners or us. This collaborative research and development revenue is recognized upon the achievement and acknowledgement of our collaborative partner of a development event,
which is generally at the date payment is received from the collaborative partner or is reasonably assured. Accordingly, our revenue recognized under our collaborative research and development agreements may fluctuate significantly from period to
period. No collaborative research and development revenue was recognized for the years ended December 31, 2009 and 2007. In the year ended December 31, 2008, we recognized $1.25 million of collaborative research and development revenue
from Santen upon the completion of its Phase 3 clinical testing relating to its formulation of diquafosol tetrasodium.



Inventories



Our inventories are related to AzaSiteand are valued at the lower of cost or market using the first-in, first-out (i.e., FIFO)
method. Cost includes materials, labor, overhead, shipping and handling costs. Our inventories are subject to expiration dating. We regularly evaluate the carrying value of our inventories and provide valuation reserves for any estimated obsolete,
short-dated or unmarketable inventories. Our determination that a valuation reserve might be required, in addition to the quantification of such reserve, requires us to utilize significant judgment. We base our analysis, in part, on the level of
inventories on hand in relation to our estimated forecast of product demand, production requirements for forecasted product demand, expected market conditions and the expiration dates or remaining shelf life of inventories. As of December 31,
2009 and 2008, we had net reserves of $25,000 and $10,000, respectively, for potential overstocking.



Taxes



We account for uncertain tax positions in accordance with FASB authoritative guidance regarding the accounting for taxes. Significant
management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. We have recorded a valuation allowance against all potential tax
assets due to uncertainties in our ability to utilize deferred tax assets, primarily consisting of certain net operating losses carried forward, before they expire. The valuation allowance is based on estimates of taxable income in each of the
jurisdictions in which we operate and the period over which our deferred tax assets will be recoverable.



Liabilities



We generally enter into contractual agreements with third-party vendors to provide research and development, manufacturing, and other
services in the ordinary course of business. Many of these contracts are subject to milestone-based invoicing and services are completed over an extended period of time. We record liabilities under these contractual commitments when we determine an
obligation has been incurred, regardless of the timing of the invoice. We monitor all significant research and development, manufacturing, sales and marketing and other service activities and the progression of work related to these activities. We
estimate the underlying obligation for each activity based upon our estimate of the amount of work performed and compare the estimated obligation against the amount that has been invoiced. Because of the nature of certain contracts and related delay
in the contracts invoicing, the obligation to these vendors may be based upon managements estimate of the underlying obligation. We record the larger of our estimated obligation or invoiced amounts for completed service. In all cases,
actual results may differ from our estimate.



53



---

##### Table of Contents

Stock-Based Compensation Expense



We recognize stock-based compensation expense in accordance
with FASB authoritative guidance regarding the accounting for share-based payments, which requires us to measure compensation cost for share-based payment awards at fair value and recognize compensation expense over the service period for awards
expected to vest. We utilize the Black-Scholes option-pricing model to value our awards and recognize compensation expense on a straight-line basis over the vesting periods of our awards. We consider many factors when estimating expected
forfeitures, including types of awards, employee class, and historical experience. Our expected volatility is determined based on our own historical volatility. The estimation of share-based payment awards that will ultimately vest requires
judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. Significant management judgment is also required in
determining estimates of future stock price volatility, forfeitures and expected life to be used in the valuation of the options. Actual results, and future changes in estimates, may differ substantially from our current estimates.



Impact of Inflation



We do not believe that our operating results have been
materially impacted by inflation during the past three years. However, we cannot assure that our operating results will not be adversely affected by inflation in the future. We will continually seek to mitigate the adverse effects of inflation on
the costs of goods and services that we use through improved operating efficiencies and cost containment and periodic price increases for our product.



Results of Operations



Years Ended December 31, 2009, 2008 and 2007



Revenues



Total revenues were approximately $92.2 million for the year ended December 31, 2009, as compared to approximately $70.5 million for the
year ended December 31, 2008, and approximately $48.7 million in 2007. The increase in 2009 revenue of approximately $21.7 million, or 31%, as compared to the same period in 2008, was primarily due to an increase in product revenue from net
sales of AzaSite, as well as increased royalty revenue from net sales of Restasis. The increase in 2008 revenue of approximately $21.8 million, or 45%, was primarily due to product revenue from a full year of net sales of AzaSite,as well as increased co-promotion revenue from net sales of Restasis, partially offset by a decrease in co-promotion revenue from net sales of Elestat. In addition, total revenues for the 2008 period included the recognition of a
development milestone of $1.25 million from Santen for its development of diquafosol tetrasodium in accordance with our development, license and supply agreement, as previously discussed in this report.



Product Sales, net



Product sales of AzaSite,net of rebates and discounts,
for the year ended December 31, 2009 were approximately $35.0 million, as compared to approximately $18.3 million in 2008 and approximately $3.1 million in 2007. AzaSite was launched by us in August 2007. The increase in 2009 revenue for
AzaSiteof approximately $16.7 million, or 91%, as compared to 2008, was primarily due to increased patient and physician usage ofAzaSite, evidenced by an increase of prescriptions year-over-year, as well as a price increase for the
product between the periods. Approximately $3.0 million to $4.0 million of revenue from sales of AzaSite for the year ended December 31, 2009 was associated with hospital usage of AzaSite as a substitute therapy during a temporary
supply shortage of erythromycin ophthalmic ointment (0.5%), as discussed below.



In September 2009, erythromycin ophthalmic ointment was placed on the FDA Drug Shortages website. Erythromycin ophthalmic ointment is a macrolide antibiotic routinely used in neonates for prophylaxis of



54



---

##### Table of Contents

ophthalmia neonatorum, a form of bacterial conjunctivitis that may be contracted by newborns during delivery. Due to this shortage, the Centers for Disease Control and Prevention (CDC) asked
healthcare professionals to reserve erythromycin supplies for neonatal use and also recommended the use of AzaSite as an acceptable substitute for neonatal prophylaxis use when erythromycin was not available. We expect the erythromycin supply
shortage to be resolved in the first quarter of 2010 and future use of AzaSitefor neonatal use, as described above, to be limited.



The increase in AzaSite revenues in 2009 as compared to 2008 was partially offset by an increase in gross-to-net sales deductions. Total
sales deductions as a percentage of gross revenues increased approximately 8%. The increase was primarily attributable to an increase in rebates associated with (1) an increase in the number of formularies that now list AzaSite and
(2) the price concessions required to secure this coverage under Medicare and commercial managed care organizations. Additionally, we incurred an increase in IMA fee rates to wholesalers. The impact of these increases in coverage and IMA fee
rates was approximately $3.6 million in additional provisions in 2009.



For the year ended December 31, 2009, based on prescription data from IMS Health, there were approximately 529,000 prescriptions written for AzaSite,excluding hospital usage, representing
approximately 4% of all prescriptions in the single agent ocular anti-infective market, defined as both branded and generic single-entity ocular antibiotics. In comparison, approximately 303,000 prescriptions were written for AzaSitein 2008,
representing approximately 2% of all prescriptions in the single agent ocular anti-infective market. In addition, our market share in our primary call audience of eye care specialists, mainly ophthalmologists and optometrists, was approximately 11%
as of December 31, 2009, as compared to approximately 7% as of December 31, 2008. Since launch, actual units of AzaSite dispensed have been slightly higher than the number of prescriptions as reported by IMS Health due to the
issuance of multiple unit prescriptions by some physicians. For the year ended December 31, 2009, the single agent ocular anti-infective market, in terms of prescriptions, was relatively unchanged from the prior year.



In July 2007, we started receiving and processing orders for
AzaSite as part of the initial stocking of the supply chain. These initial orders were offered with special terms as stocking incentives for wholesalers. Sales with these special terms were accounted for using the consignment model,
which requires that we defer revenue until such time that the product is resold further into the supply chain or the product is no longer subject to the special terms. As a result, as of December 31, 2007, approximately $371,000 of net
AzaSite revenues were deferred and subsequently recognized in the first quarter of 2008. Sales made subsequent to this specified launch time period include return rights that are customary in the industry. For these orders, we are recording
revenue at the date of shipment, when title and substantially all the risks and rewards of ownership has transferred to the customer.



Product Co-Promotion and Royalty



Total co-promotion and royalty revenue for the year ended December 31, 2009 was approximately $57.2 million, as compared to
approximately $50.9 million in 2008 and approximately $45.5 million in 2007.



Our royalty revenue from net sales of Restasis for the year ended December 31, 2009 was approximately $38.4
million, as compared to approximately $32.8 million in 2008 and approximately $24.4 million in 2007. On December 24, 2008, we amended our agreement with Allergan such that we ceased co-promoting Restasis as of December 31, 2008.
Notwithstanding the fact that we are no longer co-promoting Restasis, Allergan remains obligated to pay us royalties in relation to net sales of Restasisat the rates in effect prior to the December 2008 amendment. For the years ended
December 31, 2009, 2008 and 2007, Allergan recorded revenue from net sales of Restasis of approximately $523 million, $444 million and $345 million, respectively.



The increase in both 2009 and 2008 royalty revenue for Restasis, as compared to 2008 and 2007,
respectively, was primarily due to increased patient usage of Restasisand an increase in prescribers of Restasis,as evidenced by an increase in prescriptions year-over-year. In addition, there were annual price increases in the first
quarters of 2009 and 2008.



55



---

##### Table of Contents

Co-promotion revenue from net sales of Elestatfor the year ended December 31,
2009 was approximately $18.8 million, as compared to approximately $18.1 million in 2008 and approximately $21.1 million in 2007. The increase in co-promotion revenue from net sales of Elestat of $615,000, or 3%, as compared to 2008, was
primarily due to an annual price increase that became effective in the first quarter of 2009, partially offset by a slight decrease in the total U.S. allergic conjunctivitis market in 2009. The decrease in 2008 co-promotion revenue from net sales of
Elestat of $3.0 million, as compared to 2007, was primarily due to a decline in the U.S. allergic conjunctivitis market in terms of prescriptions as well as a decline in Elestats market share based on national prescription data
as provided by IMS Health. This decrease was partially offset by an annual price increase for Elestat that became effective during the first quarter of 2008.



Elestat is a seasonal product with product demand mirroring seasonal trends for topical allergic
conjunctivitis products. Typically, demand is highest during the Spring months followed by moderate demand in the Summer and Fall months. The lowest demand is during the Winter months. Based upon national prescription data from IMS Health, for the
years ended December 31, 2009, 2008 and 2007, Elestat prescriptions, as a percentage of the total U.S. allergic conjunctivitis market, represented approximately 7%, 7% and 9%, respectively, of the total U.S. allergic conjunctivitis
market. Subject to the entry of a generic epinastine product as discussed below, based on current trends in prescriptions for Elestat,we expect our 2010 market share to remain relatively constant with 2009 or slightly decrease. Based upon
monthly data from IMS Health, the total U.S. allergic conjunctivitis market, in terms of prescriptions as compared to the previous year, decreased approximately 1%, 6% and 3%, respectively, for the years ended December 31, 2009, 2008 and 2007,
respectively.



During the
third quarter of 2009, ISTA Pharmaceuticals, Inc. received FDA approval for BepreveTM(bepotastine besilate ophthalmic solution) 1.5% as a twice-daily prescription eye drop treatment for ocular itching associated with allergic conjunctivitis, and began commercializing this product in
October 2009.



Under our agreement with Allergan
related to our co-promotion of Elestat,prior to 2010, we were obligated to meet predetermined minimum calendar year net sales target levels, which increased annually. We were entitled to an escalating percentage of net sales of
Elestat based upon predetermined calendar year net sales target levels. During a fiscal year, we recognized product co-promotion revenue associated with targeted net sales levels for Elestat achieved during that time period and
deferred revenue in excess of the sales level achieved. Under the co-promotion agreement with Allergan, calendar year 2009 was the last year that our co-promotion revenues of Elestat are subject to annual minimum target levels.



Subject to applicable law, competitors are permitted to submit
to the FDA an ANDA for a generic version of Elestat, due to the expiration of the marketing exclusivity period for Elestat provided under the Hatch-Waxman Act on October 15, 2008.



We have been notified that Boehringer Ingelheim and Allergan
received notices from four companies: Apotex, Inc., Cypress Pharmaceutical, Inc., Paddock Laboratories, Inc., and Sandoz Inc., advising that each company filed an ANDA for a generic version of Elestat. The date of submission of the first
filing to the FDA Office of Generic Drugs was October 14, 2008, according to the FDAs website (www.fda.gov). Furthermore, we have been notified by Allergan that Boehringer Ingelheim has decided not to file infringement lawsuits against
the ANDA filers. Boehringer Ingelheim is the owner of a method of treatment patent related toElestat, and we do not have a license to this patent.



TheElestat co-promotion agreement provides that unless earlier terminated, the term of such agreement will be in effect until the
earlier of (i) the approval and launch of the first generic epinastine product after expiration of the FDA exclusivity period coveringElestat in the United States, or (ii) the approval and launch of the first over-the-counter
epinastine product after expiration of the listing ofElestat in the FDAs Orange Book. Following the termination of such co-promotion agreement, we will no longer have rights to co-promoteElestat. We will be entitled to receive
post-termination payments from Allergan, based on any remaining net sales of



56



---

##### Table of Contents

Elestat for a period of 36 months. During the three successive 12-month periods immediately following the termination of the agreement, Allergan will be obligated to pay to us 20%, 15% and
10%, respectively, on any net sales ofElestat in the United States. We expect any revenue from net sales of Elestat received during this 36-month post-termination period to be minimal. We plan to continue co-promoting and receiving
co-promotion revenues onElestat sales during the FDAs review period of these ANDAs. We do not know when the FDA will complete its review but we expect that a generic form of epinastine could be launched in the second half of 2010. Loss
of our co-promotion revenue from Elestat will significantly impact our results of operations and cash flows.



Collaborative Research and Development



In May 2008, Santen completed its Phase 3 clinical testing of diquafosol tetrasodium in Japan, which it refers to as DE-089, for which we
received a milestone payment of $1.25 million. We did not receive any collaborative research and development revenue during 2009 or 2007. Santen is responsible for all development, regulatory submissions, filings and approvals, and the
commercialization of potential products in Japan and nine other Asian countries. We could receive additional development milestone payments from Santen of up to $1.75 million, as well as royalties on net sales of diquafosol tetrasodium, if the
product candidate is approved for commercialization in Santens licensed territories. Santen filed an application for manufacturing and marketing approval of DE-089 with the Japanese Ministry of Health, Labor, and Welfare (the Japanese
equivalent of the FDA) on May 30, 2008, which is pending review.



Our future revenue will depend on various factors including the effectiveness of our commercialization of AzaSiteand continued commercial success and duration of commercial exclusivity of
Restasisand Elestat. In addition to the foregoing, pricing, rebates, discounts and returns for all products; the effect of competing products; coverage and reimbursement under commercial or government plans; and seasonality of sales
of Elestatwill impact future revenues. If Allergan significantly under-estimates or over-estimates rebate amounts, there could be a material effect on our revenue. In addition to the continuing sales of AzaSite, Restasisand
Elestat, our future revenue will also depend on our ability to enter into additional collaboration agreements, and to achieve milestones under existing or future collaboration agreements, as well as whether we obtain regulatory approvals for
our product candidates.



Cost of Sales



Cost of sales related to the sales of
AzaSite were approximately $11.3 million for the year ended December 31, 2009, as compared to approximately $6.4 million in 2008 and approximately $1.6 million in 2007. The increase in cost of sales of $4.9 million, or 76%, as
compared to 2008, was primarily due to increased sales volume of AzaSite,which has resulted in increased royalties, as well as an increase in the royalty rate, paid to InSite Vision. Through June 30, 2009, we paid a 20% royalty to
InSite Vision on net sales ofAzaSitein accordance with our licensing agreement. In July 2009, our royalty rate to InSite Vision on net sales of AzaSiteincreased from 20% to 25% and will remain at 25% for the remaining term of the
licensing agreement.



Cost of sales expense
consists of variable and fixed cost components. Variable cost components include royalties to InSite Vision on net sales of AzaSite, the cost of AzaSite inventory sold, distribution, shipping and logistic service charges from our
third-party logistics provider, and changes to our inventory reserve for overstocking or short-dated material. Fixed cost components are primarily the amortization of the $19.0 million approval milestone that we paid InSite Vision as part of our
licensing agreement. This approval milestone is being amortized ratably on a straight-line basis through the term of the underlying patent coverage for AzaSite, which expires in March 2019.



Certain costs included in cost of sales are subject to annual
increases for which we have limited control. We expect that cost of sales will increase in relation to, but not proportionately to, the increases in revenue from sales of AzaSite.



57



---

##### Table of Contents

Costs and Expenses



Research and Development Expenses



Research and development expenses were approximately $51.1
million for the year ended December 31, 2009, as compared to approximately $44.6 million in 2008 and approximately $53.4 million in 2007.



The increase in research and development expenses of approximately $6.5 million, or 15%, for the year ended December 31, 2009, as
compared to 2008, was primarily due to increased costs associated with our cystic fibrosis program, including the recognition of an approximate $3.3 million milestone payable to Yamasa Corporation upon entering into an agreement to license certain
technology related to manufacturing in support of this program. Effective September 25, 2009, we entered into a technology license agreement with Yamasa Corporation to facilitate the transfer of the current denufosol manufacturing technology,
including intellectual property, to an additional manufacturer and thus enable a two-supplier strategy for denufosol. The remaining increase in research and development expenses was due to the initiation of a Phase 2 program for AzaSitefor
the treatment of blepharitis.



These increases in
research and development expenses for the year ended December 31, 2009 were partially offset by reduced spending on our glaucoma program as a result of the completion of Phase 1 trial activities, the discontinuation of our program for the
development of epinastine nasal spray for allergic rhinitis in 2008, and cost savings from our restructuring activities in the first quarter of 2009.



The decrease in research and development expenses of approximately $8.8 million, or 16%, for the year ended December 31, 2008, as
compared to 2007, was primarily due to a one-time $13.0 million upfront AzaSite licensing fee paid in 2007 which did not occur in 2008. Excluding this one-time fee, our research and development expenses associated with our other product
candidates increased approximately $4.2 million for the year ended December 31, 2008, as compared to 2007, and was primarily due to increased activities associated with our cystic fibrosis and glaucoma product candidates. Additionally, we
incurred a general increase in annual salaries, personnel related expenses and stock-based compensation expense. See Part IItem 1. Business of this report for a detailed development status of these programs.



Research and development expenses include all direct and
indirect costs, including salaries for our research and development personnel, consulting fees, clinical trial costs, including the development and manufacture of drug product for clinical trials, sponsored research costs, clinical trial insurance,
upfront license fees, milestone and royalty payments relating to research and development, and other fees and costs related to the development of product candidates. Research and development expenses vary according to the number of programs in
clinical development and the stage of development of our clinical programs. Later stage clinical programs tend to cost more than earlier stage programs due to the length of the clinical trials and the number of patients enrolled in later stage
clinical trials.



Our future research and
development expenses will depend on the results and magnitude or scope of our clinical activities and requirements imposed by regulatory agencies. Year over year spending on active development programs can vary due to the differing levels and stages
of development activity, the timing of certain expenses and other factors. Accordingly, our research and development expenses may fluctuate significantly from period to period. In addition, if we in-license or out-license rights to product
candidates, our research and development expenses may fluctuate significantly from prior periods.



58



---

##### Table of Contents

Our research and development expenses for the years ended December 31, 2009, 2008 and
2007 and from the respective projects inception are shown below and includes the percentage of overall research and development expenditures for the years listed.



|                                                                          |  |                                       |        |                                              |     |      |   |        |  |      |  |   |        |  |     |  |   |         |  |    
|------------------------------------------------------------------------- |  | ------------------------------------- | ------ | -------------------------------------------- | --- | ---- | - | ------ |  | ---- |  | - | ------ |  | --- |  | - | ------- |  | ---
|                                                                          |  | (In thousands)Year ended
December 31, |        | Cumulative fromInception toDecember 31, 2009 |     | %   
|                                                                          |  | 2009                                  |        | %                                            |     | 2008 |   | %      |  | 2007 |  | % |        | 
|Denufosol tetrasodium for cystic fibrosis(1)                              |  | $                                     | 29,590 |                                              | 58  |      | $ | 18,633 |  | 42   |  | $ | 13,599 |  | 25  |  | $ | 94,370  |  | 26 
|Prolacria (diquafosol tetrasodium) for dry eye disease                    |  |                                       | 6,621  |                                              | 13  |      |   | 7,632  |  | 17   |  |   | 4,181  |  | 8   |  |   | 57,572  |  | 16 
|AzaSitefor blepharitis                                                    |  |                                       | 6,297  |                                              | 12  |      |   | 83     |  |     |  |   |       |  |    |  |   | 6,380   |  | 2  
|INS115644 and INS117548 for glaucoma and related research and development |  |                                       | 1,555  |                                              | 3   |      |   | 5,552  |  | 12   |  |   | 5,235  |  | 10  |  |   | 16,447  |  | 5  
|Epinastine nasal spray for allergic rhinitis(2)                           |  |                                       | 40     |                                              |    |      |   | 3,383  |  | 8    |  |   | 7,991  |  | 15  |  |   | 19,889  |  | 5  
|AzaSite(3)                                                                |  |                                       | 2,311  |                                              | 5   |      |   | 1,621  |  | 4    |  |   | 14,598 |  | 27  |  |   | 18,530  |  | 5  
|Other research, preclinical and development costs(4)                      |  |                                       | 4,720  |                                              | 9   |      |   | 7,733  |  | 17   |  |   | 7,787  |  | 15  |  |   | 150,787 |  | 41 
|                                                                          |  |                                       |        |                                              |     |      |   |        |  |      |  |   |        |  |     |  |   |         |  |    
|Total                                                                     |  | $                                     | 51,134 |                                              | 100 |      | $ | 44,637 |  | 100  |  | $ | 53,391 |  | 100 |  | $ | 363,975 |  | 100
|                                                                          |  |                                       |        |                                              |     |      |   |        |  |      |  |   |        |  |     |  |   |         |  |    



|(1) | Includes the recognition of an approximate $3.3 million milestone in September 2009.
|--- | ------------------------------------------------------------------------------------

|(2) | In April 2008, we discontinued the development of epinastine nasal spray.
|--- | -------------------------------------------------------------------------

|(3) | Expense in 2007 includes a $13.0 million upfront licensing fee upon the signing of the license agreement with InSite Vision.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|(4) | Prior to February 2009, other research, preclinical and development costs represent all unallocated research and development costs or those costs allocated to
preclinical programs as well as costs of discontinued and/or inactive programs. These unallocated costs included personnel costs of our research, preclinical programs, internal and external general research costs and other internal and external
costs of other research, preclinical and development programs. In February 2009, we restructured our operations eliminating our preclinical and molecule discovery activities.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Selling and Marketing Expenses



Selling and marketing expenses were approximately $49.3 million
for the year ended December 31, 2009, as compared to approximately $54.6 million in 2008 and approximately $45.5 million in 2007.



The decrease in selling and marketing expenses of approximately $5.3 million, or 10%, for the year ended December 31, 2009, as compared
to 2008, was due to an overall reduction in promotional and marketing activities, including Phase 4 clinical trial activities, partially offset by a general increase in personnel related expenses, including stock-based compensation expense.



