UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, DC 20549


________________




FORM 10-Q


________________




R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





For the quarterly period ended June 30, 2010.





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 Number: 000-23017





________________










ECHO THERAPEUTICS, INC.


(Exact name of registrant as specified in its charter)





________________







Delaware
41-1649949(State or other jurisdiction of
(I.R.S. Employer Identification Number)incorporation or organization)





10 Forge Parkway, Franklin, MA
02038(Address of principal executive offices)
(Zip code)





(508) 553-8850


(Registrant’s telephone number, including area code)


________________










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 R No £





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 (§232.405 of this chapter) 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.





Large accelerated filer £
Accelerated filer £
Non-accelerated filer £
Smaller reporting company R(Do not check if a smaller reporting company)





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





As of August 13, 2010, 29,108,245 shares of the registrant’s Common Stock. $0.01 par value, were issued and outstanding.





1


ECHO THERAPEUTICS, INC.Quarterly report on Form 10-Q for the period ended June 30, 2010TABLE OF CONTENTS





Item
PagePART IFINANCIAL INFORMATION1. Financial Statements
3Consolidated Balance Sheets as of June 30, 2010 and December 31, 2009
3Consolidated Statements of Operations for three and six months ended June 30, 2010 and 2009
5Consolidated Statements of Cash Flows for six months ended June 30, 2010 and 2009
6Notes to Financial Statements (Unaudited)
82. Management’s Discussion and Analysis of Financial Condition and Results of Operations
144T. Controls and Procedures
19PART IIOTHER INFORMATION2. Unregistered Sales of Equity Securities and Use of Proceeds
196. Exhibits
19SIGNATURES
20EXHIBIT INDEX
21





2
 Table of Contents


PART I—FINANCIAL INFORMATION





Item 1. Financial Statements.








Echo Therapeutics, Inc.

Consolidated Balance SheetsAs ofJune 30,


December 31,2010


2009ASSETS

UnauditedCurrent Assets:Cash and cash equivalents

$
618,064


$
1,166,858Accounts receivable


64,615



130,036Prepaid expenses and other current assets


322,262



226,641Total current assets


1,004,941



1,523,535Property and Equipment, at cost:Computer equipment


265,335



262,278Office and laboratory equipment (including assets under capitalized leases)


618,723



618,723Furniture and fixtures


14,288



14,288Manufacturing equipment


129,320



129,320Leasehold improvements


177,768



177,7681,205,434



1,202,377Less-Accumulated depreciation and amortization


(1,157,584
)


(1,143,167
)Net property and equipment (including assets under capitalized leases)


47,850



59,210Other Assets:Restricted cash


9,749



9,749Intangible assets, net of accumulated amortization


9,649,656



9,708,822Deposits and other assets


-



2,000Total other assets


9,659,405



9,720,571Total assets

$
10,712,196


$
11,303,316





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


3
 Table of Contents





As ofJune 30,


December 31,2010


2009UnauditedLIABILITIES AND STOCKHOLDERS' EQUITYCurrent Liabilities:Accounts payable

$
458,005


$
948,712Deferred revenue


433,560



591,051Current portion of  capital lease obligation


1,970



1,874Derivative warrant liability


1,244,403



2,116,696Accrued  expenses and other liabilities


181,323



481,679Total current liabilities


2,319,261



4,140,012Capital lease obligation, net of current portion


7,237



8,247Deferred revenue, net of current portion


98,371



122,451Total liabilities


2,424,869



4,270,710CommitmentsStockholders' Equity:Perpetual, Redeemable Preferred Stock:Series B, authorized 40,000 shares, issued and outstanding 146.8955 and 141.2281shares at June 30, 2010 and December 31, 2009, respectively (preferencein liquidation of $1,468,955 at June 30, 2010)


2



2Convertible  Preferred Series:Series C, authorized 10,000 shares, issued and outstanding 4,918.1 shares at June 30, 2010and December 31, 2009


49



49Common stock, $0.01 par value, authorized 100,000,000 shares, issued and outstanding29,083,245 and 27,045,792 shares at June 30, 2010 and December 31, 2009, respectively


290,834



270,459Additional paid-in capital


77,807,169



74,155,716Accumulated deficit


(69,810,727
)


(67,393,620
)Total stockholders' equity


8,287,327



7,032,606Total liabilities and stockholders' equity

$
10,712,196


$
11,303,316





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





4
 Table of Contents





Echo Therapeutics, Inc.

Consolidated Statements of Operation

UnauditedThree Months Ended

June 30,


Six Months Ended

June 30,2010


2009


2010


2009Licensing revenue

$
167,599


$
121,032


$
181,571


$
121,032Other revenue


96,520



-



96,520



-Total revenues


264,119



121,032



278,091



121,032Operating Expenses:Research and development


564,616



406,428



1,678,101



694,644Selling, general and administrative


610,875



848,232



1,888,498



1,421,596Total operating expenses


1,175,491



1,254,660



3,566,599



2,116,240Loss from operations


(911,372
)


(1,133,628
)


(3,288,508
)


(1,995,208
)Other Income (Expense):Interest income


481



537



1,172



926Interest expense


(618
)


(73,775
)


(1,707
)


(252,482
)(Loss) on extinguishment of debt


-



(1,851,668
)


-



(1,851,668
)Gain on extinguishment of financial advisor fee payable


-



-



200,000



-Derivatives gain (loss)


375,948



(3,716,316
)


671,936



(3,967,748
)Other income (expense), net


375,811



(5,641,222
)


871,401



(6,070,972
)Net  loss


(535,561
)


(6,774,850
)


(2,417,107
)


(8,066,180
)Deemed dividend on beneficial conversion of Series A and A-1 Preferred Stock


-



(2,426,876
)


-



(2,426,876
)Accretion of dividends on Convertible Preferred Stock


-



(69,003
)


-



(126,676
)In-kind dividends on Perpetual Redeemable Preferred Stock


(28,815
)


-



(56,674
)


-Net loss applicable to common shareholders

$
(564,376
)

$
(9,270,729
)

$
(2,473,781
)

$
(10,619,732
)Net loss per common share, basic and diluted

$
(0.02
)

$
(0.46
)

$
(0.09
)

$
(0.54
)Basic and diluted weighted average common shares outstanding


29,071,377



20,067,002



28,659,312



19,725,471





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


5
 Table of Contents





Echo Therapeutics, Inc.

Consolidated Statements of Cash Flows

UnauditedSix Months Ended

June 30,2010


2009Cash Flows From Operating Activities:Net loss

$
(2,417,107
)

$
(8,066,180
)Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization


73,583



80,149Share-based compensation


99,412



667,117Fair value of common stock issued for charitable contributions


113,400



—Fair value of common stock and warrants issued for services


901,393



276,853Fair value of options issued for services


46,109



—Derivative (gain) loss


(671,936
)


3,967,748Non-cash gain on extinguishment of financial advisor fee payable


(200,000
)


—Non-cash loss on extinguishment of debt


—



1,819,574Non-cash interest expense


—



234,444Changes in assets and liabilities:Accounts receivable


65,421



—Prepaid expenses and other current assets


(95,621
)


(1,405
)Deposits and other assets


2,000



—Accounts payable


(490,707
)


(4,715
)Deferred revenue


(181,571
)


1,128,968Accrued expenses and other liabilities


(100,356
)


81,979Net cash (used in) provided by operating activities


(2,855,980
)


184,532Cash Flows from Investing Activities:Purchase of property and equipment


(3,057
)


—Decrease in restricted cash


—



501Net cash (used in) provided by investing activities


(3,057
)


501Cash Flows From Financing Activities:Proceeds from the sale of Series A-2 preferred stock, net of expenses


—



699,576Proceeds from Senior Secured Note


—



1,990,000Payments on Convertible Notes and Warrants


—



(2,209,426
)Proceeds from the sale of common stock, net of expenses


2,311,157



—Principal payments for capital lease obligations


(914
)


