Table ofContents

 

 

 

**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, 2008.**                                                                                                                              |
| ** ** | ** **                                                                                                                                                                                |
| **or**     |
| ** ** | ** **                                                                                                                                                                                |
| **o**      | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934**                                                                                  |
| ** ** | ** **                                                                                                                                                                                |
| ** ** | **For  the Transition Period  From              to            .** |

 

**Commission file number 001-33782**

 

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**ARYx THERAPEUTICS, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                   | ** ** | **77-0456039**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State  or Other Jurisdiction ofIncorporation or Organization) |       | (I.R.S.  EmployerIdentification 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  x    No  o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.

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

 

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 October 31,2008, 17,689,332 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, 2008**

 

**INDEX**

** **
| ** **                                                                                                             | ** **                                                                                  | **Page**   |
|------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|------------|
| **PART I —  FINANCIAL INFORMATION**                                                                          | ** **                                                                                  |
| ** **                                                                                                             | ** **                                                                                  | ** ** |
| Item 1.                                                                                                                | Financial Statements                                                                        |       |
| Condensed  Consolidated Balance Sheets as of September 30, 2008 and December 31,  2007                       | 2                                                                                           |
| Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2008 and 2007 | 3                                                                                           |
| Condensed  Consolidated Statements of Cash Flow for the nine months ended  September 30, 2008 and 2007            | 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                                 | 22         |
| Item 4.                                                                                                                | Controls and  Procedures                                                                    | 22         |
|                                                                                                                   |                                                                                        |       |
| **PART II  — OTHER INFORMATION**                                                                             | ** **                                                                                  |
| Item 1.                                                                                                                | Legal Proceedings                                                                           | 23         |
| Item 1A.                                                                                                               | Risk Factors                                                                                | 23         |
| Item 2.                                                                                                                | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 42         |
| Item 3.                                                                                                                | Defaults Upon  Senior Securities                                                            | 42         |
| Item 4.                                                                                                                | Submission of  Matters to a Vote of Security Holders                                        | 42         |
| Item 5.                                                                                                                | Other Information                                                                           | 42         |
| Item 6.                                                                                                                | Exhibits                                                                                    | 43         |
|                                                                                                                   |                                                                                        |       |
| SIGNATURE                                                                                                              | 44                                                                                          |

 

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**PART I— FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**ARYx THERAPEUTICS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(In thousands)**

 
| ** **                                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                          | ** ** | **(unaudited)**        | ** ** | **(Note 1)**     | ** ** |
| **ASSETS**                                          |       |                   |       |                  |       |
| Current assets:                                     |       |                   |       |                  |       |
| Cash and cash equivalents                           |       | $                      | 20,811     |                  | $          | 55,476 |   |
| Marketable securities                               |       | 13,031                 |       | 7,640                 |       |
| Restricted cash - current                           |       | 150                    |       | 150                   |       |
| Prepaid research and development expenses           |       | 735                    |       | 582                   |       |
| Other prepaid, receivable, and current assets       |       | 707                    |       | 1,051                 |       |
| Total current assets                                |       | 35,434                 |       | 64,899                |       |
| Restricted cash                                     |       | 1,203                  |       | 903                   |       |
| Property and equipment, net                         |       | 3,441                  |       | 3,655                 |       |
| Other assets                                        |       | 645                    |       | 168                   |       |
| **Total assets**                                    |       | $                      | 40,723     |                  | $          | 69,625 |   |
|                                                |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**       |       |                   |       |                  |       |
| Current liabilities:                                |       |                   |       |                  |       |
| Accounts payable                                    |       | $                      | 1,586      |                  | $          | 1,369 |   |
| Accrued compensation                                |       | 843                    |       | 1,055                 |       |
| Accrued research and development expenses           |       | 3,429                  |       | 2,510                 |       |
| Current portion of notes payable                    |       | 6,354                  |       | 3,536                 |       |
| Current portion of deferred revenue                 |       | —                 |       | 3,913                 |       |
| Other accrued liabilities                           |       | 578                    |       | 1,074                 |       |
| Total current liabilities                           |       | 12,790                 |       | 13,457                |       |
| Deferred lease credit                               |       | 1,527                  |       | 1,793                 |       |
| Notes payable                                       |       | 7,368                  |       | 3,444                 |       |
| Deferred revenue                                    |       | —                 |       | 15,584                |       |
| Commitments and contingencies                       |       |                   |       |                  |       |
| Stockholders’ equity:                          |       |                   |       |                  |       |
| Common stock                                        |       | 18                     |       | 18                    |       |
| Additional paid-in capital                          |       | 160,034                |       | 158,053               |       |
| Accumulated other comprehensive loss                |       | (121                   | )          | —                |       |
| Accumulated deficit                                 |       | (140,893               | )          | (122,724              | )          |
| Total stockholders’ equity                     |       | 19,038                 |       | 35,347                |       |
| **Total liabilities and stockholders’ equity** |       | $                      | 40,723     |                  | $          | 69,625 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

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**ARYx THERAPEUTICS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(Unaudited)**

 
| ** **                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                 | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenue:                                   | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Collaboration services                     |       | $                                | —     |                            | $          | 66 |   | $ | 232 |   | $ | 252 |   |
| Technology license fees                    |       | 17,544                           |       | 974                             |       | 19,492 |   | 2,922 |   |
| Total revenue                              |       | 17,544                           |       | 1,040                           |       | 19,724 |   | 3,174 |   |
|                                       |       |                             |       |                            |       |   |   |   |   |
| Costs and expenses:                        |       |                             |       |                            |       |   |   |   |   |
| Cost of collaboration service revenue      |       | —                           |       | 66                              |       | 232 |   | 252 |   |
| Research and development                   |       | 11,757                           |       | 6,586                           |       | 29,403 |   | 17,602 |   |
| Selling, general and administrative        |       | 2,374                            |       | 1,902                           |       | 7,970 |   | 5,526 |   |
| Total costs and expenses                   |       | 14,131                           |       | 8,554                           |       | 37,605 |   | 23,380 |   |
| Income (loss) from operations              |       | 3,413                            |       | (7,514                          | )          | (17,881 | ) | (20,206 | ) |
|                                       |       |                             |       |                            |       |   |   |   |   |
| Interest and other income, net             |       | 292                              |       | 505                             |       | 1,149 |   | 1,684 |   |
| Interest expense                           |       | (474                             | )          | (292                            | )          | (1,437 | ) | (935 | ) |
| Net income (loss)                          |       | $                                | 3,231      |                            | $          | (7,301 | ) | $ | (18,169 | ) | $ | (19,457 | ) |
|                                       |       |                             |       |                            |       |   |   |   |   |
| Net income (loss) per share:               |       |                             |       |                            |       |   |   |   |   |
| Basic                                      |       | $                                | 0.18       |                            | $          | (6.30 | ) | $ | (1.03 | ) | $ | (17.75 | ) |
| Diluted                                    |       | $                                | 0.17       |                            | $          | (6.30 | ) | $ | (1.03 | ) | $ | (17.75 | ) |
|                                       |       |                             |       |                            |       |   |   |   |   |
| Weighted average shares used in computing: |       |                             |       |                            |       |   |   |   |   |
| Basic net income (loss) per share          |       | 17,663                           |       | 1,158                           |       | 17,645 |   | 1,096 |   |
| Diluted net income (loss) per share        |       | 18,628                           |       | 1,158                           |       | 17,645 |   | 1,096 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

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**ARYx THERAPEUTICS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOW**

**(In thousands)**

**(Unaudited)**

 
| ** **                                                                                                                                                   | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                                                                   | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| **Cash flows from operating activities:**                                                                                                                    | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Net loss                                                                                                                                                     |       | $                                                       | (18,169    | ) | $ | (19,457 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities:                                                                                 |       |                                                    |       |   |   |
| Depreciation and amortization                                                                                                                                |       | 866                                                     |       | 827 |   |
| Amortization of warrants and revaluation to fair value                                                                                                       |       | 254                                                     |       | (170 | ) |
| Stock-based compensation                                                                                                                                     |       | 1,693                                                   |       | 697 |   |
| Change in assets and liabilities:                                                                                                                            |       |                                                    |       |   |   |
| Prepaid research and development expenses                                                                                                                    |       | (153                                                    | )          | (484 | ) |
| Other prepaid, receivable, and assets                                                                                                                        |       | 263                                                     |       | 43 |   |
| Accounts payable and other accrued liabilities                                                                                                               |       | (272                                                    | )          | 973 |   |
| Accrued compensation                                                                                                                                         |       | (212                                                    | )          | — |   |
| Accrued research and development expenses                                                                                                                    |       | 919                                                     |       | 1,112 |   |
| Deferred lease credit                                                                                                                                        |       | (266                                                    | )          | (247 | ) |
| Deferred revenue                                                                                                                                             |       | (19,497                                                 | )          | (2,902 | ) |
| Net cash used in operating activities                                                                                                                        |       | (34,574                                                 | )          | (19,608 | ) |
|                                                                                                                                                         |       |                                                    |       |   |   |
| **Cash flows from investing activities:**                                                                                                                    |       |                                                    |       |   |   |
| Purchases of marketable securities                                                                                                                           |       | (15,716                                                 | )          | (17,360 | ) |
| Proceeds from sales of marketable securities                                                                                                                 |       | 3,500                                                   |       | 9,920 |   |
| Proceeds from maturities of marketable securities                                                                                                            |       | 6,240                                                   |       | 28,380 |   |
| Increase in restricted cash                                                                                                                                  |       | (300                                                    | )          | (150 | ) |
| Purchases of property and equipment                                                                                                                          |       | (614                                                    | )          | (395 | ) |
| Net cash (used in) provided by investing activities                                                                                                          |       | (6,890                                                  | )          | 20,395 |   |
|                                                                                                                                                         |       |                                                    |       |   |   |
| **Cash flows from financing activities:**                                                                                                                    |       |                                                    |       |   |   |
| Proceeds from exercise of stock options and issuance of common stock,  net of offering cost in connection with our initial public offering in  November 2007 |       | 57                                                      |       | (598 | ) |
| Proceeds from issuance of notes payable                                                                                                                      |       | 9,000                                                   |       | — |   |
| Principal payments on notes payable                                                                                                                          |       | (2,258                                                  | )          | (2,143 | ) |
| Net cash provided by (used in) financing activities                                                                                                          |       | 6,799                                                   |       | (2,741 | ) |
|                                                                                                                                                         |       |                                                    |       |   |   |
| **Net decrease in cash and cash equivalents**                                                                                                                |       | (34,665                                                 | )          | (1,954 | ) |
| Cash and cash equivalents at beginning of period                                                                                                             |       | 55,476                                                  |       | 18,660 |   |
| **Cash and cash equivalents at end of period**                                                                                                               |       | $                                                       | 20,811     |   | $ | 16,706 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

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** **

**ARYx THERAPEUTICS, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

Inthis 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. “PreferredStock” refers to ARYx’s convertible preferred stock, par value $0.001 pershare.

 

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

 

***TheCompany***

 

ARYx isa biopharmaceutical 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 product candidate portfolio includes an oralanticoagulant, ATI-5923, designed to have the same therapeutic benefits aswarfarin, currently in Phase 2/3 clinical trials for the treatment of patientswho are at risk for the formation of dangerous blood clots; an oralanti-arrhythmic agent, ATI-2042, designed to have the efficacy of amiodarone inPhase 2 clinical development for the treatment of atrial fibrillation, aform of irregular heartbeat; a novel, next-generation atypical antipsychoticagent, ATI-9242, currently in Phase 1 clinical trials for the treatment ofschizophrenia and other psychiatric disorders; and an oral prokinetic agent,ATI-7505, designed to have the same therapeutic benefits as cisapride inPhase 2 clinical trials for the treatment of chronic constipation, gastroesophagealreflux disease and symptoms associated with functional dyspepsia. We havemultiple product candidates in preclinical development.

 

Wewere incorporated in the State of California on February 28, 1997 andreincorporated in the State of Delaware on August 29, 2007. We maintain awholly-owned subsidiary, ARYx Therapeutics Limited, with registered offices inthe United Kingdom, 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.

 

***Basisof Presentation***

 

Theaccompanying unaudited condensed consolidated financial statements include theaccounts of our wholly-owned subsidiary, ARYx Therapeutics, Ltd. Allintercompany accounts and transactions have been eliminated. These unauditedcondensed consolidated financial statements have been prepared in accordancewith U.S. generally accepted accounting principles for interim financialinformation on the same basis as the annual financial statements and withinstructions to Form 10-Q and Rule 10-01 of Regulation S-X.Accordingly, they do not include all of the information and footnotes requiredby generally accepted accounting principles for complete financial statements.These interim financial statements include all adjustments (consisting only ofnormal recurring adjustments) that management believes are necessary for thefair presentation of the balances and results for the periods presented.Interim financial results are not necessarily indicative of results to beexpected for the full fiscal year or any future interim period.

 

Thebalance sheet data at December 31, 2007 has been derived from our auditedconsolidated financial statements for the year ended December 31, 2007,contained in our Annual Report on Form 10-K. The unaudited condensedconsolidated financial statements and related disclosures contained in thisreport have been prepared with the presumption that users of the interimfinancial statements have read or have access to our audited financialstatements for the preceding year. Accordingly, these interim financialstatements should be read in conjunction with our audited financial statementsand notes thereto for the year ended December 31, 2007, contained in ourAnnual Report on Form 10-K.

 

***Need to RaiseAdditional Capital***

 

Ourcondensed consolidated financial statements have been prepared assuming ourcompany will continue as a going concern, which contemplates the realization ofassets and the settlement of liabilities and commitments in the normal courseof business for the foreseeable future. We have incurred significant operatinglosses since our inception. As of September 30, 2008, we had workingcapital of $22.6 million and an accumulated deficit of $140.9 million.Our ability to continue operations is dependent upon our ability to obtainsubstantial additional capital to fund our research and development programsand bring any potential future products to market.

 

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There is no assurancethat we will be able to raise additional capital on terms acceptable to us orat all. If we fail to raise sufficient capital, we may be required to delay,reduce the scope of, or eliminate one or more of our research and developmentprograms, partner one or more of our product candidates at an earlier stage ofdevelopment than we might otherwise choose or conduct workforce or otherexpense reductions. Even assuming we successfully raise additional capital,there can be no assurance that we will achieve positive cash flow in theforeseeable future or at all. The accompanying condensed consolidated financialstatements do not include any adjustments to specific amounts orclassifications of assets and liabilities, which may be necessary should wereach a point that we are unable to continue with our operations. See Note 6for further discussion regarding a private placement of equity that we enteredinto on November 11, 2008.

 

***Useof Estimates***

 

The preparation of financial statements inconformity with U.S. generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsin the condensed consolidated financial statements and accompanying notes.Management bases its estimates on historical experience and on assumptionsbelieved to be reasonable under the circumstances. Actual results could differfrom those estimates.

 

***MarketableSecurities and the Adoption of SFAS 157***

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statements ofFinancial Accounting Standards No. 157, *FairValue Measurements* (“SFAS 157”). SFAS 157 defines fairvalue, establishes a framework for measuring fair value and expands fair valuemeasurement disclosure. In February 2008, the FASB issued FASB StaffPosition (“FSP”) 157-1,*Application of FASBStatement No. 157 to FASB Statement No. 13 and Other AccountingPronouncements That Address Fair Value Measurements for Purposes of LeaseClassification or Measurement under Statement 13* (“FSP 157-1”)*,*and FSP 157-2, *Effective Date of FASBStatement No. 157* (“FSP 157-2”). FSP 157-1 amends SFAS 157 toremove certain leasing transactions from its scope. FSP 157-2 delays theeffective date of SFAS 157 for all non-financial assets and non-financialliabilities, except for items that are recognized or disclosed at fair value inthe financial statements on a recurring basis (at least annually), until fiscalyear beginning after November 15, 2008. In October 2008, the FASBissued FSP 157-3, *Determining the Fair Value of a FinancialAsset When the Market for That Asset is Not Active*(“FSP 157-3”),that clarifies the application of SFAS 157 in a market that is not active andprovides an example to illustrate key considerations in determining the fairvalue of a financial asset when the market for that financial asset is notactive. FSP 157-3 is applicable to the valuation of auction rate securitiesheld by us for which there was no active market as of September 30, 2008.FSP 157-3 is effective upon issuance, including prior periods for which thefinancial statements have not been issued.

 

The measurement anddisclosure requirements of SFAS 157 related to financial assets and financialliabilities became effective for us beginning in the first quarter of 2008. Theadoption of SFAS 157 for financial assets and financial liabilities did nothave a significant impact on our consolidated financial statements. We arecurrently evaluating the impact that SFAS 157 may have on our consolidatedfinancial statements when it is applied to non-financial assets andnon-financial liabilities beginning in the first quarter of 2009. SFAS 157describes three levels of inputs that may be used to measure fair value, asfollows:

 

·                  Level 1 inputswhich include quoted prices in active markets for identical assets orliabilities;

 

·                  Level 2 inputswhich include observable inputs other than Level 1 inputs, such as quotedprices for similar assets or liabilities; quoted prices for identical orsimilar assets or liabilities in markets that are not active; or other inputsthat are observable or can be corroborated by observable market data forsubstantially the full term of the asset or liability; and

 

·                  Level 3 inputswhich include unobservable inputs that are supported by little or no marketactivity and that are significant to the fair value of the underlying asset orliability.  Level 3 assets andliabilities include those whose fair value measurements are determined usingpricing models, discounted cash flow methodologies or similar valuationtechniques, as well as significant management judgment or estimation.