The increase in selling and marketing expenses of
approximately $9.1 million, or 20%, for the year ended December 31, 2008, as compared to 2007, resulted from an overall increase in various expenses primarily associated with the full year commercialization of AzaSite, including a full
year of expenses related to our expanded sales force and managed markets group. Additionally, we had increased marketing and promotional activities and Phase 4 program costs in 2008. We also incurred a general increase in annual salaries, personnel
related expenses and stock-based compensation expense.



Our commercial organization currently focuses its promotional efforts on approximately 9,000 eye care specialists. Our selling and marketing expenses include all direct costs associated with the commercial



59



---

##### Table of Contents

organization, which include our sales force and marketing programs. Our sales force expenses include salaries, training and educational program costs, product sample costs, fleet management and
travel. Our marketing and promotion expenses include product management, promotion, advertising, public relations, Phase 4 clinical trial costs, physician training and continuing medical education and administrative expenses. We adjust the timing,
magnitude and targeting of our advertising, promotional, Phase 4 clinical trials and other commercial activities for our products based on seasonal trends and other factors, and accordingly, these costs can fluctuate from period to period.



Future selling and marketing expenses will depend
on the level of our future commercialization activities. We expect selling and marketing expenses will increase in periods that immediately precede and follow product launches. In addition, if we in-license or out-license rights to products, our
selling and marketing expenses may fluctuate significantly from prior periods.



General and Administrative Expenses



General and administrative costs were approximately $16.1 million for the year ended December 31, 2009, as compared to approximately
$14.5 million in 2008 and approximately $14.0 million in 2007.



The increase in general and administrative expenses of approximately $1.5 million, or 10%, for the year ended December 31, 2009, as compared to 2008, was primarily due to an increase in consulting
and legal expenses, as well as an increase in personnel related expenses and stock-based compensation. These increases were partially offset by a final reimbursement of legal fees in 2009 received from our insurance provider of approximately
$875,000 related to our stockholder litigation and SEC investigation.



The increase in general and administrative expenses of approximately $554,000, or 4%, for the year ended December 31, 2008, as compared to 2007, was primarily due to a general increase in annual
salaries, personnel related expenses and stock-based compensation expense as well as an increase in legal and administrative expenses associated with our stockholder litigation and SEC investigation. These increases were partially offset by a
reduction in consulting fees during 2008. In addition, general and administrative expenses for 2007 include a large initial reimbursement of legal fees received from our insurance provider related to our stockholder litigation and SEC investigation.



On September 30, 2008, the SEC approved a
non-monetary settlement of the previously announced investigation of Inspire and two of our officers by the SEC staff relating to our disclosures regarding a Phase 3 clinical trial of our dry eye product candidate, Prolacria.



On July 26, 2007, the United States District Court for the
Middle District of North Carolina granted Inspires and the other defendants motion and dismissed the previously announced Consolidated Class Action Complaint with prejudice. On December 12, 2008, the Fourth Circuit of the Unites
States Court of Appeals issued an opinion affirming the judgment of the District Court.



Our general and administrative expenses consist primarily of personnel, facility and related costs for general corporate functions, including business development, finance, accounting, legal, human
resources, quality/compliance, facilities and information systems.



Future general and administrative expenses will depend on the level and extent of support required to conduct our future research and development, commercialization, business development, and corporate
activities.



Restructuring



In March 2009, we announced that we had restructured our
operations during the first quarter of 2009, eliminating preclinical and drug discovery activities and refocusing our resources on the development of existing



60



---

##### Table of Contents

later-stage clinical programs and commercially available products. In connection with the restructuring, we recorded restructuring charges of approximately $2.0 million for the year ended
December 31, 2009, which are reported in a separate line item in our Statement of Operations. Significant components of the restructuring charge were one-time termination benefits for employees impacted by the restructuring, estimated costs to
write-down idle lab equipment to net realizable value, losses associated with leased lab space that is now vacant, and costs to satisfy contract commitments related to activities and programs no longer associated with our supported programs and
on-going operations. As a result of this restructuring, cost savings for 2009 were approximately $3 million to $3.5 million.



Other Income (Expense)



For the year ended December 31, 2009, we incurred other expense, net of approximately $2.4 million, as compared to approximately $1.9
million in other expense, net in 2008 and approximately $2.1 million in other income, net in 2007.



The increase in other expense, net of approximately $415,000 for the year ended December 31, 2009, as compared to 2008, was due to
decreased interest income partially offset by a decrease in interest expense. Interest income was negatively impacted due to lower average cash and investment balances combined with a lower rate of return during 2009, as compared to 2008. The
decrease in interest expense is the result of a lower average outstanding principal balance of our term loan facility during 2009, as compared to 2008.



The decrease in other income of approximately $4.0 million for the year ended December 31, 2008, as compared to 2007, was due to a
combination of decreased interest income and increased interest expense. Interest income was negatively impacted due to a lower rate of return on our cash and investments as well as lower average cash and investment balances in 2008 compared to
2007. The increase in interest expense was associated with additional borrowings of an aggregate of $40.0 million during 2007 under our term loan facility.



Other income/(expense) fluctuates from year to year depending on the level of interest income earned on variable cash and investment
balances, realized gains and losses on investments due to changes in fair market value and interest expense on debt and capital lease obligations. Future other income/(expense) will depend on our future cash and investment balances, the return and
change in fair market value on these investments, as well as levels of debt and the associated interest rates.



Liquidity and Capital Resources



We have financed our operations primarily through the sale of equity securities, including private sales of preferred stock and public
offerings of common stock and, to a lesser extent, through our term loan facility. We also currently receive co-promotion revenue from net sales of Elestat, royalty revenue from net sales of Restasis, and product revenue from net sales
of AzaSite. We do not expect our revenue to exceed our operating expenses in 2010.



At December 31, 2009, we had net working capital of approximately $85.4 million, an increase of approximately $32.9 million from approximately $52.5 million at December 31, 2008. The increase in
working capital was principally due to the sale of common stock described below, offset by the funding of normal operating expenses associated with commercialization activities and the development of our product candidates, as well as principal and
interest payments on our term loan facility. Our principal sources of liquidity at December 31, 2009 were approximately $52.3 million in cash and cash equivalents, approximately $76.0 million in investments, which are considered
available-for-sale, and approximately $22.7 million in trade receivables.



In August 2009, we completed a public offering of 25,555,555 shares of our common stock at a price of $4.50 per share, which included an additional 3,333,332 shares underwriter over-allotment option, for
gross proceeds of $115 million. Net proceeds were $109 million, after deducting underwriting discounts and offering expenses.



61



---

##### Table of Contents

In July 2007, we completed a sale of preferred stock to Warburg pursuant to which we sold
140,186 shares of our Exchangeable Preferred Stock at a price per share of $535.00, for net proceeds of $73.6 million. The Exchangeable Preferred Stock was exchanged for 14,018,600 shares of common stock on October 31, 2007.



In December 2006, we entered into a loan and security agreement
in order to obtain debt financing of up to $40.0 million to fund in-licensing opportunities and related development. In June 2007, we amended the loan and security agreement to enable us to draw upon a new supplemental term loan facility in the
amount of $20.0 million. We have borrowed the full $60.0 million under the term loan facility of which $25.2 million remained outstanding as of December 31, 2009. We make scheduled principal and interest payments on a monthly basis and all loan
advances made under the agreement have a final maturity date in March 2011. See Note 9 Debt to our financial statements for further discussion regarding the term loan facility.



In March 2009, we announced that we had restructured our
operations during the first quarter of 2009, eliminating preclinical and drug discovery activities and refocusing our resources on the development of existing later-stage clinical programs and commercially available products. As a result of this
restructuring, we expect to eliminate future cash expenditures of approximately $6 million on an annual basis subsequent to 2009.



Our working capital requirements may fluctuate in future periods depending on many factors, including: the number, magnitude, scope and
timing of our development programs; the commercial potential and success of our products; the potential loss of commercial exclusivity of any of our products; the loss of revenue from our products due to competition or loss of market share; the
level of ongoing costs related to the commercialization of AzaSiteand Elestat; the costs related to the potential FDA approval of our other product candidates; the cost, timing and outcome of regulatory reviews, regulatory
investigations, and changes in regulatory requirements; the costs of obtaining patent protection for our product candidates; the timing and terms of business development activities; the rate of technological advances relevant to our operations; the
timing, method and cost of the commercialization of our product candidates; the efficiency of manufacturing processes developed on our behalf by third parties; the level of required administrative support for our daily operations; the availability
of capital to support product candidate development programs we pursue; and the commercial potential of our product candidates.



2010 Financial Guidance



Based upon current trends and assumptions, we expect to record 2010 aggregate revenue in the range of $100-$111 million. Co-promotion revenue
from net sales of Elestatwill be dependent upon the timing of a launch of a generic form of epinastine which we expect may occur in the second half of 2010. Furthermore, hospital usage of AzaSiteis expected to decline significantly
due to the resolution of the supply shortage of erythromycin ophthalmic ointment (0.5%) in the first quarter of 2010. Total 2010 operating expenses are expected to be in the range of $145-$169 million based on our planned activities. Cost of sales,
which includes the amortization of the AzaSite approval milestone and royalty obligations to InSite Vision, is expected to be in the range of $13-$18 million. Total estimated selling and marketing and general and administrative expenses are
estimated to be in the range of $48-$53 million and $27-$32 million, respectively. Research and development expenses are estimated to be in the range of $60-$70 million. Included within this operating expense guidance are projected stock-based
compensation costs of approximately $8-$12 million. Due to expense associated with our CEO transition, primarily stock-based compensation expense, we expect the first quarter 2010 general and administrative expenses to be the largest as compared to
the remaining quarters of 2010. In addition, a significant portion of our promotional activities usually occur during the first quarter of each year. As a result, we expect that the first quarter commercial expenses will be the largest of 2010.



Our ability to remain within our operating
expense target range is subject to multiple factors, including unanticipated cost overruns, the need to expand or reduce the magnitude or scope of existing development programs, the need to change the number or timing of clinical trials,
unanticipated regulatory requirements, unanticipated costs to successfully commercialize our products and product candidates, the commercial success of our current products and other factors described under the Risk Factors located elsewhere in this
report.



62



---

##### Table of Contents

Operating cash utilization in 2010 is expected to be in the range of $58-$73 million, which
incorporates $20 million of principal repayment on our outstanding debt. Our need for additional working capital will largely be determined by the commercial success of our products and the successful and timely completion of our development
programs. In order for us to continue operations substantially beyond 2010 we will need to: (1) successfully increase revenues, (2) obtain additional product candidate approvals, (3) out-license rights to certain of our product
candidates, (4) raise additional capital through equity or debt financings or from other sources, (5) reduce spending on one or more research and development programs and/or (6) further restructure our operations. Additionally, after
deducting the $115 million of common stock sold in August 2009, we retain the ability to offer for sale $15 million of securities, including common stock, preferred stock, debt securities, depositary shares and securities warrants from an effective
shelf registration statement which we filed with the SEC on March 9, 2007. The loan and security agreement that we entered into in December 2006, as amended in June 2007, contains a financial covenant that requires us to maintain certain levels
of liquidity based on our cash, investment and account receivables balances, as well as negative covenants that may limit us from assuming additional indebtedness and entering into other transactions as defined in the agreement. The agreement also
includes a subjective acceleration clause which provides our lenders with the ability to accelerate repayment, even if we are in compliance with all conditions of the agreement, upon a material adverse change to our business, properties, assets,
financial condition or results of operations. At December 31, 2009, we were in compliance with all of the covenants under our loan and security agreement and project that we will be throughout 2010.



Contractual Obligations and Commitments



In the normal course of business, we
enter into various agreements that create contractual obligations and commitments that may require future cash payments. Contractual obligations at December 31, 2009 included operating leases of $2.6 million, long-term borrowings of $25.2
million, interest payments of $1.4 million, and purchase obligations and other commitments, as further described below.



As part of our drug development strategy, we outsource significant amounts of our preclinical and clinical programs and the manufacture of
drug substance used in those programs. In addition, we have manufacturing, promotion and clinical responsibilities and activities associated with the commercialization of AzaSite. Based on these requirements and activities, we have entered
into contractual commitments or purchase obligations with various clinical research organizations, promotion and advertising agencies, manufacturers of active pharmaceutical ingredients and drug product for clinical and commercial use as well as
with others. These financial commitments, which totaled approximately $17.5 million as of December 31, 2009, are reflected as purchase obligations in the table below and include both cancelable and non-cancelable arrangements. Since many of
these commitment amounts are dependent upon variable components of the agreements, actual payments and the timing of those payments may differ from managements estimates.



The terms of our existing license, collaboration and sponsored research agreements may require that we make
cash payments contingent upon the occurrence of certain future events. In the aggregate, these agreements may require payments of up to $21.4 million assuming the achievement of all development milestones and up to an additional $4.0 million
assuming the achievement of all sales milestones. Amounts payable by us under these agreements are uncertain and are contingent on a number of factors, including the progress of our research, preclinical and development programs, our ability to
obtain regulatory approvals, the commercial success of our approved products and future annual product sales levels.



If certain of our product candidates are approved by the FDA and are subsequently commercialized, we will be obligated to pay royalties on
net sales of the commercialized products. See Part IItem 1. BusinessCollaborative Agreements of this report for a full discussion of our royalty obligations under our in-licensing agreement with Wisconsin Alumni Research Foundation
for our glaucoma product candidates. In addition, we are obligated to pay royalties to InSite Vision as part of our in-licensing agreement for AzaSite.Under the terms of the agreement, our obligation to pay royalties to InSite Vision is
subject to pre-determined minimum annual



63



---

##### Table of Contents

royalty payments. The determination of whether or not we will owe any such payments is based upon the amount of royalties accrued over a 12-month royalty period. There are five successive
12-month minimum royalty periods, the first of which commenced on October 1, 2008. The minimum royalties escalate each year. Remaining minimum royalties as of December 31, 2009 total $60.0 million.



The table below reflects contractual and potential obligations
as of December 31, 2009. Some of the figures we include in this table are based on managements estimate and assumptions about these obligations, including their duration, the possibility of renewal, anticipated actions by third parties,
and other factors as previously described. Because these estimates and assumptions are necessarily subjective, the obligations we will actually pay in future periods may vary from those reflected in the table:



|                                                     |  |                                                            |         |                 |   |          |  |          |        |                  |   |        |  |   |      
|---------------------------------------------------- |  | ---------------------------------------------------------- | ------- | --------------- | - | -------- |  | -------- | ------ | ---------------- | - | ------ |  | - | -----
|                                                     |  | (In thousands)Payment due by
Periodas of December 31, 2009
|Contractual and Potential Obligations                |  | Total                                                      |         | Less than1 year |   | 1-3years |  | 3-5years |        | More than5
years
|Debt Obligations                                     |  | $                                                          | 25,175  |                 | $ | 19,940   |  | $        | 5,235  |                  | $ |       |  | $ |     
|Interest on Debt Obligations                         |  |                                                            | 1,350   |                 |   | 1,280    |  |          | 70     |                  |   |       |  |   |     
|Operating Lease Obligations(1)                       |  |                                                            | 2,626   |                 |   | 1,751    |  |          | 875    |                  |   |       |  |   |     
|Purchase Obligations(2)                              |  |                                                            | 17,489  |                 |   | 15,195   |  |          | 2,294  |                  |   |       |  |   |     
|Minimum Annual License Payments                      |  |                                                            | 25      |                 |   | 25       |  |          |       |                  |   |       |  |   |     
|Development Milestone Obligations(3)(4)              |  |                                                            | 21,350  |                 |   | 3,250    |  |          | 7,950  |                  |   | 4,800  |  |   | 5,350
|Minimum Royalties and Sales Milestone Obligations(4) |  |                                                            | 64,000  |                 |   | 9,000    |  |          | 32,000 |                  |   | 19,000 |  |   | 4,000
|                                                     |  |                                                            |         |                 |   |          |  |          |        |                  |   |        |  |   |      
|Total                                                |  | $                                                          | 132,015 |                 | $ | 50,441   |  | $        | 48,424 |                  | $ | 23,800 |  | $ | 9,350
|                                                     |  |                                                            |         |                 |   |          |  |          |        |                  |   |        |  |   |      



|(1) | Includes estimated payments of $1,219 for the cancelable portion of operating leases, primarily our fleet vehicles under a master lease agreement. See Note 14,
Commitments and Contingencies for a full discussion.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Purchase obligations reflect all contractual obligations, including amounts that are cancelable, under legally enforceable contracts with contract terms that are both
fixed and determinable. These amounts exclude obligations for goods and services that already have been incurred and are reflected on our Balance Sheet as of December 31, 2009.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Includes $1.9 million of other long-term liabilities as recorded on our Balance Sheet as of December 31, 2009.
|--- | ----------------------------------------------------------------------------------------------------------------

|(4) | Development and sales milestone obligations represent potential amounts payable by us contingent on a number of factors, including the progress of our research,
preclinical and development programs, our ability to obtain regulatory approvals, and the commercial success of our approved products.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Impact of Recently Issued Accounting Pronouncements



In January 2010, the FASB issued authoritative guidance for improving disclosures about fair value measurements. This guidance requires some
new disclosures and clarifies some existing disclosure requirements about fair value measurement. The new disclosure requirements are effective for interim and annual reporting periods beginning after December 15, 2009, except for the
disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods
within those fiscal years. Since the new guidance only impacts financial statement disclosures, there will be no impact to our financial position or results of operations upon adoption.



In October 2009, the FASB issued authoritative guidance regarding revenue arrangements with multiple
deliverables. The guidance requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The guidance further eliminates the



64



---

##### Table of Contents

residual method of revenue allocation and requires revenue to be allocated using the relative selling price method. The new guidance should be applied on a prospective basis for revenue
arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. We are currently assessing the impact of adopting this new guidance.



In August 2009, the FASB issued authoritative guidance regarding
measuring liabilities at fair value. The authoritative guidance sets forth the types of valuation techniques to be used to value a liability when a quoted price in an active market for the identical liability is not available. It also clarifies
transfer restrictions on the fair value of a liability and the ability to use the fair value of a liability that is traded as an asset as an input to the valuation of the underlying liability. The authoritative guidance is effective for interim and
annual periods beginning after August 26, 2009. We have assessed the impact of this new guidance and expect no material impact to our financial statements upon adoption.



In May 2009, the FASB issued authoritative guidance regarding subsequent events. The authoritative guidance
establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The authoritative guidance is effective for interim and annual
periods ending after June 15, 2009.



In April
2009, the FASB issued authoritative guidance to aid in determining fair value when the volume and level of activity for the assets or liabilities have significantly decreased and when identifying transactions are not orderly, such as a forced
liquidation or distressed sale. The authoritative guidance became effective for us on April 1, 2009 and the adoption of the guidance did not have a material impact on our consolidated financial statements.



In April 2009, the FASB issued authoritative guidance on the
recognition and presentation of other-than-temporary impairments. The authoritative guidance incorporates impairment guidance for debt securities from various sources of authoritative literature and clarifies the interaction of the factors that
should be considered when determining whether a debt security is other than temporarily impaired. The authoritative guidance became effective for us on April 1, 2009 and the adoption of the guidance did not have a material impact on our
consolidated financial statements.



In April 2009,
the FASB issued authoritative guidance to require disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements. The authoritative guidance is effective for interim periods
ending after June 15, 2009, and we have adopted the guidance and have provided the additional disclosures as required.



Item 7A. Quantitative and Qualitative Disclosures About Market Risk.



Interest Rate Risk



We are subject to interest rate risk on our investment
portfolio and borrowings under our term loan facility.



We invest in marketable securities in accordance with our investment policy. The primary objectives of our investment policy are to preserve capital, maintain proper liquidity to meet operating needs and maximize yields. Our investment
policy specifies credit quality standards for our investments and limits the amount of credit exposure to any single issue, issuer or type of investment. Our investment portfolio may consist of a variety of securities, including United States
government and government agency obligations, money market and mutual fund investments, municipal and corporate notes and bonds and asset or mortgage-backed securities. As of December 31, 2009, cash equivalents consisted of $6.4 million in a
money market account and $36.1 million in money market funds and $5.0 million in a U.S. government agency security with a maturity less than 90 days. Our investment portfolio as of December 31, 2009 consisted of corporate notes and bonds,
commercial paper, U.S. Government and agency securities, and negotiated certificates of deposit and had an average maturity of less than 12 months, using the stated maturity. All of our cash, cash equivalents and investments are maintained at two
banking institutions.



65



---

##### Table of Contents

Our investment exposure to market risk for changes in interest rates relates to the increase
or decrease in the amount of interest income we can earn on our portfolio, changes in the market value due to changes in interest rates and other market factors as well as the increase or decrease in any realized gains and losses. Our investment
portfolio includes only marketable securities and instruments with active secondary or resale markets to help ensure portfolio liquidity and we have implemented guidelines limiting the duration of investments. At December 31, 2009, our
portfolio of available-for-sale investments consisted of approximately $54.4 million of investments maturing within one year and approximately $21.7 million of investments maturing after one year but within 24 months. In general, securities with
longer maturities are subject to greater interest-rate risk than those with shorter maturities. A hypothetical 100 basis point drop in interest rates along the entire interest rate yield curve would not significantly affect the fair value of our
interest sensitive financial instruments. We generally have the ability to hold our fixed-income investments to maturity and therefore do not expect that our operating results, financial position or cash flows will be materially impacted due to a
sudden change in interest rates. However, our future investment income may fall short of expectations due to changes in interest rates, or we may suffer losses in principal if forced to sell securities which have declined in market value due to
changes in interest rates or other factors, such as changes in credit risk related to the securities issuers.



We do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure the safety and preservation of
invested principal funds by limiting default risk, market risk and reinvestment risk. We reduce default risk by investing in investment grade securities.



Our risk associated with fluctuating interest expense is limited to future capital leases and other short-term debt obligations we may incur
in our normal operations. The interest rates on our long-term debt borrowings under the term loan facility are fixed and as a result, interest due on borrowings are not impacted by changes in market-based interest rates.



Investment Risk



In addition to our normal investment portfolio, we have an
investment in Parion Sciences, Inc. of $200,000 as of December 31, 2009. This investment is in the form of unregistered common stock and is subject to higher investment risk than our normal investment portfolio due to the lack of an active
resale market for the Parion Sciences, Inc. securities.



Foreign Currency Exchange Risk



The majority of our transactions occur in U.S. dollars and we do not have subsidiaries or investments in foreign countries. Therefore, we are not subject to significant foreign currency exchange risk. We do, however, have foreign currency
exposure with regard to the purchase of active pharmaceutical ingredients as they relate to AzaSite, which is manufactured by a foreign-based company, future milestone payments due under the technology license agreement with Yamasa
Corporation, as well as development activities currently ongoing in Europe. We have established policies and procedures for assessing market and foreign exchange risk. As of December 31, 2009, we did not have any material foreign currency
hedges.



Item 8. Financial
Statements and Supplementary Data.



The
financial statements required to be filed pursuant to this Item 8 are appended to this Annual Report on Form 10-K. A list of the financial statements filed herewith is found at Index to Financial Statements on page F-1.



Item 9. Changes in and Disagreements with
Accountants on Accounting and Financial Disclosure.



Not applicable.



66



---

##### Table of Contents

Item 9A. Controls and Procedures.



Evaluation of Disclosure Controls and Procedures



Our management is responsible for establishing and maintaining
an adequate system of internal control over our financial reporting. The design, monitoring and revision of the system of internal accounting controls involves, among other items, managements judgments with respect to the relative cost and
expected benefits of specific control measures. The effectiveness of the control system is supported by the selection, retention and training of qualified personnel and an organizational structure that provides an appropriate division of
responsibility and formalized procedures. The system of internal accounting controls is periodically reviewed and modified in response to changing conditions. Internal audit consultants regularly monitor the adequacy and effectiveness of internal
accounting controls. In addition to the system of internal accounting controls, management maintains corporate policy guidelines that help monitor proper overall business conduct, possible conflicts of interest, compliance with laws and
confidentiality of proprietary information. Our Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Securities
Exchange Act of 1934 as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our current disclosure controls and procedures are effective.