—Deferred financing costs


—



(467
)Dividends paid in cash on Series A, A-1 and A-2 preferred stock


—



(46
)Net cash provided by financing activities


2,310,243



479,637Net Increase (Decrease) in Cash and Cash Equivalents


(548,794
)


664,670Cash and Cash Equivalents, beginning of period


1,166,858



242,867Cash and Cash Equivalents, end of period

$
618,064


$
907,537








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


6
 Table of Contents





Echo Therapeutics, IncConsolidated Statements of Cash FlowsUnauditedSix Months ended June 30,2010


2009Supplemental Disclosure of Cash Flow Information and Non Cash Financing Transactions:Cash paid for interest

$
1,707


$
18,038Accretion of dividend on Series A, A-1 and A-2 Convertible Preferred Stock

$
—


$
859In-kind dividend paid on Series B Convertible Preferred Stock

$
56,674


$
—Derivative warrant liability reclassified from stockholders’ equity

$
—


$
1,080,118Senior Convertible Notes issued for accrued interest

$
—


$
13,279Deemed dividend on beneficial conversion of Series A and A-1 Preferred Stock

$
—


$
2,426,876Conversion of Senior Secured Note to Series B and Series C Preferred

$
—


$
2,006,031Reclassification of derivative liability to additional paid-in capital

$
200,357


$
3,063,165Fair value of warrants issued to financial advisors as financing costs

$
217,141


$
—Exchange of Series A, A-1 and A-2 Preferred Stock to Series C Preferred Stock

and common stock

$
-


$
3,724,529








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








7
 Table of Contents


Echo Therapeutics, Inc.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Period Ended June 30, 2010 (Unaudited)





(1)
ORGANIZATION, BASIS OF PRESENTATION AND GOING CONCERN





Echo Therapeutics, Inc. is a transdermal medical device company with deep expertise in advanced skin permeation technology that is initially focused on diabetes care and needle-free drug delivery.  Echo is developing its PreludeTM SkinPrep System (“Prelude”) as a platform technology to allow for significantly enhanced and painless skin permeation that will enable two important applications:





·
Analyte extraction, with the SymphonyTM tCGM System (“Symphony”) for needle-free, continuous glucose monitoring in hospital patients and diabetics as the first application.





·
Needle-free drug delivery, with the topical delivery of lidocaine as the first application. Additional applications for painless, needle-free delivery of drugs are planned.





The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Sontra Medical, Inc., a Delaware corporation. All significant inter-company balances and transactions have been eliminated in consolidation.





The accompanying unaudited consolidated financial statements have been prepared in conformity with generally accepted accounting principles in the United States (“GAAP”) consistent with those applied in, and should be read in conjunction with, the Company’s audited financial statements and related footnotes for the year ended December 31, 2009 included in the Company’s Annual Report on Form 10-K as filed with the United States Securities and Exchange Commission (“SEC”) on March 31, 2010. The unaudited consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the Company’s financial position as of June 30, 2010 and its results of operations and cash flows for the interim periods presented and are not necessarily indicative of results for subsequent interim periods or for the full year. The interim financial statements do not include all of the information and footnotes required by GAAP for complete financial statements and allowed by the relevant SEC rules and regulations; however, the Company believes that its disclosures are adequate to ensure that the information presented is not misleading.





Going Concern





The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As of June 30, 2010, the Company had cash of approximately $618,000, a working capital deficit of approximately $1,314,000 and an accumulated deficit of approximately $69,811,000. Although the Company has issued securities through senior promissory notes, secured promissory notes and a series of private placements to raise capital in order to fund its operations, it is not known whether the Company will be able to continue this practice or obtain other types of financing to meet its cash operating expenses. This, in turn, raises substantial doubt about the Company’s ability to continue as a going concern. Management is currently pursuing additional financing and such financing is expected to be completed during 2010; however, no assurances can be given as to the success of these plans. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.





(2) INTANGIBLE ASSETS





As of June 30, 2010 and December 31, 2009, intangible assets related to the acquisition of assets from Durham Pharmaceuticals Ltd. in 2007 are as follows:





June 30, 2010


December 31, 2009Estimated




Accumulated


Net


NetLife

Cost


AmortizationContract related intangible asset:Cato Research discounted contract
3 years

$
355,000


$
330,344


$
24,656


$
83,822Technology related intangible assets:Patent for the AzoneTS-based product candidates and formulation
8 years


1,305,000



—



1,305,000



1,305,000Drug Master Files containing formulation, clinical and safety documentation used by the FDA
8 years


1,500,000



—



1,500,000



1,500,000Two (2) in-process Durhalieve-related pharmaceutical products
8 years


6,820,000



—



6,820,000



6,820,000Total technology related intangible assets



9,625,000



—



9,625,000



9,625,000Total


$
9,980,000


$
330,344


$
9,649,656


$
9,708,822





The technology related intangible assets are being amortized on a straight line basis over approximately 8 years beginning with the start of its useful life, which the Company has estimated to be 2011, and the contract related intangible asset over approximately 3 years beginning with the date of acquisition. Amortization expense was approximately $30,000 and $59,000 for the three and six months ended June 30, 2010 and 2009, respectively, and is included in research and development in the Statement of Operations.





(3)  CAPITAL AND OPERATING LEASE COMMITMENTS





Capital lease obligation at June 30, 2010 and December 31, 2009 consisted of the following:





June 30,


December 31,2010


2009Capital lease obligation

$
9,207


$
10,121Less current portion of capital lease obligation


1,970



1,874Capital lease obligation, net of current portion

$
7,237


$
8,247





8
 Table of Contents


Capital Lease —In 2009, the Company entered into a five-year lease of an office copier which is included with the Office and Laboratory Equipment. The value of the equipment capitalized was approximately $11,000. The lease payments of $234 per month, payable in arrears, reflect a 10% interest rate. Accumulated depreciation on the leased copier as of June 30, 2010 was approximately $2,200. During the three months ended June 30, 2010 and 2009, interest expense related to the capital lease obligation was approximately $250 and none, respectively. The interest expense related to the capital lease obligation was approximately $500 and none for the six months ended June 30, 2010 and 2009, respectively.





Operating Lease —The Company leases approximately 13,000 square feet of manufacturing, laboratory and office space in a single facility located in Franklin, Massachusetts under a lease expiring March 31, 2011. Future minimum lease payments under this operating lease are approximately as follows:





AmountFor the years ending December 31,2010

$
92,0002011


46,000Total

$
138,000





The Company’s facilities lease expense was approximately $43,000 and $46,000 for the three months ended June 30, 2010 and 2009, respectively. The lease expense was approximately $94,000 and $93,000 for the six months ended June 30, 2010 and 2009, respectively





(4)  DERIVATIVE INSTRUMENTS





Derivative financial instruments are recognized as a liability on the consolidated balance sheet and measured at fair value.





At June 30, 2010 and December 31, 2009, the Company had outstanding warrants to purchase 8,282,652 and 7,356,502 shares of its common stock, respectively. Included in these outstanding warrants at June 30, 2010 are warrants to purchase 1,342,649 shares that are considered to be derivative instruments since the agreements contain “down round” provisions whereby the number of shares covered by the warrants is subject to change in the event of certain dilutive stock issuances. The fair value of these derivative instruments at June 30, 2010 was approximately $1,244,000 and is included in Derivative Warrant Liability, a current liability. Changes in fair value of the derivative financial instruments are recognized currently in the Statement of Operations as a Derivatives Gain or Loss. The Derivative Gain in the three and six months ended June 30, 2010 was approximately $376,000 and $672,000, respectively. The Derivative loss in the three and six months ended June 30, 2009 was approximately ($3,716,000) and ($3,968,000), respectively.





The primary underlying risk exposure pertaining to the warrants is the change in fair value of the underlying common stock for each reporting period. For the six months ended June 30, 2010, warrants with down round provisions to purchase 143,793 shares were exercised which resulted in a reclassification to additional paid-in capital in the amount of approximately $200,000.





