**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

 

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| **x**      | **Quarterly  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934** |
|------------|---------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                              |
| ** ** | **For the quarterly period ended September 30, 2007.**

** **                                 |
|            |                                                                                                         |  |

** **

 

**or**

 

| **o**      | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934**                                                                                 |
|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                               |
| ** ** | **For  the Transition Period From              to            .** |
|            |                                                                                                                                                                                          |  |

 

 

 

**Commission file number 001-33782**

 

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**ARYx THERAPEUTICS, INC.**

(Exact name ofregistrant as specified in its charter)

 

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| **Delaware**                                                      | ** ** | **77-0456039**                          |
|-------------------------------------------------------------------|------------|-----------------------------------------|
| (State  or Other Jurisdiction of

Incorporation  or Organization) |       | (I.R.S.  Employer

Identification  No.) |

 

**6300 Dumbarton Circle, Fremont,California 94555**

(Address ofPrincipal Executive Offices including zip code)

 

**(510) 585-2200**

(Registrant’sTelephone Number, Including Area Code)

 

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Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90days.    Yes  o    No  x

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  o    Acceleratedfiler  o    Non-acceleratedfiler  x

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).    Yes  o    No  x

 

As of December 14,2007, 17,653,648 shares of the registrant’s common stock, $0.001 par value,were outstanding.

 

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**ARYx THERAPEUTICS, INC.**

 

**FORM 10-Q FOR THE QUARTER ENDEDSEPTEMBER 30, 2007**

 

**INDEX**

** **

| ** **                                                                                          | ** **                                                                                                            | **Page**   |
|-----------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------|------------|
| **PART I  — FINANCIAL INFORMATION**                                                       | ** **                                                                                                            | ** ** |
| ** **                                                                                          | ** **                                                                                                            | ** ** |
| Item  1. Financial Statements (unaudited)                                                           |                                                                                                                  |       |
|                                                                                                | Condensed Consolidated Balance Sheets as of  September 30, 2007 and December 31, 2006                       |       | 2 |
|                                                                                                | Condensed Consolidated Statements of Operations for  the three and nine months ended September 30, 2007 and 2006 |       | 3 |
|                                                                                                | Condensed Consolidated Statements of Cash Flow for the  nine months ended September 30, 2007 and 2006            |       | 4 |
|                                                                                                | Notes to Condensed Consolidated Financial Statements                                                                  |       | 5 |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations |                                                                                                                  | 13         |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                 |                                                                                                                  | 19         |
| Item 4. Controls and Procedures                                                                     |                                                                                                                  | 20         |
|                                                                                                |                                                                                                                  |       |
| **PART II  — OTHER INFORMATION**                                                          | ** **                                                                                                            | ** ** |
| Item  1. Legal Proceedings                                                                          |                                                                                                                  | 21         |
| Item  1A. Risk Factors                                                                              |                                                                                                                  | 21         |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                |                                                                                                                  | 41         |
| Item 3. Defaults Upon Senior Securities                                                             |                                                                                                                  | 42         |
| Item 4. Submission of Matters to a Vote of Security  Holders                                        |                                                                                                                  | 42         |
| Item  5. Other Information                                                                          |                                                                                                                  | 43         |
| Item 6.  Exhibits                                                                                   |                                                                                                                  | 44         |
|                                                                                                |                                                                                                                  |       |
| SIGNATURE                                                                                           |                                                                                                                  | 45         |
|                                                                                                |                                                                                                                  |       |

 

 

1

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**PART I— FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**ARYx THERAPEUTICS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(In thousands)**

** **
| ** **                                                                                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                  | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| ** **                                                                                  | ** ** | **(Unaudited)**        | ** ** | **(Note 1)**          | ** ** |
| **ASSETS**                                                                                  | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current assets:                                                                             |       |                   |       |                  |       |
| Cash and cash equivalents                                                                   |       | $                      | 16,706     |                  | $          | 18,660 |   |
| Marketable securities                                                                       |       | 10,696                 |       | 31,648                |       |
| Receivable from corporate partner                                                           |       | 50                     |       | —                |       |
| Restricted cash                                                                             |       | 150                    |       | —                |       |
| Current portion of receivable from an officer                                               |       | —                 |       | 45                    |       |
| Prepaid research and development expenses                                                   |       | 726                    |       | 242                   |       |
| Other prepaid and current assets                                                            |       | 558                    |       | 816                   |       |
| Total current assets                                                                        |       | 28,886                 |       | 51,411                |       |
| Property and equipment,  net                                                                |       | 3,816                  |       | 4,169                 |       |
| Receivable from an officer                                                                  |       | —                 |       | 20                    |       |
| Deferred offering costs                                                                     |       | 1,649                  |       | —                |       |
| Other assets                                                                                |       | 1,094                  |       | 1,164                 |       |
| **Total assets**                                                                            |       | $                      | 35,445     |                  | $          | 56,764 |   |
|                                                                                        |       |                   |       |                  |       |
| **LIABILITIES, CONVERTIBLE  PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)**       | ** ** |
| Current liabilities:                                                                        |       |                   |       |                  |       |
| Accounts payable                                                                            |       | $                      | 1,372      |                  | $          | 691 |   |
| Accrued research and development expenses                                                   |       | 2,461                  |       | 1,349                 |       |
| Preferred stock warrants liability                                                          |       | 668                    |       | 853                   |       |
| Current portion of notes payable                                                            |       | 3,448                  |       | 3,197                 |       |
| Current portion of deferred revenue                                                         |       | 3,911                  |       | 3,896                 |       |
| Other accrued liabilities                                                                   |       | 2,489                  |       | 1,541                 |       |
| Total current liabilities                                                                   |       | 14,349                 |       | 11,527                |       |
| Deferred lease credit                                                                       |       | 1,877                  |       | 2,124                 |       |
| Notes payable                                                                               |       | 4,286                  |       | 6,679                 |       |
| Deferred revenue                                                                            |       | 16,563                 |       | 19,481                |       |
| Commitments and  contingencies                                                              |       |                   |       |                  |       |
| Convertible preferred  stock                                                                |       | 110,679                |       | 110,665               |       |
| Stockholders’ equity  (deficit):                                                       |       |                   |       |                  |       |
| Common stock                                                                                |       | 1                      |       | 1                     |       |
| Additional paid-in capital                                                                  |       | 2,313                  |       | 1,451                 |       |
| Accumulated other comprehensive loss                                                        |       | (3                     | )          | (1                    | )          |
| Accumulated deficit                                                                         |       | (114,620               | )          | (95,163               | )          |
| Total stockholders’ equity  (deficit)                                                  |       | (112,309               | )          | (93,712               | )          |
| **Total liabilities, convertible  preferred stock and stockholders’ equity (deficit)** |       | $                      | 35,445     |                  | $          | 56,764 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

2

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**ARYx THERAPEUTICS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(In thousands, except per shareamounts)**

**(Unaudited)**

** **

| ** **                                                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                       | ** ** | **2007**                                   | ** ** | **2006**                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Revenue:**                                                                     | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Collaboration services                                                           |       | $                                          | 66         |                                      | $          | 79 |   | $ | 252 |   | $ | 79 |   |
| Technology license fees                                                          |       | 974                                        |       | 649                                       |       | 2,922 |   | 649 |   |
| Contractual milestone payments                                                   |       | —                                     |       | 1,000                                     |       | — |   | 1,000 |   |
| Total revenue                                                                    |       | 1,040                                      |       | 1,728                                     |       | 3,174 |   | 1,728 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| **Costs and expenses:**                                                          | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of collaboration service revenue                                            |       | 66                                         |       | 79                                        |       | 252 |   | 79 |   |
| Research and development                                                         |       | 6,586                                      |       | 5,293                                     |       | 17,602 |   | 20,142 |   |
| Selling, general and administrative                                              |       | 1,902                                      |       | 1,640                                     |       | 5,526 |   | 5,152 |   |
| Total costs and expenses                                                         |       | 8,554                                      |       | 7,012                                     |       | 23,380 |   | 25,373 |   |
| Loss from operations                                                             |       | (7,514                                     | )          | (5,284                                    | )          | (20,206 | ) | (23,645 | ) |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Interest income, net of other expenses                                           |       | 505                                        |       | 666                                       |       | 1,684 |   | 1,652 |   |
| Interest expense                                                                 |       | (292                                       | )          | (338                                      | )          | (935 | ) | (974 | ) |
| Loss before cumulative  effect of change in accounting principle                 |       | (7,301                                     | )          | (4,956                                    | )          | (19,457 | ) | (22,967 | ) |
| Cumulative effect of change in accounting principle                              |       | —                                     |       | —                                    |       | — |   | (10 | ) |
| **Net loss**                                                                     |       | $                                          | (7,301     | )                                         | $          | (4,956 | ) | $ | (19,457 | ) | $ | (22,977 | ) |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| **Loss per common share, basic  and diluted:**                                   | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loss per share before  cumulative effect of change in accounting principle       |       | $                                          | (6.30      | )                                         | $          | (4.83 | ) | $ | (17.75 | ) | $ | (22.65 | ) |
| Per share cumulative effect of change in accounting principle                    |       | —                                     |       | —                                    |       | — |   | (0.01 | ) |
| Net loss per common share                                                        |       | $                                          | (6.30      | )                                         | $          | (4.83 | ) | $ | (17.75 | ) | $ | (22.66 | ) |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average shares  used to compute basic and diluted loss per common share |       | 1,158                                      |       | 1,027                                     |       | 1,096 |   | 1,014 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

3

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**ARYx THERAPEUTICS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOW**

**(In thousands)**

**(Unaudited)**

** **
| ** **                                                                   | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                   | ** ** | **September 30,** | ** ** |
| ** **                                                                   | ** ** | **2007**               | ** ** | **2006** | ** ** |
| **Cash flows from operating  activities:**                                   | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                      | (19,457    | ) | $ | (22,977 | ) |
| Adjustments to reconcile  net loss to net cash used in operating activities: |       |                   |       |   |   |
| Depreciation and amortization                                                |       | 827                    |       | 644 |   |
| Revaluation of warrants to fair value and warrant net exercise               |       | (170                   | )          | 10 |   |
| Stock-based compensation                                                     |       | 697                    |       | 490 |   |
| Change in assets and liabilities:                                            |       |                   |       |   |   |
| Receivable from corporate partner                                            |       | (50                    | )          | (1,079 | ) |
| Prepaid research and development expenses                                    |       | (484                   | )          | 152 |   |
| Other prepaid, receivable and assets                                         |       | 93                     |       | (80 | ) |
| Accounts payable and other accrued liabilities                               |       | 973                    |       | (95 | ) |
| Accrued research and development expenses                                    |       | 1,112                  |       | (1,406 | ) |
| Deferred lease credit                                                        |       | (247                   | )          | (198 | ) |
| Deferred revenue                                                             |       | (2,902                 | )          | 24,351 |   |
| Cash used in operating  activities                                           |       | (19,608                | )          | (188 | ) |
|                                                                         |       |                   |       |   |   |
| **Cash flows from investing  activities:**                                   | ** ** | ** **             | ** ** | ** ** | ** ** |
| Purchases of marketable securities                                           |       | (17,360                | )          | (59,863 | ) |
| Proceeds from sales of marketable securities                                 |       | 9,920                  |       | 21,790 |   |
| Proceeds from maturities of marketable securities                            |       | 28,380                 |       | 20,225 |   |
| Other                                                                        |       | (545                   | )          | (587 | ) |
| Net cash provided by (used  in) investing activities                         |       | 20,395                 |       | (18,435 | ) |
|                                                                         |       |                   |       |   |   |
| **Cash flows from financing  activities:**                                   | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net proceeds from issuance of convertible preferred stock                    |       | —                 |       | 31,007 |   |
| Cost of issuance of common stock relating to our initial public  offering    |       | (762                   | )          | — |   |
| Proceeds from exercise of stock options and issuance of common stock         |       | 164                    |       | (791 | ) |
| Principal payments on notes payable                                          |       | (2,143                 | )          | (1,018 | ) |
| Net cash (used in) provided  by financing activities                         |       | (2,741                 | )          | 29,198 |   |
|                                                                         |       |                   |       |   |   |
| **Net (decrease) increase in cash  and cash equivalents**                    |       | (1,954                 | )          | 10,575 |   |
| Cash and cash equivalents  at beginning of period                            |       | 18,660                 |       | 12,455 |   |
| **Cash and cash equivalents at  end of period**                              |       | $                      | 16,706     |   | $ | 23,030 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

4

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**ARYx THERAPEUTICS, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

In this report, ‘‘ARYx,’’‘‘we,’’ ‘‘us’’ and ‘‘our’’ refer to ARYx Therapeutics, Inc. ‘‘Common stock’’refers to ARYx’s common stock, par value $0.001 per share. ‘‘Preferred stock’’refers to ARYx’s convertible preferred stock, $0.001 par value.

 

**1.  Organization and Summary of SignificantAccounting Policies**

 

***TheCompany***

 

ARYx is abiopharmaceutical company focused on developing a portfolio of internallydiscovered product candidates designed to eliminate known safety issuesassociated with well-established, commercially successful drugs. We use ourRetroMetabolic Drug Design technology to design structurally unique moleculesthat retain the efficacy of these original drugs but are metabolized through apotentially safer pathway to avoid specific adverse side effects associatedwith these compounds. Our most advanced product candidate, ATI-7505, is basedon cisapride and has successfully completed Phase 2 clinical trials for the treatmentof gastroesophageal reflux disease and symptoms associated with functionaldyspepsia. Our second product candidate, ATI-5923, is based on warfarin and iscurrently in Phase 2 clinical trials for use as an anticoagulant to treatpatients at risk for the formation of dangerous blood clots. Our third productcandidate, ATI-2042, is based on amiodarone and is in Phase 2 clinical trialsfor the treatment of atrial fibrillation, a form of irregular heartbeat. Wehave multiple product candidates in preclinical development. Each of ourproduct candidates is an orally available, patentable new chemical entitydesigned to address similar indications as those of the original drug uponwhich it is based. Our product candidates target multi-billion dollar markets.

 

We were incorporated inthe State of California on February 28, 1997 and reincorporated in theState of Delaware on August 29, 2007. We maintain a wholly-ownedsubsidiary, ARYx Therapeutics Limited, with registered offices in the UnitedKingdom, which has had no operations since its inception in September 2004.We currently are focused on the human drug development business and operate ina single business segment with regard to the development of humanpharmaceutical products.

 

From inception through December 31,2005, we were a development stage company and our financial statements duringthat period were prepared in conformity with U.S. generally accepted accountingprinciples governing development stage companies. In June 2006, we enteredinto a collaboration agreement with Procter & Gamble Pharmaceuticals, Inc.(‘‘P&G’’) which resulted in the recognition of significant revenues fromour principal operations. Accordingly, beginning with our fiscal year 2006, weare no longer considered a development stage company for accounting purposes.

 

***Principles of Consolidation***

 

Our consolidatedfinancial statements include the accounts of our wholly-owned subsidiary, ARYxTherapeutics, Ltd. The subsidiary has no assets other than the initialformation capital totaling one Pound Sterling.

 

***Basis of Presentation***

 

The accompanyingunaudited condensed consolidated interim financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America for interim financial information on the same basis asthe annual financial statements and with instructions to Form 10-Q and Rule 10-01of Regulation S-X. Accordingly, they do not include all of the informationand footnotes required by generally accepted accounting principles for completefinancial statements. The unaudited condensed interim financial statementsinclude all adjustments (consisting only of normal recurring adjustments) thatmanagement believes are necessary for the fair statement of the balances andresults for the periods presented. These unaudited condensed interim financialstatement results are not necessarily indicative of results to be expected forthe full fiscal year or any future interim period.

 

The balance sheetat December 31, 2006 has been derived from the audited consolidatedfinancial statements at that date. The unaudited condensed consolidated interimfinancial statements and related disclosures have been prepared with thepresumption that users of the unaudited condensed consolidated interimfinancial statements have read or have access to the audited financialstatements for the preceding fiscal year. Accordingly, these financialstatements should be read in conjunction with the audited financial statementsand notes thereto for the year ended December 31, 2006 contained in ourRegistration Statement on Form S-1 (File No. 333-145813) and theprospectus that constitutes a part thereof filed with the Securities andExchange Commission and declared effective November 7, 2007, related tothe initial public offering of our common stock.

 

5

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***Use of Estimates***

 

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

 

***Reverse Stock Split***

 

On October 22, 2007, we effected a one-for-sixreverse stock split of our convertible preferred stock and common stock. Allshare and per share amounts have been retroactively restated for the effect ofthis split for all periods presented.

 

***Initial Public Offering***

 

In November 2007,we completed the initial public offering in which we sold and issued 5,000,000shares of common stock at an issue price of $10.00 per share. We raised a totalof $50.0 million in gross proceeds from our initial public offering, orapproximately $44.0 million in net proceeds after deducting underwritingdiscounts and commissions of $3.5 million and other offering costs ofapproximately $2.5 million. Upon closing of the initial public offering, all ofthe outstanding shares of our convertible preferred stock were automaticallyconverted into 11,415,130 shares of common stock and all of our warrants topurchase preferred stock then outstanding were converted into warrants topurchase common stock.

 

***Deferred Offering Costs***

 

In connection withour initial public offering, we have recorded a total of $1.6 million ofdeferred offering costs in the accompanying balance sheets as of September 30,2007.  This amount, which is classifiedin long-term assets, will be offset against the net proceeds of the initialpublic offering in the quarter ending December 31, 2007.

 

***Unaudited Pro Forma Information***

 

The following unauditedpro forma balance sheet information as of September 30, 2007 and pro formabasic and diluted net loss per share attributable to common stockholdersdisclosed in the *Net Loss Per Common Share*section below reflect:

 

·                  The net proceeds to us from our initialpublic offering of approximately $44.0 million, after underwriting discountsand commissions and estimated offering expenses;

 

·                  The 5,000,000 shares of common stockissued upon the closing of our initial public offering;

 

·                  Upon the closing of our initial publicoffering, the automatic conversion of all the convertible preferred stock thenoutstanding into 11,415,130 shares of common stock;

 

·                  The reclassification of the preferredstock warrant liability to additional paid-in capital upon conversion of thepreferred stock underlying the warrants into common stock upon the closing ofour initial public offering; and

 

·                  The reclassification of deferred offeringcosts of $1.6 million to additional paid-in capital.

 

6

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| ** **                                                     | ** **   | **Pro Forma**             | ** **   |
|----------------------------------------------------------------|--------------|---------------------------|--------------|
| ** **                                                     | ** **   | **Balance Sheet**         | ** **   |
| ** **                                                     | ** **   | **At September 30,** | ** **   |
| ** **                                                     | ** **   | **2007**                  | ** **   |
| *** ***                                                   | *** *** | ***(In thousands)***      | *** *** |
| **ASSETS**                                                     | ** **   | ** **                | ** **   |
| Current assets:                                                |         |                      |         |
| Cash and cash equivalents                                      |         | $                         | 60,662       |   |
| Marketable securities                                          |         | 10,696                    |         |
| Receivable from corporate partner                              |         | 50                        |         |
| Restricted cash                                                |         | 150                       |         |
| Prepaid research and development expenses                      |         | 726                       |         |
| Other prepaid and current assets                               |         | 558                       |         |
| Total current assets                                           |         | 72,842                    |         |
| Property and equipment,  net                                   |         | 3,816                     |         |
| Other assets                                                   |         | 1,094                     |         |
| **Total assets**                                               |         | $                         | 77,752       |   |
| ** **                                                     | ** **   | ** **                | ** **   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY (DEFICIT)**       | ** **   | ** **                | ** **   |
| Current liabilities:                                           |         |                      |         |
| Accounts payable                                               |         | $                         | 1,372        |   |
| Accrued research and development expenses                      |         | 2,461                     |         |
| Current portion of notes payable                               |         | 3,448                     |         |
| Current portion of deferred revenue                            |         | 3,911                     |         |
| Other accrued liabilities                                      |         | 2,489                     |         |
| Total current liabilities                                      |         | 13,681                    |         |
| Deferred lease credit                                          |         | 1,877                     |         |
| Notes payable                                                  |         | 4,286                     |         |
| Deferred revenue                                               |         | 16,563                    |         |
| Commitments and  contingencies                                 |         |                      |         |
| Stockholders’ equity  (deficit):                          |         |                      |         |
| Common stock                                                   |         | 17                        |         |
| Additional paid-in capital                                     |         | 155,951                   |         |
| Accumulated other comprehensive loss                           |         | (3                        | )            |
| Accumulated deficit                                            |         | (114,620                  | )            |
| Total stockholders’ equity  (deficit)                     |         | 41,345                    |         |
| **Total liabilities and  stockholders’ equity (deficit)** |         | $                         | 77,752       |   |

 

***Related Party Transaction***

 

On August 2,2007, our board of directors authorized the forgiveness of the outstandingportion of a loan to one of our executive officers in the amount of $43,000,which includes principal and imputed interest.