Managements Report on Internal Control Over Financial Reporting



Our management is responsible for establishing
and maintaining adequate internal control over our financial reporting as defined in Rules 13a-15(f) and 15d-15(f) of the Securities Exchange Act of 1934, and for performing an assessment of the effectiveness of internal control over financial
reporting as of December 31, 2009. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting principles. Our system of internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.



Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the
framework in Internal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, management, including our principal executive officer and principal
financial officer, concluded that our internal control over financial reporting was effective as of December 31, 2009. The effectiveness of our internal control over financial reporting as of December 31, 2009 has been audited by
PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is presented in this Annual Report on Form 10-K.



Changes in Control Over Financial Reporting



There were no changes in our internal control over financial reporting identified in connection with the evaluation of our internal control
that occurred during our last fiscal quarter, which have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



Audit Committee Oversight



The Audit Committee of the Board of Directors, consisting solely of independent directors, appoints the independent registered public
accounting firm and receives and reviews the reports submitted by them. The Audit



67



---

##### Table of Contents

Committee meets several times during the year with management, the internal auditors and the independent registered public accounting firm to discuss audit activities, internal controls and
financial reporting matters. The internal auditors and the independent registered public accounting firm have full and free access to the Audit Committee.



Item 9B. Other Information.



Not applicable.



68



---

##### Table of Contents

PART III



Item 10. Directors, Executive Officers and Corporate Governance.



The information required by this item is
incorporated by reference to the material responsive to this item contained in our Proxy Statement to be filed in connection with our 2010 Annual Meeting of Stockholders.



Item 11. Executive Compensation.



The information required by this item is incorporated by reference to the material responsive to this item
contained in our Proxy Statement to be filed in connection with our 2010 Annual Meeting of Stockholders.



Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.



The following table sets forth certain information with respect
to securities authorized for issuance under equity incentive plans as of December 31, 2009.



Equity Compensation Plan Information



|                                                           |  |                                                                                             |  |                                                                              |      |                                                                                                                                           |          
|---------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------------------------- | ---- | ----------------------------------------------------------------------------------------------------------------------------------------- | ---------
|Plan category                                              |  | (a)Number of securities to beissued upon exercise ofoutstanding options,warrants and rights |  | (b)Weighted-average exerciseprice of outstanding options,warrants and rights |      | (c)Number of securities remainingavailable for future issuanceunder equity compensationplans (excluding securitiesreflected in column(a))
|Equity compensation plans approved by security holders     |  | 11,175,516                                                                                  |  | $                                                                            | 7.47 |                                                                                                                                           | 1,284,708
|Equity compensation plans not approved by security holders |  | 0                                                                                           |  |                                                                              | 0    |                                                                                                                                           | 0        
|                                                           |  |                                                                                             |  |                                                                              |      |                                                                                                                                           |          
|Total                                                      |  | 11,175,516                                                                                  |  | $                                                                            | 7.47 |                                                                                                                                           | 1,284,708



The additional information required by this item is incorporated by reference to the material responsive to this item contained in our Proxy
Statement to be filed in connection with our 2010 Annual Meeting of Stockholders.



Item 13. Certain Relationships and Related Transactions, and Director Independence.



The information required by this item is incorporated by reference to the material responsive to this item contained in our
Proxy Statement to be filed in connection with our 2010 Annual Meeting of Stockholders.



Item 14. Principal Accountant Fees and Services.



The information required by this item is incorporated by reference to the material responsive to this item contained in our Proxy Statement
to be filed in connection with our 2010 Annual Meeting of Stockholders.



69



---

##### Table of Contents

PART IV



Item 15. Exhibits and Financial Statements Schedules.



(a) The following documents are included as part of this Annual Report on Form
10-K:



1. Financial Statements:



|                                                        |  |     
|------------------------------------------------------- |  | ----
|                                                        |  | Page
|Report of Independent Registered Public Accounting Firm |  | F-2 
|Balance Sheets                                          |  | F-3 
|Statements of Operations                                |  | F-4 
|Statements of Cash Flows                                |  | F-5 
|Statements of Stockholders Equity                      |  | F-6 
|Notes to Financial Statements                           |  | F-7 



2. Financial Statement Schedule:



Schedule of Valuation and Qualifying Accounts

(in thousands)



|                                                              |  |                              |         |                         |   |                          |  |   |               |  |   |        |      |  |   |        
|------------------------------------------------------------- |  | ---------------------------- | ------- | ----------------------- | - | ------------------------ |  | - | ------------- |  | - | ------ | ---- |  | - | -------
|                                                              |  | BeginningBalance             |         | Additions               |   | DeductionsfromAllowances |  |   | EndingBalance
|                                                              |  | Charged toCosts and Expenses |         | Charged toOtherAccounts |   |                         
|Year ended December 31, 2007                                  |  |                              |         |                         |   |                          |  |   |               |  |   |        |      |  |   |        
|Allowance for rebates, chargebacks and other sales incentives |  | $                            |        |                         | $ | 366                      |  | $ | 58            |  | $ | (186   | )    |  | $ | 238    
|Allowance for returns                                         |  |                              |        |                         |   | 105                      |  |   | 13            |  |   | (23    | )    |  |   | 95     
|Allowance for uncollectible accounts                          |  |                              |        |                         |   | 10                       |  |   |              |  |   |       |      |  |   | 10     
|Inventory allowance                                           |  |                              |        |                         |   | 125                      |  |   |              |  |   |       |      |  |   | 125    
|Valuation allowance for income taxes                          |  |                              | 110,008 |                         |   | 27,201                   |  |   |              |  |   | (4,000 | )(1) |  |   | 133,209
|                                                              |  |                              |         |                         |  
|Year ended December 31, 2008                                  |  |                              |         |                         |   |                          |  |   |               |  |   |        |      |  |   |        
|Allowance for rebates, chargebacks and other sales incentives |  | $                            | 238     |                         | $ | 2,888                    |  | $ |              |  | $ | (1,824 | )    |  | $ | 1,302  
|Allowance for returns                                         |  |                              | 95      |                         |   | 677                      |  |   |              |  |   | (71    | )    |  |   | 701    
|Allowance for uncollectible accounts                          |  |                              | 10      |                         |   |                         |  |   |              |  |   | (3     | )    |  |   | 7      
|Inventory allowance                                           |  |                              | 125     |                         |   | 105                      |  |   |              |  |   | (220   | )    |  |   | 10     
|Valuation allowance for income taxes                          |  |                              | 133,209 |                         |   | 25,321                   |  |   |              |  |   |       |      |  |   | 158,530
|                                                              |  |                              |         |                         |  
|Year ended December 31, 2009                                  |  |                              |         |                         |   |                          |  |   |               |  |   |        |      |  |   |        
|Allowance for rebates, chargebacks and other sales incentives |  | $                            | 1,302   |                         | $ | 9,531                    |  | $ |              |  | $ | (6,456 | )    |  | $ | 4,377  
|Allowance for returns                                         |  |                              | 701     |                         |   | 1,560                    |  |   |              |  |   | (738   | )    |  |   | 1,523  
|Allowance for uncollectible accounts                          |  |                              | 7       |                         |   | 43                       |  |   |              |  |   |       |      |  |   | 50     
|Inventory allowance                                           |  |                              | 10      |                         |   | 15                       |  |   |              |  |   |       |      |  |   | 25     
|Valuation allowance for income taxes                          |  |                              | 158,530 |                         |   | 19,629                   |  |   |              |  |   |       |      |  |   | 178,159



|(1) | Deduction as a result of implementing FASB guidance on accounting for uncertainty in income taxes.
|--- | --------------------------------------------------------------------------------------------------



For additional information regarding the Companys reserves
and allowances for rebates, chargebacks, discounts and returns, seeManagements Discussion and Analysis of Financial Condition and Results of OperationsRevenue Recognition.



All other schedules are omitted as the information required is
inapplicable or the information is presented in the financial statements.



3. Exhibits:



See the Exhibit Index located at the end of this document.



70



---

##### Table of Contents

SIGNATURES



Pursuant to the requirements of Section 13 of 15(d) the
Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



Inspire Pharmaceuticals, Inc.By:

/s/    ADRIAN
ADAMSAdrian Adams President & Chief Executive Officer and DirectorDate: March 15, 2010




Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.



|                                               |  |                                                                                                    |  |               
|---------------------------------------------- |  | -------------------------------------------------------------------------------------------------- |  | --------------
|Signature                                      |  | Title                                                                                              |  | Date          
|                                               |  |                                                                                                   
|/s/    ADRIAN
ADAMS Adrian Adams               |  | President & Chief Executive Officer (principal executive officer) and Director                     |  | March 15, 2010
|                                               |  |                                                                                                   
|/s/    THOMAS R. STAAB,
II Thomas R. Staab, II |  | Chief Financial Officer & Treasurer (principal financial officer and principal accounting officer) |  | March 15, 2010
|                                               |  |                                                                                                   
|/s/    KENNETH B. LEE,
JR. Kenneth B. Lee, Jr. |  | Chairman of the Board of Directors                                                                 |  | March 15, 2010
|                                               |  |                                                                                                   
|/s/    GEORGE
ABERCROMBIE George Abercrombie   |  | Director                                                                                           |  | March 15, 2010
|                                               |  |                                                                                                   
|/s/    KIP A.
FREY Kip A. Frey                 |  | Director                                                                                           |  | March 15, 2010
|                                               |  |                                                                                                   
|/s/    ALAN F.
HOLMER Alan F. Holmer           |  | Director                                                                                           |  | March 15, 2010
|                                               |  |                                                                                                   
|/s/    NANCY J.
HUTSON Nancy J. Hutson         |  | Director                                                                                           |  | March 15, 2010
|                                               |  |                                                                                                   
|/s/    JONATHAN S.
LEFF Jonathan S. Leff       |  | Director                                                                                           |  | March 15, 2010
|                                               |  |                                                                                                   
|/s/    RICHARD S.
KENT Richard S. Kent         |  | Director                                                                                           |  | March 15, 2010



71



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



INDEX TO FINANCIAL STATEMENTS



|                                                        |  |        
|------------------------------------------------------- |  | -------
|                                                        |  | Page(s)
|Report of Independent Registered Public Accounting Firm |  | F-2    
|                                                        | 
|Balance Sheets                                          |  | F-3    
|                                                        | 
|Statements of Operations                                |  | F-4    
|                                                        | 
|Statements of Cash Flows                                |  | F-5    
|                                                        | 
|Statements of Stockholders Equity                      |  | F-6    
|                                                        | 
|Notes to Financial Statements                           |  | F-7    



F-1



---

##### Table of Contents

Report of Independent Registered Public Accounting Firm



To the Board of Directors
and Stockholders

of Inspire Pharmaceuticals, Inc.



In our opinion, the financial statements
listed in the index appearing under Item 15(a)1 present fairly, in all material respects, the financial position of Inspire Pharmaceuticals, Inc. at December 31, 2009 and December 31, 2008, and the results of its operations and its
cash flows for each of the three years in the period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in
the index appearing under Item 15(a)2 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. Also in our opinion, the Company maintained, in all material
respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). The Companys management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of
internal control over financial reporting, included in Managements Report on Internal Control over Financial Reporting under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement
schedule, and on the Companys internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material
respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists,
and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits
provide a reasonable basis for our opinions.



A
companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect
the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.



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



/s/ PricewaterhouseCoopers LLP

Raleigh, North Carolina

March 15, 2010



F-2



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



BALANCE SHEETS

(in thousands, except per share amounts)



|                                                                                                                         |      |              |          |      |  |   |          |  
|------------------------------------------------------------------------------------------------------------------------ | ---- | ------------ | -------- | ---- |  | - | -------- | -
|                                                                                                                         |      | December 31, |         
|                                                                                                                         | 2009 |              |          | 2008 | 
|Assets                                                                                                                   |      |              |          |      |  |   |          |  
|Current assets:                                                                                                          |      |              |          |      |  |   |          |  
|Cash and cash equivalents                                                                                                |      | $            | 52,256   |      |  | $ | 58,488   |  
|Investments                                                                                                              |      |              | 54,367   |      |  |   | 13,663   |  
|Trade receivables, net                                                                                                   |      |              | 22,682   |      |  |   | 16,544   |  
|Prepaid expenses and other receivables                                                                                   |      |              | 5,479    |      |  |   | 4,186    |  
|Inventories, net                                                                                                         |      |              | 1,717    |      |  |   | 689      |  
|Other assets                                                                                                             |      |              | 153      |      |  |   | 357      |  
|                                                                                                                         |      |              |          |      |  |   |          |  
|Total current assets                                                                                                     |      |              | 136,654  |      |  |   | 93,927   |  
|                                                                                                                         |      |             
|Property and equipment, net                                                                                              |      |              | 4,429    |      |  |   | 2,925    |  
|Assets held-for-sale                                                                                                     |      |              | 402      |      |  |   |         |  
|Investments                                                                                                              |      |              | 21,861   |      |  |   | 200      |  
|Restricted deposits                                                                                                      |      |              | 615      |      |  |   | 615      |  
|Intangibles, net                                                                                                         |      |              | 14,748   |      |  |   | 16,343   |  
|Other assets                                                                                                             |      |              | 61       |      |  |   | 214      |  
|                                                                                                                         |      |              |          |      |  |   |          |  
|Total assets                                                                                                             |      | $            | 178,770  |      |  | $ | 114,224  |  
|                                                                                                                         |      |              |          |      |  |   |          |  
|Liabilities and Stockholders Equity                                                                                     |      |              |          |      |  |   |          |  
|Current liabilities:                                                                                                     |      |              |          |      |  |   |          |  
|Accounts payable                                                                                                         |      | $            | 10,056   |      |  | $ | 9,843    |  
|Accrued expenses                                                                                                         |      |              | 21,246   |      |  |   | 13,142   |  
|Short-term debt and capital leases                                                                                       |      |              | 19,940   |      |  |   | 18,430   |  
|                                                                                                                         |      |              |          |      |  |   |          |  
|Total current liabilities                                                                                                |      |              | 51,242   |      |  |   | 41,415   |  
|                                                                                                                         |      |             
|Long-term debt and capital leases                                                                                        |      |              | 5,235    |      |  |   | 25,175   |  
|Other long-term liabilities                                                                                              |      |              | 3,125    |      |  |   | 3,247    |  
|                                                                                                                         |      |              |          |      |  |   |          |  
|Total liabilities                                                                                                        |      |              | 59,602   |      |  |   | 69,837   |  
|                                                                                                                         |      |              |          |      |  |   |          |  
|Commitments and contingencies (Note 14)                                                                                  |      |              |          |      |  |   |          |  
|Stockholders equity:                                                                                                    |      |              |          |      |  |   |          |  
|Preferred stock, $0.001 par value, 1,860 shares authorized; no shares issued and outstanding                             |      |              |         |      |  |   |         |  
|Common stock, $0.001 par value, 100,000 shares authorized; 82,346 and 56,672 shares issued and outstanding,
respectively |      |              | 82       |      |  |   | 57       |  
|Additional paid-in capital                                                                                               |      |              | 519,462  |      |  |   | 404,991  |  
|Accumulated other comprehensive income/(loss)                                                                            |      |              | 68       |      |  |   | (193     | )
|Accumulated deficit                                                                                                      |      |              | (400,444 | )    |  |   | (360,468 | )
|                                                                                                                         |      |              |          |      |  |   |          |  
|Total stockholders equity                                                                                               |      |              | 119,168  |      |  |   | 44,387   |  
|                                                                                                                         |      |              |          |      |  |   |          |  
|Total liabilities and stockholders equity                                                                               |      | $            | 178,770  |      |  | $ | 114,224  |  
|                                                                                                                         |      |              |          |      |  |   |          |  



The accompanying notes are an
integral part of these financial statements.



F-3



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)



|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------------------------------- | ---- | ----------------------- | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                  |      | Year Ended December 31, |        
|                                                                                                  | 2009 |                         |         | 2008 |  |   | 2007    |  
|Revenues:                                                                                         |      |                         |         |      |  |   |         |   |  |   |         |  
|Product sales, net                                                                                |      | $                       | 34,961  |      |  | $ | 18,349  |   |  | $ | 3,142   |  
|Product co-promotion and royalty                                                                  |      |                         | 57,198  |      |  |   | 50,899  |   |  |   | 45,523  |  
|Collaborative research and development                                                            |      |                         |        |      |  |   | 1,250   |   |  |   |        |  
|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Total revenue                                                                                     |      |                         | 92,159  |      |  |   | 70,498  |   |  |   | 48,665  |  
|Operating expenses:                                                                               |      |                         |         |      |  |   |         |   |  |   |         |  
|Cost of sales                                                                                     |      |                         | 11,271  |      |  |   | 6,412   |   |  |   | 1,622   |  
|Research and development                                                                          |      |                         | 51,134  |      |  |   | 44,637  |   |  |   | 53,391  |  
|Selling and marketing                                                                             |      |                         | 49,304  |      |  |   | 54,568  |   |  |   | 45,543  |  
|General and administrative                                                                        |      |                         | 16,053  |      |  |   | 14,540  |   |  |   | 13,986  |  
|Restructuring                                                                                     |      |                         | 2,014   |      |  |   |        |   |  |   |        |  
|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Total operating expenses                                                                          |      |                         | 129,776 |      |  |   | 120,157 |   |  |   | 114,542 |  
|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Loss from operations                                                                              |      |                         | (37,617 | )    |  |   | (49,659 | ) |  |   | (65,877 | )
|                                                                                                  |      |                         |        
|Other income/(expense):                                                                           |      |                         |         |      |  |   |         |   |  |   |         |  
|Interest income                                                                                   |      |                         | 668     |      |  |   | 2,642   |   |  |   | 5,082   |  
|Interest expense                                                                                  |      |                         | (3,027  | )    |  |   | (4,586  | ) |  |   | (2,919  | )
|Loss on investments                                                                               |      |                         |        |      |  |   |        |   |  |   | (26     | )
|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Other income/(expense), net                                                                       |      |                         | (2,359  | )    |  |   | (1,944  | ) |  |   | 2,137   |  
|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Net loss                                                                                          |      | $                       | (39,976 | )    |  | $ | (51,603 | ) |  | $ | (63,740 | )
|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Non-cash deemed dividend related to beneficial conversion feature of exchangeable preferred stock |      |                         |        |      |  |   |        |   |  |   | (8,285  | )
|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Net loss attributable to common stockholders                                                      |      | $                       | (39,976 | )    |  | $ | (51,603 | ) |  | $ | (72,025 | )
|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Basic and diluted net loss per common share                                                       |      | $                       | (0.60   | )    |  | $ | (0.91   | ) |  | $ | (1.61   | )
|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Weighted average common shares used in computing basic and diluted net loss per common share      |      |                         | 66,797  |      |  |   | 56,609  |   |  |   | 44,763  |  
|                                                                                                  |      |                         |         |      |  |   |         |   |  |   |         |  



The accompanying notes are an
integral part of these financial statements.



F-4



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                            |      |                         |         |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------------- | ---- | ----------------------- | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                            |      | Year Ended December 31, |        
|                                                                            | 2009 |                         |         | 2008 |  |   | 2007    |  
|Cash flows from operating activities:                                       |      |                         |         |      |  |   |         |   |  |   |         |  
|Net loss                                                                    |      | $                       | (39,976 | )    |  | $ | (51,603 | ) |  | $ | (63,740 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |      |                         |         |      |  |   |         |   |  |   |         |  
|Amortization expense                                                        |      |                         | 1,952   |      |  |   | 2,134   |   |  |   | 1,781   |  
|Depreciation of property and equipment                                      |      |                         | 755     |      |  |   | 939     |   |  |   | 891     |  
|Asset impairment                                                            |      |                         | 484     |      |  |   |        |   |  |   |        |  
|Loss/(gain) on disposal of property and equipment                           |      |                         | (90     | )    |  |   | 7       |   |  |   | 7       |  
|Loss on investments                                                         |      |                         |        |      |  |   |        |   |  |   | 26      |  
|Stock-based compensation expense                                            |      |                         | 5,063   |      |  |   | 4,443   |   |  |   | 2,998   |  
|Allowance for doubtful accounts                                             |      |                         | 43      |      |  |   | (3      | ) |  |   | 10      |  
|Inventory reserve                                                           |      |                         | 15      |      |  |   | 105     |   |  |   | 125     |  
|Changes in operating assets and liabilities:                                |      |                         |         |      |  |   |         |   |  |   |         |  
|Trade receivables                                                           |      |                         | (6,181  | )    |  |   | (3,567  | ) |  |   | (4,739  | )
|Prepaid expenses and other receivables                                      |      |                         | (1,413  | )    |  |   | 345     |   |  |   | (765    | )
|Inventories                                                                 |      |                         | (1,043  | )    |  |   | 486     |   |  |   | (1,405  | )
|Other assets                                                                |      |                         |        |      |  |   | (40     | ) |  |   |        |  
|Accounts payable                                                            |      |                         | (970    | )    |  |   | (3,675  | ) |  |   | 7,221   |  
|Accrued expenses and other liabilities                                      |      |                         | 7,860   |      |  |   | (671    | ) |  |   | 5,350   |  
|Deferred revenue                                                            |      |                         |        |      |  |   | (371    | ) |  |   | 371     |  
|                                                                            |      |                         |         |      |  |   |         |   |  |   |         |  
|Net cash used in operating activities                                       |      |                         | (33,501 | )    |  |   | (51,471 | ) |  |   | (51,869 | )
|                                                                            |      |                         |         |      |  |   |         |   |  |   |         |  
|Cash flows from investing activities:                                       |      |                         |         |      |  |   |         |   |  |   |         |  
|Purchase of investments                                                     |      |                         | (94,049 | )    |  |   | (7,574  | ) |  |   | (59,975 | )
|Proceeds from sale of investments                                           |      |                         | 31,945  |      |  |   | 30,694  |   |  |   | 74,501  |  
|Approval milestone payment                                                  |      |                         |        |      |  |   |        |   |  |   | (19,000 | )
|Restricted cash transfer                                                    |      |                         |        |      |  |   |        |   |  |   | (100    | )
|Purchase of property and equipment                                          |      |                         | (1,791  | )    |  |   | (1,045  | ) |  |   | (1,970  | )
|Proceeds from sale of property and equipment                                |      |                         | 161     |      |  |   |        |   |  |   |        |  
|                                                                            |      |                         |         |      |  |   |         |   |  |   |         |  
|Net cash provided by/(used in) investing activities                         |      |                         | (63,734 | )    |  |   | 22,075  |   |  |   | (6,544  | )
|                                                                            |      |                         |         |      |  |   |         |   |  |   |         |  
|Cash flows from financing activities:                                       |      |                         |         |      |  |   |         |   |  |   |         |  
|Proceeds from long-term debt                                                |      |                         |        |      |  |   |        |   |  |   | 40,000  |  
|Proceeds from issuance of exchangeable preferred stock, net                 |      |                         |        |      |  |   |        |   |  |   | 73,605  |  
|Proceeds from common stock offering, net                                    |      |                         | 109,000 |      |  |   |        |   |  |   |        |  
|Issuance of common stock, netstock compensation plans                      |      |                         | 433     |      |  |   | 88      |   |  |   | 266     |  
|Debt issuance cost                                                          |      |                         |        |      |  |   |        |   |  |   | (100    | )
|Payments on notes payable and capital lease obligations                     |      |                         | (18,430 | )    |  |   | (14,096 | ) |  |   | (3,656  | )
|                                                                            |      |                         |         |      |  |   |         |   |  |   |         |  
|Net cash provided by/(used in) financing activities                         |      |                         | 91,003  |      |  |   | (14,008 | ) |  |   | 110,115 |  
|                                                                            |      |                         |         |      |  |   |         |   |  |   |         |  
|Increase/(decrease) in cash and cash equivalents                            |      |                         | (6,232  | )    |  |   | (43,404 | ) |  |   | 51,702  |  
|Cash and cash equivalents, beginning of year                                |      |                         | 58,488  |      |  |   | 101,892 |   |  |   | 50,190  |  
|                                                                            |      |                         |         |      |  |   |         |   |  |   |         |  
|Cash and cash equivalents, end of year                                      |      | $                       | 52,256  |      |  | $ | 58,488  |   |  | $ | 101,892 |  
|                                                                            |      |                         |         |      |  |   |         |   |  |   |         |  
|Supplemental disclosure of cash flow information:                           |      |                         |         |      |  |   |         |   |  |   |         |  
|Cash paid for interest                                                      |      | $                       | 2,794   |      |  | $ | 4,257   |   |  | $ | 2,255   |  
|Supplemental disclosure of non-cash investing information:                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Purchase of equipment included in accounts payable and accrued expenses     |      | $                       | 1,409   |      |  | $ |        |   |  | $ |        |  
|Supplemental disclosure of non-cash financing information:                  |      |                         |         |      |  |   |         |   |  |   |         |  
|Conversion of exchangeable preferred stock to common stock                  |      | $                       |        |      |  | $ |        |   |  | $ | 73,605  |  



The accompanying notes are an integral part of these financial statements.