(5)  FAIR VALUES OF ASSETS AND LIABILITIES





The Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.





Level 1 – Valuation is based on quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities generally include debt and equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.





Level 2 – Valuation is based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. For example, Level 2 assets and liabilities may include debt securities with quoted prices that are traded less frequently than exchange-traded instruments or mortgage loans held for sale, for which the fair value is based on what the securitization market is currently offering for mortgage loans with similar characteristics.





Level 3 – Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. This category generally includes certain asset-backed securities, certain private equity investments, residential mortgage servicing rights, and long-term derivative contracts.





The following methods and assumptions were used by the Company in estimating fair value for the warrants considered to be derivative instruments.





The fair value of warrants is calculated using the Black-Scholes option pricing model. This option pricing model requires input of assumptions including the volatility of the Company’s stock price, the contractual term of the warrant and the risk-free interest rate.





Volatility is estimated at historical stock prices. The risk-free interest rate is based on the yield of a U.S. Treasury security with a term consistent with the warrant. The underlying stock is valued based on the closing market price for the Common Stock.





Assets and Liabilities Measured at Fair Value on a Recurring Basis





Assets and liabilities measured at fair value on a recurring basis are summarized below:





June 30, 2010Level 1


Level 2


Level 3


Fair ValueLiabilities:Derivative warrant liability

$
—


$
1,244,403


$
—


$
1,244,403





December 31, 2009Level 1


Level 2


Level 3


Fair ValueLiabilities:Derivative warrant liability

$
—


$
2,116,696


$
—


$
2,116,696





9
  Table of Contents
 The Company may also be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. In the three and six months ended June 30, 2010, there were no such other adjustments.




(6)  PREFERRED STOCK
 
 The Company is authorized to issue up to 40,000,000 shares of preferred stock with such rights, preferences and privileges as are fixed by the Board of Directors.


Convertible Preferred Stock





The Company has authorized 2,636,363 shares, 2,000,000 shares and 4,400,000 shares of Series A, Series A-1 and Series A-2 Convertible Preferred Stock, respectively.  As of June 30, 2010 and December 31, 2009, there were no shares issued and outstanding in these Series.





The Company has authorized 10,000 shares of Series C Preferred Stock (the “Series C Stock”), of which 4,918.1 shares were issued and outstanding as of June 30, 2010 and December 31, 2009.





Series B Perpetual, Redeemable Preferred Stock





The Company has authorized 40,000 shares of non-convertible, redeemable Series B Perpetual Preferred Stock (the “Series B Stock”), of which 146.8955 shares were issued and outstanding as of June 30, 2010, and 141.2281 shares were issued and outstanding at December 31, 2009.  In the three months ended June 30, 2010, the Company paid in-kind dividends in the form of 2.8815 shares of Series B Stock with a face value of approximately $29,000.





Series B Redemption Agreement —On January 19, 2010, the Company entered into a letter agreement with the sole holder of Series B Stock (the “Series B Holder”) regarding the payment to the Series B Holder of $143,750 (the “Redemption Amount”) for the redemption of 14.375 shares of Series B Stock in connection with the November 2009 financing and December 2009 financing. The Series B Holder waived payment of the Redemption Amount until the Company has a net cash balance in excess of $3,000,000. In consideration for the deferral, the Company agreed that, upon the closing of its next equity offering with gross proceeds of less than $5,000,000, it would use 25% of the gross proceeds to redeem Series B Stock (the “25% Redemption”).





On March 16, 2010, the Company entered into an additional agreement with the Series B Holder pursuant to which the Series B Holder waived both the 25% Redemption identified in the January 19, 2010 letter and the redemption required by the Series B Certificate with respect to amounts received in the February 2010 financing through March 16, 2010. Accordingly, redemption in the amount of approximately $614,000 was waived by the Series B Holder in connection with the February 2010 financing.





(7)  COMMON STOCK





The Company has authorized 100,000,000 shares of common stock, $0.01 par value per share at June 30, 2010 and December 31, 2009 of which 29,083,245 and 27,045,792 shares were issued and outstanding as of June 30, 2010 and December 31, 2009, respectively.





February 2010 Common Stock and Warrant February Financing





On February 4, 2010 the Company entered into a Common Stock and Warrant Purchase Agreement (the “February Agreement”) with certain strategic institutional and accredited investors in connection with the Company’s private placement (the “February Financing”) of shares of its Common Stock, at a price of $1.50 per share (the “February Shares”). Under the terms of the February Agreement, each investor received warrants to purchase a number of shares of Common Stock with an exercise price of $2.25 per share equal to fifty percent (50%) of the number of February Shares purchased by such investor (the “February Warrants”).





The Company received gross proceeds of approximately $2,455,000 in connection with the February Financing.





Pursuant to the February Agreement, the Company issued an aggregate of 818,362 February Warrants to the investors with a fair value of approximately $1,379,000. The February Warrants are immediately exercisable and expire no later than five (5) years from the date of issuance. The exercise price is subject to adjustment for stock splits, combinations or similar events. The February Warrants allow for cashless exercise. An exercise under the February Warrants may not result in the holder beneficially owning more than 4.99% or 9.99%, as applicable, of all of the Common Stock outstanding at the time; provided, however, that a holder may waive the foregoing provision upon sixty-one (61) days’ advance written notice to the Company.





The offer, sale and issuance to the investors of the February Shares, February Warrants, and shares of Common Stock issuable upon the exercise of the February Warrants have been made in reliance on the statutory exemption from registration in Section 4(2) of the Securities Act, have not been and will not be registered under the Securities Act, and unless so registered, may not be offered or sold in the United States, except pursuant to an applicable exemption from the registration requirements of the Securities Act, and applicable state securities laws. The Company is not required to register for resale under the Securities Act (i) the February Shares issued to the investors, (ii) the February Warrants or (iii) the Common Stock issuable upon the exercise of the February Warrants.





Issuance of Restricted Stock for Services





In April 2010, the Company issued 30,000 shares of its common stock with a fair value of approximately $48,000 to a vendor’s designee in consideration for investor relations services. In the three months ended June 30, 2010, the Company recorded $20,000 of selling, general and administrative expense and approximately $28,000 of unrecognized expense related to this arrangement.





(8)  STOCK OPTION PLANS





In 1997, the Company adopted its 1997 Long-Term Incentive and Stock Option Plan (the “1997 Plan”). Pursuant to the 1997 Plan, the Company’s Board of Directors (or committees and/or executive officers delegated by the Board of Directors) may grant incentive and nonqualified stock options to the Company’s employees, officers, directors, consultants and advisors. As of June 30, 2010, there were options to purchase an aggregate of 25,000 shares of common stock outstanding under the 1997 Plan and no shares available for future grants under the 1997 Plan.





10
 Table of Contents


In connection with the Company’s strategic merger with ChoiceTel in 2002, the Company assumed all outstanding options under the 1999 Sontra Medical, Inc. Stock Option and Incentive Plan (the “1999 Plan”). The Company may not grant any additional options under the 1999 Plan. The Company assumed options to purchase an aggregate of 86,567 shares of common stock under the 1999 Plan. As of June 30, 2010, there were options to purchase an aggregate of 5,780 shares of common stock outstanding under the 1999 Plan and none available for future grants.




In March 2003, the Company’s shareholders approved its 2003 Stock Option and Incentive Plan (the “2003 Plan”). Pursuant to the 2003 Plan, the Company’s Board of Directors (or committees and/or executive officers delegated by the Board of Directors) may grant incentive and nonqualified stock options, restricted stock and other stock-based awards to the Company’s employees, officers, directors, consultants and advisors. As of June 30, 2010, the maximum aggregate number of shares that may be authorized for issuance under the 2003 Plan for all periods is 1,600,000. As of June 30, 2010, there were restricted shares of common stock and options to purchase an aggregate of 1,545,000 shares of common stock outstanding under the 2003 Plan and 42,000 shares available for future grants under the 2003 Plan.