 

The following tablesummarizes our available-for-sale securities portfolio as of September 30,2008, and provides a reconciliation of the beginning and ending balance of ourauction rate securities measured at fair value using significant otherobservable and unobservable inputs during the three months ended September 30,2008:

 

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| ** **                                                | ** ** | ** **          | ** ** | **Fair Value Measurements Using**                                                                | ** ** |
|-----------------------------------------------------------|------------|---------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| **Available-For-Sale Securities Portfolio**     | ** ** | **Fair Value** | ** ** | **Quoted Prices in********Active Markets for  Identical Assets********(Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** |
| ** **                                                | ** ** | ** **          | ** ** | **(in thousands)**                                                                                         | ** ** | ** ** | ** ** |
| Money  market funds                                       |       | $                   | 14,495     |                                                                                                            | $          | 14,495 |   | $ | — |   | $ | — |   |
| U.S.  government agencies debt                            |       | 8,996               |       | 8,996                                                                                                           |       | — |   | — |   |
| Commercial  paper                                         |       | 4,384               |       | —                                                                                                          |       | 4,384 |   | — |   |
| Corporate  debt securities                                |       | 1,544               |       | 1,544                                                                                                           |       | — |   | — |   |
| Auction  rate securities:                                 |       |                |       |                                                                                                            |       |   |   |   |   |
| Beginning  balance as of June 30, 2008               |       | 798                 |       | —                                                                                                          |       | — |   | 798 |   |
| Sales and  maturities                                     |       | (375                | )          | —                                                                                                          |       | — |   | (375 | ) |
| Unrealized  losses included in other comprehensive income |       | (4                  | )          | —                                                                                                          |       | — |   | (4 | ) |
| Ending  balance as of September 30, 2008             |       | 419                 |       | —                                                                                                          |       | — |   | 419 |   |
| Total  available-for-sale securities                      |       | $                   | 29,838     |                                                                                                            | $          | 25,035 |   | $ | 4,384 |   | $ | 419 |   |

 

As of September 30,2008, we held in our marketable securities portfolio one auction rate securitywith a par value of $500,000. Beginning in early 2008, market auctions forcertain of the auction rate securities held in our portfolio began to failcausing those securities to become temporarily illiquid. However, during thefirst nine months of 2008 we did experience liquidity in the market for auctionrate securities as all but one of our auction rate holdings were eitherredeemed by the original issuers or were sold at par value in the open market.Based on our recent experience with the liquidity of our own auction rateportfolio and our expectations regarding near-term market conditions, weconcluded that the impairment to the fair value of our auction rate holdings asof September 30, 2008, is not other-than-temporary in accordance withguidance provided by FSP FAS 115-1.

 

The recent failure ofcertain auctions on auction rate securities and the resultant lack of liquidityrequire that certain of these securities be measured using Level 3 inputs inaccordance with guidance provided by SFAS 157. The fair value of our remainingauction rate security, which is classified as a Level 3 instrument at September 30,2008, was determined using a discounted cash flow model that considers inputssuch as expected cash flows from the auction rate instrument including expectedinterest payments, market yields for similarly rated instruments, our estimatesof time to liquidity for the security, and marketability discounts. We reviseour estimates for each input as of each financial statement reporting periodbased upon known and expected market conditions as well as specific informationwe have regarding the instrument. We have determined that as of September 30,2008, the fair value of our remaining auction rate instrument was $419,000, netof an estimated $81,000 unrealized loss representing a 16.3% reduction in thecarrying value for this instrument. As of September 30, 2008, thereduction in carrying value is reflected in our condensed consolidated balancesheet as a component of other comprehensive loss and the fair value of ourremaining auction rate security is classified as a noncurrent asset as weexpect that it is more likely than not that the instrument will remain illiquidduring the next 12 months.

 

***ComprehensiveIncome (Loss)***

 

Comprehensive loss is comprised of net loss and othercomprehensive income/loss. The only component of our other comprehensiveincome/loss is the unrealized gains and losses on our marketable securities.Comprehensive income (loss) for the three months ended September 30, 2008and 2007 was $3.2 million and $(7.3) million, respectively, and forthe nine months ended September 30, 2008 and 2007 was $(18.3) million and$(19.5) million, respectively.

 

***NetIncome (Loss) Per Share***

 

Basic net income (loss)per share is computed by dividing net income (loss) by the weighted averagenumber of fully vested common shares outstanding during the period. Diluted netincome (loss) per share is computed by giving effect to all potential dilutivecommon shares, including outstanding stock options and warrants. For the threemonths ended September 30, 2008, our computation of diluted net income pershare reflects the application of the treasury stock method by assuming theexercise of options at the beginning of the period, that proceeds from exerciseare used to purchase common stock at the average market price during theperiod, and that the incremental shares are included in the denominator of thediluted net income per share calculation. For reporting periods other than thethree months ended September 30, 2008, our computation of diluted net lossper share excludes the effects of common stock equivalents because theinclusion would have been anti-dilutive due to our net loss position.

 

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The following tablepresents the calculation of historical basic and diluted net income (loss) pershare:

 
| ** **                                                                                 | ** **   | **Three Months Ended  September 30,**                  | ** **   | **Nine Months Ended  September 30,** | ** **   |
|--------------------------------------------------------------------------------------------|--------------|-----------------------------------------------------------------------|--------------|-----------------------------------------------------|--------------|
| ** **                                                                                 | ** **   | **2008**                                                              | ** **   | **2007**                                            | ** **   | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                                 | ** **   | **(In thousands, except per share amounts)** | ** **   |
| **Basic Net Income (Loss) Per Share:**                                                     | *** *** | *** ***                                                          | *** *** | *** ***                                        | *** *** | *** *** | *** *** | *** *** | *** *** |
| *Numerator:*                                                                               | * *     | * *                                                              | * *     | * *                                            | * *     | * * | * * | * * | * * |
| Net income (loss)                                                                          |         | $                                                                     | 3,231        |                                                | $            | (7,301 | ) | $ | (18,169 | ) | $ | (19,457 | ) |
| *Denominator:*                                                                             | * *     | * *                                                              | * *     | * *                                            | * *     | * * | * * | * * | * * |
| Weighted average common shares outstanding                                                 |         | 17,684                                                                |         | 1,193                                               |         | 17,670 |   | 1,126 |   |
| Less: Weighted average unvested restricted common shares                                   |         | (21                                                                   | )            | (35                                                 | )            | (25 | ) | (30 | ) |
| Weighted average common shares used in computing basic net income  (loss) per share        |         | 17,663                                                                |         | 1,158                                               |         | 17,645 |   | 1,096 |   |
| Basic net income (loss) per share                                                          |         | $                                                                     | 0.18         |                                                | $            | (6.30 | ) | $ | (1.03 | ) | $ | (17.75 | ) |
| **Diluted Net Income (Loss) Per Share:**                                                   | *** *** | *** ***                                                          | *** *** | *** ***                                        | *** *** | *** *** | *** *** | *** *** | *** *** |
| *Numerator:*                                                                               | * *     | * *                                                              | * *     | * *                                            | * *     | * * | * * | * * | * * |
| Net income (loss)                                                                          |         | $                                                                     | 3,231        |                                                | $            | (7,301 | ) | $ | (18,169 | ) | $ | (19,457 | ) |
| *Denominator:*                                                                             | * *     | * *                                                              | * *     | * *                                            | * *     | * * | * * | * * | * * |
| Weighted average common shares outstanding in computing basic net  income (loss) per share |         | 17,663                                                                |         | 1,158                                               |         | 17,645 |   | 1,096 |   |
| Plus: Incremental dilutive options and awards shares *                                     |         | 965                                                                   |         | —                                              |         | — |   | — |   |
| Weighted average common shares used in computing diluted net loss per  share               |         | 18,628                                                                |         | 1,158                                               |         | 17,645 |   | 1,096 |   |
| Diluted net income (loss) per share                                                        |         | $                                                                     | 0.17         |                                                | $            | (6.30 | ) | $ | (1.03 | ) | $ | (17.75 | ) |

 

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*                 Outstanding warrants are excluded from the diluted netincome per share computation as the exercise price of the warrants exceeds theaverage market price of our common stock for the period.

 

The following commonstock equivalent shares related to our convertible preferred stock, warrantsand stock options were excluded from the computation of diluted net income (loss)per share for the periods presented because including them would have had anantidilutive effect:

 
| ** **                                                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                                      | ** ** | **(In thousands)**                              | ** ** |
| Series A convertible preferred stock (as if converted)                                     |       | —                                               |       | 126                                                 |       | — |   | 126 |   |
| Series B convertible preferred stock (as if converted)                                     |       | —                                               |       | 105                                                 |       | — |   | 105 |   |
| Series C convertible preferred stock (as if converted)                                     |       | —                                               |       | 2,826                                               |       | — |   | 2,826 |   |
| Series D convertible preferred stock (as if converted)                                     |       | —                                               |       | 5,539                                               |       | — |   | 5,539 |   |
| Series E convertible preferred stock (as if converted)                                     |       | —                                               |       | 2,819                                               |       | — |   | 2,819 |   |
| Warrants to purchase Series C convertible preferred stock (as if  exercised and converted) |       | —                                               |       | 11                                                  |       | — |   | 11 |   |
| Warrants to purchase Series D convertible preferred stock (as if  exercised and converted) |       | —                                               |       | 101                                                 |       | — |   | 101 |   |
| Warrants to purchase common stock (as if exercised)                                             |       | 190                                                  |       | —                                              |       | 190 |   | — |   |
| Outstanding common stock options                                                                |       | 767                                                  |       | 1,700                                               |       | 2,369 |   | 1,700 |   |
|                                                                                            |       | 957                                                  |       | 13,227                                              |       | 2,559 |   | 13,227 |   |

 

***IncomeTaxes***

 

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 the enacted tax ratesand laws that will be in effect when the differences are expected to reverse.Based on known factors, our management cannot currently conclude that it willbe more likely than not that the deferred tax assets will be utilized.Accordingly, the deferred tax assets have been fully offset by a valuationallowance.

 

Aspermitted under the provisions of FIN 48, we will classify interest andpenalties related to unrecognized tax benefits as part of our income taxprovision, although there have been no such interest or penalties recognizedto-date.

 

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***RecentAccounting Pronouncements***

 

In May 2008, the FASB issued SFAS No. 162, *The Hierarchy of Generally Accepted AccountingPrinciples*(“SFAS 162”). SFAS 162 identifies the sources ofaccounting principles and the framework for selecting the principles to be usedin the preparation of financial statements of nongovernmental entities that arepresented in conformity with GAAP. SFAS 162 is effective 60 days followingthe Securities Exchange Commission’s approval of the Public Company AccountingOversight Board amendments to AU Section 411, *The Meaning of Present Fairly in Conformity with Generally AcceptedAccounting Principles.*We do not expect the adoption of SFAS 162 tohave a significant impact on our consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assetsand Financial Liabilities - Including an amendment of FASB Statement No. 115*(“SFAS 159”). SFAS 159 permits entities to make an irrevocable election tomeasure certain financial instruments and other assets and liabilities at fairvalue on an instrument-by-instrument basis. Unrealized gains and losses onitems for which the fair value option is elected will be recognized in netearnings at each subsequent reporting date. The adoption of SFAS 159 did nothave an impact on our consolidated financial statements in 2008 as we did notelect the fair value option.

 

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.  Revenue Recognition**

 

On June 30,2006, we entered into a collaboration agreement with Procter & GamblePharmaceuticals, Inc., or P&G, pursuant to which P&G would developand commercialize ATI-7505, our product candidate for the treatment ofgastrointestinal disorders such as chronic constipation, functional dyspepsia,gastroesophageal reflux disease, gastroparesis and irritable bowel syndromewith constipation. In connection with the collaboration agreement, P&G paidus a $25.0 million nonrefundable upfront license fee. On July 2,2008, we received notice from P&G that it elected to exercise its option toterminate the collaboration agreement between P&G and ARYx, effective July 2,2008. In connection with the termination of the collaboration agreement, theobligatory performance period effectively ended and pursuant to the terms ofthe collaboration agreement, we are under no obligation to return any portion ofthe $25.0 million upfront license fee to P&G. Accordingly, werecognized the remaining $17.5 million of deferred revenue in the threemonth period ended September 30, 2008. In addition, effective with P&G’s notice of termination, we nolonger provide development support services to P&G for the development ofATI-7505 and therefore those services will no longer be a source of revenue forus.

 

**3. ****Debt Financing**

 

In March 2005, weentered into a loan agreement with Lighthouse Capital Partners V, L.P. (“Lighthouse”)that was amended on October 19, 2007. The original agreement provided forup to $10.0 million in debt financing and was fully utilized in December 2005.The amended agreement provides for up to $9.0 million in additionalfinancing for a total of $19.0 million made available over the life of thefacility. We issued two warrants to Lighthouse in connection with the originalagreement and the amended agreement. As of September 30, 2008, thesewarrants are exercisable for an aggregate of 100,704 shares of our common stockat an exercise price of $9.93 per share and 83,332 shares of our common stockat an exercise price of $10.80.

 

In February 2008,we borrowed the additional $9.0 million available to us under the loanfacility pursuant to the terms of the amended loan agreement dated October 19,2007. The amended loan agreement provides for a seven-month interest-onlyperiod and a 36 month repayment term to begin on October 1, 2008. Therelated promissory note provides for monthly cash payments of principal andinterest at an interest rate equal to the higher of 7.75% or the prime rateplus 200 basis points per annum to be fixed as of October 1, 2008, and aballoon interest payment of $675,000 to be made in September 2011.The loan agreement allows for prepayment of principal with respect to thepromissory note whereupon the $675,000 balloon interest payment would beaccelerated and due at the time of prepayment of the loan balance and aprepayment penalty equal to 3% of the outstanding principal balance would beincurred.

 

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**4.  Warrants**

 

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

 

As of September 30, 2008, the followingwarrants were issued and outstanding:

 
| ** **              | ** ** | ** **          | ** ** | ** **                       | ** ** | ** **                        | ** ** | ** **              | ** ** | **Exercise**         | ** ** | **Expiration** | ** ** |
|-------------------------|------------|---------------------|------------|----------------------------------|------------|-----------------------------------|------------|-------------------------|------------|----------------------|------------|----------------|------------|
| **Warrant Holder** | ** ** | **Issue Date** | ** ** | **In Connection With** | ** ** | **Warrant to Purchase** | ** ** | **Shares**              | ** ** | **Price**            | ** ** | **Date**       | ** ** |
| ** **              | ** ** | ** **          | ** ** | ** **                       | ** ** | ** **                        | ** ** | **(in thousands)** | ** ** | **(per share)** | ** ** | ** **     | ** ** |
| ATEL(1)                 | ** ** | 12/23/2002          | ** ** | Leasing arrangement              | ** ** | Common stock                      | ** ** | 6                       | ** ** | $                    | 8.91       | ** **     | (1         | ) |
| Lighthouse-Warrant 1(2) | ** ** | 3/28/2005           | ** ** | Debt financing                   | ** ** | Common stock                      | ** ** | 101                     | ** ** | $                    | 9.93       | ** **     | (2         | ) |
| Lighthouse-Warrant 2(3) | ** ** | 10/19/2007          | ** ** | Debt financing                   | ** ** | Common stock                      | ** ** | 83                      | ** ** | $                    | 10.80      | ** **     | (3         | ) |
| ** **              | ** ** | ** **          | ** ** | ** **                       | ** ** | ** **                        | ** ** | 190                     | ** ** |                 | ** ** | ** **     | ** ** |

 

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(1)         Exercisable, in whole or in part, until November 13,2012.

(2)         Exercisable, in whole or in part, prior to or upon theclosing of an initial public offering, a merger, change in control, or sale ofsubstantially all of our assets; expires at the earlier of (i) November 7,2009 or (ii) the effective date of a merger, as defined in the agreement.

(3)         Exercisable, in whole or in part, at anytime at theoption of the holder or deemed to have been automatically exercised in fullimmediately prior to the expiration of the warrant; expires at the earlier of (i) theclose of business on October 19, 2014, or (ii) the effective date ofa merger, as defined in the agreement.

 

We follow guidance under SFAS 150, andEITF 96-18, to measure the fair value of these warrants on the date ofissuance using the Black-Scholes option valuation model with the followingassumptions: risk-free interest rate ranging from 3.27% to 4.10%, contractuallife according to the remaining terms of the arrangements, no dividend yieldand volatility of 73%. The fair value of the warrant issued to ATEL was fullyamortized as of December 31, 2005. The fair value of the first warrantissued to Lighthouse was recorded in three separate tranches as debt issuancecost with the first tranche amortized to interest expense over the fundingcommitment period ended December 31, 2005, and the remainder amortized tointerest expense over the duration of the interest-only period plus the term ofthe loan over 42 months. The fair value of the second warrant issued toLighthouse was recorded in two separate tranches as debt issuance cost with thefirst tranche amortized to interest expense over the funding commitment periodended March 1, 2008, and the remainder amortized to interest expense overthe duration of the interest-only period plus the term of the loan over36 months. Amortization of the fair value of the warrants was charged tointerest expense as follows:

 
| ** **                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                  | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                  | ** ** | **(In thousands)**                              | ** ** |
| Lighthouse – Warrant 1 |       | $                                                    | 23         |                                                | $          | 23 |   | $ | 70 |   | $ | 70 |   |
| Lighthouse – Warrant 2 |       | 16                                                   |       | —                                              |       | 184 |   | — |   |
|                        |       | $                                                    | 39         |                                                | $          | 23 |   | $ | 254 |   | $ | 70 |   |

 

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 the exerciseand the exercise price per share, divided by the fair value of convertiblepreferred stock on the date of the exercise. The number of shares issued uponexercise of the warrants, and the exercise price per share, are adjustable inthe event of stock splits, dividends and similar fundamental changes. Nowarrant was exercised during the three and nine month periods ended September 30,2008.  During the nine month period endedSeptember 30, 2007, Life Science Group, Inc. exercised their firstwarrant on a net exercise basis which resulted in the issuance of 1,055 sharesof our Series C convertible preferred stock prior to the conversion to anequal number of common shares.