F-5



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



STATEMENTS OF STOCKHOLDERS EQUITY

(in thousands)



|                                                                                                            |                 |              |        |                          |    |  |                                            |         |   |                    |   |      |                     |  |   |          |   |  |   |         |  
|----------------------------------------------------------------------------------------------------------- | --------------- | ------------ | ------ | ------------------------ | -- |  | ------------------------------------------ | ------- | - | ------------------ | - | ---- | ------------------- |  | - | -------- | - |  | - | ------- | -
|                                                                                                            |                 | Common Stock |        | AdditionalPaid-inCapital |    |  | AccumulatedOtherComprehensiveIncome/(loss) |         |   | AccumulatedDeficit |   |      | StockholdersEquity | 
|                                                                                                            | Number ofShares |              | Amount |                          |    |  |                                           
|Balance at December 31, 2006                                                                                |                 | 42,238       |        | $                        | 42 |  | $                                          | 323,606 |   |                    | $ | (152 | )                   |  | $ | (245,125 | ) |  | $ | 78,371  |  
|Issuance of common stockstock compensation plans                                                           |                 | 244          |        |                          | 1  |  |                                            | 265     |   |                    |   |     |                     |  |   |         |   |  |   | 266     |  
|Conversion of Series A Exchangeable Preferred Stock to common stock                                         |                 | 14,019       |        |                          | 14 |  |                                            | 73,591  |   |                    |   |     |                     |  |   |         |   |  |   | 73,605  |  
|Recording of beneficial conversion feature related to the exchange of Series A Exchangeable Preferred Stock |                 |             |        |                          |   |  |                                            | 8,285   |   |                    |   |     |                     |  |   |         |   |  |   | 8,285   |  
|Accretion of beneficial conversion feature                                                                  |                 |             |        |                          |   |  |                                            | (8,285  | ) |                    |   |     |                     |  |   |         |   |  |   | (8,285  | )
|Unrealized gain on investments                                                                              |                 |             |        |                          |   |  |                                            |        |   |                    |   | 193  |                     |  |   |         |   |  |   | 193     |  
|Stock-based compensation                                                                                    |                 |             |        |                          |   |  |                                            | 2,998   |   |                    |   |     |                     |  |   |         |   |  |   | 2,998   |  
|Net loss                                                                                                    |                 |             |        |                          |   |  |                                            |        |   |                    |   |     |                     |  |   | (63,740  | ) |  |   | (63,740 | )
|                                                                                                            |                 |              |        |                          |    |  |                                            |         |   |                    |   |      |                     |  |   |          |   |  |   |         |  
|Balance at December 31, 2007                                                                                |                 | 56,501       |        |                          | 57 |  |                                            | 400,460 |   |                    |   | 41   |                     |  |   | (308,865 | ) |  |   | 91,693  |  
|Issuance of common stockstock compensation plans                                                           |                 | 171          |        |                          |   |  |                                            | 88      |   |                    |   |     |                     |  |   |         |   |  |   | 88      |  
|Unrealized loss on investments                                                                              |                 |             |        |                          |   |  |                                            |        |   |                    |   | (234 | )                   |  |   |         |   |  |   | (234    | )
|Stock-based compensation                                                                                    |                 |             |        |                          |   |  |                                            | 4,443   |   |                    |   |     |                     |  |   |         |   |  |   | 4,443   |  
|Net loss                                                                                                    |                 |             |        |                          |   |  |                                            |        |   |                    |   |     |                     |  |   | (51,603  | ) |  |   | (51,603 | )
|                                                                                                            |                 |              |        |                          |    |  |                                            |         |   |                    |   |      |                     |  |   |          |   |  |   |         |  
|Balance at December 31, 2008                                                                                |                 | 56,672       |        |                          | 57 |  |                                            | 404,991 |   |                    |   | (193 | )                   |  |   | (360,468 | ) |  |   | 44,387  |  
|Issuance of common stockstock compensation plans                                                           |                 | 118          |        |                          |   |  |                                            | 433     |   |                    |   |     |                     |  |   |         |   |  |   | 433     |  
|Common Stock Offering                                                                                       |                 | 25,556       |        |                          | 25 |  |                                            | 108,975 |   |                    |   |     |                     |  |   |          |   |  |   | 109,000 |  
|Unrealized gain on investments                                                                              |                 |             |        |                          |   |  |                                            |        |   |                    |   | 261  |                     |  |   |         |   |  |   | 261     |  
|Stock-based compensation                                                                                    |                 |             |        |                          |   |  |                                            | 5,063   |   |                    |   |     |                     |  |   |         |   |  |   | 5,063   |  
|Net loss                                                                                                    |                 |             |        |                          |   |  |                                            |        |   |                    |   |     |                     |  |   | (39,976  | ) |  |   | (39,976 | )
|                                                                                                            |                 |              |        |                          |    |  |                                            |         |   |                    |   |      |                     |  |   |          |   |  |   |         |  
|Balance at December 31, 2009                                                                                |                 | 82,346       |        | $                        | 82 |  | $                                          | 519,462 |   |                    | $ | 68   |                     |  | $ | (400,444 | ) |  | $ | 119,168 |  
|                                                                                                            |                 |              |        |                          |    |  |                                            |         |   |                    |   |      |                     |  |   |          |   |  |   |         |  



The accompanying notes are an
integral part of these financial statements.



F-6



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS

(in thousands, except per share amounts)



1. Organization



Inspire Pharmaceuticals, Inc. (the Company or Inspire) was incorporated in October 1993 and commenced operations in
March 1995. Inspire is located in Durham, North Carolina, adjacent to the Research Triangle Park.



Inspire has incurred losses and negative cash flows from operations since inception. Based on current operating plans, the Company expects it
has sufficient liquidity to continue its planned operations beyond 2010. The Companys liquidity needs will largely be determined by the commercial success of its products and key development and regulatory events. In order to continue its
operations substantially beyond 2010 it will need to: (1) successfully increase revenues; (2) obtain additional product candidate approvals; (3) out-license rights to certain of its product candidates; (4) raise additional
capital through equity or debt financings or from other sources; (5) reduce spending on one or more research and development programs; and/or (6) further restructure its operations. The Company currently receives revenue from sales of
AzaSite (azithromycin ophthalmic solution) 1%, its co-promotion of Elestat (epinastine HCl ophthalmic solution) 0.05% and royalties on Restasis (cyclosporine ophthalmic emulsion) 0.05%. The Company will continue to incur
operating losses until revenues reach a level sufficient to support ongoing operations.



2. Summary of Significant Accounting Policies and Concentrations of Risk



Use of Estimates



The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual
results could differ materially from those estimates.



Cash,
Cash Equivalents, Interest and Other Receivables



The Company considers all highly-liquid investments with a maturity of three months or less at the date of purchase to be cash equivalents. The carrying values of cash, cash equivalents, interest and receivables approximate their fair value
due to the short-term nature of these items.



Trade Receivables



The Companys trade receivables consist
of co-promotion revenue based on net sales of Elestat and royalty revenue based on net sales of Restasis, both of which are earned from Allergan, Inc. (Allergan) and product revenue from sales of AzaSite. The Company
is required to estimate the amount of trade receivables which ultimately will be uncollectible. The Company calculates an estimate of uncollectible accounts based on a review of specific customer balances, as well as a consideration of other
industry and economic environment factors.



Investments



The Company invests in high-credit quality
investments in accordance with its investment policy which minimizes the possibility of loss. Per its policy, the Company is able to invest in marketable debt securities that may consist of United States government and government agency obligations,
money market and mutual fund investments, municipal and corporate notes and bonds and asset or mortgage-backed securities. The Companys investment policy requires it to purchase high-quality marketable securities with a maximum individual
maturity of three years and requires an average portfolio maturity of no more than one year. Investments with original



F-7



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



maturities at date of purchase beyond three months and which mature at or less than 12 months from the balance sheet date are classified as current. Generally, investments with a maturity beyond
12 months from the balance sheet date are classified as long-term. Investments in marketable debt securities are classified as available-for-sale and are carried at fair value with unrealized gains and losses recognized in other comprehensive income
(loss). Realized gains and losses are determined using the specific identification method and transactions are recorded on a settlement date basis. Marketable and non-marketable equity investments are evaluated periodically for impairment. If it is
determined that a decline of any investment is other than temporary, then the investment would be written down to fair value and the write-down would be included in the Companys operating results.



The Company has an equity investment in Parion Sciences, Inc., a
non-public entity for which its fair value is not readily determinable. For this investment in which the Company does not have significant influence and owns less than 5%, the investment is carried at cost and is subject to a write-down for
impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. As of December 31, 2009 and 2008, this investments recorded value was $200.



Property and Equipment



Property and equipment is primarily comprised of furniture,
software, laboratory and computer equipment which are recorded at cost and depreciated using the straight-line method over their estimated useful lives which range from three to seven years. Leased property and equipment, which includes certain
equipment under capital leases, and leasehold improvements are depreciated over the shorter of the lease period or their estimated useful lives.



The carrying values of property and equipment are periodically reviewed to determine if the facts and circumstances suggest that a potential
impairment may have occurred. The review includes a determination of the carrying values of assets based on an analysis of undiscounted cash flows over the remaining depreciation period. If the review indicates that carrying values may not be
recoverable, the Company will reduce the carrying values to the estimated fair value.



Assets Held-For-Sale



In connection with the restructuring that occurred in the first quarter of 2009, the Company began to market and dispose of its laboratory equipment in the fourth quarter of 2009. The assets held-for-sale
are reported at the lower of the carrying value or fair value less costs to sell and the assets are no longer being depreciated. See Note 6 Restructuring for additional information. The Company expects to complete the disposal of these
assets in 2010. The Company has recorded a net gain of $90 on the disposal of property and equipment for the year ended December 31, 2009.



Restricted Deposits



Restricted deposits consist of cash and cash equivalents which collateralize letters of credit that are required under the terms of certain
agreements to which the Company is involved. Restricted deposits are classified as current or long-term based upon the expected release date of such restriction. The carrying amount of these restricted deposits approximates fair value.



F-8



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



Intangible Assets



Costs associated with obtaining patents on the Companys product candidates and license initiation and preservation fees,
including milestone payments by the Company to its licensors, are evaluated based on the stage of development of the related product candidate and whether the underlying product candidate has an alternative use. Costs of these types incurred for
product candidates not yet approved by the U.S. Food and Drug Administration (FDA) and for which no alternative future use exists are recorded as expense. In the event a product candidate has been approved by the FDA or an alternative
future use exists for a product candidate, patent and license costs are capitalized and amortized over the expected life of the related product candidate. Milestone payments to the Companys collaborators are recognized when the underlying
requirement is met.



Upon FDA approval of
AzaSitein April 2007, the Company paid a $19,000 milestone to InSite Vision Incorporated (InSite Vision). The $19,000 is being amortized ratably on a straight-line basis through the term of the underlying patent coverage for
AzaSite, or March 2019, which represents the expected period of commercial exclusivity. As of December 31, 2009 and 2008, the Company had $4,252 and $2,657, respectively, in accumulated amortization related to this milestone.



The carrying values of intangible assets are periodically
reviewed to determine if the facts and circumstances suggest that a potential impairment may have occurred. The review includes a determination of the carrying values of intangible assets based on an analysis of undiscounted cash flows over the
remaining amortization period. If the review indicates that carrying values may not be recoverable, the Company will reduce the carrying values to the estimated fair value. The Company had no impairments of its intangible assets for the years ended
December 31, 2009, 2008 and 2007.



Other Assets



In December 2006, the Company entered into a
loan and security agreement and received an initial loan advance of $20,000. In 2007, the Company amended the loan and security agreement and received additional loan advances totaling $40,000. Expenses associated with entering into the loan
agreements, including commitment fees, totaled $1,400 and have been classified as deferred financing costs. At December 31, 2009 and 2008, the Company had $158 and $515, respectively, in deferred financing costs that are being amortized to
interest expense over the term of each of the loans, which mature in March 2011, using the effective interest rate method.



Revenue Recognition



The Company records all of its revenue from: (1) sales of AzaSite; (2) product co-promotion activities and earned royalties;
and (3) collaborative research agreements when realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: 1) persuasive evidence of an arrangement exists; 2) delivery has occurred
or services have been rendered; 3) the sellers price to the buyer is fixed or determinable; and 4) collectibility is reasonably assured.



Product Revenues



The Company recognizes revenue for sales of AzaSite when title and substantially all the risks and rewards of ownership have
transferred to the customer, which generally occurs on the date of shipment, with the exception of transactions whereby product stocking incentives were offered approximately one month prior to the products August 13, 2007 launch. In the
United States, the Company sells AzaSite to wholesalers and distributors, who, in turn, sell to pharmacies and federal, state and commercial health care organizations.



F-9



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



Sales deductions consist of statutory rebates to state Medicaid, Medicare and other
government agencies, contractual rebates with commercial managed care organizations, wholesaler chargebacks, sales discounts (including trade discounts and distribution service fees), allowances for coupon and voucher programs and product returns.
These deductions are recorded as reductions to revenue from AzaSite in the same period as the related sales with estimates of future utilization derived from historical experience adjusted to reflect known changes in the factors that impact
such reserves.



The Company utilizes data from
external sources to help it estimate gross-to-net sales adjustments as they relate to the recognition of revenue for AzaSite sold. External sourced data includes, but is not limited to, information obtained from certain wholesalers with
respect to their inventory levels and sell-through to customers, targeted surveys as well as data from IMS Health, a third-party supplier of market research data to the pharmaceutical industry. The Company also utilizes this data to help estimate
and identify prescription trends and patient demand, as well as product levels in the supply chain.



The Company accounts for these sales deductions in accordance with the Financial Accounting Standards Board (FASB) authoritative
guidance on revenue recognition when consideration is given by a vendor to a customer as well as when the right of return exists.



The Company has categorized and described more fully the following significant sales deductions, all of which involve estimates and judgments
which the Company considers to be critical accounting estimates, and requires it to use information from external sources.



Rebates and Chargebacks



Statutory rebates to state Medicaid agencies and Medicare and contractual rebates to commercial managed care organizations are based on
statutory or negotiated discounts to the selling price. As it can take up to nine months or more for information to be received on actual usage of AzaSite in managed care and Medicaid and other governmental programs as well as on the
total discounts to be reimbursed, the Company maintains reserves for amounts payable under these programs relating to AzaSite sales.



Chargebacks claimed by wholesalers are based on the differentials between product acquisition prices paid by wholesalers and lower government
contract pricing paid by eligible customers covered under federally qualified programs.



The amount of the reserve for rebates and chargebacks is based on multiple qualitative and quantitative factors, including the historical and projected utilization levels, historical payment experience,
changes in statutory laws and interpretations as well as contractual terms, product pricing (both normal selling prices and statutory or negotiated prices), changes in prescription demand patterns and utilization of our product through private or
public benefit plans, and the levels of AzaSite inventory in both the wholesale and retail distribution channel. Other factors that the Company may consider, if determined relevant, would include price changes from competitors and
introductions of generics and/or competitive new products. The Company acquires prescription utilization data from IMS Health, a third-party supplier of market research data to the pharmaceutical industry. The Company applies these multiple factors,
the quantitative historical data along with other qualitative aspects, such as managements judgment regarding future utilization trends, to the respective periods sales of AzaSite to determine the rebate accrual and related
expense. The Company updates its estimates and assumptions each period and records any necessary adjustments to its reserves. Settlements of rebates and chargebacks typically occur within nine months from point of sale. To the extent actual rebates
and chargebacks differ from the



F-10



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



Companys estimates, additional reserves may be required or reserves may need to be reversed, either of which would impact current period product revenue. As of December 31, 2009 and
2008, reserves for rebates and chargebacks were $3,488 and $783, respectively.



Discounts and Other Sales Incentives



Discounts and other sales incentives consist of the following:



| |  |  | Prompt pay discountsPrompt payment discounts are offered to all wholesalers in return for payment within 30 days following the invoice
date. The Company records sales of AzaSite net of the discount amount based on historical experience. The Company adjusts the reserve at the end of each reporting period to approximate the percentage discount applicable to the outstanding
gross accounts receivable balances.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Inventory Management Agreement (IMA) FeesPer contractual agreements with the Companys largest wholesalers (which
collectively represented over 85% of 2009 AzaSite sales), the Company provides an IMA fee based on a percentage of their purchases of AzaSite. The IMA fee rates are set forth in the individual contracts. The Company tracks sales to
these wholesalers each period and accrues a liability relating to the unpaid portion of these fees by applying the contractual rates to such sales.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Product coupons and vouchersProduct coupons and vouchers offer patients the ability to receive free or discounted product through their
pharmacy or prescribing physician, to whom the Company provides an inventory of coupons or vouchers as applicable. The Company uses a third-party administrator who invoices on a periodic basis for the cost of coupons and vouchers redeemed in the
period. The Company bases its estimates on the historical coupon and voucher redemption rate of similar programs.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As of December 31, 2009 and 2008, reserves for discounts and other sales incentives were $889 and $519, respectively.



Product Returns



At the time of sale of AzaSite, the Company records
product returns allowances based on its estimate of the portion of sales that will be returned by its customers in the future. The return allowances are established in accordance with the Companys return policy. The Companys return goods
policy generally allows for returns of AzaSite within an 18-month period, from six months prior to the expiration date and up to 12 months following the expiration date, but may differ from customer to customer, depending on certain factors.
Future estimated returns of AzaSite are based primarily on the return data for comparative products and the Companys own historical experience with AzaSite. Historical returns data on AzaSite is analyzed on a specific
production lot basis. In determining the Companys return allowance, the Company also considers other relevant factors, including:



| |  |  | Levels of inventory in the distribution channel and any significant changes to these levels
| | - |  | -------------------------------------------------------------------------------------------



| |  |  | Estimated expiration date or remaining shelf life of inventory in the distribution channel
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | Current and projected demand of AzaSite that could be impacted by introductions of generic products and/or introductions of competitive new
products; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Competitive product recalls and/or discontinuances
| | - |  | --------------------------------------------------



F-11



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



The Companys estimates of the level of AzaSite inventory in the
distribution channel is based on inventory data provided by wholesalers and third-party prescription data. As of December 31, 2009 and 2008, reserves for returns of AzaSite were $1,523 and $701, respectively.



Immediately preceding the launch of AzaSite,the Company
offered wholesalers stocking incentives that allowed for extended payment terms, product discounts, and guaranteed sale provisions (collectively, special terms). These special terms were only offered during a specified time period of
approximately one month prior to the August 13, 2007 launch of AzaSite. Any sales of AzaSite made under these special term provisions were accounted for using a consignment model since substantially all the risks and rewards of
ownership did not transfer upon shipment. Under the consignment model, the Company did not recognize revenue upon shipment of AzaSite purchased with the special terms, but recorded deferred revenue at gross invoice sales price, less all
appropriate discounts and rebates, and accounted for AzaSite inventory held by the wholesalers as consignment inventory. The Company recognized the revenue from these sales with special terms at the earlier of when the inventory of
AzaSite held by the wholesalers was sold through to the wholesalers customers or when such inventory of AzaSite was no longer subject to these special terms. At December 31, 2007, the Company had net deferred revenue of $371
related to sales of AzaSite considered consignment, which was fully recognized in the three months ended March 31, 2008. All sales subsequent to this specified launch time period include return rights and pricing that are customary in
the industry, as discussed above.



Product Co-promotion and
Royalty Revenues



The Company recognizes
co-promotion revenue based on net sales of Elestat and royalty revenue based on net sales of Restasis, as defined in the co-promotion agreements, and as reported to Inspire by Allergan. Through the year ended December 31, 2008,
the Company actively promoted both Restasisand Elestat through its commercial organization. As of January 1, 2009, the Company is no longer responsible for the co-promotion of Restasis, but the Company continues to receive
royalties on Allergans net sales of Restasis. The Companys co-promotion and royalty revenues are based upon Allergans revenue recognition policy and other accounting policies over which the Company has limited or no control
and on the underlying terms of the co-promotion agreements. Allergan recognizes revenue from product sales when goods are shipped and title and risk of loss transfers to the customer. The co-promotion agreements provide for gross sales to be reduced
by estimates of sales returns, credits and allowances, normal trade and cash discounts, managed care sales rebates and other allocated costs as defined in the agreements, all of which are determined by Allergan and are outside the Companys
control. The Company records a percentage of Allergans reported net sales to Inspire for Elestat and Restasis,as co-promotion revenue and royalty revenue, respectively. The Company receives monthly sales information from
Allergan and performs analytical reviews and trend analyses using prescription information that it receives from IMS Health. In addition, the Company exercises its audit rights under the contractual agreements with Allergan to annually perform an
examination of Allergans sales records of both Restasisand Elestat. The Company makes no adjustments to the amounts reported to it by Allergan other than reductions in net sales to reflect the incentive programs managed by the
Company. The Company offers and manages certain incentive programs associated with Elestat, which are utilized by it in addition to those programs managed by Allergan. The Company reduces co-promotion revenue from net sales of Elestatby estimating the portion of sales that are subject to these incentive programs based on information reported to it by a third-party administrator of the incentive program. The rebates associated with the programs that the Company manages
represent an insignificant amount, as compared to the rebate and discount programs administered by Allergan and as compared to the Companys aggregate co-promotion and royalty revenue. Under the co-promotion agreement for Elestat, the
Company is obligated to meet predetermined minimum calendar year net sales target levels. If the annual minimum is not achieved, the Company records revenues using a reduced percentage of net



F-12



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



sales based upon its level of achievement of the predetermined calendar year net sales target levels. Amounts receivable from Allergan in excess of recorded co-promotion revenue are recorded as
deferred revenue. Calendar year 2009 was the last year in which there is a minimum annual net sales target level for Elestatunder the co-promotion agreement.