On May 20, 2008, the Company’s shareholders approved the Echo Therapeutics, Inc. 2008 Equity Compensation Plan (the “2008 Plan”). The 2008 Plan provides for grants of incentive stock options to employees and nonqualified stock options and restricted stock to employees, consultants and non-employee directors of the Company. As of June 30, 2010, the number of shares authorized for issuance under the 2008 Plan was 2,700,000 shares. As of June 30, 2010, there were restricted shares of common stock and options to purchase an aggregate of 1,894,750 shares of common stock outstanding under the 2008 Plan and 805,250 shares available for future grants under the 2008 Plan.





Share-Based Compensation





For options and restricted stock issued and outstanding during the six months ended June 30, 2010 and 2009, the Company recorded additional paid-in capital and non-cash compensation expense of approximately $99,000 and $667,000, respectively, each net of estimated forfeitures.





The fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of the Company’s common stock using historical periods consistent with the expected term of the options. The Company uses historical data, as well as subsequent events occurring prior to the issuance of the financial statements, to estimate option exercise and employee termination within the valuation model. The expected term of options granted under the Company’s stock plans is based on the average of the contractual term (generally 10 years) and the vesting period (generally 24 to 42 months).  The risk-free rate is based on the yield of a U.S. Treasury security with a term consistent with the option. Restricted stock grants are valued based on the closing market price for the Company’s common stock on the grant date.





The assumptions used principally for options granted to employees and members of the Company’s Board of Directors in the six months ended June 30, 2010 and 2009 were as follows:





2010


2009Risk-free interest rate


2.97 - 3.71
%


2.43% – 3.53
%Expected dividend yield


—



—Expected term (employee / director grants)

6.75 years


6.75 yearsForfeiture rate (excluding fully vested options)


0% - 37
%


11% - 33
%Expected volatility


145% - 151
%


150% - 155
%





A summary of option activity under the Company’s stock plans and options granted to officers of the Company outside any plan as of June 30, 2010 and changes during the six months then ended is presented below:





Options

Shares


Weighted-

Average

Exercise

Price

Weighted-

Average

Remaining

Contractual

Term

Aggregate

Intrinsic

ValueOutstanding at January 1, 2010


2,924,530


$
0.90Granted


100,000



1.70Exercised


—



—Forfeited or expired


(5,000
)


0.40Outstanding at June 30, 2010


3,019,530


$
0.93

7.31 years

$
1,821,200Exercisable at June 30, 2010


2,836,233


$
0.93

7.33 years

$
1,726,231





The weighted-average grant-date fair value of options granted during the six months ended June 30, 2010 was $1.55 per share. Share-based compensation expense recognized in the six months ended June 30, 2010 was approximately $46,000 for options granted in the six months ended June 30, 2010. Total share-based compensation expense recognized in the six months ended June 30, 2010 was approximately $99,000. As of June 30, 2010, there was approximately $737,000 of total unrecognized compensation expense related to non-vested share-based option compensation arrangements. With the exception of the unrecognized share-based compensation related to certain restricted stock grants to officers and employees that contain performance conditions  related to United States Food and Drug Administration (“FDA”) approval for Symphony or the sale of substantially all of the stock or assets of the Company, unrecognized compensation is expected to be recognized over the next 12 months.





Restricted Stock Grants





During the quarter ended June 30, 2010, the Company recognized approximately $130,000 of selling general and administrative expense related to 150,000 shares of its unregistered common stock previously issued to a vendor in consideration for investor relations services.  This amount represents the portion of the total fair value of the shares from the date of the grant until June 30, 2010.  The remaining fair value of $93,000 is included in prepaid expense at June 30, 2010 and will be amortized over the remaining period of the agreement.





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As of June 30, 2010, the Company had outstanding restricted stock grants amounting to 2,323,094 shares at a weighted-average grant-date fair value of $1.24 per share. Of the outstanding vested restricted stock grants, 468,500 shares have not been registered under the Securities Act. A summary of the status of the Company’s non-vested restricted stock grants as of June 30, 2010, and changes during the six months ended June 30, 2010, is presented below:





Nonvested Shares

Shares


Weighted-

Average

Grant-Date

Fair ValueNon-vested at January 1, 2010


1,779,594


$
1.13Granted


40,000



1.65Vested


(170,000
)


(1.51
)Forfeited


--



--Non-vested at June 30, 2010


1,649,594


$
1.13Vested at June 30, 2010


673,500


$
1.62





As of June 30, 2010, there was approximately $1,651,000 of total unrecognized compensation expense related to non-vested share-based restricted stock arrangements granted under the Company’s stock plans. As of June 30, 2010, the Company cannot estimate the timing of completion of performance vesting requirements included in these restricted stock grant arrangements.





(9)  WARRANTS





At June 30, 2010, the Company had the following outstanding warrants:





Number ofShares


Exercise

Date ofExercisable


Price

ExpirationGranted to investors and placement agent in private placement.


476,830


$
5.80

3/7/2011Granted to investors and placement agent in private placement.


419,250


$
1.32

6/15-7/16/2012Granted to investors and placement agent in private placement.


180,000


$
0.75

6/15/2012Granted to financial investment advisor


6,000


$
1.46

7/25/2012Granted to financial advisor in connection with an acquisition


80,750


$
1.92

9/14/2012Granted to financial investment advisor


39,978


$
1.36

2/11/2013Granted to investors in private placement


733,412


$
0.50

2/11/2013Granted to investors in private placement


641,681


$
1.61

3/24/2013Granted to investors in private placement of preferred stock


121,663


$
0.75

9/30/2013Granted to investors in private placement of preferred stock


32,249


$
1.00

9/30/2013Granted to investors in private placement of preferred stock


198,333


$
1.50

10/28/2013Granted to investors in private placement of preferred stock


70,000


$
0.75

10/31/2013Granted to investors in private placement of preferred stock


640,000


$
0.75

2/28/2014Granted to vendor


50,000


$
0.70

3/2/2012Granted to vendor


60,000


$
0.60

3/15/2014Granted to investors in private placement


400,000


$
1.59

6/30/2014Granted to investors in private placement


1,598,339


$
2.00

11/13/2014Granted to investors in private placement


800,000


$
1.60

11/13/2014Granted to placement agent in private placement


256,906


$
1.50

11/13/2014Granted to vendor


50,000


$
2.00

12/1/2012Granted to investors in private placement


315,000


$
2.00

12/3/2014Granted to placement agent in private placement


45,000


$
1.38

12/3/2014Granted to investors in private placement


811,987


$
2.25

2/9/2015Granted to placement agents in private placement


128,899


$
2.25

2/9/2015Granted to investor in private placement


6,375


$
2.25

3/18/2015Granted to financial investment advisor


100,000


$
1.50

2/10/2013Granted to financial investment advisor


20,000


$
2.00

3/3/2013Total


8,282,652Weighted average exercise price





$
1.78Weighted average duration in years








3.52 years





(10)
LICENSING AND OTHER REVENUE





Ferndale License of PreludeTM SkinPrep System





On May 27, 2009, the Company entered into a License Agreement with Ferndale Pharma Group, Inc. (“Ferndale”) pursuant to which the Company granted Ferndale a license in North America and the United Kingdom to develop, assemble, use, market, sell and export Prelude for skin preparation prior to the application of a topical analgesic or anesthetic cream for local dermal anesthesia or analgesia prior to a needle insertion or IV procedure (the “Ferndale License”). The Ferndale License has a minimum term of 10 years from the date of the first commercial sale of Prelude product components in North America or the United Kingdom.


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The Company received a licensing fee of $750,000 upon execution of the Ferndale License. The Company recognizes the upfront, nonrefundable payments as revenue on a straight-line basis over the contractual or estimated performance period. During the six months ended June 30, 2010, the estimated date of performance under the License was extended a total of six months and approximately $109,000 and $107,000 of the nonrefundable license revenue was recognized in the six months ended June 30, 2010 and 2009, respectively.  Approximately $237,000 of remaining deferred revenue is recognizable over the next 12 months and is shown as current deferred revenue. There was no licensing revenue or deferred revenue in the six months ended June 30, 2009.