 

***University of Toledo License Agreement***

 

On August 21,2007, we provided the University of Toledo with notice of termination of ourlicense agreement, dated February 21, 2005. The termination of the licenseagreement did not have a material impact on our consolidated results ofoperations or financial position.

 

***Comprehensive Loss***

 

Comprehensive income (loss) generally represents allchanges in stockholders’ equity except those resulting from investments orcontributions by stockholders. Our unrealized gains (losses) on marketablesecurities represent the components of comprehensive loss that are excludedfrom the net loss. Comprehensive loss for the three months ended September 30,2007 and 2006 was $7.3 million and $4.9 million, respectively, and for the ninemonths ended September 30, 2007 and 2006 was $19.5 million and $23.0million, respectively.

 

***Net Loss Per Common Share***

 

Basic and diluted net loss per common shareis computed using the weighted average number of shares of common stockoutstanding during the period as follows:

 

7

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| ** **                                                                                                          | ** **   | **Three Months Ended  September 30,**      | ** **   | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|--------------|-------------------------------------------------|--------------|-------------------------------------------|------------|
| ** **                                                                                                          | ** **   | **2007**                                        | ** **   | **2006**                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                                                          | *** *** | ***(In  thousands, except per share amounts)*** | *** *** |
| **HISTORICAL:**                                                                                                     | ** **   | ** **                                      | ** **   | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator:*                                                                                                        | * *     | * *                                        | * *     | * *                                  | * *   | * * | * * | * * | * * |
| Net loss applicable to common stockholders                                                                          |         | $                                               | (7,301       | )                                         | $          | (4,956 | ) | $ | (19,457 | ) | $ | (22,977 | ) |
| *Denominator:*                                                                                                      | * *     | * *                                        | * *     | * *                                  | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                                                          |         | 1,193                                           |         | 1,030                                     |       | 1,126 |   | 1,018 |   |
| Less: Weighted average unvested restricted common shares                                                            |         | (35                                             | )            | (3                                        | )          | (30 | ) | (4 | ) |
| Weighted average common shares used in computing basic and diluted  net loss per common share                       |         | 1,158                                           |         | 1,027                                     |       | 1,096 |   | 1,014 |   |
| Basic and diluted net loss  per common share                                                                        |         | $                                               | (6.30        | )                                         | $          | (4.83 | ) | $ | (17.75 | ) | $ | (22.66 | ) |
|                                                                                                                |         |                                            |         |                                      |       |   |   |   |   |
| **PRO FORMA:**                                                                                                      | ** **   | ** **                                      | ** **   | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator:*                                                                                                        | * *     | * *                                        | * *     | * *                                  | * *   | * * | * * | * * | * * |
| Net loss applicable to common stockholders, as used above                                                           |         | $                                               | (7,301       | )                                         | $          | (4,956 | ) | $ | (19,457 | ) | $ | (22,977 | ) |
| *Denominator:*                                                                                                      | * *     | * *                                        | * *     | * *                                  | * *   | * * | * * | * * | * * |
| Basic and diluted weighted average common shares, as used above                                                     |         | 1,158                                           |         | 1,027                                     |       | 1,096 |   | 1,014 |   |
| Add: Pro forma adjustments to reflect assumed weighted average effect  of conversion of convertible preferred stock |         | 11,415                                          |         | 11,414                                    |       | 11,415 |   | 11,132 |   |
| Weighted average shares used in computing pro forma basic and diluted  net loss per common share                    |         | 12,573                                          |         | 12,441                                    |       | 12,511 |   | 12,146 |   |
| Pro forma basic and  diluted net loss per common share                                                              |         | $                                               | (0.58        | )                                         | $          | (0.40 | ) | $ | (1.56 | ) | $ | (1.89 | ) |

 

The following commonstock equivalent shares related to outstanding convertible preferred stock,warrants and stock options were excluded from the computation of diluted netloss per common share for the periods presented because including them wouldhave had an antidilutive effect:

 
| ** **                                                                                        | ** **   | **Three Months Ended  September 30,** | ** **   | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|--------------|--------------------------------------------|--------------|-------------------------------------------|------------|
| ** **                                                                                        | ** **   | **2007**                                   | ** **   | **2006**                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
| *** ***                                                                                      | *** *** | ***(In thousands)***                       | *** *** |
| Series A  convertible preferred stock   (as if converted)                                    |         | 126                                        |         | 126                                       |       | 126 |   | 126 |   |
| Series B  convertible preferred stock   (as if converted)                                    |         | 105                                        |         | 105                                       |       | 105 |   | 105 |   |
| Series C  convertible preferred stock   (as if converted)                                    |         | 2,826                                      |         | 2,825                                     |       | 2,826 |   | 2,825 |   |
| Series D  convertible preferred stock   (as if converted)                                    |         | 5,539                                      |         | 5,539                                     |       | 5,539 |   | 5,539 |   |
| Series E  convertible preferred stock   (as if converted)                                    |         | 2,819                                      |         | 2,819                                     |       | 2,819 |   | 2,819 |   |
| Warrants  to purchase Series C convertible preferred stock   (as if exercised and converted) |         | 11                                         |         | 17                                        |       | 11 |   | 17 |   |
| Warrants  to purchase Series D convertible preferred stock   (as if exercised and converted) |         | 101                                        |         | 101                                       |       | 101 |   | 101 |   |
| Outstanding  common stock options                                                                 |         | 1,700                                      |         | 1,382                                     |       | 1,700 |   | 1,382 |   |
|                                                                                              |         | 13,227                                     |         | 12,914                                    |       | 13,227 |   | 12,914 |   |
|                                                                                                   |              |                                            |              |                                           |            |  |  |  |  |  |  |  |  |

 

***Recent Accounting Pronouncements***

 

In September 2006, the Financial AccountingStandards Board (“FASB”) issued Statements of Financial Accounting Standards No. 157(“SFAS 157”), *Fair Value Measurements*.SFAS 157 defines fair value, establishes a framework for measuring fairvalue in accordance with U.S. generally accepted accounting principles andexpands disclosures about fair value measurements. SFAS 157 is effectivefor financial statements issued for fiscal years beginning after November 15,2007. We are currently evaluating the impact of the provisions of SFAS 157on our consolidated financial position, results of operations and cash flows.

 

8

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In February 2007, the FASB issued Statements ofFinancial Accounting Standards No. 159 (“SFAS 159”), *The Fair Value Option for Financial Assets andFinancial Liabilities- Including an amendment of FASB Statement No. 115*.SFAS 159 provides companies with an option to report selected financial assetsand liabilities at fair value. The objective of SFAS 159 is to reduce both thecomplexity in accounting for financial instruments and the volatility inearnings caused by measuring related assets and liabilities differently. Mostof the provisions in SFAS 159 are elective; however, the amendment to FASB StatementNo. 115, *Accounting for CertainInvestments in Debt and Equity Securities*, applies to all entitieswith available-for-sale and trading securities. SFAS 159 is effective as of thebeginning of an entity’s fiscal year beginning after November 15, 2007. Weare currently evaluating the impact of the provisions of SFAS 159 on ourconsolidated financial position, results of operations and cash flows.

 

In June 2007, the FASB ratified Emerging IssuesTask Force Issue (“EITF”) No. 07-3, “*Accountingfor Nonrefundable Advance Payments for Goods or Services Received for Use inFuture Research and Development Activities*” (“EITF 07-3”). EITF 07-3requires that nonrefundable advance payments for goods and services that willbe used or rendered in future R&D activities pursuant to executorycontractual arrangements be deferred and recognized as an expense in the periodthat the related goods are delivered or services are performed. We will adoptEITF 07-3 as of January 1, 2008, and the adoption is not expected to havea material impact on our consolidated results of operations or financialposition.

 

In December 2007, the FASB ratified EITF 07-1, *“Accounting for Collaborative Arrangements”*(“EITF 07-1”).EITF 07-1 defines collaborative arrangements and establishes reportingrequirements for transactions between participants in a collaborativearrangement and between participants in the arrangement and third parties. EITF07-1 also establishes the appropriate income statement presentation andclassification for joint operating activities and payments betweenparticipants, as well as the sufficiency of the disclosures related to thesearrangements. EITF 07-1 is effective for fiscal years beginning after December 15,2008. We are currently evaluating the impact of EITF 07-1 on our consolidatedfinancial position, results of operations and cash flows.

 

**2.  Collaboration with Procter & GamblePharmaceuticals (P&G)**

 

                InJune 2006, we entered into a collaboration agreement with P&G pursuantto which P&G will develop and commercialize ATI-7505, our product candidatefor the treatment of gastrointestinal disorders such as chronic constipation,functional dyspepsia, gastroesophageal reflux disease, gastroparesis andirritable bowel syndrome with constipation. In connection with this agreement,P&G paid us a $25.0 million nonrefundable upfront license fee. Inaccordance with our revenue recognition policy, we concluded that the$25.0 million nonrefundable upfront license fee should be deferred uponreceipt, as objective evidence of the fair value of the undelivered elementsunder the agreement could not be established. This fee is being recognized asrevenue on a straight-line basis over the estimated period of our obligatoryperformance and provision of services under the terms of the agreement. Weestimate on an on-going basis the expected duration of the performance andservice period and adjust our recognition of deferred revenue accordingly. Atpresent, we estimate that our performance period under the agreement willcontinue through December 2012.  Asof September 30, 2007, we have recognized $4.5 million of the $25.0million nonrefundable upfront license fee.

 

                Underthe terms of the agreement, we are obligated to provide certain transitionalservices to P&G. These transitional services represent the pass through ofactual costs billed to ARYx by third party vendors, are standard supportservices for the biopharmaceutical industry and are readily available frommultiple vendors. We are also entitled to compensation from P&G for certainpre-determined development services, such as formulation, development andmanufacturing of drug substance and products, as well as other activitiesrelated to the licensed technology. Under the agreement, we have no obligationto perform any development activities nor do we have any manufacturingobligations. As of September 30, 2007, we have recognized a total of $2.4million of collaboration service revenue in connection with both transitionaland other development services under the agreement.  P&G has the right to terminate ourcollaboration agreement at any time upon written notice pursuant to its terms.

 

9

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**3. ****Preferred Stock Warrant Liability**

 

                As of September 30, 2007,the following warrants were issued and outstanding:

 
| ** **                                 | ** ** | ** **          | ** ** | ** **                       | ** ** | ** **                                 | ** ** | ** ** | ** ** | **Exercise**         | ** ** | ** **        | ** ** |
|--------------------------------------------|------------|---------------------|------------|----------------------------------|------------|--------------------------------------------|------------|------------|------------|----------------------|------------|-------------------|------------|
| ** **                                 | ** ** | ** **          | ** ** | ** **                       | ** ** | ** **                                 | ** ** | ** ** | ** ** | **Price**            | ** ** | **Expiration**    | ** ** |
| **Warrant Holder**                         | ** ** | **Issue Date** | ** ** | **In Connection With** | ** ** | **Warrant to Purchase**          | ** ** | **Shares** | ** ** | **(per share)** | ** ** | **Date(1)(2)(3)** | ** ** |
| ATEL(2)                                    |       | 12/23/2002          |       | Leasing  arrangement             |       | Series C  convertible preferred stock |       | 5,611      |       | $                    | 8.91       |              | 12/23/2012 |   |
| Life Science Group, Inc.(1) |       | 9/3/2003            |       | Placement  agent services        |       | Series C  convertible preferred stock |       | 5,667      |       | $                    | 8.91       |              | 9/3/2008   |   |
| Lighthouse(3)                              |       | 3/28/2005           |       | Debt financing                   |       | Series D  convertible preferred stock |       | 100,704    |       | $                    | 9.93       |              | 3/28/2012  |   |
|                                       |       |                |       |                             |       |                                       |       | 111,982    |       |                 |       |              |       |

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(1)          Exercisable, in whole or inpart, until the earlier of (i) immediately prior to the closing of aninitial public offering, a merger, change in control, or sale of substantiallyall of our assets or (ii) the fifth anniversary of the issue date.

 

(2)          Exercisable, in whole or inpart, until the earlier of the 10th anniversary of the issue date or the fifthanniversary of the closing of an initial public offering.

 

(3)          Exercisable, in whole or inpart, at the option of the warrant holder; automatically deemed exercised infull at the earlier of (i) close of business on March 28, 2012, (ii) twoyears following the effective date of an initial public offering or (iii) theeffective date of a merger.

 

The warrants may be exercised using the net exercisemethod. Under this method, the number of shares issued upon exercise is reducedby an amount equal to the product of the number of shares subject to theexercise and the exercise price per share, divided by the fair value ofconvertible preferred stock on the date of the exercise. The number of sharesissued upon exercise of the warrants, and the exercise price per share, areadjustable in the event of stock splits, dividends and similar fundamentalchanges. In June 2007, Life Science Group, Inc. exercised their firstwarrant on a net exercise basis and resulted in the issuance of 1,055 shares ofSeries C convertible preferred stock.

 

Following guidance under SFAS 150, we re-measured thefair value of these warrants on September 30, 2007 and December 31,2006 using the Black-Scholes valuation model under the following assumptions:risk-free interest rate between 4.30% and 4.77%, contractual life according tothe remaining terms of the arrangements, no dividend yield and volatility of73%. We recorded a benefit of $130,000 and $170,000 to interest income duringthe three and nine months ended September 30, 2007, respectively, toreflect decreases in the fair value of the preferred stock warrantliability.  We recorded an immaterialamount of benefit during the three and nine months ended September 30,2006 to reflect decreases in the fair value of the preferred stock warrantliability.

 

Upon completion of our initial public offering in November 2007,all outstanding warrants to purchase our convertible preferred stock wereconverted in accordance with their original terms into warrants to purchase ourcommon stock.

 

**4. ****Stock-Based Compensation**

 

We account foremployee stock-based compensation under SFAS No. 123(R), *Share-Based Payment* (“SFAS 123R”), whichrequires compensation expense related to stock-based payments, including stockoptions and awards granted to employees and directors, to be measured andrecognized in the financial statements based on grant date fair value. Employeestock-based compensation expense recognized under SFAS 123R was determinedusing the Black—Scholes option valuation model. Option valuation models requirethe input of highly subjective assumptions and these assumptions can vary overtime. As we have been a private entity, company specific historical volatilitydata have not been available as input assumptions. As a result, we followguidance discussed in the Securities and Exchange Commission’s Staff AccountingBulletin No. 107 (“SAB 107”) basing the estimate of expected volatility onthe expected volatility of a group of similar entities whose share prices arepublicly available. We will continue to consistently apply this process usingthe same similar entities until a sufficient amount of historical informationregarding the volatility of our own share price is established. The fair valueof stock options was estimated at the grant date using the followingweighted-average assumptions:

 
| ** **                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected volatility                               |       | 73                                                   | %          | 73                                                  | %          | 73 | % | 73 | % |
| Expected term (in years)                          |       | 4.06                                                 |       | 4.11                                                |       | 4.10 |   | 3.79 |   |
| Weighted-average risk-free  interest rate         |       | 4.8                                                  | %          | 5.0                                                 | %          | 4.6 | % | 4.9 | % |
| Expected dividends                                |       | —                                               |       | —                                              |       | — |   | — |   |
| Weighted-average grant  date fair value per share |       | $                                                    | 3.45       |                                                | $          | 1.91 |   | $ | 1.93 |   | $ | 1.73 |   |
|                                                   |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |

 

In accordance withprovisions under SFAS 123R, employee stock-based compensation expenserecognized in the three and nine months ended September 30, 2007 and 2006was calculated based on awards ultimately expected to vest and has been reducedfor

 

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estimated forfeitures.SFAS 123R requires forfeitures to be estimated at the time of grant andrevised, if necessary, in subsequent periods if actual forfeitures differ fromthose estimates.

 

We continue toaccount for stock options issued to non-employees in accordance with therecognition provisions of SFAS 123R and EITF Issue 96-18, *Accounting for Equity Instruments That Are Issued toOther Than Employees for Acquiring, or in Conjunction with Selling, Goods orServices*, using a fair value approach. Compensation costs of thesearrangements are subject to re-measurement over the vesting terms as earned. Asof September 30, 2007, options to purchase 3,959 shares of our commonstock remain subject to re-measurement under EITF Issue 96-18.

 

Total compensation costthat has been recorded in the statement of operations, which includesstock-based compensation expense under SFAS 123R and the value of optionsissued to non-employees for services rendered, are allocated as follows:

 
| ** **                           | ** **   | **Three Months Ended  September 30,** | ** **   | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------|--------------|--------------------------------------------|--------------|-------------------------------------------|------------|
| ** **                           | ** **   | **2007**                                   | ** **   | **2006**                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
| *** ***                         | *** *** | ***(In thousands)***                       | *** *** |
| Research and development:            |         |                                       |         |                                      |       |   |   |   |   |
| Officer compensation                 |         | $                                          | 23           |                                      | $          | 13 |   | $ | 89 |   | $ | 42 |   |
| Employee and consultant compensation |         | 92                                         |         | 29                                        |       | 232 |   | 78 |   |
| Selling, general and administrative: |         |                                       |         |                                      |       |   |   |   |   |
| Director and officer compensation    |         | 89                                         |         | 140                                       |       | 334 |   | 347 |   |
| Employee and consultant compensation |         | 17                                         |         | 10                                        |       | 45 |   | 23 |   |
|                                 |         | $                                          | 221          |                                      | $          | 192 |   | $ | 700 |   | $ | 490 |   |

 

As of September 30,2007, total compensation cost related to unvested stock options not yet recognizedwas $1.2 million, which is expected to be allocated to expense over aweighted-average period of 1.89 years.

 

We issued 89,651 sharesand 111,422 shares of common stock as a result of stock option exercises duringthe three and nine months ended September 30, 2007, respectively, and43,333 shares of common stock as a result of the release of restricted stockawards during the nine months ended September 30, 2007.

 

**5. ****Commitments and Contingencies**

 

***Indemnification***

 

As permitted underDelaware law and in accordance with our bylaws, we indemnify our officers anddirectors for certain events or occurrences, subject to certain limits, whilethe officer or director is or was serving at our request in such capacity. In August 2007,we entered into indemnification agreements with our officers and directors. Themaximum amount of potential future indemnification is unlimited; however, weintend to obtain director and officer insurance that limits our exposure andmay enable us to recover a portion of any future amounts paid. We believe thefair value for these indemnification obligations is minimal. Accordingly, wehave not recognized any liabilities relating to these obligations as of September 30,2007.