 

Before conversion of the convertible preferred stockwarrants into common stock warrants, we followed guidance under SFAS 150and re-measured the fair value of these warrants on each subsequent balancesheet date until the date of conversion using the Black-Scholes optionvaluation model with the following assumptions: risk-free interest rate between3.78% and 4.96%, contractual life according to the remaining terms of thearrangements, no dividend yield and volatility of 73%. Accordingly, we recordedinterest and other income of $130,000 and $171,000 to reflect the decrease infair value of the then preferred stock warrant liability for the three and ninemonths ended September 30, 2007, respectively, before the conversion ofthe warrants.

 

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**5. ****Stock-Based Compensation**

 

Weaccount for employee stock-based compensation under SFAS No. 123(R), *Share-Based Payment* (“SFAS 123R”), whichrequires compensation expense related to stock-based payments made to employeesand directors, including employee stock options and employee stock purchases,to be measured based on grant date fair value and recognized as expense in thefinancial statements over the requisite service period. We estimate the fairvalue of our stock-based payments to employees and directors using theBlack-Scholes option valuation model. Option valuation models require the inputof highly subjective assumptions and these assumptions can vary over time. Dueto the fact that we are a newly public company, there is limited historicalinformation available to support our estimate of expected volatility requiredto value our stock-based payments. We, therefore, follow guidance discussed inSAB No. 107 basing our estimate of expected volatility on the expectedvolatility of a group of similar entities whose stock prices are publiclyavailable. We will continue to consistently apply this approach using similarentities until a sufficient amount of historical information regarding thevolatility of our own stock price becomes available. The fair value of ourstock options and awards was estimated at the date of grant using the followingassumptions:

 
| ** **                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Expected volatility                              |       | 73                                                   | %          | 73                                                  | %          | 73 | % | 73 | % |
| Weighted-average expected term (in years)        |       | 5.89                                                 |       | 4.06                                                |       | 5.77 |   | 4.10 |   |
| Weighted-average risk-free interest rate         |       | 3.0                                                  | %          | 4.8                                                 | %          | 3.0 | % | 4.6 | % |
| Expected dividends                               |       | —                                               |       | —                                              |       | — |   | — |   |
| Weighted-average grant date fair value per share |       | $                                                    | 3.87       |                                                | $          | 3.45 |   | $ | 4.76 |   | $ | 1.93 |   |
|                                                  |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |

 

SFAS 123Rrequires forfeitures to be estimated at the time of grant and revised, ifnecessary, in subsequent periods if actual forfeitures differ from estimates.Forfeitures are estimated based on our historical experience and separategroups of employees that have similar historical forfeiture behavior areseparately considered for expense recognition.

 

In July 2007,our Board of Directors adopted the 2007 Employee Stock Purchase Plan (“ESPP”),which was approved by stockholders in August 2007. Under the ESPP,statutory employees may purchase our common stock up to a specified maximumamount through payroll deductions. We began to offer our common stock forpurchase under the ESPP in August 2008 when the first offering period ofnine months commenced on August 15, 2008. Thereafter, each subsequent offering period will be for six monthscommencing May 15th and November 15th each yearbeginning in 2009. Under the plan, our common stock will be purchased at aprice equal to the lesser of 85% of the fair market value on the first or lastdate of each offering period. At September 30, 2008, we had322,369 shares of our common stock reserved for issuance under the ESPP.The fair value of stock-based payments under the ESPP was estimated on the dateof grant using the following assumptions: risk-free interest rate of 2.09%, contractual life equal to the term ofthe offering of nine months for the first offering period, no dividend yieldand volatility of 73%.

 

Total compensation costthat has been recorded in the statement of operations, which includesstock-based compensation expense under SFAS 123R for employee stockoptions and stock purchases and the value of options issued to non-employeesfor services rendered, are allocated as follows:

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                           | ** ** | **(In thousands)**                              | ** ** |
| Research and development:            |       |                                                 |       |                                                |       |   |   |   |   |
| Officer compensation                 |       | $                                                    | 80         |                                                | $          | 23 |   | $ | 240 |   | $ | 89 |   |
| Employee and consultant compensation |       | 169                                                  |       | 92                                                  |       | 501 |   | 232 |   |
| Selling, general and administrative: |       |                                                 |       |                                                |       |   |   |   |   |
| Director and officer compensation    |       | 264                                                  |       | 89                                                  |       | 819 |   | 334 |   |
| Employee and consultant compensation |       | 43                                                   |       | 17                                                  |       | 133 |   | 45 |   |
| Total compensation expense           |       | $                                                    | 556        |                                                | $          | 221 |   | $ | 1,693 |   | $ | 700 |   |

 

As of September 30,2008, total compensation cost related to unvested stock options not yetrecognized was $2.4 million, which is expected to be allocated to expenseover a weighted-average period of 1.35 years. As a result of stock option exercises,we issued 5,713 shares and 89,651 shares of common stock during the threemonths ended September 30, 2008 and 2007, respectively, and 33,056 sharesand 111,422 shares of common stock during the nine months ended September 30,2008 and 2007, respectively.

 

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**6. ****Subsequent Events**

 

***DebtRestructure***

 

On October 17,2008, we entered into an amendment to our loan agreement with Lighthouse dated March 28,2005, as amended. The loan amendment provides for an interest-only monthlyrepayment period with respect to our outstanding loan obligation of$12.2 million with Lighthouse through June 30, 2009 at a statedinterest rate of 9.75% per annum. Thereafter, we are obligated to repay $3.2million of the total loan obligation over a 12-month period commencing from July 1,2009 on an amortized basis, consisting of monthly principal and interestpayments, at a stated interest rate of 9.75% per annum through June 30,2010, with a balloon interest payment of $1.2 million payable in June 2010.The remaining $9.0 million loan obligation is required to be repaid over 36months commencing from July 1, 2009 on an amortized basis, consisting ofmonthly principal and interest payments, at a stated interest rate of 12.25%per annum through June 30, 2012, with a balloon interest payment of$675,000 payable in June 2012. Any mandatory or voluntary prepayment ofthe $9.0 million portion of the outstanding loan obligation will trigger aprepayment penalty equal to 3% of the outstanding principal balance that isprepaid. The other material terms of our loan agreement with Lighthouse werenot impacted by the loan amendment.

 

Inconnection with the loan amendment, we agreed to pay Lighthouse a restructurefee of $200,000 which is payable upon the earlier of a prepayment or maturityof the $3.2 million portion of our total outstanding loan obligation.  We also issued Lighthouse a warrant to purchaseup to 158,770 shares of our common stock. The warrant is exercisableimmediately, has a five-year term and an exercise price of $3.97516 per share.

 

***EquityFinancing***

 

On November 11, 2008, we entered into a securitiespurchase agreement with certain institutional and other accredited investorspursuant to which we agreed to sell and issue, in a private placement, anaggregate of 9,649,545 shares of our common stock, par value $0.001 per share,and warrants to purchase an aggregate of 2,894,864 shares of our common stock.Under the terms of the securities purchase agreement, the price for each shareof common stock being purchased is $2.20. The total number of shares of commonstock underlying each purchaser’s warrant will be equal to 30% of the total numberof shares purchased by such purchaser in the private placement and will have apurchase price per underlying share of common stock of $0.125. The combinedpurchase price of each share of common stock and each warrant to purchase 0.30of a share of common stock to be issued in the private placement is $2.2375.The warrants will be exercisable for a term of five years from the closing dateof the private placement and have an exercise price of $2.64 per share. Uponthe closing of the private placement, we will receive gross proceeds ofapproximately $21.6 million. The net proceeds, after deducting the placementagent fees and other expenses of approximately $1.1 million, are expected to beapproximately $20.5 million. The closing of the private placement is expectedto occur on or about November 13, 2008, subject to the closing conditions andthe other terms set forth in the securities purchase agreement.

 

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

 

*The following discussion of our financial condition and theresults of operations should be read in conjunction with the condensedconsolidated financial statements and notes to condensed consolidated  financial statements included elsewhere inthis quarterly report on Form 10-Q. This discussion contains forwardlooking statements that involve risks and uncertainties. When reviewing thediscussion below, you should keep in mind the substantial risks anduncertainties that characterize our business. In particular, we encourage youto review the risks and uncertainties described in Part II - Item 1A.“RISK FACTORS” elsewhere in this report. These risks and uncertainties couldcause actual results to differ materially from those projected inforward-looking statements contained in this report or implied by past resultsand trends. Forward-looking statements are statements that attempt to forecastor anticipate future developments in our business; we encourage you to reviewthe examples of our forward-looking statements under the heading “CautionaryNote Regarding Forward-Looking Statements” that appears at the end of thisdiscussion. These statements, like all statements in this report, speak only asof their date (unless another date is indicated), and we undertake noobligation to update or revise these statements in light of futuredevelopments.*

 

**Overview**

 

ARYxTherapeutics, Inc. is a biopharmaceutical company focused on developing aportfolio of internally discovered product candidates designed to eliminateknown safety issues associated with well-established, commercially successfuldrugs. We were incorporated in the State of California on February 28,1997 and reincorporated in the State of Delaware on August 29, 2007. Wemaintain a wholly-owned subsidiary, ARYx Therapeutics Limited, with registeredoffices in the United Kingdom, which has had no operations since its inceptionin September 2004 and was established to serve as a legal entity insupport of our clinical trial activities conducted in Europe.

 

We useour RetroMetabolic Drug Design technology to design structurally uniquemolecules that retain the efficacy of these original drugs but are metabolizedthrough a potentially safer pathway to avoid specific adverse side effectsassociated with these compounds. We have established proof of concept with ourthree leading product candidates, ATI-5923, ATI-2042, and ATI-7505. Thefollowing is a summary of our product candidates that are currently in clinicaldevelopment:

 

***ATI-5923***

 

ATI-5923is an oral anticoagulant in Phase 2/3 clinical trials for the treatment ofpatients who are at risk for the formation of dangerous blood clots, such asthose with atrial fibrillation or those at risk of venous thromboembolism.ATI-5923 was designed to have the same therapeutic benefits as the drugwarfarin, which for over 50 years has been the treatment of choice as anoral anticoagulant. Despite its widespread use, warfarin has severalsignificant limitations. It is metabolized by CYP450 and has many drug-druginteractions that often lead to serious side effects. We designed ATI-5923 to bemetabolized through the esterase pathway, eliminating metabolism through CYP450and avoiding drug-drug interactions. Warfarin also has a very steep doseresponse curve which means that a small change in dose may lead to asubstantial change in the anticoagulation status of the patient. This can putpatients at risk for either life-threatening clotting or bleeding. Inpreclinical testing, it appears that ATI-5923 may have a more predictable rateof anticoagulation than warfarin, although confirmation of this observationwill require substantial additional clinical data. The rate of anticoagulationfor both warfarin and ATI-5923 is measured by INR, or International NormalizedRatio. We completed a Phase 2 clinical trial with ATI-5923 involving 66patients. In this study, ATI-5923 achieved a significant improvement in themaintenance of these patients at the targeted INR and also demonstrated asignificant reduction in the occurrence of dangerously low levels ofanticoagulation compared to these patients’ historical levels ofanticoagulation when on warfarin. We have also completed a pilot study of 50patients to prepare for an ongoing large Phase 2/3 trial. In the pilot trial,we successfully established the trial methodologies for the current blindedPhase 2/3 trial, and, even though the primary purpose of the pilot trial wasnot to measure the effectiveness of ATI-5923 in achieving the patient’s targetINR, the efficacy results essentially matched those of the earlier 66 patientstudy. In June 2008, we initiated a double-blinded, placebo-controlledPhase 2/3 clinical trial involving approximately 600 patients to study theefficacy of ATI-5923 in a head-to-head comparison to warfarin. We announced, onNovember 3, 2008, that enrollment in this Phase 2/3 study has beencompleted. Inpreliminary discussions, the U.S. Food and Drug Administration, or FDA,indicated that the ability to maintain patients within the targeted INR willlikely be an acceptable surrogate and primary endpoint for ATI-5923’s clinicaldevelopment. Using INR as a surrogate and primary endpoint should reduce boththe size of and time to complete our planned clinical trials for ATI-5923compared to clinical trials based on survival rates or other outcomes. Basedupon other discussions with the FDA, we believe the current Phase 2/3 trialwill qualify as a part of the patient population needed to seek commercialapproval.

 

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***ATI-2042***

 

ATI-2042is an oral anti-arrhythmic agent in Phase 2 clinical development for thetreatment of patients with atrial fibrillation. ATI-2042 was designed to havethe efficacy of amiodarone, a drug that has been used for many years, despiteits adverse side effects, because physicians consider it to be the mosteffective drug for treating patients with atrial fibrillation. Amiodaroneaccumulates in many different organs and can only be metabolized by CYP450,potentially leading to serious side effects that are not immediately reversibleupon withdrawal of the drug. Since ATI-2042 is predominantly metabolizedthrough the esterase pathway, accumulation in the organs and drug-druginteractions are expected to be reduced. We have completed a Phase 2clinical trial with ATI-2042 involving six atrial fibrillation patients withimplanted recordable pacemakers who failed previous drug therapy. ATI-2042quickly reduced the amount of time these patients were in atrial fibrillationby up to 87%. We are conducting an additional Phase 2 clinical trial tofurther demonstrate the efficacy of ATI-2042 in patients with atrialfibrillation. Enrollment in this trial is complete and we currently expect tohave top-line efficacy results by the end of 2008.

 

***ATI-9242***

 

ATI-9242 is a novel antipsychotic agent inPhase 1 clinical development for the treatment of schizophrenia and otherpsychiatric disorders. ATI-9242’s receptor profile is targeted at the treatmentof both the positive and the negative symptoms of schizophrenia as well as theimprovement of cognitive function. To date, preclinical work has supported thisprofile. ATI-9242 is also designed to avoid certain drug-drug interactions byavoiding CYP450 enzymes for metabolism, as well as reduce certain metabolicproblems associated with this class of therapy, including weight gain and type2 diabetes. We received clearance from the FDA to initiate a Phase 1 clinicaltrial for ATI-9242 in April 2008, which is designed to test ATI-9242’ssafety and tolerability. We currently expect to complete this clinical trial bythe end of 2008.

 

***ATI-7505***

 

ATI-7505is an oral prokinetic drug or an agent that speeds up the motion of contentsthrough the gut, which has successfully completed Phase 2 clinical trialsfor the treatment of multiple gastrointestinal disorders includinggastroesophageal reflux disease, or GERD, functional dyspepsia and chronicidiopathic constipation. ATI-7505 was designed to have the same therapeuticbenefits as cisapride, a drug marketed by Johnson & Johnson asPropulsid in the United States. Launched in 1993, cisapride was withdrawn fromthe market in 2000 due to serious cardiovascular side effects. These sideeffects occurred as blood levels of the drug rose significantly when CYP450clearance was blocked because of the presence of other drugs cleared by thesame metabolic pathway. We designed ATI-7505 to be metabolized through theesterase pathway, eliminating metabolism through CYP450 as well as off-targetcardiovascular effects. We have treated more than 900 subjects with ATI-7505 aspart of our clinical trial program, including four Phase 2 trials. In June 2006,we entered into a collaboration agreement with Procter & GamblePharmaceuticals, Inc., or P&G, to develop and commercialize ATI-7505.On July 2, 2008, we received notice from P&G that it elected toexercise its option to terminate the collaboration agreement between P&Gand ARYx, effective July 2, 2008. Upon termination of the agreement byP&G, all rights to ATI-7505 reverted to ARYx.  Also on July 2, 2008, we announced theoverall successful results of a so-called Thorough QT study (TQT) on ATI-7505,which we believe support the favorable cardiac safety profile of the agent. We arefinalizing our submission of the results of the TQT study to the FDA and willseek a new collaboration partner for ATI-7505 as our resources allow. On August 22,2008, we announced the results of a Phase 2b clinical trial testing the safetyand efficacy of ATI-7505 in patients with chronic idiopathic constipation. Theclinical trial, conducted by P&G, was designed to enroll 400 patientsevaluating four doses of the agent compared to placebo. As a result of thetermination of the collaboration between ARYx and P&G, the study wasterminated early after only 214 patients had been enrolled.  In spite of the early termination of the study,ATI-7505 achieved statistical significance at the study’s primary endpoint inthe 80 mg twice daily dose. In addition, all doses tested demonstrated aclinically meaningful increase in spontaneous bowel movements over baselinecompared to placebo after one week of treatment.

 

Sinceour inception, we have incurred significant net losses, and we expect tocontinue to incur net losses for the next several years as we develop, acquireor in-license additional products or product candidates, conduct clinicaltrials, manufacture materials for use in nonclinical studies and clinicaltrials, expand our research and development activities, seek regulatoryapprovals and engage in commercialization preparation activities. It is veryexpensive to gain approval of and launch a pharmaceutical product, and manyexpenses are incurred before revenue is received. We are unable to predict theextent of any future losses or when we will become profitable, if at all.

 

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***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. Upon terminationof the collaboration agreement on July 2, 2008, the performance andservice period effectively ended and pursuant to the terms of the collaborationagreement, we are under no obligation to return any portion of the upfrontlicense fee to P&G. As a result, we have recognized all $25.0 millionof the nonrefundable upfront license fee as of September 30, 2008.

 

Inaddition, we have recognized a cumulative total of $2.6 million as of September 30,2008 as collaboration service revenue in connection with product formulationand manufacturing, patent filing and maintenance, and other developmentservices related to the ATI-7505 program since the beginning of ourcollaboration with P&G. Effective with P&G’s notice of termination on July 2,2008, we no longer provide these support services to P&G for thedevelopment of ATI-7505 and therefore those services will no longer be a sourceof revenue for us.