Other Revenue —The Company has retained contract engineering services in connection with product development pursuant to the Ferndale License and the Company is reimbursed by Ferndale for the cost of product development engineering services. Other Revenue of approximately $97,000 relates to product development costs incurred during the six months ended June 30, 2010. The expenses billed to the Company are included in Research and Development expenses on the Statements of Operations. There was no markup on these expenses. There was no Other Revenue in the six months ended June 30, 2009.





Handok License of SymphonyTM tCGM System





On June 15, 2009, the Company entered into a License Agreement with Handok Pharmaceuticals Co., Ltd. (“Handok”) pursuant to which the Company granted Handok a license to develop, use, market, sell and import Symphony for continuous glucose monitoring for use by medical facilities and/or individual consumers in South Korea (the “Handok License”). The Handok License has a minimum term of 10 years from the date of the first commercial sale of Symphony in South Korea.





The Company received a licensing fee of approximately $500,000 upon execution of the Handok License. The Company recognizes the upfront, nonrefundable payments as revenue on a straight-line basis over the contractual or estimated performance period. During the six months ended June 30, 2010, the estimated date of performance under the Handok License was extended a total of six months and approximately $72,000 of the non-refundable license revenue was recognized in the six months ended June 30, 2010.   Approximately $197,000 is recognizable over the next 12 months and is shown as current deferred revenue and approximately $98,000 is recognizable as revenue beyond the 12 month period and is classified as non-current. Approximately $14,000 of the nonrefundable license revenue was recognizable in the six months ended June 30, 2009.





(11)
PLACEMENT AGENT AGREEMENTS





In connection with the February Financing, the Company retained Boenning & Scattergood and Burnham Hill Partners LLC (“BHP”) as its placement agents (each, a “Placement Agent”). The Company agreed to pay each Placement Agent for its services as follows: (a) a cash fee equal to seven percent (7%) of the gross cash proceeds received by the Company in connection with the February Financing from investors the Placement Agent directly introduced to the February Financing; and (b) warrants to acquire a number of shares of Common Stock equal to 10% of the number of February Shares issued to the investors directly introduced to the February Financing by the Placement Agent at a per share exercise price equal to $2.25 and with such other terms and conditions as are equal or substantially similar to those included in the February Warrants. The Company also agreed to pay reasonable out of pocket expenses of each Placement Agent incurred in connection with the February Financing in an amount not to exceed $5,000 per Placement Agent.  In connection with the February Financing, the Company has issued warrants to the Placement Agents to purchase 128,899 shares of common stock in the aggregate with a fair value of approximately $217,000 and has paid the Placement Agents in the aggregate fees amounting to approximately $135,000.





On March 5, 2010, the Company entered into an agreement for placement agent services. In the event that an investor makes an investment in the Company, the consultant will receive 5% fee on the total investment amount and warrants to purchase common shares of the Company equal to 7% of the number of shares issued to the investor. The warrants would be exercisable over a period of 5 years at a price equal to the price per share of the warrants issued to the investor.





On September 30, 2009, the Company and BHP entered into a letter agreement (the “Letter”) extending the due date of a $200,000 placement fee (the “Fee”) payable by the Company to BHP to in connection with placement agent services provided by BHP pursuant to an engagement letter between the parties dated June 30, 2009.  The Fee was originally due upon the earlier of (i) the Company having a net cash balance in excess of $2,000,000 or (ii) October 1, 2009.  The Letter provides that the Fee is due and payable by the Company upon the earlier of (i) the Company having a net cash balance in excess of $2,000,000 or (ii) June 30, 2010.  On March 16, 2010, BHP LLC agreed that the Company does not owe BHP LLC any fees pursuant to any and all previous agreements between BHP LLC and the Company. Accordingly, the Fee was waived and the Company recorded a gain on extinguishment of financing fee payable of $200,000 in March 2010.





(12)  SUBSEQUENT EVENT




In August, 2010, the Company issued 25,000 shares of its common stock with a fair value of approximately $28,000 to a vendor’s designee in consideration for public relations services. The fair value of these common shares will be amortized to selling, general and administrative expenses over the term of the services.  The shares were issued in a transaction not involving any public offering pursuant to an exemption from registration under Section 4(2) of the Securities Act.




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





The following discussion of our consolidated financial condition and results of operations should be read in conjunction with the financial statements and the related notes thereto included in the Company’s Form 10-K for the year ended December 31, 2009 and elsewhere in this Form 10-Q. The matters discussed herein contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Section 27A of the Securities Act of 1933, as amended, which involve risks and uncertainties. All statements other than statements of historical information provided herein may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes”, “anticipates”, “plans”, “expects” and similar expressions are intended to identify forward-looking statements. The factors that could cause actual future results to differ materially from current expectations include, but are not limited to, risks related to regulatory approvals and the success of our ongoing studies, including the efficacy of Symphony and Prelude, the failure of future development and preliminary marketing efforts related to Symphony and Prelude, risks and uncertainties relating to our ability to develop, market and sell diagnostic products based on our skin permeation platform technologies, the availability of substantial additional equity or debt capital to support our research, development and product commercialization activities, the success of our research, development, and regulatory approval, marketing and distribution plans and strategies, including those plans and strategies related to Symphony and Prelude and those discussed in “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009 and elsewhere in this report and the risks discussed in our other filings with the SEC. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis, judgment, belief or expectation only as of the date hereof. We undertake no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof.





Overview





The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As of June 30, 2010, we had cash of approximately $618,000, a working capital deficit of approximately $1,314,000 and an accumulated deficit of approximately $69,811,000. Through June 30, 2010, we have not been able to generate sufficient revenues from operations to cover costs and operating expenses. Although we have been able to obtain unsecured and secured debt and issue securities through a series of private placements to raise capital in order to fund our operations, it is not known whether we will be able to continue this practice, or be able to obtain other types of financing to meet our cash operating expenses. This, in turn, raises substantial doubt about our ability to continue as a going concern. Additional financing is necessary to fund operations for the remainder of 2010 and beyond. We are currently pursuing additional financing and such financing is planned to be completed during 2010; however, no assurances can be given as to the success of these plans. The financial statements do not include any adjustments that might result from the outcome of these uncertainties.





Operating Plan





We are principally involved with product development, pursuing contract manufacturing, supporting our product licensees and planning clinical studies for our Symphony tCGM System and our Prelude SkinPrep System. Symphony is a next-generation, non-invasive (needle-free), wireless transdermal continuous glucose monitoring (“tCGM”) system designed to provide reliable, continuous blood glucose data conveniently and cost-effectively. We have completed our principal research and advanced the feasibility development of our Symphony prototype, including Prelude, and have engaged several product development, engineering, and contract manufacturing firms to assist us with our plan to finalize product development and advance our regulatory approval process through the FDA. We have completed several clinical studies in prior years using Symphony in an acute care (hospital) environment, as well as in ambulatory settings for Type 1 and Type 2 diabetics. In order to complete our product development and clinical development programs and obtain regulatory approval for Symphony, we need to obtain substantial additional financing.





In connection with a license agreement with Ferndale Pharma Group, Inc., we have substantially completed product development on Prelude for use as needle-free skin preparation prior to the application of lidocaine cream for fast-acting, local dermal anesthesia prior to a wide-range of needle-based medical procedures.  Currently, the Prelude System is being tested in a clinical trial for the topical delivery of lidocaine.





Our specialty pharmaceuticals pipeline is based on our proprietary AzoneTS transdermal drug reformulation technology. We believe that, despite their commercial success in large, chronic markets, many FDA-approved products are candidates for our AzoneTS reformulation technology that is focused on improved and enhanced dermal penetration. Our lead product candidate is Durhalieve, an AzoneTS topical reformulation of triamcinolone acetonide. Durhalieve is covered by our NDA on file with the FDA for treatment of corticosteroid-responsive dermatoses. Also, we believe that Durhalieve has the potential to be an effective topical treatment for keloid scarring.