 

We have certainagreements with licensors, licensees and collaborators that containindemnification provisions. In such provisions, we typically agree to indemnifythe licensor, licensee and collaborator against certain types of third-partyclaims. We accrue for known indemnification issues when a loss is probable andcan be reasonably estimated. There were no accruals for expenses related toindemnification issues for any period presented.

 

**6. ****Income Taxes**

 

We utilize the liability method of accounting forincome taxes. Under this method, deferred tax assets and liabilities aredetermined based on differences between financial reporting bases and the taxbases of assets and liabilities and are measured using enacted tax rates andlaws that will be in effect when the differences are expected to reverse. Basedon known factors, our management cannot currently conclude that it will be morelikely than not that the deferred tax assets will be utilized. Accordingly, thedeferred tax assets have been fully offset by a valuation allowance.

 

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                We adopted FIN 48 effective January 1,2007. FIN 48 requires us to recognize the financial statement effects of a taxposition when it is more likely than not, based on the technical merits, thatthe position will be sustained upon examination. No cumulative adjustment toour accumulated deficit was required upon our adoption of FIN 48. As permittedunder the provisions of FIN 48, we will classify interest and penalties relatedto unrecognized tax benefits as part of our income tax provision, although therehave been no such interest or penalties recognized to-date.

 

Upon adoption of FIN 48, we had approximately $0.4million of unrecognized tax benefits. As of September 30, 2007, there wereno unrecognized tax benefits that, if recognized, would impact our effectivetax rate. We currently have a full valuation allowance against our net deferredtax asset which would impact the timing of the effective tax rate benefitshould any of these uncertain tax positions be favorably settled in the future.We do not anticipate that the amount of existing unrecognized tax benefits willsignificantly increase or decrease within the next 12 months. Because of ournet operating loss carryforwards, substantially all of our tax years remainopen to federal tax examination. We file income tax returns in the UnitedStates and in California, which typically have three and four tax years open,respectively, at any point in time.

 

**7. ****Subsequent Events**

 

                On October 19, 2007, we entered into an amendedloan agreement with Lighthouse Capital Partners which provides us with anadditional $9 million in debt financing that is available for borrowinguntil the expiration of the supplemental financing commitment date, or March 1,2008. We are under no obligation to utilize any of the funding provided underthe amended agreement. In accordance with the terms of the amendment we issuedLighthouse an additional warrant to purchase 41,666 shares of our Series Epreferred stock at an exercise price of $10.80 per share. To the extent that weborrow additional funds under the amended agreement, the number of sharesexercisable by Lighthouse pursuant to the new warrant will increase by 5% ofthe amount borrowed divided by the exercise price of $10.80 per share. Theagreement provides that amounts borrowed will be subject to an interest-onlyperiod expiring in September 2008 followed by 36 equal monthly payments ofprincipal and interest at a fixed rate of the prime rate as quoted in thewestern edition of the Wall Street Journal plus 2%, to be fixed as of September 2008.In addition, we will be obligated to make a final payment of 7.5% of the amountborrowed at loan maturity. All other provisions under the original loanagreement remain intact.

 

On November 13,2007, we closed our initial public offering in which we sold 5,000,000 sharesof our common stock at $10.00 per share for net cash proceeds of approximately$44.0 million, net of underwriting discounts and commissions of $3.5million and estimated offering expenses of $2.5 million. (Also see Note 1.)

 

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

 

*Thefollowing discussion of our financial condition and the results of operationsshould be read in conjunction with the condensed consolidated financialstatements and notes to condensed consolidated financial statements included elsewhere in this quarterly report on Form 10-Q.This discussion contains forward looking statements that involve risks anduncertainties. When reviewing the discussion below, you should keep in mind thesubstantial risks and uncertainties that characterize our business. Inparticular, we encourage you to review the risks and uncertainties described inPart II - Item 1A. “RISK FACTORS” elsewhere in this report. Theserisks and uncertainties could cause actual results to differ materially fromthose projected in forward-looking statements contained in this report orimplied by past results and trends. Forward-looking statements are statementsthat attempt to forecast or anticipate future developments in our business; weencourage you to review the examples of our forward-looking statements underthe heading “Cautionary Note Regarding Forward-Looking Statements” that appearsat the end of this discussion. These statements, like all statements in thisreport, speak only as of their date (unless another date is indicated), and weundertake no obligation to update or revise these statements in light of futuredevelopments.*

 

**Overview**

 

ARYx is abiopharmaceutical company focused on developing a portfolio of internallydiscovered product candidates designed to eliminate known safety issuesassociated with well-established, commercially successful drugs. We use ourRetroMetabolic Drug Design technology to design structurally unique moleculesthat retain the efficacy of these original drugs but are metabolized through apotentially safer pathway to avoid specific adverse side effects associatedwith these compounds. Our most advanced product candidate, ATI-7505, is basedon cisapride and has successfully completed Phase 2 clinical trials forthe treatment of gastroesophageal reflux disease and symptoms associated withfunctional dyspepsia. Our second product candidate, ATI-5923, is based on warfarinand recently completed a Phase 2 proof-of-concept clinical trial for useas an anticoagulant to treat patients at risk for the formation of dangerousblood clots. Our third product candidate, ATI-2042, is based on amiodarone andis in Phase 2 clinical trials for the treatment of atrial fibrillation, aform of irregular heartbeat. We have multiple product candidates in preclinicaldevelopment. Each of our product candidates is an orally available, patentablenew chemical entity designed to address similar indications as those of theoriginal drug upon which it is based. Our product candidates target what webelieve to be multi-billion dollar markets. We have entered into a worldwidecollaboration with Procter & Gamble Pharmaceuticals, Inc., orP&G, for the development and commercialization of ATI-7505 and we hold allworldwide commercial rights to our other product candidates.

 

Since ourinception, we have incurred significant net losses, and we expect to continueto incur net losses for the next several years as we develop, acquire orin-license additional products or product candidates, conduct clinical trials,manufacture materials for use in nonclinical studies and clinical trials,expand our research and development activities, seek regulatory approvals andengage in commercialization preparation activities. It is very expensive togain approval of and launch a pharmaceutical product, and many expenses areincurred before revenue is received. We are unable to predict the extent of anyfuture losses or when we will become profitable, if at all.

 

***Revenue***

 

In connection with ourcollaboration agreement with P&G, we received a $25.0 millionnonrefundable upfront license fee in August 2006. The $25.0 millionpayment was recorded in our balance sheet as deferred revenue upon receipt andrecognized in our consolidated statement of operations as revenue on astraight-line basis over the performance and service period. We estimate on an on-going basis the expected duration of theperformance and service period and adjust our recognition of deferred revenueaccordingly. At present, we estimate that our performance period under theagreement will continue through December 2012. As of September 30,2007, we have recognized $4.5 million of the $25.0 million nonrefundableupfront license fee.

 

Under the terms ofthe agreement, we are obligated to provide certain transitional services toP&G. These transitional services represent the pass through of actual costsbilled to the Company by third party vendors, are standard support services forthe biopharmaceutical industry and are readily available from multiple vendors.We are also entitled to compensation from P&G for specified developmentservices provided by us. These services include product formulation and manufacturing,patent filing and maintenance, and other development services related to theATI-7505 program. Reimbursements we receive for these services are recorded ascollaboration service revenue. Pursuant to the agreement, we are under noobligation to perform any such services. As of September 30, 2007, we haverecognized a cumulative total of $2.4 million as collaboration servicerevenue. We anticipate that 

 

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revenue related to theseservices in the future will be minimal and will decline as we transition toP&G direct responsibility for all development costs related to our ATI-7505product candidate.

 

Revenue generatedfrom the P&G agreement is currently our only source of revenue. We are atrisk of loss of anticipated future revenue if P&G terminates the agreementor is unable or unwilling to remit to us amounts that will be owed inaccordance with the terms of the agreement. P&G may terminate the agreementat any time pursuant to its terms.

 

***Cost of Collaboration Service Revenue***

 

Related to theservice revenue we generate in connection with our collaboration agreement withP&G, we incur costs for certain services provided including costs forpharmaceutical development, patent filing and maintenance and other activitiesrelated to the ATI-7505 program. These expenses are reported separately in ourincome statement as cost of collaboration service revenue. As of September 30,2007, we have recorded a cumulative total of $2.4 million of expenserelated to these activities.

 

***Research and Development***

 

Our research anddevelopment expense consists of expenses incurred in identifying, testing anddeveloping our product candidates. These expenses consist primarily of feespaid to contract research organizations and other third parties to assist us inmanaging, monitoring and analyzing our clinical trials, clinical trial costspaid to sites and investigators’ fees, costs of nonclinical studies includingtoxicity studies in animals, costs of contract manufacturing services, costs ofmaterials used in clinical trials and nonclinical studies, laboratory relatedexpenses, research and development support costs including certain regulatory,quality assurance, project management and administration, allocated expensessuch as facilities and information technology that are used to support ourresearch and development activities and related personnel expenses, includingstock-based compensation. Research and development costs are expensed asincurred.

 

Clinical trialcosts are a significant component of our research and development expense.Currently, we conduct our clinical trials primarily through coordination withcontract research organizations and other third-party service providers. Werecognize research and development expense for these activities based upon avariety of factors, including actual and estimated patient enrollment, clinicalsite initiation activities, direct pass-through costs and other activity-basedfactors.

 

The followingtable summarizes our research and development expense for the three and ninemonths ended September 30, 2007 and 2006:

 
| ** **                                                                           | ** ** | **Three Months Ended  September 30,** | ** **   | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|--------------|-------------------------------------------|------------|
| ** **                                                                           | ** ** | **2007**                                   | ** **   | **2006**                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                 |       | ***(In thousands)***                       | *** *** |
| Direct research and  development expense by program:                                 |       |                                       |         |                                      |       |   |   |   |   |
| ATI-7505                                                                             |       | $                                          | 109          |                                      | 1,103      |   | $ | 136 |   | $ | 7,208 |   |
| ATI-5923                                                                             |       | 2,179                                      |         | 329                                       |       | 3,674 |   | 2,831 |   |
| ATI-2042                                                                             |       | 451                                        |         | 989                                       |       | 2,550 |   | 1,625 |   |
| ATI-9242                                                                             |       | 670                                        |         | 136                                       |       | 1,621 |   | 415 |   |
| Other research programs                                                              |       | 156                                        |         | 111                                       |       | 403 |   | 246 |   |
| Total direct research and  development program expense                               |       | 3,565                                      |         | 2,668                                     |       | 8,384 |   | 12,325 |   |
| Personnel, administrative  and other expense                                         |       | 3,072                                      |         | 2,704                                     |       | 9,399 |   | 7,896 |   |
| Less:  Research and development portion of the cost of collaboration service revenue |       | (51                                        | )            | (79                                       | )          | (181 | ) | (79 | ) |
| Total research and development expense                                               |       | $                                          | 6,586        |                                      | $          | 5,293 |   | $ | 17,602 |   | $ | 20,142 |   |
|                                                                                      |            |                                            |              |                                           |            |  |  |  |  |  |  |  |  |

 

We designatedevelopment programs to which we have allocated significant research anddevelopment resources with the term “ATI” and a unique number. All of theproduct candidates designated with “ATI” are currently in development. Theexpenditures summarized in the above table reflect costs directly attributableto each development candidate and to our other research programs. We do notallocate salaries, employee benefits, or other indirect costs to ourdevelopment candidates or other research programs and have included thoseexpenses in “Personnel, administrative and other costs” in the above table. Theportion of our research and development expense that is identified as cost ofcollaboration service revenue is included within a separate category of expensein our 

 

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consolidated financialstatements and is subtracted from total expenses in the above table to derivetotal research and development expense as reported in our consolidatedfinancial statements.

 

At this time, dueto the risks inherent in the clinical trial process and given the variousstages of development of our product candidates, we are unable to estimate withany certainty the costs we will incur in the continued development of ourproduct candidates, except for ATI-7505 for which costs will be negligible dueto the provisions of our collaboration agreement with P&G. Clinicaldevelopment timelines, the probability of success and development costs can differmaterially from expectations. While we are currently focused on advancing eachof our product development programs, our future research and developmentexpense will depend on the clinical success of each product candidate, as wellas ongoing assessments as to each product candidate’s commercial potential. Inaddition, we cannot forecast with any degree of certainty which productcandidates will be subject to future collaborations, when such arrangementswill be secured, if at all, and to what degree such arrangements would affectour development plans and capital requirements.

 

The process ofdeveloping and obtaining FDA approval of products is costly and time consuming.Development activities and clinical trials can take years to complete, andfailure can occur at any time during the development and clinical trialprocess. In addition, the results from early clinical trials may not bepredictive of results obtained in subsequent and larger clinical trials, andproduct candidates in later stages of clinical trials may fail to show thedesired safety and efficacy despite having progressed successfully throughinitial clinical testing. Although our program for identifying and developingnew product candidates is designed to mitigate risk, the successful developmentof our product candidates is highly uncertain. Further, even if our productcandidates are approved for sale, they may not be successfully commercializedand therefore the future revenue we anticipate may not materialize.

 

If we fail tocomplete the development of any of our product candidates in a timely manner,it could have a material effect on our operations, financial position andliquidity. In addition, any failure by us or our partners to obtain, or anydelay in obtaining, regulatory approvals for our product candidates could havea material effect on our results of operations. A further discussion of therisks and uncertainties associated with completing our programs on schedule, orat all, and certain consequences of failing to do so are discussed further inthe “Risk Factors” section of this report.

 

**CriticalAccounting Policies and Significant Estimates**

 

Our critical accountingpolicies are more fully described in Note 1 of the audited financial statementsfor the year ended December 31, 2006 which are included in ourRegistration Statement on Form S-1/A (File No. 333-147385), initiallyfiled with the Securities and Exchange Commission on August 30, 2007, asamended, relating to our initial public offering. There have been no materialchanges in our critical accounting policies during the nine months ended September 30,2007.

 

The discussion of ourfinancial condition and results of operations is based upon our financialstatements, which have been prepared in accordance with U.S. generally acceptedaccounting principles. The preparation of these financial statements requiresus to make estimates, judgments and assumptions that affect the reported amountof assets, liabilities, revenues and expenses. On an ongoing basis, we evaluateour estimates. These estimates, assumptions and judgments about future eventsand their effects on our results cannot be determined with certainty, and aremade based upon our historical experience and on other assumptions that arebelieved to be reasonable under the circumstances. Different estimates that wecould have used, or changes in the estimates that are reasonably likely tooccur, may have a material impact on our financial condition or results ofoperations. Management has discussed the development, selection and disclosureof these estimates with the audit committee of our board of directors. Ouractual results may differ from these estimates under different assumptions orconditions.

 

**Resultsof Operations**

 

***Comparison of Three and Nine Months Ended September 30,2007 and 2006***

 

***Revenue***

 
| ** **                      | ** **   | **Three Months Ended**         | ** ** | ** ** | ** ** | **Nine Months Ended**  | ** ** | ** ** | ** ** |
|---------------------------------|--------------|--------------------------------|------------|------------|------------|------------------------|------------|------------|------------|
| ** **                      | ** **   | **September 30,**         | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change** | ** ** |
| ** **                      | ** **   | **2007**                       | ** ** | **2006**   | ** ** | **$**                  | ** ** | **%**      | ** ** | **2007** | ** ** | **2006** | ** ** | **$** | ** ** | **%** | ** ** |
| *** ***                    | *** *** | ***(In thousands, except %)*** | ** ** |
| Collaboration services          |         | $                              | 66         |       | $          | 79                     |       | $          | (13        | ) | (16 | )%  | $ | 252 |   | $ | 79 |   | $ | 173 |   | 219 |  % |
| Technology license fees         |         | 974                            |       | 649        |       | 325                    |       | 50         |       | 2,922 |   | 649 |   | 2,273 |   | 350 |   |
| Contractual milestone  payments |         | —                         |       | 1,000      |       | (1,000                 | )          | (100       | )          | — |   | 1,000 |   | (1,000 | ) | (100 | ) |
| Total revenue                   |         | $                              | 1,040      |       | $          | 1,728                  |       | $          | (688       | ) | (40 | )%  | $ | 3,174 |   | $ | 1,728 |   | $ | 1,446 |   | 84 |  % |

 

15

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All revenue in theperiods presented is related to our collaboration agreement with P&G. Thedecline in revenue in the three months ended September 30, 2007 ascompared to the same period in 2006 was primarily due to the receipt of amilestone payment related to the completion of a Phase 2 clinical trial in thethree months ended September 30, 2006, partially offset by an increase intechnology license fee revenue due to the recognition of additional deferredrevenue in the current period.

 

The increase inrevenue for the nine months ended September 30, 2007 as compared to thesame period in 2006 was primarily due to the recognition of additional deferredlicense fee revenue in the current period partially offset by the milestonerevenue recognized in 2006. The increase in collaboration service revenue forthe nine months ended September 30, 2007 as compared to the same period in2006 was due to additional development services provided by us to P&G.

 

***Cost of Collaboration ServiceRevenue***

 
| ** **                             | ** **   | **Three Months Ended**         | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------|--------------|--------------------------------|------------|------------|------------|------------------------|------------|-----------------------|------------|------------|------------|------------|------------|
| ** **                             | ** **   | **September 30,**         | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**            | ** ** |
| ** **                             | ** **   | **2007**                       | ** ** | **2006**   | ** ** | **$**                  | ** ** | **%**                 | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$** | ** ** | **%** | ** ** |
| *** ***                           | *** *** | ***(In thousands, except %)*** | ** ** |
| Cost of collaboration  service revenue |         | $                              | 66         |       | $          | 79                     |       | $                     | (13        | )          | (16        | )%         | $          | 252 |   | $ | 79 |   | $ | 173 |   | 219 | % |
|                                        |              |                                |            |            |            |                        |            |                       |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

Cost ofcollaboration service revenue primarily consists of the pass-through of actualcosts billed to ARYx by third party vendors. The decrease or increase in costof service revenue in the three and nine months ended September 30, 2007as compared to the same period in 2006 was due to the level of pass-throughcosts incurred related to the specific development services provided by us toP&G.

 

***Research and Development Expense***

 
| ** **                        | ** **   | **Three Months Ended**         | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------|--------------|--------------------------------|------------|------------|------------|------------------------|------------|-----------------------|------------|------------|------------|------------|------------|
| ** **                        | ** **   | **September 30,**         | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**            | ** ** |
| ** **                        | ** **   | **2007**                       | ** ** | **2006**   | ** ** | **$**                  | ** ** | **%**                 | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$** | ** ** | **%** | ** ** |
| *** ***                      | *** *** | ***(In thousands, except %)*** | ** ** |
| Research and development  expense |         | $                              | 6,586      |       | $          | 5,293                  |       | $                     | 1,293      |       | 24         | %          | $          | 17,602 |   | $ | 20,142 |   | $ | (2,540 | ) | (13 | )% |
|                                   |              |                                |            |            |            |                        |            |                       |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

                For the three months ended September 30, 2007 ascompared to the same period in 2006, our research and development expenseincreased by approximately $1.3 million. The increase was primarily due to:

 

·                  An increase in clinical developmentexpense of approximately $0.5 million primarily due to an increase in clinicaltrial costs related to our ATI-5923 program partially offset by lower clinicaldevelopment costs related to our ATI-2042 and ATI-7505 programs;

 

·                  An increase in research and non-clinicaldevelopment expense of approximately $1.0 million primarily due to highernon-clinical development costs related to our ATI-9242 and ATI-5923 programs;and

 

·                  A partial offset due to lowerpharmaceutical manufacturing costs of approximately $0.3 million primarily dueto the transitioning of our ATI-7505 program to P&G.