 

Revenuegenerated from the P&G agreement was our only source of revenue. While weintend to seek partners for each of the four product candidates in ourportfolio, there is no assurance that partnering arrangements will be availableto us or on terms acceptable to us. See Part II – Item 1A.Risk Factors ofthis report for further discussion.

 

***Cost of Collaboration Service Revenue***

 

Weincurred costs for certain services provided to P&G, including costs forpharmaceutical development, patent filing and maintenance and other activitiesrelated to the ATI-7505 program, which are related to the service revenue wegenerated in connection with our collaboration agreement with P&G. Theseexpenses are reported separately in our income statement as cost ofcollaboration service revenue. As of September 30, 2008, we have recordeda cumulative total of $2.6 million of expense related to these activitiessince the commencement of our collaboration arrangement with P&G in June 2006.

 

***Research and Development***

 

Ourresearch and development expense consists of expenses incurred in identifying,testing and developing our product candidates. These expenses consist primarilyof fees paid to contract research organizations and other third parties toassist us in managing, monitoring and analyzing our clinical trials, clinicaltrial costs paid to sites and investigators’ fees, costs of nonclinical studiesincluding toxicity studies in animals, costs of contract manufacturingservices, costs of materials used in clinical trials and nonclinical studies,laboratory related expenses, research and development support costs includingcertain regulatory, quality assurance, project management and administration,allocated expenses such as facilities and information technology that are usedto support our research and development activities and related personnel expenses,including stock-based compensation. Research and development costs are expensedas incurred.

 

Clinicaltrial costs are a significant component of our research and developmentexpense. Currently, we conduct our clinical trials primarily through coordinationwith contract research organizations and other third-party service providers.We recognize 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.

 

Thefollowing table summarizes our research and development expense for the threeand nine months ended September 30, 2008 and 2007:

 
| ** **                                                                           | ** ** | **Three Months Ended  September  30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2008**                                                   | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                           | ** ** | **(In thousands)**                                    | ** ** |
| Direct research and development expense by program:                                  |       |                                                       |       |                                                |       |   |   |   |   |
| ATI-5923                                                                             |       | $                                                          | 6,573      |                                                | $          | 2,179 |   | $ | 12,654 |   | $ | 3,674 |   |
| ATI-2042                                                                             |       | 1,592                                                      |       | 451                                                 |       | 4,930 |   | 2,550 |   |
| ATI-9242                                                                             |       | 80                                                         |       | 670                                                 |       | 1,172 |   | 1,621 |   |
| ATI-7505                                                                             |       | 93                                                         |       | 109                                                 |       | 226 |   | 136 |   |
| Other research programs                                                              |       | 148                                                        |       | 156                                                 |       | 796 |   | 403 |   |
| Total direct research and development program expense                                |       | 8,486                                                      |       | 3,565                                               |       | 19,778 |   | 8,384 |   |
| Personnel, administrative and other expense                                          |       | 3,271                                                      |       | 3,072                                               |       | 9,664 |   | 9,399 |   |
| Less: Research and development portion of the cost of collaboration  service revenue |       | —                                                     |       | (51                                                 | )          | (39 | ) | (181 | ) |
| Total research and development expense                                               |       | $                                                          | 11,757     |                                                | $          | 6,586 |   | $ | 29,403 |   | $ | 17,602 |   |

 

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Fromour inception through September 30, 2008, we incurred total research anddevelopment expense of approximately $131.8 million. During the period from ourinception through September 30, 2008, we estimate that approximately$27.4 million was directly incurred for our ATI-5923 program,approximately $22.5 million was directly incurred for our ATI-2042program, approximately $4.9 million was directly incurred for our ATI-9242program, approximately $22.4 million was directly incurred for ourATI-7505 program, and approximately $54.6 million was incurred (includinginternal and external activities) for our other research and developmentprogram expense, personnel, administrative and other expense.

 

 Wedesignate development programs to which we have allocated significant researchand development 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 expense” in the above table.The portion of our research and development expense that is identified as costof collaboration service revenue is included within a separate category ofexpense in our condensed consolidated financial statements and is subtractedfrom total expenses in the above table to derive total research and developmentexpense as reported in our condensed consolidated financial statements.

 

Atthis time, due to the risks inherent in the clinical trial process and giventhe various stages of development of our product candidates, we are unable toestimate with any certainty the costs we will incur in the continueddevelopment of our product candidates. Clinical development timelines, theprobability of success and development costs can differ materially fromexpectations. While we are currently focused on advancing each of our productdevelopment programs, our future research and development expense will dependon the clinical success of each product candidate, as well as ongoingassessments as to each product candidate’s commercial potential. In addition,we cannot forecast with any degree of certainty which product candidates willbe subject to future collaborations, when such arrangements will be secured, ifat all, and to what degree such arrangements would affect our development plansand capital requirements.

 

Theprocess of developing and obtaining FDA approval of products is costly and timeconsuming. Development activities and clinical trials can take years tocomplete, and failure can occur at any time during the development and clinicaltrial process. 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 wefail to complete the development of any of our product candidates in a timelymanner, it could have a material effect on our operations, financial positionand liquidity. 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**

 

The discussion of ourfinancial condition and results of operations is based upon our condensedconsolidated financial statements, which have been prepared in accordance withU.S. generally accepted accounting principles. The preparation of thesefinancial statements requires us to make estimates, judgments and assumptionsthat affect the reported amount of assets, liabilities, revenues and expenses.On an ongoing basis, we evaluate our estimates. These estimates, assumptionsand judgments about future events and their effects on our results cannot bedetermined with certainty, and are made based upon our historical experienceand on other assumptions that are believed to be reasonable under thecircumstances. Different estimates that we could have used, or changes in theestimates that are reasonably likely to occur, may have a material impact onour financial condition or results of operations. Management has discussed thedevelopment, selection and disclosure of these estimates with the auditcommittee of our board of directors. Our actual results may differ from theseestimates under different assumptions or conditions.

 

Our critical accountingpolicies are more fully described in Note 1 of the audited consolidatedfinancial statements for the year ended December 31, 2007, which areincluded in our Annual Report on Form 10-K filed with the Securities andExchange Commission on March 17, 2008. There have been no material changesin our critical accounting policies and significant estimates during the threeand nine months ended September 30, 2008 except for the fair valueestimates on our auction rate securities as discussed below.

 

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***FairValue Estimates of Auction Rate Securities***

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statements ofFinancial Accounting Standards No. 157, *FairValue Measurements* (“SFAS 157”). SFAS 157 defines fairvalue, establishes a framework for measuring fair value and expands fair valuemeasurement disclosure. The measurement and disclosure requirements related tofinancial assets and financial liabilities became effective for us beginning inthe first quarter of 2008. Accordingly, we began to measure the fair value offinancial assets in our available-for-sale securities portfolio beginning inthe first quarter of 2008 and began to value our auction rate securities usingsignificant other observable and unobservable inputs.

 

In early 2008, marketauctions for certain of the auction rate securities held in our portfolio beganto fail causing those securities to become temporarily illiquid. We believethat the failed auctions are the result of temporary credit market conditions.During the first nine months of 2008, we experienced liquidity in the auctionrate market as all but one of our auction rate holdings were either redeemed bythe original issuers or were sold at par value in the open market. Based on ourrecent experience with the liquidity of our own auction rate portfolio and ourexpectations regarding near-term market conditions, we concluded that theimpairment to the fair value of our auction rate holdings as of September 30,2008, is not other-than-temporary in accordance with guidance provided by FSPFAS 115-1.

 

The fair value of ourremaining auction rate security, which is classified as a Level 3 instrument atSeptember 30, 2008, was determined using a discounted cash flow model thatconsiders inputs such as expected cash flows from the auction rate instrumentincluding expected interest payments, market yields for similarly ratedinstruments, our estimates of time to liquidity for the security, andmarketability discounts. We revise our estimates for each input as of eachfinancial statement reporting period based upon known and expected marketconditions as well as specific information we have regarding the instrument. Wehave determined that as of September 30, 2008, the fair value of ourremaining auction rate instrument was $419,000, net of an estimated $81,000unrealized loss representing a 16.3% reduction in the carrying value for theinstrument and have classified this instrument as a noncurrent asset as webelieve that it is more likely than not that it will remain illiquid during thenext twelve months. The remaining auction rate security in our portfolio resetsevery 28 days with a recent interest payment reset rate of 2.90% and finalmaturity in 2045. As of September 30, 2008, our auction rate instrumentwas current with respect to its interest payment obligations. The estimates andassumptions used in determining the fair values of our auction rate securitiesare made based upon our recent experiences in the market and other assumptionsthat are believed to be reasonable under current market conditions. Differentestimates that we could have used, or changes in the estimates that arereasonably likely to occur, may have a material impact on our financialcondition or results of operations.

 

**Resultsof Operations**

 

***Comparison of Three and Nine months ended September 30,2008 and 2007***

 

***Revenue***

 
| ** **                    | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|------------|------------|------------------------|------------|---------------------------------|------------|------------|------------|------------|------------|
| ** **                    | ** ** | **September 30,**                      | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**                      | ** ** |
| ** **                    | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**                  | ** ** | **%**                           | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                    | ** ** | **(In thousands, except %)** | ** ** |
| Collaboration service revenue |       | $                                           | —     |       | $          | 66                     |       | $                               | (66        | )          | (100       | )%         | $          | 232 |   | $ | 252 |   | $ | (20 | ) | (8 | )% |
| Technology license fees       |       | 17,544                                      |       | 974        |       | 16,570                 |       | 1701                            | %          | 19,492     |       | 2,922      |       | 16,570 |   | 567 | % |
| Total revenue                 |       | $                                           | 17,544     |       | $          | 1,040                  |       | $                               | 16,504     |       | 1587       | %          | $          | 19,724 |   | $ | 3,174 |   | $ | 16,550 |   | 521 | % |

 

Revenuefor the three months ended September 30, 2008, as compared to the sameperiod in 2007, increased by $16.5 million. Revenue for thenine months ended September 30, 2008, as compared to the same period in2007, increased by $16.6 million. Theincrease to the three and nine month periods was primarily due to therecognition of the remaining unrecognized nonrefundable upfront license feereceived from P&G as a result of their termination of the collaborationagreement.

 

***Cost of Collaboration ServiceRevenue***

 
| ** **                            | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|------------|------------|------------------------|------------|---------------------------------|------------|------------|------------|------------|------------|
| ** **                            | ** ** | **September 30,**                      | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**                      | ** ** |
| ** **                            | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**                  | ** ** | **%**                           | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                            | ** ** | **(In thousands, except %)** | ** ** |
| Cost of collaboration service revenue |       | $                                           | —     |       | $          | 66                     |       | $                               | (66        | )          | (100       | )%         | $          | 232 |   | $ | 252 |   | $ | (20 | ) | (8 | )% |
|                                       |            |                                             |            |            |            |                        |            |                                 |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

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Costof revenue was associated with certain services provided to P&G inconnection with the collaboration agreement. The decrease in cost of revenuefor both the three and nine months ended September 30, 2008, as comparedto the same periods in 2007, was directly associated with the termination ofthe collaboration agreement by P&G.

 

***Research and Development Expense***

 
| ** **                       | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|------------|------------|------------------------|------------|---------------------------------|------------|------------|------------|------------|------------|
| ** **                       | ** ** | **September 30,**                      | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**                      | ** ** |
| ** **                       | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**                  | ** ** | **%**                           | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                       | ** ** | **(In thousands, except %)** | ** ** |
| Research and development expense |       | $                                           | 11,757     |       | $          | 6,586                  |       | $                               | 5,171      |       | 79         | %          | $          | 29,403 |   | $ | 17,602 |   | $ | 11,801 |   | 67 | % |
|                                  |            |                                             |            |            |            |                        |            |                                 |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

Forthe three months ended September 30, 2008, as compared to the same periodin 2007, our research and development expense increased by $5.2 million,or 79%. The increase was primarily due to:

 

·                  a $5.0 million increase in clinicaltrial expenditures related to the double-blinded,placebo-controlled ATI-5923 Phase 2/3 clinical trial involving approximately600 patients and a $600,000 increase in related pharmaceutical manufacturing costs in support of thistrial, partially offset by a net $900,000 decrease in clinical trialexpenditures related to the completion of other studies on ATI-5923;

 

·                  a $1.1 million increase inexpenditures related to the completion of patient enrollment in ourongoing ATI-2042 Phase 2 clinical study and other ATI-2042 non-clinical studies;

 

·                  partially offset by a $600,000 reductionin external pharmaceutical manufacturing costs and non-clinical studies relatedto our ATI-9242 program.

 

Forthe nine months ended September 30, 2008, as compared to the same periodin 2007, our research and development expense increased by $11.8 million,or 67%. The increase was primarily due to:

 

·                  a $7.5 million increase in clinicaltrial expenditures related to the Phase 2/3 clinicalstudy of ATI-5923 and an increase of $2.4 million in pharmaceutical manufacturing costs insupport of this trial;

 

·                  a $1.4 million increase in clinicaltrial expenditures related to an ATI-5923 pilot efficacy study and approximately$500,000 in ATI-5923 non-clinical study expenditures, offset by anaggregate $2.8 million reduction in expenditures due to the completion ofa proof-of-concept study and other studies on ATI-5923 in 2007;

 

·                  a $1.4 million increase inexpenditures related to our ongoing ATI-2042 Phase 2 clinical study anda $1.2 millionincrease in ATI-2042 non-clinical expenditures; and

 

·                  a $400,000 increase in spending on ourother research programs.

 

***Selling, General andAdministrative Expense***

 
| ** **                                  | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|------------|------------|------------------------|------------|---------------------------------|------------|------------|------------|------------|------------|
| ** **                                  | ** ** | **September 30,**                      | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**                      | ** ** |
| ** **                                  | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**                  | ** ** | **%**                           | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                  | ** ** | **(In thousands, except %)** | ** ** |
| Selling, general and administrative expense |       | $                                           | 2,405      |       | $          | 1,902                  |       | $                               | 503        |       | 26         | %          | $          | 8,001 |   | $ | 5,526 |   | $ | 2,475 |   | 45 | % |
|                                             |            |                                             |            |            |            |                        |            |                                 |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

Thehigher selling, general and administrative expense for the three and ninemonths ended September 30, 2008 as compared to the same periods in 2007was primarily due to increases in personnel and personnel related costs,including stock-based compensation expense, legal and professional services,insurance and other administrative costs, much of which was attributable to ourtransition as a public company. Non-cash stock-based compensation expense includedin selling, general and administrative expense was $376,000 for the threemonths ended September 30, 2008, representing an increase of $270,000 ascompared to the same period in 2007, and $1.0 million for the nine monthsended September 30, 2008, representing an increase of $642,000 as comparedto the same period in 2007.

 

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***Interest and Other Income, Net***

 
| ** **                     | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------|------------|---------------------------------------------|------------|------------|------------|------------------------|------------|---------------------------------|------------|------------|------------|------------|------------|
| ** **                     | ** ** | **September 30,**                      | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**                      | ** ** |
| ** **                     | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**                  | ** ** | **%**                           | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                     | ** ** | **(In thousands, except %)** | ** ** |
| Interest and other income, net |       | $                                           | 292        |       | $          | 505                    |       | $                               | (213       | )          | (42        | )%         | $          | 1,149 |   | $ | 1,684 |   | $ | (535 | ) | (32 | )% |
|                                |            |                                             |            |            |            |                        |            |                                 |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

Interest and otherincome, net of other expenses, consists of interest income from our investmentsin marketable securities and benefits related to the reassessment of the fairvalue of our preferred stock warrant liability prior to the conversion of ourpreferred stock warrants into common stock warrants in 2007. Lower interestincome for the three and nine months ended September 30, 2008 as comparedto the same periods in 2007 was primarily attributable to lower prevailing short-term interestrates and a change in mix of investments held within our investment portfolio.

 

***Interest Expense***

 
| ** **       | ** ** | **Three Months Ended**            | ** ** | ** ** | ** ** | ** **             | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------|------------|---------------------------------------------|------------|------------|------------|------------------------|------------|---------------------------------|------------|------------|------------|------------|------------|
| ** **       | ** ** | **September 30,**                      | ** ** | **Change** | ** ** | **September 30,** | ** ** | **Change**                      | ** ** |
| ** **       | ** ** | **2008**                                    | ** ** | **2007**   | ** ** | **$**                  | ** ** | **%**                           | ** ** | **2008**   | ** ** | **2007**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(In thousands, except %)** | ** ** |
| Interest expense |       | $                                           | 474        |       | $          | 292                    |       | $                               | 182        |       | 62         | %          | $          | 1,437 |   | $ | 935 |   | $ | 502 |   | 54 | % |
|                  |            |                                             |            |            |            |                        |            |                                 |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

The increase in interestexpense for three and nine months ended September 30, 2008 as compared tothe same periods in 2007 was primarily due to additional interest expense relatedto the amortization of warrants and debt servicing costs related to theutilization of the additional $9.0 million loan facility extended to us by LighthouseCapital Partners.

 

**Liquidityand Capital Resources**

 
| ** **                  | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **September 30,**          | ** ** |
| ** **                  | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| ** **                  | ** ** | **(In thousands)**         | ** ** |
| Cash (used in) provided by: |       |                            |       |   |   |
| Operating activities        |       | (34,574                         | )          | (19,608 | ) |
| Investing activities        |       | (6,890                          | )          | 20,395 |   |
| Financing activities        |       | 6,799                           |       | (2,741 | ) |
| Total cash (used) provided  |       | (34,665                         | )          | (1,954 | ) |

 

In November 2007,we completed our initial public offering of common stock and received aggregatenet proceeds of approximately $43.8 million. Prior to our initial publicoffering, we financed our operations primarily through the private placement ofequity securities, receiving aggregate net proceeds from such sales totaling$110.7 million. In August 2006, we received a $25.0 millionnonrefundable upfront license fee in connection with our collaborationagreement with P&G. As of September 30, 2008, we had $33.8 millionin cash, cash equivalents and marketable securities. Since inception, we haveincurred significant net operating losses and, as of September 30, 2008,we had an accumulated deficit of $140.9 million. We have not achievedsustainable profitability and anticipate that we will continue to incursignificant net losses for the next several years. Additionally, there can beno assurance that we will achieve positive cash flow in the foreseeable futureor at all.