We have engaged a clinical research organization to advise us on the remaining product development requirements established by the FDA for our Durhalieve drug candidate. Presently, we are working to satisfy the FDA’s remaining manufacturing and clinical study requirements necessary to secure FDA approval of Durhalieve. In order to complete our product development program and to continue efforts to obtain regulatory approval for Durhalieve, we need to obtain substantial additional financing.





Research and Development





A significant portion of our research and development expenses includes salaries paid to personnel, outside product development design and engineering firms, and other contract service providers, as well as for the allocation of facilities costs.





Our product development efforts are principally concentrated on our medical device products: Symphony and Prelude. While our medical device product development programs are moving forward, financial constraints have prevented us from advancing these programs in accordance with the timelines we had originally anticipated.





In connection with our specialty pharmaceuticals pipeline and due to financial constraints, we have been unable to advance and finalize our AzoneTS product development programs as rapidly as we had originally anticipated, and none of the specialty pharmaceutical development programs have been completed. If we are unable to obtain sufficient funding necessary to complete our current planned development schedule for Durhalieve, then we may incur additional time and expenses to obtain FDA approval for Durhalieve and to commercialize Durhalieve. Should Durhalieve not receive FDA approval, then we may be required to write-off all or a portion of the intangible assets acquired as an impairment charge based on the specific facts and circumstances that will be evaluated at a future date.





Critical Accounting Policies and Estimates





Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the 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.





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 Table of Contents


On an ongoing basis, we evaluate our estimates and judgments for all assets and liabilities, including those related to stock-based compensation expense and the fair value determined for stock purchase warrants classified as derivative liabilities. We base our estimates and judgments on historical experience, current economic and industry conditions and on various other factors that are believed to be reasonable under the circumstances. This forms the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. There have been no changes in our critical accounting policies and estimates as filed with the SEC on June 30, 2010.





We believe that full consideration has been given to all relevant circumstances that we may be subject to, and the consolidated financial statements accurately reflect our best estimate of the results of operations, financial position and cash flows for the periods presented.





Revenue





To date, we have generated revenue primarily from licensing agreements, including upfront, nonrefundable license fees, and from amounts reimbursed by licensees for third-party engineering services for product development. We recognize revenue when the following criteria have been met:





•
persuasive evidence of an arrangement exists;





•
delivery has occurred and risk of loss has passed;





•
the price to the buyer is fixed or determinable; and





•
collectability is reasonably assured.





In addition, when evaluating multiple element arrangements, we consider whether the components of the arrangement represent separate units of accounting. Multiple elements are divided into separate units of accounting if specified criteria are met, including whether the delivered element has stand-alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. The consideration received is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units. Otherwise, the applicable revenue recognition criteria are applied to combined elements as a single unit of accounting.





We typically receive upfront, nonrefundable payments for the licensing of our intellectual property upon the signing of a license agreement. We believe that these payments generally are not separable from the payments we receive for providing research and development services because the license does not have stand-alone value from the research and development services we provide under these agreements. Accordingly, we account for these elements as one unit of accounting and recognize upfront, nonrefundable payments as revenue on a straight-line basis over its contractual or estimated performance period. Revenue from the reimbursement of research and development efforts is recognized as the services are performed based on proportional performance adjusted from time to time for any delays or acceleration in the development of the product. We determine the basis of the estimated performance period based on the contractual requirements of its collaboration agreements. At each reporting period, we evaluate whether events warrant a change in the estimated performance period.





Other Revenue includes amounts earned and billed under the license and collaboration agreements for reimbursement for research and development costs for contract engineering services. For the services rendered, principally third-party contract engineering services, the revenue recognized approximates the costs associated with the services.





We believe that full consideration has been given to all relevant circumstances that we may be subject to, and the consolidated financial statements accurately reflect our best estimate of the results of operations, financial position and cash flows for the periods presented.





Results of Operations





As of June 30, 2010, we had eleven (11) employees and used the services of three (3) independent contractors. Of this group of employees and contractors, eight (8) are involved with finance and administration and six (6) are involved with research and development, and clinical and regulatory matters. In addition to these individuals, we utilize outside contract engineering and contract manufacturing firms to support our operations. Further, we have engaged a clinical research organization and several consulting firms involved with regulatory strategy and clinical trial planning. We believe that with sufficient funding during the next 12 months, we will increase the number of employees in the areas of engineering, clinical research and testing, regulatory and quality assurance.





As of June 30, 2009, we had nine (9) employees and used the services of three (3) independent contractors.





We conduct our operations in leased facilities pursuant to a lease that expires in March 2011. Our property and equipment does not include manufacturing machinery and is limited to laboratory testing equipment, office furniture and computer systems (network hardware and software and employee desk top systems). Except for the purchase (possibly through capital lease financing) of tooling, molds and dies in connection with Symphony and Prelude, we do not anticipate any significant purchases or sales of property and equipment during the next 12 months.





Comparison of the six months ended June 30, 2010 and 2009





Licensing Revenue— We signed two licensing agreements, each with a minimum term of ten years, during 2009 that required up-front non-refundable license payments. The total up-front non-refundable license payments received in cash totaled $1,250,000. We are recognizing the upfront, nonrefundable payments as revenue on a straight-line basis over our contractual or estimated performance period. Accordingly, we determined that approximately $182,000 and $121,000 of the non-refundable license revenue was recognizable in the six months ended June 30, 2010 and 2009, respectively. This was an increase of approximately $61,000. Approximately $434,000 is recognizable over the next 12 months and is shown as current deferred revenue and approximately $98,000 that remains is recognizable as revenue beyond the 12 month period and is classified as non-current.





Other Revenue— We recognize amounts earned and billed under the license and collaboration agreements for reimbursement for research and development costs for contract engineering services. For the services rendered, principally third-party contract engineering services, the revenue recognized approximates the costs associated with the services.   Other revenue was approximately $97,000 and none for the six months ended June 30, 2010 and 2009, respectively.


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 Table of Contents





Research and Development Expenses— Research and development expenses increased by approximately $983,000 to approximately $1,678,000 for the six months ended June 30, 2010 from approximately $695,000 for the six months ended June 30, 2009. Research and development expenses increased primarily as a result of our increased product development activity for Symphony and Prelude, for outside contract engineering and manufacturing  costs. During the six months ended June 30, 2009, our operations were at less than full capacity due to the pursuit of necessary funding for normal operating levels. Research and development expenses amounted to approximately 47% and 33% of total operating expenses during the six months ended June 30, 2010 and 2009, respectively, and included product development expenses for Prelude and Symphony, activities with contract engineering and manufacturing firms relating principally to Prelude and regulatory consulting expenses related to Symphony and Prelude. We used the services of several engineering and product development firms during the six months ended June 30, 2009 in connection with the development of Symphony and Prelude.





Selling, General and Administrative Expenses— Selling, general and administrative expenses increased by approximately $466,000 to approximately $1,888,000 for the six months ended June 30, 2010 from approximately $1,422,000 for the six months ended June 30, 2009. The net increase was due to the combination of a decrease of approximately $568,000 in share-based compensation expenses from approximately $667,000 in 2009 to approximately $99,000 in 2010, an increase of approximately $161,000 in salaries and payroll taxes, an increase of approximately $908,000 ($820,000 relates to non-cash expenses) in outside investor relations services, an increase in legal expenses of approximately of $14,000, an increase of approximately $113,000 in charitable contributions ($113,000 relates to non-cash expense) and an increase of approximately $16,000 in corporate excise taxes, a decrease of approximately $195,000 in consulting fees, and a net increase of approximately $17,000 in other expenses. Selling, general and administrative expenses represented 53% and 67% of total operating expenses during the six months ended June 30, 2010 and 2009, respectively. Share-based compensation expenses are non-cash charges relating to the fair value of restricted common stock, options and warrants to purchase our common stock issued to employees, directors and certain service providers. We are not engaged in selling activities and, accordingly, general and administrative expenses relate principally to salaries and benefits for our executive, financial and administrative staff, public company reporting costs, legal, accounting, printing and media costs, capital-raising costs, and costs for general operations.