 

For the ninemonths ended September 30, 2007 as compared to the same period in 2006,our research and development expense decreased by approximately $2.5 million.The decrease was primarily due to:

 

·                  A decrease in clinical developmentexpense of approximately $3.3 million primarily due to the completion in 2006of ARYx funded clinical trial activities related to our ATI-7505 productcandidate partially offset by higher clinical development costs related to ourATI-5923 and ATI-2042 programs;

 

·                  A decrease in pharmaceutical manufacturingcosts of approximately $0.6 million primarily due to lower costs on account ofour transitioning of the ATI-7505 program to P&G and lower overallpharmaceutical development costs related to our other development programs;

 

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·                  A partial offset due to an increase inresearch and non-clinical development expense of approximately $0.8 millionprimarily due to higher non-clinical development costs related to our ATI-9242program and research costs related to multiple research programs; and

 

·                  A partial offset due to an increase inresearch and development administrative and other expense of approximately $0.6million primarily due to headcount additions and higher personnel relatedexpenses.

 

*Selling, General and AdministrativeExpense*

 
| ** **                           | ** **   | **Three Months Ended**         | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------|--------------|--------------------------------|------------|------------|------------|------------------------|------------|-----------------------|------------|------------|------------|------------|------------|
| ** **                           | ** **   | **September 30,**         | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**            | ** ** |
| ** **                           | ** **   | **2007**                       | ** ** | **2006**   | ** ** | **$**                  | ** ** | **%**                 | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$** | ** ** | **%** | ** ** |
| *** ***                         | *** *** | ***(In thousands, except %)*** | ** ** |
| Selling, general and  administrative |         | $                              | 1,902      |       | $          | 1,640                  |       | $                     | 262        |       | 16         | %          | $          | 5,526 |   | $ | 5,152 |   | $ | 374 |   | 7 | % |
|                                      |              |                                |            |            |            |                        |            |                       |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

The higherselling, general and administrative expense for the three and nine months endedSeptember 30, 2007 as compared to the same periods in 2006 was primarilydue to higher personnel related costs in support of our expanded research anddevelopment operations.

 

*Interest Income, Net of OtherExpenses*

 
| ** **                              | ** **   | **Three Months Ended**         | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------|--------------|--------------------------------|------------|------------|------------|------------------------|------------|-----------------------|------------|------------|------------|------------|------------|
| ** **                              | ** **   | **September 30,**         | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**            | ** ** |
| ** **                              | ** **   | **2007**                       | ** ** | **2006**   | ** ** | **$**                  | ** ** | **%**                 | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$** | ** ** | **%** | ** ** |
| *** ***                            | *** *** | ***(In thousands, except %)*** | ** ** |
| Interest  income, net of other expenses |         | $                              | 505        |       | $          | 666                    |       | $                     | (161       | )          | (24        | )%         | $          | 1,684 |   | $ | 1,652 |   | $ | 32 |   | 2 | % |
|                                         |              |                                |            |            |            |                        |            |                       |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

                Interestincome, net of other expenses, consists of interest income from our investmentsin marketable securities, other expenses, and benefits related to thereassessment of the fair value of our preferred stock warrant liability. Lowerinterest income for the three months ended September 30, 2007 as comparedto the same period in 2006 was a result of lower cash and marketable securities on hand partiallyoffset by the benefit of reassessment of the estimated fair value of ourpreferred stock warrant liability. For the nine months ended September 30,2007, as compared to the same period in 2006, interest income increasedprimarily due to the benefit of reassessment of the estimated fair value of ourpreferred stock warrant liability, partially offset by lower cash andmarketable securities on hand.

 

*Interest Expense*

 
| ** **       | ** ** | **Three Months Ended**         | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------|------------|--------------------------------|------------|------------|------------|------------------------|------------|-----------------------|------------|------------|------------|------------|------------|
| ** **       | ** ** | **September 30,**         | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**            | ** ** |
| ** **       | ** ** | **2007**                       | ** ** | **2006**   | ** ** | **$**                  | ** ** | **%**                 | ** ** | **2007**   | ** ** | **2006**   | ** ** | **$** | ** ** | **%** | ** ** |
|             |       | ***(In thousands, except %)*** | ** ** |
| Interest expense |       | $                              | 292        |       | $          | 338                    |       | $                     | (46        | )          | (14        | )%         | $          | 935 |   | $ | 974 |   | $ | (39 | ) | (4 | )% |
|                  |            |                                |            |            |            |                        |            |                       |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

                Thedecrease in interest expense in the three and nine months ended September 30,2007 as compared to the same periods in 2006 was primarily due to lower loanprincipal balances outstanding.

 

**Liquidityand Capital Resources**

 
| ** **                   | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **2007**                                  | ** ** | **2006** | ** ** |
| ** **                   | ** ** | ***(In thousands)***                      | ** ** |
| Cash (used in) provided  by: |       |                                      |       |   |   |
| Operating activities         |       | (19,608                                   | )          | (188 | ) |
| Investing activities         |       | 20,395                                    |       | (18,435 | ) |
| Financing activities         |       | (2,741                                    | )          | 29,198 |   |
| Total cash (used) provided   |       | (1,954                                    | )          | 10,575 |   |

 

 

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In November 2007,we completed our initial public offering of equity securities and receivedaggregate net proceeds of approximately $44.0 million. Prior to our initialpublic offering, we financed our operations primarily through privateplacements of equity securities, receiving aggregate net proceeds from suchsales totaling $110.7 million. In August 2006, we received a$25.0 million nonrefundable upfront license fee in connection with ourcollaboration agreement with P&G. As of September 30, 2007, we had$27.4 million in cash, cash equivalents and marketable securities and a$50,000 receivable from P&G. Since inception, we have incurred significantnet operating losses and, as of September 30, 2007, we had an accumulateddeficit of $114.6 million. We have not achieved profitability and anticipatethat we will continue to incur significant net losses for the next severalyears. We believe that our current capital resources will be sufficient to fundour planned operations for at least the next twelve months.

 

Net cash used inoperating activities for the nine months ended September 30, 2007 was$19.6 million as compared to $0.2 million for the same period in 2006. Netcash used in each of these periods was primarily due to the funding of ouroperating costs and expenses in connection with the conduct of our research,development and administrative activities, partially offset by the receipt of a$25.0 million nonrefundable upfront license fee payment and other revenuefrom P&G in 2006.

 

Net cash providedby investing activities was $20.4 million for the nine months ended September 30,2007 and net cash used in investing activities was $18.4 million for thenine months ended September 30, 2006. Investing activities consistprimarily of purchases and sales of marketable securities and property andequipment purchases. Purchases of property and equipment were $0.4 million and$0.6 million for the nine months ended September 30, 2007 and 2006,respectively.

 

Net cash used infinancing activities was $2.8 million during the nine months ended September 30,2007 and was primarily related to principal payments made to lenders forlong-term debt financing and costs incurred related to our initial publicoffering. Net cash provided by financing activities was $29.2 million duringthe nine months ended September 30, 2006 and consisted primarily of thenet proceeds from our Series E convertible preferred stock financingcompleted in January 2006, offset by principal payments on our long-termdebt.

 

On March 28,2005, we entered into a loan agreement with Lighthouse that was amended on October 19,2007. The original agreement provided for up to $10.0 million in debtfinancing. The amended agreement in October 2007 provides for up to$9.0 million in additional financing. The original loan agreement providedfor a 42 month repayment term which began on April 1, 2006. To date,the total principal amount borrowed under the agreement is $10.0 millionand as of September 30, 2007, the total unpaid principal balanceoutstanding was $6.1 million. The current outstanding promissory noteprovides for monthly cash payments of principal and interest at a statedinterest rate of 9.75% per annum through September 2009 and a ballooninterest payment of $1.2 million in September 2009. The agreement alsoallows for prepayment of principal with respect to the promissory notecurrently outstanding whereupon the $1.2 million terminal interest paymentis accelerated and due at the time of prepayment of the loan balance. We areunder no obligation to utilize any of the $9.0 million of additionalfunding available to us under the amended agreement. The amended agreementprovides that amounts borrowed, if any, under a new promissory note will besubject to an interest-only period expiring in September 2008 followed by36 equal monthly payments of principal and interest at a fixed rate of theprime rate plus 2.0%, to be fixed as of September 2008. In addition, wewill be obligated to make a final interest payment of 7.5% of the amountborrowed at loan maturity. The agreement contains no financial covenants.Default terms under the agreement are standard terms including borrower defaultupon nonpayment of amounts due, noncompliance with loan covenants,misrepresentations under the agreement, bankruptcy and other standardprovisions. Under the terms of the original and amended agreement, Lighthousehas a first priority security interest in all of our tangible and intangibleassets except for the following: (i) assets specifically identified andused as security for GE equipment loans, (ii) any first priority interestComerica Bank may have in our operating bank accounts at Comerica Bank, (iii) anycertificates of deposit that are used as security for letters of credit issuedto third parties, (iv) any interest or claims our landlord may have incertain leasehold improvements and (v) our intellectual property assets.The agreement precludes us from incurring additional material debt amounts withthe exception of up to an aggregate of $3.0 million in equipment financingand up to $500,000 in other indebtedness.

 

As of September 30,2007, the total unpaid principal balance outstanding under the existing GEequipment loans was $1.1 million. Our debt financing with GE provides fora 42 month repayment term from each date of funding, a stated interest ratethat is based on an average of the Federal Reserve’s three-year and five-yearTreasury Constant Maturities rate plus a spread of 766 basis points andstandard default provisions. We currently have three promissory notesoutstanding under the agreement with stated interest rates ranging from 11.73%to 12.89%. Under the agreement, events of default include non-payment ofamounts owed, a non-permitted sale or transfer of collateral,misrepresentations under the agreement, bankruptcy and other standardprovisions. Funds borrowed under the agreement are secured by specificequipment assets and GE has a first priority security interest in those assets.The 

 

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agreement contains nofinancial covenants and no warrants to purchase shares of our capital stockwere issued to GE in connection with the debt financing. The arrangementprovides for monthly payments of principal and interest through July 2010.

 

Our future fundingrequirements will depend upon many factors, including:

 

·                  the scope, rate of progress, results andcost of our preclinical testing, clinical trials and other research anddevelopment activities;

 

·                  the terms and timing of anycollaborative, licensing and other arrangements that we may establish;

 

·                  the cost, timing and outcomes ofregulatory approvals;

 

·                  the number and characteristics of productcandidates that we pursue;

 

·                  the cost and timing of establishingsales, marketing and distribution capabilities;

 

·                  the cost of establishing clinical andcommercial supplies of our product candidates and any products that we maydevelop;

 

·                  the timing, receipt and amount of salesor royalties generated, if any, from our product candidates; and

 

·                  the cost of preparing, filing,prosecuting, defending and enforcing any patent claims and other intellectualproperty rights.

 

We will need toraise additional funds to support our operations, and such funding may not beavailable to us on acceptable terms, or at all. If we are unable to raiseadditional funds when needed, we may not be able to continue development of ourproduct candidates or we could be required to delay, scale back or eliminatesome or all of our research and development programs. We may seek to raise anynecessary additional funds through public or private equity, debt financings,collaborative arrangements with corporate partners or other sources. If weraise additional funds through the issuance of debt securities, thesesecurities could have rights that are senior to the holders of our common stockand could contain covenants that restrict our operations. If we raiseadditional funds by issuing equity securities, dilution to our existingstockholders may result. In addition, if we raise additional funds through thesale of equity securities, new investors could have rights superior to ourexisting stockholders. To the extent that we raise additional capital throughlicensing arrangements or arrangements with collaborative partners, we may berequired to relinquish, on terms that are not favorable to us, rights to someof our technologies or product candidates that we would otherwise seek todevelop or commercialize ourselves for higher profit margin. The terms offuture financings may restrict our ability to raise additional capital, whichcould delay or prevent the further development of our product candidates orcommercialization of our products. Our failure to raise capital when needed mayharm our business and operating results.

 

**ContractualObligations**

 

There were no material changes in our contractual obligations from thosedisclosed in our Form S-1 filed with the SEC on August 30, 2007, asamended, in connection with our initial public offering, other than scheduledpayments made through September 30, 2007. Please see *“Management’sDiscussion and Analysis of Financial Condition and Results of Operations —Liquidity and Capital Resources”* in our Registration Statement on Form S-1for a description of our contractual obligations.

 

**RecentAccounting Pronouncements**

 

See Note 1 of theNotes to our Condensed Consolidated Financial Statements included elsewhere inthis report for recent accounting pronouncements that could have an effect onus.

 

**Off-BalanceSheet Arrangements**

 

Since inception,except for standard operating leases, we have not engaged in any off-balancesheet arrangements, including the use of structured finance, special purposeentities or variable interest entities.

 

**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

***Interest Rate Risk***

 

                Our exposure to interest rate risk is related to ourcash, cash equivalents and marketable securities portfolio. As of September 30,2007, we had cash, cash equivalents and marketable securities of$27.4 million individually having maturities or interest rate resetperiods of less than one year. Some of our investments may be subject tointerest rate risk and could decline in value if market interest ratesincrease. Since our inception, unrealized and realized losses in our marketablesecurities portfolio arising from interest rate 

 

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fluctuations have notbeen material. We actively monitor changes in the interest rate environment toassess its potential impact on our investment portfolio. A portion of ourmarketable securities are invested in auction rate securities having long-termcontractual maturities with short-term interest rate reset periods giving themcharacteristics of short-term maturity instruments. We are at risk ofilliquidity in those instruments if in the event that an interest rate resetperiod should experience a short-fall in demand for those instruments.

 

                The primary objective of our marketable securitiesinvestment activity is to preserve our capital to fund operations. We also seekto maximize income from such investments without assuming significant risk.

 

***Foreign Currency Risk***

 

                In conducting our business, we occasionally enterinto contractual arrangements with third-party research and development serviceproviders having operations in locations outside of the United States. To theextent that payments for those services are contractually required to be madein currencies other than the U.S. dollar, we may be subject to exposure tofluctuations in foreign exchange rates. To date, the effect of our exposure tothese fluctuations in foreign exchange rates has not been material, and we donot expect it to become material in the foreseeable future. We do not hedge ourforeign currency exposures and have not used derivative financial instrumentsfor speculation or trading purposes.

 

**ITEM 4.CONTROLS AND PROCEDURES**

 

***Evaluation of DisclosureControls and Procedures***

 

As of September 30,2007, an evaluation was performed by management, with the participation of ourChief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), of theeffectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15-d and 15(e) under the Securities Exchange Act of 1934, as amended).Disclosure controls and procedures are controls and procedures that aredesigned to ensure that information required to be disclosed in our reportsfiled or submitted under the Securities Exchange Act of 1934, as amended, isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms. Based on thatevaluation, our CEO and CFO have concluded that, subject to the limitationsdescribed below, our disclosure controls and procedures were effective as of September 30,2007.

 

***Limitations on the Effectivenessof Controls***

 

Ourmanagement, including our CEO and CFO, does not expect that our disclosurecontrols and procedures or our internal controls will prevent all error and allfraud. A control system, no matter how well conceived and operated, can provideonly reasonable, not absolute, assurance that the objectives of the controlsystem are met. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within the company have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and that breakdowns can occur because of simple error ormistake. Additionally, controls can be circumvented by the individual acts ofsome persons, by collusion of two or more people, or by management override ofthe control. The design of any system of controls also is based in part uponcertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. Over time, control may become inadequate becauseof changes in conditions, or the degree of compliance with the policies orprocedures may deteriorate. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected.

 

***Changes in Internal Control overFinancial Reporting***

 

There were nochanges in our internal control over financial reporting that occurred duringour fiscal quarter ended September 30, 2007 that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting.

 

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**PART II — OTHER INFORMATION**

 

**ITEM 1.LEGAL PROCEEDINGS**

 

From time to timewe are involved in legal proceedings arising in the ordinary course of ourbusiness. We believe there is no litigation pending that could have,individually or in the aggregate, a material adverse effect on our results ofoperations or financial condition.

 

**ITEM 1A.RISK FACTORS**

 

*Wehave identified the following risks and uncertainties that may have a materialadverse effect on our business, financial condition or results of operations.The risks described below are not the only ones we face. Additional risks notpresently known to us or that we currently believe are immaterial may alsosignificantly impair our business operations. Our business could be harmed byany of these risks. We have marked with an asterisk (*) those risksdescribed below that reflect substantive changes from the risks described inour Registration Statement on Form S-1(File No. 333-145813),initially filed with the Securities and Exchange Commission on August 30,2007, as amended. In addition, the risks described under, and the captionsentitled, “If you purchase our common stock in this offering, you will incurimmediate and substantial dilution in the book value of your shares” and “Wehave broad discretion in the use of the net proceeds from this offering and maynot use them effectively” included in our above-referenced RegistrationStatement on Form S-1 have been removed. In assessing these risks, youshould also refer to the other information contained in this quarterly reporton Form 10-Q, including our financial statements and related notes.*

 

**Risks Related to Our Business andIndustry**

 

***We have incurred significant operatinglosses since inception and expect to continue to incur substantial andincreasing losses for the foreseeable future. We may never achieve or sustainprofitability.***

 

We have a limitedoperating history and have incurred significant losses since our inception. Asof September 30, 2007, we had an accumulated deficit of approximately$114.6 million. We expect our research and development expenses to continue toincrease as we continue to expand our development programs, and, subject toregulatory approval for any of our product candidates, we expect to incursignificant expenses associated with the potential establishment of a NorthAmerican specialty sales force and increased manufacturing expenses. Althoughit is not expected to occur in the next several years, we estimate our cost ofestablishing a 100-person specialty sales force to co-promote ATI-7505 toamount to approximately $20.0 million. Manufacturing expenses in 2008 and2009 could be as much as $6.0 million and $8.0 million, respectively,compared to an estimated total cost of manufacturing of $3.0 million in 2007.As a result, we expect to continue to incur substantial and increasing lossesfor the foreseeable future. These losses have had and will continue to have anadverse effect on our stockholders’ equity (deficit) and working capital.

 

Because of thenumerous risks and uncertainties associated with drug development, we areunable to predict the timing or amount of increased expenses or when or if wewill be able to achieve or sustain profitability. Currently, we have noproducts approved for commercial sale, and, to date, we have not generated anyproduct revenue. We have financed our operations primarily through the sale ofequity securities, capital lease and equipment financings, debt financings anda single corporate partnership with Procter & Gamble Pharmaceuticals, Inc.,or P&G. We have devoted substantially all of our efforts to research anddevelopment, including clinical trials. If we are unable to develop andcommercialize any of our product candidates, if development is delayed or ifsales revenue from any product candidate that receives marketing approval isinsufficient, we may never become profitable. Even if we do become profitable,we may not be able to sustain or increase our profitability on a quarterly orannual basis.

 

***Our success depends substantially on our mostadvanced product candidates, which are still under development. If we areunable to bring any or all of these product candidates to market, or experiencesignificant delays in doing so, our ability to generate product revenue and ourlikelihood of success will be harmed.***

 

Our three mostadvanced product candidates are in Phase 2 clinical trials. Our ability togenerate product revenue in the future will depend heavily on the successfuldevelopment and commercialization of these product candidates. Our otherproduct candidates are in the discovery stage. Any of our product candidatescould be unsuccessful for a variety of reasons, including that they:

 

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·                  do not demonstrate acceptable safety and efficacy inpreclinical studies or clinical trials or otherwise do not meet applicableregulatory standards for approval;

 

·                  do not offer therapeutic, safety or other improvementsover existing or future drugs used to treat the same conditions;

 

·                  are not capable of being produced in commercialquantities at acceptable costs; or

 

·                  are not accepted in the medical community and bythird-party payors.

 

We do not expectany of our current product candidates to be commercially available before 2012,if at all. If we are unable to make our product candidates commerciallyavailable, we will not generate product revenues and we will not be successful.The results of our clinical trials to date do not provide assurance thatacceptable efficacy or safety will be shown upon completion of Phase 3clinical trials.