 

Subsequentto the end of our third quarter, on November 11, 2008, we entered into asecurities purchase agreement with certain institutional and other accreditedinvestors pursuant to which we agreed to sell and issue, in a privateplacement, an aggregate of 9,649,545 shares of our common stock, par value$0.001 per share, and warrants to purchase an aggregate of 2,894,864 shares ofour common stock. Under the terms of the securities purchase agreement, theprice for each share of common stock being purchased is $2.20. The total numberof shares of common stock underlying each purchaser’s warrant will be equal to30% of the total number of shares purchased by such purchaser in the privateplacement and will have a purchase price per underlying share of common stockof $0.125. The combined purchase price of each share of common stock and eachwarrant to purchase 0.30 of a share of common stock to be issued in the privateplacement is $2.2375. The warrants will be exercisable for a term of five yearsfrom the closing date of the private placement and have an exercise price of$2.64 per share. Upon the closing of the private placement, we will receivegross proceeds of approximately $21.6 million. The net proceeds, afterdeducting the placement agent fees and other expenses of approximately $1.1million, are expected to be approximately $20.5 million. The closing of theprivate placement is expected to occur on or about November 13, 2008, subjectto the closing conditions and the other terms set forth in the securitiespurchase agreement. We believe our current cash on hand, together with the cashresources we expect to secure in connection with this private placement will besufficient to fund our operations through the end of the first quarter of 2010.Even though the securities purchase agreement represents a legally bindingobligation on the part of the participating investors to provide funds asstipulated by the agreement, there remains a risk that this transaction may notbe fully funded as we anticipate or may not close at all. In the event thistransaction is not funded as we expect, our current level of capital resourcesmay not be sufficient to fund our operations beyond the end of the secondquarter of 2009, in which case we may be required to delay, reduce the scopeof, or eliminate one or more of our research and development programs, partnerone or more of our product candidates at an earlier stage of development thanwe might otherwise choose or conduct workforce or other expense reductions.

 

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Due tothe recent adverse developments in global financial markets, we may experiencereduced liquidity with respect to certain of our investments in cashequivalents and marketable securities. These investments are generally held tomaturity, which is less than one year with the exception of our remainingholding in an auction rate instrument. If the need arose to liquidate suchsecurities before maturity, we may experience realized losses upon liquidation.However, due to the short duration of the securities in our portfolio, webelieve that we have the ability to hold our securities to maturity when theywill be redeemed at par value.

 

Netcash used in operating activities for the nine months ended September 30,2008 was $34.6 million as compared to $19.6 million for the sameperiod in 2007. Net cash used in each of these periods was due to the fundingof our operating costs and expenses in connection with the conduct of ourresearch, development and administrative activities.

 

Netcash used in investing activities was $6.9 million for the nine months ended September 30,2008, as compared to net cash provided by investing activities of $20.4 millionfor the same period in 2007. Investing activities consist primarily ofpurchases and sales of marketable securities and property and equipmentpurchases. Purchases of property and equipment were $614,000 and $395,000 forthe nine months ended September 30, 2008 and 2007, respectively. As amajority of the cash proceeds from our initial public offering remainedinvested in our cash and cash equivalent portfolio during most of thenine-month period ended September 30, 2008, cash used in investingactivities during this period reflects a net transfer of cash into ourinvestment portfolio.

 

Netcash provided by financing activities was $6.8 million during the ninemonths ended September 30, 2008 and was primarily due to the utilizationof the additional $9.0 million loan facility extended to us by LighthouseCapital Partners, partially offset by $2.3 million in principal payments on our long-termdebt. Net cash used in financing activities was $2.7 million duringthe nine months ended September 30, 2007 and was due to principal paymentson our long-term debt.

 

On March 28,2005, we entered into a loan agreement with Lighthouse Capital Partners, orLighthouse, that was amended on October 19, 2007. The original agreementprovided for up to $10.0 million in debt financing. The agreement wasamended in October 2007 to provide for up to $9.0 million ofadditional financing. The original loan agreement provided for a 42 monthrepayment term which began on April 1, 2006. The original outstandingpromissory note provides for monthly cash payments of principal and interest ata stated interest rate of 9.75% per annum through September 2009 and aballoon interest payment of $1.2 million in September 2009. Theagreement also allows for prepayment of principal with respect to the originalpromissory note whereupon the $1.2 million balloon interest payment isaccelerated and due at the time of prepayment of the outstanding loan balance.The October 2007 amended loan agreement provides that the additional$9.0 million borrowed under a separate promissory note is subject to aninterest-only period expiring in September 2008 followed by 36 equalmonthly payments of principal and interest at an interest rate to be fixed asof October 1, 2008. Pursuant to the October 2007 amended loanagreement, we are obligated to make a balloon interest payment of $675,000 attime of prepayment or at loan maturity. Any mandatory or voluntary prepaymentof the $9.0 million borrowed will trigger a prepayment penalty equal to 3% ofthe outstanding principal balance being prepaid.

 

Theloan agreement with Lighthouse contains no financial covenants and no materialadverse change clause. Default terms under the loan agreement are standardterms including borrower default upon nonpayment of amounts due, noncompliancewith loan covenants, misrepresentations under the agreement, bankruptcy andother standard provisions. Under the terms of the loan agreement, as amended,Lighthouse has a first priority security interest in all of our tangible andintangible assets except for the following: (i) assets specificallyidentified and used as security for equipment loans, (ii) any firstpriority interest Comerica Bank may have in our operating bank accounts atComerica Bank, (iii) any certificates of deposit that are used as securityfor letters of credit issued to third parties, (iv) any interest or claimsour landlord may have in certain leasehold improvements and (v) ourintellectual property assets. The loan agreement precludes us from incurringadditional material debt amounts with the exception of up to an aggregate of$3.0 million in equipment financing and up to $500,000 in otherindebtedness. As of September 30, 2008, we had fullyutilized the total debt commitment available under the loan agreement, asamended, and had a total unpaid principal balance outstanding of $12.2 million.

 

Ourdebt financing with GE provides for a 42 month repayment term from eachdate of funding, a stated interest rate that is based on an average of theFederal Reserve’s three-year and five-year Treasury Constant Maturities rateplus a spread of 766 basis points and standard default provisions. We currentlyhave three promissory notes outstanding under the loan agreement with GE withstated interest rates ranging from 11.73% to 12.89%. Under the loan agreementwith GE, events of default include nonpayment of amounts owed, a non-permittedsale or transfer of collateral, misrepresentations under the agreement,bankruptcy and other standard provisions. Funds borrowed under the loanagreement with GE are secured by 

 

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specific equipment assetsand GE has a first priority security interest in those assets. The loanagreement with GE contains no financial covenants and no warrants to purchaseshares of our capital stock were issued to GE in connection with the debtfinancing. The loan agreement provides for monthly payments of principal andinterest through July 2010. As of September 30, 2008, the total unpaid principal balanceoutstanding under our existing GE equipment loans was $500,000.

 

Ourfuture funding requirements will depend upon 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;

 

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

 

·                  the timing, receipt and amount of sales or royaltiesgenerated, if any, from our product candidates; and

 

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

 

Wewill need to raise additional funds to support our operations, and such fundingmay not be available to us on acceptable terms, or at all. If we are unable toraise additional funds when needed, we may not be able to continue developmentof our product candidates or we could be required to delay, scale back oreliminate some or all of our research and development programs. We may seek toraise any necessary additional funds through public or private equity, debtfinancings, collaborative arrangements with corporate partners or othersources. If we raise additional funds through the issuance of debt securities,these securities could have rights that are senior to the holders of our commonstock and 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 a 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**

 

In February 2008, we fully utilized theadditional $9.0 million loan facility pursuant to the termsof the loan agreement with Lighthouse Capital Partners dated October 19, 2007, as amended. There were no additional material changes in our contractual obligationsfrom those disclosed in our annual report on Form 10-K filed with the SECon March 17, 2008, other than scheduled payments made through September 30,2008.

 

**RecentAccounting Pronouncements**

 

SeeNote 1 of the Notes to our Condensed Consolidated Financial Statements includedelsewhere in this report for recent accounting pronouncements that could havean effect on us.

 

**Off-BalanceSheet Arrangements**

 

Sinceinception, except for standard operating leases, we have not engaged in anyoff-balance sheet arrangements, including the use of structured finance,special purpose entities or variable interest entities.

 

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** **

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

 

Therewere no material changes to our market risk from those disclosed in our annualreport on Form 10-K filed with the SEC on March 17, 2008.  As of September 30, 2008, $419,000 of auctionrate securities remained in our marketable securities portfolio. As of September 30,2008, the security had limited market liquidity. While we believe that the limitedliquidity for this instrument is due to temporary market conditions, in lightof current market conditions, we have revalued our estimate of fair value forthe remaining auction rate security held in our portfolio. Based on ourrevaluation, we recorded $81,000 in unrealized losses as a component of othercomprehensive loss as of September 30, 2008, representing a 16.3%reduction to the carrying value of our auction rate holdings.

 

In light of recentdislocations within global financial markets, we have taken measures to ensurethat our cash equivalents and marketable securities portfolio is invested inaccordance with our investment policy which places an emphasis on capitalpreservation and liquidity to allow us the ability to fund our operations.

 

**ITEM 4.CONTROLS AND PROCEDURES**

 

***Evaluation of Disclosure Controls and Procedures***

 

As of September 30,2008, 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 30,2008.

 

***Limitations on the Effectiveness of 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***

 

Nochange was made in our internal control over financial reporting during thequarter ended September 30, 2008 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

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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**

 

*We have identified the following risks and uncertaintiesthat may have a material adverse effect on our business, financial condition orresults of operations. The risks described below are not the only ones we face.Additional risks not presently known to us or that we currently believe areimmaterial may also significantly impair our business operations. Our businesscould be harmed by any of these risks.**The trading price of ourcommon stock could decline due to any of these risks, and our investors maylose all or part of their investment.**We have marked with an asterisk(*) those risks described below that reflect substantive changes from therisks described in our Annual Report on Form 10-K  filed with the Securities and ExchangeCommission on March 17, 2008. In assessing these risks, you should alsorefer to the other information contained in this quarterly report on Form 10-Q,including our financial statements and related notes.*

 

**Risks Related to Our Business andIndustry**

 

**We will need substantial additional funding and may be unable to raisecapital when needed, which would force us to limit or cease our operations andrelated product development programs.***

 

As further explained in Note 1 to our condensedconsolidated financial statements included elsewhere in this report, our ability to continue operations isdependent upon our ability to obtain substantial additional capital. Ouroperations have consumed substantial amounts of cash since inception. We expectto continue to spend substantial amounts of cash to fund our operations,including research and development expenses and costs associated with theconduct of clinical trials for our product candidates. Net cash used inoperating activities was $34.6 million and $19.6 million in the ninemonths ended September 30, 2008 and 2007, respectively. We expect that ournet cash used in operations may increase significantly in each of the nextseveral years in order to support our operations and complete the developmentand commercialization of our product candidates. We will need to raiseadditional capital to fund our operations and complete the development of ourproduct candidates. It is our intention to enter into collaborationarrangements to commercialize our products. However, within those arrangements,we may retain the commercial right to co-promote our products to selectedphysicians through a specialty sales force. If any of our product candidatesreceive regulatory approval for commercial sale, we may need to raiseadditional capital to fund our portion of the commercialization efforts. Ourfuture funding requirements will depend on many factors, including:

 

·                  the scope, rate of progress, results and cost of our preclinicaltesting, clinical trials and other research and development activities;

 

·                  the terms and timing of any collaborative, licensing and otherarrangements that we may establish;

 

·                  the cost, timing and outcomes of regulatory approvals;

 

·                  the number and characteristics of product candidates that we pursue;

 

·                  the cost and timing of establishing sales, marketing and distributioncapabilities for our specialty sales force;

 

·                  the cost of establishing clinical and commercial supplies of ourproduct candidates and any products that we may develop;

 

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

 

·                  the cost of preparing, filing, prosecuting, defending and enforcing anypatent claims and other intellectual property rights; and

 

·                  the extent to which we acquire or invest in businesses, products ortechnologies, although we currently have no commitments or agreements relatingto any of these types of transactions.

 

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Untilwe can generate a sufficient amount of product revenue, if we ever do, weexpect to finance future cash needs through public or private equity offerings,debt financings or corporate collaboration and licensing arrangements, as wellas through interest income earned on cash balances.

 

If we raise additionalfunds by issuing equity securities, our stockholders will experience dilution.Any debt financing or additional equity that we raise may contain terms thatare not favorable to our stockholders or us. If we raise additional fundsthrough collaboration and licensing arrangements with third parties, we may berequired to relinquish some rights to our technologies or our productcandidates, grant licenses on terms that are not favorable to us or enter intoa collaboration arrangement for a product candidate at an earlier stage ofdevelopment than we might otherwise choose.

 

We donot expect our existing capital resources to be sufficient to enable us to fundthe completion of the development of any of our product candidates. Although webelieve our current cash on hand, together with the cash resources we expect tosecure in connection with the private placement described in Note 6 to ourcondensed consolidated financial statements, is sufficient to fund ouroperations through the end of the first quarter of 2010, there can be noassurance that if we fail to receive the proceeds from such financing our cashon hand would be sufficient to fund our operations beyond the second quarter of2009. However, our operating plan may change, and we may need additionalfunds sooner than planned to meet operational needs and capital requirementsfor product development and commercialization. Additional funds may not be available when we needthem on terms that are acceptable to us, or at all. If adequate funds are notavailable on a timely basis, we may:

 

·                  terminate or delay clinical trials for one or more of our productcandidates;

 

·                  delay our establishment of sales andmarketing capabilities or other activities that may be necessary tocommercialize our product candidates; or

 

·                  curtail significant drug development programsthat are designed to identify new product candidates.

 

***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.****

 

Wehave a limited operating history and have incurred significant losses since ourinception. As of September 30, 2008, we had an accumulated deficit ofapproximately $140.9 million. We expect our research and developmentexpenses to continue to increase as we continue to expand our developmentprograms.  Subject to regulatory approvalfor any of our product candidates, we expect to incur significant expensesassociated with the potential establishment of a North American specialty salesforce and increased manufacturing expenses. Although it is not expected tooccur in the next several years, the cost of establishing a 100-person NorthAmerican specialty sales force will be substantial. As a result, we expect tocontinue to incur substantial and increasing losses for the foreseeable future.These losses have had and will continue to have an adverse effect on ourstockholders’ equity and working capital.

 

Becauseof the numerous risks and uncertainties associated with drug development, weare unable to predict the timing or amount of increased expenses or when or ifwe will 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 P&G that was terminated in July 2008.We have devoted substantially all of our efforts to research and development,including clinical trials. If we are unable to develop and commercialize any ofour product candidates, if development is delayed or if sales revenue from anyproduct candidate that receives marketing approval is insufficientor if we fail to enter into partneringarrangements for our product candidates on terms favorable to us, we may neverbecome profitable. Even if we do become profitable, we may not be able tosustain or increase our profitability on a quarterly or annual basis.

 

***Our success depends substantially on ourmost advanced 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.****

 

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Two ofour most advanced product candidates are in Phase 2 clinical trials, athird compound entered Phase 2/3 clinical trial in June 2008 and a fourthcompound entered into Phase 1 clinical trial in April 2008. 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:

 

·                  do not demonstrate acceptable safety and efficacy in preclinicalstudies or clinical trials or otherwise do not meet applicable regulatorystandards for approval;

 

·                  do not offer therapeutic, safety or other improvements over existing orfuture drugs used to treat the same conditions;

 

·                  are not capable of being produced in commercial quantities atacceptable costs; or

 

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

 

We donot expect any of our current product candidates to be commercially availablebefore 2012, if at all. If we are unable to make our product candidatescommercially available, we will not generate product revenues and we will notbe successful. The results of our clinical trials to date do not provideassurance that acceptable efficacy or safety will be shown upon completion ofPhase 3 clinical trials.

 

***We expect to depend on collaborativearrangements to complete the development and commercialization of each of ourproduct candidates. Potential collaborative arrangements will likely place thedevelopment of our product candidates outside of our control and will likelyrequire us to relinquish important rights or may otherwise be on termsunfavorable to us.***

 

Weplan to enter into collaborative arrangements with third parties to develop andcommercialize each of our lead product candidates. Dependence on collaborativearrangements for development and commercialization of our product candidateswill subject us to a number of risks, including:

 

·                  we may not complete a collaborative arrangement in time to avoid delaysin clinical development, if at all, and if no collaborative arrangement isachieved, product development may be halted altogether;

 

·                  we may not be able to control the amount and timing of resources thatour collaborators may devote to the development or commercialization of productcandidates or to their marketing and distribution;

 

·                  collaborators may delay clinical trials, provide insufficient fundingfor a clinical trial program, stop a clinical trial or abandon a productcandidate, repeat or conduct new clinical trials or require a new formulationof a product candidate for clinical testing;

 

·                  we may have limited control over our clinical trial design;

 

·                  disputes may arise between us and our collaborators that result in thedelay or termination of the research, development or commercialization of ourproduct candidates or that result in costly litigation or arbitration thatdiverts management’s attention and resources;

 

·                  our collaborators may experience financial difficulties;

 

·                  collaborators may not properly maintain or defend our intellectualproperty rights or may use our proprietary information in such a way as toinvite litigation that could jeopardize or invalidate our proprietaryinformation or expose us to potential litigation;

 

·                  business combinations or significant changes in a collaborator’sbusiness strategy may adversely affect a collaborator’s willingness or abilityto fulfill its obligations under any arrangement;

 

·                  a collaborator could independently move forward with a competingproduct candidate developed either independently or in collaboration withothers, including our competitors; and

 

·                  any collaborative arrangement may be terminated or allowed to expire,which would delay the development and may increase the cost of developing ourproduct candidates.