Interest Income— Interest income was approximately $1,200 for the six months ended June 30, 2010 compared to approximately $1,000 for the six months ended June 30, 2009, an increase of approximately $200. The increase in interest income was attributable to our higher average amount of cash equivalents on hand during the six months ended June 30, 2010 compared to the same period in 2009.





Interest Expense —Interest expense was approximately $2,000 for the six months ended June 30, 2010, compared to interest expense of approximately $252,000 for the same period in 2009, a decrease of $250,000. The decrease in interest expense was due to the payment or conversion to equity securities of debt obligations during 2009. The approximate net decrease in interest expense for each note payable obligation is shown in the table below:





Six months endedNote Payable Obligation

June 30,2010


June 30,2009


Increase

(Decrease)Senior convertible notes

$
—


$
32,000


$
(32,000
)2008 Senior secured notes


—



204,000



(204,000
)Other short-term financing


2,000



16,000



(14,000
)Total notes payable

$
2,000


$
252,000


$
(250,000
)Non-cash Interest included above

None


$
234,000


$
(234,000
)





Derivatives Gain (Loss)— At June 30, 2010, we had outstanding warrants to purchase 8,282,652 shares of our common stock. Included in these warrants are outstanding warrants to purchase 1,342,649 shares that are considered to be derivative instruments since the agreements contain “down round” provisions whereby the number of shares covered by the warrants is subject to change in the event of certain dilutive stock issuances. The fair value of these derivative instruments at June 30, 2010 was approximately $1,244,000 and is included in Derivative Warrant Liability, a current liability. Changes in fair value of the derivative financial instruments are recognized currently in the Statement of Operations as a Derivative Gain (Loss). The primary underlying risk exposure pertaining to the warrants is the change in fair value of the underlying common stock. The Derivative gain on warrants subject to “down round” provisions for the six months ended June 30, 2010 amounted to approximately $672,000. During the six months ended June 30, 2010, warrants to purchase 143,793 shares of common stock were exercised which resulted in a reclassification to additional paid-in capital in the amount of approximately $200,000.  The Derivative loss on warrants subject to “down round” provisions for the six months ended June 30, 2009 amounted to approximately $(3,968,000).




Loss on Extinguishment of Debt— There were no loss on the extinguishment of debt during the six months ended June 30, 2010.  During the six months ended June 30, 2009, the Company recorded a loss on extinguishment of debt in the amount of approximately $1,820,000 relating to the retirement of Senior Secured Convertible Notes in exchange for Series B Perpetual Preferred Stock and Series C Preferred Stock.  Additionally, the Company recorded a loss on extinguishment of debt in the amount of approximately $32,000 relating to the Secured Senior Convertible Notes.





Gain on Extinguishment of Financial Advisory Fee Payable— On September 30, 2009, we entered into the Letter with BHP extending the due date of the Fee payable by us to BHP to in connection with placement agent services provided by BHP pursuant to an engagement letter dated June 30, 2009.  The Fee was originally due upon the earlier of (i) our net cash balance exceeding $2,000,000 or (ii) October 1, 2009.  The Letter provides that the Fee is due and payable by us upon the earlier of (i) our net cash balance exceeding $2,000,000 or (ii) June 30, 2010.  In March 2010, BHP agreed that we do not owe BHP any fees pursuant to any and all previous agreements between BHP and us. Accordingly, the Fee was waived and we recorded a gain on extinguishment of financing fee payable of $200,000 in March 2010. There were no similar financial arrangements during the six months ended June 30, 2009.





Net Loss— As a result of the factors described above, we had a net loss of approximately $2,417,000 for the six months ended June 30, 2010 compared to approximately $8,066,000 for the six months ended June 30, 2009.





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Comparison of the three months ended June 30, 2010 and 2009





Licensing Revenue— We signed two licensing agreements, each with a minimum term of ten years, during 2009 that required up-front non-refundable license payments. The total up-front non-refundable license payments received in cash totaled $1,250,000. We are recognizing the upfront, nonrefundable payments as revenue on a straight-line basis over our contractual or estimated performance period. Accordingly, we determined that approximately $168,000 and $121,000 of the non-refundable license revenue was recognizable in the three months ended June 30, 2010 and 2009, respectively. Approximately $434,000 is recognizable over the next 12 months and is shown as current deferred revenue and approximately $98,000 that remains is recognizable as revenue beyond the 12 month period and is classified as non-current.





Other Revenue— We recognize amounts earned and billed under the license and collaboration agreements for reimbursement for research and development costs for contract engineering services. For the services rendered, principally third-party contract engineering services, the revenue recognized approximates the costs associated with the services.   Other revenue was approximately $97,000 and none for the three months ended June 30, 2010 and 2009, respectively .





Research and Development Expenses— Research and development expenses increased by approximately $158,000 to approximately $565,000 for the three months ended June 30, 2010 from approximately $406,000 for the three months ended June 30, 2009. Research and development expenses increased primarily as a result of our increased product development activity for Symphony and Prelude, mainly due to an approximate increase of $48,000 in outside contract engineering and manufacturing  costs, an increase of approximately $58,000 for legal expenses related to patents, an increase of approximately $55,000 in salaries and a decrease of approximately $3,000 in other expenses. During the three months ended June 30, 2009, our operations were at less than full capacity due to the pursuit of necessary funding for normal operation levels. Research and development expenses amounted to approximately 48% and 32% of total operating expenses during the three months ended June 30, 2010 and 2009, respectively, and included product development expenses for Prelude and Symphony, activities with contract engineering and manufacturing firms relating principally to Prelude and regulatory consulting expenses related to Symphony and Prelude. We used the services of several engineering and product development firms during the three months ended June 30, 2009 in connection with the development of Symphony and Prelude.





Selling, General and Administrative Expenses— Selling, general and administrative expenses decreased by approximately $237,000 to approximately $611,000 for the three months ended June 30, 2010 from approximately $848,000 for the three months ended June 30, 2009. The net decrease was due to the combination of a decrease of approximately $229,000 in share-based compensation expenses from approximately $269,000 in 2009 to approximately $40,000 in 2010, an increase of approximately $21,000 in salaries and payroll taxes, an increase of approximately $177,000 ($139,000 relates to non-cash expenses) in outside investor relations services, an increase in legal expenses of approximately of $5,000, and a decrease of approximately $234,000 in consultants fees, and a net increase of approximately $23,000 in other expenses. Selling, general and administrative expenses represented 52% and 68% of total operating expenses during the three months ended June 30, 2010 and 2009, respectively. Share-based compensation expenses are non-cash charges relating to the fair value of restricted common stock, options and warrants to purchase our common stock issued to employees, directors and certain service providers. We are not engaged in selling activities and, accordingly, general and administrative expenses relate principally to salaries and benefits for our executive, financial and administrative staff, public company reporting costs, legal, accounting, printing and media costs, capital-raising costs, and costs for general operations.





Interest Income— Interest income was approximately $500 for the three months ended June 30, 2010 and 2009.





Interest Expense —Interest expense was approximately $1,000 for the three months ended June 30, 2010, compared to interest expense of approximately $74,000 for the same period in 2009, a decrease of $73,000. The decrease in interest expense was due to the payment or conversion to equity securities of debt obligations during 2009. The approximate net decrease in interest expense for each note payable obligation is shown in the table below:





Three months endedNote Payable Obligation

June 30,2010


June 30,2009


Increase

(Decrease)Senior convertible notes

$
—


$
16,000


$
(16,000
)2008 Senior secured notes


—



41,000



(41,000
)2009 Senior secured notes


—



16,000



(16,000
)Other short-term financing


1,000



1,000



—Total notes payable

$
1,000


$
74,000


$
(73,000
)Non-cash Interest included above

None


$
58,000


$
(58,000
)




Loss on Extinguishment of Debt— There was no loss on extinguishment of debt in the six months ended June 30, 2010.  During the three months ended June 30, 2009, we recorded a loss on extinguishment of debt in the amount of approximately $1,820,000 relating to the retirement of Senior Secured Notes.  Additionally, the Company recorded a loss on extinguishment of debt in the amount of approximately $32,000 relating to the Senior Secured Notes.