 

***We expect to depend on collaborativearrangements to complete the development and commercialization of each of ourproduct candidates. The existing and potential collaborative arrangements willlikely place the development of our product candidates outside of our controland will likely require us to relinquish important rights or may otherwise beon terms unfavorable to us.***

 

We plan to enterinto collaborative arrangements with third parties to develop and commercializeeach of our lead product candidates. Dependence on collaborative arrangementsfor development and commercialization of our product candidates will subject usto a number of risks, including:

 

·                  we may not complete a collaborative arrangement intime to avoid delays in clinical development, if at all, and if nocollaborative arrangement is achieved, product development may be haltedaltogether;

 

·                  we may not be able to control the amount and timing ofresources that our collaborators may devote to the development orcommercialization of product candidates or to their marketing and distribution;

 

·                  collaborators may delay clinical trials, provideinsufficient funding for a clinical trial program, stop a clinical trial orabandon a product candidate, repeat or conduct new clinical trials or require anew formulation of a product candidate for clinical testing;

 

·                  we may have limited control over our clinical trialdesign;

 

·                  disputes may arise between us and our collaboratorsthat result in the delay or termination of the research, development orcommercialization of our product candidates or that result in costly litigationor arbitration that diverts management’s attention and resources;

 

·                  our collaborators may experience financialdifficulties;

 

·                  collaborators may not properly maintain or defend ourintellectual property rights or may use our proprietary information in such away as to invite litigation that could jeopardize or invalidate our proprietaryinformation or expose us to potential litigation;

 

·                  business combinations or significant changes in acollaborator’s business strategy may adversely affect a collaborator’swillingness or ability to fulfill its obligations under any arrangement;

 

·                  a collaborator could independently move forward with acompeting product candidate developed either independently or in collaborationwith others, including our competitors; and

 

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·                  any collaborative arrangement may be terminated orallowed to expire, which would delay the development and may increase the costof developing our product candidates.

 

We haveestablished the first such collaboration arrangement with P&G relating toATI-7505. The terms of this arrangement give P&G ultimate control over thedevelopment and commercialization of ATI-7505 and subject us to many of therisks described above. If there is a disagreement between the parties, P&Ghas the right to make the final decision. Therefore, we are dependent onP&G to undertake the clinical and regulatory requirements as well as togenerate product sales of ATI-7505 that are required in order for us to receivemilestone and royalty revenue under the agreement. This revenue may notmaterialize due to the occurrence of one or more of the conditions describedabove and, as a result, our results of operations will be adversely affected.

 

***To date, we have established a singlecorporate partnership with P&G to develop and commercialize ATI-7505.Collaborative arrangements do not currently exist for our other productcandidates. If we do not establish collaborations for each of our ATI-5923 andATI-2042 product candidates or future product candidates, we may have to alterour development and commercialization plans.***

 

Our strategyincludes selectively collaborating with leading pharmaceutical andbiotechnology companies to assist us in furthering the development andpotential commercialization of some of our product candidates, includingATI-7505 (in place with P&G), ATI-5923 and ATI-2042. We intend to seek partnersbecause the commercialization of each of our three lead product candidatesinvolves a large, primary care market that must be served by large sales andmarketing organizations and because we do not currently have Phase 3clinical trial capabilities. We face significant competition in seekingappropriate collaborators, and these collaborations are complex andtime-consuming to negotiate and document. We may not be able to negotiatecollaborations on acceptable terms, if at all. We are unable to predict when,if ever, we will enter into any collaborations because of the numerous risksand uncertainties associated with establishing collaborations. If we are unableto negotiate an acceptable collaboration, we may have to curtail thedevelopment of a particular product candidate, reduce or delay its developmentprogram or one or more of our other development programs, delay its potentialcommercialization or reduce the scope of our sales or marketing activities orincrease our expenditures and undertake development or commercializationactivities at our own expense. If we elect to increase our expenditures to funddevelopment or commercialization activities on our own, we may need to obtainadditional capital, which may not be available to us on acceptable terms, if atall. If we do not have sufficient funds, we will not be able to bring ourproduct candidates to market and generate product revenues.

 

***The commercial success of our collaborationwith P&G depends in part on the development and marketing efforts of P&G,over which we have limited control. If our collaboration with P&G isunsuccessful, our ability to develop and commercialize and to generate futurerevenue from the sale of ATI-7505 would be significantly reduced.***

 

Our dependence onour collaboration arrangement with P&G subjects our company to a number ofrisks. Our ability to develop and commercialize ATI-7505 with our collaborationpartner depends on our and P&G’s ability to establish the safety andefficacy of ATI-7505, obtain and maintain regulatory approvals and achievemarket acceptance of ATI-7505 once commercialized. Our collaboration partnermay elect to delay or terminate development of ATI-7505, independently developproducts that compete with ATI-7505, or fail to commit sufficient resources tothe marketing and distribution of ATI-7505. Competing products, eitherdeveloped by P&G or to which they have rights or acquire such rights in thefuture, may result in their withdrawal of support for ATI-7505.

 

In the event thatP&G fails to use commercially reasonable efforts to diligently develop orcommercialize ATI-7505 under our collaboration agreement, we have the right toterminate their rights to ATI-7505, but we will not receive any future revenuefrom that product candidate unless we are able either to find another partneror to commercialize the product candidate on our own, which is likely to resultin significant additional expense. Business combinations, significant changesin business strategy, litigation and/or financial difficulties may alsoadversely affect the willingness or ability of P&G to fulfill theirobligations under our collaboration agreement. If P&G fails to perform inthe manner we expect, our potential to develop and commercialize ATI-7505through other collaborations and to generate future revenue from the sale ofATI-7505 would be significantly reduced. If a conflict of interest arisesbetween us and P&G, they may act in their own self-interest and not in theinterest of our company or our stockholders. P&G may terminate ourcollaboration agreement at any time pursuant to its terms. If P&G breachesor terminates their collaboration agreement with us or otherwise fails toperform their obligations thereunder in a timely manner, the clinicaldevelopment or commercialization of ATI-7505 could be delayed or terminated.

 

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***If we are not able to obtain requiredregulatory approvals, we will not be able to commercialize our productcandidates, our ability to generate revenue will be materially impaired and ourbusiness will not be successful.***

 

Our productcandidates and the activities associated with their development andcommercialization are subject to comprehensive regulation by the Food and DrugAdministration, or FDA, and other federal and state regulatory agencies in theUnited States and by comparable authorities in other countries. The inabilityto obtain FDA approval or approval from comparable authorities in othercountries would prevent us and our collaborative partners from commercializingour product candidates in the United States or other countries. Under ourcollaborative partnership with P&G, they are responsible for all regulatoryinteractions regarding ATI-7505 and future collaborative agreements will alsolikely force us to give up control of these interactions. We or our partnersmay never receive regulatory approval for the commercial sale of any of ourproduct candidates. We have only limited experience in preparing and filing theapplications necessary to gain regulatory approvals and have not receivedregulatory approval to market any of our product candidates in anyjurisdiction. The process of applying for regulatory approval is expensive,often takes many years and can vary substantially based upon the type, complexityand novelty of the product candidates involved.

 

Because ourproduct candidates are modeled after drugs which are known to have safetyproblems, the FDA and other regulatory agencies may require additional safetytesting which may delay our clinical progress, increase our expected costs ormake further development unfeasible. For instance, we were required to conductsignificant monitoring for cardiac toxicity in our clinical studies ofATI-7505.

 

Changes inregulatory approval policies during the development period, changes in, or theenactment of, additional regulations or statutes or changes in the regulatoryreview team for each submitted product application may cause delays in theapproval or rejection of an application. Even if the FDA or a foreignregulatory agency approves a product candidate, the approval may imposesignificant restrictions on the indicated uses, conditions for use, labeling,advertising, promotion, marketing and/or production of such product and mayimpose requirements for post-approval studies, including additional researchand development and clinical trials. The FDA and other agencies also may imposevarious civil or criminal sanctions for failure to comply with regulatoryrequirements, including substantial monetary penalties and withdrawal ofproduct approval.

 

The FDA hassubstantial discretion in the approval process and may refuse to accept anyapplication or decide that our data are insufficient for approval and requireadditional preclinical, clinical or other studies. For example, varyinginterpretations of the data obtained from preclinical and clinical testingcould delay, limit or prevent regulatory approval of a product candidate.Moreover, the FDA may not agree that certain target indications are approvable.For instance, the FDA has never approved a drug for postprandial distresssyndrome, or PDS, and we cannot be certain that the FDA will recognize PDS asan indication for which ATI-7505 or other drugs can be approved.

 

We will need toobtain regulatory approval from authorities in foreign countries to market ourproduct candidates in those countries. We have not yet initiated the regulatoryprocess in any foreign jurisdictions. Approval by one regulatory authority doesnot ensure approval by regulatory authorities in other jurisdictions. If wefail to obtain approvals from foreign jurisdictions, the geographic market forour product candidates would be limited.

 

***Safety issues relating to our productcandidates or the original drugs upon which our product candidates have beenmodeled, or relating to approved products of third parties that are similar toour product candidates, could give rise to delays in the regulatory approvalprocess.***

 

Discovery ofpreviously unknown problems with an approved product may result in restrictionson its permissible uses, including withdrawal of the medicine from the market.Each of the opportunities upon which we have chosen to focus is based upon ourbelief that our RetroMetabolic Drug Design technology can be used to create a newproduct based upon an existing product which is efficacious in treating aspecific condition, but which has a known safety problem. Each of our threelead product candidates is modeled on drugs which have significant safetyproblems. ATI-7505 is modeled on cisapride which was withdrawn from the marketowing to fatal cardiac problems. ATI-5923 is modeled on warfarin which is knownto have safety risks because of its potential for bleeding and for drug-druginteractions with numerous other drugs as listed on the package insert for theproduct. ATI-2042 is modeled on amiodarone which is used, but not approved, foratrial fibrillation in spite of known safety problems due to its accumulationin the body and interaction with other drugs. Both amiodarone and ATI-2042contain iodine which can accumulate in the thyroid and must be monitored forsafety purposes. As will be required with each of our product candidates,P&G will soon initiate the standard regulatory study designed to moredefinitively determine what effect, if any, ATI-7505 has on Qt interval, or ameasure of 

 

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the relaxation phase ofthe heart which occurs after each beat. In addition, ATI-2042 is partiallymetabolized by CYP450 and, at high dose levels has caused drug-druginteractions with warfarin which increased INR and could increase the risk ofhemorrhage complications. Although we have designed our drugs to largelyaddress each of the original drugs’ key safety problems, we will need tocontinue to demonstrate this through continued clinical testing. It is possiblethat the FDA may impose additional requirements on the development or approvalof our products because of its concern about the original drug’s safetyproblems. These potential additional barriers could delay, increase the costof, or prevent the commercialization of our product candidates.

 

Our productcandidates are engineered to be broken down by the body’s natural metabolicprocesses in a manner we believe to be safer than that of the original drug.There can be no assurance that the products we develop will actually bemetabolized as we expect. While we have designed the breakdown products to besafe, it is possible that there will be unexpected toxicity associated withthese breakdown products that could cause our products to be poorly toleratedby, or toxic to, humans. Additionally, while we believe we have addressed thekey safety problem of each of the original drugs, it is possible that ourchange to the chemical structure may result in new unforeseen safety issues.Any unexpected toxicity or suboptimal tolerance of our products would delay orprevent commercialization of these product candidates.

 

Additionally,problems with approved products marketed by third parties that utilize the sametherapeutic target as our product candidates could adversely affect thedevelopment of our product candidates. For example, the recent productwithdrawals of Vioxx by Merck & Co., Inc. and Bextra by Pfizerbecause of safety issues caused other drugs that have the same therapeutictarget, such as Celebrex from Pfizer, to receive additional scrutiny fromregulatory authorities. Another prokinetic, tegaserod marketed by NovartisPharmaceuticals Corporation as Zelnorm, was withdrawn from the market due tocertain cardiac effects which we believe were related to its off-targeteffects. It is possible we may be required by regulatory agencies to performtests, in addition to those we have planned, in order to demonstrate thatATI-7505 does not have the safety problems associated with Zelnorm. Any failureor delay in commencing or completing clinical trials or obtaining regulatoryapprovals for our product candidates would delay commercialization of ourproduct candidates and severely harm our business and financial condition.

 

***We will need substantial additional fundingand may be unable to raise capital when needed, which would force us to delay,reduce or eliminate our product development programs or commercializationefforts.****

 

Our operationshave consumed substantial amounts of cash since inception. We expect tocontinue to spend substantial amounts of cash to fund our operations, includingresearch and development expenses and costs associated with the conduct ofclinical trials for our product candidates. Net cash used in operatingactivities was $20.2 million, $22.4 million and $4.2 million in2004, 2005 and 2006, respectively. Our net cash used in operating activitiesfor 2006 accounts for the receipt of a $25.0 million nonrefundable upfrontlicense fee payment and other revenue from P&G, without which our net cashused would have been significantly higher in 2006. For the nine months ended September 30,2007, our average monthly cash used by all aspects of the business wasapproximately $2.5 million. We expect that our net cash used in operationswill increase significantly in each of the next several years in order tosupport our operations and complete the development and commercialization ofour product candidates. We will need to raise additional capital to fund ouroperations and complete the development of our product candidates. It is ourintention to enter into collaborations to commercialize our products, but weretained the commercial right to co-promote ATI-7505 to selected physicians througha specialty sales force. If ATI-7505 or any other product candidates receiveregulatory approval for commercial sale, we will need to raise additionalcapital to fund our portion of the commercialization efforts. Our futurefunding requirements will depend on many factors, including:

 

·                  the scope, rate of progress, results and cost of ourpreclinical testing, clinical trials and other research and developmentactivities;

 

·                  the terms and timing of any collaborative, licensingand other arrangements that we may establish;

 

·                  the cost, timing and outcomes of regulatory approvals;

 

·                  the number and characteristics of product candidatesthat we pursue;

 

·                  the cost and timing of establishing sales, marketingand distribution capabilities for our specialty sales force;

 

·                  the cost of establishing clinical and commercialsupplies of our product candidates and any products that we may develop;

 

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·                  the timing, receipt and amount of sales or royalties,if any, from our potential products;

 

·                  the cost of preparing, filing, prosecuting, defendingand enforcing any patent claims and other intellectual property rights; and

 

·                  the extent to which we acquire or invest inbusinesses, products or technologies, although we currently have no commitmentsor agreements relating to any of these types of transactions.

 

Until we cangenerate a sufficient amount of product revenue, if we ever do, we expect tofinance future cash needs through public or private equity offerings, debtfinancings or corporate collaboration and licensing arrangements, as well asthrough interest income earned on cash balances.

 

If we raiseadditional funds by issuing equity securities, our stockholders will experiencedilution. Any debt financing or additional equity that we raise may containterms that are not favorable to our stockholders or us. If we raise additionalfunds through collaboration and licensing arrangements with third parties, wemay be required to relinquish some rights to our technologies or our productcandidates or grant licenses on terms that are not favorable to us.

 

We do not expectour existing capital resources and the net proceeds from this offering to besufficient to enable us to fund the completion of the development of any of ourproduct candidates. We expect that our existing capital resources and the netproceeds from this offering will enable us to maintain currently plannedoperations into the fourth quarter of 2009. However, our operating plan maychange, and we may need additional funds sooner than planned to meetoperational needs and capital requirements for product development andcommercialization.

 

Additional fundsmay not be available when we need them on terms that are acceptable to us, orat all. If adequate funds are not available on a timely basis, we may:

 

·                  terminate or delay clinical trials for one or more ofour product candidates;

 

·                  delay our establishment of sales and marketingcapabilities or other activities that may be necessary to commercialize our productcandidates; or

 

·                  curtail significant drug development programs that aredesigned to identify new product candidates.

 

***Any failure or delay in commencing orcompleting clinical trials for our product candidates could severely harm ourbusiness.***

 

To date, we havenot completed the clinical trial program of any product candidate. Thecommencement and completion of clinical trials for our product candidates maybe delayed or terminated as a result of many factors, including:

 

·                  our inability or the inability of our collaborators orlicensees to manufacture or obtain from third parties materials sufficient foruse in preclinical studies and clinical trials;

 

·                  delays in patient enrollment, which we haveexperienced in the past specifically in the enrollment of atrial fibrillationpatients with implanted recordable pacemakers as part of our Phase 2clinical trials for ATI-2042, and variability in the number and types ofpatients available for clinical trials;

 

·                  difficulty in maintaining contact with patients aftertreatment, resulting in incomplete data;

 

·                  poor effectiveness of product candidates duringclinical trials;

 

·                  unforeseen safety issues or side effects; and

 

·                  governmental or regulatory delays and changes inregulatory requirements, policies and guidelines.

 

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Any delay incommencing or completing clinical trials for our product candidates would delaycommercialization of our product candidates and severely harm our business andfinancial condition. It is also possible that none of our product candidateswill complete clinical trials in any of the markets in which our collaboratorsor we intend to sell those product candidates. Accordingly, our collaboratorsor we would not receive the regulatory approvals needed to market our productcandidates, which would severely harm our business and financial condition.

 

***We rely on third parties to conduct ourclinical trials. If these third parties do not perform as contractuallyrequired or expected, we may not be able to obtain regulatory approval for orcommercialize our product candidates.***

 

We do not have theability to independently conduct clinical trials for our product candidates,and we must rely on our existing corporate partner for ATI-7505, and for eachof our other product candidates we must rely on third parties such as contractresearch organizations, medical institutions, clinical investigators andcontract laboratories, to conduct our clinical trials. We have, in the ordinarycourse of business, entered into agreements with these third parties. To date,we have utilized 13 vendors to provide clinical trial management, datacollection and analysis, laboratory and safety analysis services to us in theconduct of our clinical trials. In addition, to date we have conducted ourclinical trials at more than 100 sites in North America and Europe. Ourcorporate partner for ATI-7505, P&G, also engages third parties to conductclinical trials. Nonetheless, we or our corporate partner are responsible forconfirming that each of our clinical trials is conducted in accordance with itsgeneral investigational plan and protocol. Moreover, the FDA requires us tocomply with regulations and standards, commonly referred to as good clinicalpractices, for conducting and recording and reporting the results of clinicaltrials to assure that data and reported results are credible and accurate andthat the trial participants are adequately protected. Our reliance on thirdparties that we do not control does not relieve us of these responsibilitiesand requirements. If these third parties do not successfully carry out theircontractual duties or regulatory obligations or meet expected deadlines, if thethird parties need to be replaced or if the quality or accuracy of the datathey obtain is compromised owing to the failure to adhere to our clinicalprotocols or regulatory requirements or for other reasons, our clinical trialsmay be extended, delayed, suspended or terminated, and we may not be able toobtain regulatory approval for, or successfully commercialize, our productcandidates.

 

***If some or all of our patents expire, areinvalidated or are unenforceable, or if some or all of our patent applicationsdo not yield issued patents or yield patents with narrow claims, competitorsmay develop competing products using our intellectual property and our businesswill suffer.***

 

Our success willdepend in part on our ability to obtain and maintain patent and trade secretprotection for our technologies and product candidates both in the UnitedStates and other countries. We rely on composition of matter patents for thecompounds we develop. We cannot guarantee that any patents will issue from anyof our pending or future patent applications. Alternatively, a third party maysuccessfully circumvent our patents. Our rights under any issued patents maynot provide us with sufficient protection against competitive products orotherwise cover commercially valuable products or processes.