 

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***Collaborative arrangements do not currentlyexist for any of our product candidates. If we do not establish collaborationsfor each of our ATI-5923, ATI-2042, ATI-9242 and ATI-7505 product candidates orfuture product candidates, we may have to alter our development andcommercialization plans.***

 

Ourstrategy includes selectively collaborating with leading pharmaceutical andbiotechnology companies to assist us in furthering the development andpotential commercialization of some of our product candidates, including  ATI-5923, ATI-2042, ATI-9242 and ATI-7505. Weintend to seek partners because the commercialization of each of our first fourproduct candidates involves a large, primary care market that must be served bylarge sales and marketing organizations and because we do not currently havethe capabilities to perform Phase 3 clinical trials. We face significantcompetition in seeking appropriate collaborators, and these collaborations arecomplex and time-consuming to negotiate and document. We may not be able tonegotiate collaborations on acceptable terms, if at all. We are unable topredict when, if ever, we will enter into any collaborations because of thenumerous risks and uncertainties associated with establishing collaborations.If we are unable to negotiate an acceptable collaboration, we may have tocurtail the development of a particular product candidate, reduce or delay itsdevelopment program or one or more of our other development programs, delay itspotential commercialization or reduce the scope of our sales or marketingactivities or increase our expenditures and undertake development orcommercialization activities at our own expense. If we elect to increase ourexpenditures to fund development or commercialization activities on our own, wemay need to obtain additional capital, which may not be available to us onacceptable terms, if at all. If we do not have sufficient funds, we will not beable to bring our product candidates to market and generate product revenues.

 

***The commercial success of our potentialcollaborations will depend in part on the development and marketing efforts ofour potential partners, over which we will have limited control. If ourcollaborations are unsuccessful, our ability to develop and commercialize andto generate future revenue from the sale of our products will be significantlyreduced.***

 

Ourdependence on future collaboration arrangements will subject our company to anumber of risks. Our ability to develop and commercialize each of our productcandidates will depend on our and our potential collaboration partner(s)’ability to establish the safety and efficacy of each respective productcandidate, obtain and maintain regulatory approvals and achieve marketacceptance of the product candidate(s) once commercialized. Our potentialcollaboration partner(s) may elect to delay or terminate development ofour product candidates, independently develop products that compete with ours,or fail to commit sufficient resources to the marketing and distribution of ourproduct candidates. The termination of a collaboration agreement may cause usto incur additional and unanticipated costs that may be material to ouroperations.

 

Businesscombinations, significant changes in business strategy, litigation and/orfinancial difficulties may also adversely affect the willingness or ability ofour potential collaboration partners to fulfill their obligations to us. If apartner fails to perform in the manner we expect, our potential to develop andcommercialize the respective product candidate(s) through othercollaborations and to generate future revenue from the sale of the productcandidate(s) may be significantly reduced. If a conflict of interestarises between us and our collaboration partner(s), they may act in their ownself-interest and not in the interest of our company or our stockholders. If acollaboration partner breaches or terminates their collaboration agreement withus or otherwise fails to perform their obligations thereunder in a timelymanner, the clinical development or commercialization of the respective productcandidate(s) could be delayed or terminated. For example, ourcollaboration with P&G on the development and commercialization of ATI-7505was terminated by P&G and we may experience a similar result withcollaboration partners in the future on any of our product candidates.

 

***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.***

 

Ourproduct candidates 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. Futurecollaborative agreements will likely cause us to give up control ofinteractions with the FDA and other regulatory bodies. We or our partners maynever receive regulatory approval for the commercial sale of any of our productcandidates. 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,complexity and novelty of the product candidates involved.

 

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Becauseour product 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, because of known problemswith the drug after which it was modeled, we were required to conductsignificant monitoring for cardiac toxicity in our clinical studies ofATI-7505.

 

Changesin regulatory approval policies during the development period, changes in, orthe enactment of, additional regulations or statutes or changes in theregulatory review team for each submitted product application may cause delaysin the approval 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.

 

TheFDA has substantial discretion in the approval process and may refuse to acceptany application or decide that our data are insufficient for approval andrequire additional 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. As anotherexample, while we believe we have clear direction from the FDA as to thedevelopment path for ATI-5923 based on our initial discussions, the FDA maychange their judgment on the appropriate development pathway for ATI-5923 atany time.

 

Wewill need to obtain regulatory approval from authorities in foreign countriesto market our product candidates in those countries. We have not yet initiatedthe regulatory process in any foreign jurisdictions. Approval by one regulatoryauthority does not ensure approval by regulatory authorities in otherjurisdictions. If we fail to obtain approvals from foreign jurisdictions, thegeographic market for our 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.***

 

Discoveryof previously unknown problems with an approved product may result inrestrictions on its permissible uses, including withdrawal of the medicine fromthe market. Each of the opportunities upon which we have chosen to focus isbased upon our belief that our RetroMetabolic Drug Design technology can beused to create a new product based upon an existing product which isefficacious in treating a specific condition, but which has a known safetyproblem. Each of our four lead product candidates is modeled on drugs whichhave significant safety problems. ATI-5923 is modeled on warfarin which isknown to have safety risks because of its potential for bleeding and fordrug-drug interactions with numerous other drugs as listed on the packageinsert for the product. ATI-2042 is modeled on amiodarone which is used, butnot approved, for atrial fibrillation in spite of known safety problems due toits accumulation in the body and interaction with other drugs. Both amiodaroneand ATI-2042 contain iodine which can accumulate in the thyroid and must bemonitored for safety purposes.  Inaddition, ATI-2042 is partially metabolized by CYP450 and, at high dose levelshas caused drug-drug interactions with warfarin which increased INR and couldincrease the risk of hemorrhage complications. ATI-9242 is modeled to retaincertain of the positive features of the class of atypical antipsychotic drugswhile lessening certain of the safety issues that vary but exist within theclass. The receptor profile which yields the positive and avoids the negativefeatures of this class of drugs is a matter of great debate. While we havedesigned ATI-9242 to have an appropriate balance across a very complex set ofreceptors, we may have targeted an inappropriate profile or the profile attainedmay result in an unanticipated lack of efficacy or safety problems. ATI-7505 ismodeled on cisapride which was withdrawn from the market due to fatal cardiacproblems. Although we have designed our drugs to largely address each of theoriginal drugs’ key safety problems, we will need to continue to demonstratethis through continued clinical testing. It is possible that the FDA may imposeadditional requirements on the development or approval of our products becauseof its concern about the original drug’s safety problems. These potentialadditional barriers could delay, increase the cost of, or prevent thecommercialization of our product candidates.

 

Ourproduct candidates are engineered to be broken down by the body’s naturalmetabolic processes in a manner we believe to be safer than that of theoriginal drug. There can be no assurance that the products we develop willactually be metabolized as we expect. While we have designed the breakdownproducts to be safe, it is possible that there will be unexpected toxicityassociated with these breakdown products that could cause our products to bepoorly tolerated by, or toxic to, humans. Additionally, while we believe wehave addressed the key safety problem of each of the original drugs, it is possiblethat our change to the chemical structure may result in new unforeseen safetyissues. Any unexpected toxicity or suboptimal tolerance of our products woulddelay or prevent commercialization of these product candidates.

 

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Additionally, problems with approved productsmarketed by third parties that utilize the same therapeutic target as ourproduct candidates could adversely affect the development of our productcandidates. For example, the recent product withdrawals of Vioxx by Merck & Co., Inc.and Bextra by Pfizer because of safety issues caused other drugs that have thesame therapeutic target, such as Celebrex from Pfizer, to receive additionalscrutiny from regulatory authorities. Another prokinetic, tegaserod marketed byNovartis Pharmaceuticals Corporation as Zelnorm, was temporarily withdrawn fromthe market and then reintroduced in a very limited manner due to certaincardiac effects which we believe were related to its off-target effects. It ispossible that we or a future collaboration partner may be required byregulatory agencies to perform tests, in addition to those we have planned, inorder to demonstrate that ATI-7505 does not have the safety problems associatedwith Zelnorm. Any failure or delay in commencing or completing clinical trialsor obtaining regulatory approvals for our product candidates would delaycommercialization of our product candidates and severely harm our business andfinancial condition.

 

***Globalcredit and financial market conditions could negatively impact the value of ourcurrent portfolio of cash equivalents or short-term investments and******makeit more difficult and costly for us to raise additional capital.****

 

Currently, there is turmoilin the U.S. economy due to a global credit crisis that has resulted intightening credit markets and rising liquidity concerns across most industries,including the banking and investments sector. While as of the date ofthis filing, we are not aware of any material losses, or other significantdeterioration in the fair value of our cash equivalents or investments inmarketable securities since September 30, 2008, no assurance can be giventhat further deterioration in conditions of the global credit and financialmarkets would not negatively impact our current portfolio of cash equivalentsor investments in marketable securities or our ability to meet our financingobjectives to allow us to continue our operations. In addition, as a result of current market conditions,banks and other credit grantors have tightened their lending standards,investors have become more risk adverse and economic growth has been negativelyimpacted. These factors are contributing to reduced credit availability andrising costs for issuers needing to raise additional capital. If these factorscontinue to affect the credit and equity markets, our ability to raise capitalmay be adversely affected if not completely hindered.

 

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

 

Todate, we have not completed the clinical trial program of any productcandidate. The commencement and completion of clinical trials for our productcandidates may be delayed or terminated as a result of many factors, including:

 

·                  our inability or the inability of our collaborators or licensees tomanufacture or obtain from third parties materials sufficient for use inpreclinical studies and clinical trials;

 

·                  delays in patient enrollment, which we previously experienced in the enrollmentof atrial fibrillation patients with implanted recordable pacemakers as part ofour Phase 2 clinical trials for ATI-2042, and variability in the numberand types of patients available for clinical trials;

 

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

 

·                  poor effectiveness of product candidates during clinical trials;

 

·                  unforeseen safety issues or side effects; and

 

·                  governmental or regulatory delays and changes in regulatoryrequirements, policies and guidelines.

 

Anydelay in commencing or completing clinical trials for our product candidateswould delay commercialization of our product candidates and severely harm ourbusiness and financial condition. It is also possible that none of our productcandidates will complete clinical trials in any of the markets in which ourcollaborators or we intend to sell those product candidates. Accordingly, ourcollaborators or we would not receive the regulatory approvals needed to marketour product candidates, which would severely harm our business and financialcondition.

 

***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.***

 

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We donot have the ability to independently conduct clinical trials for our productcandidates, and thus for each of our product candidates we must rely on thirdparties such as contract research organizations, medical institutions, clinicalinvestigators and contract laboratories, to conduct our clinical trials. We have,in the ordinary course of business, entered into agreements with these thirdparties. To date, we have utilized numerous vendors to provide clinical trialmanagement, data collection and analysis and laboratory and safety analysisservices to us in the conduct of our clinical trials. In addition, to date wehave conducted our clinical trials at numerous sites in North America andEurope.  Nonetheless, we are responsiblefor confirming that each of our clinical trials is conducted in accordance withits general 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 clinical protocolsor regulatory requirements or for other reasons, our clinical trials may beextended, delayed, suspended or terminated, and we may not be able to obtainregulatory approval for, or successfully commercialize, our product candidates.

 

***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.****

 

Oursuccess will depend in part on our ability to obtain and maintain patent andtrade secret protection for our technologies and product candidates both in theUnited States and other countries. We rely on composition of matter patents forthe compounds we develop. We cannot guarantee that any patents will issue fromany of our pending or future patent applications. Alternatively, a third partymay successfully circumvent our patents. Our rights under any issued patentsmay not provide us with sufficient protection against competitive products orotherwise cover commercially valuable products or processes.

 

Thedegree of future protection for our proprietary technologies and productcandidates is uncertain because legal means afford only limited protection andmay not adequately protect our rights or permit us to gain or keep ourcompetitive advantage. For example:

 

·                  we might not have been the first to make the inventions covered by eachof our pending patent applications and issued patents;

 

·                  we might not have been the first to file patent applications for theseinventions;

 

·                  others may independently develop similar or alternative technologies orduplicate any of our technologies;

 

·                  it is possible that none of our pending patent applications will resultin issued patents;

 

·                  any patents issued to us or our collaborators may not provide a basisfor commercially viable products or may be challenged by third parties;

 

·                  the patents of others may have an adverse effect on our ability to dobusiness; or

 

·                  regulators or courts may retroactively diminish the value of ourintellectual property.

 

Evenif valid and enforceable patents cover our product candidates and technologies,the patents will provide protection only for a limited amount of time. As ourpatents are based on a parent drug where much research has been conducted, wemay encounter many competitive patents from covered analogs of the parent drug.Our know-how and trade secrets may only provide a competitive advantage for ashort amount of time.

 

Ourability and our potential collaborators’ ability to obtain patents is highlyuncertain because, to date, some legal principles remain unresolved, there hasnot been a consistent policy regarding the breadth or interpretation of claimsallowed in patents in the United States and the specific content of patents andpatent applications that are necessary to support and interpret patent claimsis highly uncertain due to the complex nature of the relevant legal, scientificand factual issues. Recent patent-related decisions in the United StatesFederal Courts may make protection of patents in our industry even more difficult.Similarly, the U.S. Patent and Trademark Office, or USPTO, recently attemptedto promulgate changes to patent

 

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rules that couldhave materially affected the ability of companies in our industry to obtainpatents. An April 1, 2008 decision by the U.S. District Court for theEastern District of Virginia set aside the new rules, but the USPTO hasindicated that they intend to appeal the decision. The USPTO has furtherproposed rule changes that could be enacted at any time. While such rule changesmay also be challenged, there is no guarantee of a decision that is favorableto patent holders’ rights.  In addition tothe changes originating in the courts and the USPTO, Congress has been debatingthe enactment of substantial changes to U.S. patent law, which may makeobtaining new patents more difficult, diminish the value of our intellectualproperty or narrow the scope of our patent protection. The patent reform billhas passed in the House (H.R. 1908) but has not yet passed in the Senate (S.1145). At present, it is uncertain whether S.1145 will be introduced or passedin the current session of Congress.  Itis also uncertain whether the bills will be reintroduced in future years if notpassed this year. The above-described changes, as well as future changes, toeither patent rules, 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.

 

Evenif patents are issued regarding our product candidates or methods of usingthem, those patents can be challenged by our competitors who can argue suchpatents are invalid and/or unenforceable. Patents also may not protect ourproduct candidates if competitors devise ways of making these or similarproduct candidates without legally infringing our patents. The Federal Food,Drug and Cosmetic 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 30,2008, we held 43 issued or allowed U.S. patents and had 17 patent applicationspending before the U.S. Patent and Trademark Office, or USPTO. For some of ourinventions, corresponding foreign patent protection is pending. Of the 43 U.S.patents that we hold, 39 patents are compound- and composition-related, havingexpiration dates from 2013 to 2025.  Thecomposition of matter patent for ATI-5923, our compound for anticoagulation,issued in August 2007 and has an expiration date in 2025. Our compositionof matter patent for ATI-2042, our compound for the treatment of atrialfibrillation, issued in April 2002 and has an expiration date in 2020. Thecomposition of matter patent for ATI-7505, our compound for the treatment ofgastrointestinal disorders, issued in February 2007 and has an expirationdate in 2025. Although third parties may challenge our rights to, or the scopeor validity of, our patents, to date we have not received any communicationsfrom third parties challenging our patents or patent applications covering ourclinical candidates.

 

WhileATI-5923, ATI-2042 and ATI-7505 are all covered in the United States by issuedcomposition of matter patents, additional patent applications would be requiredto extend patent protection beyond 2025, 2020 and 2025, 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 future patentapplications would be subject to the same risks described herein for currentlyissued patents.

 

Ourresearch and development collaborators may have rights to publish data andother information in which we have rights. In addition, we sometimes engage individualsor entities to conduct research that may be relevant to our business. Theability of these individuals or entities to publish or otherwise publiclydisclose data and other information generated during the course of theirresearch is subject to certain contractual limitations. In most cases, theseindividuals or entities are, at the least, precluded from publicly disclosingour confidential information and are only allowed to disclose other data orinformation generated during the course of the research after we have beenafforded an opportunity to consider whether patent and/or other proprietaryprotection should be sought. If we do not apply for patent protection prior tosuch publication 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.

 

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

 

Wealso rely on trade secrets to protect our technology, especially where we donot believe that patent protection is appropriate or obtainable. This isparticularly true for our RetroMetabolic Drug Design technology. However, tradesecrets are difficult to protect. Our employees, consultants, contractors,outside scientific collaborators and other advisors are required to signconfidential disclosure agreements but they may unintentionally or willfullydisclose our confidential information to competitors. Enforcing a claim that athird party illegally 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.