Collaborative Research and Development Revenues



The Company recognizes revenue under its collaborative research and development agreements when it has
performed services under such agreements or when the Company or its collaborative partner have met a contractual milestone triggering a payment to the Company. The Company recognizes revenue from its research and development service agreements
ratably over the estimated service period as related research and development costs are incurred and the services are substantially performed. Upfront non-refundable fees and milestone payments received at the initiation of collaborative agreements
for which the Company has an ongoing research and development commitment are deferred and recognized ratably over the period in which the services are substantially performed. This period, if not defined in the collaborative agreement, is based on
estimates by the Companys management and the progress towards agreed upon development events as set forth in the collaborative agreements. These estimates are subject to revision as the Companys development efforts progress and it gains
knowledge regarding required additional development. Revisions in the commitment period are made in the period that the facts related to the change first become known. If the estimated service period is subsequently modified, the period over which
the upfront fee or revenue related to ongoing research and development services is modified on a prospective basis. The Company is also entitled to receive milestone payments under its collaborative research and development agreements based upon the
achievement of agreed upon development events that are substantively at-risk by its collaborative partners or the Company. This collaborative research and development revenue is recognized upon the achievement and acknowledgement of the
Companys collaborative partner of a development event, which is generally at the date payment is received from the collaborative partner or is reasonably assured. Accordingly, the Companys revenue recognized under its collaborative
research and development agreements may fluctuate significantly from period to period.



Research and Development



Research and development expenses include all direct costs and indirect development costs related to the development of the Companys portfolio of product candidates. These expenses include: salaries
for research and development personnel, consulting fees, clinical trial costs, including the development and manufacture of drug product for clinical trials, sponsored research costs, clinical trial insurance, up-front license fees, milestone and
royalty payments relating to research and development, and other fees and costs related to the development of product candidates. These costs have been charged to operating expense as incurred. License milestone payments to the Companys
licensors are recognized as expense when the underlying requirement is met or service has been provided.



Income Taxes



The Company accounts for income taxes using the liability method which requires the recognition of deferred tax assets or liabilities for the temporary differences between financial reporting and tax
bases of the Companys assets and liabilities and for tax carryforwards at enacted statutory tax rates in effect for the years in which the differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized



F-13



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



in income in the period that includes the enactment date. The Company accounts for uncertain tax positions in accordance with FASB authoritative guidance regarding the accounting for taxes.
Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. The Company has recorded a valuation allowance
against all potential tax assets due to uncertainties in the Companys ability to utilize the deferred tax assets, primarily consisting of certain net operating losses carried forward, before they expire. The valuation allowance is based on
estimates of taxable income in each of the jurisdictions in which the Company operates and the period over which the deferred tax assets will be recoverable.



Stock-Based Compensation



The Company recognizes stock-based compensation expense in accordance with FASB authoritative guidance regarding the accounting for
share-based payments, which requires that share-based payments be measured at fair value and recognized as compensation expense over the service period in which the awards are expected to vest. The Company utilizes the Black-Scholes option-pricing
model to value its share-based awards and recognizes compensation expense on a straight-line basis over the vesting periods of the awards, which is generally three to five years. The Company considers many factors when estimating expected
forfeitures, including types of awards, employee class, and historical experience. Expected volatility is determined based on the Companys own historical volatility. The estimation of share-based awards that will ultimately vest requires
judgment, and to the extent actual results or updated estimates differ from the Companys current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. Significant management judgment is
required in determining estimates of future stock price volatility, forfeitures and expected life to be used in the valuation of the awards. Actual results, and future changes in estimates, may differ substantially from current estimates.



In accordance with SEC authoritative guidance, if
a company concludes that its historical share option experience does not provide a reasonable basis upon which to estimate expected term, it may use the simplified method to estimate the expected term of its options. The Company has utilized the
simplified method to estimate expected term for share-based payment awards issued in the years ended December 31, 2009, 2008 and 2007. See Note 11 to the Financial Statements for a further discussion on stock-based compensation.



Net Loss Per Common Share



Basic net loss per common share is computed by dividing net
loss attributable to common stockholders by the weighted average number of common shares outstanding. Diluted net loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common
shares outstanding and dilutive potential common shares then outstanding. Dilutive potential common shares consist of shares issuable upon the exercise of stock options and restricted stock units that are paid in shares of the Companys stock
upon conversion. The calculation of diluted earnings per share for the years ended December 31, 2009, 2008 and 2007 does not include 261, 183 and 457, respectively, of potential common shares, as their impact would be antidilutive.



Comprehensive Loss



Accumulated other comprehensive loss is comprised of unrealized
gains and losses on marketable securities and is disclosed as a component of stockholders equity. At December 31, 2009, the Company had $68 of unrealized gains on its investments. At December 31, 2008, the Company had $193 of
unrealized losses on its investments.



F-14



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



Comprehensive loss consists of the following components for the years ended
December 31,:



|                                                  |  |      |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                  |  | 2009 |         |   | 2008 |   |         | 2007 | 
|Net loss                                          |  | $    | (39,976 | ) |      | $ | (51,603 | )    |  | $ | (63,740 | )
|Adjustment for realized losses in net loss        |  |      |        |   |      |   |        |      |  |   | 26      |  
|Change in unrealized gain/(losses) on investments |  |      | 261     |   |      |   | (234    | )    |  |   | 167     |  
|                                                  |  |      |         |   |      |   |         |      |  |   |         |  
|Total comprehensive loss                          |  | $    | (39,715 | ) |      | $ | (51,837 | )    |  | $ | (63,547 | )
|                                                  |  |      |         |   |      |   |         |      |  |   |         |  



Advertising



The Company engages in general and direct-response advertising
when promoting and marketing AzaSiteand Elestat. These advertising costs are expensed as the costs are incurred. Advertising and product promotion expenses were $9,666, $12,314 and $11,541 for the years ended December 31, 2009,
2008 and 2007, respectively.



Significant Customers and Risk



The Company relies primarily on three
pharmaceutical wholesalers to purchase and supply the majority of AzaSite at the retail level. These three pharmaceutical wholesalers accounted for greater than 85% of all AzaSiteproduct sales in the years ended December 31, 2009
and 2008, respectively, and account for 27% of the Companys outstanding trade receivables as of December 31, 2009. The loss of one or more of these wholesalers as a customer could negatively impact the commercialization of AzaSite.
All co-promotion and royalty revenues recognized and recorded were from one collaborative partner, Allergan. The Company is entitled to receive co-promotion revenue from net sales of Elestat and royalty revenue from net sales of
Restasis under the terms of its collaborative agreements with Allergan, and accordingly, all trade receivables for these two products are solely due from Allergan and account for 72% of the Companys outstanding trade receivables as of
December 31, 2009. Due to the nature of these agreements, Allergan has significant influence over the commercial success of Restasisand Elestat.



Risk from Generic Competition



The Companys revenues are subject to risk due to generic product entrants. TheElestat co-promotion agreement provides that
unless earlier terminated, the term of such agreement will be in effect until the earlier of (i) the approval and launch of the first generic epinastine product after expiration of the FDA exclusivity period coveringElestat in the
United States, or (ii) the approval and launch of the first over-the-counter epinastine product after expiration of the listing ofElestat in the FDAs Orange Book. Following the termination of such co-promotion agreement, the
Company will no longer have rights to co-promoteElestat. The Company will be entitled to receive post-termination payments from Allergan, based on any remaining net sales ofElestat for a period of 36 months. The Company has been
notified that Boehringer Ingelheim and Allergan received notices from four companies, advising that each company filed an Abbreviated New Drug Application (ANDA) for a generic version of Elestat. The date of submission of the
first ANDA filing to the FDA Office of Generic Drugs was October 14, 2008. The Company does not know when the FDA will complete its review of these ANDAs, but it expects that a generic form of epinastine could be launched in the second half of
2010.



Following the expiration of a use patent in
August 2009, the manufacture and sale of Restasis is protected in the United States by a formulation patent that expires in May 2014. While a formulation patent may afford certain limited protection, a competitor may attempt to gain FDA
approval for a cyclosporine product using a



F-15



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



different formulation. Furthermore, following the expiration of the formulation patent in 2014, a generic form of Restasis could be introduced into the market. If and when Restasis
experiences competition from a cyclosporine product, including a generic cyclosporine product, the Companys revenues attributable to Restasis may be significantly impacted.



Credit Risk



Cash equivalents and investments are financial instruments which potentially subject the Company to concentration of risk to the extent
recorded on the balance sheet. The Company deposits excess cash with major financial institutions in the United States. Balances may exceed the amount of insurance provided on such deposits. Management of the Company believes it has established
guidelines for investment of its excess cash relative to diversification and maturities that maintain safety and liquidity. To minimize the exposure due to adverse shifts in interest rates, the Company currently maintains a portfolio of investments
with an average maturity of 12 months or less as of December 31, 2009.



Risks from Third Party Manufacturing and Distribution Concentration



The Company relies on single source manufacturers for its commercial products and product candidates. Allergan is responsible for the
manufacturing of both Restasis and Elestat and relies on single source manufacturers for the active pharmaceutical ingredients in both products. The Company relies on InSite Vision for the supply of the active pharmaceutical ingredient
for AzaSite, which InSite Vision obtains from a single source manufacturer. The Company is responsible for the remaining finished product manufacturing of AzaSite, for which it relies on a single source manufacturer. Additionally, the
Company relies upon a single third party to provide distribution services for AzaSite.



The Company relies upon one vendor as the sole manufacturer of the supply of active pharmaceutical ingredients for both Prolacriaand denufosol; however, the Company has initiated development of a
secondary supplier for denufosol.



Effective
September 25, 2009, the Company and Yamasa Corporation entered into a Technology License Agreement for the Manufacture of Denufosol. The purpose of the agreement is to facilitate the transfer of the current denufosol manufacturing technology,
including intellectual property, to an additional manufacturer and thus enable a two-supplier strategy for denufosol. In consideration of the grant of rights under the agreement, in October 2009, the Company paid Yamasa three hundred million
Japanese Yen (¥ 300,000,000), which was approximately $3,302 at the prevailing exchange rate. Additionally, the Company shall pay Yamasa (i) three hundred million Yen (¥ 300,000,000) within thirty (30) days after the receipt of a
process validation report by December 31, 2010 following the successful completion of three validation batches; and (ii) four hundred million Yen (¥ 400,000,000) within thirty (30) days after both (a) the acceptance of a
pre-approval inspection of denufosol at Yamasa by the FDA, and (b) the approval of a New Drug Application of a formulated denufosol drug product at Inspire by the FDA.



Delays in the manufacture or distribution of any product or manufacture of any product candidate could
adversely impact the marketing of the Companys products or the development of the Companys product candidates. Furthermore, the Company has no control over the manufacturing or the overall product supply chain of Restasisand
Elestat.



F-16



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



Recent Accounting Pronouncements



In January 2010, the FASB issued authoritative guidance for improving disclosures about fair value
measurements. This guidance requires some new disclosures and clarifies some existing disclosure requirements about fair value measurement. The new disclosure requirements are effective for interim and annual reporting periods beginning after
December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after
December 15, 2010, and for interim periods within those fiscal years. Since the new guidance only impacts financial statement disclosures, there will be no impact to the Companys financial position or results of operations upon adoption.



In October 2009, the FASB issued authoritative
guidance regarding revenue arrangements with multiple deliverables. The guidance requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The
guidance further eliminates the residual method of revenue allocation and requires revenue to be allocated using the relative selling price method. The new guidance should be applied on a prospective basis for revenue arrangements entered into or
materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The Company is currently assessing the impact of adopting this new guidance.



In August 2009, the FASB issued authoritative guidance regarding measuring liabilities at fair value. The
authoritative guidance sets forth the types of valuation techniques to be used to value a liability when a quoted price in an active market for the identical liability is not available. It also clarifies transfer restrictions on the fair value of a
liability and the ability to use the fair value of a liability that is traded as an asset as an input to the valuation of the underlying liability. The authoritative guidance is effective for interim and annual periods beginning after
August 26, 2009. The Company has assessed the impact of this new guidance and expects no material impact to its financial statements upon adoption.



In May 2009, the FASB issued authoritative guidance regarding subsequent events. The authoritative guidance establishes general standards of
accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The authoritative guidance is effective for interim and annual periods ending after
June 15, 2009.



In April 2009, the FASB
issued authoritative guidance to aid in determining fair value when the volume and level of activity for the assets or liabilities have significantly decreased and when identifying transactions are not orderly, such as a forced liquidation or
distressed sale. The authoritative guidance became effective for the Company on April 1, 2009, and the adoption of the guidance did not have a material impact on the Companys consolidated financial statements.



In April 2009, the FASB issued authoritative guidance on the
recognition and presentation of other-than-temporary impairments. The authoritative guidance incorporates impairment guidance for debt securities from various sources of authoritative literature and clarifies the interaction of the factors that
should be considered when determining whether a debt security is other than temporarily impaired. The authoritative guidance became effective for the Company on April 1, 2009 and the adoption of the guidance did not have a material impact on
the Companys consolidated financial statements.



In April 2009, the FASB issued authoritative guidance to require disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements. The authoritative guidance is effective
for interim periods ending after June 15, 2009, and the Company has adopted the guidance and has provided the additional disclosures as required.



F-17



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



3. Fair Value



The Companys financial assets recorded at fair value on a recurring basis have been categorized based
upon a fair value hierarchy in accordance with FASB authoritative guidance. Under the guidance, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (the exit price) in an orderly
transaction between market participants at the measurement date. The guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that
the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are
inputs that reflect the Companys own assumptions about the market participant assumptions that would be used in pricing the asset or liability based on the best information available in the circumstances. The hierarchy gives the highest
priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). As of January 1, 2009, the Company adopted the guidance for
its fair value measure of non-financial assets and liabilities and there was no material impact.



The Company has not elected the fair value option for financial assets and liabilities existing at January 1, 2008 that were not already
measured at fair value or newly transacted in the years ended December 31, 2009 and 2008. Any future transacted financial assets or liabilities will be evaluated for the fair value election.



The following fair value hierarchy tables present information
about the Companys financial assets measured at fair value on a recurring basis as of December 31, 2009 and 2008:



|                                           |  |               |         |                                                             |   |                                             |  |   |       
|------------------------------------------ |  | ------------- | ------- | ----------------------------------------------------------- | - | ------------------------------------------- |  | - | ------
|                                           |  | Total Balance |         | Quoted Prices in ActiveMarkets for IdenticalAssets(Level 1) |   | Significant OtherObservable Inputs(Level 2)
|As of December 31, 2009:                   |  |               |         |                                                             |   |                                             |  |   |       
|Cash equivalents                           |  | $             | 41,052  |                                                             | $ | 36,053                                      |  | $ | 4,999 
|InvestmentsAvailable-for-sale securities: |  |               |         |                                                             |   |                                             |  |   |       
|U.S. Treasury                              |  |               | 5,980   |                                                             |   | 5,980                                       |  |   |      
|U.S. Government agencies                   |  |               | 12,658  |                                                             |   |                                            |  |   | 12,658
|Corporate bonds and commercial paper       |  |               | 44,778  |                                                             |   |                                            |  |   | 44,778
|Negotiated certificates of deposit         |  |               | 12,612  |                                                             |   |                                            |  |   | 12,612
|                                           |  |               |         |                                                             |   |                                             |  |   |       
|Total                                      |  | $             | 117,080 |                                                             | $ | 42,033                                      |  | $ | 75,047
|                                           |  |               |         |                                                             |   |                                             |  |   |       
|As of December 31, 2008:                   |  |               |         |                                                             |   |                                             |  |   |       
|Cash equivalents                           |  | $             | 53,062  |                                                             | $ | 51,066                                      |  | $ | 1,996 
|InvestmentsAvailable-for-sale securities: |  |               |         |                                                             |   |                                             |  |   |       
|U.S. Treasury                              |  |               | 5,000   |                                                             |   | 5,000                                       |  |   |      
|Corporate bonds and commercial paper       |  |               | 8,663   |                                                             |   |                                            |  |   | 8,663 
|                                           |  |               |         |                                                             |   |                                             |  |   |       
|Total                                      |  | $             | 66,725  |                                                             | $ | 56,066                                      |  | $ | 10,659
|                                           |  |               |         |                                                             |   |                                             |  |   |       



Level 1 fair value measurements are based on quoted market prices in active markets and include U.S. government and agency securities. Level 1 cash equivalents consist of investments concentrated in money
market funds which are primarily invested in U.S. Treasury securities.



Level 2 fair value measurements are based on quoted prices in markets that are not active, broker dealer quotations, or other methods by which all significant inputs are observable, either directly or
indirectly. Level 2 cash equivalents and available-for-sale securities consist of investments in corporate bonds and commercial paper, U.S. government agencies and negotiated certificates of deposit.



F-18



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



The Companys investment policy dictates that investments in money market
instruments are limited to those that have a rating of at least A-1 and P-1 according to Standard & Poors and Moodys Investor Services, respectively. Likewise, for investments made in corporate obligations, the Companys
investment policy requires ratings of at least A and A-2 according to Standard & Poors and Moodys Investor Services. The Company does not have any direct investments in auction-rate securities or securities that are
collateralized by assets that include mortgages or subprime debt.



Non-recurring fair value amounts for assets held at December 31, 2009 were $402 and are considered Level 3. These assets represent assets held-for-sale and reflect the lower of the carrying
value or fair value less costs to sell. As a result of its restructuring activity, the Company assessed the fair value of assets, primarily property and equipment associated with idle lab facilities, on a non-recurring basis. In the first quarter of
2009, the Company recorded an impairment of $484 to reflect the estimated fair value of the idle assets, based on internally established estimates and the selling prices of similar assets. In the fourth quarter of 2009, the Company began marketing
and disposing of all its laboratory equipment. Fair value of this equipment was assessed by the third-party marketer and no additional impairment charges were recorded.



4. Investments



A summary of the fair market value of the Companys investments by classification, as well as contractual maturities of marketable debt
securities, is as follows:



|                                         |      |              |        |  |   |       
|---------------------------------------- | ---- | ------------ | ------ |  | - | ------
|                                         |      | December 31,
|                                         | 2009 |              | 2008  
|Available-for-sale debt securities:      |      |              |        |  |   |       
|Less than one year                       |      | $            | 54,367 |  | $ | 13,663
|After one year through five years        |      |              | 21,661 |  |   |      
|                                         |      |              |        |  |   |       
|Total available-for-sale debt securities |      | $            | 76,028 |  | $ | 13,663
|Preferred stock                          |      |              | 200    |  |   | 200   
|                                         |      |              |        |  |   |       
|Total Investments                        |      | $            | 76,228 |  | $ | 13,863
|                                         |      |              |        |  |   |       



The following is a summary of the Companys marketable debt securities which are classified as available-for-sale as of December 31, 2009 and 2008:



|                                     |  |      |        |                     |   |                     |  |   |           |   |  |   |       
|------------------------------------ |  | ---- | ------ | ------------------- | - | ------------------- |  | - | --------- | - |  | - | ------
|                                     |  | Cost |        | GrossUnrealizedGain |   | GrossUnrealizedLoss |  |   | FairValue
|As of December 31, 2009:             |  |      |        |                     |   |                     |  |   |           |   |  |   |       
|Corporate bonds and commercial paper |  | $    | 44,702 |                     | $ | 88                  |  | $ | (12       | ) |  | $ | 44,778
|U.S. Treasury                        |  |      | 5,981  |                     |   |                     |  |   | (1        | ) |  |   | 5,980 
|U.S. Government agencies             |  |      | 12,664 |                     |   |                    |  |   | (6        | ) |  |   | 12,658
|Negotiated certificates of deposit   |  |      | 12,612 |                     |   |                    |  |   |          |   |  |   | 12,612
|                                     |  |      |        |                     |   |                     |  |   |           |   |  |   |       
|Total                                |  | $    | 75,959 |                     | $ | 88                  |  | $ | (19       | ) |  | $ | 76,028
|                                     |  |      |        |                     |   |                     |  |   |           |   |  |   |       
|As of December 31, 2008:             |  |      |        |                     |   |                     |  |   |           |   |  |   |       
|Corporate bonds and commercial paper |  | $    | 8,858  |                     | $ | 5                   |  | $ | (200      | ) |  | $ | 8,663 
|U.S. Treasury                        |  |      | 4,998  |                     |   | 2                   |  |   |          |   |  |   | 5,000 
|                                     |  |      |        |                     |   |                     |  |   |           |   |  |   |       
|Total                                |  | $    | 13,856 |                     | $ | 7                   |  | $ | (200      | ) |  | $ | 13,663
|                                     |  |      |        |                     |   |                     |  |   |           |   |  |   |       



F-19



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



The Company does not consider its investment in available-for-sale debt securities to be
other-than-temporarily impaired at December 31, 2009.



The following table shows the gross unrealized losses and fair value of the Companys investment in marketable debt securities with unrealized losses that are deemed to be temporarily impaired, aggregated by length of time that the
individual securities have been in a continuous unrealized loss position as of December 31, 2009 and 2008:



|                         |  |                     |        |                |   |      |  
|------------------------ |  | ------------------- | ------ | -------------- | - | ---- | -
|                         |  | Less than 12 months |       
|                         |  | FairValue           |        | UnrealizedLoss |  
|As of December 31, 2009: |  |                     |        |                |   |      |  
|Corporate bonds          |  | $                   | 20,586 |                | $ | (12  | )
|U.S. Treasury            |  |                     | 5,980  |                |   | (1   | )
|U.S. Government agencies |  |                     | 9,158  |                |   | (6   | )
|                         |  |                     |        |                |   |      |  
|Total                    |  | $                   | 35,724 |                | $ | (19  | )
|                         |  |                     |        |                |   |      |  
|As of December 31, 2008: |  |                     |        |                |   |      |  
|Corporate bonds          |  | $                   | 6,140  |                | $ | (200 | )
|                         |  |                     |        |                |   |      |  
|Total                    |  | $                   | 6,140  |                | $ | (200 | )
|                         |  |                     |        |                |   |      |  



The unrealized losses on the
Companys investments in corporate bonds as of December 31, 2009 were primarily due to changes in credit ratings and changes in market interest rates. The unrealized losses on the Companys investments in corporate bonds as of
December 31, 2008 were primarily due to changes in credit ratings. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Because the Company has
the ability and intent to hold its investments until a recovery of fair value, which may be at maturity, the Company does not consider its investments to be other-than-temporarily impaired at December 31, 2009. The Company did not have any
investments in marketable debt securities that have been in a continuous unrealized loss position for 12 months or greater as of December 31, 2009 and 2008. Gross realized losses on the Companys available-for-sale securities were $26 for
the year ended December 31, 2007. There were no realized gains or losses on the Companys available-for-sale securities for the years ended December 31, 2009 and 2008.