 

The degree offuture protection for our proprietary technologies and product candidates isuncertain because legal means afford only limited protection and may notadequately protect our rights or permit us to gain or keep our competitiveadvantage. For example:

 

·                  we might not have been the first to make theinventions covered by each of our pending patent applications and issuedpatents;

 

·                  we might not have been the first to file patentapplications for these inventions;

 

·                  others may independently develop similar oralternative technologies or duplicate any of our technologies;

 

·                  it is possible that none of our pending patentapplications will result in issued patents;

 

·                  any patents issued to us or our collaborators may notprovide a basis for commercially viable products or may be challenged by thirdparties;

 

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·                  the patents of others may have an adverse effect onour ability to do business; or

 

·                  regulators or courts may retroactively diminish thevalue of our intellectual property.

 

Even if valid andenforceable patents cover our product candidates and technologies, the patentswill provide protection only for a limited amount of time. As our patents arebased on a parent drug where much research has been conducted, we may encountermany competitive patents from covered analogs of the parent drug. Our know-howand trade secrets may only provide a competitive advantage for a short amountof time.

 

Our ability andour collaborators’ ability to obtain patents is highly uncertain because, todate, some legal principles remain unresolved, there has not been a consistentpolicy regarding the breadth or interpretation of claims allowed in patents inthe United States and the specific content of patents and patent applicationsthat are necessary to support and interpret patent claims is highly uncertaindue to the complex nature of the relevant legal, scientific and factual issues.Recent changes to patent law in the United States may make protection ofpatents in our industry even more difficult. In addition, these changes orfuture changes to either patent laws or interpretations of patent laws in theUnited States and other countries may diminish the value of our intellectualproperty or narrow the scope of our patent protection. Furthermore, thepolicies governing biotechnology patents outside the United States are evenmore uncertain.

 

Even if patentsare issued regarding our product candidates or methods of using them, thosepatents can be challenged by our competitors who can argue such patents areinvalid and/or unenforceable. Patents also may not protect our productcandidates if competitors devise ways of making these or similar productcandidates without legally infringing our patents. The Federal Food, Drug andCosmetic Act and FDA regulations and policies provide incentives tomanufacturers to challenge patent validity or create modified, noninfringingversions of a drug in order to facilitate the approval of generic substitutes.These same types of incentives encourage manufacturers to submit new drugapplications that rely on literature and clinical data not prepared for or bythe drug sponsor.

 

As of September 30,2007, we held 39 issued or allowed U.S. patents and had 15 patent applicationspending before the U.S. Patent and Trademark Office, or USPTO. For some of ourinventions, corresponding foreign patent protection is pending. Of the 39 U.S.patents that we hold, 36 patents are compound- and composition-related, havingexpiration dates from 2013 to 2025. The composition of matter patent for our leadcompound ATI-7505 for the treatment of gastrointestinal disorders issued in February 2007,and has an expiration date in 2025. Our composition of matter patent forATI-5923, our compound for anticoagulation, issued in August 2007 and hasan expiration date in 2025. Our composition of matter patent for ATI-2042, ourcompound for the treatment of atrial fibrillation, issued in April 2002and has an expiration date in 2020. Although third parties may challenge ourrights to, or the scope or validity of, our patents, to date we have notreceived any communications from third parties challenging our patents orpatent applications covering our clinical candidates.

 

While ATI-7505,ATI-5923 and ATI-2042 are all covered in the United States by issuedcomposition of matter patents, additional patent applications would be requiredto extend patent protection beyond 2025, 2025 and 2020, respectively (assumingthe validity and enforceability of the current composition of matter patents).We cannot guarantee that any patents will be issued from our pending or futurepatent applications, and any patents that issue from such pending or futurepatent applications would be subject to the same risks described herein forcurrently issued patents.

 

Our research anddevelopment collaborators may have rights to publish data and other informationin which we have rights. In addition, we sometimes engage individuals orentities to conduct research that may be relevant to our business. The abilityof these individuals or entities to publish or otherwise publicly disclose dataand other information generated during the course of their research is subjectto certain contractual limitations. In most cases, these individuals orentities are, at the least, precluded from publicly disclosing our confidentialinformation and are only allowed to disclose other data or informationgenerated during the course of the research after we have been afforded anopportunity to consider whether patent and/or other proprietary protectionshould be sought. If we do not apply for patent protection prior to suchpublication or if we cannot otherwise maintain the confidentiality of ourtechnology and other confidential information, then our ability to receivepatent protection or protect our proprietary information may be jeopardized.

 

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***Failure to adequately protect our tradesecrets and other intellectual property could substantially harm our businessand results of operations.***

 

We also rely ontrade secrets to protect our technology, especially where we do not believethat patent protection is appropriate or obtainable. This is particularly truefor our RetroMetabolic Drug Design technology. However, trade secrets aredifficult to protect. Our employees, consultants, contractors, outsidescientific collaborators and other advisors are required to sign confidentialdisclosure agreements but they may unintentionally or willfully disclose ourconfidential information to competitors. Enforcing a claim that a third partyillegally obtained and is using our trade secrets is expensive andtime-consuming, and the outcome is unpredictable. Failure to obtain or maintaintrade secret protection could adversely affect our competitive businessposition.

 

***Third-party claims of intellectual propertyinfringement would require us to spend significant time and money and couldprevent us from developing or commercializing our products.***

 

Our commercialsuccess depends in part on not infringing the patents and proprietary rights ofother parties and not breaching any licenses that we have entered into withregard to our technologies and products. Because others may have filed, and inthe future are likely to file, patent applications covering products or othertechnologies of interest to us that are similar or identical to ours, patentapplications or issued patents of others may have priority over our patentapplications or issued patents. There are numerous issued and applied forpatents related to the original molecules and analogs of such from which ourproducts are engineered. If the patents are determined to be valid andconstrued to cover our products, the development and commercialization of anyor all could be affected. We do not believe that our activities infringe the patentsof others or that the patents of others inhibit our freedom to operate.However, it is possible that others may choose to challenge this position andthat a judge or jury will disagree with our conclusions, and we could incursubstantial costs in litigation if we are required to defend against patentsuits brought by third parties. Similarly, if we initiate suits to defend ourpatents, such litigation could be costly and there is no assurance we would besuccessful in such processes. Any legal action against our collaborators or usclaiming damages and seeking to enjoin commercial activities relating to theaffected products and processes could, in addition to subjecting us topotential liability for damages, require our collaborators or us to obtain a licenseto continue to manufacture or market the affected products and processes.Licenses required under any of these patents may not be available oncommercially acceptable terms, if at all. Failure to obtain such licenses couldmaterially and adversely affect our ability to develop, commercialize and sellour product candidates. We believe that there may continue to be significantlitigation in the biotechnology and pharmaceutical industry regarding patentand other intellectual property rights. If we become involved in litigation, itcould consume a substantial portion of our management and financial resourcesand we may not prevail in any such litigation.

 

Furthermore, ourcommercial success will depend, in part, on our ability to continue to conductresearch to identify additional product candidates in current indications ofinterest or opportunities in other indications. Some of these activities mayinvolve the use of genes, gene products, screening technologies and otherresearch tools that are covered by third-party patents. Court decisions haveindicated that the exemption from patent infringement afforded by Title 35, Section 271(e)(1) ofthe United States Code does not encompass all research and developmentactivities associated with product development. In some instances, we may berequired to obtain licenses to such third-party patents to conduct our researchand development activities, including activities that may have alreadyoccurred. It is not known whether any license required under any of thesepatents would be made available on commercially acceptable terms, if at all.Failure to obtain such licenses could materially and adversely affect ourability to maintain a pipeline of potential product candidates and to bring newproducts to market. If we are required to defend against patent suits broughtby third parties relating to third-party patents that may be relevant to ourresearch activities, or if we initiate such suits, we could incur substantialcosts in litigation. Moreover, an adverse result from any legal action in whichwe are involved could subject us to damages and/or prevent us from conductingsome of our research and development activities.

 

***If third parties do not manufacture ourproduct candidates in sufficient quantities or at an acceptable cost, clinicaldevelopment and commercialization of our product candidates would be delayed.***

 

We presently donot have sufficient quantities of our product candidates to complete clinicaltrials of any of our lead product candidates. We do not currently own oroperate manufacturing facilities, and we rely and expect to continue to rely ona small number of third-party manufacturers and active pharmaceuticalingredient formulators for the production of clinical and commercial quantitiesof our product candidates. We do not have long-term agreements with any ofthese third parties, and our agreements with these parties are generallyterminable at will by either party at any time. If for any reason, these thirdparties are unable or unwilling to perform under our agreements or enter intonew agreements, we may not be able to locate alternative manufacturers orformulators or enter into favorable agreements with them. Any inability toacquire sufficient quantities of our product candidates in a timely manner fromthese third parties could delay clinical trials and prevent us from developingand commercializing our product candidates in a cost-effective manner or on atimely basis.

 

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Under ourcollaborative agreement, P&G is responsible for the production of ATI-7505for both clinical and commercial purposes. They presently do not havesufficient quantities of ATI-7505 to complete clinical trials of the productcandidate. They do not currently produce ATI-7505 in their manufacturingfacilities, and they rely and expect to continue to rely on a small number ofthird-party manufacturers and active pharmaceutical ingredient formulators forthe production of clinical and commercial quantities of ATI-7505. P&Gcurrently uses two vendors, SCI Pharmtech, Inc. and Corum, Inc., forthe production of clinical and commercial quantities of ATI-7505. If, for anyreason, these third parties are unable or unwilling to perform under theiragreements or enter into new agreements, P&G may not be able to locatealternative manufacturers or formulators or enter into favorable agreementswith them. Any inability to acquire sufficient quantities of ATI-7505 in atimely manner from these third parties could delay clinical trials and preventus and P&G from developing and commercializing ATI-7505 in a cost-effectivemanner or on a timely basis. P&G is also attempting to develop acommercially viable manufacturing process for ATI-7505. There is no assurancethey will be able to do so.

 

To date, theactive pharmaceutical ingredient for ATI-5923 has been produced exclusively byChemShop BV of the Netherlands, as a single source supplier, on an ongoingpurchase order basis. However, we have transferred the ATI-5923 manufacturingprocesses to an additional vendor, Ampac Fine Chemicals, or Ampac, and arecurrently qualifying this vendor. Should Ampac not be qualified as a vendor tomanufacture ATI-5923, an additional manufacturer would need to be qualified.Should ChemShop BV cease to serve as the supplier of ATI-5923 and our currentvendor qualification efforts fail, a delay in the development of ATI-5923 couldoccur, impairing our ability to commercialize ATI-5923 on our existingtimeline. ATI-5923’s active pharmaceutical ingredient is processed into 1milligram, 5 milligram or 10 milligram tablets by QS Pharma.

 

The startingmaterials for production of ATI-2042 are provided by the following vendors: SCIPharmtech, Inc., Lexen Inc., Panchim, Julich GmbH andWeylchem Inc. To date, Ricerca and ScinoPharm Ltd. have produced allof ATI-2042’s active pharmaceutical ingredient. We have also qualified anadditional vendor, SCI Pharmtech. Historically, we have relied on Ricerca andScinoPharm as single-source suppliers for ATI-2042’s active pharmaceuticalingredients. In the event that Ricerca or ScinoPharm could not produceATI-2042, we would not be able to manufacture ATI-2042’s active pharmaceuticalingredients unless SCI Pharmtech is able to produce ATI-2042. This could delaythe development of, and impair our ability to, commercialize ATI-2042. Toproduce ATI-2042 drug product, drug substance is processed into 50 milligram or200 milligram capsule forms by Patheon Inc.

 

All of our currentarrangements with third-party manufacturers and suppliers for the production ofour product candidates are on a purchase order basis. P&G’s arrangementswith the third-party manufacturers and suppliers for ATI-7505 are also on apurchase order basis. We, and P&G with respect to ATI-7505, currently donot have long-term supply contracts with any of the third-party manufacturersand suppliers for our product candidates, and they are not required to supplyus, or P&G in the case of ATI-7505, with products for any specifiedperiods, in any specified quantities or at any set price, except as may bespecified in a particular purchase order. We have no reason to believe any ofthe current manufacturers and suppliers for our product candidates is the solesource for the materials they supply us. However, if we or P&G were to loseone of these vendors and were unable to obtain an alternative source on atimely basis or on terms acceptable to us, our clinical and productionschedules could be delayed. In addition, to the extent that any of these vendorsuses technology or manufacturing processes that are proprietary, we may beunable to obtain comparable materials from alternative sources.

 

***If we are required to obtain alternatethird-party manufacturers, it could delay or prevent the clinical development andcommercialization of our product candidates.***

 

We may not be ableto maintain or renew our existing or any other third-party manufacturingarrangements on acceptable terms, if at all. If we are unable to continuerelationships with our current suppliers, or to do so at acceptable costs, orif these suppliers fail to meet our requirements for these product candidatesfor any reason, we would be required to obtain alternative suppliers. Anyinability to obtain qualified alternative suppliers, including an inability toobtain or delay in obtaining approval of an alternative supplier from the FDA,would delay or prevent the clinical development and commercialization of theseproduct candidates.

 

Changes inmanufacturing site, process or scale can trigger additional regulatoryrequirements that could delay our or P&G’s ability to perform certainclinical trials or obtain approval.

 

The manufacturingand formulation of each of our lead product candidates that have been tested inhumans to date has been performed by entities other than those that will likelymanufacture the products for future clinical trials or commercial use. There isa possibility that analysis of future clinical trials will show that theresults from our earlier clinical trials have not been replicated. The 

 

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failure to replicatethese earlier clinical trials would delay our clinical development timelines.New impurity profiles that occur as a result of changing manufacturers may leadto delays in clinical trial testing and approvals.

 

***Use of third-party manufacturers mayincrease the risk that we will not have adequate supplies of our productcandidates.***

 

Our current andanticipated future reliance on third-party manufacturers will expose us and ourcollaborative partner, P&G, to risks that could delay or prevent theinitiation or completion of our clinical trials, the submission of applicationsfor regulatory approvals, the approval of our product by the FDA or thecommercialization of our products or result in higher costs or lost productrevenues. In particular, our contract manufacturers could:

 

·                  encounter difficulties in achieving volume production,quality control and quality assurance or suffer shortages of qualifiedpersonnel, which could result in their inability to manufacture sufficientquantities of drugs to meet our clinical schedules or to commercialize ourproduct candidates;

 

·                  terminate or choose not to renew manufacturingagreements, based on their own business priorities, at a time that is costly orinconvenient for us;

 

·                  fail to establish and follow FDA-mandated current goodmanufacturing practices, or cGMPs, which are required for FDA approval of ourproduct candidates, or fail to document their adherence to cGMPs, either ofwhich could lead to significant delays in the availability of material forclinical studies and delay or prevent marketing approval for our productcandidates; and

 

·                  breach or fail to perform as agreed undermanufacturing agreements.

 

If we are not ableto obtain adequate supplies of our product candidates, it will be moredifficult for us to develop our product candidates and compete effectively. Ourproduct candidates and any products that we may develop may compete with otherproduct candidates and products for access to manufacturing facilities.

 

In addition,Lexen, SCI Pharmtech, Scinopharm and ChemShop BV are located outside of theUnited States. This may give rise to difficulties in importing our productcandidates or their components into the United States as a result of, amongother things, FDA import inspections, incomplete or inaccurate importdocumentation, or defective packaging.

 

***If our preclinical studies do not producesuccessful results or our clinical trials do not demonstrate safety andefficacy in humans, we will not be able to commercialize our productcandidates.***

 

To obtain therequisite regulatory approvals to market and sell any of our productcandidates, we must demonstrate, through extensive preclinical studies andclinical trials, that the product candidate is safe and effective in humans. Todate, we have not completed the clinical trials of any product candidate.Preclinical and clinical testing is expensive, can take many years and has anuncertain outcome. A failure of one or more of our clinical trials could occurat any stage of testing. In addition, success in preclinical testing and earlyclinical trials does not ensure that later clinical trials will be successful,and interim results of a clinical trial do not necessarily predict finalresults. We may experience numerous unforeseen events during, or as a resultof, preclinical testing and the clinical trial process, which could delay orprevent our ability to commercialize our product candidates, including:

 

·                  regulators or institutional review boards may notauthorize us to commence a clinical trial at a prospective trial site;

 

·                  our preclinical studies or clinical trials may producenegative or inconclusive results, which may require us to conduct additionalpreclinical or clinical testing or to abandon development projects;

 

·                  we may suspend or terminate our clinical trials if theparticipating patients are being exposed to unacceptable health risks;

 

·                  regulators or institutional review boards may suspendor terminate clinical research for various reasons, including noncompliancewith regulatory requirements;

 

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·                  the effects of our product candidates may not be thedesired effects or may include undesirable side effects; and

 

·                  our preclinical studies or clinical trials may showthat our product candidates are not superior to the original drugs on which ourproduct candidates are modeled.

 

For instance, ourpreclinical studies and clinical trials may indicate that our productcandidates cause unexpected drug-drug interactions and result in adverseevents. As another example, more extensive and robust clinical trials ofATI-5923 will be necessary in order to demonstrate clinical superiority towarfarin. Even if we adequately demonstrate that ATI-5923 is safe and effectiveand obtain FDA approval, we may not be permitted to market it as superior towarfarin. In addition, ATI-2042’s preclinical studies contain results that arecurrently being monitored in the clinic. Inhibition of testicular function wasobserved in one animal species as part of these studies. No such effect hasbeen observed to date in the clinic and monitoring continues. In publishedstudies, a similar effect is thought to be correlated with the accumulation ofamiodarone in tissues. A possible renal effect was also observed at high dosesin our rat and dog toxicology studies for ATI-2042. While we will continue tomonitor patients for these effects, there is no assurance these effects willnot occur in patients as part of our ongoing and planned clinical trials forATI-2042, and have a resulting adverse effect on our ability to obtainrequisite regulatory approval to market and sell ATI-2042. In an ongoing caninetoxicology study of ATI-7505 being performed by P&G, six deaths occurred atdoses that were 10 and 20 times greater than doses currently being used inclinical trials. Our clinical trials to date have indicated only mild tomoderate side effects in humans. However, further observation is warranted.

 

Even when ourproduct candidates do not cause any adverse effects, clinical studies ofefficacy may show that our product candidates do not have significant effectson target symptoms or may be inconclusive. For example, ATI-7505 was tested intwo Phase 2 clinical trials in which the primary endpoints were not met incomparison to placebo. Although these studies did support ATI-7505’s efficacyagainst certain symptoms as secondary endpoints, if future studies show thatATI-7505 is not sufficiently efficacious to justify its use as a therapy, ourbusiness and prospects will be materially adversely affected.

 

Unforeseen eventscould cause us to experience significant delays in, or the termination of,clinical trials. Any such events would increase our costs and could delay orprevent our ability to commercialize our product candidates, which wouldadversely impact our financial results.

 

***We may not be successful in our efforts toidentify or discover additional candidates using our RetroMetabolic Drug DesignTechnology.***

 

An importantelement of our strategy is to continue to identify existing molecules whichhave demonstrated efficacy, but have safety problems that are amenable to ourRetroMetabolic Drug Design technology. Other than ATI-7505, ATI-2042 and ATI-5923,all of our programs are in the preclinical or discovery stage. Researchprograms to identify new product candidates require substantial technical,financial and human resources. These programs may initially show promise inidentifying potential product candidates, yet fail to yield product candidatesfor clinical development for a number of reasons, including:

 

·                  the research methodology used may not be successful inidentifying potential product candidates; or

 

·                  potential product candidates may, on further study, befound not to retain the efficacy profile of the original molecule or be shownto retain harmful side effects or other characteristics suggesting that theyare unlikely to be effective products. For instance, at high doses our ATI-2042product candidate interacts with warfarin and causes prolonged INR which couldincrease the risk of hemorrhage complications.

 

If we are unableto develop suitable product candidates through internal research programs orotherwise, we may not be able to increase our revenues in future periods, whichcould result in significant harm to our financial position and adversely impactour stock price.