 

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

 

Ourcommercial success depends in part on not infringing the patents andproprietary rights of other parties and not breaching any licenses that we haveentered into with regard to our technologies and products. Because others mayhave filed, and in the future are likely to file, patent applications coveringproducts or other technologies of interest to us that are similar or identicalto ours, patent applications or issued patents of others may have priority overour patent applications or issued patents. There are numerous issued andapplied for patents related to the original molecules and analogs of such fromwhich our products are engineered. If the patents are determined to be validand construed to cover our products, the development and commercialization ofany or all could be affected. We do not believe that our activities infringethe patents of others or that the patents of others inhibit our freedom tooperate. However, it is possible that others may choose to challenge thisposition and that a judge or jury will disagree with our conclusions, and wecould incur substantial costs in litigation if we are required to defendagainst patent suits brought by third parties. Similarly, if we initiate suitsto defend our patents, such litigation could be costly and there is noassurance we would be successful in such processes. Any legal action againstour collaborators or us claiming damages and seeking to enjoin commercialactivities relating to the affected products and processes could, in additionto subjecting us to potential liability for damages, require our collaboratorsor us to obtain a license to continue to manufacture or market the affectedproducts and processes. Licenses required under any of these patents may not beavailable on commercially acceptable terms, if at all. Failure to obtain suchlicenses could materially and adversely affect our ability to develop,commercialize and sell our product candidates. We believe that there maycontinue to be significant litigation in the biotechnology and pharmaceuticalindustry regarding patent and other intellectual property rights. If we becomeinvolved in litigation, it could consume a substantial portion of ourmanagement and financial resources and we may not prevail in any suchlitigation.

 

Furthermore,our commercial success will depend, in part, on our ability to continue toconduct research to identify additional product candidates in currentindications of interest or opportunities in other indications. Some of theseactivities may involve the use of genes, gene products, screening technologiesand other research tools that are covered by third-party patents. Courtdecisions have indicated that the exemption from patent infringement affordedby Title 35, Section 271(e)(1) of the United States Code does notencompass all research and development activities associated with productdevelopment. In some instances, we may be required to obtain licenses to suchthird-party patents to conduct our research and development activities,including activities that may have already occurred. It is not known whetherany license required under any of these patents would be made available oncommercially acceptable terms, if at all. Failure to obtain such licenses couldmaterially and adversely affect our ability to maintain a pipeline of potentialproduct candidates and to bring new products to market. If we are required todefend against patent suits brought by third parties relating to third-partypatents that may be relevant to our research activities, or if we initiate suchsuits, we could incur substantial costs in litigation. Moreover, an adverseresult from any legal action in which we are involved could subject us todamages and/or prevent us from conducting some of our research and developmentactivities.

 

***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.****

 

Wepresently do not have sufficient quantities of our product candidates tocomplete clinical trials of any of our lead product candidates. We do notcurrently own or operate manufacturing facilities, and we rely and expect tocontinue to rely on a small number of third-party manufacturers and activepharmaceutical ingredient formulators for the production of clinical andcommercial quantities of our product candidates. We do not have long-termagreements with any of these third parties, and our agreements with theseparties are generally terminable at will by either party at any time. If forany reason, these third parties are unable or unwilling to perform under ouragreements or enter into new agreements, we may not be able to locatealternative manufacturers or formulators or enter into favorable agreementswith them. Any inability to acquire sufficient quantities of our product candidatesin a timely manner from these third parties could delay clinical trials andprevent us from developing and commercializing our product candidates in acost-effective manner or on a timely basis.

 

Thestarting materials for the production of ATI-5923 are provided by Synquest Labs, Inc.and Chem Uetikon, GmbH. To date, the active pharmaceutical ingredient forATI-5923 has been produced by ChemShop BV of the Netherlands andCorum Inc. of Taiwan on an ongoing purchase order basis. ShouldChemShop BV or Corum Inc. cease to serve as the supplier of ATI-5923and our current vendor qualification efforts fail, a delay in the developmentof ATI-5923 could occur, impairing our ability to commercialize ATI-5923 on ourexisting timeline. ATI-5923’s active pharmaceutical ingredient is processedinto 1 milligram, 2 milligram, 5 milligram or 10 milligram tablets by QSPharma.

 

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Thestarting materials for the production of ATI-2042 are provided by the followingvendors: SCI Pharmtech, Inc., Lexen Inc., Panchim, Julich GmbHand Weylchem Inc. To date, Ricerca, Biosciences, LLC,ScinoPharm Ltd. and SCI Pharmtech have produced all of ATI-2042’s activepharmaceutical ingredient. Historically, we have relied on Ricerca, ScinoPharmand SCI Pharmtech as single-source suppliers for ATI-2042’s activepharmaceutical ingredients. In the event that Ricerca, Biosciences, LLC,ScinoPharm Ltd. or SCI Pharmtech could not produce ATI-2042, we would notbe able to manufacture ATI-2042’s active pharmaceutical ingredient. This coulddelay the 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.

 

Thestarting materials for the production of ATI-9242 are provided by the followingvendors: Corum Inc., Alfa Aesar, Apollo Scientific Ltd., and SKECHEM.To date, the active pharmaceutical ingredient for ATI-9242 has been producedexclusively by Corum Inc. in Taiwan. In the event that Corum Inc.could not produce ATI-9242, we would not be able to manufacture ATI-9242’sactive pharmaceutical ingredient. This could delay the development of, andimpair our ability to, commercialize ATI-9242. To produce ATI-9242 drugproduct, drug substance is processed into 20 milligram capsule form by Xcelience LLC.

 

The starting materials for the production ofATI-7505 are provided by the following vendors: SCI Pharmtech, Inc., Corum, Inc.,and Lexen Inc. To produce ATI-7505 drug products, drug substance is processedinto 20 milligram or 40 milligram tablet form by Pharmaceutics International, Inc.In the event that any of these vendors are unable or unwilling to producesufficient quantities of material for the manufacture of ATI-7505, thedevelopment and/or commercialization of ATI-7505 could be delayed or impaired.

 

All ofour current arrangements with third-party manufacturers and suppliers for theproduction of our product candidates are on a purchase order basis.  We currently do not have long-term supplycontracts with any of the third-party manufacturers and suppliers for ourproduct candidates, and they are not required to supply us with products forany specified periods, in any specified quantities or at any set price, exceptas may be specified in a particular purchase order. We have no reason tobelieve that any of the current manufacturers and suppliers for our productcandidates is the sole source for the materials they supply us. However, if wewere to lose one of these vendors and were unable to obtain an alternativesource on a timely basis or on terms acceptable to us, our clinical andproduction schedules could be delayed. In addition, to the extent that any ofthese vendors uses technology or manufacturing processes that are proprietary,we may be unable to obtain comparable materials from alternative sources.

 

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

 

We maynot be able to maintain or renew our existing or any other third-partymanufacturing arrangements on acceptable terms, if at all. If we are unable tocontinue relationships with our current suppliers, or to do so at acceptablecosts, or if these suppliers fail to meet our requirements for these productcandidates for any reason, we would be required to obtain alternativesuppliers. Any inability to obtain qualified alternative suppliers, includingan inability to obtain or delay in obtaining approval of an alternativesupplier from the FDA, would delay or prevent the clinical development andcommercialization of these product candidates.

 

Changesin manufacturing site, process or scale can trigger additional regulatoryrequirements that could delay our ability to perform certain clinical trials orobtain product approval.

 

Themanufacturing and formulation of each of our lead product candidates that havebeen tested in humans to date has been performed by entities other than thosethat will likely manufacture the products for future clinical trials orcommercial use. There is a possibility that analysis of future clinical trialswill show that the results from our earlier clinical trials have not beenreplicated. The failure to replicate these earlier clinical trials would delayour clinical development timelines. New impurity profiles that occur as aresult of changing manufacturers may lead to delays in clinical trial testingand approvals.

 

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

 

Ourcurrent and anticipated future reliance on third-party manufacturers willexpose us and our future collaborative partners to risks that could delay orprevent the initiation or completion of our clinical trials, the submission ofapplications for regulatory approvals, the approval of our product by the FDAor the commercialization of our products may result in higher costs or lostproduct revenues. In particular, our contract manufacturers could:

 

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·                  encounter difficulties in achievingvolume production, quality control and quality assurance or suffer shortages ofqualified personnel, which could result in their inability to manufacturesufficient quantities of drugs to meet our clinical schedules or tocommercialize our product candidates;

 

·                  terminate or choose not to renew manufacturing agreements, based ontheir own business priorities, at a time that is costly or inconvenient for us;

 

·                  fail to establish and follow FDA-mandated current good manufacturingpractices, or cGMPs, which are required for FDA approval of our productcandidates, or fail to document their adherence to cGMPs, either of which couldlead to significant delays in the availability of material for clinical studiesand delay or prevent marketing approval for our product candidates; and

 

·                  breach or fail to perform as agreed under manufacturing agreements.

 

If weare not able to obtain adequate supplies of our product candidates, it will bemore difficult for us to develop our product candidates and competeeffectively. Our product candidates and any products that we may develop maycompete with other product candidates and products for access to manufacturingfacilities.

 

Inaddition, Lexen, SCI Pharmtech, Scinopharm, Corum Inc. andChemShop BV are located outside of the United States. This may give riseto difficulties in importing our product candidates or their components intothe United States as a result of, among other things, FDA import inspections,incomplete or inaccurate import documentation, 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.***

 

Toobtain the requisite 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 not authorize us tocommence a clinical trial at a prospective trial site;

 

·                  our preclinical studies or clinical trials may produce negative orinconclusive results, which may require us to conduct additional preclinical orclinical testing or to abandon development projects;

 

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

 

·                  regulators or institutional review boards may suspend or terminateclinical research for various reasons, including noncompliance with regulatoryrequirements;

 

·                  the effects of our product candidates may not be the desired effects ormay include undesirable side effects; and

 

·                  our preclinical studies or clinical trials may show that our productcandidates are not superior to the original drugs on which our productcandidates are modeled.

 

Forinstance, our preclinical studies and clinical trials may indicate that ourproduct candidates cause unexpected drug-drug interactions and result inadverse events. As another example, more extensive and robust clinical trialsof ATI-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 

 

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possible renal effect wasalso observed at high doses in our rat and dog toxicology studies for ATI-2042.While we will continue to monitor patients for these effects, there is noassurance these effects will not occur in patients as part of our ongoing andplanned clinical trials for ATI-2042, and have a resulting adverse effect onour ability to obtain requisite regulatory approval to market and sellATI-2042. In a canine toxicology study of ATI-7505 performed by our formercollaboration partner, P&G, six deaths occurred at doses that were 10 and20 times greater than doses currently being used in clinical trials. Ourclinical trials to date have indicated only mild to moderate side effects inhumans. However, further observation is warranted.

 

Evenwhen our product candidates do not cause any adverse effects, clinical studiesof efficacy may show that our product candidates do not have significanteffects on target symptoms or may be inconclusive. For example, ATI-7505 wastested in two Phase 2 clinical trials in which the primary endpoints werenot met in comparison to placebo. Although these studies did support ATI-7505’sefficacy against certain symptoms as secondary endpoints, if future studiesshow that ATI-7505 is not sufficiently efficacious to justify its use as atherapy, our business and prospects may be materially adversely affected.

 

Unforeseenevents could cause us to experience significant delays in, or the terminationof, clinical trials. Any such events would increase our costs and could delayor prevent 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.***

 

Animportant element of our strategy is to continue to identify existing moleculeswhich have demonstrated efficacy, but have safety problems that are amenable toour RetroMetabolic Drug Design technology. Other than ATI-5923, ATI-2042,ATI-9242 and ATI-7505, all of our programs are in the preclinical or discoverystage. Research programs to identify new product candidates require substantialtechnical, financial and human resources. These programs may initially showpromise in identifying potential product candidates, yet fail to yield productcandidates for clinical development for a number of reasons, including:

 

·                  the research methodology used may not be successful in identifyingpotential product candidates; or

 

·                  potential product candidates may, on further study, be found not toretain the efficacy profile of the original molecule or be shown to retainharmful side effects or other characteristics suggesting that they are unlikelyto be effective products. For instance, at high doses our ATI-2042 productcandidate interacts with warfarin and causes prolonged INR which could increasethe risk of hemorrhage complications.

 

If weare unable to develop suitable product candidates through internal researchprograms or otherwise, we may not be able to increase our revenues in futureperiods, which could result in significant harm to our financial position andadversely impact our stock price.

 

***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.***

 

Evenif we receive regulatory approval to market a particular product candidate, theapproval could be conditioned on our conducting additional costly post-approvalstudies or 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 wefail to comply with the regulatory requirements of the FDA and other applicableU.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 or manufacturing processes;

 

·                  warning letters;

 

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·                  civil or criminal penalties or fines;

 

·                  injunctions;

 

·                  product seizures, detentions or import bans;

 

·                  voluntary or mandatory product recalls and publicity requirements;

 

·                  suspension or withdrawal of regulatory approvals;

 

·                  total or partial suspension of production; and

 

·                  refusal to approve pending applications for marketing approval of newdrugs 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.***

 

Becausewe have limited financial and managerial resources, we must focus on researchprograms and product candidates for the specific opportunities that we believeare the most amenable to our RetroMetabolic Drug Design and are the mostcommercially promising. As a result, we may forego or delay pursuit ofopportunities with other product candidates or other indications that laterprove to have greater commercial potential. Our resource allocation decisionsmay cause us to fail to capitalize on viable commercial products or profitablemarket opportunities. In addition, we may spend valuable time and managerialand financial resources on research programs and product candidates forspecific indications that ultimately do not yield any commercially viableproducts. If we do not accurately evaluate the technical feasibility and thecommercial potential or target market for a particular product candidate, wemay relinquish valuable rights to that product candidate through collaboration,licensing or other royalty arrangements in situations where it would have beenmore advantageous for us to retain sole rights to development andcommercialization.

 

***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.***

 

Anyproducts that we may develop may not gain market acceptance among physicians,patients, healthcare payors and the medical community. If these products do notachieve an adequate level of acceptance, we may not generate material productrevenues and we may not become profitable. The degree of market acceptance ofany of our product candidates, if approved for commercial sale, will depend ona number of factors, including:

 

·                  demonstration of efficacy and safety in clinical trials;

 

·                  demonstration that we have adequately addressed the specific safetyproblem of the original molecule;

 

·                  the prevalence and severity of any side effects;

 

·                  potential or perceived advantages over alternative treatments;

 

·                  perceptions about the relationship or similarity between our productcandidates and the original drug upon which each RetroMetabolic Drug Designcandidate was based;

 

·                  advantage over other drugs may not be sufficiently great enough toobtain premium pricing;

 

·                  the timing of market entry relative to competitive treatments;

 

·                  the ability to offer our product candidates for sale at competitiveprices;

 

·                  relative convenience and ease of administration;

 

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·                  the strength of marketing and distribution support;

 

·                  sufficient third-party coverage or reimbursement; and

 

·                  the product labeling or product insert required by the FDA orregulatory 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 donot have a sales and marketing organization and have no experience in thesales, marketing and distribution of pharmaceutical products. It is ourintention to use collaborative arrangements to gain access to large sales and marketingorganizations in order to commercialize our product candidates. Additionally,in the event we enter into any collaboration arrangements for any of ourproduct candidates, we may retain the right to co-promote the sales of anyultimate product(s) by establishing a small specialty sales force tomarket such product(s) to specific physician groups. There are risksinvolved with establishing our own sales and marketing capabilities andentering into arrangements with third parties to perform these services.Developing an internal sales force is expensive and time-consuming and coulddelay any product launch.  On the otherhand, if we enter into arrangements with third parties to perform sales,marketing and distribution services, our product revenues are likely to belower than if we market and sell any products that we develop ourselves.

 

We maydecide to establish our own specialty sales force and engage pharmaceutical orother healthcare companies with an existing sales and marketing organizationand distribution system to sell, market and distribute our products. We may notbe able 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 to allow us toretain commercialization rights for specific physician groups;

 

·                  our inability to obtain financing to establish the specialty salesforce;

 

·                  our inability to recruit and retain adequate numbers of effective salesand marketing personnel;

 

·                  the inability of sales personnel to obtain access to or persuadeadequate numbers of physicians to prescribe our products;

 

·                  the lack of complementary products to be offered by sales personnel,which may put us at a competitive disadvantage relative to companies with moreextensive product lines; and

 

·                  unforeseen costs and expenses associated with creating an independentsales and marketing organization.

 

Becausethe establishment 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.***

 

Manypatients may be unable to pay for any products that we may develop. In theUnited States, many patients will rely on Medicare, Medicaid, private healthinsurers and other third-party payors to pay for their medical needs. Ourability to achieve acceptable levels of reimbursement for drug treatments bygovernmental authorities, private health insurers and other organizations willhave an effect on our ability to successfully commercialize, and attractcollaborative partners to invest in the development of, our product candidates.We cannot be sure that reimbursement in the United States, Europe or elsewherewill be available for any products that we may develop, and any reimbursementthat may become available may be decreased or eliminated in the future.Third-party payors increasingly are challenging prices charged for medicalproducts and services, and many third-party payors may refuse to providereimbursement for particular drugs when an equivalent generic drug isavailable. Although we believe that the safety profile of any products that wemay develop will be sufficiently different from 

 

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the original drugs fromwhich they are modeled to be considered unique and not subject to substitutionby a generic of the original drug in the case of ATI-2042 and ATI-5923, it ispossible that a third-party payor may consider our product candidate and thegeneric original drug as equivalents and only offer to reimburse patients forthe generic drug. There are five atypical antipsychotics which currentlydominate an estimated $16 billion market for such drugs. Most will be genericcompetitors against ATI-9242 if it ever reaches the marketplace. While we havedesigned ATI-9242 to have the improved efficacy and safety features over theexisting atypical antipsychotics, these desired features may not be proven inclinical testing or payors may be unwilling to pay a higher price for improvedfeatures when generic alternatives are available. Even if we show improvedsafety with our product candidates, pricing of the existing original drug maylimit the amount we will be able to charge for each of our product candidates.In the case of ATI-7505, the original molecule, cisapride, was withdrawn fromthe market and no generic version exists, but there are many competitiveproducts which may limit the amount we can charge for this product candidate.If reimbursement is not available or is available only at limited levels, wemay not be able to successfully commercialize our product candidates, and maynot be able to obtain a satisfactory financial return on products that we maydevelop.