5. Inventories



The Companys inventories are related to AzaSiteand are valued at the lower of cost or market using the first-in, first-out
(i.e., FIFO) method. Cost includes materials, labor, overhead, shipping and handling costs. The Companys inventories are subject to expiration dating and the Company has reserved for potential overstocking. The Companys inventories
consisted of the following:



|                       |  |                  |       |   |                  |   |     |  
|---------------------- |  | ---------------- | ----- | - | ---------------- | - | --- | -
|                       |  | As of            |      
|                       |  | December 31,2009 |       |   | December 31,2008 |  
|Finished Goods         |  | $                | 808   |   |                  | $ | 47  |  
|Work-in-Process        |  |                  | 96    |   |                  |   | 160 |  
|Raw Materials          |  |                  | 838   |   |                  |   | 492 |  
|                       |  |                  |       |   |                  |   |     |  
|Total Inventories      |  | $                | 1,742 |   |                  | $ | 699 |  
|Less Valuation Reserve |  |                  | (25   | ) |                  |   | (10 | )
|                       |  |                  |       |   |                  |   |     |  
|Total Inventories, net |  | $                | 1,717 |   |                  | $ | 689 |  
|                       |  |                  |       |   |                  |   |     |  



F-20



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



During the years ended December 31, 2009, 2008 and 2007, the Company recorded
valuation reserves of $15, $105 and $125, respectively, for potential overstocking and short-dated product. During the year ended December 31, 2008, the Company wrote-off approximately $220 of short-dated product from finished goods.



6. Restructuring



In March 2009, the Company announced that it had restructured
its operations during the first quarter of 2009, eliminating preclinical and drug discovery activities and refocusing its resources on the development of existing later-stage clinical programs and commercially available products. In connection with
the restructuring, the Company recorded restructuring charges of $2,014 for the year ended December 31, 2009, which are reported as a separate line item in the accompanying Condensed Statement of Operations. The Company recorded its
restructuring activities in accordance with FASB authoritative guidance regarding the accounting for the impairment and disposal of long-lived assets and the accounting for costs associated with exit or disposal activities.



The following table summarizes the components of the
restructuring charges:



|                            |          |                              |                |  |       |     |  |   |      
|--------------------------- | -------- | ---------------------------- | -------------- |  | ----- | --- |  | - | -----
|                            |          | Year ended December 31, 2009
|                            | Accruals |                              | Non-cash items |  | Total
|Facilities related          |          | $                            | 255            |  | $     |    |  | $ | 255  
|Employee separation costs   |          |                              | 1,072          |  |       |    |  |   | 1,072
|Asset impairment            |          |                              |               |  |       | 484 |  |   | 484  
|Contracts                   |          |                              | 203            |  |       |    |  |   | 203  
|                            |          |                              |                |  |       |     |  |   |      
|Total Restructuring Charges |          | $                            | 1,530          |  | $     | 484 |  | $ | 2,014
|                            |          |                              |                |  |       |     |  |   |      



Employee separation costs consist of one-time termination benefits, primarily severance costs, associated with the reduction in the Companys workforce.



Asset impairments consist of property and equipment, primarily
lab equipment, that was used for discovery and preclinical research activities at the Companys facility. The Company performed an impairment analysis and determined that the carrying value of the idle assets exceeded their fair value and
recorded an impairment charge of $484. Fair value was based on internally established estimates and the selling prices of similar assets.



Contract charges consist of costs associated with contractual commitments and work performed subsequent to the restructuring related to
programs the Company no longer supports as part of its planned ongoing research and development activities.



Facility related charges consist of estimated losses associated with leased lab space at the Companys Durham, North Carolina
headquarters that the Company no longer uses in its operations. The unoccupied leased space is approximately 14,000 square feet and the lease term is through January 2011. The Company used a discounted cash-flow analysis to calculate the amount of
this liability. The probability-weighted discounted cash-flow analysis is based on managements assumptions and estimates of its ongoing lease obligations, including contractual rental commitments, build-out commitments and building operating
costs, estimates of income from subleases, and market conditions for similar rental properties in its geographic area. The estimated cash flows were discounted using a credit-adjusted risk free rate of approximately 15%. The Company expects to incur
approximately $45 of accretion expense over the term of the lease.



F-21



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



The following table sets forth activity in the restructuring liability for the year
ended December 31, 2009:



|                             |  |                          |        |   |                           |   |      |                            |  |   |       |   |  |   |        |  
|---------------------------- |  | ------------------------ | ------ | - | ------------------------- | - | ---- | -------------------------- |  | - | ----- | - |  | - | ------ | -
|                             |  | Employee separationcosts |        |   | Facilities relatedcharges |   |      | Other restructuringcharges |  |   | Total |  
|Balance at December 31, 2008 |  | $                        |       |   |                           | $ |     |                            |  | $ |      |   |  | $ |       |  
|Accruals                     |  |                          | 1,072  |   |                           |   | 255  |                            |  |   | 203   |   |  |   | 1,530  |  
|Payments                     |  |                          | (1,072 | ) |                           |   | (140 | )                          |  |   | (203  | ) |  |   | (1,415 | )
|                             |  |                          |        |   |                           |   |      |                            |  |   |       |   |  |   |        |  
|Balance at December 31, 2009 |  | $                        |       |   |                           | $ | 115  |                            |  | $ |      |   |  | $ | 115    |  
|                             |  |                          |        |   |                           |   |      |                            |  |   |       |   |  |   |        |  



The liability associated with
employee separation costs was fully paid as of December 31, 2009. The liability associated with facilities will be reduced as monthly rental payments are made through the lease term, which ends in January 2011.



7. Property and Equipment



Property and equipment consist of the following:



|                              |  |                                 |  |              |        |   |      |   |        |  
|----------------------------- |  | ------------------------------- |  | ------------ | ------ | - | ---- | - | ------ | -
|                              |  | Useful Life (Years)             |  | December 31, |       
|                              |  |                                 |  | 2009         |        |   | 2008 |  
|Equipment                     |  | 5                               |  | $            | 6,339  |   |      | $ | 6,228  |  
|Leasehold improvements        |  | Lesser of lease term or 5 years |  |              | 2,236  |   |      |   | 2,225  |  
|Software                      |  | 5                               |  |              | 1,165  |   |      |   | 1,134  |  
|Furniture and fixtures        |  | 7                               |  |              | 836    |   |      |   | 983    |  
|Computer hardware             |  | 3                               |  |              | 578    |   |      |   | 979    |  
|                              |  |                                 |  |              |        |   |      |   |        |  
|                              |  |                                 |  |              | 11,154 |   |      |   | 11,549 |  
|Less accumulated depreciation |  |                                 |  |              | (6,725 | ) |      |   | (8,624 | )
|                              |  |                                 |  |              |        |   |      |   |        |  
|Property and equipment, net   |  |                                 |  | $            | 4,429  |   |      | $ | 2,925  |  
|                              |  |                                 |  |              |        |   |      |   |        |  



8. Accrued Expenses



Accrued expenses are comprised of the following:



|                                                           |      |              |        |  |   |       
|---------------------------------------------------------- | ---- | ------------ | ------ |  | - | ------
|                                                           |      | December 31,
|                                                           | 2009 |              | 2008  
|Compensation and benefits                                  |      | $            | 7,574  |  | $ | 6,060 
|Allowances for discounts, rebates, chargebacks and returns |      |              | 5,900  |  |   | 2,004 
|Development costs                                          |      |              | 4,617  |  |   | 3,226 
|Selling and marketing costs                                |      |              | 906    |  |   | 479   
|Inventory                                                  |      |              | 893    |  |   |      
|Professional fees                                          |      |              | 314    |  |   | 351   
|Duties and taxes                                           |      |              | 226    |  |   | 168   
|Accrued interest                                           |      |              | 169    |  |   | 293   
|Other                                                      |      |              | 647    |  |   | 561   
|                                                           |      |              |        |  |   |       
|                                                           |      | $            | 21,246 |  | $ | 13,142
|                                                           |      |              |        |  |   |       



The carrying value of accrued expenses approximates fair value due to their short-term settlement.



F-22



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



9. Debt



In December 2006, the Company entered into a loan and security agreement with two participating financial institutions, which provided a
term loan facility to the Company in an aggregate amount of $40,000. Any borrowings under the loan agreement are collateralized by substantially all of the Companys assets, with the exception of its intellectual property but including all
accounts, license and royalty fees and other revenues and proceeds arising from its intellectual property. In addition, the Company established and maintains its primary depository accounts and security accounts with one of the participating
financial institutions and will keep a certain percentage of its cash and investments within these accounts depending upon its total cash and investment balances. In June 2007, the Company amended the loan and security agreement with the two
participating financial institutions to enable the Company to draw upon a new supplemental term loan facility in the amount $20,000, effectively increasing the total term loan facility to $60,000. The Company has borrowed the full $60,000 available
under the term loan facility. The interest rates associated with each of the borrowings under the facility range from approximately 7.6% to 8.0%.



The final maturity date for all loan advances under the original term loan facility and the supplemental term loan facility is March 2011.
Interest accrues on the unpaid principal amount of each loan advance at a per annum rate equal to the five-year U.S. Treasury note yield plus a predetermined percentage at the time each advance is made. Repayment of each advance is made according to
a schedule of six monthly installments of interest-only followed by equal monthly installments of principal and interest until the maturity date. During the term of the loan and security agreement, the Company is required to maintain minimum
liquidity levels at a ratio of 1:1.35 based on the balance of the outstanding advances of the first $40,000 under the original term loan facility. There is no minimum liquidity requirement on the $20,000 borrowed under the supplemental term loan
facility. In addition to other financial and non-financial covenants within the agreement, the agreement contains a subjective acceleration clause such that repayment could be accelerated upon a material adverse change to the business, properties,
assets, financial condition or results of operations of the Company. In addition, under the terms of the agreement, the Company may not enter into certain transactions such as a merger, acquisition, additional indebtedness or dispose of certain
assets of the business as defined in the agreement without written approval of the lenders.The Company has the right to prepay the principal of any advance in minimum incremental amounts of $1,000. Any prepayment of borrowings made under the
original term loan facility are not subject to a penalty; however, any prepayments of borrowings made under the new supplemental term loan facility are subject to a 2% penalty, if prepaid within the first two years. All repayments of principal by
the Company are subject to a final payment of $1,200, equal to 2% of the principal amount being repaid. Amounts cannot be re-borrowed by the Company once repaid. At December 31, 2009, the Company was in compliance with all of the covenants
under the loan and security agreement and projects that it will be throughout 2010.



As of December 31, 2009, the Company had net borrowings of $25,175 under the loan and security agreement that bears interest at a weighted average rate of 7.8%. The fair value of the Companys
long-term debt as of December 31, 2009 is $24,366. The fair value is estimated by discounting the projected cash flows using the current rates available to the Company as of the balance sheet date for debt of similar terms and maturities.
Scheduled maturities, representing principal repayments, of the term loan facility are as follows:



|                     |  |   |       
|-------------------- |  | - | ------
|Term-Loan Maturities
|2010                 |  | $ | 19,940
|2011                 |  |   | 5,235 
|                     |  |   |       
|Total                |  | $ | 25,175
|                     |  |   |       



F-23



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



10. Stockholders Equity



Sales of Common Stock



In August 2009, the Company completed a public offering of 25,556 shares of its common stock at a price of $4.50 per share, which included
the underwriters over-allotment allocation of an additional 3,333 shares, for gross proceeds of $115,000. Net proceeds were $109,000, after deducting underwriting discounts and offering expenses, including reimbursing Warburg Pincus Private
Equity IX, L.P. (Warburg), a related party, for $500 of expenses incurred. Warburg purchased $40,000, or 8,889 shares, of the common stock offering for total holdings of 22,907 shares of the Companys common stock, which represented
approximately 28% of the Companys outstanding stock as of December 31, 2009.



The sale of the shares was made pursuant to the Companys registration statement on Form S-3 filed with the SEC on March 9, 2007, which provided the Company the ability to offer for sale
approximately $130,000 of securities, including common stock, preferred stock, debt securities, depositary shares and securities warrants.



In July 2007, the Company sold approximately 140 shares of its Series A Exchangeable Preferred Stock, par value $0.001 per share (the
Exchangeable Preferred Stock), to Warburg at a price per share of $535.00, for aggregate gross proceeds of $75,000 under a Securities Purchase Agreement. The purchase price was based on a $5.35 per share value for the Companys
common stock, par value $0.001 per share. The Company incurred issuance costs of approximately $1,395 in connection with the sale of the Exchangeable Preferred Stock. The Exchangeable Preferred Stock was exchangeable for shares of common stock at a
ratio of 1:100. In October 2007, the Company held a special meeting of stockholders at which the proposed exchange of all outstanding Exchangeable Preferred Stock for shares of the Companys common stock was approved by the Companys
stockholders. The total number of shares of common stock issued in the exchange was 14,019. Subsequent to the exchange, the Company retired the 140 shares of the Exchangeable Preferred Stock, reducing total authorized shares of preferred stock
available for issuance to 1,860.



The Exchangeable
Preferred Stock was accounted for in accordance with FASB authoritative guidance on accounting for convertible securities with beneficial conversion features. The difference between the effective conversion price per share of underlying common stock
in the exchange provision and the market value per share of common stock as of the closing date of the Exchangeable Preferred Stock transaction resulted in the recording of an embedded contingent beneficial conversion feature, which is required to
be treated as a non-cash deemed dividend to preferred stockholders. Upon the stockholders approval on October 31, 2007, the contingency was resolved and the Exchangeable Preferred Stock was immediately converted to common stock, resulting
in full accretion of the beneficial conversion feature. The calculated value of the beneficial conversion feature was approximately $8,285 and was credited to additional paid-in capital upon resolution of the contingency in the quarter ended
December 31, 2007. Due to the absence of retained earnings, the accretion of the beneficial conversion feature was recorded as a debit to additional paid-in-capital.



The holders of the Companys common stock are entitled to receive dividends from time to time as may be declared by the
Board of Directors, but a common stock dividend has never been declared, nor is a dividend payment expected in the near-term. The holders of shares of common stock are entitled to one vote for each share held with respect to all matters voted on by
the stockholders of the Company.



Rights Agreement



In October 2002, the Company entered into a
Rights Agreement with Computershare Trust Company. The Rights Agreement provides for a dividend of one preferred stock purchase right for each outstanding share of the



F-24



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



Companys common stock. Each right entitles a stockholder, after the rights become exercisable, to buy 1/1,000th of a share of Inspires Series H Preferred Stock at an exercise price of
$50. Each right will become exercisable following the tenth day after an acquiring person or group acquires, or announces its intention to acquire, 15% or more of the common stock. The Company will be entitled to redeem the rights at $0.001 per
right at any time on or before the close of business on the tenth day following acquisition by a person or group of 15% or more of the common stock. Under the Rights Agreement, if a person acquires 15% or more of the common stock without the
approval of the Companys Board of Directors, all other stockholders will have the right to purchase securities from the Company at a price that is less than its fair market value, which would substantially reduce the value of the common stock
owned by the acquiring person. As a result, the rights will cause substantial dilution to a person or group that attempts to acquire the Company on terms not approved by the Companys Board of Directors, except pursuant to an offer conditioned
on a substantial number of Rights being acquired. The rights should not interfere with any merger or other business combination approved by the Board of Directors since the rights may be redeemed by the Company at the redemption price of $0.001
prior to the occurrence of a distribution date. In connection with the transaction with Warburg, the Company and Computershare entered into a First Amendment to Rights Agreement dated July 17, 2007. The First Amendment to Rights Agreement
provides that Warburg and its affiliates will be exempt from the definition of an Acquiring Person under the Rights Agreement, unless Warburg or certain of its affiliates becomes the beneficial owner of the lesser of: (x) 32.5% of
the Companys voting securities on a fully diluted basis and (y) 34.9% of the Companys then outstanding voting securities plus the outstanding Exchangeable Preferred Stock on an as exchanged to common stock basis.



11. Stock-Based Compensation



The Company accounts for stock-based compensation in accordance
with FASB authoritative guidance regarding share-based payments. Total stock-based compensation was allocated as follows:



|                                       |      |                         |       |  |      |       |  |   |      
|-------------------------------------- | ---- | ----------------------- | ----- |  | ---- | ----- |  | - | -----
|                                       |      | Year Ended December 31,
|                                       | 2009 |                         | 2008  |  | 2007
|Research and development               |      | $                       | 1,295 |  | $    | 1,319 |  | $ | 822  
|Selling and marketing                  |      |                         | 1,849 |  |      | 1,402 |  |   | 882  
|General and administrative             |      |                         | 1,919 |  |      | 1,722 |  |   | 1,294
|                                       |      |                         |       |  |      |       |  |   |      
|Total stock-based compensation expense |      | $                       | 5,063 |  | $    | 4,443 |  | $ | 2,998
|                                       |      |                         |       |  |      |       |  |   |      



Equity Compensation Plans



The
Company has two stock-based compensation plans, the Amended and Restated 1995 Stock Plan (the 1995 Plan) and the Amended and Restated 2005 Equity Compensation Plan (the 2005 Plan), that allow for share-based payments to be
granted to directors, officers, employees and consultants. The 1995 Plan allows for the granting of non-qualified stock options and restricted stock to directors, officers, employees and consultants. The 2005 Plan allows for the granting of both
incentive and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units to directors, officers, employees and consultants. At December 31, 2009, there were 389 and 896 shares available for grant as
options or other forms of share-based payments under the 1995 Plan and 2005 Plan, respectively.



The Board of Directors, or an appropriate committee of the Board of Directors, determines the terms of all options and other equity
arrangements under both plans. The maximum term for any option grant under the 1995 Plan and the 2005 Plan are ten and seven years, respectively, from the date of the grant. Prior to July 2006,



F-25



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



options granted to employees under both plans generally vested 25% upon completion of one full year of employment from date of grant and on a monthly basis over the following three years of their
employment and the term of the options was the maximum permitted under the applicable plan. Beginning in July 2006, the Compensation Committee of the Companys Board of Directors authorized stock option grants with a three-year vesting period
and a term of five years for all future issuances to non-executive employees. Under these new terms, options granted to non-executive employees will vest 33% upon completion of one full year of employment from date of grant and on a monthly basis
over the following two years of their employment. The vesting period typically begins on the date of hire for new employees and on the date of grant for existing employees.



Basis for Fair Value Estimate of Share-Based Payments



Stock Options



The Company uses its own historical volatility to estimate its future volatility. Actual volatility, and future changes in estimated
volatility, may differ substantially from the Companys current estimates.



The Company utilizes the simplified method of calculating the expected life of options for grants made to its employees under the 1995 Plan and 2005 Plan in accordance with authoritative guidance due to
the lack of adequate historical data with regard to exercise activity on options. For options granted to directors under the 1995 Plan or the 2005 Plan, the Company uses the contractual term of seven years as the expected life of options. The
Company will continue with these assumptions in determining the expected life of options under the 1995 Plan and the 2005 Plan until such time that adequate historical data is available. The Company estimates the forfeiture rate based on its
historical experience. These estimates will be revised in future periods if actual forfeitures differ from the estimate. Changes in forfeiture estimates impact compensation cost in the period in which the change in estimate occurs.



The table below presents the weighted average expected life in
years of options granted under the two plans as described above. The risk-free rate of the stock options is based on the U.S. Treasury yield curve in effect at the time of grant, which corresponds with the expected term of the option granted. The
fair value of share-based payments, granted during the period indicated, was estimated using the Black-Scholes option pricing model with the following assumptions and weighted average fair values as follows:



|                                                   |      |                                          |           |      |  |   |           |   |  |   |           |  
|-------------------------------------------------- | ---- | ---------------------------------------- | --------- | ---- |  | - | --------- | - |  | - | --------- | -
|                                                   |      | Stock Options for Year EndedDecember 31, |          
|                                                   | 2009 |                                          |           | 2008 |  |   | 2007      |  
|Risk-free interest rate                            |      |                                          | 1.73      | %    |  |   | 2.43      | % |  |   | 4.43      | %
|Dividend yield                                     |      |                                          | 0         | %    |  |   | 0         | % |  |   | 0         | %
|Expected volatility                                |      |                                          | 71        | %    |  |   | 65        | % |  |   | 67        | %
|Expected life of options                           |      |                                          | 3.9 years |      |  |   | 3.9 years |   |  |   | 3.9 years |  
|Weighted average fair value of grants (per option) |      | $                                        | 2.34      |      |  | $ | 2.01      |   |  | $ | 3.22      |  



F-26



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



The following table summarizes the stock option activity for both the 1995 Plan and 2005
Plan:



|                                            |  |                 |   |  |                                          |       |   |                                                    |     |                          |   |      
|------------------------------------------- |  | --------------- | - |  | ---------------------------------------- | ----- | - | -------------------------------------------------- | --- | ------------------------ | - | -----
|                                            |  | Number ofShares |   |  | WeightedAverageExercise Price(per share) |       |   | WeightedAverageRemainingContractual Term(in Years) |     | AggregateIntrinsic Value
|Outstanding at December 31, 2008            |  | 9,531           |   |  | $                                        | 8.16  |   |                                                    | 4.2 |                          | $ | 253  
|Granted                                     |  | 2,112           |   |  |                                          | 4.41  |   |                                                    |     |                          |   |      
|Exercised                                   |  | (110            | ) |  |                                          | (3.93 | ) |                                                    |     |                          |   |      
|Forfeited/cancelled/expired                 |  | (532            | ) |  |                                          | (8.44 | ) |                                                    |     |                          |   |      
|                                            |  |                 |   |  |                                          |       |   |                                                    |     |                          |   |      
|Outstanding at December 31, 2009            |  | 11,001          |   |  |                                          | 7.47  |   |                                                    | 3.5 |                          | $ | 6,503
|                                            |  |                 |   |  |                                          |       |   |                                                    |     |                          |   |      
|Vested and exercisable at December 31, 2009 |  | 7,620           |   |  | $                                        | 8.80  |   |                                                    | 3.1 |                          | $ | 2,734
|Expected to vest at December 31, 2009       |  | 10,727          |   |  | $                                        | 7.54  |   |                                                    | 3.5 |                          | $ | 6,208



Total intrinsic value of stock options exercised for the years ended December 31, 2009, 2008 and 2007 was $174, $534 and $1,211,
respectively. Cash received from stock option exercises for the year ended December 31, 2009 was $433. Due to the Companys net loss position, no windfall tax benefits have been realized during the year ended December 31, 2009. As of
December 31, 2009, approximately $6,808 of total unrecognized compensation cost related to unvested stock options is expected to be recognized over a weighted-average period of 2.1 years.



The following table summarizes information concerning options
outstanding at December 31, 2009:



|                                  |  |                    |  |                                         |       |                                                   |     |                    |      
|--------------------------------- |  | ------------------ |  | --------------------------------------- | ----- | ------------------------------------------------- | --- | ------------------ | -----
|                                  |  | OptionsOutstanding |  | WeightedAverageExercisePrice(per share) |       | WeightedAverageRemainingContractualTerm(in Years) |     | OptionsExercisable
|Exercise Price range (per share): |  |                    |  |                                         |       |                                                   |     |                    |      
|$   2.25 - $   3.98               |  | 2,522              |  | $                                       | 3.71  |                                                   | 3.9 |                    | 958  
|$   4.06 - $   5.10               |  | 2,457              |  |                                         | 4.79  |                                                   | 4.3 |                    | 1,090
|$   5.22 - $   6.49               |  | 2,411              |  |                                         | 5.88  |                                                   | 3.1 |                    | 1,966
|$   6.85 - $ 13.60                |  | 2,202              |  |                                         | 10.29 |                                                   | 2.4 |                    | 2,197
|$ 13.65 - $ 20.30                 |  | 1,409              |  |                                         | 17.18 |                                                   | 3.6 |                    | 1,409
|                                  |  |                    |  |                                         |       |                                                   |     |                    |      
|                                  |  | 11,001             |  | $                                       | 7.47  |                                                   | 3.5 |                    | 7,620
|                                  |  |                    |  |                                         |       |                                                   |     |                    |      



Restricted Stock Units



In July 2006, the Compensation Committee authorized the issuance of restricted stock units (RSUs) to each of the Companys then executive officers. The value of RSUs granted was based on
the closing market price of the Companys common stock on the date of grant and is amortized on a straight-line basis over the five year requisite service period. A total of 195 RSUs were granted and had a total fair value at the date of grant
of $811. The RSUs vest 20% annually over five years from the date of grant or earlier upon the event of a change in control. Any RSUs that have not vested at the time of termination of service to the Company are forfeited. The RSUs do not have
voting rights, and the shares underlying the RSUs are not considered issued and outstanding until conversion. Any vested units will convert into an equivalent number of shares of common stock upon termination of employment with the Company.