 

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***Our product candidates will remain subjectto ongoing regulatory review even if they receive marketing approval. If wefail to comply with continuing regulations, we could lose these approvals andthe sale of our products could be suspended.***

 

Even if we receiveregulatory approval to market a particular product candidate, the approvalcould be conditioned on our conducting additional costly post-approval studiesor could limit the indicated uses included in our labeling. Moreover, theproduct may later cause adverse effects that limit or prevent its widespreaduse, force us to withdraw it from the market or impede or delay our ability toobtain regulatory approvals in additional countries. In addition, themanufacturer of the product and its facilities will continue to be subject toFDA review and periodic inspections to ensure adherence to applicable GMPAregulations. After receiving marketing approval, the manufacturing, labeling,packaging, adverse event reporting, storage, advertising, promotion and recordkeeping related to the product will remain subject to extensive regulatoryrequirements.

 

If we fail tocomply with the regulatory requirements of the FDA and other applicable U.S.and foreign regulatory authorities or previously unknown problems with ourproducts, manufacturers or manufacturing processes are discovered, we could besubject to administrative or judicially imposed sanctions, including:

 

·                  restrictions on the products, manufacturers ormanufacturing processes;

 

·                  warning letters;

 

·                  civil or criminal penalties or fines;

 

·                  injunctions;

 

·                  product seizures, detentions or import bans;

 

·                  voluntary or mandatory product recalls and publicityrequirements;

 

·                  suspension or withdrawal of regulatory approvals;

 

·                  total or partial suspension of production; and

 

·                  refusal to approve pending applications for marketingapproval of new drugs or supplements to approved applications.

 

***Because we have a number of productcandidates and are considering a variety of target indications, we may expendour limited resources to pursue a particular candidate or indication and failto capitalize on candidates or indications that may be more profitable or forwhich there is a greater likelihood of success.***

 

Because we havelimited financial and managerial resources, we must focus on research programsand product candidates for the specific opportunities that we believe are themost amenable to our RetroMetabolic Drug Design and are the most commerciallypromising. As a result, we may forego or delay pursuit of opportunities withother product candidates or other indications that later prove to have greatercommercial potential. Our resource allocation decisions may cause us to fail tocapitalize on viable commercial products or profitable market opportunities. Inaddition, we may spend valuable time and managerial and financial resources onresearch programs and product candidates for specific indications thatultimately do not yield any commercially viable products. If we do notaccurately evaluate the technical feasibility and the commercial potential ortarget market for a particular product candidate, we may relinquish valuablerights to that product candidate through collaboration, licensing or otherroyalty arrangements in situations where it would have been more advantageousfor us to retain sole rights to development and commercialization.

 

***The commercial success of any products thatwe may develop will depend upon the degree of market acceptance amongphysicians, patients, healthcare payors and the medical community.***

 

Any products thatwe may develop may not gain market acceptance among physicians, patients,healthcare payors and the medical community. If these products do not achievean adequate level of acceptance, we may not generate material product revenuesand we may not become profitable. The degree of market acceptance of any of ourproduct candidates, if approved for commercial sale, will depend on a number offactors, including:

 

·                  demonstration of efficacy and safety in clinicaltrials;

 

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·                  demonstration that we have adequately addressed thespecific safety problem of the original molecule;

 

·                  the prevalence and severity of any side effects;

 

·                  potential or perceived advantages over alternativetreatments;

 

·                  perceptions about the relationship or similaritybetween our product candidates and the original drug upon which eachRetroMetabolic Drug Design candidate was based;

 

·                  advantage over other drugs may not be sufficientlygreat enough to obtain premium pricing;

 

·                  the timing of market entry relative to competitive treatments;

 

·                  the ability to offer our product candidates for saleat competitive prices;

 

·                  relative convenience and ease of administration;

 

·                  the strength of marketing and distribution support;

 

·                  sufficient third-party coverage or reimbursement; and

 

·                  the product labeling or product insert required by theFDA or regulatory authorities in other countries.

 

***If we are unable to establish sales andmarketing capabilities or enter into agreements with third parties to marketand sell our product candidates, we may be unable to generate product revenue.***

 

We do not have asales and marketing organization and have no experience in the sales, marketingand distribution of pharmaceutical products. It is our intention to usecollaborative arrangements to gain access to large sales and marketingorganizations in order to commercialize our product candidates. By exercisingour co-promotion rights under our agreement with P&G, we intend toeventually build a small specialty sales force to market our product candidatesto specific physician groups. There are risks involved with establishing ourown sales and marketing capabilities and entering into arrangements with thirdparties to perform these services. Developing an internal sales force isexpensive and time-consuming and could delay any product launch. Importantly,our co-promotion agreement with P&G only provides for a partialreimbursement of the cost of our sales force and only for the cost of salesactually made. The cost to establish the sales force will not be reimbursed byP&G. The sales force only has the potential to become a profitable effortif additional products are obtained that could be marketed by this specialtysales force. However, there is no assurance that future products will beobtained through internal or external efforts. On the other hand, if we enterinto arrangements with third parties to perform sales, marketing anddistribution services, our product revenues are likely to be lower than if wemarket and sell any products that we develop ourselves.

 

We plan toestablish our own specialty sales force and engage pharmaceutical or otherhealthcare companies with an existing sales and marketing organization anddistribution system to sell, market and distribute our products. We may not beable to establish these sales and distribution relationships on acceptableterms, or at all. Factors that may inhibit our efforts to commercialize ourproducts without collaborators or licensees include:

 

·                  our inability to convince future corporate partners toallow us to retain commercialization rights for specific physician groups;

 

·                  our inability to obtain financing to establish thespecialty sales force;

 

·                  our inability to recruit and retain adequate numbersof effective sales and marketing personnel;

 

·                  the inability of sales personnel to obtain access toor persuade adequate numbers of physicians to prescribe our products;

 

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·                  the lack of complementary products to be offered bysales personnel, which may put us at a competitive disadvantage relative tocompanies with more extensive product lines; and

 

·                  unforeseen costs and expenses associated with creatingan independent sales and marketing organization.

 

Because theestablishment of sales and marketing capabilities depends on the progresstoward commercialization of our product candidates and because of the numerousrisks and uncertainties involved with establishing our own sales and marketingcapabilities, we are unable to predict when we will establish our own sales andmarketing capabilities. If we are not able to partner with a third party andare not successful in recruiting sales and marketing personnel or in building asales and marketing infrastructure, we will have difficulty commercializing ourproduct candidates, which would adversely affect our business and financialcondition.

 

***Our ability to generate revenue from anyproducts that we may develop will depend on reimbursement and drug pricingpolicies and regulations.***

 

Many patients maybe unable to pay for any products that we may develop. In the United States,many patients will rely on Medicare, Medicaid, private health insurers andother third-party payors to pay for their medical needs. Our ability to achieveacceptable levels of reimbursement for drug treatments by governmentalauthorities, private health insurers and other organizations will have aneffect on our ability to successfully commercialize, and attract collaborativepartners to invest in the development of, our product candidates. We cannot besure that reimbursement in the United States, Europe or elsewhere will beavailable for any products that we may develop, and any reimbursement that maybecome available may be decreased or eliminated in the future. Third-partypayors increasingly are challenging prices charged for medical products andservices, and many third-party payors may refuse to provide reimbursement forparticular drugs when an equivalent generic drug is available. Although webelieve that the safety profile of any products that we may develop will besufficiently different from the original drugs from which they are modeled tobe considered unique and not subject to substitution by a generic of theoriginal drug in the case of ATI-2042 and ATI-5923, it is possible that athird-party payor may consider our product candidate and the generic originaldrug as equivalents and only offer to reimburse patients for the generic drug.Even if we show improved safety with our product candidates, pricing of theexisting original drug may limit the amount we will be able to charge for eachof our product candidates. In the case of ATI-7505, the original molecule,cisapride, was withdrawn from the market and no generic version exists, butthere are many competitive products which may limit the amount we can chargefor this product candidate. If reimbursement is not available or is availableonly at limited levels, we may not be able to successfully commercialize ourproduct candidates, and may not be able to obtain a satisfactory financialreturn on products that we may develop.

 

The trend towardmanaged healthcare in the United States and the changes in health insuranceprograms, as well as legislative proposals to reform healthcare or reducegovernment insurance programs, may result in lower prices for pharmaceuticalproducts, including any products that may be offered by us. In addition, anyfuture regulatory changes regarding the healthcare industry or third-partycoverage and reimbursement may affect demand for any products that we maydevelop and could harm our sales and profitability.

 

***If our competitors are able to develop andmarket products that are more effective, safer or less costly than any productsthat we may develop, our commercial opportunity will be reduced or eliminated.***

 

We facecompetition from established pharmaceutical and biotechnology companies, aswell as from academic institutions, government agencies and private and publicresearch institutions. Our commercial opportunity will be reduced or eliminatedif our competitors develop and commercialize products that are safer, moreeffective, have fewer side effects or are less expensive than any products thatwe may develop. In addition, significant delays in the development of ourproduct candidates could allow our competitors to bring products to marketbefore us and impair our ability to commercialize our product candidates.

 

ATI-7505 haspotential use in five indications: chronic constipation, functional dyspepsia,GERD, gastroparesis and IBS with constipation. Some of these indications maynot be recognized by the FDA as sufficiently defined to enable regulatoryapproval of a drug for treatment. ATI-7505 is a prokinetic which has been shownto increase motility in the upper and lower gastrointestinal tract, includingthe ability to improve gastric emptying and colonic motility. Products whichaffect the gastrointestinal system’s motility could be useful in the treatmentof each of these disorders. Other prokinetics are on the market or indevelopment which will also be competitive to ATI-7505, including tegaserod,marketed by Novartis Pharmaceuticals Corporation as Zelnorm, which waswithdrawn from the market and recently re-introduced with restrictive uselabeling, renzapride, being developed by Alizyme plc, and 

 

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erythromycin. Manyadditional prokinetics are in development targeting these indications. Webelieve the most significant competition to ATI-7505 for the treatment of GERDare proton pump inhibitors and H2 blockers, which are currently on the marketin both prescription formulations and strengths as well as in over-the-counterforms. Many major pharmaceutical companies currently market proton pumpinhibitors and H2 blockers generating worldwide sales of over$17.0 billion in 2006. ATI-7505 is targeted at the approximately 20—25% ofGERD patients who do not receive adequate relief from proton pump inhibitors,which reduce the creation of acid in the stomach. ATI-7505 will facecompetition from the prokinetics as well as many inexpensive over-the-counterindications for the treatment of these gastrointestinal disorders.

 

Competition forATI-5923 for use as an oral anticoagulant will continue to come from genericcoumadin owing to its pricing and the years of experience physicians andpatients have with the drug. Other oral anticoagulants are in developmentthroughout the pharmaceutical and biotechnology industry. Most of thesedevelopment programs fall into either the factor Xa or direct thrombininhibitor categories. We are aware that Johnson & Johnson incollaboration with Bayer AG, Bristol-Myers Squibb Company in collaboration withPfizer, Inc., Eli Lilly and Company and Portola Pharmaceuticals, Inc.each have factor Xa programs in Phase 2 or Phase 3 testing. We areaware of a direct thrombin inhibitor program at Boehringer-Ingelheim GmbH. Thefirst direct thrombin inhibitor presented to the FDA for approval,ximelagatran, previously marketed as Exanta by AstraZeneca plc, has not beenrecommended for approval due to idiosyncratic liver toxicity problems. Althoughwe believe ATI-5923’s mechanism of action (VKOR inhibition as with warfarin)and broadly available inexpensive monitoring methodology (INR) provide anadvantage, these factor Xa and direct thrombin inhibitor programs will likelyprovide major competition in this market. In addition, there may be othercompounds of which we are not aware that are at an earlier stage of developmentand may compete with our product candidates. If any of those compounds are successfullydeveloped and approved, they could compete directly with our productcandidates.

 

We believe genericamiodarone will continue to provide competition to ATI-2042 for the treatmentof atrial fibrillation, even though it is not labeled for use in atrialfibrillation. Amiodarone will continue to be used off-label in spite of itssafety problems because of its generic pricing. Other treatments for atrialfibrillation, such as sotalol, marketed by Bayer HealthCare Pharmaceuticals, Inc.,flecainide marketed by 3M Company and propafenone, marketed by ReliantPharmaceuticals, Inc., do not have equivalent efficacy to amiodarone, butwill continue to compete in the atrial fibrillation marketplace. CardiomePharma Corp. is in Phase 2 testing with an oral product, vernakalant, forthe treatment of atrial fibrillation which they hope will have efficacy equalto or better than flecainide or sotalol, but with reduced pro-arrhythmiceffects. There are other companies developing devices or procedures to treat atrialfibrillation through ablation, including CryoCor, Inc. and CryoCathTechnologies, Inc.

 

Many of ourcompetitors have significantly greater financial resources and expertise inresearch and development, manufacturing, preclinical testing, conducting clinicaltrials, obtaining regulatory approvals and marketing approved products than wedo. Established pharmaceutical companies may invest heavily to quickly discoverand develop novel compounds that could make our product candidates obsolete.Smaller or early-stage companies may also prove to be significant competitors,particularly through collaborative arrangements with large and establishedcompanies. In addition, these third parties compete with us in recruiting andretaining qualified scientific and management personnel, establishing clinicaltrial sites and patient registration for clinical trials, as well as inacquiring technologies and technology licenses complementary to our programs oradvantageous to our business. Accordingly, our competitors may succeed inobtaining patent protection, receiving FDA approval or discovering, developingand commercializing medicines before we do. We are also aware of othercompanies that may currently be engaged in the discovery of medicines that willcompete with the product candidates that we are developing. In addition, in themarkets that we are targeting, we expect to compete against currentmarket-leading medicines. If we are not able to compete effectively against ourcurrent and future competitors, our business will not grow and our financialcondition will suffer.

 

***If we fail to attract and keep seniormanagement and key scientific personnel, we may be unable to successfullydevelop or commercialize our product candidates.***

 

Our successdepends on our continued ability to attract, retain and motivate highlyqualified management, clinical and scientific personnel and on our ability todevelop and maintain important relationships with leading clinicians. If we arenot able to retain Dr. Goddard, our Chairman and Chief Executive Officer, Dr. Milner,our President, Research and Development, Dr. Canafax, our Vice Presidentand Chief Development Officer, and Dr. Druzgala, our Vice President andChief Scientific Officer, we may not be able to successfully develop or commercializeour product candidates. Competition for experienced scientists may limit ourability to hire and retain highly qualified personnel on acceptable terms. Inaddition, none of our employees have employment commitments for any fixedperiod of time and could leave our employment at will. We carry “key person”insurance in the amount of $1 million for each of Drs. Milner andDruzgala, but do not carry “key person” insurance covering any other members ofsenior management or key 

 

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scientific personnel. Ifwe fail to identify, attract and retain qualified personnel, we may be unableto continue our development and commercialization activities.

 

***We will need to hire additional employeesin order to commercialize our product candidates. Any inability to managefuture growth could harm our ability to commercialize our product candidates,increase our costs and adversely impact our ability to compete effectively.***

 

In order tocommercialize our product candidates, we will need to expand the number of ourmanagerial, operational, financial and other employees. We currently anticipatethat we will need between 164 and 204 additional employees by the time thatATI-7505 is initially commercialized, which includes 80 to 120 salesrepresentatives in the United States. Because the projected time frame forhiring these additional employees depends on the development status of ourproduct candidates and because of the numerous risks and uncertaintiesassociated with drug development, we are unable to project when we will hirethese additional employees. While to date we have not experienced difficultiesin recruiting, hiring and retaining qualified individuals, the competition forqualified personnel in the pharmaceutical and biotechnology field is intense.

 

Future growth willimpose significant added responsibilities on members of management, includingthe need to identify, recruit, maintain and integrate additional employees. Ourfuture financial performance and our ability to commercialize our productcandidates and compete effectively will depend, in part, on our ability tomanage any future growth effectively.

 

***If product liability lawsuits are broughtagainst us, we will incur substantial liabilities and may be required to limitcommercialization of any products that we may develop.***

 

We face aninherent risk of product liability exposure related to the testing of ourproduct candidates in human clinical trials and will face an even greater riskif we commercially sell any products that we may develop. If we cannotsuccessfully defend ourselves against claims that our product candidates orproducts that we may develop caused injuries, we will incur substantialliabilities. Regardless of merit or eventual outcome, liability claims mayresult in:

 

·                  decreased demand for any product candidates orproducts that we may develop;

 

·                  injury to our reputation;

 

·                  withdrawal of clinical trial participants;

 

·                  costs to defend the related litigation;

 

·                  substantial monetary awards to clinical trialparticipants or patients;

 

·                  loss of revenue; and

 

·                  the inability to commercialize any products that wemay develop.

 

We have productliability insurance that covers our clinical trials up to an aggregate$5.0 million annual limit. We intend to expand our insurance coverage toinclude the sale of commercial products if marketing approval is obtained forany products that we may develop. Insurance coverage is increasingly expensive,and we may not be able to maintain insurance coverage at a reasonable cost andwe may not be able to obtain insurance coverage that will be adequate tosatisfy any liability that may arise.

 

***If we use biological and hazardousmaterials in a manner that causes contamination, injury or violates laws, wemay be liable for damages.***

 

Our research anddevelopment activities involve the use of potentially harmful biologicalmaterials as well as hazardous materials, chemicals and various radioactivecompounds. We cannot completely eliminate the risk of accidental contaminationor injury from the use, storage, handling or disposal of these materials. Inthe event of contamination or injury, we could be held liable for damages thatresult, and any liability could exceed our resources. We, the third partiesthat conduct clinical trials on our behalf and 

 

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the third parties thatmanufacture our product candidates are subject to federal, state and local lawsand regulations governing the use, storage, handling and disposal of thesematerials and waste products. The cost of compliance with these laws andregulations could be significant. The failure to comply with these laws andregulations could result in significant fines and work stoppages and mayharm our business.

 

Our principalfacility is located in California’s Silicon Valley, in an area with a longhistory of industrial activity and use of hazardous substances, includingchlorinated solvents. Certain environmental laws, including the U.S.Comprehensive, Environmental Response, Compensation and Liability Act of 1980,impose strict, joint and several liabilities on current operators of realproperty for the cost of removal or remediation of hazardous substances. Theselaws often impose liability even if the owner or operator did not know of, orwas not responsible for, the release of such hazardous substances. As a result,while we have not been notified of any claim against us, we are not aware ofany such release, nor have we been held liable for costs to address contaminationat the property beneath our facility in the past, we cannot rule out thepossibility that this may occur in the future. We do not carry specificinsurance against such a claim.

 

***We will need to implement additionalfinance and accounting systems, procedures and controls in the future as wegrow our business and organization and to satisfy new reporting requirements.***

 

As a publicreporting company, we will need to comply with the Sarbanes-Oxley Act of 2002and the related rules and regulations of the Securities and ExchangeCommission, including expanded disclosures and accelerated reportingrequirements and more complex accounting rules. Compliance with Section 404of the Sarbanes-Oxley Act of 2002 and other requirements will increase ourcosts and require additional management resources. We recently have beenupgrading our finance and accounting systems, procedures and controls and willneed to continue to implement additional finance and accounting systems,procedures and controls as we grow our business and organization and to satisfynew reporting requirements. Compliance with Section 404 will first applyto our annual report on Form 10-K for our fiscal year ending December 31,2008. If we are unable to complete the required assessment as to the adequacyof our internal control over financial reporting or if our independentregistered public accounting firm is unable to provide us with an unqualifiedreport as to the effectiveness of our internal controls over financialreporting as of December 31, 2008, investors could lose confidence in thereliability of our internal controls over financial reporting, which couldadversely affect our stock price and our ability to raise capital.