Derivatives Gain (Loss)— At June 30, 2010, we had outstanding warrants to purchase 8,282,652 shares of our common stock. Included in these warrants are outstanding warrants to purchase 1,342,649 shares that are considered to be derivative instruments since the agreements contain “down round” provisions whereby the number of shares covered by the warrants is subject to change in the event of certain dilutive stock issuances. The fair value of these derivative instruments at June 30, 2010 was approximately $1,244,000 and is included in Derivative Warrant Liability, a current liability. Changes in fair value of the derivative financial instruments are recognized currently in the Statement of Operations as a Derivative Gain (Loss). The primary underlying risk exposure pertaining to the warrants is the change in fair value of the underlying common stock. The Derivative Gain on warrants subject to “down round” provisions for the three months ended June 30, 2010 amounted to approximately $376,000.  The Derivative Loss on warrants subject to “down round” provisions for the three months ended June 30, 2009 amounted to approximately ($3,716,000).





Net Loss— As a result of the factors described above, we had a net loss of approximately $536,000 for the three months ended June 30, 2010 compared to approximately $6,775,000 for the three months ended June 30, 2009.





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Liquidity and Capital Resources





We have financed our operations since inception primarily through private sales of our common stock and preferred stock, the issuance of convertible promissory notes and secured promissory notes, the issuance of intellectual property and product licenses and, cash received in connection with exercises of common stock purchase options and warrants. As of June 30, 2010, we had approximately $618,000 of cash and cash equivalents.





Net cash used in operating activities was approximately $2,856,000 for the six months ended June 30, 2010. The use of cash in operating activities was primarily attributable to the net loss of approximately $2,417,000 for the six months ended June 30, 2010.  Net cash used in operations was reduced by non-cash expenses of approximately $74,000 for depreciation and amortization, $99,000 for share-based compensation expense, $901,000 for fair value of warrants and common stock provided to outside service providers, $46,000 for fair value of options provided to outside service providers, and approximately $113,000 for fair value of common stock granted as a charitable contribution.  Net cash used in operations was negatively impacted by a non-cash gain on extinguishment of a financial advisory fee payable in the amount of $200,000, a decrease in deferred revenue of approximately $182,000 and a non-cash gain of approximately $672,000 related to a fair value adjustment to derivative liability. Net cash was used in operations due to a decrease in accounts payable of approximately $491,000, a decrease in accrued expenses and other liabilities of approximately $100,000, an increase in prepaid expenses of approximately $96,000, and a decrease of approximately $2,000 in deposits and other current assets.  A decrease in accounts receivable and deposits, and other current assets provided approximately $65,000 and 2,000 of cash, respectively.





Net cash was used in investing activities of approximately $3,000 for the six months ended June 30, 2010 and related to the purchase of office equipment.





Net cash provided by financing activities was approximately $2,310,000 for the six months ended June 30, 2010, primarily attributable to approximately $2,311,000 (net of cash financing costs) from the sale of common stock and warrants in February 2010, less approximately $900 for capital lease payments.





At June 30, 2010, we had outstanding warrants to purchase 8,282,652 shares of common stock at exercise prices ranging from $0.50 to $5.80.





As of August 9, 2010, we had cash and cash equivalents of approximately $400,000.





We continue to aggressively pursue additional financing from existing relationships (prior shareholders, investors and lenders) and from new investors. We have engaged investment banking and financial advisory firms to assist us with these efforts.





While we have been successful in raising funds to support our operations, we require substantial additional capital to fund our product development, research and clinical programs in accordance with our current projected level of operations. We manage our costs aggressively and have increased our operating efficiencies while advancing our product development, research and clinical programs, thereby maximizing the time available to obtain additional financing.  During the six months ended June 30, 2010, we increased our operating costs and advanced our product development programs.  Accordingly, our costs related to our pursuit of FDA approval for Symphony, the support of product licensing arrangements, product development and contract manufacturing  have increased during the period.  In order to fund these activities at the same level that we have in the six months ended June 30, 2010 and to achieve our business objectives, we are actively pursuing additional funding for receipt in the near term.  Our ability to fund our product development, research and clinical programs will be based on the availability of additional financing.  A delay in securing additional financing may cause us to delay or halt scheduled product development activities for Symphony and Prelude. Although we continue to vigorously pursue acceptable financing, there can be no guarantee that additional capital will be available in sufficient amounts on terms favorable to us, if at all.


Even if we are successful in raising necessary capital in the near term, we will still be required to raise substantial additional capital in the future to fund our product research, development and clinical programs, commercialize our product candidates and achieve profitability. Our ability to fund our future operating requirements will depend on many factors, including the following:





•
our ability to obtain funding from third parties, including any future collaborative partners, on reasonable terms;





•
our progress on research and development programs;





•
the time and costs required to gain regulatory approvals;





•
the costs of manufacturing, marketing and distributing our products, if successfully developed and approved;





•
the costs of filing, prosecuting and enforcing patents, patent applications, patent claims and trademarks;





•
the status of competing products; and





•
the market acceptance and third-party reimbursement of our products, if successfully developed and approved.




We conduct our operations in leased facilities pursuant to a lease that expires in March 2011. Our property and equipment does not include manufacturing machinery and is comprised of laboratory testing equipment, office furniture and computer systems (network hardware and software and employee desk top systems). Except for the purchase (possibly through capital lease or other  financing) of tooling, molds and dies in connection with Symphony and Prelude, we do not anticipate any significant purchases or sales of property and equipment during the next 12 months.





Off-Balance Sheet Arrangements





We have no off-balance sheet arrangements, including unrecorded derivative instruments that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. We have certain warrants and options outstanding but we do not expect to receive sufficient proceeds from the exercise of these instruments unless and until the trading price of our common stock is significantly greater than the applicable exercise prices of the options and warrants and mainly following any necessary registering of underlying securities.





Effect of Inflation and Changes in Prices





Management does not believe that inflation and changes in price will have a material effect on our operations.





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Item 4T. Controls and Procedures.





Disclosure Controls and Procedures





Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this report were effective in ensuring that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that the information required to be disclosed by us in such reports is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.





Internal Control over Financial Reporting





There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during the fiscal quarter to which this report relates that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.








PART II—OTHER INFORMATION





Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.





In April 2010, we issued 30,000 shares of common stock to the designee of a vendor in connection with the provision of investor relations services. The shares were issued in a transaction not involving any public offering pursuant to an exemption from registration under Section 4(2) of the Securities Act.





Item 6. Exhibits.





The Exhibits listed in the Exhibit Index immediately preceding such Exhibits are filed with or incorporated by reference in this report.


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SIGNATURES





Pursuant to the requirements of 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.








ECHO THERAPEUTICS, INC.





Date: August 16, 2010




By:
/s/ Patrick T. Mooney, M.D.


Patrick T. Mooney, M.D.


Chief Executive Officer and Chairman of the Board








By:
/s/ Harry G. Mitchell, CPA Harry G. Mitchell, CPA
 Chief Operating Officer, Chief Financial Officer and Treasurer














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EXHIBIT INDEX





Exhibit No.
Item.10.1
Common Stock and Warrant Purchase Agreement by and among the Company and the Investors named therein, dated as of February 4, 2010, is incorporated herein by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K dated February 4, 2010.10.2
Form of Common Stock Purchase Warrant is incorporated herein by reference to Exhibit 4.1 of the Company’s Current Report on Form 8-K dated February 4, 2010.31.1
Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
Certification of the Chief Operating Officer, Chief Financial Officer and Treasurer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
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 Operating Officer, Chief Financial Officer and Treasurer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.





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