F-27



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



The following table summarizes the Companys restricted stock unit activity:



|                                      |  |                 |  
|------------------------------------- |  | --------------- | -
|                                      |  | Number ofShares |  
|Nonvested awards at December 31, 2008 |  | 105             |  
|Granted                               |  |                |  
|Vested                                |  | (35             | )
|Forfeited                             |  |                |  
|                                      |  |                 |  
|Nonvested awards at December 31, 2009 |  | 70              |  
|                                      |  |                 |  



Total fair value of RSUs vested
during the years ended December 31, 2009, 2008 and 2007 were $146, $162 and $162, respectively. Approximately $209 of unrecognized share-based compensation expense related to unvested RSUs is expected to be recognized over the next 1.6 years.



12. Income Taxes



The Company had no federal, state or foreign income tax expense
for the years ended December 31, 2009, 2008 and 2007.



Significant components of the Companys deferred tax assets and liabilities consist of the following:



|                                          |      |              |          |      |  |   |          |  
|----------------------------------------- | ---- | ------------ | -------- | ---- |  | - | -------- | -
|                                          |      | December 31, |         
|                                          | 2009 |              |          | 2008 | 
|Current deferred tax assets:              |      |              |          |      |  |   |          |  
|Compensation related items                |      | $            | 307      |      |  | $ | 289      |  
|Accrued expenses and other                |      |              | 508      |      |  |   | 427      |  
|                                          |      |             
|Noncurrent deferred tax assets:           |      |              |          |      |  |   |          |  
|Accrued expenses and other                |      |              | 861      |      |  |   | 820      |  
|Domestic net operating loss carryforwards |      |              | 125,234  |      |  |   | 116,945  |  
|Research and development credits          |      |              | 38,660   |      |  |   | 29,000   |  
|Property, equipment and intangible assets |      |              | 7,666    |      |  |   | 6,693    |  
|Stock-based compensation                  |      |              | 4,255    |      |  |   | 3,509    |  
|Contributions                             |      |              | 434      |      |  |   | 434      |  
|Investments                               |      |              | 234      |      |  |   | 413      |  
|                                          |      |              |          |      |  |   |          |  
|Total deferred tax assets                 |      |              | 178,159  |      |  |   | 158,530  |  
|Valuation allowance                       |      |              | (178,159 | )    |  |   | (158,530 | )
|                                          |      |              |          |      |  |   |          |  
|Deferred tax assets                       |      | $            |         |      |  | $ |         |  
|                                          |      |              |          |      |  |   |          |  



At December 31, 2009 and
2008, the Company provided a full valuation allowance against its net deferred tax assets since realization of these benefits could not be reasonably assured. The valuation allowance has increased $19,629, $25,321 and $23,201 for the years ended
December 31, 2009, 2008 and 2007, respectively. The increase in the valuation allowance of $19,629 during the year ended December 31, 2009 resulted primarily from the generation of additional net operating loss carryforwards and research
and development credits, partially offset by a reduction in deferred tax assets related to 2009 and prior years of $2,535 that are unlikely to be realized.



F-28



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



As of December 31, 2009, the Company had federal and state net operating loss
carryforwards of $312,257 and $355,497, respectively. The net operating loss carryforwards expire in various amounts starting in 2009 and 2010 for federal and state tax purposes, respectively. The net operating loss carryforwards that expire in 2010
are not significant. The utilization of the federal net operating loss carryforwards may be subject to limitation under the rules regarding a change in stock ownership as determined by the Internal Revenue Code. If the Companys utilization of
its net operating loss carryforwards is limited and the Company has taxable income which exceeds the permissible yearly net operating loss carryforward, the Company would incur a federal income tax liability even though its net operating loss
carryforwards exceed its taxable income. Additionally, as of December 31, 2009 and 2008, the Company had federal research and development and orphan drug credit carryforwards of $38,660 and $29,000, respectively. The research and development
carryforwards and orphan drug carryforwards begin to expire in varying amounts starting in 2011 and 2013, respectively.



On January 1, 2007, the Company adopted the provisions of FASB authoritative guidance related to accounting for uncertainty in income
taxes. The guidance prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax
position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. At
the adoption date of January 1, 2007, the Company had $110,008 of deferred tax assets, all of which was subject to a full valuation allowance, effectively reducing the deferred tax benefits to $0, since realization of these benefits could not
be reasonably assured. As a result of adopting the guidance, the Company reduced its deferred tax assets by approximately $4,000 and reduced its full valuation allowance against the deferred tax assets by the same amount. Consequently, there was no
impact to the Companys accumulated deficit upon adoption of the guidance. In conjunction with the adoption of the guidance, the Company did not recognize any amount for the payment of interest or penalties at January 1, 2007. During 2009
and 2008, the Company did not record any expense to the income statement for interest and penalties. The Company does not expect its unrecognized tax benefits to change significantly over the next 12 months.



A reconciliation of the beginning and ending amount of
unrecognized tax benefits is as follows:



|                                          |  |      |        |      |   |      
|----------------------------------------- |  | ---- | ------ | ---- | - | -----
|                                          |  | 2009 |        | 2008
|Balance at January 1                      |  | $    | 8,388  |      | $ | 6,651
|Additions to current year tax positions   |  |      | 2,442  |      |   | 1,689
|Additions to tax positions of prior years |  |      | 93     |      |   | 48   
|                                          |  |      |        |      |   |      
|Balance at December 31                    |  | $    | 10,923 |      | $ | 8,388
|                                          |  |      |        |      |   |      



All of the Companys unrecognized tax benefits of $10,923 as of December 31, 2009, would, if recognized, reduce the Companys effective tax rate; however, currently all of the
Companys deferred tax assets are subject to a full valuation allowance. The Company has no current pending or open tax examinations or audits. The Company is subject to tax examinations by U.S. Federal and state and local authorities for tax
years subsequent to 2004. However, the net operating loss carryforwards and various research and development credits dating back to 1993 are open to adjustment by the taxing authorities.



F-29



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



Taxes computed at the statutory federal income tax rate of 35% (34% prior to 2008) are
reconciled to the provision for income taxes as follows:



|                                              |  |                         |         |   |      |   |         |      |  |   |         |  
|--------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                              |  | Year Ended December 31, |        
|                                              |  | 2009                    |         |   | 2008 |   |         | 2007 | 
|U.S. Federal tax at statutory rate            |  | $                       | (13,992 | ) |      | $ | (20,685 | )    |  | $ | (21,672 | )
|State taxes (net of Federal benefit)          |  |                         | (1,619  | ) |      |   | (2,140  | )    |  |   | (2,810  | )
|Change in valuation reserve                   |  |                         | 19,629  |   |      |   | 25,321  |      |  |   | 23,201  |  
|Research and development credit               |  |                         | (9,660  | ) |      |   | (6,395  | )    |  |   | (1,928  | )
|NOL expiration                                |  |                         | (308    | ) |      |   | (22     | )    |  |   |        |  
|Reversal of the benefit booked in prior years |  |                         | 415     |   |      |   | 29      |      |  |   |        |  
|Nondeductible expenses due to credits         |  |                         | 56      |   |      |   | (3      | )    |  |   | 301     |  
|Other nondeductible expenses                  |  |                         | 5,479   |   |      |   | 3,895   |      |  |   | 2,908   |  
|                                              |  |                         |         |   |      |   |         |      |  |   |         |  
|Provision for income taxes                    |  | $                       |        |   |      | $ |        |      |  | $ |        |  
|                                              |  |                         |         |   |      |   |         |      |  |   |         |  



13. Collaboration Agreements



Allergan, Inc.



In December 2003, the Company entered into an agreement with
Allergan to co-promote Elestat in the United States. Under the agreement, Inspire has the responsibility for promoting and marketing Elestat to ophthalmologists, optometrists and allergists in the United States and paying the
associated costs. Inspire receives co-promotion revenue from Allergan on its U.S. net sales of Elestat. Allergan records sales of Elestat and is responsible for supply chain management, managed health care, customer order processing
and regulatory compliance, as well as any international marketing and selling activities.



TheElestat co-promotion agreement provides that unless earlier terminated, the term of such agreement will be in effect until the earlier of (i) the approval and launch of the first generic
epinastine product after expiration of the FDA exclusivity period coveringElestat in the United States, or (ii) the approval and launch of the first over-the-counter epinastine product after expiration of the listing of Elestatin the FDAs Orange Book. Following the termination of such co-promotion agreement, Inspire will no longer have rights to co-promote Elestat. Inspire will be entitled to receive post-termination payments from Allergan, based on any
remaining net sales of Elestat for a period of 36 months. During the three successive 12-month periods immediately following the termination of the agreement, Allergan will be obligated to pay to Inspire 20%, 15% and 10%, respectively, on any
net sales ofElestat in the United States.



Notices have been received from four companies, advising that each company filed an ANDA for a generic version of Elestat. The date of submission of the first ANDA filing to the FDA Office of Generic Drugs was October 14, 2008,
according to the FDAs website (www.fda.gov).



Either Allergan or Inspire may terminate the agreement in the event of a material breach of the agreement by the other or in the event of the others insolvency. Allergan can terminate the agreement upon a change of control where
Inspire becomes an affiliate of a direct competitor of Allergan as that term is defined in the agreement. Inspire can terminate the agreement in the event that Elestat is withdrawn from the market for more than 90 days.



In June 2001, the Company entered into a joint license,
development and marketing agreement with Allergan to develop and commercialize the Companys product candidate, Prolacria. The agreement also



F-30



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



provided the Company with revenue on net sales of Allergans Restasis. Under the terms of the agreement, Allergan obtained an exclusive license to develop and commercialize
Prolacriaworldwide, with the exception of Japan and nine other Asian countries covered by Inspires agreement with Santen Pharmaceutical Co., Ltd. (Santen). In return, Inspire received an up-front payment of $5,000 in 2001
on execution of the agreement and has received additional payments of $6,000 associated with the achievement of certain milestones. Inspire is entitled to receive up to an additional $28,000 in milestone payments assuming the successful completion
of all the remaining milestones.



The Company is
responsible for conducting, in collaboration with Allergan, the Phase 3 clinical trials needed to file a U.S. New Drug Application for Prolacria. Allergan is responsible for all other development activities under the agreement, including all
development and regulatory activities needed for potential approval outside the United States and in its territories, and for ex-U.S. regulatory submissions, filings, and approvals relating to products. Allergan is responsible for all commercial
costs except for the cost of Inspires sales force in the United States. Allergan is required to use commercially reasonable efforts to conduct these development activities, seek ex-U.S. regulatory approvals and market and sell
Prolacria.



The Company
is also entitled to receive revenue from Allergan on net sales of RestasisandProlacria, if any, worldwide, excluding most larger Asian markets. The Company began receiving revenue from net sales of Restasis in April 2004. In
December 2008, the Company amended its agreement with Allergan such that the Company ceased co-promoting Restasis as of December 31, 2008. Notwithstanding the fact that the Company is no longer co-promoting Restasis, Allergan
remains obligated to pay the Company royalties in relation to sales of Restasisat the rates in effect prior to the December 2008 amendment.



Unless earlier terminated pursuant to other terms of the agreement, the agreement will expire as to each product (Restasis or
Prolacria, as the case may be) in each applicable country on the later of (i) the 10th anniversary of the first commercial sale of such product in the applicable country, or (ii) the date on which the sale of such product ceases to
be covered by any claim of any applicable Inspire or Allergan patent. The agreement will expire in its entirety upon the expiration of the agreement with respect to all products in all countries as described in the previous sentence.



Cystic Fibrosis Foundation Therapeutics, Inc.



In October 2002, the Company entered into a study funding
agreement with the Cystic Fibrosis Foundation Therapeutics, Inc. (CFFT), whereby the majority of the expenses for one Phase 2 clinical trial for denufosol for the treatment of cystic fibrosis were funded by the CFFT, but the Company also
recorded the corresponding expenses and liabilities as the CFFT incurred these costs. This clinical trial was completed in 2004. If the Company receives FDA approval for denufosol for the treatment of cystic fibrosis, the Company will be obligated
to pay a development milestone, and possibly a sales milestone, to the CFFT. The aggregate potential milestones under this agreement are approximately $16,000. The Company has recorded $1,915 of contingent liabilities in Other long-term
liabilities associated with this agreement as of December 31, 2009 and 2008. If it does not receive FDA approval, the Company will have no financial obligation to the CFFT, including the Phase 2 clinical trial costs the CFFT funded on the
Companys behalf.



InSite Vision Incorporated.



In February 2007, the Company entered into a
license agreement with InSite Vision pursuant to which Inspire acquired exclusive rights to commercialize AzaSite, as well as other potential topical anti-infective products containing azithromycin as the sole active ingredient for use in the
treatment of human ocular or



F-31



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



ophthalmic indications. The license agreement also grants Inspire exclusive rights to develop, make, use, market, commercialize and sell each product in the United States and Canada. Inspire is
currently responsible for all regulatory obligations and strategies relating to the further development and commercialization of a product in the United States and Canada.



Pursuant to the license agreement, the Company paid an upfront licensing fee of $13,000. The Company paid an additional
$19,000 milestone payment upon regulatory approval of AzaSite by the FDA. Additionally, the Company is obligated to pay a royalty on net sales of AzaSite for ocular infections in the United States and Canada. The royalty rate was 20%
on net sales of AzaSite for the first two years of commercialization and in July 2009, the Company began paying a 25% royalty rate, which will continue for the duration of the agreement. The Company is obligated to pay royalties under the
agreement for the longer of (i) 11 years from the launch of the subject product and (ii) the period during which a valid claim under a patent licensed from InSite Vision covers a subject product. Under the terms of the agreement, the
Companys obligation to pay royalties to InSite Vision is subject to pre-determined minimum annual royalty payments. The determination of whether or not the Company will owe any such payments is based upon the amount of royalties accrued over a
12-month royalty period. There are five successive 12-month minimum royalty periods, the second of which commenced on October 1, 2009. The Company launched AzaSitein August 2007, and began paying royalties to InSite Vision in the fourth
quarter of 2007.



Santen Pharmaceuticals Co., Ltd.



In December 1998, the Company entered into a
development, license and supply agreement with Santen for the development of diquafosol tetrasodium for the therapeutic treatment of ocular surface diseases. Under the agreement, the Company granted Santen an exclusive license to develop and market
diquafosol tetrasodium for ocular surface diseases in Japan, China, South Korea, the Philippines, Thailand, Vietnam, Taiwan, Singapore, Malaysia and Indonesia in the field. The Company is obligated to supply Santen with its requirements of
diquafosol tetrasodium in bulk drug substance form for all preclinical studies, clinical trials and commercial requirements at agreed-upon prices.



Under the terms of the agreement, Inspire has received a total of $1,500 in equity and $3,000 in milestone payments, including a $1,250
milestone payment received in May 2008 and a $1,250 milestone payment received in March 2006. Depending on whether all milestones under the agreement are achieved, the Company could receive additional milestone payments of up to $1,750. In addition,
the Company is entitled to receive royalties on net sales of diquafosol tetrasodium by Santen, if any.



The agreement will terminate when all patents licensed under the agreement have expired. Either Santen or the Company may terminate the
agreement if the other materially breaches the agreement. In addition, the Company has the right to terminate the agreement at any time, subject to the coordinating committees review and arbitration, if the Company determines that Santen has
not made reasonably sufficient progress in the development or commercialization of potential products. If Santen breaches the agreement, or if the Company terminates the agreement because Santen has not made sufficient progress, Santens
license will terminate. Santen will provide the Company with all data and information relating to the Companys products, and will assign or permit it to cross-reference all regulatory filings and approvals.



Wisconsin Alumni Research Foundation



In November 2004, the Company licensed several patents for use
in developing and commercializing new treatments for glaucoma from the Wisconsin Alumni Research Foundation (WARF). Under the terms of the



F-32



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



agreement, Inspire paid an upfront licensing payment of $150 in 2004 upon execution of the agreement and a $50 milestone payment related to the filing of an Investigational New Drug Application
for its glaucoma program in 2006. The Company is obligated for additional contingent payments of up to an aggregate of $1,750 upon the achievement of development milestones, and royalties on sales of any regulatory approved product utilizing the
licensed patents.



Inspire will design and fund
all future research, development, testing, regulatory filings and potential marketing activities related to any product candidate under development or product developed from the license. Unless terminated earlier, the agreement will expire on a
country-by-country basis upon the expiration of the patents in such country. The U.S. government may have limited rights in some of this patented technology. WARF may terminate the license if Inspire fails to make timely payment of any amount due to
WARF under the agreement or commit a material breach of any material covenant contained in the agreement, subject to the right to cure.



14. Commitments and Contingencies



Operating Leases



Total rent expense for operating leases during 2009, 2008 and 2007 was $1,869, $2,098 and $1,813, respectively. Future minimum lease payments
under non-cancelable operating leases as of December 31, 2009 are as follows:



|                             |  |                  |      
|---------------------------- |  | ---------------- | -----
|Year Ending December 31,     |  | Operating Leases
|2010                         |  | $                | 985  
|2011                         |  |                  | 203  
|2012                         |  |                  | 73   
|                             |  |                  |      
|Total minimum lease payments |  | $                | 1,261
|                             |  |                  |      



The Company has entered into non-cancelable operating leases for its fleet of vehicles, facilities and office equipment that extend through 2012 and are subject to voluntary renewal options. The Company
leases vehicles for its commercial organization under a Master Lease Agreement that allows for individual vehicle leases to be cancelable after one year. The Master Lease Agreement requires the Company to maintain a Standby Letter of Credit in the
amount of $515 during the term of the lease. The vehicle Master Lease Agreement also requires that the vehicles under lease serve as collateral for the obligation.



Other Commitments



The Company has entered into contractual commitments or purchase obligations with various clinical research organizations, promotion and
advertising agencies, manufacturers of active pharmaceutical ingredients and drug product for clinical and commercial use as well as with others. These financial commitments, which include both cancelable and non-cancelable arrangements, totaled
approximately $17,489 as of December 31, 2009. Since many of these commitment amounts are dependent upon variable components of the agreements, actual payments and the timing of those payments may differ from managements estimates. In
addition, the Company is obligated to pay royalties to InSite Vision as part of its license agreement for AzaSite.Under the terms of the agreement, the Companys obligation to pay royalties to InSite Vision is subject to pre-determined
minimum annual royalty payments. The determination of whether or not the Company will owe any such payments is based upon the amount of royalties accrued over a 12-month royalty period. There are five



F-33



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



successive 12-month minimum royalty periods, the first of which commenced on October 1, 2008. The minimum royalties escalate each year. Remaining minimum royalties as of December 31,
2009 total $60,000.



Contingencies



As of December 31, 2009, the Companys existing
license, collaboration and sponsored research agreements may require cash payments contingent upon the occurrence of certain future events. In the aggregate, these agreements may require payments of up to $21,350 assuming the achievement of all
development milestones and up to an additional $4,000 assuming the achievement of all sales milestones. Amounts payable by the Company under these agreements are uncertain and are contingent on a number of factors, including the progress of its
research, preclinical and development programs, its ability to obtain regulatory approvals, the commercial success of its approved products and future annual product sales levels. The Company is also obligated to pay royalties on net sales, if any,
of certain product candidates currently in its portfolio. Some of the Companys license agreements require minimum annual license preservation fees.



15. Related Party Transactions



In February 2009, the Company entered into an agreement with Clinipace, Inc. (Clinipace) for the provision of various data
management and biostatistics services to support two Phase 2 clinical trials of AzaSite for the treatment of blepharitis. Under this agreement, the Company paid Clinipace $365 upon execution and is obligated to pay an additional $171 per
month for 12 months commencing in March 2009. In addition, Clinipace has performed similar services in support of other development programs of the Company in 2009 and 2008, considered insignificant. The Company had expenses associated with
Clinipace activities in 2009 and 2008, of $2,137 and $24, respectively. Kenneth B. Lee, Jr., the Chairman of the Companys Board of Directors, is a general partner of Hatteras Venture Partners, LLC, which owns approximately 28% of Clinipace.
Christy Shaffer, the Companys President and Chief Executive Officer during 2009, also serves as a director of Clinipace. Neither Mr. Lee nor Dr. Shaffer have a personal interest in any amounts paid by the Company to Clinipace.



In August 2009, the Company completed a public
offering of its common stock. Warburg participated in the public offering and acquired an additional 8,889 shares of common stock for total holdings of 22,907 shares of the Companys common stock, which represented approximately 28% of the
Companys outstanding stock as of December 31, 2009. As part of the offering, the Company reimbursed Warburg for $500 of expenses incurred, related to their participation in the common stock sale. Prior to the sale of common stock in this
offering, Warburg owned approximately 14,019, or 25%, of the then outstanding common stock of the Company. Jonathan S. Leff, serves as a member of the Companys Board of Directors and as a member of its Corporate Governance Committee. Since
January 2000, he has served as a General Partner of Warburg, Pincus & Company, which is the managing partner of Warburg Pincus LLC, and as a Member and Managing Director of Warburg Pincus LLC, a private equity investment firm.



16. Employee Benefit Plan



The Company adopted a 401(k) Profit Sharing Plan (the
401(k) Plan) covering all qualified employees on August 1, 1995. Participants may elect a salary reduction of 1% or more up to the IRS allowed maximum as a tax-deferred contribution to the 401(k) Plan. The 401(k) Plan permits
discretionary employer contributions. If employer discretionary contributions are implemented, participants will begin vesting 100% immediately in such contributions. In 2009, 2008 and 2007, the Company elected a safe harbor contribution at 3.0% of
annual compensation. These safe harbor contributions totaled $935, $938 and $752 for the years ended December 31, 2009, 2008 and 2007, respectively.