 

***Our principal facility is located nearknown earthquake fault zones, and the occurrence of an earthquake, extremistattack or other catastrophic disaster could cause damage to our facilities andequipment, which could require us to cease or curtail operations.***

 

Our principalfacility is located in California’s Silicon Valley near known earthquake faultzones and, therefore, is vulnerable to damage from earthquakes. In October 1989,a major earthquake struck this area and caused significant property damage anda number of fatalities. We are also vulnerable to damage from other types ofdisasters, including power loss, attacks from extremist organizations, fire,floods and similar events. If any disaster were to occur, our ability tooperate our business could be seriously impaired. In addition, the uniquenature of our research activities and of much of our equipment could make itdifficult for us to recover from this type of disaster. We currently may nothave adequate insurance to cover our losses resulting from disasters or othersimilar significant business interruptions, and we do not currently plan topurchase additional insurance to cover such losses because of the cost ofobtaining such coverage. Any significant losses that are not recoverable underour insurance policies could seriously impair our business and financial condition.Our current insurance does not specifically cover property loss or businessinterruption due to earthquake damage.

 

**Risks Relating to Ownership of Our Common Stock**

 

***Our stock price may be extremely volatile, and yourinvestment in our common stock could suffer a decline in value.****

 

You shouldconsider an investment in our common stock risky and invest only if you canwithstand a significant loss and wide fluctuations in the market value of yourinvestment. Investors who purchase our common stock may not be able to selltheir shares at or above the purchase price. Security Market prices forsecurities of biopharmaceutical companies have been highly volatile. Inaddition, the volatility of biopharmaceutical company stocks often does notcorrelate to the operating performance of the companies represented by suchstocks. Some of the factors that may cause the market price of our common stockto fluctuate include:

 

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·                  adverse results or delays in our clinical trials;

 

·                  the timing of achievement of our clinical, regulatory,partnering and other milestones, such as the commencement of clinicaldevelopment, the completion of a clinical trial, the receipt of regulatoryapproval or the establishment of a commercial partnership for one or more ofour product candidates;

 

·                  announcement of FDA approval or nonapproval of ourproduct candidates or delays in the FDA review process;

 

·                  actions taken by regulatory agencies with respect toour product candidates, our clinical trials or our sales and marketingactivities;

 

·                  the commercial success of any product approved by theFDA or its foreign counterparts;

 

·                  regulatory developments in the United States andforeign countries;

 

·                  changes in the structure of healthcare paymentsystems;

 

·                  any intellectual property infringement lawsuitinvolving us;

 

·                  announcements of technological innovations or newproducts by us or our competitors;

 

·                  market conditions for the biotechnology orpharmaceutical industries in general;

 

·                  changes in financial estimates or recommendations bysecurities analysts;

 

·                  sales of large blocks of our common stock;

 

·                  sales of our common stock by our executive officers,directors and significant stockholders;

 

·                  restatements of our financial results and/or materialweaknesses in our internal controls; and

 

·                  the loss of any of our key scientific or managementpersonnel.

 

The stock marketsin general, and the markets for biotechnology stocks in particular, haveexperienced extreme volatility that has often been unrelated to the operatingperformance of particular companies. These broad market fluctuations mayadversely affect the trading price of our common stock. In the past, classaction litigation has often been instituted against companies whose securitieshave experienced periods of volatility in market price. Any such litigationbrought against us could result in substantial costs, which would hurt ourfinancial condition and results of operations, divert management’s attentionand resources, and possibly delay our clinical trials or commercializationefforts.

 

***Fluctuations in our operating results couldcause our stock price to decline.***

 

The followingfactors are likely to result in fluctuations of our operating results fromquarter to quarter and year to year:

 

·                  adverse results or delays in our clinical trials;

 

·                  the timing and achievement of our clinical,regulatory, partnering and other milestones, such as the commencement ofclinical development, the completion of a clinical trial, the receipt ofregulatory approval or the establishment of a commercial partnership for one ormore of our product candidates;

 

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·                  announcement of FDA approval or nonapproval of ourproduct candidates or delays in the FDA review process;

 

·                  actions taken by regulatory agencies with respect toour product candidates, our clinical trials or our sales and marketingactivities;

 

·                  the commercial success of any product approved by theFDA or its foreign counterparts;

 

·                  regulatory developments in the United States andforeign countries;

 

·                  changes in the structure of healthcare paymentsystems;

 

·                  any intellectual property infringement lawsuitinvolving us; and

 

·                  announcements of technological innovations or newproducts by us or our competitors.

 

Because of thesepotential fluctuations in our operating results, a period-to-period comparisonof our results of operations may not be a good indication of our futureperformance. In any particular financial period the actual or anticipatedfluctuations could be below the expectations of securities analysts orinvestors and our stock price could decline.

 

***Because a small number of existingstockholders own a large percentage of our voting stock, they may be able tocontrol our management and operations, acting in their best interests and notnecessarily those of other stockholders.***

 

Based on ouroutstanding shares as of September 30, 2007, and after giving effect tothe five million shares of common stock sold in our initial public offering,our executive officers, directors and holders of 5.0% or more of ouroutstanding common stock beneficially own approximately 54.4% of our commonstock. As a result, these stockholders, acting together, will be able tocontrol all matters requiring approval by our stockholders, including theelection of directors and the approval of mergers or other business combinationtransactions. The interests of this group of stockholders may not alwayscoincide with our interests or the interests of other stockholders.

 

***Anti-takeover provisions in our charterdocuments and under Delaware law could make an acquisition of us, which may bebeneficial to our stockholders, more difficult and may prevent attempts by ourstockholders to replace or remove our current management.***

 

Provisions in ourcertificate of incorporation and our bylaws may delay or prevent an acquisitionof us, a change in our management or other changes that stockholders mayconsider favorable. These provisions include:

 

·                  a classified board of directors;

 

·                  a prohibition on actions by our stockholders bywritten consent;

 

·                  the ability of our board of directors to issuepreferred stock without stockholder approval, which could be used to adopt astockholders’ rights plan that would make it difficult for a third party toacquire us;

 

·                  notice requirements for nominations for election tothe board of directors; and

 

·                  limitations on the removal of directors.

 

Moreover, we aregoverned by the provisions of Section 203 of the Delaware General CorporationLaw, which prohibits a person who owns in excess of 15% of our outstandingvoting stock from merging or combining with us for a period of three yearsafter the date of the transaction in which the person acquired in excess of 15%of our outstanding voting stock, unless the merger or combination is approvedin a prescribed manner.

 

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***Future sales of our common stock in thepublic market could cause our stock price to drop substantially.****

 

Sales of asubstantial number of shares of our common stock in the public market, or theperception that these sales might occur, could depress the market price of ourcommon stock and could impair our ability to raise capital through the sale ofadditional equity securities. As of September 30, 2007, we had 17,626,308shares of common stock outstanding, assuming the conversion of our thenoutstanding convertible preferred stock and the sale of five million shares ofcommon stock in our initial public offering.

 

The five millionshares of common stock sold in our initial public offering are freely tradablewithout restriction, in the public market unless held by an affiliate of ours.Any common stock purchased by affiliates in the initial public offering will besubject to the lock-up agreements relating to our initial public offering.Except as set forth below, the 17,626,308 shares of common stock outstanding asof September 30, 2007, assuming the conversion of our then outstandingconvertible preferred stock and the sale of five million shares of common stockin our initial public offering, are restricted as a result of securities lawsor lock-up agreements. Morgan Stanley & Co. Incorporated, asrepresentative of the underwriters for our initial public offering, may, in itssole discretion, permit our officers, directors, employees and currentstockholders who are subject to the 180-day contractual lock-up to sell sharesprior to the expiration of the lock-up agreements. The 180-day restrictedperiod under the lock-up agreements may be extended under specifiedcircumstances. In addition, the shares that are either subject to outstandingoptions or warrants or reserved for future issuance under our 2001 EquityIncentive Plan, 2007 Equity Incentive Plan, 2007 Non-Employee Directors’ StockOption Plan and 2007 Employee Stock Purchase Plan could become eligible forsale in the public market to the extent permitted by the provisions of variousvesting agreements, the lock-up agreements and Rules 144 and 701 under theSecurities Act. If these additional shares are sold, or if it is perceived thatthey will be sold, in the public market, the trading price of our common stockcould decline.

 

As of September 30,2007, the holders of approximately 11,415,130 shares of common stock, based onshares outstanding as of that date on an as-if converted basis, and holders of111,982 shares underlying outstanding warrants, will be entitled to rightswith respect to registration of such shares under the Securities Act of 1933,as amended. If such holders, by exercising their registration rights, sell alarge number of shares, they could adversely affect the market price for ourcommon stock. If we file a registration statement and include shares held bythese holders pursuant to the exercise of their registration rights, thesesales may impair our ability to raise capital. In addition, we filed aregistration statement on Form S-8 under the Securities Act of 1933, asamended, to register up to 2,638,845 shares of our common stock for issuanceunder our stock option and employee stock purchase plans.

 

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

 

**UnregisteredSales of Equity Securities**

 

From July 1,2007 through September 30, 2007, we sold and issued the followingunregistered securities:

 

We granted optionsto our employees for the purchase of an aggregate of 9,749 shares of our commonstock at an exercise price of $6.00 per share, pursuant to our 2001 EquityIncentive Plan. During this period, stock options to purchase an aggregate of13,344 shares of our common stock were cancelled without being exercised and89,651 shares of our common stock were issued upon exercise of outstandingstock options at a weighted average exercise price of $3.45 per share. Thestock options granted during this period pursuant to our 2001 Equity IncentivePlan are subject to vesting over four years from the date of grant, subject tothe optionee’s continuous service with us.

 

These issuanceswere deemed exempt from registration under the Securities Act in reliance on Rule 701promulgated under the Securities Act of 1933, as amended, as offers and sale ofsecurities pursuant to certain compensatory benefit plans and contractsrelating to compensation in compliance with Rule 701.

 

**Use ofProceeds**

 

On November 7,2007, our registration statement on Form S-1/A (File No. 333-145813)was declared effective by the U.S. Securities and Exchange Commission for ourinitial public offering, pursuant to which we registered 5,000,000 shares ofcommon stock to be sold by us. The stock was offered at $10.00 per share. Ourcommon stock commenced trading on November 7, 2007. The offering closed onNovember 13, 2007 after the sale of all securities registered, and as aresult, we received net proceeds of approximately $44.0 million, afterunderwriters’ discounts of $3.5 million and other expenses of approximately$2.5 million. Entities affiliated with MPM Capital and OrbiMed Advisors, LLC,two of our principal stockholders, purchased an aggregate of 600,000 

 

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shares of common stock inthis offering at the initial public offering price of $10.00 per share. Theunderwriters of the offering were Morgan Stanley & Co. Incorporated,CIBC World Markets Corp., Jefferies and Company, Inc. and LeerinkSwann LLC. No offering expenses were paid directly or indirectly to ourdirectors, officers or their associates, or to persons owning 10% or more ofany of our equity securities.

 

We intend to use the netproceeds to fund our (i) research and development activities other thanexternal clinical trial expenses; (ii) external clinical trial activities,including funding manufacturing expenses related to the clinical development ofour product candidates; and (iii) general and administrative expenses,working capital needs and other general corporate purposes. We may also use aportion of the proceeds for the potential acquisition of, or investment in,technologies, products or companies that complement our business, although wehave no current understandings, commitments or agreements to do so.  Theamounts and timing of our actual expenditures will depend upon numerousfactors, including the status of our development and commercialization efforts,the amount of cash generated through our existing strategic collaborations andany additional strategic collaboration into which we may enter. Accordingly,our management will have significant flexibility in applying the net proceedsof this offering and continually assess the specific uses and allocations forthese funds. However, we do not expect our existing capital resources and thenet proceeds from this offering to be sufficient to enable us to fund thecompletion of the development of any of our product candidates without a futureraise of additional capital. Until the net proceeds of our initial publicoffering are used, we have invested the funds in interest-bearing, investmentgrade, short-term marketable securities.

 

**ITEM 3.DEFAULTS UPON SENIOR SECURITIES**

 

Not applicable.

 

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

 

In August 2007,we submitted the following matters to our stockholders for their approval. On August 29,2007, our stockholders approved each of these matters, as set forth below, bywritten consent. As of the record date for taking such action, we had12,622,452 shares of our common stock outstanding (on an as-if converted tocommon stock basis). The following actions were approved:

 

1.               Our reincorporation in the State of Delaware byeffecting a merger of ARYx Therapeutics, a California corporation, with ARYxTherapeutics, Inc., a Delaware corporation (“ARYx Delaware”).

 

2.               The adoption of the Certificate of Incorporation andBylaws of ARYx Delaware.

 

3.               The approval of certain ancillary transactions inconnection with our reincorporation in the State of Delaware.

 

4.               The approval of a form of Indemnity Agreement to beentered into by us with each of our directors and officers.

 

In October 2007,we submitted the following matters to our stockholders for their approval. On October 22,2007, our stockholders approved each of these matters, as set forth below, bywritten consent. As of the record date for taking such action, we had12,651,707 shares of our common stock outstanding (on an as-if-converted tocommon stock basis). The following actions were approved:

 

1.               The approval of the amendment and restatement of ourcertificate of incorporation to effect a 1-for-6 reverse stock split of ourcapital stock (including all outstanding warrants and options exercisable forshares of our capital stock).

 

2.               The consent to the conversion of all shares of ourpreferred stock into shares of our common stock immediately prior to andsubject to the closing of our initial public offering.

 

3.               The approval of the amendment and restatement of ourcertificate of incorporation that became effective upon the completion of ourinitial public offering to, among other things, (i) delete the provisionsin the certificate designating the rights and preferences of the preferredstock which are no longer outstanding following the conversion of suchpreferred stock into shares of our common stock upon the closing of the initialpublic offering, (ii) authorize the issuance of up to 

 

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150,000,000 shares of common stock, (iii) authorizethe issuance of up to 10,000,000 shares of preferred stock and (iv) providefor certain stockholder protection measures.

 

4.               The approval and adoption of our 2007 Equity IncentivePlan, 2007 Non-Employee Directors Stock Option Plan and 2007 Employee StockPurchase Plan.

 

5.               Approval of an amendment to our credit financingarrangement with Lighthouse Capital Partners V, L.P. entered into in October 2007.

 

**ITEM 5.OTHER INFORMATION**

 

Not applicable.

 

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**ITEM 6.****EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description of Document**                                                                                                                                                      | ** ** |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                |       |                                                                                                                                                                             |       |
| 3.2(1)              |       | Amended and Restated Certificate of Incorporation.                                                                                                                               |       |
|                |       |                                                                                                                                                                             |       |
| 3.3(2)              |       | Bylaws.                                                                                                                                                                          |       |
|                |       |                                                                                                                                                                             |       |
| 4.2(2)              |       | Specimen Common Stock Certificate.                                                                                                                                               |       |
|                |       |                                                                                                                                                                             |       |
| 4.3(2)              |       | Form of Warrant to purchase shares of Series C preferred  stock, issued September 3, 2003.                                                                        |       |
|                |       |                                                                                                                                                                             |       |
| 4.4(2)              |       | Form of Warrant to purchase shares of Series C preferred  stock, issued December 23, 2002.                                                                        |       |
|                |       |                                                                                                                                                                             |       |
| 4.5(2)              |       | Form of Warrant to purchase shares of Series D preferred  stock, issued March 28, 2005.                                                                           |       |
|                |       |                                                                                                                                                                             |       |
| 4.6(2)              |       | Amended and Restated Investor Rights Agreement by and between  Registrant and certain of its security holders.                                                                   |       |
|                |       |                                                                                                                                                                             |       |
| 4.7(2)              |       | Form of Warrant to purchase shares of Series E preferred  stock, issued October 19, 2007.                                                                         |       |
|                |       |                                                                                                                                                                             |       |
| 31.1                |       | Certification of the Chief Executive Officer pursuant to  Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange  Act, as amended.                     |       |
|                |       |                                                                                                                                                                             |       |
| 31.2                |       | Certification of the Chief Financial Officer pursuant to  Rule 13a-14(a) and Rule 15d-14(a) of the Securities  Exchange Act, as amended.                     |       |
|                |       |                                                                                                                                                                             |       |
| 32.1                |       | Certification of the Chief Executive Officer and Chief Financial  Officer pursuant to 18U.S.C. 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |       |

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(1)          Previously filed as the like numbered exhibit to ARYxTherapeutics, Inc.’s Current Report on Form 8-K (No. 001-33782),as filed with the Securities and Exchange Commission on November 13, 2007and incorporated by reference herein.

 

(2)          Previously filed as the like numbered exhibit to ARYxTherapeutics, Inc.’s Registration Statement on Form S-1 (File No. 333-145813),initially filed with the Securities and Exchange Commission on August 30,2007, as amended, and incorporated by reference herein.

 

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**SIGNATURE**

 

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

 

Dated: December 21,2007

 

 
|   | **ARYx Therapeutics, Inc.** |
|--------|----------------------------------|
|   |                             |   |
|   |                             |   |
|   | By:                              |       /s/ Paul Goddard |
|   |                             |   Paul Goddard, Ph.D. |
|   |                             | *  Chairman of the Board and Chief  Executive Officer* |
|   |                             |   |

 

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**EXHIBITINDEX**

 
| **Exhibit  Number** | ** ** | **Description of Document**                                                                                                                                                      | ** ** |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                |       |                                                                                                                                                                             |       |
| 3.2(1)              |       | Amended and Restated Certificate of Incorporation.                                                                                                                               |       |
|                |       |                                                                                                                                                                             |       |
| 3.3(2)              |       | Bylaws.                                                                                                                                                                          |       |
|                |       |                                                                                                                                                                             |       |
| 4.2(2)              |       | Specimen Common Stock Certificate.                                                                                                                                               |       |
|                |       |                                                                                                                                                                             |       |
| 4.3(2)              |       | Form of Warrant to purchase shares of Series C preferred  stock, issued September 3, 2003.                                                                        |       |
|                |       |                                                                                                                                                                             |       |
| 4.4(2)              |       | Form of Warrant to purchase shares of Series C preferred  stock, issued December 23, 2002.                                                                        |       |
|                |       |                                                                                                                                                                             |       |
| 4.5(2)              |       | Form of Warrant to purchase shares of Series D preferred  stock, issued March 28, 2005.                                                                           |       |
|                |       |                                                                                                                                                                             |       |
| 4.6(2)              |       | Amended and Restated Investor Rights Agreement by and between  Registrant and certain of its security holders.                                                                   |       |
|                |       |                                                                                                                                                                             |       |
| 4.7(2)              |       | Form of Warrant to purchase shares of Series E preferred  stock, issued October 19, 2007.                                                                         |       |
|                |       |                                                                                                                                                                             |       |
| 31.1                |       | Certification of the Chief Executive Officer pursuant to  Rule 13a-14(a) and Rule 15d-14(a) of the Securities  Exchange Act, as amended.                     |       |
|                |       |                                                                                                                                                                             |       |
| 31.2                |       | Certification of the Chief Financial Officer pursuant to  Rule 13a-14(a) and Rule 15d-14(a) of the Securities  Exchange Act, as amended.                     |       |
|                |       |                                                                                                                                                                             |       |
| 32.1                |       | Certification of the Chief Executive Officer and Chief Financial  Officer pursuant to 18U.S.C. 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |       |

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(1)          Previously filed as the like numbered exhibit to ARYxTherapeutics, Inc.’s Current Report on Form 8-K (No. 001-33782),as filed with the Securities and Exchange Commission on November 13, 2007and incorporated by reference herein.

 

(2)          Previously filed as the like numbered exhibit to ARYxTherapeutics, Inc.’s Registration Statement on Form S-1 (File No. 333-145813),initially filed with the Securities and Exchange Commission on August 30,2007, as amended, and incorporated by reference herein.

 

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