 

Thetrend toward managed healthcare in the United States and the changes in healthinsurance programs, as well as legislative proposals to reform healthcare orreduce government insurance programs, may result in lower prices forpharmaceutical products, including any products that may be offered by us. Inaddition, any future regulatory changes regarding the healthcare industry orthird-party coverage and reimbursement may affect demand for any products thatwe may develop 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.***

 

Weface competition from established pharmaceutical and biotechnology companies,as well as from academic institutions, government agencies and private andpublic research institutions. Our commercial opportunity will be reduced oreliminated if our competitors develop and commercialize products that aresafer, more effective, have fewer side effects or are less expensive than anyproducts that we may develop. In addition, significant delays in thedevelopment of our product candidates could allow our competitors to bringproducts to market before us and impair our ability to commercialize ourproduct candidates.

 

Competitionfor ATI-5923 for use as an oral anticoagulant will continue to come fromgeneric coumadin owing to its pricing and the years of experience physiciansand patients 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.The first direct thrombin inhibitor presented to the FDA for approval,ximelagatran, previously marketed as Exanta by AstraZeneca plc, has notbeen recommended for approval due to idiosyncratic liver toxicity problems.Although we believe ATI-5923’s mechanism of action (VKOR inhibition as withwarfarin) and broadly available inexpensive monitoring methodology (INR)provide an advantage, these factor Xa and direct thrombin inhibitor programswill likely provide major competition in this market. In addition, there may beother compounds of which we are not aware that are at an earlier stage ofdevelopment and may compete with our product candidates. If any of thosecompounds are successfully developed and approved, they could compete directlywith our product candidates.

 

Webelieve generic amiodarone will continue to provide competition to ATI-2042 forthe treatment of atrial fibrillation, even though it is not labeled for use inatrial fibrillation. Amiodarone will continue to be used off-label in spite ofits safety 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 treatatrial fibrillation through ablation, including CryoCor, Inc. and CryoCathTechnologies, Inc.

 

Competitionfor ATI-9242 will likely come from the five largest selling atypicalantipsychotics: Risperdal by Janssen Pharmaceutica, Seroquel by AstraZenecaPharmaceuticals LP, Zyprexa by Eli Lilly and Company, Abilify by Bristol-MyersSquibb/Otsuka America Pharmaceutical, Inc., and Geodon by Pfizer Inc.,which sold a collective $15.7 billion in 2007. It is likely that virtually allof these would be sold as generic versions by the time ATI-9242 could come tomarket. Other antipsychotics are in development which may also be competitiveto ATI-9242.

 

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ATI-7505has potential use in five indications: chronic constipation, functionaldyspepsia, GERD, gastroparesis and IBS with constipation. Some of theseindications may not be recognized by the FDA as sufficiently defined to enableregulatory approval of a drug for treatment. ATI-7505 is a prokinetic which hasbeen shown to increase motility in the upper and lower gastrointestinal tract,including the ability to improve gastric emptying and colonic motility.Products which affect the gastrointestinal system’s motility could be useful inthe treatment of each of these disorders. Other prokinetics are on the marketor in development which will also be competitive to ATI-7505, includingtegaserod, marketed by Novartis Pharmaceuticals Corporation as Zelnorm, whichwas temporarily withdrawn from the market and recently re-introduced withrestrictive use labeling, TD-5108 being developed by Theravance, anderythromycin. Many additional prokinetics are in development targeting theseindications. We believe the most significant competition to ATI-7505 for thetreatment of GERD is proton pump inhibitors and H2 blockers, which arecurrently on the market in both prescription formulations and strengths as wellas in over-the-counter forms. Many major pharmaceutical companies currentlymarket proton pump inhibitors and H2 blockers generating worldwide sales ofover $17.0 billion in 2006. ATI-7505 is targeted at the approximately20-25% of GERD patients who do not receive adequate relief from proton pumpinhibitors, which reduce the creation of acid in the stomach. ATI-7505 willface competition from the prokinetics as well as many inexpensiveover-the-counter indications for the treatment of these gastrointestinaldisorders.

 

Manyof our competitors have significantly greater financial resources and expertisein research and development, manufacturing, preclinical testing, conductingclinical trials, obtaining regulatory approvals and marketing approved productsthan we do. Established pharmaceutical companies may invest heavily to quicklydiscover and develop novel compounds that could make our product candidatesobsolete. Smaller or early-stage companies may also prove to be significantcompetitors, particularly through collaborative arrangements with large andestablished companies. In addition, these third parties compete with us inrecruiting and retaining qualified scientific and management personnel,establishing clinical trial sites and patient registration for clinical trials,as well as in acquiring technologies and technology licenses complementary toour programs or advantageous to our business. Accordingly, our competitors maysucceed in obtaining patent protection, receiving FDA approval or discovering,developing and commercializing medicines before we do. We are also aware ofother companies that may currently be engaged in the discovery of medicinesthat will compete with the product candidates that we are developing. Inaddition, in the markets that we are targeting, we expect to compete againstcurrent market-leading medicines. If we are not able to compete effectivelyagainst our current and future competitors, our business will not grow and ourfinancial condition 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.***

 

Oursuccess depends 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 Senior Vice Presidentand Chief Scientific Officer, we may not be able to successfully develop orcommercialize our product candidates. Competition for experienced scientistsmay limit our ability to hire and retain highly qualified personnel onacceptable terms. In addition, none of our employees have employmentcommitments for any fixed period of time and could leave our employment atwill. We carry “key person” insurance in the amount of $1 million for eachof Drs. Milner and Druzgala, but do not carry “key person” insurancecovering any other members of senior management or key 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.***

 

Inorder to commercialize our product candidates, we will need to expand thenumber of our managerial, operational, financial and other employees.  Because the projected time frame for hiringthese additional employees depends on the development status of our productcandidates and because of the numerous risks and uncertainties associated withdrug development, we are unable to project when we will hire these additionalemployees. While to date we have not experienced difficulties in recruiting,hiring and retaining qualified individuals, the competition for qualifiedpersonnel in the pharmaceutical and biotechnology field is intense.

 

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Futuregrowth will impose significant added responsibilities on members of management,including the need to identify, recruit, maintain and integrate additional employees.Our future 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.***

 

Weface an inherent risk of product liability exposure related to the testing ofour product candidates in human clinical trials and will face an even greaterrisk if 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 substantial liabilities.Regardless of merit or eventual outcome, liability claims may result in:

 

·                  decreased demand for any product candidates or products that we maydevelop;

 

·                  injury to our reputation;

 

·                  withdrawal of clinical trial participants;

 

·                  costs to defend the related litigation;

 

·                  substantial monetary awards to clinical trial participants or patients;

 

·                  loss of revenue; and

 

·                  the inability to commercialize any products that we may develop.

 

Wehave product liability insurance that covers our clinical trials up to anaggregate $10.0 million annual limit. We intend to expand our insurancecoverage to include the sale of commercial products if marketing approval isobtained for any products that we may develop. Insurance coverage isincreasingly expensive, and we may not be able to maintain insurance coverageat a reasonable cost and we may not be able to obtain insurance coverage thatwill be adequate to satisfy 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.***

 

Ourresearch and development activities involve the use of potentially harmfulbiological materials as well as hazardous materials, chemicals and variousradioactive compounds. We cannot completely eliminate the risk of accidentalcontamination or injury from the use, storage, handling or disposal of thesematerials. In the event of contamination or injury, we could be held liable fordamages that result, and any liability could exceed our resources. We, thethird parties that conduct clinical trials on our behalf and the third partiesthat manufacture our product candidates are subject to federal, state and locallaws and 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.

 

Ourprincipal facility is located in California’s Silicon Valley, in an area with along history 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.

 

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***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 apublic reporting company, we 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 are continuing to upgradeour finance and accounting systems, procedures and controls and may need tocontinue to implement additional finance and accounting systems, procedures andcontrols as we grow our business and organization and to satisfy new reportingrequirements. Compliance with Section 404 will first apply to our annualreport on Form 10-K for our year ending December 31, 2008. If we areunable to complete the required assessment as to the adequacy of our internalcontrol over financial reporting as of December 31, 2008, or if ourindependent registered public accounting firm is unable to provide us with anunqualified report as to the effectiveness of our internal controls overfinancial reporting as of December 31, 2009, investors could loseconfidence in the reliability of our internal controls over financial reporting,which could adversely 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.***

 

Ourprincipal facility is located in California’s Silicon Valley near knownearthquake fault zones and, therefore, is vulnerable to damage fromearthquakes. In October 1989, a major earthquake struck this area andcaused significant property damage and a number of fatalities. We are alsovulnerable to damage from other types of disasters, including power loss,attacks from extremist organizations, fire, floods and similar events. If anydisaster were to occur, our ability to operate our business could be seriouslyimpaired. In addition, the unique nature of our research activities and of muchof our equipment could make it difficult for us to recover from this type ofdisaster. We currently may not have adequate insurance to cover our lossesresulting from disasters or other similar significant business interruptions,and we do not currently plan to purchase additional insurance to cover suchlosses because of the cost of obtaining such coverage. Any significant lossesthat are not recoverable under our insurance policies could seriously impairour business and financial condition. Our current insurance does notspecifically cover property loss or business interruption due to earthquakedamage.

 

**Risks Relating to Ownership of OurCommon Stock**

 

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

 

Youshould consider an investment in our common stock risky and invest only if youcan withstand a significant loss and wide fluctuations in the market value ofyour investment. Investors who purchase our common stock may not be able tosell their shares at or above the purchase price. Security market prices for securitiesof biopharmaceutical companies have been highly volatile. In addition, thevolatility of biopharmaceutical company stocks often does not correlate to theoperating performance of the companies represented by such stocks. Some of thefactors that may cause the market price of our common stock to fluctuateinclude:

 

·                  adverse results or delays in our clinical trials;

 

·                  the timing of achievement of our clinical, regulatory, partnering andother milestones, such as the commencement of clinical development, thecompletion of a clinical trial, the receipt of regulatory approval or theestablishment of a commercial partnership for one or more of our productcandidates;

 

·                  announcement of FDA approval or nonapproval of our product candidatesor delays in the FDA review process;

 

·                  actions taken by regulatory agencies with respect to our productcandidates, our clinical trials or our sales and marketing activities;

 

·                  the commercial success of any product approved by the FDA or itsforeign counterparts;

 

·                  regulatory developments in the United States and foreign countries;

 

·                  changes in the structure of healthcare payment systems;

 

·                  any intellectual property infringement lawsuit involving us;

 

·                  announcements of technological innovations or new products by us or ourcompetitors;

 

·                  market conditions for the biotechnology or pharmaceutical industries ingeneral;

 

·                  changes in financial estimates or recommendations by securitiesanalysts;

 

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·                  sales of large blocks of our common stock;

 

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

 

·                  restatements of our financial results and/or material weaknesses in ourinternal controls; and

 

·                  the loss of any of our key scientific or management personnel.

 

Thestock markets in general, and the markets for biotechnology stocks inparticular, have experienced extreme volatility and price and volumefluctuations that have often been unrelated or disproportionate to theoperating performance of particular companies. These broad market and industryfactors may seriously harm the market price of our common stock, regardless ofour operating performance. In the past, class action litigation has often beeninstituted against companies whose securities have experienced periods ofvolatility in market price. Any such litigation brought against us could resultin substantial costs, which would hurt our financial condition and results ofoperations, divert management’s attention and resources, and possibly delay ourclinical trials or commercialization efforts.

 

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

 

Thefollowing factors are likely to result in fluctuations of our operating resultsfrom quarter to quarter and year to year:

 

·                  adverse results or delays in our clinical trials;

 

·                  the timing and achievement of our clinical, regulatory, partnering andother milestones, such as the commencement of clinical development, thecompletion of a clinical trial, the receipt of regulatory approval or theestablishment of a commercial partnership for one or more of our productcandidates;

 

·                  announcement of FDA approval or nonapproval of our product candidatesor delays in the FDA review process;

 

·                  actions taken by regulatory agencies with respect to our productcandidates, our clinical trials or our sales and marketing activities;

 

·                  the commercial success of any product approved by the FDA or itsforeign counterparts;

 

·                  regulatory developments in the United States and foreign countries;

 

·                  changes in the structure of healthcare payment systems;

 

·                  any intellectual property infringement lawsuit involving us; and

 

·                  announcements of technological innovations or new products by us or ourcompetitors.

 

Becauseof these potential fluctuations in our operating results, a period-to-periodcomparison of our results of operations may not be a good indication of ourfuture performance. In any particular financial period the actual oranticipated fluctuations could be below the expectations of securities analystsor investors and our stock price could decline.

 

***Because a small number of existing stockholders own a large percentageof our voting stock, they may be able to control our management and operations,acting in their best interests and not necessarily those of other stockholders.***

 

Basedon our outstanding shares as of February 29, 2008, our executive officers,directors and holders of 5.0% or more of our outstanding common stockbeneficially own approximately 55.0% of our common stock. As a result, thesestockholders, acting together, will be able to control all matters requiringapproval by our stockholders, including the election of directors and theapproval of mergers or other business combination transactions. The interestsof this group of stockholders may not always coincide with our interests or theinterests of other stockholders.

 

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***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.***

 

Provisionsin our certificate of incorporation and our bylaws may delay or prevent anacquisition of us, a change in our management or other changes thatstockholders may consider favorable. These provisions include:

 

·                  a classified board of directors;

 

·                  a prohibition on actions by our stockholders by written consent;

 

·                  the ability of our board of directors to issue preferred stock withoutstockholder approval, which could be used to adopt a stockholders’ rights planthat would make it difficult for a third party to acquire us;

 

·                  notice requirements for nominations for election to the board ofdirectors; and

 

·                  limitations on the removal of directors.

 

Moreover,we are governed by the provisions of Section 203 of the Delaware GeneralCorporation Law, which prohibits a person who owns in excess of 15% of ouroutstanding voting stock from merging or combining with us for a period ofthree years after the date of the transaction in which the person acquired inexcess of 15% of our outstanding voting stock, unless the merger or combinationis approved in a prescribed manner.

 

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

 

Salesof a substantial number of shares of our common stock in the public market, orthe perception that these sales might occur, could depress the market price ofour common stock and could impair our ability to raise capital through the saleof additional equity securities.

 

As of September 30,2008, we had 17,686,704 shares of common stock outstanding. These shares arefreely tradable without restriction in the public market unless held by anaffiliate of ours. Shares held by our affiliates are eligible for sale in thepublic market only in accordance with the volume limitationsand manner of sale requirements under Rule 144. Any common stock that is either subject to outstanding options orwarrants or reserved for future issuance under our 2001 Equity Incentive Plan,2007 Equity Incentive Plan, 2007 Non-Employee Directors’ Stock Option Plan and2007 Employee Stock Purchase Plan could also become eligible for sale in thepublic market to the extent permitted by the provisions of various vestingagreements, and Rules 144 and 701 under the Securities Act. If theseadditional shares are sold, or if it is perceived that they will be sold, inthe public market, the trading price of our common stock could decline.

 

As of September 30, 2008, the holders ofapproximately 11,415,130 shares of common stock based on shares outstanding,including 189,647 shares underlying outstanding warrants, will be entitled torights with respect to registration of such shares under the Securities Act of1933, as amended. If such holders, by exercising their registration rights, causea large number of securities to be registered and sold in the public market,these sales could have an adverse effect on the market price for our commonstock. If we were toinitiate a registration and include shares held by these holders pursuant to theexercise of their registration rights, these sales may impair our ability toraise capital. In addition, we filed a registration statement on Form S-8under the Securities Act of 1933, as amended, to register up to 2,638,845shares of our common stock for issuance under our stock option and employeestock purchase plans, and intend to file additional registration statements on Form S-8to register the shares automatically added each year to the share reservesunder these plans.

 

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

 

None.

 

**ITEM 3.DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

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

 

None.

 

**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(1)              |       | Bylaws.                                                                                                                                                                          |
|                |       |                                                                                                                                                                             |
| 4.2(1)              |       | Specimen  Common Stock Certificate.                                                                                                                                              |
|                |       |                                                                                                                                                                             |
| 4.3(1)              |       | Form of  Warrant to purchase shares of Series C preferred stock, issued  September 3, 2003.                                                                       |
|                |       |                                                                                                                                                                             |
| 4.4(1)              |       | Form of  Warrant to purchase shares of Series C preferred stock, issued  December 23, 2002.                                                                       |
|                |       |                                                                                                                                                                             |
| 4.5(1)              |       | Form of  Warrant to purchase shares of Series D preferred stock, issued  March 28, 2005.                                                                          |
|                |       |                                                                                                                                                                             |
| 4.6(1)              |       | Amended  and Restated Investor Rights Agreement by and between Registrant and certain  of its security holders.                                                                  |
|                |       |                                                                                                                                                                             |
| 4.7(1)              |       | 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 numberedexhibit to registrant’s Registration Statement on Form S-1 (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: November 13,2008

 

 
| ** ** | **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(1)              |       | Bylaws.                                                                                                                                                                          |
|                |       |                                                                                                                                                                             |
| 4.2(1)              |       | Specimen  Common Stock Certificate.                                                                                                                                              |
|                |       |                                                                                                                                                                             |
| 4.3(1)              |       | Form of  Warrant to purchase shares of Series C preferred stock, issued  September 3, 2003.                                                                       |
|                |       |                                                                                                                                                                             |
| 4.4(1)              |       | Form of  Warrant to purchase shares of Series C preferred stock, issued  December 23, 2002.                                                                       |
|                |       |                                                                                                                                                                             |
| 4.5(1)              |       | Form of  Warrant to purchase shares of Series D preferred stock, issued  March 28, 2005.                                                                          |
|                |       |                                                                                                                                                                             |
| 4.6(1)              |       | Amended  and Restated Investor Rights Agreement by and between Registrant and certain  of its security holders.                                                                  |
|                |       |                                                                                                                                                                             |
| 4.7(1)              |       | 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 numberedexhibit to registrant’s Registration Statement on Form S-1 (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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