F-34



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



17. Revenue by Product Line



The Company operates its business as one operating segment. The Company derives all of its product revenue for
AzaSiteand all its co-promotion revenue for Elestat from product sales in the United States. Approximately 98% of royalty revenue for Restasis in fiscal years 2009, 2008 and 2007, was derived from product sales in the United
States.



|                                |      |                         |        |  |      |        |  |   |       
|------------------------------- | ---- | ----------------------- | ------ |  | ---- | ------ |  | - | ------
|                                |      | Year ended December 31,
|                                | 2009 |                         | 2008   |  | 2007
|Product Sales:                  |      |                         |        |  |      |        |  |   |       
|AzaSite                         |      | $                       | 34,961 |  | $    | 18,349 |  | $ | 3,142 
|Co-Promotion and Royalty Sales: |      |                         |        |  |      |        |  |   |       
|Restasis                        |      |                         | 38,445 |  |      | 32,761 |  |   | 24,442
|Elestat                         |      |                         | 18,753 |  |      | 18,138 |  |   | 21,081
|                                |      |                         |        |  |      |        |  |   |       
|Total                           |      | $                       | 92,159 |  | $    | 69,248 |  | $ | 48,665
|                                |      |                         |        |  |      |        |  |   |       



18. Quarterly Financial Data (unaudited)



|                                            |       |      |         |        |  |   |        |   |  |        |        |   |       |   |        |   |  |   |         |  
|------------------------------------------- | ----- | ---- | ------- | ------ |  | - | ------ | - |  | ------ | ------ | - | ----- | - | ------ | - |  | - | ------- | -
|                                            |       | 2009 |        
|                                            | First |      |         | Second |  |   | Third  |   |  | Fourth |        |   | Total |  
|Revenue                                     |       | $    | 14,331  |        |  | $ | 23,051 |   |  | $      | 25,168 |   |       | $ | 29,609 |   |  | $ | 92,159  |  
|Cost of sales                               |       |      | 1,961   |        |  |   | 2,284  |   |  |        | 3,032  |   |       |   | 3,994  |   |  |   | 11,271  |  
|Net loss                                    |       |      | (19,407 | )      |  |   | (9,511 | ) |  |        | (8,493 | ) |       |   | (2,565 | ) |  |   | (39,976 | )
|Net loss per common sharebasic and diluted |       | $    | (0.34   | )      |  | $ | (0.17  | ) |  | $      | (0.12  | ) |       | $ | (0.03  | ) |  | $ | (0.60   | )
|                                            |      
|                                            |       | 2008 |        
|Revenue                                     |       | $    | 9,703   |        |  | $ | 21,984 |   |  | $      | 19,952 |   |       | $ | 18,859 |   |  | $ | 70,498  |  
|Cost of sales                               |       |      | 1,007   |        |  |   | 1,643  |   |  |        | 1,624  |   |       |   | 2,138  |   |  |   | 6,412   |  
|Net loss                                    |       |      | (25,913 | )      |  |   | (6,362 | ) |  |        | (9,619 | ) |       |   | (9,709 | ) |  |   | (51,603 | )
|Net loss per common sharebasic and diluted |       | $    | (0.46   | )      |  | $ | (0.11  | ) |  | $      | (0.17  | ) |       | $ | (0.17  | ) |  | $ | (0.91   | )



19. Subsequent Events



Appointment of Adrian Adams



Effective February 22, 2010, the Board of Directors (the Board) of the Company appointed Adrian Adams as President and Chief Executive Officer of the Company, and as a member of the Board.



On February 18, 2010, the Company entered into an
employment agreement (the Employment Agreement) with Mr. Adams. The Employment Agreement provides for an initial term from February 22, 2010 to December 31, 2014.



Resignation of Christy L. Shaffer, Ph.D.



On February 19, 2010, the Companys Board of
Directors received and accepted Christy L. Shaffers resignation from the Companys Board of Directors and as President and Chief Executive Officer, effective February 22, 2010.



F-35



---

##### Table of Contents

INSPIRE PHARMACEUTICALS, INC.



NOTES TO FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



In connection with her resignation, Dr. Shaffer has entered into a Separation of
Employment and Consulting Agreement, effective February 22, 2010 (the Separation and Consulting Agreement) with the Company, pursuant to which she will provide consulting services to the Company for a period of twenty-four
(24) months. The Separation and Consulting Agreement provides for: (i) a separation payment of $983; (ii) an award of 100 stock options; (iii) a stock award for 100 shares of the Companys common stock; and
(iv) consulting payments, to be paid quarterly, at the annual rate of $468. The stock award and awards of stock options granted to Dr. Shaffer under the Separation and Consulting Agreement are fully vested and exercisable upon the grant
date.



In addition, Dr. Shaffers
existing stock options with an exercise price equal to or less than $9.42 per share have been amended to provide that the exercise period for such options will be extended to the earlier of (i) the applicable awards expiration date, and
(ii) February 22, 2013. All such options, to the extent unvested, became fully vested and exercisable. All of Dr. Shaffers stock options with an exercise price greater than $9.42 per share were terminated on February 22,
2010. Additionally, all of Dr. Shaffers existing unvested restricted stock units (20 units) became fully vested.



F-36



---

##### Table of Contents

Exhibit Index



|               |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|3.1            |  | Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 to the Companys Quarterly Report on Form 10-Q filed on August 8,
2006).                                                                                                                                                                                                                                                                                                        
|               | 
|3.2            |  | Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.1 to the Companys Current Report on Form 8-K filed on December 18, 2007).                                                                                                                                                                                                                                                                                                                              
|               | 
|3.3            |  | Certificate of Designations of Series H Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 3.3 to the Companys Annual Report on Form
10-K filed March 7, 2003).                                                                                                                                                                                                                                                                        
|               | 
|3.4            |  | Certificate of Amendment to Certificate of Designations of Series H Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 4.4 to the
Companys Current Report on Form 8-K filed on July 23, 2007).                                                                                                                                                                                                                                         
|               | 
|3.5            |  | Certificate of Designations, Number, Voting Powers, Preferences and Rights of Series A Exchangeable Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by
reference to Exhibit 4.3 to the Companys Current Report on Form 8-K filed on July 23, 2007).                                                                                                                                                                                                         
|               | 
|3.6            |  | Certificate of Retirement of Series A Exchangeable Preferred Stock of Inspire Pharmaceuticals, Inc. (Incorporated by reference to Exhibit 3.1 to the Companys Current Report
on Form 8-K filed on December 21, 2007).                                                                                                                                                                                                                                                      
|               | 
|4.1            |  | Specimen Common Stock Certificate (Incorporated by reference to Exhibit 4.1 to the Companys registration statement on Form S-1 (Registration No. 333-31174) which became
effective on August 3, 2000).                                                                                                                                                                                                                                                                     
|               | 
|4.2            |  | Rights Agreement, dated as of October 21, 2002, between the Company and Computershare Trust Company, which includes the form of Certificate of Designation of Series H Preferred
Stock of Inspire Pharmaceuticals, Inc. as Exhibit A, the form of Rights Certificate as Exhibit B and the Summary of Rights to Purchase Preferred Stock as Exhibit C (Incorporated by reference to Exhibit 4.1 to the
Companys Current Report on Form 8-K filed on October 22, 2002).
|               | 
|4.3            |  | First Amendment to Rights Agreement, dated July 17, 2007, by and between Inspire Pharmaceuticals, Inc. and Computershare Trust Company (Incorporated by reference to Exhibit 4.2
to the Companys Current Report on Form 8-K filed on July 23, 2007).                                                                                                                                                                                                                       
|               | 
|10.1          |  | Inspire Pharmaceuticals, Inc. Amended and Restated 1995 Stock Plan, as amended (Incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed
on April 21, 2005).                                                                                                                                                                                                                                                                             
|               | 
|10.2          |  | Form of Incentive Stock Option (Incorporated by reference to Exhibit 10.2 to the Companys registration statement on Form S-1 (Registration No. 333-31174) which became
effective on August 3, 2000).                                                                                                                                                                                                                                                                       
|               | 
|10.3*          |  | Development, License and Supply Agreement between Inspire Pharmaceuticals, Inc. and Santen Pharmaceutical Co., Ltd., dated as of December 16, 1998 (Incorporated by reference to
Exhibit 10.15 to the Companys registration statement on Form S-1 (Registration No. 333-31174) which became effective on August 3, 2000).                                                                                                                                                  
|               | 
|10.4          |  | Employee Confidentiality, Invention Assignment and Non-Compete Agreement between Inspire Pharmaceuticals, Inc. and Benjamin R. Yerxa dated February 4, 2000 (Incorporated by
reference to Exhibit 10.26 to the Companys registration statement on Form S-1 (Registration No. 333-31174) which became effective on August 3, 2000).                                                                                                                                         
|               | 
|10.5          |  | Employee Confidentiality, Invention Assignment and Non-Compete Agreement between Inspire Pharmaceuticals, Inc. and Christy L. Shaffer dated February 10, 2000 (Incorporated
by reference to Exhibit 10.28 to the Companys registration statement on Form S-1 (Registration No. 333-31174) which became effective on August 3, 2000).                                                                                                                                       



---

##### Table of Contents

|               |  |                                                                                                                                                                                                                                                                                                                                                  
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                                                                                                      
|10.6          |  | Employee Confidentiality, Invention Assignment and Non-Compete Agreement between Inspire Pharmaceuticals, Inc. and Joseph Schachle dated April 3, 2001 (Incorporated by reference
to Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q filed on August 10, 2001).                                                                      
|               | 
|10.7*          |  | License, Development and Marketing Agreement between Inspire Pharmaceuticals, Inc. and Allergan, Inc., dated as of June 22, 2001 (Incorporated by reference to Exhibit 10.1 to the
Companys Current Report on Form 8-K filed on June 29, 2001).                                                                                                 
|               | 
|10.8*          |  | Study Funding Agreement, dated as of October 3, 2002, between Inspire Pharmaceuticals, Inc. and The Cystic Fibrosis Foundation Therapeutics, Inc. (Incorporated by reference to
Exhibit 10.1 to the Companys Current Report on Form 8-K filed on October 4, 2002).                                                                              
|               | 
|10.9          |  | Form of Inspire Pharmaceuticals, Inc. Employee Stock Option Agreement (Incorporated by reference to Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q filed on
August 11, 2003).                                                                                                                                                       
|               | 
|10.10         |  | Form of Inspire Pharmaceuticals, Inc. Director Non-Statutory Stock Option Agreement (Incorporated by reference to Exhibit 10.3 to the Companys Quarterly Report on Form 10-Q
filed on August 11, 2003).                                                                                                                                         
|               | 
|10.11*         |  | First Amendment to License, Development and Marketing Agreement, dated December 8, 2003, between Inspire Pharmaceuticals, Inc. and Allergan, Inc. and Allergan Sales, LLC and
Allergan Pharmaceuticals Holdings (Ireland) Ltd. (Incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed on December 9, 2003).
|               | 
|10.12*         |  | Elestat (Epinastine) Co-Promotion Agreement, entered into as of December 8, 2003, by and between Allergan Sales, LLC and Inspire Pharmaceuticals, Inc. (Incorporated by reference
to Exhibit 10.1 to the Companys Current Report on Form 8-K filed on July 1, 2004).                                                                            
|               | 
|10.13         |  | Employee Confidentiality, Invention Assignment and Non-Compete Agreement between Inspire Pharmaceuticals, Inc. and Thomas R. Staab, II, dated May 16, 2003 (Incorporated by
reference to Exhibit 10.35 to the Companys Annual Report on Form 10-K filed March 12, 2004).                                                                        
|               | 
|10.14          |  | Master Lease Agreement between GE Capital Fleet Services and Inspire Pharmaceuticals, Inc., dated as of November 18, 2003, and related documentation (Incorporated by reference to
Exhibit 10.38 to the Companys Annual Report on Form 10-K filed March 12, 2004).                                                                              
|               | 
|10.15          |  | Master Security Agreement between General Electric Capital Corporation and Inspire Pharmaceuticals, Inc., dated as of November 12, 2003, and related documentation (Incorporated
by reference to Exhibit 10.39 to the Companys Annual Report on Form 10-K filed March 12, 2004).                                                                
|               | 
|10.16         |  | Employee Confidentiality, Invention Assignment and Non-Compete Agreement between the Company and R. Kim Brazzell, dated August 5, 2004 (Incorporated by reference to Exhibit 10.4
to the Companys Quarterly Report on Form 10-Q filed November 9, 2004).                                                                                        
|               | 
|10.17*         |  | Exclusive License Agreement between Inspire Pharmaceuticals, Inc. and the Wisconsin Alumni Research Foundation, effective November 2, 2004 (Incorporated by reference to Exhibit
10.44 to the Companys Annual Report on Form 10-K filed March 11, 2005).                                                                                        
|               | 
|10.18         |  | Form of Inspire Pharmaceuticals, Inc. Employee Stock Option Agreement (Incorporated by reference to Exhibit 10.56 to the Companys Annual Report on Form 10-K filed March 11,
2005).                                                                                                                                                             
|               | 
|10.19         |  | Form of Incentive Stock Option Grant Agreement (Incorporated by reference to Exhibit 10.2 to the Companys Current Report on Form 8-K filed on June 16,
2005).                                                                                                                                                                                   
|               | 
|10.20         |  | Form of Nonqualified Stock Option Grant Agreement (Incorporated by reference to Exhibit 10.3 to the Companys Current Report on Form 8-K filed on June 16,
2005).                                                                                                                                                                                
|               | 
|10.21         |  | Form of Directors Nonqualified Stock Option Grant Agreement (Incorporated by reference to Exhibit 10.4 to the Companys Current Report on Form 8-K filed on June 16,
2005).                                                                                                                                                                     



---

##### Table of Contents

|               |  |                                                                                                                                                                                                                                                                                                                                                                                         
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                                                                                                                                             
|10.22         |  | Form of Stock Appreciation Right Grant Agreement (Incorporated by reference to Exhibit 10.5 to the Companys Current Report on Form 8-K filed on June 16,
2005).                                                                                                                                                                                                                        
|               | 
|10.23         |  | Form of Stock Award Grant Agreement (Incorporated by reference to Exhibit 10.6 to the Companys Current Report on Form 8-K filed on June 16, 2005).                                                                                                                                                                                                                                     
|               | 
|10.24         |  | Form of Restricted Stock Unit Agreement (Incorporated by reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q filed on November 7,
2006).                                                                                                                                                                                                                           
|               | 
|10.25          |  | Amended and Restated Lease Agreement, dated as of November 30, 2006, by and between Inspire Pharmaceuticals, Inc. and Royal Center IC, LLC with respect to certain premises
located within the Royal Center I building at 4222 Emperor Blvd., Durham, North Carolina (Incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed on December 6, 2006). 
|               | 
|10.26          |  | Amended and Restated Lease Agreement, dated as of November 30, 2006, by and between Inspire Pharmaceuticals, Inc. and Royal Center IC, LLC with respect to certain premises
located within the Royal Center II building at 4222 Emperor Blvd., Durham, North Carolina (Incorporated by reference to Exhibit 10.2 to the Companys Current Report on Form 8-K filed on December 6, 2006).
|               | 
|10.27         |  | Employee Confidentiality, Invention Assignment and Non-Compete Agreement between Inspire Pharmaceuticals, Inc. and Joseph M. Spagnardi, dated May 10, 2005 (Incorporated by
reference to Exhibit 10.43 to the Companys Annual Report on Form 10-K filed on March 16, 2007).                                                                                                            
|               | 
|10.28          |  | Loan and Security Agreement, dated as of December 22, 2006, among Inspire Pharmaceuticals, Inc., Merrill Lynch Capital and Silicon Valley Bank (Incorporated by reference to
Exhibit 10.45 to the Companys Annual Report on Form 10-K filed on March 16, 2007).                                                                                                                        
|               | 
|10.29*         |  | License Agreement by and between Inspire Pharmaceuticals, Inc. and InSite Vision Incorporated, dated as of February 15, 2007 (Incorporated by reference to Exhibit 10.1 to the
Companys Quarterly Report on Form 10-Q filed on May 10, 2007).                                                                                                                                          
|               | 
|10.30*         |  | Supply Agreement by and between Inspire Pharmaceuticals, Inc. and InSite Vision Incorporated, dated as of February 15, 2007 (Incorporated by reference to Exhibit 10.2 to the
Companys Quarterly Report on Form 10-Q filed on May 10, 2007).                                                                                                                                           
|               | 
|10.31          |  | Trademark License Agreement by and between Inspire Pharmaceuticals, Inc. and InSite Vision Incorporated, dated as of February 15, 2007 (Incorporated by reference to Exhibit 10.3
to the Companys Quarterly Report on Form 10-Q filed on May 10, 2007).                                                                                                                                
|               | 
|10.32          |  | Side Letter by and between Inspire Pharmaceuticals, Inc., InSite Vision Incorporated and Pfizer Inc., dated as of February 15, 2007 (Incorporated by reference to Exhibit 10.4 to
the Companys Quarterly Report on Form 10-Q filed on May 10, 2007).                                                                                                                                   
|               | 
|10.33         |  | Form of Nonqualified Stock Option Grant Agreement (Incorporated by reference to Exhibit 10.6 to the Companys Quarterly Report on Form 10-Q filed on May 10,
2007).                                                                                                                                                                                                                     
|               | 
|10.34         |  | Form of Directors Nonqualified Stock Option Grant Agreement (Incorporated by reference to Exhibit 10.7 to the Companys Quarterly Report on Form 10-Q filed on
May 10, 2007).                                                                                                                                                                                                          
|               | 
|10.35         |  | Executive Officer Annual Cash Bonus Plan (Incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed on June 13, 2007).                                                                                                                                                                                                                                
|               | 
|10.36          |  | Standstill Agreement, dated July 20, 2007, among Inspire Pharmaceuticals, Inc., Warburg Pincus Private Equity IX, L.P., Warburg Pincus IX, LLC, Warburg Pincus Partners, LLC and
Warburg Pincus & Co. (Incorporated by reference to Exhibit 10.2 to the Companys Current Report on Form 8-K filed on July 23, 2007).                                                                   
|               | 
|10.37          |  | First Amendment to Loan and Security Agreement by and among Merrill Lynch Capital, Silicon Valley Bank, and Inspire Pharmaceuticals, Inc., dated as of June 27, 2007 (Incorporated
by reference to Exhibit 10.3 to the Companys Quarterly Report on Form 10-Q filed on August 9, 2007).                                                                                                



---

##### Table of Contents

|               |  |                                                                                                                                                                                                                                                                                                                                                
|-------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                                                                                                    
|10.38         |  | Amended and Restated 2005 Equity Compensation Plan (Incorporated by reference to Exhibit 10.4 to the Companys Quarterly Report on Form 10-Q filed on August 9,
2007).                                                                                                                                                                         
|               | 
|10.39*         |  | Manufacturing Services Agreement, dated September 11, 2007, by and between Inspire Pharmaceuticals, Inc. and Catalent Pharma Solutions, LLC (Incorporated by reference to Exhibit
10.3 to the Companys Quarterly Report on Form 10-Q filed on November 9, 2007).                                                                              
|               | 
|10.40         |  | Executive Change in Control Severance Benefit Plan, effective as of March 29, 2008 (Incorporated by reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q
filed on May 9, 2008).                                                                                                                                            
|               | 
|10.41         |  | Change in Control Severance Benefit Plan, amended and restated as of March 29, 2008 (Incorporated by reference to Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q
filed on May 9, 2008).                                                                                                                                           
|               | 
|10.42          |  | Second Amendment to License, Development and Marketing Agreement, dated December 24, 2008, between Inspire Pharmaceuticals, Inc. and Allergan, Inc., Allergan Sales, LLC and
Allergan Pharmaceuticals Holdings (Ireland) Ltd. (Incorporated by reference to Exhibit 10.62 to the Companys Annual Report on Form 10-K filed on March 13, 2009).
|               | 
|10.43         |  | Amended and Restated Director Compensation Policy dated March 1, 2009 (Incorporated by reference to Exhibit 10.63 to the Companys Annual Report on Form 10-K filed on March
13, 2009).                                                                                                                                                        
|               | 
|10.44         |  | Inspire Pharmaceuticals, Inc. Executive Change in Control Severance Benefit Plan, Amended and Restated as of July 8, 2009 (Incorporated by reference to Exhibit 10.1 to the
Companys Current Report on Form 8-K filed on July 13, 2009).                                                                                                      
|               | 
|10.45         |  | Inspire Pharmaceuticals, Inc. Change in Control Severance Benefit Plan, Amended and Restated as of July 8, 2009 (Incorporated by reference to Exhibit 10.2 to the Companys
Current Report on Form 8-K filed on July 13, 2009).                                                                                                                
|               | 
|10.46         |  | Inspire Pharmaceuticals, Inc. Amended and Restated 2005 Equity Compensation Plan, as amended effective July 8, 2009 (Incorporated by reference to Exhibit 10.3 to the
Companys Current Report on Form 8-K filed on July 13, 2009).                                                                                                            
|               | 
|10.47         |  | Form of 1995 Stock Plan Nonqualified Stock Option Grant Agreement (Incorporated by reference to Exhibit 10.4 to the Companys Current Report on Form 8-K filed on July 13,
2009).                                                                                                                                                              
|               | 
|10.48         |  | Form of Restricted Stock Unit Agreement Under the Amended and Restated 2005 Equity Compensation Plan (Incorporated by reference to Exhibit 10.5 to the Companys Current
Report on Form 8-K filed on July 13, 2009).                                                                                                                           
|               | 
|10.49         |  | Form of Inspire Pharmaceuticals, Inc. 1995 Stock Plan Directors Nonqualified Stock Option Grant Agreement (Incorporated by reference to Exhibit 10.6 to the Companys
Current Report on Form 8-K filed on July 13, 2009).                                                                                                                     
|               | 
|10.50         |  | Form of Inspire Pharmaceuticals, Inc. 2005 Equity Compensation Plan Directors Nonqualified Stock Option Grant Agreement (Incorporated by reference to Exhibit 10.7 to the
Companys Current Report on Form 8-K filed on July 13, 2009).                                                                                                       
|               | 
|10.51          |  | Amendment No. 1 to Standstill Agreement, dated August 4, 2009, between Inspire Pharmaceuticals, Inc. and Warburg Pincus Private Equity IX, L.P. (Incorporated by reference to
Exhibit 10.1 to the Companys Current Report on Form 8-K filed on August 10, 2009).                                                                              
|               | 
|10.52          |  | Technology License Agreement For the Manufacture of Denufosol, dated as of October 2, 2009, between Inspire Pharmaceuticals, Inc. and Yamasa Corporation, with an effective date
of September 25, 2009 (Incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 10-Q filed on November 6, 2009).                     
|               | 
|10.53         |  | Executive Incentive Compensation Recovery (Clawback) Policy, dated December 18, 2009.                                                                                                                                                                                                                                                        



---

##### Table of Contents

|               |  |                                                                                                                                                                                                                                                                            
|-------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                                
|10.54         |  | Amended and Restated Equity Compensation Grant Policy, dated December 18, 2009.                                                                                                                                                                                            
|               | 
|10.55         |  | Amended and Restated Director Compensation Policy, dated December 18, 2009.                                                                                                                                                                                                
|               | 
|10.56         |  | Executive Employment Agreement, between Inspire Pharmaceuticals, Inc. and Adrian Adams, made as of February 18, 2010 (Incorporated by reference to Exhibit 10.1 to the
Companys Current Report on Form 8-K filed on February 24, 2010).                                   
|               | 
|10.57         |  | Stock Option Agreement by and between Inspire Pharmaceuticals, Inc. and Adrian Adams, effective as of February 22, 2010 (Incorporated by reference to Exhibit 10.2 to the
Companys Current Report on Form 8-K filed on February 24, 2010).                                
|               | 
|10.58         |  | Separation of Employment and Consulting Agreement between Inspire Pharmaceuticals, Inc. and Dr. Christy L. Shaffer, Ph.D., made as of February 19, 2010 (Incorporated by
reference to Exhibit 10.3 to the Companys Current Report on Form 8-K filed on February 24, 2010).
|               | 
|23.1           |  | Consent of PricewaterhouseCoopers LLP, independent registered public accounting firm.                                                                                                                                                                                      
|               | 
|31.1           |  | Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.                                                                                                                                                  
|               | 
|31.2           |  | Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.                                                                                                                                                  
|               | 
|32.1           |  | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                     
|               | 
|32.2           |  | Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                     



|* | Confidential treatment has been granted with respect to a portion of this Exhibit.
|- | ----------------------------------------------------------------------------------

|** | Confidential treatment has been requested with respect to a portion of this Exhibit.
|-- | ------------------------------------------------------------------------------------

| | Denotes a management contract or compensation plan or arrangement required to be filed as an exhibit pursuant to Item 15(c) of this Form 10-K.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------